Auction Rate Securities

Auction rate securities are created by governments, municipalities and corporations, in order to raise finances. They work just as other securities, where an investor purchases the security, retains it for future benefit, or sells it for an instant benefit. These securities are characterized by long-term nominal maturity. The changing rate of interest makes it a really unique, negotiable and trade-able financial instrument. The rate of interest of the ARS is reset after a certain time period with the help of a process which is known as the Dutch auction.

Auction Rate Securities and Dutch Auction

Before we understand the concept of change in the rate of interest, it is important to know the concept of a Dutch auction. This kind of auction is different from the usual auctions. In this auction, the object (in this case the auction rate security) is presented to the public and all possible bids are taken in. The person with the highest bid becomes the new owner of object.

In reality, these securities are long-term debt instruments, that usually mature at their nominal value. However, the concept of Dutch auction makes it behave like a short-term security or instrument. During the Dutch auction, the ownership of the instrument changes. The change in ownership also means that there is a change in the rate of interest, depending upon the tax exemption and time of payment of interest. Investors, bankers and broker-dealers, use the Dutch auction to raise finances, through the trade of the ARS.

How Does the Auction Rate Securities Work?

The two types of parties that are involved are termed as 'existing holders' and 'potential investors'. During a Dutch auction, these parties enter into a bidding process. During the bidding, potential investors or the buyers, specify the number of securities that they are willing to purchase. The lowest rate or interest that they are ready to accept is also defined by them. It has become a convention to define these bids in denominations of $25,000. The bids are then arranged in an ascending order. The lowest bid at which all the securities can be sold at 'par', establishes the rate of interest for all securities that are being traded in the auction. This rate of interest is known as the clearing rate. The 'clearing rate' is then paid to the highest bidders before the next auction. Thought the process sounds a bit complex, the inward cash flow of interest is very, very resourceful. The next Dutch auction is conducted within a time period of 7, 28 or 35 days, before which the interest is paid by the originator to the new owner in an ARS settlement.

The brokers and auctioneer often conduct a session known as the 'price talk', before the start of the auction, to give an estimated 'clearing rate' to their clients who are willing to purchase the securities. The clearing rate during the auction is determined on the sheer basis of law of demand and supply. In some cases, macroeconomic events such as decisions by the Federal Reserve Board affect the clearing rate

In the recent past, after February 2008, litigation about these securities has led to the freezing of the ARS market which had grown to about $200 billion worth. The current owners of the securities have been unable to dispose off their holdings, and originators have also defaulted a considerable amount of payments of interest and maturity amounts, which has led to a considerable number of lawsuits. This securities failure has raised several concerns in the United States money and security markets, and has led to investigations by the United States Attorney General.