Earlier this morning we discussed how changes in the way accounting rules treated auction-rate securities helped drive corporate investors out of the market. (For a rousing debate of exactly which accounting changes stamped out demand, click here.) Credit market concerns and the changes in the way auction-rate securities are treated on cash flow statements contributed to the rush out of the securities by bringing additional scrutiny to the once obscure financial instruments. At the end of 2007, many companies made the decision to shift assets out of auction rate securities as these changes were implemented for the new fiscal year.
The Apollo Group owned as much as $365 million in ARS at the end of 2007, according to a recent filing. But by February 19, 2008, all but $107 million of the ARS investments had been liquidated and not reinvested in the ARS market. Apollo says this well-timed exit was part of a plan to intentionally reduce its exposure to the auction rate securities, although they do not reveal what prompted the exit. The timing wasn’t perfect, however, and Apollo found itself unable to liquidate approximately $79 million in ARS due to auction failures.
Despite not completely exiting the ARS market, we’ll count Apollo a winner. So who’s still holding the securities? After the jump, we reveal two companies trapped by the auction failures.


When turmoil in the credit markets began to impact a wide variety of credit products, some companies engaged financial advisors to assist in determining the fair values of investments that they had once considered as good as cash. US Airways, for instance, held auction-rate securities worth $411million at par value was advised that the fair value was only $353 million, a decline of $58 million, according to the 10-K filed today. With the help of outside financial advisors, they determined that most of this was only a temporary impairment. The only portion of the write-down that seemed lasting was $10 million from auction-rate securities linked to subprime.
But in late January, the commercial banks managing US Airways auction-rate securities warned them that the fair value was likely to decline. According to the banks, the fair market value decline was closer to $70 million. US Airways concluded, however, that most of this was also just a temporary impairment, and decided to hold onto its investments unless the market deteriorates further. In the coming weeks, of course, the auction failures became even more wide-spread. US Airways has not disclosed whether it has re-evaluated its position.
Others corporations were spooked by the credit market deterioration and early auction troubles. Often they were tipped off by the banks managing their accounts that the auctions were failing or very close to it. When they ran for the exits, the auctions failed dramatically, with sellers vastly outnumbering buyers for the securities. For a time, the banks stepped in to support the market but withdrew their support when the balance sheet strain become too much.
Some corporations and individual investors were left holding the bag, so to speak. This morning, Continental Airlines revealed in an SEC filing that it got stuck holding $314 million in auction rate securities. Apparently all of the auctions for the ARS held by Continental were successful in January, but in February auctions involving $128 million failed. Continental seems to have a slightly less active risk management policy and less attentive bankers. Unlike US Airways, it does not record any impairment to these investments on its 10-K and was apparently not warned by its bankers that the fair market value of these investments had declined. Continental continues to account for about a quarter of its auction rate securities as “restricted cash.”
As additional companies report earnings, we should learn even more about who got out early and who got stuck holding the auction-rate securities.

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Comments (7)

  1. Posted by Lowly Assistant | February 21, 2008 at 1:37 PM

    Carney,
    Heads up: first link didn’t take.
    Interesting article, nonetheless.

  2. Posted by Anal_yst | February 21, 2008 at 1:49 PM

    WebMD also holding what, $350M of ARS if I’m not correct…

  3. Posted by guest | February 21, 2008 at 1:49 PM

    Awesome article. Ron Blarney for a pulitzer!

  4. Posted by guest | February 21, 2008 at 2:13 PM

    If the banks were supporting the auctions last cycle, and let them fail this time by not bidding, then don’t the banks find themselves in the same position as the investors, keeping their previous holdings but being paid the failed-auction rate instead of the clearing rate?
    So they must have faced a large drop in 3rd party demand this cycle that they didn’t want to cover, or they decided getting the higher rates for a month or two was worth irritating their customers.
    And why the synchrony? Would collusion between banks to let the auctions fail at the same time be actionable?

  5. Posted by diablo | February 21, 2008 at 3:23 PM

    Sounds like the SEC is watching. The broker-dealers should be counted as losers too.
    Bloomberg, today:
    Auction Debt Succumbs to Bid-Rig Taint as Citi Flees (Update3)
    By Darrell Preston
    Feb. 21 (Bloomberg) — The collapse of the auction-rate bond market, where state and local governments go to raise cash, demonstrates that regulators are no match for Wall Street.
    Hundreds of auctions have failed this month, sending borrowing costs as high as 20 percent because dealers from Goldman Sachs Group Inc. to Citigroup Inc., UBS AG and Merrill Lynch & Co. stopped using their own capital to support the sales. Regulators, who allowed the manipulation of bids and lack of information to persist even after two probes in the past 15 years, are now watching a $342 billion market evaporate at the expense of taxpayers.
    Inadequate disclosure “may have masked the impact of broker-dealer bidding on rates and liquidity,” Martha Haines, head of the Securities and Exchange Commission’s municipal office, said in an interview. “The large numbers of recent auction failures, which are reported to have occurred due to a reduction in bidding by broker-dealers, appears to indicate those concerns were well founded.”

  6. Posted by onetwo | February 21, 2008 at 3:35 PM

    @2:13
    Yes, the banks did find themselves in the same situation as individual investors: they built up inventory of the securities and were unable to unload them. And yes, they were earning the failed rate.
    The large drop in demand was outlined by Carney (and others), which occurred for multiple reasons.
    The synchrony probably occured for the same reason other banking “collusions” appear: herding. Each of the banks had an ARS inventory that was increasing with every backstopped auction. These securities then became part of the banks’ balance sheets, and had to be included in the same risk/balance sheet assesments they made each day. No one wanted to be the first to let their auction fail for fear they were the only ones, would simply lose credibility for being in the WSJ as the first, or fear of litigation. Eventually some banks simply couldn’t take on more “risk” (measured however you like) and just had to bite the bullet. When that capitulation happened everyone else was in the clear to do the same. They all got tied up in the ever recurring fallacy that “if we just cover these now then liquidity will eventually return and we can unload them”. Unfortunately, as always, liquidity problems persisted far longer than originally envisioned and they simply couldnt add to their balance sheets.
    It’s the same way all the banks started issuing subprime-related ABSs at the same time, then all started writing them down at the same time. It wasn’t collusion, just fear/greed/and cognitive dissonance.
    But what do I know…

  7. Posted by guest | February 21, 2008 at 5:25 PM

    Having been very involved and held huge amts of ARS in 2007, it was obvious to me these auctions would eventually fail. The firms that got stuck either got greedy or didn’t do their homework.