Auction-Rate Securities: Bidder's Remorse?

By Stephanie Lee

Auction-rate securities (ARS) are long-term variable-rate instruments with their interest rates reset at periodic and frequent auctions. They are often marketed to issuers as an alternative variable-rate financing vehicle and to investors as a "higher-yielding cash alternative." Investors have historically been able to liquidate ARS positions at face value at frequent auctions, leading many to consider them cash-like. After hundreds of auction failures in February 2008, however, the Wall Street Journal declared that the ARS market had "virtually collapsed."

Recent media coverage has pointed to broker-dealers withdrawing support from this market. Many articles have discussed credit rating downgrades of monoline insurers. In this paper, NERA Senior Consultant Stephanie Lee argues that the auction-rate market encompasses securities and issuers of varying characteristics and that an understanding of recent events requires detailed analyses of these characteristics. The paper explores the evolution of auction-rate securities in depth, from their creation in the mid-1980s through continued market developments in the 1990s and 2000s, up through the present crisis. Ms. Lee then explains the "Dutch auction" process as well as the responses to auction failures by a number of key participants, including issuer restructuring, corporate write-downs, and litigation.

This paper has been published in the October 2008 issue of Pratt's Journal of Bankruptcy Law.