Forecasting a Perfect Storm: New developments aggravate the potential fall of the auction rate securities market
The auction rate securities (ARS) market may be on the verge of a systemic meltdown after the recent PriceWaterhouseCoopers’ FAS 95 & 115 interpretations of ARS as long-term investments.
- Corporate cash managers may exit the ARS market. At a minimum, firms will likely scramble to comply with the new interpretation, experience technical defaults of bank loan covenants, delay 10- K filings, and have to restate financial results prior to March 31st, 2005.
- The SEC’s ongoing probe into the ARS market should discourage dealers from “rigging” auctions at this critical juncture, making auctions more likely to fail.
- Auction rate securities’ esoteric and option-like nature provides for the possibility of a classic “bank run” situation. Market contagion may set in, causing a chain of failed auctions that could continue for weeks or months.
- Significant credit deterioration of asset collateral and/or discovery of fraud by ARS issuers/servicers may be made public as the result of failed auctions, leading to more bad press and contagion.
- Investors with near-term cash needs may be gravely impacted as they are forced to sell at steep discounts. Those without cash needs may also incur credit losses as some issuers may become insolvent after successive failed auctions.
In a game of poker, as the old adage goes, if you don’t see a fool around you, you are probably the fool. Ever since our May 2003 publication of “Seven Facts… and Fiction about Auction Rate Securities”, we have been beating the drums on the risks of ARS investments in cash portfolios. Liquidity risk, credit risk, and market-making irregularity were some of the factors that led us to shy away from these seemingly “yield rich” and innocent looking “cash” instruments.
Recent developments on the accounting and regulatory fronts have led us to believe that a market-wide failure is possible and that investors, particularly corporate cash investors with near-term cash needs, should rid themselves of ARS immediately to avoid a potential “run” on the fragile auctions market.
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