As I posted last week, Auction rate securities (ARSs) is a $330 billion market for long-term bonds that are supposed to pay lower rates because their interest rates are set through auctions. Municipalities who issued ARSs are suffering because 1,000 of these auctions failed and instead of paying 3% interest rates, they have to pay 20%. And if that wasn't bad enough, the investment banks that oversee these auctions are refusing to let investors withdraw their money.

DealBreaker explains that the demand for ARSs dried up sometime last year, and evaporated completely in 2008. This shift was driven by a March 2007 decision by the Financial Accounting Standards Board (FASB) that the heading "cash equivalents" should be eliminated from balance sheets and cash-flow statements. The FASB recommended that cash-flow statements should present only flow related to cash. Items currently classified as cash equivalents would be classified in the same way as other short-term investments.

Corporations responded to this by moving out of the ARSs so that their balance sheet cash positions would not be reduced as a result of the FASB decision. This meant that many corporations no longer wanted to buy ARSs. As corporate demand for ARSs vanished, banks had to keep more ARS inventory onto their own books. Since banks need to maintain a constant ratio of capital to assets, they needed to increase their capital commitment at the same time the banks faced challenges from other parts of the credit markets -- such as Collateralized Debt Obligations (CDOs). Last week they decided against committing additional capital to supporting the auction, and let them fail.

Continue reading Why the $330 billion auction-rate securities market failed

Why the $330 billion auction-rate securities market failed originally appeared on BloggingStocks on Thu, 21 Feb 2008 11:45:00 EST. Please see our terms for use of feeds.