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.
As bank liquidity has become more expensive, the auction market became increasingly attractive to issuers seeking the low cost and flexibility of variable rate debt.
By early 2008 the ARS market had grown to over $200 billion, with roughly half of it being composed of corporate issues. 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).
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 Board of a change in the federal funds rate. Clients, however, are not required to bid within the price talk range.
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.
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.
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.
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.
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.
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.
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.
Also on August 7, a few hours after Citigroup's settlement announcement, Merrill Lynch announced 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 Lynch would have a year, beginning on January 15, 2009, and ending January 15, 2010, in which to sell Merrill Lynch their 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. Breakdown of Broker-Dealer Buybacks
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 market instruments 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.
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 . 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. 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 Hathaway took no impairment on their more than $3.5 billion of these securities. Some of the higher-profile firms taking writedowns include Bristol-Myers Squibb, 3M and US Airways. Citigroup took a $1.5 billion loss on their inventory of Auction Rate Securities.
Duke University Law School professor James Cox summed this discrepancy up: “I think some people act opportunistically, some people act optimistically and some people act fairly.”
The valuation of Auction Rate Securities has proved especially difficult as Bank of America and other brokerage houses refuse to assign a value to their clients’ holdings. UBS AG has 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.