A Dearth of Diligence
Experts say that CFOs and treasurers should have seen signs of trouble (see “Dead Canaries” at the end of this article). Indeed, even if ARS investors had done nothing more than simply follow sound cash-management practices, the damage would have been far less.
For example, nearly half of organizations polled by the Association for Financial Professionals (AFP) in 2008 had policies limiting their investments in ARS to 25% of the portfolio, yet one in four allowed ARS investments to reach 50% or more. “You can’t do anything about greed [finance departments chasing yield], but some clients had 100% of their excess cash invested in ARS,” says Wallace. “That violates a cardinal rule of investment: diversify asset classes.”
Investors were also not adequately compensated for the risk that auctions could fail, notes Adam Dean, president of SVB Asset Management. Average premiums over money-market funds ranged from just 15 to 20 basis points.
The sheer lack of information on auction-rate holdings also should have been a warning sign. Some brokers didn’t even provide a prospectus until after auctions concluded. Data on monthly collateral performance was not available, unlike with other asset-backed securities, says Lance Pan, director of research for Capital Advisors Group. Some finance executives whose firms bought ARS relied on a monthly statement detailing the name of the security and the investment’s size and performance, and a letter declaring that the investments were in line with corporate policy. “That level of rigor doesn’t fly anymore,” says Courtlandt Gates, CEO of Clearwater Analytics, a portfolio reporting tool maker.
Paul LaRock, a principal at Treasury Strategies, says that many finance executives just didn’t understand that the risk profile of ARS had changed. Entering 2008, there was not as much corporate money to soak up the supply. (According to the AFP survey, the number of companies permitting cash investments in ARS declined to 18% in 2008, from 33% a year earlier.) What’s more, the weakening of monoline insurance companies meant greater risk from an issuer defaulting.
ARS investors basically have four options, say experts. One, they may decide simply to hold on to the securities. Says Gates, “In some cases they are money-good and quite attractive at the penalty rate” that the securities reset to after a failed auction.
A second option is to “put” ARS back to the broker-dealer, under agreements with federal regulators. In the deals banks have made with regulators, retail investors were paid first. Citigroup, JPMorgan Chase, and Morgan Stanley have until the end of this year to settle with institutions; Wachovia (now part of Wells Fargo) has until the end of June. UBS does not have to start liquidating institutional holdings until June 30, 2010.
A third option is to offload ARS in the secondary market, albeit sometimes at a deep discount. While some hedge funds have emerged as buyers of ARS in the secondary market, they are paying well below par. In early June, prices for student-loan-backed ARS ranged from 60 cents to 80 cents on the dollar, says Chris Chakford, a managing director at SecondMarket.