Auction rate security

Auction rate securities are a financial instrument, which is normally used by companies or municipalities in the United States. It involves long-running (usually 20 to 30 years ) bonds with floating ( up limited ) interest rate. The amount of this interest rate is fixed at regular auctions. The period between the sale is regulated differently depending on bond and can be any length, but are typical 7 or 28 days. These bonds were first marketed in 1988 by the U.S. bank Goldman Sachs

Market

In the U.S., there was the beginning of 2008 a market for auction rate securities with a volume of about 330 billion U.S. dollars. Publisher of these bonds ( borrowers ) with variable interest rate were generally larger companies or municipalities. Bidder for these bonds ( lenders ) were usually institutional investors, but also many individuals. The loan amounts are normally traded in installments of 25,000 U.S. dollars.

Auction procedure

For example, a bond of 1 billion U.S. dollars for the period of 28 days for auction, giving market participants for partial sums of a billion each bids at certain interest rates. This could be the following bids:

  • 200 million U.S. dollars to 4.80%
  • 100 million U.S. dollars to 4.83%
  • 300 million U.S. dollars to 4.91%
  • 200 million U.S. dollars to 5.07%
  • 500 million U.S. dollars to 5.20%
  • 800 million U.S. dollars to 5.33%
  • 900 million U.S. dollars to 5.40%

In this example, the commands would be executed as long as from the lowest to the highest bidder until the loan amount over 1 billion U.S. dollars has been applied. Bidders from 4.80 % to 5.07% so would get a 100 % allocation, the tenderers at 5.20% given a 40 % allocation. All bidders with bids greater than 5.20% did not receive any loans.

Interest payment

The company or local authority, which has issued the bond, must pay in this case to all bidders the interest rate of 5.20 %. Bidders who would have been happy with a lower interest rate (eg 4.80% ), have thus obtained an additional consumer surplus. The determined in the auction rate is now valid until the next periodic auction. The interest payment date is governed by the terms of the bond, but it takes at least an interest settlement per auction period instead.

Failed auction

Walking at an auction insufficient bids for a bond a, then one speaks of a failed auction. For failed auctions may occur for example, when the tenderers have concerns about the creditworthiness of the issuer and therefore do not offer. Furthermore, it could also be that bidders invest their money in other, higher profits promising financial instruments (because the maximum interest rate of the bond, for example, under the prevailing market rates is ).

The interest rate will be set at such an auction to the maximum permissible value. This is governed by the terms of the bond.

Since the bonds usually still run over many years / decades, remain in such a case, some "old Bidder" on their bonds sit. Although the bonds are not worthless, but as long as there are no new bidders, remain the "old Bidder" owner of the bond and receive only the interest payments at the maximum possible rate. Only after the bond expires they get their capital back given ( the debtor's solvency required).

Market turbulence in 2008

From 1988 to early 2008, there were almost never failed auctions, as the mediator of this form of financing ( mediators were almost exclusively the large U.S. banks ) almost always have yourself on the bonds at an interest rate slightly below the maximum interest rate to offer. For the market for institutional investors and individuals became very illiquid because they could sell their bonds to each auction date with almost 100 percent certainty again.

But when these big banks fell in early 2008 due to the financial crisis starting in 2007, even in distress, they were no longer in a position to bid at the auctions. At the same grip on the market a general fear of unsecured loans to themselves, so suddenly barely bidder for these types of loans were available.

As a result, the interest rates for borrowers jumped abruptly to the maximum possible amount, and the "old Bidder" were no longer able to make their short term liquid capital given.

Comparison with regulatory authorities

The U.S. Securities and Exchange Commission and regulatory authorities in several U.S. states instituted as a result of this development against a number of participating banks investigation, since the banks had to tenderers sells the investment in auction rate securities as liquid money system.

In August 2008, the major banks relented and pledged in a settlement with the SEC and the regulatory authorities to withdraw billions of dollars in bonds by investors willing to sell and also pay a fine for false information upon sale of financial products to the SEC to be paid.

The repurchased bonds go thus into the possession of the banks. There the bond as long as the debtor must not declare bankruptcy or the bank's bonds can continue to sell in an auction again, normally bear interest at the maximum possible rate of interest.

Currently, the following banks have accepted the following repurchases and fines:

  • UBS buys back bonds worth about 19.4 billion U.S. dollars and accepted a fine of 150 million U.S. dollars.
  • Merrill Lynch buys back bonds worth about 12.0 billion U.S. dollars and accepted a fine of 125 million U.S. dollars.
  • Wachovia buys back bonds worth about 8.5 billion U.S. dollars and accepted a fine of 50 million U.S. dollars.
  • Citigroup buys back bonds worth about 7.4 billion U.S. dollars and accepted a fine of 100 million U.S. dollars.
  • Morgan Stanley buys back bonds worth about 4.5 billion U.S. dollars and accepted a fine of 35 million U.S. dollars.
  • J. P. Morgan buys back bonds worth about 3.0 billion U.S. dollars and accepted a fine of 25 million U.S. dollars.
  • German bank buys back bonds worth about 1.0 billion U.S. dollars and accepted a fine of 15 million U.S. dollars.

Swell

  • Interest-bearing securities
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