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.