Definition of Auction Rate Bonds
An auction rate security (ARS) is a bond with a long-term nominal maturity but for which the interest rate is regularly reset through what's known as a "Dutch" auction. The interest set through such an auction is referred to as that security's clearing rate.
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Mechanics
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The Dutch auction employed to reset ARS interest rates is a competitive bidding process in which potential buyers specify both the number of shares and the lowest interest rate they're willing to accept. The bids are ranked from lowest to highest minimum bid rate, and the interest rate established by the process is the clearing rate --- that is, the lowest bid rate at which all the shares can be sold at par. If there are more bids at the clearing rate than necessary to distribute all the securities for sale, the securities not allocated to the lower bidders are distributed among the clearing rate bidders on a pro rata basis. Thus, would-be investors who bid above the minimum rate receive no bonds.
Investors
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Both high-net-worth individuals and institutions invest in ARS. Money market funds cannot invest in these instruments because a Securities and Exchange Commission (SEC) rule restricts them to securities with a maturity of 307 days or less, as of October 2010.
As a new auction date approaches, an investor holding ARS might "hold at market," that is, hang on to the existing position regardless of the new interest rate; "hold at rate," meaning to participate in the auction and specify either the existing rate or some other as a new minimum rate; or sell regardless of the interest rate set at the auction.
The "hold at rate" decision could have the effect of a sell. If the holder specifies a minimum rate that turns out to be higher than the clearing rate, then the holder has failed to win at the auction and its securities are sold.
The regular opportunity to sell, and the routine way in which auctions proceeded to successful conclusions for many years, together gave the ARS market its reputation until February 2008 as a highly liquid cash equivalent.
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Failed Auction
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It has always been implicit in the system that an auction could fail, due to the absence of sufficient demand to establish a clearing price. In such a case, existing bondholders would have to hold their positions, and issuers would receive the maximum rate of interest set in an official statement, aptly known as the "fail rate."
Broker Interventions
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Failed auctions were rare prior to late 2007. But they weren't rare because the mechanism was functioning smoothly: Failures were kept rare because the broker-dealer sponsoring the auction would often step in and make its own bid, establishing a clearing rate where there would otherwise have been a failure.
A study for the Federal Reserve published in October 2008 indicated that in the "pre-crisis periods" the broker-dealers routinely bought undersubscribed sell orders at auctions and sold them in the secondary markets during the period between auctions.
History
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The failed auction of February 2008 was a key part of the lead-up to the worldwide financial crisis in the autumn of 2008. According to a story in "The New York Times" on February 15, 2008, nearly 1,000 auctions failed in the second week of that month, and banks --- including Lehman Brothers, Merrill Lynch and Goldman Sachs --- told investors their cash was frozen. These investors included such major corporations as Bristol-Meyers, JetBlue and Palm, Inc.
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