When an unprecedented number of auctions for auction-rate securities failed last week, many individual investors and corporations found themselves wondering how they had suddenly become the latest victims of the credit crunch. The immediate answer soon became obvious—the banks who had sold them on the idea that the investment were so liquid that they were the equivalent of cash had stopped using their balance sheets to support the auctions. Without the banks to prop up the auctions by buying the securities, auction failure became widespread and investors were left holding suddenly illiquid securities.
For several months the banks and brokerages had been “stabilizing” the market. Which is to say, the auctions were already on the precipice of failure and were only clearing because of the banks were stepping in to pull them back from the edge. While this kind of market-making activity has long been a feature of the ARS market, with banks soaking up excess inventory to support the auctions, it became much more extreme in recent weeks and perhaps months.
So far the banks have pinned the blame for the broad-based failures on “strains in the credit market” and “illiquidity.” That’s somewhat unsatisfying—it’s become the universal explanation for everything these days. What they haven’t said is that something more happened in the market, a fundamental shift in the demand for auction-rate securities that will not likely reverse itself in the foreseeable future.
Find out why after the jump.
The demand for auction-rate securities dried up sometime last year, and became absolutely arid in 2008. This shift was driven by a March 2007 decision by the Financial Accounting Standards Board that the heading "cash equivalents" should be eliminated from balance sheets and cash-flow statements. The FASB 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.
Corporations responded to this by moving out of the auction-rate securities so that their balance sheet cash positions would not take a hit. This meant that many corporations were no longer in the market for the securities. As corporate demand for auction-rate securities vanished, banks found themselves having to soak up more and more inventory. The capital commitment required to do this grew at the same time the banks faced challenges from other parts of the credit markets. Last week they decided that against committing additional capital to supporting the auction, and let them fail.
History offers little guidance on a way out of the massive auction failures. They’ve simply never failed on this scale before. Banks and brokerages are attempting to re-assure customers that the auctions will get up and running again—and, indeed, some are—but there is no reason to believe the market will return to where it was. Corporate demand for the auction rate securities is not going to come back because it is driven by an accounting change that made these far less attractive to hold on balance sheets. Ironically, the current crisis that this change set off will serve to confirm the wisdom of that change. The auction-rate securities were never equivalent to cash because they were dependent on third-party demand, and now everyone knows it.
Posted by 36th Chamber , Feb 21, 2008 9:51AM
But everything is subject to third party demand. Even the value of cash is subject to third party demand.
Posted by lemmerdeur , Feb 21, 2008 10:01AM
Good post. In fact, first time I see this mentioned anywhere.
Posted by John Carney , Feb 21, 2008 10:10AM
Thanks, Lemm. This comes from extensive conversations over the last week with corporate funds managers and investment banking sources. Everyone else is running with vague talk of "credit squeeze." As far as I know, this is the only story that explains the specific mechanics how how the auction failures came to pass.
Posted by diablo , Feb 21, 2008 10:31AM
this is good stuff, carney. there's more to the freezing of the asr market than just monoline insurers risking a downgrade and you offer good info.
ok, so how we get the retail investor into this racket? lehman got the maher brothers in, without them knowing, but that's a little detail... closed end funds, done, what else, hedge funds? how are the hedgies making this a playground, or are they running for the exits now?
Posted by guest , Feb 21, 2008 10:33AM
great article. More posts like this one please and less annoying ones from Bess trying sooooo hard to be funny
Posted by miami , Feb 21, 2008 10:42AM
Hundreds of firms move in and out of the ARS prior to quarter end. [Or at least they used to.] That's one of the few things that kept this game afloat past Dec 31, that firms with cash balances went back into the market, at least until now.
Posted by guest , Feb 21, 2008 10:45AM
@ 10:33. you're alone there, dude. she's fucking hilarious, get a life.
Posted by guest , Feb 21, 2008 10:46AM
Oh please, stick to reporting gossip and not substance--you guys aren't journalists.
As early as March 2005, PWC was taking the position that auction rate securities did not count as cash or cash equivalents, and had to be recorded as short term investments. See PWC Capital Markets Accounting Developments Advisory 2005-04.
This is not news. You guys are monkeys.
Posted by guest , Feb 21, 2008 10:49AM
Oh, and by the way, all of the other Big 4 accounting firms followed PWC's lead on this, as well as PWC's subsequent pronouncement a year later applying the same logic to VRDNs. This interpretation of FAS-95 was nothing new or surprising from existing practice. God you guys are pompous.
Posted by guest , Feb 21, 2008 10:52AM
@10:45 - unfortunately for Dealbreaker, I'm not alone
Posted by guest , Feb 21, 2008 10:58AM
Good Work Carney, really enjoying these report posts!
Posted by guest , Feb 21, 2008 11:01AM
And seriously, not to pile on, but have you guys actually ever tied out a cash flow statement? Whether ARSs are treated as "ST marketable securities" or "cash equivalents" has zero effect on the result.
Posted by guest , Feb 21, 2008 11:02AM
@10:52/10:33- what's unfortunate is that your suicide attempts have been, so far, unsuccessful.
Posted by golden girl , Feb 21, 2008 11:06AM
JC - great post!
Posted by guest , Feb 21, 2008 11:13AM
Bess should be working for PerezHilton, not Dealbreaker
Posted by guest , Feb 21, 2008 11:17AM
if bess left dealbreaker this thing would shut down within a week.
Posted by Anonymous , Feb 21, 2008 11:22AM
on that note, I have pictures of Bess wearing nothing but a thong and a gorilla mask.
Post your email address and credit card number and I'll shoot them over to you.
Posted by diablo , Feb 21, 2008 11:33AM
to guest @10:46 & 10:49
PWC is not the FASB. In fact, the AFP wrote to the FASB bitching about the PWC advisory. The membership of AFP represents approximately 14,000 finance and treasury professionals employed by over 5,000 corporations and other organizations. Their membership includes a significant number of corporate treasurers who oversee the management of cash and short and long-term investments.
See here:
http://www.afponline.org/pub/pdf/cl_20050628_smith.pdf
If you follow Carney's story line it was in March of 2007 that the FASB "ruled" and it was not good news for the AFP. So as corporates started to run for the exits, the liquidity provided by the dealer/brokers for the ASR dried up for obvious reasons, and the monolines got caught, and all hell broke lose.
Hopefully Carney didn't lift his story from CFO.com:
http://www.cfo.com/article.cfm/10683650?f=most_read
Now,would like to how are the hedgies playing this?
Posted by Anal_yst , Feb 21, 2008 11:33AM
@ 10:46
Hey dipshit
if you knew that, is there a reason you didn't, oh, I dunno, tell Carney prior to criticizing him for not being aware?
F'in asshat
Posted by guest , Feb 21, 2008 11:47AM
This website is so boring now that Filomena is not going to jail.
Posted by guest , Feb 21, 2008 11:47AM
Hey Diablo, you've demonstrated you know how to use Google, now please stop swimming in the deep end of the pool.
There's a lot of stuff that constitutes guidance before you get to FASB rulemaking (e.g., SABs, EITFs, even internal audit manuals of the Big 4).
The FASB "official" rule change didnt do a damn thing to existing practice, since every company audited by a Big 4 accounting firm had been treating ARSs as ST investments and not cash equivalents, since 2005.
Also, please dont lecture me on how the hedge funds are playing the ARS turmoil, because I happen to know a sh!tload about this, and I'm not talking about what your little $250M bucketshop is doing.
Posted by guest , Feb 21, 2008 11:51AM
A significant portion of the run for the exit in the ARS market is directly tied back to moneymarket and tob funds selling due the bond insurer downgrades.
Posted by guest , Feb 21, 2008 11:55AM
to anal_yst @ 11:33am
I ripped Carney a new one because of his smug-ass tone in the original post that made it seem like he was Bob Woodward breaking the Watergate story.
The fact is that Dealbreaker is good for gossip about layoffs, fund blowups, unsubstantiated/unsubstantiatable rumors, monkeys like Vayner, etc. and it is absolute crap for real thought.
Whenever DB tries to get into "real" reporting or analysis, I feel like I'm watching Squawk Box, where 75% of the stuff is wrong, and the other 25% is old hat to anybody who works on a trading desk.
Just stick to the stuff like Seth Tobias, and you guys will be off my sh!t list.
Posted by guest , Feb 21, 2008 11:56AM
to guest @ 11:51 am
You're an idiot, too. Money market funds are prohibited by SEC Rule 2a-7 from holding ARSs, because they lack a backup liquidity facility. Thanks, try again.
Posted by Ben_H , Feb 21, 2008 12:01PM
Definitely hedge funds getting involved, we actually missed by a wide margin on a couple of auctions. Funny aside: at the height of the turmoil our Goldman coverage helpfully makes us offer of failede paper we were considering bidding on in reset auction... above par. Love the stones on those GS guys!
Posted by diablo , Feb 21, 2008 12:01PM
guest @ 11:47 AM
You demonstrated that you don't know how to read. Read the CFO.com link. Note the date. Note that 2/3 of the AFP companies surveyed in August were not following the accounting firms recommendation. Somehow they got religion after that, and as the credit markets were going for a wild ride.
And here's a statement in the article that shows how lax the the Big 4 are:
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."
Posted by just me , Feb 21, 2008 12:02PM
@11.55 guest - My experience is that folks who hold themselves out as experts from working on "trading desks" tend to be back office slugs, or more likely unemployed clerks.
Posted by EE , Feb 21, 2008 12:09PM
diablo, good CFO article, thank you
Posted by guest , Feb 21, 2008 12:10PM
To Diablo at 12:01:
No sorry pal, you dont know how to read. Page 2 of the article says nothing about "2/3 of the AFP companies surveyed in August were not following the accounting firms recommendation."
In fact, the article said: "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."
You incorrectly conclude that 2/3 of the companies just ignored their auditor's pronouncement. You obviously know nothing about how financial statements are prepared--the auditor says what the rules are, and the company provides the data. There was no latitude for companies to "ignore" their auditor's interpreation of FAS95.
Thanks, want to play again, or are you tired of me crushing you yet?
Posted by John Carney , Feb 21, 2008 12:24PM
Diablo, Thanks for pointing out the CFO.com article. It is very good, although it doesn't quite connect the dots. We linked to it in the Elsewhere section (which everyone should check out--lots of good stuff there) on Monday, and it helped inspire us to contact the corporate and investment banking sources we used to build our conclusion.
The folks who think the earlier client advisories from the big accounting firms had already pushed corporate America to stop counting ARS as "cash equivalents" don't understand the relationship between accounting firms and their clients. Clients are not obliged to accept the advisories of the accounting firms. But FASB decisions have the weight of law since the SEC has delegated to the board its authority to make accounting rules.
Posted by diablo , Feb 21, 2008 12:33PM
Carney, your new layout must be confusing you. It was diablo who brought up the cfo.com article.
You may also consider putting a list of links that you used or are relevant to your story at the end of the story. I'm not even sure where "Elsewhere" is.
Posted by guest , Feb 21, 2008 12:36PM
The accounting issue was, as already noted, factored into the market a long time ago. The ARS market was functioning just fine after March of '07... all the way up until August of '07 when Merrill, DB, & Lehman walked away from ARS deals they had structured out of CDO & CLNs. Corps started selling these back b/c of the "subprime" headlines... and their dealers just let them fail. Within 28 days there were over 60 deals totalling over $6 billion of these failed CDO/CLN auctions on the street. Corps who had invested in them were forced to sell the liquid ARS as they needed cash. This was the beginning of the balance sheet pressure that ultimately resulted in the whole market finally falling over last 2 weeks ago. The ARS market was built on confidence... now that there is none, it is done as we know it.
Posted by golden girl , Feb 21, 2008 12:39PM
diablo: i think you make a good point. i was talking to someone who is a consultant for ernst and young in the derivatives group, and he said they have had to re-write all their models because the underlying assumptions are no longer valid. he said this will affect companies in all sorts of business industries, not just the usual suspects.
Posted by John Carney , Feb 21, 2008 12:44PM
Diablo, You are correct. That was you. I've now credited you for the link. Elsewhere is contained at the bottom of the middle column. It's where we link to articles we're reading but haven't written about yet.
CFO.com is an invaluable resource for all these accounting issues, and we're proud to count them as a sponsor of the site.
Posted by Debter , Feb 21, 2008 12:45PM
Hahaha, some have it correct, most don't. Unless you participate in this market (which I did not until last week) it's tough to understand. Also, dealers are shopping bids to their prop desks. I would advise anyone bidding on this stuff to wait until the absolute last second to put their bid in with their coverage at wherever. Even then, it might be tough to avoid. When you bid 50mm at 7.00 at it clears at 6.95 something is up (not every one mind you).
Posted by onetwo , Feb 21, 2008 12:46PM
FYI - Hedgies are buying all the ARS/ARC/ARPs they can get their hands on. They're short liquidity because of their lockups/redemption intervals.
Posted by diablo , Feb 21, 2008 12:58PM
Thanks Debter and onetwo, that makes sense.
Posted by guest , Feb 21, 2008 1:14PM
JC, great article. how should i say this... the most vocal do not always represent the majority. This is my feeling regarding DB. Yeah, all these creepy Bess stalkers are always clamoring for her but here is the difference...
a meal is much more satisfying if you have an entree, instead of only eating a piece of cheesecake. bess is all cheesecake.
Keep up the good work and cover all the relevant topics, irrespective if it is widely known or not. it is much more conducive to great comments from DB readers.
oh yeah, and don't believe anything i say.
Posted by guest , Feb 21, 2008 1:41PM
Decent piece and good comments. Worthwhile. Don't become all gossip and crap. I can get the Enquirer for real gossip and read about the 5th Coming of Christ and Sasquatch delivering a baby on Lexington.
Posted by Finnegan , Feb 21, 2008 1:56PM
Carney, good contribution, and also it's good to see comments that debate or amplify the material as well.
As for Bess, echoing others, her efforts create a nice balance.
Posted by Cov Lite , Feb 21, 2008 2:49PM
Finally, a post that can justify the inordinate amount of time I spend on this site.
Posted by guest , Feb 21, 2008 3:00PM
THE only way to settle this is with a poll about Bess.
Posted by guest , Feb 21, 2008 3:06PM
Disagree. I have gone all the way to Brooklyn before just for a slice of Junior's cheesecake. Likewise, I would come here just for a slice of Bessicakes.
Also for a slice of Keith Hahn.
Posted by guest , Feb 21, 2008 6:22PM
"The folks who think the earlier client advisories from the big accounting firms had already pushed corporate America to stop counting ARS as "cash equivalents" don't understand the relationship between accounting firms and their clients. Clients are not obliged to accept the advisories of the accounting firms."
Uh, have you heard of Sarbanes Oxley, Carney? Post-Enron, my retarded misinformed friend, CFOs simply do not disregard audit policy/methodology handbook. There are still many "gray" areas in accounting, but stuff that is specifically addressed in the audit policy manual is not where you should be looking.
Posted by guest , Feb 21, 2008 6:58PM
I've spilled many pixels on Sarbanes Oxley, and I'll tell you again that many companies continue to count ARS as "cash equivalents." I'm afraid you simply don't understand the difference between suggestions from PWC and decisions by FASB.
Look into it.
Posted by guest , Feb 21, 2008 7:08PM
Has it happened? Undoubtedly. I'm sure that on select occasions the issue was taken to national and maybe they signed off on materiality grounds or something. But was it the practice for most firms? No way. Particularly not at any of the major Fortune 500 firms. The fact is that the vast majority of practice in accounting for ARSs changed in 2005 when the auditors put it into the audit policy manual. To say otherwise is ridiculous. Carney is just dead wrong that the FASB rule had anything to do with the lockup in the ARS market. It was the credit crunch, plain and simple, since banks couldn't hold this stuff on their books given the various net capital, regulatory, ISDA, and other leverage related requirements.
Posted by guest , Feb 22, 2008 11:14AM
Heh. He said "ARS Market." ARSe. Heh. Heh. I thought Bess covered the ARS market. Heh.
Shut up Butthead.
Posted by guest , Feb 22, 2008 4:35PM
"...because the auction rate securities have long-term maturity dates and there is no guarantee the holder will be able to liquidate its holdings, these securities do not meet the definition of cash equivalents..."
SEC Current Issues and Rulemaking Projects 11/30/2006
Companies including ARS in Cash and Cash Equivalents would be doing so in direct violation of SEC policy.
The FASB decision in March relates to a ongoing project on overall financial statement presentation. The decision is preliminary and won't required until the project is finalized (which is many years and at least two rounds of public exposure for comment away). The FASB discussion at that meeting did not make mention of ARS.
Posted by guest , Feb 29, 2008 7:04PM
Heres an impressive recap of what just happened to the ARPS market.
http://www.stockbroker-fraud.com/lawyer-attorney-1284530.html
I'm not sure I agree with the 60 cents on the dollar figure given. In the case of the CEF ARP I'm in, a regular preferred fund , it pays the greater of 2.50% over the CP rate OR (175% of the CP rate), I am not aware of a cap on the payout rate. A CP rate of 6% would produce a 10.75% yield at the FULL PAR VALUE, or they would deleverage. I would think that was worth more than 60% of par.
Thus , even though its long term paper, I don't see how it would trade at a current 9%+ yield (its currently paying 5.45%).
Yes, the liquidity is now a problem, but presumably, unless the entire system collapses or they steal all the money from the fund, principal risk is not much of a factor. An entire portfolio of diversified investments would have to implode to nothing for you to lose the principle and its interest earning ability. Possible but quite unlikely.
And there is inflation protection implied by the CP rate. If inflation heats up, the CP rate will not be 3%.
In fact, in the case of a severe drop in the value of the underlying assets, they would be forced to liquidate at par. Of course, if everyone tries this at the same time, we'll have a problem.
Thats one reason I think these funds should be FORCED BY THE COURTS to deleverage, and make whole the many investors victimized by the charade outlined in the article link I posted. The money is there, and it belongs to the holders of the ARPS, should they desire to retrieve it. Misrepresentation should not go unpunished, lest it encourage more of the same.
Posted by diablo , Feb 29, 2008 9:30PM
@guest 7:04 PM
OK, lawsuits are coming, and closed end funds watch out. (That blurb needs more proofreading than a DB story, but it's quite informative).
I wonder if a big component in the sharp and continuous drop in muni bond prices (even when treasuries are going higher in price) is due to close end funds liquidating their warehoused long muni bonds for the sake of their own liquidity. That blood bath is impressive. (Hedge funds are also blamed for the drop for liquidating their TOBs). There are bidders for long muni bonds (like PIMCO admits) but understandably they are lowballing.