Auction rate security
From Wikipedia, the free encyclopedia
An auction rate security (ARS) typically refers to a debt instrument (corporate or municipal bonds) with a long-term nominal maturity for which the interest rate is reset through a dutch auction. It could also refer to a preferred stock for which the dividend is reset through the same process. In a dutch auction, a broker-dealer submits bids, on behalf of current and prospective investors, to the auction agent. Based on the submitted bids, the auction agent will set the next interest rate by determining the lowest rate to clear the total outstanding amount of ARS. ARS holders do not have the right to put their securities back to the issuer; as a result 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 ARS auction daily, with 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 has become 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 Sachs in 1988.[1] Today the market for ARS has grown to over $200 billion, with roughly half of it being composed of corporate issues.[2] 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.
Some negative aspects of ARS include lower liquidity and potential drops in the coupon rate.
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[edit] 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.
[edit] Price Talk
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.
[edit] 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" order is identical to a "Buy" order. In both cases, the bidders (whether they are the existing security holder or a new purchaser) both submit bids in the format of a certain principal amount at a certain coupon. The bids that are below the clearance rate are awarded a certain principal amount of the securities depending on the principal amount that they bid to purchase. You do not receive any preferential treatment if you are an existing holder. Therefore, there is no distinction between a "Hold at Rate" order and a "Buy" order. You can "Hold," "Sell" or "Buy" an auction rate security. "Hold at Rate" should be deleted.)
- 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).
[edit] All-Hold Auction
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 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.
[edit] Failed Auction
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.
[edit] Secondary 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 they in doing so they would necessitate markdowns to the value of other clients' holdings.
[edit] 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 Stanley and 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 these own firm's need to protect their capital during the 2008 financial crisis.[citation needed]
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. [3]
On March 28th, 2008, UBS AG said it is marking down the value of auction-rate securities in brokerage accounts from a few percentage points to more than 20%. The markdowns reflect the estimated drop in value of the securities that the market has seized up, while UBS isn't offering to buy the securities at the new lower prices.[4]
Beginning in March 2008, several class action lawsuits have been 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.
[edit] 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 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.[5]
[edit] 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 writedown 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[6] . 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[7]. 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.[8]
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.”[1]
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.
[edit] See also
[edit] References
- ^ A Dutch Auction Security Debut. The New York Times (1988-03-17). Retrieved on 2007-01-18.
- ^ Auction-Rate Securities: Hold That Gavel. CFO.com (2005-04-25). Retrieved on 2007-01-18.
- ^ Florida Schools, California Convert Auction-Rate Debt. Bloomberg L.P. (2008-02-22). Retrieved on 2008-03-10.
- ^ Morgenson, Gretchen. "3 Firms Are Asked for Data on Auction-Rate Shares", The New York Times, 2008-03-29. Retrieved on 2008-03-28.
- ^ Morgenson, Gretchen. "As Good as Cash, Until It’s Not", The New York Times, 2008-03-09. Retrieved on 2008-04-30.
- ^ Auction-Rate Securities Give Firms Grief. The Wall Street Journal (2008-05-27). Retrieved on 2008-06-02.
- ^ Companies split on taking ARS cash hit. Financial Week (2008-06-02). Retrieved on 2008-06-02.
- ^ Citigroup Plans to Sell $6 Billion of Hybrid Bonds. Bloomberg.com (2008-04-21). Retrieved on 2008-06-02.
[edit] External links
- As Good as cash, Until It's Not
- Restricted Securities Trading Network - Secondary Market and pricing information for auction rate securities.
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