There's a storm brewing in the frothy world of financial alphabet soup. I'm not talking about collateralized mortgage-backed securities (CMBSs) or collateralized debt obligations (CDOs) today, but the latest acronym du jour: auction-rate securities (ARS).

Why are these important? For the most part, you only have to worry about CMBSs and CDOs if you're investing in banks. They're the ones playing around with these particular "financial weapons of mass destruction." Unfortunately, the same is not true for ARSs -- these are rapidly evolving into a problem for everybody.

Background
As fellow Fool Dan Caplinger explained in last month's "Auction-Rate Anxiety," an ARS is a debt offering that's come into favor among certain issuers recently. It works like this:

  • A borrower, such as New York's Port Authority, needs cash. It can raise cash by floating a traditional bond that offers a fixed interest rate, or take the (perceived to be only slightly) riskier route of auctioning ARSs to the lowest bidder.
  • A "lender" such as Bed Bath & Beyond (Nasdaq: BBBY) has cash and wants to deploy it profitably, but doesn't want to tie its money up in a long-term commitment.
  • Enter the ARS. The borrower offers ARSs to interested buyers, looking for someone to lend it money at a low interest rate.
  • Rates reset every seven, 28, or 35 days, as new auctions are held. Thus, the borrower can take advantage of falling interest rates. For the lender, its cash is only tied up for a week, or, at worst, a month, at which point it can convert its ARSs back into cash.

Or it should
In February 2008, the system described above blew up. Or rather, froze up. Banks, strapped for cash, refused to fulfill their implied role of stepping in to buy ARSs when bids failed to materialize. As a result, auctions began to "fail."

As borrowers' ARSs came up for reset, not enough lenders bid to take over the ARSs at attractive interest rates. In this situation, a current ARS holder (Bed Bath in the above example) must hold the ARS. Bed Bath cannot force the issuer to repurchase the ARS, but it is compensated for the inconvenience by being paid a specified "penalty" interest rate. Media reports cite spikes from 3% and 4% auction rates, to as high as 12% and 15% penalty rates.

Watch your ARS
Lousy news for the borrowers, no doubt. Lately, everyone from the Port Authority, to the District of Columbia, to Georgetown University has seen its ARS interest rates skyrocket. But for individual investors, the crisis poses a different dilemma.

You see, the lenders stuck with all these illiquid ARSs are the companies we own. Bed Bath & Beyond isn't just a name I pulled out of a hat. In an 8-K filing with the SEC last month, it confirmed that: "the auction process for the Company's auction-rate securities has recently failed ... These failed auctions result in a lack of liquidity in the security ..."

Sure, some companies have sidestepped the issue -- Paychex (Nasdaq: PAYX) boasts that: "We invest in highly liquid, investment-grade fixed income securities. We have no exposure to any sub-prime mortgage securities, auction-rate securities, asset-backed securities or asset-backed commercial paper ..." But reviewing 8-K filings on the SEC's website, I found more than a dozen companies discussing the issue over just the past few weeks: Qwest (NYSE: Q), American Eagle (NYSE: AEO), Family Dollar (NYSE: FDO), Continental Airlines (NYSE: CAL), Palm (Nasdaq: PALM) -- the murmur of worry that began in February is fast becoming a tumult.

Foolish takeaway
What does all this mean to you, if you own shares in one of the above-named firms, or any of the scores more I expect to reveal their own exposure to ARS risk during the new earnings season? Several things:

  • Asset shift: Bed Bath says it "may reclassify all or a portion of its auction-rate securities from current assets to long-term assets." Many firms -- Qwest, Continental, and Palm among them -- have already taken this step.
  • Liquidity: Long-term assets for a company are like CDs for an individual. It's still "money," but you can't pay the rent with it until you get it unfrozen. For companies, the ARS freeze-up may cause liquidity problems, and hamstring efforts to take certain desirable actions -- for example, share buybacks.
  • Impairments: Opinions differ on whether this hurts earnings. Bed Bath argues that even if its ARS assets are impaired, "an impairment, if any, would be temporary." American Eagle hasn't yet decided what to do. Meanwhile, other firms are getting ahead of the curve. Yesterday, for example, Palm marked down the value of its ARSs, and took a $0.23 hit to its third-quarter earnings per share.
  • Benefits: On the plus side, while an ARS is frozen, its holder still earns interest; and at the "punitive" interest rates quoted, perhaps a whole lot of interest. Bed Bath confirms that, "The Company continues to earn and receive interest on these securities." Qwest puts an even brighter face on things, "we still hold these long-term securities and are due interest at a higher rate than similar securities for which auctions have cleared."

So how serious is this latest mess? Well, the picture's blurry, and still evolving. But for now at least, you know what we know.

More Foolishness:

American Eagle, Bed Bath & Beyond, and Palm are Stock Advisor newsletter recommendations. Bed Bath & Beyond is also an Inside Value pick. The Motley Fool owns stock in American Eagle and Bed Bath & Beyond.

Fool contributor Rich Smith does not own shares of any company named above. The Motley Fool has a disclosure policy.