The press in late February 2008 was high on auction rate securities (ARS). ARS refers to debt instruments with a long-term maturity tied to a short term interest rate. The broker-dealer submits a bid on behalf of investors, to the auction agent. The agent sets the next interest rate by determining the lowest rate to clear the total outstanding amount of ARS.
A failed auction occurs when there is lack of demand. Existing holders in a failed auction hold their positions at the maximum rate until sufficient bids are entered to set a clearing bid in the next auction. The holders may sell earlier at a discount. Otherwise, they must wait, making them unable to access their cash.
ARS are priced and traded as short term instruments because of the liquidity provided through the interest rate reset. Issuers of ARS include utilities, student loan finance authorities, municipalities. ARS may be rated with high credit quality.
When banks are not able to back auction rate securities, holders left with illiquid securities may file lawsuits against the credit raters who rated the securities with high ratings. There are issues relating to proper disclosures.
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