Thursday, February 21, 2008

Blame FASB on auction-rate market breakdown

(Dealbreaker) 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.

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.

(Calculated Risk) Mastercard has invested some of their working capital in Auction Rate Securities (ARS). Right now they can't sell the ARS. There is little credit risk, but this could be a liquidity concern for other companies.

From the Mastercard SEC 10-K filing today:

The Company sold approximately $100 [million] in auction rate securities subsequent to December 31, 2007, however starting on February 11, 2008, the Company experienced difficulty in selling additional securities due to the failure of the auction mechanism which provides liquidity to these securities. The securities for which auctions have failed will continue to accrue interest and be auctioned every 35 days until the auction succeeds, the issuer calls the securities, or they mature. Accordingly, there may be no effective mechanism for selling these securities and the Company may own long-term securities. As of February 15, 2008, the Company had approximately $252 [million] of auction rate securities and at this time it does not believe such securities are impaired or that the failure of the auction mechanism will have a material impact on the Company’s liquidity.

And it appears, according to the following Bloomberg article that the reason the auctions are failing is because the investment banks are no longer backstopping the auctions:

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.''

This shows the spread of the credit crunch. The banks are suffering a liquidity crisis (because of a solvency crisis). They are not backstopping the ARS, forcing state and local governments to pay higher rates on the ARS or refinance at a higher rate with longer term maturities - and causing a potential liquidity problem for corporations.

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