Liquidity pool for Auction Rate Securities is running dry Tuesday, March 11, 2008
For many years, Auction Rate Securities ("ARS") have been a competitor of money funds by virtue of their apparent liquidity and higher rates. ARS are municipal bonds, corporate bonds, and preferred stocks whose rates, or dividend yields, reset through "Dutch auctions, which typically happen every 7, 28, or 30 days.
Investors enter a blind competitive bid process via a broker to set the rate on the securities, with the lowest rate to clear the market applying for the next period. Investors can elect to
- hold existing positions regardless of the rate determined
- sell them regardless of the rate
- re-bid on existing holdings, which will be automatically sold if they bid too high
- buy holdings via the auction
However, you can only liquidate your existing holdings if there are buyers in the auctions. When they aren't, as is currently the case, then you are forced to hold the assets. Of course, if you don't need the cash, the good news is that when the market fails to clear and determine a rate, the issuer of the ARS is normally required to pay a punitive rate specified at issue [this may be an absolute rate of say 20% or a reference rate e.g. LIBOR + 800bp]. Naturally not good news for the issuer though who can find itself hit with a huge hike in interest costs. To illustrate The Port Authority of New York and New Jersey, ended up paying 20% rather than 4% on their loan – costing them an extra $300,000 a week.
Depending upon their view of conditions and the terms of issue, issuer could redeem the bonds and re-finance them, but it's not obvious where such financing will come from in some cases. Bloomberg reports that New York plans to sell $448 million to refinance debt, including auction-rate securities. The Port Authority of New York and New Jersey is refinancing $700 million of auction-rate debt after interest costs jumped as high as 20 percent. The California Statewide Communities Development Authority may offer as much as $10 billion of notes.
Banks with stretched balance sheets are unwilling to act as buyer of last resort in these auctions, nor are they legally obligated to make a market in ARS.
From recollection, US money market funds cannot own the bonds. Thus, the biggest investors in auction-rate securities are individuals and corporations, some of whom are now insisting they were mis-sold the investment as "cash equivalents" by brokers - queue more litigation.
One group hard hit are VC-backed companies, which invested the cash they got from VCs in these securities, pending use. For me, this demonstrates dumbness on the part of the VCs affected as they evidently took little interest in how cash was being used - "the good news is the cash burn rate is low, but did we mention the mattress we used is burning?". Is it wise to leave cash investment to inexperienced firms? The result is that these early stage companies now find themselves strapped for cash.
SEC's Division of Corporation Finance has had to remind US corporations who made considerable use of these instruments to properly classify them. "Auction rate securities are not cash or cash equivalents -- they are investments," emphasising that impairments of the securities should make auditors give them a second look.