If you read financial news on a regular basis, or if you are an investor in financial markets, or if you simply know someone who does, you have probably heard something about a crash in the auction rate securities (ARS) market.
However, unless you are unusually well-versed in the realm of finance or are a participant in the ailing auction rate market yourself, news about the ARS crisis may not be very informative or interesting, particularly when compared to the arrest of two major ex-Bear Sterns hedge fund managers.
And yet, the two topics are, in many ways, related to one another -and not just because they both concern the financial industry.
What are Auction Rate Securities? Auction rate securities are long-term bonds with variable interest rates which are reset periodically at auction.
At these auctions, a new interest rate, known as the clearing rate, is determined by finding the lowest interest rate at which there are enough buyers to purchase all available shares.
Though long-term bonds are often very illiquid, the auction rate system allows transactions to take place every 7, 28, or 35 days, creating an artificially liquid arrangement for investors to take advantage of.
Why Did the Market Fail? The ARS system is far from flawless.
In order for auctions to succeed, there must be enough bids to determine a clearing rate.
If there are insufficient bids, the auction fails.
To prevent such an occurrence, the broker-dealers who are in charge of running ARS auctions have also historically opted to also bid in their own auctions to provide a buyer for otherwise unwanted shares.
In early 2008, broker-dealers were under great financial pressure.
After sustaining heavy losses in the subprime loan market, many were unwilling or unable to support the auction rate securities market.
Furthermore, the steady decline in the credit ratings of bond insurers made many broker-dealers nervous about the reliability of the ARS bonds they backed.
In February, dozens of major broker-dealers and investment banks abruptly pulled their funding from ARS auctions, causing a chain reaction of auction failures which shut down the $300 billion market within weeks.
Investor and Regulatory Agency Response After the auction rate market collapsed, investors were outraged by the loss of liquidity they suffered, and sought to hold investment firms responsible for the promises they made regarding ARS stocks and bonds.
Reacting to this public outcry, several government regulatory agencies and state governments also launched investigations into the marketing and business practices of major investment firms, seeking to determine if they had fraudulently sold auction rate securities to investors.