A developing breakdown in an obscure corner of the credit-market involving debt instruments called “auction rate securities” could represent the latest threat to emerge from the credit crisis. According to news reports (here and here), the absence of buyers for these securities has caused several recent auctions to fail, forced isuers to abandon their offerings or pay exorbitant rates, and stuck many holders with instruments they did not intend to keep. The declining values for these securities confronts many holders with the prospect of significant balance sheet write-offs, and presents another source of possible litigation arising from the evolving crisis. These circumstances also present more evidence to support my view (expressed most recently here) that the fallout from the credit crisis will ultimately extend far beyond just the financial sector.
Auction rate securities are long-term bonds or preferred stock on which the interest rates are reset periodically, usually every seven, 28 or 35 days. The interest rate resets make the instruments more like short-term securities. Holders can also sell the instruments on the reset dates – assuming there are enough buyers.
According to a February 13, 2008 article in the Wall Street Journal entitled “Credit Woes Hit Funding for Loans to Students” (here) the market for these securities has “gone into the deep freeze.” Roughly half of the $20 billion in these securities put up for auction on February 12 “failed to generate enough demand to sell.” Problems have been mounting for weeks. According to one commentator in a February 13, 2008 Bloomberg article entitled “Auction-Bond Failures Roil Munis, Pushing Rates Up” (here), “it’s the beginning of the end of the auction rate market.” UPDATE: The lead article on the front page of the February 14, 2008 Wall Street Journal (here) says that this "once-obscure type of bond is now sending shock waves through a broad swatch of the U.S. economy. The February 14 Wall Street Journal also has a separate article entitled "Train Pulls Out of New Corner of Debt Market" (here)
According to the Bloomberg article, “investor demand for the securities has declined on waning confidence in the credit insurers backing the debt.” Whereas in the past, the broker-dealers selling the securities might have intervened to support the market, these dealers are now wrestling with balance sheet issues of their own and can’t take the risk of getting stuck with the securities. These conditions are hitting issuers, such as student lenders, who depend on these instruments to raise funds to loan to students, and municipalities, who are finding the lending costs skyrocketing. The conditions are also hitting investors that purchased the securities in the past and now fund themselves unable to sell, or with interest rate reset mechanisms that are malfunctioning.
The February 13 Journal article reports that the size of the auction rate securities market is “$325 billion to $360 billion,” and the Bloomberg article reports that about a third of the 449 companies responding to a May 2007 survey reported that their companies permitted investment in auction rate securities.
The turmoil in the market for auction rate securities is already taking a toll on some companies. As I previously noted (here), Bristol-Myers Squibb recently took an impairment charge of $275 million in connection with its investment in auction rate securities. Lawson Software also recently took a charge to adjust for the fair market value on auction rate securities. The February 14 Journal reports that 3M and US Air have also made auction rate securities related accounting adjustments.
As I noted in my prior post discussing the Bristol-Myers write-down, these balance sheet issues potentially affect companies in many different sectors. As I have long said (refer here), before all is said and done, the subprime meltdown is going to be about a lot more than just the financial sector.
Indeed, according to a February 6, 2008 CFO.com article entitled “Subprime Woes Just Beginning” (here) Samuel DiPizza, the CEO of PricewaterhouseCoopers, says that the next wave from the subprime mortgage crisis “will flow past lenders and homebuilders and strike nonfinancial U.S. companies with forced writedowns.” DiPiazza specifically referenced the fact that “these securities sit in cash equivalent accounts of industrials; they sit in investment portfolios of pensions. We are having to deal with thousands of companies, not just a handful of big banks.” In a Reuters account of his comments (here), DiPiazza added that a "first wave" of write-downs was likely in the current audit cycle this quarter.
Nor does the disruption of the auction rate securities market raise only accounting and valuation issues. There have already been at least two lawsuits brought by auction rate securities investors against investment managers based on soured auction rate securities investments.
The first, as reported in the Wall Street Journal (here), was the Texas state court lawsuit (complaint here) brought by Metro PCS against Merrill Lynch. The lawsuit alleges that Merrill invested $133.9 million of the company’s cash in 10 auction-rate securities without appropriate authorization or disclosure and that Merrill later misrepresented the riskiness of the assets and their suitability under the company’s investment guidelines. I previously discussed the Metro PCS lawsuit here.
The second lawsuit, first reported Bloomberg (here), involves a FINRA arbitration complaint brought against Lehman Brothers Holdings by Brian and Basil Maher, who claim that Lehman’s investment of $286 million of the brothers’ funds in auction rate securities was inconsistent with the brothers’ stated investment objectives. UPDATE: The February 14, 2008 Wall Street Journal has a front-page article entitled "Debt Crisis Hits a Dynasty" (here) that details how the Mahers earned their fortune and what happened after they invested a portion with Lehman. The article also describes the Mahers’ arbitration complaint in greater detail.
Both of these lawsuits relate to an earlier freeze-up in the market for auction rate securities, in August and September 2007. The more recent market seizure is much more widespread, affects many different levels of securities, and many more investors, including corporate investors. As the PricewaterhouseCoopers CEO’s remarks underscore, many of the companies and investment funds holding these investments face complicated evaluation and accounting issues. Many companies may find themselves compelled (perhaps at their auditor’s insistence) to take asset write-downs or impairment charges. Shareholders and fund investors who may feel they were not fully informed about the balance sheet assets and valuation risks may, like the plaintiffs in the lawsuits cited above, seek legal redress.
An excellent February 13, 2008 CFO.com article entitled "Is Your ‘Cash" in Danger" (here) discusses the current state of the auction rate securities market in greater detail (the market is "coming to a screeching halt") and discusses the valuation and accounting implications for companies that hold these securities on the balance sheets. My prior post regarding asset valuation issues in the context of the current credit crisis can be found here.
Opt-Out Lookout: As I have tracked the rising significance of securities class action opt-out settlements (most recently here), I have tried to discern whether or not the rash of recent opt-out cases was a temporary phenomenon or more enduring. And while it does not definitively answer the question, the recent analysis on the Securities Litigation Watch blog (here) regarding the opt-outs from the Tyco class action settlement provides some very interesting additional data.
According to the SLW, 288 class members excluded themselves from the class settlement (which was finally approved on December 19, 2007). While not all the opt-outs have filed individual actions (yet), so far 88 institutional investors and high net worth individuals have joined in a total of five separate opt-out complaints. The opt-outs include several high profile mutual fund families and investment fund groups, as the SLW details at length.
The presence of such a significant number of opt-outs certainly suggests that opting out may prove to be a more enduring phenomenon. On the other hand, the fact that the specific class settlement involved is the Tyco securities case means that we will have to await another day to assess whether the opt-out phenomenon is merely an attribute of the corporate scandals or will become a standard fixture of all securities class action settlements.
A Rare Spectacle — Securities Litigation Trials: Another interesting recent phenomenon was the surprising recent coincidence of two securities class action trials, in the JDS Uniphase case and the Apollo Group case. In the latest issue of InSights (here), I take a more detailed look at these two trials and analyze their possible significance.