About
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 coupon being 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 liquidity 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 it being owned by corporate investors. Because of their complexity and the minimum denomination of $25,000 or more, 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 munitipalities, 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.
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, now over 9 months without knowing when their cash will be returned.