Auction rate securities (ARS) are financial instruments used by companies or municipalities in the United States. They are typically long-term (20-30 years) bonds with variable interest rate, the rate is set at regular auctions.
These bonds were first marketed in 1988 by the U.S. bank Goldman Sachs. Bidders for these loans (lenders) are usually institutional investors, but also a number of individuals.
Failed auctions can occur, for example, if the bidders have concerns about the creditworthiness of the issuer and therefore abstain from making offers.
Furthermore, it could also be that the bidders invest their money in other financial instruments promising higher profits (because the maximum interest rate of borrowing, for instance, could be below market interest rates).
A Dutch auction procedure is used in the determination of the interest rate on auction rate securities. While the sum of shares available to auction at any given time is dictated by the number of bond holders ready to dispose or keep bonds on a minimum yield basis.
Current bond holders and potential investors embark on a bidding process, buyers typically stipulate the number of shares they intend purchasing, accompanied by the minimum interest rate they are going for.
Every bid and order size is rated accordingly using the above variables. The clearing rate (interest rate) is formed by the lowest bid rate at which all the shares can be traded. Investors bidding a lower limit rate beyond the clearing rate obtain no bonds, at the same time bidders whose minimum bid rates equal or fall beneath the clearing rate obtain the clearing rate for the next period.
In August 2008, one of the major banks committed themselves in a settlement with the Securities and Exchange Commission (SEC), to withdraw consent on retail investors’ bonds worth billions and to pay a penalty for false statements in marketing of financial products to the SEC.
The repurchased bonds thus went into the ownership of banks. There, the bonds unless the debtor must declare bankruptcy or the bank may resell the bonds again in an auction, normally remunerated with the maximum possible rate.
If a bond worth one billion dollars falling under a period of twenty-eight days is offered for auction, market participants commit components of that one billion for each bid on particular interest rates.
A company or municipality that has issued the bond has to pay in this case to all bidders the interest rate of 5.20%. Bidders who would have initially been content with a lower interest rate of (say) 4.80%, will have therefore made a surplus. The interest rate determined in the auction is now in effect until the next periodic auction. The interest payment date is governed by the terms of the loan, but it will be at least one interest account for each auction period.
In this example, the bids from the lowest to the highest bidder are processed until the credit amount applied is over one billion dollars. Tenderers of rates 4.80% to 5.07% would receive a 100% allocation, while tenderers at 5.20% obtain a 40% allocation. All bidders with bids greater than 5.20% will therefore not receive loans.