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Lawrence Cunningham

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Auction-Rate Bonds Hurt by Accounting, Probe of $200 Bln Market
By Otis Bilodeau

March 7 (Bloomberg) -- The $200 billion auction-rate bond market, already the subject of a regulatory probe, is getting hit with another blow: an accounting shift that's sapping demand from corporate buyers.

The world's four largest accounting firms told holders of auction-rate bonds that they must reclassify the securities as investments rather than cash equivalents. The change may diminish the bonds' appeal for companies such as Applied Materials Inc. and EMC Corp., which bought them to squeeze extra income from cash on hand.

Some are responding by cutting their holdings. Agile Software Corp., a data-management firm in San Jose, California, plans to sell its $15 million of auction-rate debt to avoid getting stuck with securities no one wants to buy, Chief Financial Officer Carolyn Aver said in an interview. Others may have to sell because they need to show enough cash on their books to fund operations and meet loan obligations.

``We have heard several companies say that they're planning to dump these in sizeable amounts,'' said Muneera Carr, 36, a senior manager at PricewaterhouseCoopers LLP who wrote a Feb. 16 report to clients on the new guidelines. Carr, who's based in Florham Park, New Jersey, declined to name potential sellers.

Dwindling demand may mean higher borrowing costs for issuers such as the Brazos Higher Education Authority, a Waco, Texas-based provider of student loans, and the New York State Dormitory Authority, a college-funding agency. Municipalities have been the biggest sellers of auction-rate bonds, so named because their yields are reset in a bidding process as often as once a week.

SEC Probe
The accounting shift clouds the future of a market that's already under investigation by the U.S. Securities and Exchange Commission. At least seven securities firms -- Citigroup Inc., UBS AG, Lehman Brothers Holdings Inc., Merrill Lynch & Co., Wachovia Corp., Bank of America Corp., and A.G. Edwards Inc. -- have said since July that they were contacted as part of the probe.

The investigation is examining whether the firms rigged the supposedly blind auctions by letting some favored customers know what other bidders were offering for the bonds, people familiar with the matter have said. The probe encompasses 25 brokerages. The SEC backs the auditors' mandate to make companies treat auction-rate bonds as investments, according to the report from PricewaterhouseCoopers, the third-largest U.S. accounting firm.

SEC spokesman John Nester declined to comment.

KPMG LLP, Ernst & Young LLP and Deloitte & Touche LLP, the other three accounting firms, also have told clients to reclassify the debt. PriceWaterhouseCoopers said the shift in treatment reflects the risk that buyers of auction-rate debt will have to hold the securities longer than they intended.

``If an auction fails because sell orders exceed buy orders, or if it fails for any other reason, existing holders must hold their positions,'' the firm said in the Feb. 16 report. ``Investors cannot force issuers to redeem auction rate securities if an auction fails.''

A March 3 SEC filing by Goldman Sachs Trust notes: ``There is some risk that an auction will fail due to insufficient demand
for the securities.''

So far, at least 15 companies, including Applied Materials, the biggest maker of semiconductor equipment, and EMC, the No. 1 seller of data storage computers and software, have reclassified their auction-rate bonds as investments under the new guidelines. San Jose, California-based Applied disclosed on March 1 that it moved $589 million of auction-rate debt from the cash equivalents line on its balance sheet to short-term investments.

EMC, based in Hopkinton, Massachusetts, disclosed three days later that it similarly shifted $274 million of the bonds. Other companies that have reclassified their holdings include Purchase, New York-based Mastercard Inc., the world's second-biggest credit-card brand, and Urban Outfitters Inc., the Philadelphia-based clothing and home-furnishings retailer.

`Minimizing Exposure'
``If most companies have to show these as investments on their balance sheets, they won't want them,'' said Lance Pan, 39, head of credit research at Newton, Massachusetts-based Capital Advisors Group Inc. Pan's firm, which manages $5.5 billion and doesn't own any auction rate bonds, held a conference call with corporate clients on March 3 to discuss the potential fallout from the accounting change.

``We're minimizing our exposure to these right now,'' Agile Software's Aver, 45, said. ``For the moment, I'm not buying new ones because I want the dust to settle. I don't want to be holding something I can't get out of.'' Agile counts Dell Inc. and Microsoft Corp. as clients. Sycamore, PanAmSat, Staples, Sycamore Networks Inc., a Chelmsford, Massachusetts-based maker of optical-networking equipment, cut its auction-rate bond holdings to $14.8 million as of Jan. 29 from $107.3 million six months earlier. Scott Larson, a company spokesman, declined to
comment on the reduction.

PanAmSat Holding Corp., the largest U.S. commercial satellite operator, sold off its entire $335 million of auction rate bonds during the past year, according to a March 1 regulatory filing. Kathryn Lancioni, spokeswoman for Wilton, Connecticut-based PanAmSat, said she's prohibited from commenting on the company's finances because of its pending $1.12 billion initial public offering.

Staples Inc., the world's largest office-supplies retailer, also cut its auction-rate holdings last year. It opted instead for ``cash equivalents, including commercial paper and money market investments,'' according to the Framingham, Massachusetts- based company's annual report to the SEC.

``In 2004, our investment strategy changed,'' Staples said in the Feb. 24 report. The company didn't elaborate or detail the amount of auction rate securities sold, and spokesman Owen Davis didn't return a call seeking comment.

Market Mushroomed
The market for auction-rate bonds mushroomed from almost nothing in 1984, as issuers used the securities to raise long- term debt at lower short-term interest rates. Although most of the bonds mature in 20 or 30 years, many companies accounted for them like Treasury bills, banker's acceptances and commercial paper -- instruments that can be sold quickly at near-certain prices.

``Despite the long-term maturities, from an investor's perspective, auction-rate securities are priced and subsequently trade as short-term investments because of the interest-rate reset feature,'' PricewaterhouseCoopers said in its report. Corning Inc., the world's largest maker of glass for flat- panel screens, had $215 million of auction-rate bonds among its .$1.8 billion in cash and short-term investments at the end of last year. Treasurer Mark Rogus said he gets a quarter-point more interest from auction-rate bonds than from commercial paper, or an extra $2,500 a year for every $1 million invested.

Higher Yields
The Corning, New York-based company said in a Feb. 22 SEC filing that it reclassified its auction-rate bonds as investments instead of cash equivalents.

``We buy these securities because they offer us a more attractive short-term yield than other securities,'' said Rogus, 46. ``I'm not planning on changing my investment actions because accountants tell us we need to put these in another bucket.'' During the so-called rate auctions, investors place bids through brokers, resetting the interest that the bonds pay. For example, in a March 3 auction for $67.5 million in North Texas Higher Education Authority municipal bonds, the yield was reset to 2.76 percent from 2.62 percent on Feb. 2.

Many companies that hold auction-rate bonds as cash equivalents, including Morristown, New Jersey-based Honeywell International Inc. and Cypress Semiconductor Corp., of San Jose, California, have yet to file reclassifications. Most holders that have made the accounting change now treat the securities as short-term investments.

Short-Term Investments
Petsmart Inc., the largest U.S. pet-supplies retailer, said on March 2 that it reclassified $314 million in auction-rate bonds as investments.Timothy Kullman, the Phoenix-based company's CFO, said he likely won't exit the market ``in the short term'' unless auditors or regulators say the bonds must be considered long-term investments.

``If we were going to increase the length of our holdings, we'd probably be looking at other instruments than auction- rates,'' Kullman, 49, said.

Lawrence Cunningham, a professor of law and accounting at Boston College, said the bonds ought to be treated as long-term investments because they don't mature for decades. Should demand for the securities drop as more holders exit the market, issuers such as Brazos may have to boost yields to attract buyers. The result would be higher borrowing costs for the students who come to Brazos, which has more than $5 billion in outstanding loans.

Potential for Defaults ``If an investor needed to cash out, if he couldn't be replaced, he might get stuck holding the bonds,'' said Steve Sayler, finance director for Jefferson County, Alabama, which has $2 billion of outstanding auction-rate securities. ``If many buyers wanted to cash out, interest rates would rise if there was .no liquidity in the market.''

The accounting change may have more serious consequences for companies that have to maintain certain amounts of cash under loan agreements. Once auction-rate bonds are reclassified as investments, a company's cash position is reduced by the same amount, even if total assets don't change.

``It could trigger defaults,'' said Cunningham, the Boston College professor. ``Banks should be notified. Discussions need to be held.''

A search of SEC filings didn't show any companies in default because of the reclassification order.

--With reporting by Darrell Preston in Dallas.
Editors: Schatzker, Rooney, Wolfson