Background
The first auction rate security for the tax-exempt market was introduced by Goldman Sachs in 1988. However, the security was invented by Ronald Gallatin at Lehman Brothers in 1984.
Auctions are typically held every 7, 28, or 35 days; interest on these securities is paid at the end of each auction period. Certain types of daily auctioned ARSs have coupons paid on the first of every month. There are also other, more unusual, reset periods, including 14 day, 49 days, 91 days, semi-annual and annual. Non-daily ARS settle on the next business day, daily ARS settle the same day.
As bank loans became more expensive, the auction market became increasingly attractive to issuers seeking the low cost and flexibility of variable rate debt. Buyers received a slightly higher interest and an apparent assurance of liquidity through the auction process.
By early 2008 the ARS market had grown to over $200 billion, with roughly half of the securities owned by corporate investors. Because of their complexity and the minimum denomination of $25,000, most holders of auction rate securities are institutional investors and high net worth individuals.
In February 2008, the auction market failed, and most auction rate securities have been frozen since then, with holders unable to dispose of their securities. Investment banks that participated in the distribution and marketing have agreed to repurchase around $50 billion in securities from investors, including municipalities, under duress of investigations by U.S. state attorneys general.
Student loan auction rate securities (SLARS) make up a large percentage of the ARS market.
Read more about this topic: Auction Rate Security
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