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Auction Rate Security - Wikipedia, the Free Encyclopedia Page 1 of 4 Auction rate security - Wikipedia, the free encyclopedia Page 1 of 4 Auction rateYou securitycan support Wikipedia by making a tax -deductible donation. From Wikipedia, the free encyclopedia Securities 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. Securities Bond Auctions are typically held every 7, 28, or 35 days; interest on these securities is paid at the Equities end of each auction period. Certain types of ARS auction daily, with coupon being paid on the Investment Fund Derivatives first of every month. There are also other, more unusual, reset periods, including 14 day, 49 Structured finance days, 91 days, semi-annual and annual. Non-daily ARS settle on the next business day, daily Agency Securities ARS settle the same day. Markets As bank liquidity has become more expensive, the auction market has become increasingly Bond market Stock market attractive to issuers seeking the low cost and flexibility of variable rate debt. Futures market Foreign exchange market The first auction rate security for the tax-exempt market was introduced by Goldman Sachs in Commodity market 1988.[1] Today the market for ARS has grown to over $200 billion, with roughly half of it Spot market Over-the-counter Market (OTC) 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 Bonds by coupon investors and high net worth individuals. Fixed rate bond Floating rate note Some negative aspects of ARS include lower liquidity and potential drops in the coupon rate. Zero coupon bond Inflation-indexed bond Commercial paper Contents Perpetual bond Bonds by issuer 1 Auction Rate Securities Overview Corporate bond 1.1 Price Talk Government bond 1.2 Types of ARS Orders Municipal bond 1.3 All-Hold Auction Sovereign bonds 1.4 Failed Auction Equities (Stocks) 1.5 Secondary Market for ARS Stock 2 2008 Auction Failures Share 3 Benefits of Auction Rate Securities IPO 4 Valuation of Auction Rate Securities Short Selling 5 See also 6 References Investment Funds Mutual fund 7 External links Index Fund Exchange-traded fund (ETF) Closed-end fund Auction Rate Securities Overview Segregated fund Hedge fund 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 Structured Finance Securitization holders who wish to sell or hold bonds only at a minimum yield. Asset-backed security Collateralized debt obligation Existing holders and potential investors enter a competitive bidding process through Collateralized mortgage obligation broker/dealer(s). Buyers specify the number of shares, typically in denominations of $25,000, Credit-linked note they wish to purchase with the lowest interest rate they are willing to accept. Mortgage-backed security Commercial mortgage-backed security Residential mortgage-backed security Each bid and order size is ranked from lowest to highest minimum bid rate. The lowest bid Unsecured bond rate at which all the shares can be sold at par establishes the interest rate, otherwise known as Agency Securities 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 Derivatives http://en.wikipedia.org/w/index.php?title=Auction_rate_security&printable=yes 6/16/2008 Auction rate security - Wikipedia, the free encyclopedia Page 2 of 4 rates were at or below the clearing rate receive the clearing rate for the next period. Options Warrants Futures Price Talk Forwards Swaps Before the day's auction starts, broker-dealers will typically provide "price talk" to their Credit Derivatives clients which includes a range of likely clearing rates for that auction. The price talk is based Hybrid Securities on a number of factors including the issuer's credit rating, reset period of the ARS, and the last edit this box 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. 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). 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. 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. 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. 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. 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] http://en.wikipedia.org/w/index.php?title=Auction_rate_security&printable=yes 6/16/2008 Auction rate security - Wikipedia, the free encyclopedia Page 3 of 4 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. 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.
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