Back in 2008, the monetary settlements associated with auction-rate securities (ARS) were frequently in the news as brokerage houses agreed to refund billions of dollars to clients. This occurred shortly after this $330 billion market collapsed, and millions of investors found themselves with securities they could not sell.
In this article, we're going to provide an explanation and definition of auction-rate securities. We're also going to discuss how the market was supposed to function. Finally, we will give a brief chronology of events, and the settlements that were made between brokerage houses and their clients.
Auction-rate securities, also known as ARS, are long-term, variable rate bonds, which are tied to short-term interest rates. The rate on an ARS is determined through 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.
The auction process normally occurs on a 7, 28, or 35-day cycle. The Dutch auction, also referred to as a descending 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 is paid on the entire issue for bid during the upcoming period.
Potential investors that bid a minimum rate above the clearing rate will not receive any bonds at auction. Those investors that bid a minimum rate at or below the clearing rate will receive the clearing rate on the bonds they purchased.
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:
Buyers of ARS:
The Dutch auction itself takes place using a seven-step process:
The benefits of auction-rate securities are twofold, and realized by both the issuers of these debt obligations as well as buyers:
When the concept of buying auction-rate securities was first sold to investors, brokers positioned them as safe investments (most securities were AAA rated), and investors were promised liquidity similar to holding cash. But in February 2008 that 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.
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 investors and small businesses.
In addition to the above financial institutions, Wachovia Securities and Commerce Bancshares Inc. also made announcements:
In 2008, then 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.
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