How can a failure in one market snowball and create failures in others? Here’s a simplified example, in the case of auction rate securities (ARS).
Much has been written this year about the sudden illiquidity of the ARS market. ARS are a product often used by companies to invest their excess cash. The inability to properly value such securities led to problems because they need to be properly valued on a company’s balance sheet for financial reporting. Additionally, when that cash was needed, reselling the ARS at what was their supposedly appropriate value was an issue, as they were trading at significant discounts because of market illiquidity.
An ARS is a debt security, most often a municipal or corporate bond, in which the interest rate is reset via a Dutch auction on each payment date. Essentially, it is a long-term bond with a 20 or 30-year term, but with variable interest rate, so that it acts like short-term debt. A Dutch auction, also known as a descending price auction, is the winning bid at which the lowest possible interest rate at which equilibrium occurs (equal numbers of buyers and sellers exist), such that all securities can be sold. For ARS, the auctions to reset the interest rate usually are held every 7, 28 or 35 days.
In February, 2008, the market for ARS collapsed and more than 1,000 auctions failed. This is because the ARS’ insurers were in financial difficulties because they previously had insured mortgage-backed securities that were now defaulting at higher rates. Suddenly, the ARS were seen as riskier because the insurers backing them were less secure. Although an auction may fail, the ARS’ rates do reset, typically increasing to the maximum rate allowed for the issuer of that particular ARS. Demand for the securities decreased. The investment banks that make a market in these securities refused to act as bidders of last resort, which they previously had done. Consequence: the market for ARS froze.
Investment banks had pitched these securities as “cash or cash equivalents” to companies. But cash and cash equivalents are considered liquid. Suddenly, many companies which held ARS had to revalue their holdings, and some reclassified them as short-term investments. These changes reduce cash holdings on the balance sheet. In some cases, a company may technically default on its debt covenants based on the ratio of cash on its balance sheets. Public companies with significant amounts of ARS as a percentage of cash could see a drop in their share prices.
Even if the issuer underlying a particular ARS is fine, the lack of liquidity and auction failure created problems for investors. These problems, with began with the failure of mortgage-backed securities, spiraled into auction rate securities, affected companies’ balance sheets and perhaps, share prices. This, simply put, is how the failure of one market can snowball into other markets.