Auction rate securities

"The people you are after are the people you depend on. We cook your meals, we haul your trash, we connect your calls, we drive your ambulances. We guard you while you sleep. Do not fuck with us."
- Tyler Durden

This quote comes from one of the more disturbing scenes in Fight Club. It's the one where Project Mayhem kidnaps the police commissioner and threaten to castrate him. The statement perfectly encapsulates the current mess in the credit markets and specifically the problems in the area of auction-rate securities(ARS).

They are part of the plumbing in the financial world that no one notices until it breaksdown. Corporations, universities, municipalities, and even individuals enter and exit this market like Mario and Luigi. ARSs are a relatively small(only $250 billion) backwater of the collosal $25 trillion U.S. debt market. The market has recently come to a screeching halt due to problems elsewhere in the credit markets; this has meant higher borrowing costs for a variety of entities, as well as massive losses due to the failure of buyers to emerge at auctions.

One of the benefits? of any dislocation is that we actually get to see how markets work or fail to work. It's like standing next to Gil Grissom during an autopsy.

So what are auction rate securities? Auction rate securities are variable rate bonds with long-term(usually 30 years)maturities that pay short-term interest rates through a Dutch auction process that occurs every 7, 28, or 35 days. They are often listed as off-balance sheet debts, so you'll have to scour the footnotes of 10-Ks and 10-Qs to find out about a company's exposure. Why use them? They are a fairly common cash management tool offered by investment banks. ARSs are marketed as an alternative to tax-exempt money market funds, commercial paper, CDs, and Treasuries for holding short-term funds. Usually, they offer AAA ratings, preservation of principal, liquidity, and greater yield than the above-mentioned alternatives.

This is not the first whiff of trouble in these markets though. Problems began arising as early as 2004. Back in 2006, 15 banks settled claims that they favored certain clients in these auctions. On February 1st of this year, Bristol-Myers Squibb took a $275 million charge related to these securities.

So who got rich? The usual suspects. The big banks.

The bath that the Maher Brothers took courtesy of Lehman Brothers is actually a blessing in disguise. The rich brothers' travails have shed light upon and put a human face on what otherwise would've been dismissed as an arcane piece of financial engineering. We may now get prudent regulation or at the very least greater transparency.

On Tuesday, I'll discuss how to profit from this debacle.