Auction Rate Securities Basics

By Joseph Devine

Amid the ongoing crisis in the auction rate securities (ARS) market, complicated information about investment banks, investment firms, and broker-dealers is easily available, while information on the basics of the auction rate securities market is surprisingly scarce.

For many people, coverage of the ARS market collapse is more confusing than helpful. Without details as to how the auction rate system works, why these securities were attractive, and the factors which contributed to the market's downfall, reports on the subject are little more than gibberish.

What Are Auction Rate Securities?

When a corporation, local government, or other entity needs to raise money or capital, they often sell issues of bonds or stocks. A bond is basically a type of loan, where the bond seller is the borrower who pays interest on the loan, and the bond buyer is the lender who receives interest payments. Bonds typically come with a maturity period or date, which is when the face value of the debt (i.e., the amount that was borrowed) is due.

Auction rate securities are a form of variable rate debt. In other words, they are a type of long term financial obligation (very long maturity period) with interest rates which change periodically. They are essentially long term bonds or preferred stock which can be bought and sold at the same auctions which are used to determine their new interest rates.

ARS auctions are held according to a 'Dutch system,' in which buyers submit bids to purchase shares at a given interest rate. The issue is sold at the lowest interest rate at which there are enough bids to cover all available shares - known as the clearing rate.

Market Failure and Collapse

ARS auctions can only be completed when a clearing rate is successfully determined - that is, when there are enough or more than enough bids to account for all the sell orders at a particular auction. Traditionally, the broker-dealers and investment banks that ran ARS auctions also submitted their own bids, ensuring that all shares would be bought. This practice was largely responsible for the success of the auction rate market.

In February of 2008, broker-dealers were under pressure from the economic woes facing the financial industry, and abruptly ceased to bid in their auctions. Without their support, hundreds of auctions failed within weeks, bringing the entire market to a standstill.

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