I was recently contacted by Alan Zibel, a reporter from the Associated Press. He asked for my opinion on the credit crunch and its effects on corporate “cash and marketable securities” holdings (see my post Where’s the Stuff Buried for background). He was particularly interested in how short-term, auction-rate securities that non-financial firms (such as Bristol-Myers) hold have been, and will be, affected by the credit crunch.

Alan did a more than admirable job explaining the underlying problem (see the full column Companies Cash-like Holdings Pose Risks). There were several minor factual errors, but otherwise, Alan was spot on. For example, he writes:

…these investments, known as auction-rate securities… [have] become extremely difficult for companies and wealthy individuals to sell…which are backed by mortgages, student loans and municipal bonds.

I could be mistaken here, but my understanding of the auction-rate securities is that they also (if not mainly) include corporate debt. But that’s really just a minor quibble. The more important fact about these securities is that the debt generally has a long-term maturity (20-30 years or so), but they are auctioned off to the highest bidder in a Dutch-style auction every few weeks to 6 months, essentially marking them to market.

The most important piece of the story Alan gets quite right. Specifically, that

Hundreds of auctions have failed over the past week…

This implies that there were no buyers for some of these securities. Now, for non-financial firms (and there are many) like Bristol-Myers this suggests that a portion of their “marketable” securities no longer have much of a market. So now what?

I am not an expert in accounting, however, my understanding is that firms can switch the securities from short-term holdings to long-term holdings to the extent that they believe that the securities that they hold from a failed auction still have value. However, to the extent that the underlying asset to which the auction-rate security is tied is non-performing (e.g., insolvent, not just a result of temporary illiquidity in the market), then the firm should write those down. The question then becomes – How do you determine which auctions failed because the market is tough right now and buyers are scared and therefore scarce (temporarily preferring the security of Treasuries), versus, those that failed because the underlying asset to which the securities are tied really do not have value so buyers are rightly not interested? For non-financial companies holding such assets, there is a fine line between the two, …and this is a gray area in reporting.

I spent a good amount of time with Alan talking over various aspects of the issues. I must say that I was impressed. He was a pleasure to talk to – very kind, very humble, and with a genuine curiosity about the underlying phenomenon. I certainly wished he had chosen a more flattering quote of mine to use, but I do not dispute the content. I certainly did say what he claims that I said, and I’m sure those of you who know me could verify that, in fact, that’s the way I speak. Zibel writes,

Still, Robert Salomon, a professor at New York University’s Stern School of Business, said many executives likely were unaware of what they were buying. “I would expect to see corporate treasurers raise the question of: well, what the heck is in our portfolio?” he said.

What I was trying to point out was that corporate treasurers likely did not have the time to perform the due diligence necessary on the assets they were buying. They are too busy on a day-to-day basis trying to manage corporate cash flow. They therefore most likely relied on the ratings agencies and assumed that if the paper was rated AAA, they were buying high quality securities. We’ve since learned that although they were buying AAA-rated securities, the quality of the underlying securities did not deserve such a rating. In that sense then, many treasurers were probably left wondering what, exactly, their portfolios contained, and their true exposure to “risky” securities. And if they hadn’t started asking relevant questions about their portfolio in August, they certainly are now.

To the question of what will happen next. My answer was to expect more, and greater, write-downs.

This entry was posted on Wednesday, February 20th, 2008 at 8:57 pm and is filed under Corporate Strategy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.