Risk ManagementCorporate Finance
Treasurers are swearing off exotic investment options for plain old vanilla
By Russ Banham
Russell Paquette liked auction-rate securities (ARS) as much as the next treasurer. At Recreational Equipment Inc. (REI) in Kent, Wash., he had been particularly attracted to those backed by student loans. “They were AAA-rated, over-collateralized by 30% and roughly 97% guaranteed by the Department of Education,” the REI treasurer points out. But when asset-backed investments began to lose their auction market liquidity, an alert Paquette bailed out of ARS investments. “We exited that market in December and January,” he notes. “We were fortunate.”A neighbor down the road in Redmond, Wash., also invested in the ARS market and escaped intact. In 2006, when the SEC ruled that auction-rate paper no longer qualified as a cash equivalent, Microsoft Corp.’s treasury saw an opportunity in the market dislocation that followed and decided to buy. “At a time when others were selling, we went overweight in auction-rate securities, relative to our benchmarks,” reports Microsoft treasurer George Zinn. It was a big bet. “We went overweight by billions of dollars,” he explains. “That allowed us to reap considerable value and outperform our benchmarks by taking advantage of the dislocation. We bought auction-rate for all our portfolios where it was permitted, including our liquidity portfolio.”
But in early 2007, Zinn and his team of CFAs became leery of credit risk and began to pare down Microsoft’s ARS holdings. Then last summer, his staff noticed collateral in Microsoft’s securities lending portfolio that it wouldn’t buy for its own portfolios. It called in its two securities lending agents and asked for a fix. “One offered to rewrite its guidelines and take back the securities we didn’t want,” Zinn recalls. “The other one wouldn’t. We ended that relationship, marked the collateral to market, sold it and took a $100,000 loss. When I saw that an investment bank would burn a relationship over $100,000, I knew there were larger issues down the pike.” By the end of the year, Microsoft’s ARS investments were down to “the equivalent of zero,” Zinn says. “We navigated the troubled waters superbly.”
Unfortunately, most treasurers have a much sadder story to recount when it comes to the fate of their ARS bet in liquidity investment portfolios. “I’ve been told that only about 20% of the organizations that invested in auction-rate securities escaped unscathed,” notes REI’s Paquette.
The pounding was so unsettling that some market veterans now predict treasurers will be inclined to quit the cash investment game altogether. “This is a game-ending event,” insists Lee Epstein, president and CEO of Money Market One, a San Francisco broker-dealer specializing in corporate cash investments. “The cash investment game treasury staffs have been playing for the past 25 years is over. People thought they could pick up a few basis points of yield without taking real risk. Well, the free lunch ain’t free.”
Epstein is not alone in this analysis that treasurers and treasuries feel burned and, particularly after the Bristol Myers Squibb treasurer and assistant treasurer were pushed out in February for losing $275 million on ARS, are recognizing what is at stake when they take investment risks. “Treasurers are finally throwing in the towel,” suggests Anthony Carfang, founding partner of Treasury Strategies Inc. (TSI).“They’re deciding it’s not their job to manage an investment portfolio. Once they saw that they could not depend on the rating agencies to keep them apprised of credit risk, they’re moving to institutional money funds or turning to outside managers to do the investing for them. The big fund managers can do their own credit analysis and don’t have to depend on rating agencies.”
But is this just another case of the pendulum swinging too far the other way? At the end of the day, whether treasurers handle the day-to-day or hand it over to an investment manager, it won’t just be the investment manager’s head on the line if cash strategies head south—the treasurer’s and CFO’s will be right next to the manager’s. The key, say experts, is not to run portfolios on auto-pilot—expecting that a credit rating awarded months earlier is necessarily holding up. What CFOs and treasurers should be doing and are doing, according to veteran cash managers like Ron Hart, a corporate cash investments group director in Citigroup Global Markets Inc., is re-engaging in the investment activity. “Advice now matters to them,” Hart reports, “and they want it from people with a long history in the corporate cash area.”
The carnage from the subprime spilloff has no doubt taken a toll. In March, Treasuries Strategies released a survey showing liquidity falling for the first time in nearly 10 years—down by $250 billion at $5.25 trillion domestically. This, however, follows an unprecedented ascent of roughly $1.6 trillion in the short eight years between 1999 and June 2007, and TSI’s Carfang is quick to point out that corporate cash is still plentiful, Carfang notes. “Left to its own devices, the market will recover its balance,” he says. “The problem lies in the financial economy, not the real economy.”
In the meantime, a lot of rearranging the deck chairs is underway. In Treasury Strategies’ Flash Surveys, auction-rate securities comprised 4% of the corporate liquidity portfolios of those surveyed last July. By yearend, it was down to 2%. In the asset-backed commercial paper shakeout, holdings in these same portfolios fell from 15% to 3%, Carfang reports. “That’s a redistribution of $500 billion in funds,” he notes. Before the shakeout, investors were holding $350 billion of outstanding auction-rates, considering them 7-day or 35-day instruments, he adds. The shift within portfolios to more conservative investments means that, overall, corporate treasurers have reallocated more than $1 trillion, he observes.
The flight to money markets has disrupted those relatively tame markets as well. The spread between a prime fund and a Treasury fund, normally 10 to 15 basis points, has been more than 200 basis points at times, notes Kirk Black, liquidity management service executive at Bank of New York/Mellon. The yield on Treasury funds is so low that many treasury investors choose government funds as a reasonable compromise between safety and yield, he adds.
Corporate investors who are confident in their due diligence and stay with high-quality prime funds can pick up 30 basis points over a government fund and 200 basis points over a Treasury fund, Black points out. The flight to money funds has pushed their assets up to $3.4 trillion, an all-time high and an annual growth rate of about 40%, he notes.