The market for auction-rate securities seems to be coming to a screeching halt. And that’s a frightening prospect for those companies that consider ARS to have the safety of cash on their balance sheets.
Citigroup has told the Associated Press that about $6 billion of mostly municipal debt auctions failed on Tuesday alone. The financial services giant was the lead underwriter for most of those sales. But the wire service also pointed out that six other offerings failed prior to Tuesday.
And the problems in the auction-rate market, estimated at $250 billion, could have a huge spill-over effect on corporations.
Auction-rate securities are long-term bonds and preferred stocks that resemble short-term instruments because their interest rates are reset periodically — usually every 7, 28, 35, or 49 days. The rate is reset by a modified Dutch-auction process; because investors can sell or buy the securities on those auction dates, the AP explained, the securities have long been regarded as cash equivalents.
Earlier this month, we reported that in the fourth quarter Bristol-Myers Squibb took an impairment charge of $275 million on investments in auction rate securities, partially consisting of subprime mortgages. The company said it had $811 million of principal invested in ARS at year-end. Its estimated market value, however, was $419 million, reflecting a $392 million adjustment to the principal value.
The impairment charge reflects the portion of ARS holdings that the company has concluded have an “other-than-temporary decline in value.”
The company’s investments in ARS represent interests in collateralized debt obligations supported by pools of residential and commercial mortgages or credit cards, insurance securitizations and other structured credits, including corporate bonds. Some of the underlying collateral for the ARS held by the company consists of subprime mortgages, the company said.
Other companies taking hits from their ARS investments include 3M Co. And others, such as Foundry Networks Inc. and Texas Instruments, showed up in a Merrill Lynch report suggesting that many companies had vulnerability to the deteriorating position of what they considered cash-equivalents, although executives of Foundry Networks and Texas Insturments both were reported to have disagreed with that assessment.
Last week Samuel DiPiazza, the CEO of PricewaterhouseCoopers, pointed out in a speech that many nonfinancial companies were exposed through securities in their own investment portfolios, noting, “It’s not just in banks…. These securities sit in cash equivalent accounts of industrials; they sit in investment portfolios of pensions. We are having to deal with this with thousands of companies, not just a handful of big banks.”
Indeed, DiPiazza refers to the issue as one of the biggest stories being largely overlooked by the financial press, and possibly affecting “thousands of companies.”
Three years ago, PwC and the others among the Big Four reportedly advised their corporate clients to change the way they accounted for auction-rate securities. Their suggestion was that U.S. corporations no longer treat ARS as similar to a cash equivalent, and the accounting firms asserted that they are more appropriately classified as “investments.”
In March 2007, the Financial Accounting Standards Board approved a staff recommendation to eliminate the heading “cash equivalents” from balance sheets and cash-flow statements. The FASB staff had recommended that cash-flow statements should present only flow related to cash. Items currently classified as cash equivalents would be classified in the same way as other short-term investments.
FASB had considered the change because critics have claimed that the description of cash and cash equivalents put forth in Statement FAS No. 95, “Statement of Cash Flows,” is outdated. The 20-year-old rule loosely defines cash equivalents as liquid assets with a maturity of three months or less.
It acknowledged at the time that in today’s market it’s possible to have short-term investments that are more liquid — closer to maturity — than cash equivalents. With additionaly disclosure notes, presenting what are now cash equivalents as short-term investments on the balance sheet thus “will provide users with the same, if not more, liquidity information than what they receive today,” the staff wrote. Such short-term investments include ARS and variable-rate demand notes (VRDNs).
We noted at the time that according to a PwC advisory, FAS 95 “allows only slight leeway for maturities to exceed three months,” and the legal maturity of ARS and VRDNs are 20 to 30 years. PwC acknowledged that corporations that hold the instruments achieve liquidity by selling them into an established marketplace. However, the holder must “rely on third parties to provide current liquidity.”
Last month, Deloitte sent out an advisory asserting that current fair value is the appropriate measure of impairment even if the investor is convinced that the market is undervaluing the instrument.
“All non-trading securities whose fair value is less than amortized cost should be evaluated for other-than-temporary impairments, even if the investor concludes that full repayment is likely or that decreases in fair value are attributable solely to interest rates,” the accounting firm wrote. “If a security is determined to be other-than-temporarily impaired, the cost basis of the security must be written down to fair value, regardless of whether the investor expects to recover principal and interest that are in excess of fair value.”
One potential silver lining emerged from a survey conducted by the Association of Financial Professionals last August.
It found that one-third of the companies that invested in either auction-rate securities or variable-rate demand notes reduced use of the vehicles after the major accounting firms ruled that such investments were not cash equivalents.
This could mitigate the potential fallout for companies in a crisis in the ARS market.