An auction rate security (ARS) typically refers to a debt instrument (corporate or municipal bonds) with a long-term nominal maturity for which the interest rate is regularly reset through a dutch auction. Since February 2008, most such auctions have failed, and the auction market has been largely frozen. In late 2008, investment banks that had marketed and distributed auction rate securities agreed to repurchase most of them at par.
Background
The first auction rate security for the tax-exempt market was introduced by Goldman Sachs in 1988. However, the security was invented by Ronald Gallatin at Lehman Brothers in 1984.
Auctions are typically held every 7, 28, or 35 days; interest on these securities is paid at the end of each auction period. Certain types of daily auctioned ARSs have coupons paid on the first of every month. There are also other, more unusual, reset periods, including 14 day, 49 days, 91 days, semi-annual and annual. Non-daily ARS settle on the next business day, daily ARS settle the same day.
As bank loans became more expensive, the auction market became increasingly attractive to issuers seeking the low cost and flexibility of variable rate debt. Buyers received a slightly higher interest and an apparent assurance of liquidity through the auction process.
By early 2008 the ARS market had grown to over $200 billion, with roughly half of the securities owned by corporate investors. Because of their complexity and the minimum denomination of $25,000, most holders of auction rate securities are institutional investors and high net worth individuals.
In February 2008, the auction market failed, and most auction rate securities have been frozen since then, with holders unable to dispose of their securities. Investment banks that participated in the distribution and marketing have agreed to repurchase around $50 billion in securities from investors, including municipalities, under duress of investigations by U.S. state attorneys general.
Student loan auction rate securities (SLARS) make up a large percentage of the ARS market.
The future, if any, of the auction rate securities market remains unclear as of late 2008.
Auction Rate Securities Overview
The interest rate on ARS is determined through a Dutch auction process. The total number of shares available to auction at any given period is determined by the number of existing bond holders who wish to sell or hold bonds only at a minimum yield.
Existing holders and potential investors enter a competitive bidding process through broker/dealer(s). Buyers specify the number of shares, typically in denominations of $25,000, they wish to purchase with the lowest interest rate they are willing to accept.
Each bid and order size is ranked from lowest to highest minimum bid rate. The lowest bid rate at which all the shares can be sold at par establishes the interest rate, otherwise known as the "clearing rate". This rate is paid on the entire issue for the upcoming period. Investors who bid a minimum rate above the clearing rate receive no bonds, while those whose minimum bid rates were at or below the clearing rate receive the clearing rate for the next period.
Many financial services companies have been involved in packaging a collection of similar instruments, such as municipal bonds, into closed funds that were sold as both preferred and common shares. One of the largest issuer of auction rate securities was NUVEEN Investments, which since the failure of the auction market has begun to provide disclosure on their website. These funds were then labeled with names, such as "MuniPreferred", and actively marketed by brokers, such as TD Ameritrade. According to multiple reports, these were widely sold as "cash equivalents", such that the cash would be available for return within as little as 7 days. However, once the auctions were abandoned by the banks, thousands of investors were left with these illiquid funds since February 2008, without knowing when their cash will be returned.
Price Talk
Before the day's auction starts, broker-dealers will typically provide "price talk" to their clients which includes a range of likely clearing rates for that auction. The price talk is based on a number of factors including the issuer's credit rating, reset period of the ARS, and the last clearance rate for this and other similar issues. It might also take into account general macroeconomic events, such as announcements by the Federal Reserve Board of a change in the federal funds rate. Clients, however, are not required to bid within the price talk range.
Types of ARS Orders
- Hold - Hold an existing position regardless of the new interest rate (these shares are not included in auction).
- Hold at Rate - Bid to hold an existing position at a specified minimum rate. If the clearance rate is below the bid to hold rate, the securities are sold. (A "Hold at Rate" is not identical to a "Buy", but it's one type of "Buy". It is the same as "Buy" bidding with a certain rate (a hold rate) and current amount in participating the auction. Therefore, if the clearing rate is lower than the hold rate, the holder fails to win the auction and the securities are sold. And if the clearing rate is higher than (or the same as) the hold rate, the holder wins the auction and gets the same amount of securities at the clearing rate.)
- Sell - Sell an existing position regardless of the interest rate set at the auction.
- Buy - Submit a bid to buy a new position at a specified minimum interest rate (new buyers or existing holders adding to their position at a specified interest rate).
All-Hold Auction
If all current holders decide to hold their securities without specifying a minimum rate, the auction is called an "All Hold" auction and the new rate will be set to the "All Hold Rate" defined in the offering documents for the issue. The "All Hold Rate" typically is based on a certain percentage of a reference rate, usually the London Interbank Offered Rate (LIBOR), the Bond Market Association (TBMA) index, or an index of Treasury security. This rate is usually significantly below the market rate.
Failed Auction
If there are not enough orders to purchase all the shares being sold at the auction, a failed auction occurs. In this scenario, the rate is set to the maximum rate defined for the issuer (typically a multiple of LIBOR or the TBMA index). The purpose of the higher rate is to compensate the holders who have not been able to sell their positions. Broker-dealers usually bid on their own behalf to prevent failed auctions from happening. This made failed auctions extremely rare, although they did occur on occasion. In 2008 the market froze when broker-dealers withdrew.
The SEC Cease-and-Desist Order of 2006
In 2006, the SEC concluded an investigation of 15 firms, representing the Auction Rate Securities industry. The SEC summarized its findings: "between January 2003 and June 2004, each firm engaged in one or more practices that were not adequately disclosed to investors, which constituted violations of the securities laws." The SEC issued a cease-and-desist order to stop these violations.
The SEC order listed several illegal practices in the conduct of auctions, and noted: "In addition, since the firms were under no obligation to guarantee against a failed auction, investors may not have been aware of the liquidity and credit risks associated with certain securities. By engaging in these practices, the firms violated Section 17(a)(2) of the Securities Act of 1933, which prohibits material misstatements and omissions in any offer or sale of securities."
The auction failures in February 2008 led to industry-wide freezing of clients' accounts while requiring municipalities to pay excessive interest rates, reported to exceed 20% in some cases. A renewed investigation of the auction rate securities industry was led by Andrew Cuomo, the Attorney General of New York, and William Galvin, Secretary of the Commonwealth of Massachusetts. These investigations discovered continued industry-wide violations of the law by misrepresenting auction rate securities as liquid cash alternatives while failing to meet the SEC order to disclose to clients the liquidity and credit risks involved. Many, but not all, of the firms involved in these practices chose to settle out of court, refund the auction rate securities they sold to clients and pay respective penalties.
Secondary Market for ARS
Although not obligated to do so, auction-running broker-dealers may provide a secondary market for auction rate securities between auctions. If such a market develops, securities can be traded between interested clients at a discount from par value with accrued interest. However, auction-running broker-dealers are generally reluctant to facilitate secondary trading at a discount from par, due to the fact that in doing so they would necessitate markdowns to the value of other clients' holdings.
2008 Auction Failures
Beginning on Thursday, February 7, 2008, auctions for these securities began to fail when investors declined to bid on the securities. The four largest investment banks who make a market in these securities (Citigroup, UBS AG, Morgan Stanley and Merrill Lynch) declined to act as bidders of last resort, as they had in the past. This was a result of the scope and size of the market failure, combi
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