Felix Salmon

ARS datapoint of the day

By Felix Salmon
August 5, 2009

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.

9 comments so far | RSS Comments RSS

One man’s showoff is another man’s financially solid company (that was criticized for not taking out enough debt…until Sept’08).

Posted by otto | Report as abusive

If they can’t be sold then their value is what they are worth to Google. Which is the value at which Google would buy more. 86 sounds generous to me.


These ARS are likely now traded to final maturity of 20 or 25 years…using a wide berth for the discount value makes sense. A suddenly much longer cash-flow with a capped rate…

Those bonds will never get refunded by new issue, which is how most of the student loan ABS were designed (FFELP-issuance, +/-). Never is a strong word…perhaps in the future at a much later date.

Posted by Griff | Report as abusive

What’s interesting about the discount rate is that they seem to be arguing that 2000bp is the credit component of the market inferred discount rate, while 400bp is the liquidity component. That seems backward to me.

That said, Griff’s component makes sense. These have gone from being very short term securities to very long term ones. That justifies a pretty huge discount rate.

Posted by Ginger Yellow | Report as abusive

Felix: you are right about the 86 cents, but this is very odd in light of the 2400 bps discount rate and very long maturity of the ARS, guess the discount rate was applied to a very piece of their ARS…


“I’m still struggling to work out what planet Google got its discount rates from.”

Putting on my deerstalker cap, I would say follow the money. What individuals or companies make money from that estimate?

Posted by Ken | Report as abusive

Can someone explain “and which are certain to make all their payments in full for the foreseeable future.”? I’m not saying it’s untrue, I just don’t understand.

Posted by nwf | Report as abusive

It varies dependent on an issuer’s specific deal document (trustee guidelines), but most ARS securities are tied to a variable index (generic 90-day CP, one example). These securities are capped on interest payments by referencing to that index, and in some instances that deal document can limit what interest is paid according to how much cash flow is available to pay it.

The trustee can not pay interest to the investor above what cash is available to pay. Interest can accrue, but in some instances becomes deferred to a future date when/if additional cash becomes available. It’s a fluid situation which typically adjusts quarterly upon accruals being paid out.

Posted by Griff | Report as abusive

I think the ARS securities Google holds mature in 15 years or more. If inflation picks up significantly between now and the maturity date, the return of the principal at maturity might not count for much. There’s a marketplace for these illiquid assets through http://www.secondmarket.com/ , but I don’t get quotes just by visiting the web-site.

David Bernier

Posted by David Bernier | Report as abusive

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