Auction Rate Securities1
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Auction Rate Securities1 Auction Rate Securities (ARS) were marketed by broker-dealers to investors, including individuals, corporations and charitable foundations as liquid, short-term, cash-equivalent investments similar to traditional commercial paper. The securities, however, were long-term floating rate bonds or preferred stock with floating rate coupons which gave them a superficial similarity to short-term investments. ARS’s liquidity and similarity to short-term investments were entirely dependent on the presence of sufficient orders to buy outstanding ARS at periodic auctions in which they were bought and sold subject to a contractual ceiling on the interest rate the issuer would have to pay. If the interest rate that would clear the market was greater than this maximum rate, the auctions “failed” and existing holders of the securities were forced to hold securities they wanted to sell and had previously thought were liquid. If the demand for an ARS was too low to clear the market, broker dealers sponsoring the auction could place bids just below the maximum interest rate to clear the auction. The lower the public demand for an issue, the larger the quantity broker dealers had to buy to avoid a failed auction. Participating broker dealers had better information than public investors about the creditworthiness of the ARS issuers and were the only parties with information about the broker dealers’ holdings and inclination to abandon their support of the auctions. In addition, brokerage firms involved in the auctions knew of temporary maximum rate waivers negotiated with the issuers and the ratings agencies that allowed auctions that would have failed in late 2007 to continue to clear. This severe asymmetry of information made public investors in ARS vulnerable to the brokerage firms’ strategic behavior. In this paper, we explain what auction rate securities were, how they evolved, how their auctions worked, and why their flaws caused them to become illiquid securities. I. Introduction Auction Rate Securities (ARS) were long-maturity floating rate securities issued by municipalities, closed-end mutual funds, structured finance trusts and corporations. Their coupon payments were determined within limits by supply and demand in periodic Dutch 1 © 2011 Securities Litigation and Consulting Group, Inc., 3998 Fair Ridge Drive, Suite 250, Fairfax, VA 22033. www.slcg.com. The primary authors can be contacted at [email protected] or 703-246-9381 and [email protected] or (336) 655-8718. We received helpful comments from Guohua Li, Joshua Mallett and Joseph Prendergast. 2 auctions held at intervals of 7, 14, 21, 28 or 35 days.2 At each auction, buyers and sellers were constrained to pay par value for the securities but could bid on the interest rate that would be paid by the issuer until the next auction. When an auction cleared, buyers paid the par value of the bonds, and received the (auction) market clearing interest rate at the next auction if there were sufficient buyers.3 As long as the ARS could be sold at the auctions, investors effectively held a short-term security. ARS were marketed by broker-dealers as liquid investments, alternatives to money markets, and cash-equivalent investments, but the design of the securities exposed investors to significant liquidity risk. In particular, ARS did not have a “put” feature that granted investors an option to force the issuer to buy the bond back at par, as is the case with true short-term securities such as variable rate demand notes or tender option bonds. It was only the continued success of the periodic auctions that created the appearance that these long- term securities were short-term securities.4 In a successful auction, a single market clearing coupon rate was determined that equated the amount of securities participants were willing to buy to the amount of securities participants were willing to sell. If there were insufficient buyers to clear the market at any coupon rate below the “maximum rate” specified in the security’s prospectus, the auction failed and the coupon was set to the maximum rate. This restriction on how high the coupon rate could be was economically equivalent to setting a floor on the price at which the bonds could be sold in the auction. In 2007 and 2008, the ARS were recognized to be worth less than this effective minimum price, the auctions failed and investors were stuck holding securities they couldn’t sell. Moreover, the way the maximum rate was determined was often complex and opaque. Thus, many investors would not have been able to tell when market clearing coupon rates were getting close to the maximum rate and therefore when auctions were close to failing. 2 In financial markets, Dutch auctions are also known as uniform-price or single-price auctions. In these auctions, each winning bid is filled at the lowest winning price (or highest winning yield). See Back and Zender (1993). 3 “Auction Rate Securities,” California Debt and Investment Advisory Commission, August 2004. 4 Adrian D’Silva, Haley Gregg and David Marshall, “Explaining the Decline in the Auction Rate Securities Market,” Chicago Fed Letter, November 2008. Auction Rate Securities 3 Prior to 2007, auction failures were infrequent. In August 2007, the market’s assessment of the risk in auction rate securities increased and some auctions failed as the interest rate that would clear the auction exceeded the maximum rates issuers and underwriters agreed would be paid. In the last half of 2007, the financial condition of monoline bond insurance companies that had guaranteed subprime mortgage backed securities deteriorated. These insurers also guaranteed municipal bonds, many of which were issued in ARS form. With the capital adequacy of the monoline insurers in doubt, investors increased their assessment of credit risk in municipal ARS. In addition, as financial conditions worsened generally, investors increased the liquidity premium they required to hold all but the safest, most liquid securities. In February 2008 the auction market failed en masse. As a result, the majority of ARS investors were unable to liquidate their holdings when they needed cash and suffered sizeable damages. The auction failures were not the result of dramatic contemporaneous market events. The design of auction rate securities and the manipulated implementation of the auctions led to auction failures. The coupon rates determined in ARS auctions were limited to a maximum rate (or cap) defined in each security’s prospectus. If the credit or liquidity risk of a particular ARS warranted a higher coupon rate than the maximum rate, the auction would fail. McConnell and Saretto (2008) found empirical evidence that auctions failed because of “maximum rates” that constrained the ARS coupons to be below what was required to compensate investors. Also, the broker-dealers that underwrote, distributed and remarketed ARS propped up auctions by bidding when the demand for particular ARS was too low to clear the auction at interest rates below the maximum rate allowed in the ARS’s prospectus.5 The repeated undisclosed involvement of the broker-dealers allowed auctions to clear that would have otherwise failed and gave ARS an artificial appearance of liquidity. In late 2007 and early 2008, broker-dealers saw their inventories of auction rate securities increase dramatically as the brokerage firms had to buy more and more of the securities to keep the auctions from failing. The issuers of some auction rate securities 5 In 2006, 15 broker-dealers settled with the SEC. The SEC found that the broker-dealers intervened in auctions to prevent auctions from failing without adequately disclosing their interventions, and that investors may have been unaware of the liquidity or credit risks associated with ARS because the broker- dealers prevented auctions from failing. See “15 Broker-Dealer Firms Settle SEC Charges Involving Violative Practices in the Auction Rate Securities Market,” SEC Press Release 2006-83. Securities Litigation and Consulting Group, Inc. © 2011. 4 temporarily waived maximum rates; without these waivers it would have been more costly for the brokerage firms to force the auctions to clear. When the brokerage firms ultimately withdrew their support for auctions there was a precipitous drop in liquidity for investors. If it were not for the brokerage firms’ non-public and increasing intervention in the auctions, investors would have been able to observe the ARS gradually become riskier and illiquid.6 Absent manipulation of the auctions, interest rates paid at the auctions would have increased gradually and auctions of the poorest ARS would have failed early. Then issuers of the higher quality ARS would have gradually redeemed the securities or would have permanently adjusted the maximum rate formulas to allow the auctions to clear. When auctions failed, some investors suffered significant damages. For example, while many auction rate securities issuers were forced to pay interest rates at or above market when auctions failed, student loan auction rate securities (“SL ARS”) issuers paid interest rates substantially less than what was required to compensate investors. Figure 1 reports the yield on AAA-rated, student loan asset backed securities (“SL ABS”). Figure 1. SL Asset Backed Securities yields7 and indicative SL Auction Rate Securities yields. 7% 6% 5% 4% 3% 2% 1% 0% Jul-08 Jul-07 Jan-09 Jan-08 Jan-07 Jun-09 Jun-08 Jun-07 Oct-08 Oct-07 Feb-09 Sep-08 Feb-08 Sep-07 Feb-07 Apr-09 Apr-08 Apr-07 Dec-08 Dec-07 Mar-09 Mar-08 Mar-07 Nov-08 Aug-08 Nov-07 Aug-07 May-09 May-08 May-07 Student Loan ABS Index 110% of 30-Day AA CP 6 In a Federal Reserve Board paper, Han and Li (2008) found that the withdrawal of support by broker- dealers resulted in the collapse of the ARS market and revealed the flawed design of the ARS product.