As we close 2008, one of the biggest stories of the year, the auction rate security meltdown, comes full circle.  Pimco, a company roundly criticized for not redeeming investor money locked in illiquid auction rate securities, has now delayed the divided payments from these funds because it continued to hold auction rate security cash, against the wishes of many investors.  Talk about irony.  Investors have now been screwed on both sides of the investment.  But there might be a silver lining for long suffering auction rate security holders.

While Bloomberg reported on the delayed dividends it didn't discuss the auction rate security side to it::

"Proceeds from the Pimco Municipal Income Fund and the Pimco New York Municipal Income Fund II were due today and on Feb. 2, Newport Beach, California-based Pimco said in a statement.

“The funds intend to resume paying and declaring dividends as soon as possible,” the company said. Pimco said continuing problems in the capital market caused the values of the funds’ portfolios to decline and led to the decision.

Auction-rate preferred shares, with which the funds borrowed money to boost returns, must be backed by underlying assets worth at least 200 percent, the company said. When that threshold was missed, dividends couldn’t be paid.

The funds may redeem some of the auction-rate shares so dividends may resume, Pimco said. Shares in the funds are sold to investors and are exchange traded."

For those that haven't followed this whole saga, this is how the double-screwing works:

Investors put money into Pimco auction rate security funds.  Auction rate securities at one time were short term bond funds whose values were reset periodically via a Dutch auction. For the bond issuer they presented an opportunity to raise cash at lower rates, since the money was more liquid than a typical 20 or 30 year bond. For the holder, they were a way of generating a safe, liquid, and insured return that was generally higher than a CD or money market account.

Early this year as the credit crisis picked up steam, the auctions for auction rate securities began to fail and investors were often unable to cash out their money.  Investors in municipal auction rate securities were often able to get out because their bonds held provisions siginficantly increasing the interest rate in the event of a failed auction.  If you owned an auction rate security from a municipality, a hospital, a university, etc. and you couldn't redeem it at auction, the rate you would receive would spike considerably.  At that point, the issuing entity had an incentive to redeem the bond since they didn't want to pay such an exorbitant amount of interest.

But investment companies like Pimco issued auction rate preferred shares to help leverage their close ended bond funds.  Funds like Pimco Municipal Income Fund and the Pimco New York Municipal Income Fund II.  These auction rate preferred shares did not have the same reset provisions as the municipal auction rate securities.  In most cases, they reset to slightly above the Fed Funds rate or some other benchmark.  The investment companies had no incentive to cash out their customers and make them liquid and as a result many have been trapped in these investments since last February.  It's important to note that the funds have not lost principle or interest but investors who thought they were investing in a cash equivalent, liquid investment have not been able to withdraw their money.  Pimco in particular has been singled out for not cashing out investors.

Now, it turns out that tthe auction rate security money that Pimco has kept against many investors wishes has forced it to susped paying dividends.  The credit crisis drove down the value of the assets in Pimco funds.  The covenants around the auction rate preferreds require that they be backed by at least 2x the amount of underlying assets.  Because the assets have shrunk in value, Pimco has to susped dividends to rebuilt its assets and keep it at this ratio. 

So, auction rate security holders can't get their money out, and bondholders can't get their dividends.  Screwed on both ends.

The only bright side to this is that the drop in asset values may finally force Pimco to redeem some of its auction rate preffered shareholders to lower the assets needed to maintain the 2x ration.  In order to start paying dividends again, the company told Bloomberg it will begin to cash them out.