ARS datapoint of the day

By Felix Salmon
August 5, 2009
how Google did it:

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How do you put a value on AAA-rated, student-loan-backed auction-rate securities which are paying a nice rate of interest but which can’t really be sold at all? Here’s how Google did it:

We used a discounted cash flow model based on estimated interest rates, timing and amount of cash flows, the credit quality of the underlying securities and illiquidity considerations. Specifically, we estimated the future cash flows of our ARS over the expected workout periods using a projected weighted average interest rate of 5.2% per annum, which is based on the forward swap curve at the end of June 2009 plus any additional basis points currently paid by the issuers assuming these auctions continue to fail. A discount factor was applied over these estimated cash flows of our ARS, which is calculated based on the interpolated forward swap curve adjusted by up to 2,000 basis points to reflect the current market conditions for instruments with similar credit quality at the date of the valuation and additionally adjusted for a liquidity discount of up to 400 basis points to reflect the risk in the marketplace for these investments that has arisen due to the lack of an active market.

Essentially, they took the present value of the income stream, discounted by up to 2,400 basis points to adjust for “current market conditions” and “the lack of an active market”. The upshot is that Google ended up valuing its ARSs at about 86 cents on the dollar.

My take is that this is just Google showing off: they’re basically saying “hey, look at us, we can lowball the value of our auction rate securities as much as we like, because our shareholders don’t care in the slightest one way or the other”. But for people who are still holding ARSs, and for whom the level of their marks really makes a difference, this Google precedent is not a happy one.

And let’s be clear: it makes no sense. These are (admittedly illiquid) triple-A bonds with no prospect of a downgrade, a healthy coupon, and which are certain to make all their payments in full for the foreseeable future. Given that junk bonds, loaded to the gills with excess credit risk, are trading at a spread of less than 1,000 basis points these days, it’s just silly to discount these ARSs at 2,400bp, and I’m still struggling to work out what planet Google got its discount rates from.


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