The term “auction-rate securities” (ARS) is used to refer to the universe of (formerly) highly liquid long-term debt and preferred securities, issued mainly by corporations and municipalities, which changed hands frequently at variable interest rates reset through a Dutch auction process. These securities include municipal auction-rate securities (MARS), or bonds issued by municipalities; auction-rate preferred securities (ARPS), or preferred shares issued by closed end investment funds; student loan auction-rate securities (SLARS), or bonds sold by student loan issuers; and other ARS issued by corporations, non-profits, collateralized debt obligations (CDOs), etc.

First developed in 1984, the auction-rate market grew steadily over time to over $300 billion by the end of 2007. Auctions were typically held every 7, 28 or 35 days, at which time the sponsoring broker-dealers would match buyers and sellers through a competitive auction process, setting interest rates accordingly. The underlying credit quality of auction-rate securities was very good, with the vast majority being AAA rated. In times when more ARS were offered for sale then bid upon, broker-dealers often would step in to “support” the auctions by purchasing ARS to help correct the imbalance, which is one of the reasons why so few auctions ever “failed” over the years. Due to this combination of high credit quality, implied liquidity and broker-dealer sponsorship, these securities were sold to investors as cash equivalents- offering a slightly better yield to treasuries.

In February 2008, with the credit crisis well on its way, auctions began failing en masse. With a flood of sellers, dwindling buyers, and broker-dealers unable to support auctions by taking the securities on their balance sheets - all ARS auctions failed on some days. While many municipalities, closed end funds and student loan issuers have been able to replace their auction-rate securities with alternative sources of financing, approximately $160B of ARS remain outstanding as of January 2009, with the majority of auctions continuing to fail daily.

Student Loan Auction-rate Securities (SLARS)

Student Loan Auction-Rate Securities (referred to as SLARS) are long-term (often 30 year), asset backed bonds issued by a combination of corporations, non-profit organizations and state agencies. These bonds were issued out of a trust structure, which essentially were formed from the securitization of thousands of underlying student loans contained within each trust. As students repay their interest and principal payments, SLARS interest payments are made, and bonds are redeemed over time. Issuing SLARS became a popular financing tool for student loan issuers, as the federal government mandated thin operating margins and low interest rates to student borrowers. The credit quality was also very high, due to the fact that the majority (95% plus) of the underlying student loans were backed by the Federal government.

The majority of SLARS issuances were structured in such a way that maximum rates triggered at failed auctions were capped, such that interest paid to bondholders never exceeded interest income and expenses incurred by the trusts. This left SLARS investors receiving less than 3% interest in some cases- rates so low that issuers had little incentive to search for alternative financing. This is one of the reasons why less than 10% of SLARS have been refinanced by issuers, among other factors. Student loan issuers Sallie Mae, the Pennsylvania Higher Education Assistance Agency and College Loan Corporation were three of the largest SLARS issuers.

Municipal Auction-Rate Securities (MARS)

Municipal Auction-Rate Securities (referred to as MARS) are long-term bonds that were issued by states and municipalities as both budget and project financing tools. Essentially, MARS are a combination of general obligation (GO) and revenue bonds which simply have the auction-rate component. By issuing MARS which required paying lower, short-term rates alongside their traditional 20-30 year bonds, they were able to lower their overall interest expense. Unlike many of the SLARS and ARPS issuers, which had a cap on the maximum amount of interest that they could pay out, many MARS issuers saw sharp increases in interest rate payments as auctions began failing- some rates reaching over 20%, such a $100M tranche of auction-rate bonds issued by the Port Authority of New York and New Jersey. Although the cost of borrowing rose dramatically as 2008 wore on, many MARS issuers pushed on with refinancing plans to lower their interest burden. Over 50% of issuers have redeemed their MARS as of 2008 year-end.

Auction-Rate Preferred Securities (ARPS)

Auction-Rate Preferred Securities (ARPS) are preferred shares issued by closed-end investment funds. ARPS can be issued for a 20 or 30 year term, but are often issued in perpetuity. The closed-end funds, which are publicly traded, issued ARPS as a source of fund leverage to enhance returns for common shareholders. The majority of funds issuing ARPS invest in highly rated municipal and corporate securities, and are also protected from a credit standpoint by common shareholder investment, with a preferred share to fund asset ratio of at least 2:1 (that is, there must be $200M in assets, or $100M in common equity, for every $100M in preferred investment). Eaton Vance, Nuveen and BlackRock are the largest issuers of ARPS through their families of closed-end funds. While the fund managers have redeemed some ARPS over the past year, the combination of non-punitive interest rates, common shareholder conflict and the frozen credit market have kept the majority of these securities outstanding.     

Other ARS

Other issuers of ARS include non-profit organizations such as the Metropolitan Museum of Art in New York, and corporations. The biggest corporate issuers which have utilized ARS issuance have been life and monoline insurance companies, in order to raise cash for statutory reserves. Scottish RE, First Colony Life and Ambac are large corporate insurers that have utilized auction-rate securities as a reserve funding mechanism.

ARS Dutch Auction Process

Auction-rate securities change hands at regularly scheduled auctions, with the interest rate on ARS 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 bondholders who wish to sell or hold ARS at a minimum yield. Existing holders and potential investors enter a competitive bidding process through their broker-dealer, which submits their bids to the broker-dealer acting as the auction agent. Buyers specify the number of shares, typically in denominations of $25,000, that 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.

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