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SLCG Research: Auction Rate Securities

SLCG released today 'Auction Rate Securities'.

Auction rate securities were first issued in the mid-1980s by corporations. Over the next two decades ARS were issued widely by institutions ranging from closed-end mutual funds, municipalities to student loan trusts. ARS were long-term floating rate securities whose coupon payments were determined at auctions that were typically held every 7 to 35 days. ARS were long-term securities with short-term floating rates.

Broker dealers marketed ARS as liquid, short-term cash equivalents. However, ARS auctions failed en masse in February 2008 and proved to be illiquid and unsellable in the short-term.

In this paper, we explain what ARS were, how they evolved, how their auctions worked and how they auctions failed.

ARS were typically subject to maximum rates, which is a ceiling on the rate received by ARS investors. When ARS investors wanted rates higher than the maximum rate, auctions began to face the risk of failing. Unbeknownst to investors, broker dealers, in an effort to prevent auctions from failing, intervened in auctions by buying up excess supply at maximum rates and, at times, by waiving maximum rates to induce demand. When broker dealers suddenly gave up intervening in February 2008, auctions failed en masse, leaving ARS investors with long-term illiquid securities.

We conclude that the ARS were not liquid short-term cash equivalents. We also conclude that the inherent flaw of maximum rates contributed to the mass failures and that investors were exposed to the strategic behavior of broker dealers during the period leading up to the mass failures.