- Auction rate security
An auction rate security (ARS) typically refers to a
debtinstrument (corporate or municipal bonds) with a long-term nominal maturity for which the interest rateis regularly reset through a dutch auction. It could also refer to a preferred stockfor which the dividendis reset through the same process. In the dutch auction, broker-dealers submit bids on behalf of potential buyers and sellers of the bond. Based on the submitted bids, the auction agent will set the next interest rate as the lowest rate to match supply and demand. Since ARS holders do not have the right to put their securities back to the issuer, no bank liquidity facility is required.
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.
liquidityhas become more expensive, the auction market became increasingly attractive to issuers seeking the low cost and flexibility of variable rate debt.
The first auction rate security for the tax-exempt market was introduced by
Goldman Sachsin 1988. [cite web| url = http://query.nytimes.com/gst/fullpage.html?res=940DE5D9153EF934A25750C0A96E948260
title = A Dutch Auction Security Debut
accessdate = 2007-01-18
date = 1988-03-17
publisher = "The New York Times"] However, the security was invented by Ronald Gallatin at
Lehman Brothersin 1984. [cite web| url = http://www.nytimes.com/2008/02/20/business/20place.html?_r=4&sq=auctions%20norris&st=nyt&adxnnl=1&oref=slogin&scp=1&pagewanted=print&adxnnlx=1223219804-EkR2OGEyvLS7s8WyvxTZbA
title = Auctions Yield Chaos for Bonds
accessdate = 2008-10-05
date = 2008-02-20
publisher = "The New York Times"]
By early 2008 the ARS market had grown to over $200 billion, with roughly half of it being composed of corporate issues. [cite web| url = http://www.cfo.com/article.cfm/3905502?f=archives
title = Auction-Rate Securities: Hold That Gavel
accessdate = 2007-01-18
date = 2005-04-25
publisher = "CFO.com"] 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. Banks have agreed to repurchase around $50 billion in securities from investors, mostly individuals and municipalities. The future, if any, of the ARS market remains unclear (September 2008).
Auction Rate Securities 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.
Before the day's auction starts,
broker-dealers will typically provide "price talk" to their clients which includes a range of likely clearing rates for that auction. The price talk is based on a number of factors including the issuer's credit rating, reset period of the ARS, and the last clearance rate for this and other similar issues. It might also take into account general macroeconomic events, such as announcements by the Federal Reserve Boardof a change in the federal funds rate. Clients, however, are not required to bid within the price talk range.
Types of ARS Orders
*Hold - Hold an existing position regardless of the new interest rate (these shares are not included in auction).
*Hold at Rate - Bid to hold an existing position at a specified minimum rate. If the clearance rate is below the bid to hold rate, the securities are sold. (A "Hold at Rate" is not identical to a "Buy", but it's one type of "Buy". It is the same as "Buy" bidding with a certain rate(a hold rate) and current amount in participating the auction. Therefore, if the clearing rate is lower than the hold rate, the holder fails to win the auction and the securities are sold. And if the clearing rate is higher than(or the same as) the hold rate, the holder wins the auction and gets the same amount of securities at the clearing rate.)
*Sell - Sell an existing position regardless of the interest rate set at the auction.
*Buy - Submit a bid to buy a new position at a specified minimum interest rate (new buyers or existing holders adding to their position at a specified interest rate).
If all current holders decide to hold their securities without specifying a minimum rate, the auction is called an "All Hold" auction and the new rate will be set to the "All Hold Rate" defined in the offering documents for the issue. The "All Hold Rate" typically is based on a certain percentage of a reference rate, usually the
London Interbank Offered Rate(LIBOR), the Bond Market Association(TBMA) index, or an index of Treasury security. This rate is usually significantly below the market rate.
If there are not enough orders to purchase all the shares being sold at the auction, a failed auction occurs. In this scenario, the rate is set to the maximum rate defined for the issuer (typically a multiple of LIBOR or the TBMA index). The purpose of the higher rate is to compensate the holders who have not been able to sell their positions. Broker-dealers usually bid on their own behalf to prevent failed auctions from happening. This made failed auctions extremely rare, although they did occur on occasion. In 2008 the market froze when broker-dealers withdrew.
The SEC Cease-and-Desist Order of 2006
In 2006, the SEC concluded an investigation of 15 firms, representing the Auction Rate Securities industry. The SEC summarized its findings: "between January 2003 and June 2004, each firm engaged in one or more practices that were not adequately disclosed to investors, which constituted violations of the securities laws." The SEC issued a cease-and-desist order to stop these violations ( see http://www.sec.gov/news/press/2006/2006-83.htm).
The SEC order lists several illegal practices in the conduct of auctions, and notes: "In addition, since the firms were under no obligation to guarantee against a failed auction, investors may not have been aware of the liquidity and credit risks associated with certain securities. By engaging in these practices, the firms violated Section 17(a)(2) of the Securities Act of 1933, which prohibits material misstatements and omissions in any offer or sale of securities. "
The auction failures in February 2008 led to industry-wide freezing of clients' accounts while requiring municipalities to pay excessive interest rates, reported to exceed 20% in some cases. A renewed investigation of the Auction Rate Securities industry has been lead by Mr. Andrew Cuomo, the Attorney General of New York, and by Mr. William Galvin, Secretary of the Commonwealth of Massachusetts. These investigations discovered, among other, continued industry-wide violations of the law by misrepresenting Auction Rate Securities as liquid cash alternatives while failing to meet the SEC order, to disclose to clients the liquidity and credit risks involved. Many, but not all, of the firms involved in these practices, chose to settle out of court, refund the Auction Rate Securities they sold to clients and pay respective penalties.
econdary Market for ARS
Although not obligated to do so, auction-running broker-dealers may provide a secondary market for auction rate securities between auctions. If such a market develops, securities can be traded between interested clients at a discount from par value with
accrued interest. However, auction-running broker-dealers are generally reluctant to facilitate secondary trading at a discount from par, due to the fact that in doing so they would necessitate markdowns to the value of other clients' holdings.
2008 Auction Failures
Beginning on Thursday, February 7th, 2008, auctions for these securities began to fail when investors declined to bid on the securities. The four largest investment banks who make a market in these securities (
Citigroup, UBS AG, Morgan Stanleyand Merrill Lynch) declined to act as bidders of last resort, as they had in the past. This was a result of the scope and size of the market failure, combined with the firm's needs to protect their capital during the 2008 financial crisis.Fact|date=April 2008
On February 13 (2008) 80% of auctions failed.On February 20th, 62% failed (395 out of 641 auctions). As a comparison, from 1984 until the end of 2007, there were a total of 44 failed auctions. [cite web| url = http://www.bloomberg.com/apps/news?pid=20601103&sid=awCJRyi5ngcQ&refer=us
title = Florida Schools, California Convert Auction-Rate Debt
accessdate = 2008-03-10
date = 2008-02-22
publisher = "Bloomberg L.P."]
On March 28th, 2008, UBS AG said it was marking down the value of auction-rate securities in brokerage accounts from a few percentage points to more than 20%. The markdowns reflected the estimated drop in value of the securities because the market had frozen, while UBS didn't offer to buy the securities at the new lower prices. [cite news
last = Morgenson
first = Gretchen
title = 3 Firms Are Asked for Data on Auction-Rate Shares
publisher = The New York Times
date = 2008-03-29
url = http://www.nytimes.com/2008/03/29/business/29rate.html?ex=1364443200&en=20f1038c08d4745b&ei=5090&partner=rssuserland&emc=rss&pagewanted=all
accessdate = 2008-03-28]
Beginning in March 2008, several class action lawsuits were filed against several of the large banks. The lawsuits were filed in federal court in Manhattan alleging that these investment banks deceptively marketed auction-rate securities as cash alternatives.
On July 17th a National Task Force is said to be made up of officials from several states including Missouri began investigating at the St. Louis, MO Headquarters of Wachovia Securities. Some in the media were calling it a raid and officials called it a "Special Investigation" at the St. Louis offices. Media reports also said that Wachovia Securities part of Wachovia Corp based in Charlotte, NC did not comply with request by officials which prompted the "Special Investigation". It is also stated that other Securities Firms are also a part of the investigation. The Missouri State action was prompted by complaints to the state and total of more than $40 million of investments that were frozen. [ [http://www.boston.com/business/articles/2008/07/18/securities_investigators_pay_a_visit_at_wachovia/ Securities investigators pay a visit at Wachovia - The Boston Globe ] ]
On August 1, New York State Attorney General notified Citigroup of his intent to file charges over the sale of troubled auction-rate securities and claimed Citigroup destroyed documents. [ [http://money.cnn.com/2008/08/01/news/companies/citigroup_cuomo/index.htm?postversion=2008080115 Citigroup faces auction rate security fraud charges - Aug. 1, 2008 ] ]
On August 7, in response to state and federal regulators charges, Citigroup agreed in principle to settle the auction rate securities mess by buying back about $7.3 billion of auction-rate securities it had sold to charities, individual investors, and small businesses. The agreement also called for Citigroup to use its "best efforts" to make liquid all of the US$12b auction-rate securities it sold to institutional investors, including retirement plans, by the end of 2009. The settlement allowed Citigroup to avoid admitting or denying claims that it had sold auction-rate securities as safe, liquid investments. [ [http://money.cnn.com/news/newsfeeds/articles/djf500/200808071456DOWJONESDJONLINE000748_FORTUNE5.htm 3rd UPDATE: Citigroup Agrees In Principle To Settlement ] ]
Also on August 7, a few hours after Citigroup's settlement announcement,
Merrill Lynchannounced that effective January 15, 2009, and through January 15, 2010, it would offer to buy at par auction rate securities sold by it to its retail clients. Merrill Lynch's action created liquidity for more than 30,000 clients who held municipal, closed-end funds and student loan auction rate securities. Under the plan, retail clients of Merrill Lynchwould have a year, beginning on January 15, 2009, and ending January 15, 2010, in which to sell Merrill Lynchtheir auction rate securities, if they so wished.
In August of 2008, the Securities and Exchange Commission’s Division of Enforcement engaged in preliminary settlements with several of the larger broker-dealers including Citigroup, JPMorgan Chase, Merrill Lynch, Morgan Stanley, RBC Group and UBS. The proposed settlement called for these broker-dealers to repurchase outstanding ARS from their invidual investors. [https://www.restrictedsecurities.net/announced-bd-settlements.pdf Breakdown of Broker-Dealer Buybacks]
Benefits of Auction Rate Securities
For issuers, ARS offered low financing cost, in some cases more attractive than traditional
variable rate debt obligations(VRDOs). No third-party bank support was required, and there were typically fewer parties to the financing process. ARS eliminated renewal risk and the risk of increased fees. There was no exposure to bank rating downgrades, and ARS offered the same flexibility found in traditional VRDOs.
For buyers, ARS provided a slightly higher after tax yield than
money marketinstruments due to their complexity with an increase in risk. Most securities were AAA rated as well as federal, state and local tax exempt. They also provided an opportunity to diversify one's cash equivalent holdings.
Whatever benefits were present, the market is currently frozen. [cite news
last = Morgenson
first = Gretchen
title = As Good as Cash, Until It’s Not
publisher = The New York Times
date = 2008-03-09
url = http://www.nytimes.com/2008/03/09/business/09gret.html
accessdate = 2008-04-30]
Valuation of Auction Rate Securities
Accounting Statement FAS 157 defines
fair value, which under the new guideline, is typically referred to as “ mark to market” accounting. With Auction Rate Securities no longer being liquid, public companies began to write down their ARS holdings starting in the first quarter of 2008. Through May 31, 2008, 402 publicly traded companies have reported Auction Rate Securities on their books [cite web| url = http://online.wsj.com/article/SB121185073143321559.html
title = Auction-Rate Securities Give Firms Grief
accessdate = 2008-06-02
date = 2008-05-27
publisher = "The Wall Street Journal"] . Of those 402, 185 have taken some level of impairment. However, there has been no ascertainable trend in the amount of writedowns taken. Firms have reported discounts ranging from 0-73% of
par value[cite web| url = http://www.financialweek.com/apps/pbcs.dll/article?AID=/20080602/REG/806020323#
title = Companies split on taking ARS cash hit
accessdate = 2008-06-02
date = 2008-06-02
publisher = "Financial Week"] .
IncrediMail, Ltd. proved the most extreme example of this as they booked an impairment of 98% off face value for their ARS holdings, while Berkshire Hathawaytook no impairment on their more than $3.5 billion of these securities. Some of the higher-profile firms taking writedowns include Bristol-Myers Squibb, 3Mand US Airways. Citigrouptook a $1.5 billion loss on their inventory of Auction Rate Securities. [cite web| url = http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aYef.hg7qqXY
title = Citigroup Plans to Sell $6 Billion of Hybrid Bonds
accessdate = 2008-06-02
date = 2008-04-21
publisher = "Bloomberg.com" ]
Duke UniversityLaw School professor James Cox summed this discrepancy up: “I think some people act opportunistically, some people act optimistically and some people act fairly.” [http://www.financialweek.com/apps/pbcs.dll/article?AID=/20080602/REG/806020323]
The valuation of Auction Rate Securities has proved especially difficult as
Bank of Americaand other brokerage houses refuse to assign a value to their clients’ holdings. UBS AGhas presented clients with several different values for ARS. Also, Interactive Data Real Time Services, a provider of independent pricing services for the investment industry, discontinued the pricing of approximately 1,100 student-loan Auction Rate Securities on May 5, 2008.
Floating rate note
* [http://www.nytimes.com/2008/03/09/business/09gret.html?_r=1&ref=business&oref=slogin As Good as cash, Until It's Not]
* [http://www.secondmarket.com SecondMarket Inc.(f/k/a Restricted Securities Trading Network)] - Secondary Market and pricing information for auction rate securities.
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