Capital Markets

What’s Your ARS Worth?

A look at the various ways companies are dealing with the financial joke that is auction-rate securities.
Tim ReasonSeptember 12, 2008

Could there possibly be a stranger financial reporting conundrum than auction-rate securities?

A year ago, they were simple: Most companies recorded auction-rate securities as cash equivalents on their balance sheets. End of story.

Today, the same securities are still AAA-rated and financially-sound, but can’t be sold at any price. In some cases, however, companies do have buyers in the form of the brokers who sold them and who, under heavy pressure from regulators, have agreed to repurchase the securities at face value — but not immediately.

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Earlier this week, Bank of America became the latest financial institution to agree — under heavy pressure from regulators — to buy back auction rate securities. Citigroup, UBS, J.P. Morgan Chase, and Merrill Lynch have also agreed to settlements with regulators to repurchase more than $50 billion worth of the securities.

But those settlements were aimed first at helping retail investors, followed by institutional investors. Not all settlements guaranteed that corporate treasuries could return ARS to their brokers, and many of those that did give the brokers and banks in question a year or more before they must buy back illiquid ARS.

Alas, financial reporting rules are not so forgiving. Even before regulators stepped in, individual companies, most notably Bristol-Myers Squibb, were forced into the unusual step of writing down the cash line on their financial reports as a result of ARS illiquidity.

The auction-rate security crisis also coincided with the roll-out of FAS 157, a new rule defining how fair-value measurements should be made. The rule defined three-tiers of fair-value measurements–those based on quoted or actual prices, those based on significant observable inputs, and those based, in the curious language of accounting, on unobservable information. These days, ARS fall into the last category.

To look at how companies are handling the reporting of auction-rate securities, took a random look at financial filings released in the last 48 hours that mentioned ARS, and chose five different companies: Advanced Analogic Technologies, Sigma Designs, The L.S. Starrett Company, Magma Design Automation, and Buckle Inc. All five handled the ARS issue slightly differently, but they also included detailed explanations of their thinking in terms of both classification and valuation.

All but one of the filings examined by were quarterly or annual reports; the fifth was a stock option repricing. Three of the five companies (Sigma, L.S. Starrett, and Magma), mentioned that their ARS were AAA-rated. Likewise, three of the five (Advanced Analogic, Sigma, and L.S. Starrett) mentioned the form of debt underlying the ARS — student loans backed by either state- or federal-government guarantees.

Of the five companies, three — Sigma, L.S. Starrett, and Magma — said specifically that their banks or brokers had agreed to repurchase ARS, though only one, L.S. Starrett, said that would happen this year.

Santa Clara, California-based Advanced Analogic Technologies, whose most recent discussion of ARS appeared in its filing of an offer to exchange stock options, had $2.6 million in ARS as of June 30, collateralized largely with Federal Family Education Loan Program student loans. The company first reported changes to its ARS accounting in the first quarter of the year, moving its ARS investments from Level 1 to Level 3 under FAS 157 after February 2008, when ARS auctions began failing.

Advanced Analogic’s filing explains that the company uses a discounted cash flow model to determine the fair value of its ARS as of June 30, 2008, a model whose assumptions included estimates for interest rates, estimates for discount rates using yields of comparable traded instruments adjusted for illiquidity and other risk factors, amount of cash flows and expected holding periods of the ARS. In its filing, Advanced Analogic noted that its estimates reflect the company’s own assumptions “about the assumptions market participants would use in pricing the ARS, including assumptions about risk.”

As a result, the company concluded there was an additional decline in the fair value of its ARS investments of approximately $0.2 million, bringing its impairment loss for the year to approximately $0.6 million. The company deemed the loss temporary, since it has “the ability and intent to hold these ARS investments until a recovery of the auction process or until maturity.” Since the company believes it will take longer than a year for its ARS investments to recover par value, it moved them to “long-term other assets” on the balance sheet.

Milpitas, California-based Sigma Designs said it held nine auction rate securities at a cost of $43 million as of August 2, 2008, and had reclassified them as long-term marketable securities, “consistent with their stated maturities, which range from 30 to 40 years.”

Sigma said the ARS were bought on its behalf by its cash investment advisor, UBS, one of the banks that has since settled with regulators. As a result, Sigma has a two-year window, beginning in June 2010, during which it can redeem the securities at par with UBS.

Because the ARS are of high-investment quality (AAA-rated and backed by Federal Department of Education guarantees), Sigma said it believed the fair value of the ARS is their carrying value of $43 million, and said it would hold the securities. Indeed, Sigma rejected an estimate provided by its investment firm, which valued the ARS at approximately $40.8 million, with an unrealized loss of $2.2 million. In its filing, Sigma said it had reviewed its investment firm’s assumptions “and has not recorded this unrealized loss of $2.2 million. The Company does not believe the valuation calculated by the investment firm represents the fair value.”

The L.S. Starrett Company, based in Athol, Massachusettts, said it held $2.5 million in ARS as of June 28, and recorded an unrealized loss of $235,000 in stockholders equity “based upon a proxy of current market rates for similar debt offerings within the AAA-rated ARS market.”

L.S. Starret said it expects to liquidate $1.7 million in the next two months under its broker’s announced buyback program, and continued to hold that amount on its books as investments. The company said it was unsure whether or when it could liquidate the remaining $0.8 million and had classified that portion as long-term investments in other assets..

San Jose, California-based Magma Design Automation said its investment bank has publicly announced that it will purchase outstanding ARS between June 2010 and 2012. In the meantime, Magma reported, it classifies its ARS investment as available-for-sale, and the illiquidity in the market required that it determine the fair value of its ARS using FAS 157’s Level 3. Magma said it relied on its investment bank’s valuations. According to Magma, its investment bank valued student loan ARSs as floating rate notes with three pricing inputs: the coupon, the current discount margin or spread, and the maturity. The coupon was generally assumed to equal the maximum rate allowed under the terms of the instrument, the current discount margin was based on an assessment of observable yields on instruments bearing comparable risks, and the maturity was based on an assessment of the terms of the underlying instrument and the potential for restructuring the ARS. The primary unobservable input to the valuation was the maturity assumption which was set at five years for the majority of ARS instruments.

Based on the valuation, Magma recorded an unrealized loss of $0.9 million to accumulated other comprehensive loss. “Since the commitment by the Company’s investment bank to purchase the ARS beginning in June 2010 did not occur until after quarter end,” the company noted, “it did not affect the valuation as of August 3, 2008.” And noting that it expects the investments to take more than a year to recover, it classified them as noncurrent assets.

Kearney, Nebraska-based Buckle Inc reported it its quarterly filing that it had $55,795 invested in ARS, which it was reporting at an estimated fair value of $54,246, an unrealized loss of $1,549. Buckle noted that it “has no reason to believe that any of the underlying issuers of its ARS are currently at risk,” adding that it was able to liquidate $94,640 of its investments in ARS during the first half of fiscal 2008.

As of August 2, 2008, Buckle classified $8,355 of its ARS in short-term investments and $45,891 in long-term investments. The latter amount has not experienced a successful auction since the end of the company’s fiscal year and is net of the $1,549 unrealized loss.