Russell Paquette liked auction-rate securities (ARS) as much as the next treasurer. At Recreational Equipment Inc. (REI) in Kent, Wash., he had been particularly attracted to those backed by student loans. “They were AAA-rated, over-collateralized by 30% and roughly 97% guaranteed by the Department of Education,” the REI treasurer points out. But when asset-backed investments began to lose their auction market liquidity, an alert Paquette bailed out of ARS investments. “We exited that market in December and January,” he notes. “We were fortunate.”
A neighbor down the road in Redmond, Wash., also invested in the ARS market and escaped intact. In 2006, when the SEC ruled that auction-rate paper no longer qualified as a cash equivalent, Microsoft Corp.’s treasury saw an opportunity in the market dislocation that followed and decided to buy. “At a time when others were selling, we went overweight in auction-rate securities, relative to our benchmarks,” reports Microsoft treasurer George Zinn. It was a big bet. “We went overweight by billions of dollars,” he explains. “That allowed us to reap considerable value and outperform our benchmarks by taking advantage of the dislocation. We bought auction-rate for all our portfolios where it was permitted, including our liquidity portfolio.”
But in early 2007, Zinn and his team of CFAs became leery of credit risk and began to pare down Microsoft’s ARS holdings. Then last summer, his staff noticed collateral in Microsoft’s securities lending portfolio that it wouldn’t buy for its own portfolios. It called in its two securities lending agents and asked for a fix. “One offered to rewrite its guidelines and take back the securities we didn’t want,” Zinn recalls. “The other one wouldn’t. We ended that relationship, marked the collateral to market, sold it and took a $100,000 loss. When I saw that an investment bank would burn a relationship over $100,000, I knew there were larger issues down the pike.” By the end of the year, Microsoft’s ARS investments were down to “the equivalent of zero,” Zinn says. “We navigated the troubled waters superbly.”
Unfortunately, most treasurers have a much sadder story to recount when it comes to the fate of their ARS bet in liquidity investment portfolios. “I’ve been told that only about 20% of the organizations that invested in auction-rate securities escaped unscathed,” notes REI’s Paquette.
The pounding was so unsettling that some market veterans now predict treasurers will be inclined to quit the cash investment game altogether. “This is a game-ending event,” insists Lee Epstein, president and CEO of Money Market One, a San Francisco broker-dealer specializing in corporate cash investments. “The cash investment game treasury staffs have been playing for the past 25 years is over. People thought they could pick up a few basis points of yield without taking real risk. Well, the free lunch ain’t free.”
Epstein is not alone in this analysis that treasurers and treasuries feel burned and, particularly after the Bristol Myers Squibb treasurer and assistant treasurer were pushed out in February for losing $275 million on ARS, are recognizing what is at stake when they take investment risks. “Treasurers are finally throwing in the towel,” suggests Anthony Carfang, founding partner of Treasury Strategies Inc. (TSI).”They’re deciding it’s not their job to manage an investment portfolio. Once they saw that they could not depend on the rating agencies to keep them apprised of credit risk, they’re moving to institutional money funds or turning to outside managers to do the investing for them. The big fund managers can do their own credit analysis and don’t have to depend on rating agencies.”
But is this just another case of the pendulum swinging too far the other way? At the end of the day, whether treasurers handle the day-to-day or hand it over to an investment manager, it won’t just be the investment manager’s head on the line if cash strategies head south–the treasurer’s and CFO’s will be right next to the manager’s. The key, say experts, is not to run portfolios on auto-pilot–expecting that a credit rating awarded months earlier is necessarily holding up. What CFOs and treasurers should be doing and are doing, according to veteran cash managers like Ron Hart, a corporate cash investments group director in Citigroup Global Markets Inc., is re-engaging in the investment activity. “Advice now matters to them,” Hart reports, “and they want it from people with a long history in the corporate cash area.”
The carnage from the subprime spilloff has no doubt taken a toll. In March, Treasuries Strategies released a survey showing liquidity falling for the first time in nearly 10 years–down by $250 billion at $5.25 trillion domestically. This, however, follows an unprecedented ascent of roughly $1.6 trillion in the short eight years between 1999 and June 2007, and TSI’s Carfang is quick to point out that corporate cash is still plentiful, Carfang notes. “Left to its own devices, the market will recover its balance,” he says. “The problem lies in the financial economy, not the real economy.”
In the meantime, a lot of rearranging the deck chairs is underway. In Treasury Strategies’ Flash Surveys, auction-rate securities comprised 4% of the corporate liquidity portfolios of those surveyed last July. By yearend, it was down to 2%. In the asset-backed commercial paper shakeout, holdings in these same portfolios fell from 15% to 3%, Carfang reports. “That’s a redistribution of $500 billion in funds,” he notes. Before the shakeout, investors were holding $350 billion of outstanding auction-rates, considering them 7-day or 35-day instruments, he adds. The shift within portfolios to more conservative investments means that, overall, corporate treasurers have reallocated more than $1 trillion, he observes.
The flight to money markets has disrupted those relatively tame markets as well. The spread between a prime fund and a Treasury fund, normally 10 to 15 basis points, has been more than 200 basis points at times, notes Kirk Black, liquidity management service executive at Bank of New York/Mellon. The yield on Treasury funds is so low that many treasury investors choose government funds as a reasonable compromise between safety and yield, he adds.
Corporate investors who are confident in their due diligence and stay with high-quality prime funds can pick up 30 basis points over a government fund and 200 basis points over a Treasury fund, Black points out. The flight to money funds has pushed their assets up to $3.4 trillion, an all-time high and an annual growth rate of about 40%, he notes.
How do you choose a safe money fund? Carfang has several suggestions. First, pick a fund that has at least $5 billion in assets. That means that smart investors are parking their money there. Second, invest only in funds that grew in the last six months of 2007. That shows that they’ve passed muster with other credit-conscious investors. To the extent that AAA prime money funds had paper that was tainted with credit or liquidity concerns, they have now had time to flush most of that paper out of their funds and replace it with safe, highly liquid alternatives, he explains.
Treasury Strategies does not recommend reflexively rushing to the quality of Treasury funds because the exit strategy no longer carries low risk. So much money has rushed into low-yielding Treasury funds, Carfang explains, that once the market turns and rates start to rise there will be a rush among investors to leave, which will force those funds to sell securities at a loss in a rising-rate environment. This could well result in a loss of principal to investors, Carfang explains. “Don’t jump into a crowded elevator,” he advises.
Even treasury investors who stay in safe institutional money market funds are finding they need to watch both tax-exempt and taxable funds for credit issues. For example, Eastman Chemical Co., based in Kingsport, Tenn., normally would keep its $400 million of liquidity portfolio in tax-exempt funds, reports John Nypaver, manager of global cash management. When taxable funds showed up with some holdings in SIVs and CDOs, Eastman inquired and stayed in tax-exempts. But when concerns arose about bond insurers earlier this year, Eastman switched to taxables, which by that time looked safer. Now, it is considering a swing back to tax-exempts, Nypaver says.
Another important item on a checklist is to revisit the company’s investment policy–something that no doubt many boards and senior managements are requiring anyway. “We’re seeing much greater emphasis on enforcing adherence to investment policies and guidelines,” says Elyse Weiner, global product head for liquidity and investments at Citigroup. “They’re centralizing investment as much as possible so that operating entities can’t stray from those guidelines.”
As the credit crunch persists, despite aggressive Federal Reserve efforts to bolster faltering financial institutions and cut the cost of lending, “the whole concept of liquidity efficiency and working capital management is getting renewed emphasis,” Weiner says. Companies are “looking at supply chain finance for ways to speed up cash velocity through the sales cycle, hoping to find creative ways to reduce their working capital investment in days sales outstanding. They’re tapping bank lines, including back-up lines, when necessary but only after they’ve searched internally for pockets of cash they can grab,” she adds.
Beyond using money funds, the liquidity squeeze is driving money to outside investment managers, according to consultant David Stowe, director and head of the risk management practice at Strategic Treasurer LLC in Atlanta. When times were good, many treasurers wanted to hire a senior analyst to manage the portfolio and keep the 5 to 10 basis points a money manager would charge in the corporate coffer. Now, they’re more willing to pay that price to get in-depth credit analysis, he explains.
For cash that’s tied up in illiquid securities and can’t be swept into a money fund or turned over to an outside manager, the options are grim. The first thing treasury cash investors need to do, Epstein says, is read those prospectuses now and find out just what they’re holding–something easier said than done. Even if they came in and worked on weekends doing that reading, the typical treasury analysts and cash managers wouldn’t understand what they’re reading, and the outside experts who can understand the prospectuses are scarce and expensive, he notes.
Treasury investors holding unexpectedly illiquid paper need to analyze their holdings and other sources of liquidity to determine whether holding onto some and riding out the market turbulence may be a smarter course than disposing them at fire-sale prices, Stowe advises.
Just don’t be desperate. Fire-sales represent opportunities, primarily for hedge funds out to scoop up bargains, advises Lance Pan, director of credit research at Capital Advisors Group in Newton, Mass. Don’t accept the first offer you get, even if you’re eager to unload some bricks, he says.
The situation is at least as painful for treasuries that issued auction-rate securities, one of the asset classes caught in the liquidity freeze. An institution Carfang works with is currently struggling with that very situation. “They issued $20 million of auction-rate debt and paid the underwriter $1 million in fees to put it out there,” he reports. “They also paid a small fortune to insurance companies to provide credit enhancement. They expected to amortize that $1 million over 30 years. Now they’re paying 12% on the auction-rate debt instead of 4%. They can redeem the debt and take the big hit for all that front-end expense, or they can continue to take the small hits from the high coupon payments and wait for a successful auction. They’re tempted to tough it out for a few months and hope that equilibrium comes back to the market.”
Until bidders return, auction-rate securities are behaving like the long-term obligations they truly are, and cash investors are being pressured by auditors to reclassify them as long-term assets, Carfang says, assets that usually put the cash portfolio in violation of investment policies. In some cases, investors have to write down the investment, even if they expect to be made whole eventually. “It’s a treasurer’s nightmare,” he notes.
What’s needed now for cash investment portfolios is not simply valuation, which looks at what a buyer is willing to pay, but evaluation, which looks into the rights of the investor as spelled out by the prospectus, Epstein insists. “You need to find out where you are,” he observes. “You need to be prepared to argue with your auditors, and you need an exit strategy, which in many cases will not be pretty.”
By RUSS BANHAM