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Explaining the decline in the auction rate securities
by Adrian D’Silva, vice president, Financial Markets Group; Haley Gregg, former associate economist,
Financial Markets Group; and David Marshall, senior vice president, Financial Markets Group

Auction rate securities are an example of a relatively obscure financial market
instrument that has been caught up in the recent negative sentiment affecting
the financial markets. This article examines these securities and sheds some
light on recent events.
Until recently, the market for auction rate securities (ARSs) was a thriving, if little-known, segment of the capital
markets. Auction rate securities are long-term securities, but with time-varying interest rates that are reset periodically via
an auction process. As U.S. financial markets have struggled to absorb the problems of subprime mortgages and
tightened credit conditions, the ARS market has attracted a good deal of negative attention. Auctions to reset the rates
of these instruments repeatedly failed, resulting in numerous lawsuits in which ARS investors claimed that the nature
of the risks of these securities had been misrepresented.1 The U.S. Securities and Exchange Commission (SEC) and
several state attorneys general have also initiated investigations of several major underwriters of ARSs. These
developments are but one example of a relatively obscure portion of the capital markets falling victim to the recent
credit crisis.
In this article, we describe these securities and the market in which they operate. We then examine the collapse of this
market, starting in February of 2008, and the aftereffects that are still being felt.
What are auction rate securities?
The ARS market started in 1984 as an alternative to long-maturity debt for entities needing long-term funding. The
market for these securities expanded significantly during the current decade and was estimated to have reached about
$330 billion in 2007. The idea behind an ARS is to create a funding instrument that behaves like a long-term bond for
the issuer but resembles a short-term security, such as commercial paper, for the investor. Specifically, ARSs are
long-term securities (typically 20 years or longer), but with interest rates that are reset at fixed intervals through a socalled Dutch auction, which we describe later. These interest rate resets are typically done at intervals of one, four,
five, or seven weeks, although other reset intervals are possible. When functioning as designed, these periodic
auctions give the bonds a degree of liquidity comparable to very short-term assets. Because of the frequent interest
rate resets, ARSs normally trade at close to par value (the face value or issue price of the bond). Often, an ARS
includes a provision that allows the issuer to convert the ARS to a more conventional long-term security, such as a
fixed-rate bond.
Historically, ARSs have usually been issued by municipalities, student loan finance authorities, and other tax-exempt
entities. Prior to the recent financial turmoil, most municipal ARSs earned high credit ratings from the rating agencies,
often benefiting from credit enhancement in the form of insurance. Another important class of ARS issuers is closedend mutual funds. These mutual funds use auction rate debt as a way of enhancing returns via leveraging.
The auction process
The interest rate on ARSs is reset through an auction process. In this auction, securities are supplied to the auction by
existing holders of the ARS issue who wish to sell. Potential purchasers (including existing holders who wish to
reinvest) bid for securities by specifying both the quantity of securities they wish to buy and the minimum interest rate
they will accept. The lowest rate that clears the market is called the “clearing rate.” The entire supply of securities is
allocated to those bidders who specified a minimum acceptable interest rate at or below this clearing rate. (If the total
number of bids at or below the clearing rate exceeds the quantity of securities offered for sale, the bids at the clearing rate
are allocated on a prorated basis.) These investors all receive the clearing rate, regardless of the specific rate they bid. No
securities are allocated to bidders who specified a minimum rate above the clearing rate. If the auction process works
correctly, it gives ARSs a high degree of liquidity for investors, since the investors can choose to redeem their ARS
holdings at par at the next scheduled auction.

While ARSs are clearly long-term bonds, these periodic auctions allowed holders to treat them as short-term securities.
As described in a newsletter from August 2004 published by the State of California, “[Auction rate securities] are priced
and traded as short term instruments because of the liquidity provided through the interest rate reset mechanism.”2
Indeed, the investors (typically high-net-worth individuals and corporate treasurers) viewed these instruments mainly
as a vehicle to park short-term cash. One of the keys to the growth of this market was the belief on the part of investors
that these instruments were the equivalent of a money market fund. In the earlier years of this market, most buyers
classified ARSs for accounting purposes as cash equivalents. Starting in 2005, the Big Four accounting firms3 required
their clients to reclassify ARSs as short-term, and, in a few cases, long-term holdings per FAS (Financial Accounting
Standard) 95.4 However, many financial service firms continued to show ARSs on client statements as cash equivalents,
in violation of FAS 95.
Failed auctions
An auction fails when there are insufficient bidders to cover the number of securities offered for sale. In this case, the
securities are priced at a penalty rate as specified in the prospectus. The penalty rate typically equals the state usury
maximum or a certain spread over a reference rate (generally the London interbank offered rate, or Libor). Failed
auctions result in the investors’ not being able to redeem their money and the issuer paying a higher rate.
Before the recent turmoil, auctions for ARSs rarely failed. In part, this was because the banks that specialized in
running auctions would step in with their capital to prevent failures when bidding faltered. Starting in fall 2007, there were
anecdotal reports that these banks—as they suffered significant credit losses and mortgage write-downs stemming
from the subprime mortgage collapse—were less willing to commit their money to supporting auctions in danger of
By February 2008, fears of auction failure became self-fulfilling as potential investors withdrew from the ARS market.
The resulting widespread auction failures significantly increased borrowing costs for many municipalities and corporate
entities. For example, following a failed auction on February 12, 2008, the interest rate on the New York Port Authority’s
ARS issues jumped up to 20% from 4.3%.5 Although that rate subsequently came back down to 8%, it remained significantly
higher than it was before the market turmoil. Similarly, rates on auction rate debt of University of Pittsburgh Medical
Center topped 17% the week ending February 15, 2008, following a failed auction. During this period the ARS market
displayed chaotic behavior, with significantly different rates produced for virtually identical ARSs. For example, the East
Bay Municipal Utility District in California issued two ARSs with virtually identical terms, except for the original
underwriter—one was underwritten by Merrill Lynch, the other by Citigroup. On February 19, 2008, the reset auction
for the Merrill Lynch issue produced a clearing rate of 7.98%, while that for the Citigroup issue produced a clearing rate
of 5%. (The previous week’s auctions for the same securities had produced interest rates of 4.25% for the Merrill issue
versus 7% for the Citigroup issue.)6
These examples of higher ARS rates due to failed auctions illustrate a more general pattern: The average spread
between the one-month ARS rate and the one-month Libor has increased markedly during the recent market turmoil, as
can be seen in figure 1, Prior to the onset of the crisis, the average ARS rate was about 175 basis points below the Libor.
Once the turmoil started, this pattern reversed. The rates converged on January 9, 2008, and subsequently the average
ARS rate exceeded the Libor—a historical anomaly. In the course of the turmoil, the Libor fell by about 300 basis points as
the U.S. Federal Reserve eased monetary policy, while the average ARS rate rose by about 200 basis points. The
ARS rate peaked in mid-March around the time of the near collapse of investment bank Bear Stearns. While this rate
fell somewhat thereafter, as of mid-August, the ARS rate was still about 80 basis points above the Libor, a very large
spread by historical standards.
The rash of failed auctions in the ARS markets starting in February 2008 has prompted issuers to consider a variety of
potential solutions, including: finding buyers for ARSs in the secondary market;7 converting ARSs to variable-rate demand
notes; and replacing ARSs with short-term debt funding. These efforts have met with limited success. In addition,
some closed-end mutual funds with ARS liabilities sold other fund assets to raise money for auction rate redemptions.
As the number of failed auctions rose, the value of these securities fell, with many dealers marking down the value of
these securities on client statements by amounts ranging from 10% to 50% over the past few months.
The failure of the ARS market has affected many different sectors of the economy. In particular, it has put additional
pressure on the already stressed municipal bond market. In addition, ARSs were a preferred funding vehicle for many

state student loan organizations. The collapse of this market has limited the amount of loans available for the coming
school year.
Legal developments
Even before the recent financial turmoil, practices in the ARS market were subject to scrutiny from the SEC, which regulates
securities markets. In May 2006, the SEC levied fines of $13 million against 15 broker–dealers8 for auction practices
that were not adequately disclosed to investors, which constituted violations of securities laws. Among the violations listed
were: 1) interventions in auctions to prevent failed auctions without adequate disclosure, and 2) illegal allocation of
securities. In particular, it was charged that certain respondents “exercised discretion in allocating securities to investors
who bid at the clearing rate instead of allocating the securities pro rata as stated in the disclosure documents.”9
Following these actions, SIFMA (the Securities Industry and Financial Markets Association) issued a “best practices”
document.10 The best practices dealt with the mechanics of the auction process, but also stressed the need to educate
both issuers and investors about the material features of auction rate securities.
Not surprisingly, the failure of the ARS market in February 2008 has increased the pace of legal action, mainly
lawsuits by investors against ARS brokers and funds. The main thrust of these lawsuits is that “broker–dealers and
materially misrepresented the liquidity and risks of the auction rate securities to individual investors and corporations
by labeling these securities as ‘cash equivalents,’ in press releases, monthly account statements, individual
communications with investors, and other investment guidance material.”11
In addition many state securities regulators and state attorneys general have filed civil fraud charges against ARS
dealers. These investigations involve allegations that dealers were misrepresenting ARSs as cash-equivalent securities
and failed to disclose the risks associated with potential auction failure. For example, the attorney general of New York
charged investment bank UBS with “falsely selling and marketing auction rate securities as safe, highly liquid, and cashequivalent securities.”12 As a result of these investigations, some firms have been subjected to fines and have agreed to
buy back the securities from investors at par value. Specifically, starting in early August 2008, UBS, Citigroup,
JPMorgan Chase, Morgan Stanley, Wachovia, and Merrill Lynch, among others, have announced agreements to pay
fines and buy back a total of $56 billion of these securities. In addition, the State of Massachusetts announced
settlements in mid-August with UBS and Merrill Lynch. A number of other investigations by various state and national
entities, including the
Financial Industry Regulatory Authority and the attorneys general of Mississippi and Alabama, are ongoing.
Auction rate securities represented an ingenious attempt to square a particular financial circle: to create a funding
instrument that appears long term from the borrower’s perspective but short term from the lender’s perspective. We
now see what should have been obvious before: Such an arrangement is impossible. If a funding instrument is long
term for one party, it also must be long term for the counterparty; any appearance to the contrary must be an illusion.
The collapse of the ARS market is but one example of how the recent liquidity crisis in our financial markets has
adversely affected all arrangements that funded long-term investments with short-duration liabilities. Because such
arrangements are inherently unstable, their failure can cause great discomfort for borrowers or lenders or both.

A Texas law firm even started a website ( in an effort to find potential


Douglas Skarr, 2004, “Auction rate securities,” California Debt and Investment Advisory Commission, issue brief,
August, available at


The Big Four accounting firms are
Deloitte Touche Tohmatsu,
PricewaterhouseCoopers, Ernst and Young, and KPMG.


FAS 95 was set by the Financial Accounting Standards Board (FASB)—the designated organization in the private sector
for establishing standards of financial accounting and reporting. The FASB’s standards are officially recognized as
authoritative by the SEC. See


Martin Z. Braun, 2008, “Auction-bond failures roil munis, pushing rates up,”, February 13,
available at 20601087&sid=aVE0T47ZqK5c&refer=home.


Floyd Norris, 2008, “Auctions yield chaos for bonds,” New York Times, February 20, available at 20/business/20place.html.


A secondary market is a market where an investor purchases an asset from
another investor rather than from the original issuer.


See the SEC’s press release, No. 2006-83, available at 2006/2006-83.htm.


See the SEC’s administrative proceeding file, No. 3-12310, available at litigation/admin/2006/338684.pdf.






See 2008/jul/july24a_08.html.

Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102