Auction Rate Securities

News hasn't been good for auction-rate securities, and brokerage houses agreed to refund billions of dollars to clients.  This happened back in February 2008, when the $330 billion market for auction-rate securities (ARS) collapsed and millions of investors found themselves with securities they could not sell.

In this publication, we're going to provide an explanation and definition of auction-rate securities.  We're also going to discuss how the auction-rate security market was to theoretically function.  Finally, we will give a brief chronology of events, and the settlements that were made between brokerage houses and their clients.

Purpose and Definition of Auction-rate Securities

Auction-rate securities, also known as ARS, are long-term, variable rate bonds, which are tied to short-term interest rates.  The interest rate on an auction-rate security is determined via a Dutch auction, and these securities are typically sold in $25,000 denominations.

Investors in tax-exempt auction-rate securities are usually high net worth individuals, while taxable securities are frequently held by mid-to-large corporations.

ARS Dutch Auction Process

The auction process normally occurs on a 7, 28, or 35 day cycle.  The Dutch auction, also referred to as a decending price auction, determines the minimum interest rate at which all bonds can be sold at par.  This interest rate is referred to as the clearing rate, and this rate of interest is paid on the entire issue for bid during the upcoming period.

Potential investors that bid a minimum rate above this clearing rate will not receive any bonds at auction.  Those investors that bid a minimum rate that was at or below the clearing rate will receive the clearing rate on the bonds they purchased.

ARS Order Options

There are a total of four order types that can be placed during an auction, three of these are used by sellers of these securities, while bidders have one choice:

Sellers of ARS:

• Hold at Market - these investors wish to hold onto an existing position, regardless of the interest rate paid at auction.
• Hold at Rate - these investors wish to hold onto their securities at a specified minimum rate.
• Sell - these investors wish to sell their securities, regardless of the interest rate achieved through the auction.

Buyers of ARS:

• Buy - these investors are willing to submit a bid to buy securities at a specified minimum interest rate.

The Dutch auction itself takes place using a seven-step process:

1. Investors identify the par amount of securities they wish to purchase, and what they are willing to pay for those securities.
2. Each dealer passes along these bids to an auction agent.
3. The auction agent collects the bids from all the dealers participating in the auction.
4. The auction agent then sorts the bids in ascending rate order until a clearing rate is found.
5. Investors that bid a rate that was lower than, or equal to, the clearing rate are scheduled to receive bonds.
6. The auction agent notifies each dealer of the auction results.
7. Dealers record and settle the bond trades on the next business day.

Benefits of Auction-Rate Securities

The benefits of auction-rate securities are twofold, and are realized by both the issuers of these debt obligations as well as buyers of these securities.

• Issuers are able to secure low-cost financing, since third party banks are not needed and the financing process is simpler.  Issuers also avoid exposure to rating downgrades and enjoy lower issuing fees.
• Buyers of ARS enjoy the ability to diversify their cash holdings, and because of their additional complexity, these securities provide investors with a slightly higher yield than bonds with similar ratings.

Auction-Rate Freeze

When the concept of buying auction-rate securities was first sold to investors, brokers positioned these securities as safe investments (most securities were AAA rated), and investors were promised liquidity similar to holding cash.  But in February 2008 that all changed as banks and other financial institutions began marking down the value of their clients' holdings, initially in the 3% to 5% range.

The auction-rate lockout for investors began when credit worries forced large investment banks to pull back from this market.  In the past, these financial institutions participated actively in the auctions and often acted as a bidder of last resort to help the process run smoothly.

A failed auction occurs when there are insufficient investors willing to buy the securities up for bid.  As these financial institutions began to pull back from ARS, this once active market vanished, leaving behind investors holding bonds they could no longer trade.

Auction-rate Security Settlements

The four largest investment banks responsible for maintaining a market for auction-rate securities included Citigroup, Merrill Lynch, Morgan Stanley, and USB AG.  In 2008, each of these banks announced settlements with ARS investors and small businesses.

• Citigroup - On August 7, 2008, Citigroup and the Securities and Exchange Commission's Division of Enforcement announced a preliminary settlement that included a plan to return to investors $7.5 billion in ARS purchased from the firm.  Citigroup was also required to liquidate all of the $12 billion in ARS sold to retirement plans and institutional investors.
• Merrill Lynch & Co. - On August 7, 2008, Merrill Lynch offered to buy back $10 billion in frozen auction-rate securities beginning in January 2009.
• Morgan Stanley - On August 11, 2008, Morgan Stanley announced that it would repurchase at par those securities bought by their clients prior to February 13, 2008.  This program was scheduled to commence no later than September 30, 2008, and include all investors with accounts valued at $10 million or less.  The total size of the buy-back program is anticipated to be in the area of $4.5 billion.
• USB AG - On August 9, 2008, USB AG also agreed to repurchase from their clients nearly $19 billion in auction-rate securities as part of a settlement reached with federal and state regulators.  USB AG scheduled their buy back program to commence in October 2008.

In addition to the above financial institutions, Wachovia Securities and Commerce Bancshares Inc.  also made announcements:

• Wachovia Securities - On August 18, 2008, Wachovia Securities agreed to buy back $9 billion in auction-rate securities from clients.  In addition, Wachovia agreed to pay $50 million in fines.
• Commerce Bancshares Inc. - On August 18, 2008, Commerce Bancshares offered to buy back $545 million in auction-rate securities from its clients.

In 2008, New York Attorney General Andrew Cuomo also sought settlements with Bank of America Corp., Deutsche Bank AG, and Goldman Sachs Group Inc.  Brokerage houses such as Ameritrade Holding Corp., Charles Schwab Corp., E-Trade Financial Corp., Fidelity Investments, TD and Oppenheimer & Co. were also under investigation.

About the Author - Auction-Rate Securities

Copyright © 2008 - 2011 Money-Zine.com