Their proprietary research and valuation data is key in an age when you can’t just apply the Black-Scholes model anymore.

Mike Boswell
TriPoint Capital Advisors, LLC

Auction-Rate Securities Get No Bidders


By: Mike Meyers and Chris Serres | May 24, 2008

In the world of lending or borrowing, the price of creativity can be steep.

Just ask more than a dozen Minnesota companies and nonprofits stuck with money in exotic financial paper that nobody wants to buy.

Buying or selling esoteric debt vehicles called "auction-rate securities" has cost some Minnesota companies millions of dollars in the last few months. Millions more remain at risk, as the securities go begging for buyers.

The $320 billion U.S. "auction-rate securities" market promised low, short-term interest rates on long-term debt, but instead delivered more risks than almost anyone imagined, especially in places like Minnesota, a business arena unaccustomed to the unorthodox.

The troubled companies range from marquee names, such as Best Buy, Park Nicollet Health Services, Qwest and ADC Telecommunications, to the likes of Cardiovascular Systems, casino company Lakes Entertainment, and NorthStar Education Finance.

NorthStar, a leading student-loan lender, recently halted new student loans in the face of a meltdown of the auction-rate security market, where NorthStar has raised $800 million.

Although commercial loans can have maturities decades from today, auction-rate securities are different. Every month or so, an auction is held to trade the securities on the open market. In successful auctions, the interest rates often are somewhat lower than those on conventional long-term loans.

NorthStar offered its auction-rate securities in February, but no one made a bid. Auction attempts failed again in March, April and May.

"I think every single auction is in failure," said Jamie Wolfe, NorthStar chief financial officer. "Investors are stuck with the paper."

The company on Thursday said fresh federal education financing will free enough new money for NorthStar to resume lending to students this week.

Park Nicollet, the nonprofit operator of medical clinics across the Twin Cities, three months ago was scrambling to avoid penalties on auction-rate securities that threatened to drain $23 million a year from its coffers.

But, like some other companies in a similar fix, Park Nicollet officials won't say now how -- or whether -- they were able to find new sources of money to pay off investors in the auction-rate securities.

Indeed, while some companies have written off millions as a result of auction-rate financing ventures, others continue to hold their breath, hoping the market will thaw.

Best Buy, the world's largest consumer electronics retailer, owned $397 million in auction-rate securities as of April 25. Yet the retailer has not deemed it necessary to mark down this investment. "We believe that the credit quality of our auction-rate securities is high and that we will ultimately recover all the amounts invested in these securities," the company said in its Securities and Exchange Commission (SEC) filing.

Some experts say that's wishful thinking. Pluris Valuation Advisors, a national firm based in New York, tracks about 400 companies that own auction-rate securities. About half of them already have taken write-downs, the firm said.

"This market can't come back," said Espen Robak, president, of Pluris Valuation. "For these auctions to succeed, you would have to believe that these auctions will never fail again. And that makes absolutely no sense, since we've all seen them fail."

Added Brady Lemos, a retail analyst at Morningstar: "Given how difficult these securities are to unload, it will be no surprise to the market if [Best Buy] takes a write-down."

Jennifer Driscoll, Best Buy's vice president of investor relations, said a markdown isn't necessary because the securities' underlying assets -- AAA-rated student bonds backed by the U.S. government -- are still safe and can be redeemed at a later date. She noted that the company has a $2.5 billion revolving line of credit and doesn't need to liquidate the securities to generate cash, so any recent drop in their value is irrelevant.

"Our position is that we are in reasonably good shape," Driscoll said.

But the company's recent 10-K filing with the SEC acknowledged that it may incur losses "if market conditions persist and we are unable to recover the cost of our investments in auction-rate securities."

Some companies have managed to squeak out of trouble, however.

CentraCare Health System, operator of St. Cloud Hospital, last summer planned a $200 million debt issue to finance hospital and other construction projects before the end of 2007. Instead, the project, to be financed with auction-rate securities, was delayed, said John Seckinger, CentraCare chief financial officer.

"We got very, very fortunate that we didn't do it last fall. I think we would have done auction-rate securities," he said. "That's what all the financial advisers and underwriters said was the best market."

Instead, CentraCare turned to a different kind of financing in February, just as the auction-rate securities market was collapsing.

"Our $200 million in bonds sold in 15 minutes," Seckinger said.

Despite such dramas, auction-rate securities have not become a topic of conversation at the watercooler.

"This isn't like the savings-and-loan crisis," Robak said. "Most of those burned are corporations, or very, very wealthy people who put a small part of their investment portfolio into this because they wanted a slightly higher yield."

Accounting experts saw warning signs long before the auctions collapsed.

In 2005, PriceWaterhouseCoopers warned in a memo to clients that auction-rate securities should no longer be considered as "cash and cash equivalents" on corporate financial statements, but should instead be considered short-term investments. The firm cited the potential failure of the auctions as one reason for reclassifying them.

Yet large brokerage houses, in an effort to keep the auction-securities market afloat and keep earning fees, continued to buy the securities and pitch them to large corporations. And executives stocked up on them, largely because they offered slightly higher yields than conventional short-term investments, such as money-market accounts.

"There was a greed factor here," said Clayton Forester, a professor of accounting at the University of Minnesota's Carlson School of Management. "They were trying to gain access to a better return at a similar level of risk."

The debate continues about how corporations should account for these illiquid securities. Some Minnesota companies already have taken multimillion dollar losses on them, while others cling to the notion that a market will redevelop.

One company that acted early in taking a write-down is ADC Telecommunications in Eden Prairie. Last month, the company said it had marked down the value of its auction-rate securities by nearly half, to $90.2 million from $169.8 million, adding that it expects to take markdowns of $12 million to $22 million more in the second quarter. "People have lost faith, not so much in the securities, but in the auction process itself," said James Matthews, chief financial officer.

James Cox, a professor of securities law at Duke University in Durham, N.C., said he is surprised that so many companies have refrained from taking losses on these investments months after the auctions have failed.

"I think some corporate managers are acting opportunistically," Cox said. "If it's in their interest to avoid a write-down, they will do so. But some of these companies may end up taking a big bath later."