Auction Rate Security - Overview

Overview

The interest rate on ARS is determined through a Dutch auction process. The total number of shares available to auction at any given period is determined by the number of existing bond holders who wish to sell or hold bonds only at a minimum yield.

Existing holders and potential investors enter a competitive bidding process through broker/dealer(s). Buyers specify the number of shares, typically in denominations of $25,000, they wish to purchase with the lowest interest rate they are willing to accept.

Each bid and order size is ranked from lowest to highest minimum bid rate. The lowest bid rate at which all the shares can be sold at par establishes the interest rate, otherwise known as the "clearing rate". This rate is paid on the entire issue for the upcoming period. Investors who bid a minimum rate above the clearing rate receive no bonds, while those whose minimum bid rates were at or below the clearing rate receive the clearing rate for the next period.

Many financial services companies have been involved in packaging a collection of similar instruments, such as municipal bonds, into closed funds that were sold as both preferred and common shares. One of the largest issuer of auction rate securities was NUVEEN Investments, which since the failure of the auction market has begun to provide disclosure on their website. These funds were then labeled with names, such as "MuniPreferred", and actively marketed by brokers, such as TD Ameritrade. According to multiple reports, these were widely sold as "cash equivalents", such that the cash would be available for return within as little as 7 days. However, once the auctions were abandoned by the banks, thousands of investors were left with these illiquid funds since February 2008, without knowing when their cash will be returned.