Types of Auction-Rate Securities

Auction-rate securities (ARSs) include municipal bonds, corporate bonds and preferred stocks with interest rates or dividend yields that periodically re-set through auctions, typically every seven, 14, 28 or 35 days.

ARSs are usually issued with intermediate to long-term stated maturities or with no stated maturity (perpetuity). They are typically of high-grade credit quality, but the credit quality may vary over time; especially in the current market environment, where many issuers are paying interest that is well above what they expected to pay and perhaps above their interest-paying capacity. Interest is paid in the current period based on the interest rate determined in the prior auction period.

The ARS market first developed in 1984 and subsequently grew to well over $300 billion, prior to the ARS market meltdown in February 2008. The securities were typically sold using a single broker-deal structure, where the same broker underwrote, ran and sold the majority of the auction. While early on the ARS market was created by corporate issuers (American Express being the first, in July 1984), as of year-end 2007, the market was dominated by municipal, student loan and closed-end fund issuers, representing $165 billion, $85 billion, and $63 billion, respectively.

Municipal Auction-Rate Securities

Municipal Auction Rate Securities (also referred to as MARS, municipal ARCS, or municipal auction rate certificates) were issued to fund specific projects such as bridges, buildings or sewers, or to provide general financing for counties, school districts, or other municipalities. They are often backed by monoline insurers to improve their credit ratings.

Generally, municipalities were the least well protected among the issuers from the consequences of auction failures. Many MARS issuers do not have favorable rate-caps or look-back provisions to limit their interest exposure, beyond those provided by state usury laws or similar provisions. As a result, once auctions began failing across the ARS market, MARS issuers were hit with very high penalty rates. Consequently, this segment has seen much lower failure rates than the overall ARS market and a more significant move than other issuers toward refinancing and redemptions. (For more on MARS valuation, click here).

Auction Rate Preferred Shares

Closed-end mutual funds issue Auction-Rate Preferred Shares (also referred to as ARPS or auction preferred shares (APS)) to enhance returns for their common shareholders. Closed-end funds may be unable to refinance (and redeem their ARPS at par) with debt, if doing so would clearly disadvantage their common shareholders. In addition, leverage requirements may in some cases be stricter for debt financing than for preferred equity financing. Nevertheless, many closed-end funds announced plans, shortly after auctions began failing, to refinance and redeem their ARPS. (For more on ARPS valuation, click here).

Student Loan Auction Rate Securities

Student Loan Auction Rate Securities (also referred to as SLARS or Student Loan ARS) are securitizations, typically of very large student loan pools, held in a trust estate. Active securitizers include Sallie Mae, non-profit specialized student loan lenders and for-profit lenders with roots in the non-profit sector. Student loans have historically had low expected losses and longer maturities than other loans. In addition, most student loans are guaranteed, often by the federal government.

Unfortunately, student loans have also historically had low profit margins. Thus, when the student loan securitization market began in 1992, it was critical that student loan pools be financed at low rates. As a result, SLARS have the most severe failure rate of all classes of auction-rate securities. In addition, SLARS issuers may have more limited options for refinancing than other issuers in the ARS market. SLARS, in other words, likely have among the poorest prospects for liquidity and tend to trade at significantly higher average discounts than MARS and ARPS. (For more on SLARS valuation, click here).

Other Auction Rate Securities

Auction-rate securities other than the three classes mentioned above include ARS issued by corporate issuers such as monoline insurance companies, and collateralized debt obligations (CDOs). This segment of the ARS market has experienced more significant concerns about credit quality than the other segments and in August 2007 was the first segment of the ARS market to begin experiencing wide-spread auction failures. These ARS issues, while a highly differentiated group, have very little buy interest and may, in many cases, trade at deep discounts from par (and generally at higher average discounts than the three segments discussed above). (For more on Other ARS valuation, click here).