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Auction rate security

An Auction rate security is a fixed income investment vehicle that pays interest based on a variable rate that resets at predetermined intervals.

Expanded Definition

Auction rate securities (ARS) have grown tremendously in popularity over the last two decades. These instruments which could invest in stocks or bonds provide regular payments on variable interest that resets periodically (in practice it is often every 7,28 or 35 days. They are however far less liquid than other cash instruments, investors usually can only cash out at their ARS's particular rate reset periods through an auction. Furthermore ARS when bought or sold can only be bought in complete blocks, as a result most private investors who own ARS tend to have high net worth. Typically a minimum investment of twenty five thousand dollars is required to buy an ARS.

You may wonder why an investor would want an ARS with the restrictions that is involved. Well in return for surrendering their liquidity the ARS investor typically receives a higher amount of interest than other cash instruments such as certificates of deposits, money markets and savings accounts.

The ARS issuer benefits because they can offer less interest than they would to a bond holder without having to worry about reissuing securities every reset period. Thus for the issuer the ARS offers a way for the issuer to give lower payout to the investor while the issuer still receives the benefit of the holding period of a long term instrument. Leveraged mutual funds used ARS as an inexpensive way to be able to buy more assets.

2008 Market Freeze

The ARS market was seen as a win-win for all involved until early 2008. The ARS market was one of the first markets to be affected by the ongoing Credit Crisis. In early 2008 the ARS market began to experience massive auction failures (in that when a investor tried to sell his/her ARS they found no taker). In practice the majority of the ARS holders were corporations looking for a place to store their cash at a higher rate than money markets. When the credit crisis began many corporations immediately divested (or tried to) in a flight to safety, as a result the market froze as there was an immediate dearth of buyers.

Suddenly the ARS market was dramatically less liquid than it had been in its entire existence. In the past when auctions failed the various brokerages houses bought them for the convenience of their clients. In February 2008, the firms suddenly discontinued this practice when ARS auctions started pouring in, this action froze the market. Most ARS have penalties built in for the issuer to help prevent auction failures from occurring (or at least for long). Some investors were receiving as high as 20% interest but at the cost of not being able to sell their instruments.

The ARS market stayed frozen throughout the spring as brokers and issuers clashed over how to free the investor's assets. A mixture a broker and issuer redemptions at par seems to have been the end result for most cases. The redemptions are ongoing as fall 2008.

The future of ARS as a result of this crisis is in doubt. The negative media and more importantly inability for investors to get their cash out of these supposedly cash instruments have seriously damaged the investment vehicles reputation, perhaps irrevocably. Many investors went months without being able to get their cash back. Major corporations have had to suffer writedowns as a result of ARS impairment. Leveraged mutual funds run by companies such as Nuveen and Blackrock that issued many ARS have had to payout the higher penalty rates negatively impacting their performance. Perhaps worst of all for the ARS market's future The New York Attorney General and other government lawyers are currently investigating how ARS were advertised to investors. Whether the ARS market can ever regain investor confidence remains to be seen.

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