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Auction rate securities ("ARS") are now entering the infamous collection of securities that no one had heard of until companies began incurring losses from writing them down. ARS are debt instruments with long-term maturities (student loans, municipal bonds, CDOs and preferred stock are typically the underlying securities), but with interest rates that are reset regularly (typically every 7, 28 or 35 days) based on a Dutch auction. With a ready market, the ARS were carried at par on company's balance sheets and were viewed as a safe way to achieve a higher return than short-term bonds. Unfortunately, beginning at the end of 2007, the auctions began failing. By February, 100% of the auctions were failing and the ARS essentially became illiquid. This is where FAS 157 enters the scene. Without a ready market to support valuation at par, companies are being required to determine fair value for the securities.

With a limited secondary market, the discounted cash flow method is the most common means used to value ARS. Some of the key drivers of value are the penalty rate formula after a failed auction, the time to maturity and the likelihood of redemption, the creditworthiness of the underlying security and the appropriate liquidity discount.

The one piece of good news is that auctions in the municipal market seem to have recovered somewhat with about half of the auctions going through in April. The secondary market also seems to be growing, providing a path of liquidity, although at a discount, for some companies.

Category(s): Fair Value Accounting
Posted by Denise Curd at 09:41 PM | Permalink | Comments (0) | TrackBacks (0)