Moneyzine
/Investment Guides /Auction-Rate Securities (ARS)

Auction-Rate Securities (ARS)

Moneyzine Editor
Author: 
Moneyzine Editor
6 mins
January 8th, 2024
Advertiser Disclosure
Auction-Rate Securities (ARS)

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:

  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 agent collects the bids from all the dealers participating in the auction.

  4. The 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 agent notifies each dealer of the auction results.

  7. 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.

Additional Resources

Asset-Backed Securities (ABS)
The term asset-backed security, or ABS, is used to describe a variety of securities that rely on a collection of assets as collateral, and provide a cash flow back to lenders. The most common pools of assets include home equity and automobile loans, credit card receivables, student loans, and even leases. In this article, we're going to talk about a special class of investments: asset-backed securities. We'll start by providing a definition of the term; describe how these investments are typically structured, and how they're traded. Next, we'll describe the most common types of securities offered on the market. Then...
Moneyzine Editor
Moneyzine Editor
January 5th, 2024
Collateralized Debt Obligations (CDO)
Collateralized debt obligations take an asset and slice it into an investment that offers various levels of risk and reward. These asset-backed securities consist of bank loans as well as fixed income issues such as bonds and similar debt instruments. In this article, we're going to be discussing the topic of collateralized debt obligations, or CDOs. As part of that discussion we'll talk briefly about the history of these investments. Next, we'll talk about how CDOs are structured, including an example that demonstrates how the tranches might be sold to investors. Then we'll finish up with the pros and cons...
Moneyzine Editor
Moneyzine Editor
January 11th, 2024
Collateralized Mortgage Obligations (CMO)
A collateralized mortgage obligation, or CMO, is a type of bond that is structured using mortgage-backed securities. The performance of these investments depends on the quality of the home mortgages on which they're based. Traditional lenders package these loans, and pass them on to an intermediary company. Principal and interest payments from homeowners are eventually passed on to investors in the CMO. In this article, we're going to cover the topic of collateralized mortgage obligations. We'll start with a review of the history of these investments, as well as how they're typically prepared. Finally, we'll talk about the challenges of...
Moneyzine Editor
Moneyzine Editor
January 11th, 2024
Also known as TruPS, trust-secured preferred securities were popular issues with bank holding companies until the credit crisis of 2007. TruPS contained features of both debt as well as equity, and can yield more than traditional bonds or preferred stock, making them attractive to investors too.
Moneyzine Editor
Moneyzine Editor
September 21st, 2023
It's possible to compare bond yields to other investments using only four data points: par value, market price, maturity date, and the coupon rate. That's all the information needed to calculate the return from a bond. But as will be discussed later on, understanding the value derived from a bond is more complex than just calculating a yield to maturity.
Moneyzine Editor
Moneyzine Editor
September 21st, 2023
Bond Prices and Interest Rates
The price of high quality bonds is directly related to interest rates. Investors looking to expand the diversity of a portfolio of stocks need to understand the relationship between prices and interest rates before buying bonds.
Moneyzine Editor
Moneyzine Editor
January 9th, 2024

Contributors

Moneyzine 2024. All Rights Reserved.