Tuesday, April 01, 2008

Why the auction-rate security market really imploded

There have been a lot of stories about the problems with auction-rate securities, but a column in Bloomberg by Joe Mysak entitled "High Net Worth Takes On New Meaning in Auction Mess" actually highlights the core problem that led to the implosion:

In March 2007, the Financial Accounting Standards Board required that auction-rate securities had to be listed on balance sheets as short-term investments rather than cash equivalents. Corporate and institutional clients no longer wanted them.

The big securities firms kept "managing" the auctions, putting in bids themselves when there wasn't enough demand. They knew that a "failed" auction might create a panic. They found themselves holding more auction-rate securities.

So they told the brokers to get rid of it. And when they did, the securities firms pulled the rug out from under the market, saying they would no longer support the auctions.

And, as they say, the rest is history. Sure, the subprime problems contributed. Sure, questions about municipal bond insurance contributed. Sure, a lot of factors contributed to the ARS debacle, but it was this core issue of an accounting change that made an entire asset class unattractive to a large fraction of its holders and a willingness by executives at brokerage firms to remain silent when even FASB knew that there was a problem considering the securities to be the same as cash that led to where the ARS market is now.

OTOH, if back in March 2007 a broker had alerted his client that FASB had changed an accounting rule that might dramatically affect the liquidity of ARS, would the situation have "ended" any less horribly? Maybe, maybe not, but at least such disclosures would have occurred in a more benign financial environment and maybe a resolution might have unfolded more gracefully in a more benign credit environment. At a minimum, new money would not have flowed (been sucked) from client wallets into the ARS swamp.

So, what is the lesson learned here to be applied going forward? Simply to pay much more attention to the asset classes and asset allocations in your account. My proposal would be that the client is responsible for informing the broker (money manager) what range of asset allocation is tolerable (minimum, maximum, and nominal percentage of portfolio allocated for each asset class) and then the broker is responsible for alerting the client of any significant changes in asset allocation, whether it be due to market movement or asset reclassification. Now, one question is whether brokers have a clear view of what client assets are truly considered "cash", money market funds, ultra-short bond funds, etc., and whether business accounting rules and definitions of FASB apply to retail investors as well. Ultimately, the expectation should be that the client is responsible for informing the broker of the timeframe when they will need to convert an asset to ready cash and the broker is then responsible for both assuring that the client's requirements are met and informing the client promptly when a change of any kind might interfere with the client's stated needs.

Even this description of the cause of the ARS mess begs the question of why businesses and brokers and fund managers were ever able to get away with claiming that ARS assets would be safe at all. Money market funds are safe because their assets are both safe and very short-term. At a minimum, ARS fund managers and brokers should have alerted ARS holders that there had been at least some change in the safety of their assets. Hmmm... well, actually, since ARS holders will eventually get their money back, there is technically no issue of "safety" per se. It is a matter of liquidity, but the underlying assets (long-term bonds) actually are quite solvent. So, we have to suggest that fund managers and brokers of cash-like securities regularly supply investors with some realistic measure of liquidity as well as a short-term (month or so) commitment on liquidity for some relatively significant fraction of client assets (maybe 10% to 25%.) People are able to cope with risk, but only when it is expressed in a comprehensible and believable form and the financial intermediaries take at least some financial risk themselves to assure that client assets are not put at risk beyond the level tolerable by the client. Sure, people may have been aware that there was some risk, but they were not informed that there was a non-zero risk that they would have no access to any of their principal.

-- Jack Krupansky

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