Did FASB Scupper the Auction-Rate Market?

Auction-rate securities certainly don’t look very much like cash equivalents these days, as the WSJ shows, citing retail investor Naveen Ahuja, who is unable to sell $665,000 of the things.

For investors like Mr. Ahuja, the unrest in a formerly sedate corner of the credit markets is hitting close to home. In recent years, auction-rate securities have been sold to finance everything from hospital expansions to student loans. Issuers liked them because they paid lower rates on an instrument that functioned much like long-term debt, which typically carries higher rates. Investors liked them because they got higher rates than other so-called cash equivalents, but they still could be liquidated quickly. It seemed a marriage made in heaven — until the market failed.

Clearly auction-rate securities aren’t "cash equivalents" any more, if they ever were. So the Financial Accounting Standards Board looks positively prescient for once: way back in March 2007, it announced that the heading "cash equivalents" should be eliminated from balance sheets and cash-flow statements. And a good thing too: investors don’t want to be poring over balance sheets, wondering whether thos "cash equivalents" are actually completely illiquid auction-rate securities.

On the other hand, John Carney today looks at all this another way, and basically says that it’s FASB’s fault the auction-rate securities are failing.

Corporations responded to [FASB] by moving out of the auction-rate securities so that their balance sheet cash positions would not take a hit. This meant that many corporations were no longer in the market for the securities. As corporate demand for auction-rate securities vanished, banks found themselves having to soak up more and more inventory. The capital commitment required to do this grew at the same time the banks faced challenges from other parts of the credit markets. Last week they decided that against committing additional capital to supporting the auction, and let them fail.

In a narrow sense, this is silly. The proximate cause for the failure of the auctions has nothing to do with FASB: it’s the fact that no one has any faith in monoline wraps any more. If the FASB decision had never been handed down, investors wanting lots of liquidity and zero credit risk would still have exited the auction-rate market en masse, just because they no longer trust the monolines.

On the other hand, the FASB decision hardly helped matters. Many of the corporate investors who left the market in the wake of the FASB decision might well have been perfectly happy with a little bit of credit risk. And if they had stayed, we probably wouldn’t have had as many auction failures as we’re seeing now.

Update: Mark Conner says in the comments that the change happened in 2005, not 2007; that it wasn’t driven by FASB and in any case hasn’t even taken official effect yet; and that, after a very brief pause back then, corporate demand for auction-rate securities actually increased in its wake.

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