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Auction-Rate Anxiety

Consumers aren't the only ones with a debt problem these days. Leveraged mutual funds and other institutional borrowers have started to feel the pinch as well -- and it bodes ill for investors.

So far, most people have felt the effects of the credit crunch in two ways: They've seen the value of their homes go down, and they've watched stock prices decline, largely because of the struggling financial sector. But recent failures in yet another arcane area of the credit markets have caused the impact of tightening credit to spread across an even broader segment of the economy.

The nuts and bolts of auction-rate securities
This time, the latest three-letter acronym related to troubled fixed-income securities is ARS, which stands for auction-rate security. These investments are used by a variety of issuers to raise capital, ranging from municipal governments and agencies to corporate issuers. They come in a number of types -- both bonds and preferred stock can have auction-rate features -- and have common traits.

The defining feature of an ARS is how its interest rate is set. Rather than paying a fixed rate of interest throughout its term, ARSs have variable interest rates that change every time there's a new auction -- typically between seven and 35 days. Because ARS owners have such a short holding period, they are usually willing to accept relatively low rates of return. But for issuers, ARSs are attractive because they don't have to reissue debt every few weeks -- they can use the same securities and count on the auction process to keep rates low.

What went wrong
Recently, however, the auction process that ARSs depend on started to break down. Underwriters such as UBS (NYSE: UBS  ) and Goldman Sachs (NYSE: GS  ) couldn't find enough buyers for the auctions, so their owners had to keep holding the securities. Even though these owners were paid high default interest rates -- as high as 20% in some cases -- the failures meant that they were stuck with securities they had intended to own for a short time.

Those auction failures have caused problems for businesses in nearly every industry. Many companies used ARSs as a tool for short-term cash management. US Airways (NYSE: LCC  ) , Bristol-Myers Squibb (NYSE: BMY  ) , and Qwest (NYSE: Q  ) are some businesses that have had to report minor writedowns related to their ARS holdings.

A hit to fund investors
Yet potentially far more troubling is the impact of auction failures on leveraged mutual funds. Fund managers such as Nuveen Investments, Eaton Vance (NYSE: EV  ) , and BlackRock (NYSE: BLK  ) commonly issue ARSs to make leveraged bets on the assets their funds invest in. Managers take the proceeds from the ARSs and buy more assets. That helps the funds get superior performance when their assets perform well.

Yet shareholders in these funds are now taking a double hit. With chaos in the financial markets, most assets are falling in price, and leveraged funds are suffering even more than traditional funds. To add insult to injury, when the ARS auctions that support that leverage fail and penalty rates kick in, fund shareholders are the ones who pay the higher financing costs.

Be careful
The failure of auction-rate securities is a good reminder of the dangers of leveraged investing. Although normal interest rate relationships make the use of leverage beneficial to investors under ordinary circumstances, prolonged episodes of instability can cause costly market failures. The full extent of the damage to the leveraged fund market is yet to be seen.

For more on mutual fund investing, read:

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