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.
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 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.
Dutch Auctions
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.
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: desire to hold onto an existing position, regardless of the interest rate paid at auction.
Hold at Rate: desire to hold onto their securities at a specified minimum rate.
Sell: desire to sell their securities, regardless of the interest rate achieved through the auction.
Buyers of ARS:
Buy: desire to submit a bid to buy securities at a specified minimum interest rate.
Auction Process
The Dutch auction itself takes place using a seven-step process:
Investors identify the par amount of securities they wish to purchase, and what they are willing to pay for those securities.
Each dealer passes along these bids to an auction agent.
The agent collects the bids from all the dealers participating in the auction.
The agent then sorts the bids in ascending rate order until a clearing rate is found.
Investors that bid a rate that was lower than, or equal to, the clearing rate are scheduled to receive bonds.
The agent notifies each dealer of the auction results.
Dealers record and settle the bond trades on the next business day.
Benefits of ARS
The benefits of auction-rate securities are twofold, and realized by both the issuers of these debt obligations as well as buyers:
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 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 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.
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 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 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 was 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 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 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, 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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