Auction Rate Securities

For an auction rate security the mechanism is the auction. Typical reset periods are 7, 28 and 35 days, and at each auction the rate for the next period is fixed. Because the rate keeps moving toward the short-term market, transactions in these securities are normally executed at a dollar price of par: the investor's return lies in the rate, not in a change of price. The auction process is designed so that holders can normally sell their positions at par in any auction. That design is the instrument's appeal and also its weakness, because the ability to sell at par depends on the auction attracting enough buyers.

The MSRB has described auction rate securities as primarily a retail product, and in 2008 it noted that the number of auction rate issues was relatively small, particularly when set against the variable rate demand obligation market, where an industry association put the count at some 16,500 outstanding transactions serviced by about 80 remarketing agents.

The Parties to an Auction Rate Program

Each programme has one auction agent, typically a bank. Rule G-34 defines the auction agent as the agent responsible for conducting the auction process on behalf of the issuer or other obligated person and receiving orders from dealers. The agent takes its orders from dealers and runs the auction according to the method set out in the programme documents.

Between the investors and the agent stand one or more program dealers. A program dealer is designated through an agreement with the auction agent and the issuer or other obligated person, and it solicits orders from investors who wish to own the securities over the next reset period. Rule G-34 defines a program dealer by what it does: it is each broker, dealer or municipal securities dealer that submits an order directly to an auction agent, whether for its own account or on behalf of another account, to buy, hold or sell an auction rate security through the auction process. A firm that hands its customer's order to a program dealer, rather than to the agent, does not become a program dealer by doing so.

The program dealers must submit their order information before the auction deadline. The auction agent then applies the programme's algorithm, returns the results to the program dealers, and the program dealers tell their bidders the outcome and which securities, if any, have been allocated to them.

The Orders an Auction Takes In

The auction method set out in the programme documents works from the total quantity of orders received in each order category. The typical categories are four. An existing holder may choose to hold at any rate the auction produces. A potential investor may bid to buy a stated amount of the securities, naming the minimum interest rate it will accept. An existing holder may choose to hold only if the auction produces a rate equal to or greater than a rate the holder names. And an existing holder may choose to sell a stated amount.

The conditional hold order is the one that changes character during the auction. Industry practice, as described to the SEC in 2010, is that when the rate falls below the rate a holder named in a hold-at-rate order, that order is automatically converted into a sell order. For that reason the MSRB dropped a proposed separate reporting category of orders to sell at a specific rate: hold-at-rate orders together with orders to sell at any rate already account for every sell order the auction receives.

How the Clearing Rate Is Found

The auction methodology is of a type similar to a Dutch auction. Using the orders submitted before the deadline, the auction agent's algorithm determines the lowest interest rate at which all of the securities offered for sale by current holders will clear the market. That rate is the clearing rate, and it then becomes the interest rate for all of the securities in the issue for the next reset period, not only for the securities that changed hands.

A simple illustration shows the logic. Suppose holders submit sell orders for 5 million dollars of a 20 million dollar issue, and buyers bid 2 million dollars at a minimum of 2.40 percent, 2 million dollars at 2.50 percent and 3 million dollars at 2.60 percent. At 2.50 percent the bids cover only 4 million dollars of the 5 million offered, so the securities do not clear at that rate. At 2.60 percent the bids cover more than the 5 million dollars offered, so 2.60 percent is the lowest rate at which everything offered for sale clears, and it becomes the rate on the whole 20 million dollars, including the holdings of investors who simply held at any rate.

The same illustration shows the risk carried by a hold-at-rate order. A holder who named 2.55 percent keeps its securities when the clearing rate is 2.60 percent, because the auction produced a rate at or above its floor. Had the clearing rate come out below 2.55 percent, its order would have become a sell order and added to the supply the bids had to cover.

The All-Hold Rate

Programme documents also provide for outcomes in which no clearing rate can be found through the normal process. One is the case in which every existing holder wants to hold at any rate. Nothing is offered for sale, so there is nothing for bids to clear, and the documents instead apply an all-hold rate.

The all-hold rate is usually set as a multiple of a market index, and it is designed to be lower than the rate that would normally be expected as a clearing rate. A holder who submits a hold-at-any-rate order therefore accepts more than the uncertainty of the auction: if every other holder does the same, all of them earn the all-hold rate for the period, a rate built to sit below an ordinary clearing result. When the rate is reported to the MSRB it carries a designation saying whether it is a maximum rate, an all-hold rate, or a rate set by auction.

Failed Auctions and the Maximum Rate

An auction can also fail. It fails if the auction agent does not receive enough bids to cover the aggregate amount of securities that need to be sold, or if the clearing rate would be above a maximum rate set in the programme documents. In a failed auction all existing holders keep their securities, including those who had asked to sell, and the rate for the next reset period is set at the maximum rate.

Like the all-hold rate, the maximum rate may be a multiple of a specified index, but it is designed to run in the opposite direction: it is normally set higher than the rate that would be expected in a successful auction. A failed auction thus does not stop interest from being paid. What it removes is the exit: holders who wanted to sell are not able to liquidate their positions at par through the auction, and they remain holders of the securities.

Some maximum rates cannot be worked out on the day of the auction, for example where the maximum rate for an auction rate security is determined through a clawback provision. In that case the dealer reports to the MSRB that the rate is not calculable. The exception does not reach maximum rates linked to an index or to a bank lending rate; those must be computed and reported. The MSRB's 2008 and 2010 filings gave LIBOR as the example of such a rate.

Auction Rate Securities Compared With Variable Rate Demand Obligations

A variable rate demand obligation is distinguished by a put or tender feature that lets holders tender their securities back, at par, to a representative appointed by the issuer on a periodic basis. It normally operates with a letter of credit or a stand-by bond purchase agreement designed to ensure liquidity, and its rate is typically reset by a dealer acting as remarketing agent at a rate that allows the securities to be sold at par. Rule G-34 defines the remarketing agent as the dealer responsible for reselling to new investors the securities that holders have tendered for purchase, and it defines the notification period as the advance notice period during which a holder may put the issue back to the trustee, tender agent or other agent of the issuer.

Auction rate securities are not characterised by, and generally do not have, put features or liquidity facilities. A holder of an auction rate security who wants par has only the auction and the bids it attracts; a holder of a demand obligation has a contractual right to tender, with a bank's facility behind it.

The difference shows in what happens when buyers disappear. Demand obligations held by the liquidity provider are known as bank bonds. The MSRB added a requirement to report the par amount of bank bonds precisely because, where a demand obligation is held entirely by its liquidity provider, the interest rate set on it is not set by market demand. The equivalent event for an auction rate security is a failed auction: the holders themselves remain in the securities at the maximum rate.

The 2008 Breakdown of the Auction Market

Since early 2008, the MSRB reported, downgrades of municipal bond insurers and other short-term liquidity concerns had created extreme volatility in the market for auction rate securities. The result was an unprecedented number of failed auctions, meaning that investors who chose to liquidate positions through the auction process could not do so.

The disruption pushed issuers and investors toward variable rate demand obligations, and interest in that market rose. But the same turmoil put heavy pressure on the supply of liquidity facilities on which demand obligations depend, and their rates became much more volatile. The MSRB's concern about the lack of information on auction rate securities therefore extended to demand obligations as well.

In commenting on the MSRB's 2010 proposals, an investor who held positions in two auction rate securities told the SEC that he had been unable to obtain certain information about them and argued that the lack of transparency created opportunities for manipulation and unfair dealing.

Why Trade Reports Did Not Reveal the Return

As short-term securities under Rule G-14 on transaction reporting, auction rate securities and demand obligations were already subject to slightly different reporting rules from other municipal securities. When the MSRB proposed its Real-Time Transaction Reporting System in 2003, it required trades to be reported no later than fifteen minutes after execution and customer trade reports to include both a dollar price and a yield. Dealers responded that their special processing methods for short-term variable rate securities made those requirements difficult or impossible to meet, and the MSRB gave these securities an end-of-day exception from the reporting deadline and allowed customer transactions in them to be reported without a yield.

The consequence was a blind spot. Trades in short-term variable rate securities normally execute at a price of par, and their current interest rates were not carried in the data sources used by RTRS or by the industry generally. A par price with no yield says nothing about what the investor earns, so the transaction reporting system gave no means of determining the return on these securities. The MSRB had acknowledged as much in 2003, saying it did not then plan to require reports of yields or reset rates on variable rate and auction rate products but would explore other ways to make those short-term rates transparent. By 2008 it was not aware of any ready source of reset information available to retail investors.

The SHORT System and Free Access Through EMMA

The answer was the Short-term Obligation Rate Transparency System, which Rule G-34 defines as a facility operated by the MSRB for the collection and public dissemination of information and documents about securities bearing interest at short-term rates. As the MSRB described the system in its 2008 and 2010 filings, information submitted to SHORT was to be processed on receipt and disseminated in real time, free of charge, on the MSRB's Electronic Municipal Market Access (EMMA) website, and the MSRB would not be responsible for the content of what submitters placed in it.

The 2010 filing set out the submission arrangements then in place. Only authorised submitters using password-protected accounts in MSRB Gateway could submit. The classes of submitter were program dealers, remarketing agents, auction agents and designated agents, and a designated agent could submit on behalf of a dealer or auction agent only if that party had designated it. Submissions could be made through a web-based form or by a computer-to-computer connection using XML files.

As described when the system was proposed in 2008, it was to check what it received in two different ways. Format edits would verify that required data elements were present in the correct form, and a submission that failed them would not be processed further. Content edits would test whether values fell within reasonable ranges, to catch input errors; a possible error would produce an error message describing the deficiency, but a submission that had passed the format edits would still be processed and disseminated. The time of receipt would also be recorded and compared with the deadline, and submissions arriving after it were treated as late.

What a Program Dealer Must Report After Each Auction

Rule G-34(c)(i) requires each program dealer to report, or ensure the reporting of, a defined set of information about the security and the results of each auction. It includes the CUSIP number; the interest rate the auction produced, with a designation of whether it is a maximum rate, an all-hold rate or a rate set by auction; the identity of every program dealer that submitted orders, including hold orders; the date and time of the auction; the number of days the new rate applies; the minimum denomination; any minimum and maximum rates; and the date and time the result was communicated to program dealers. Since the 2010 amendments it also includes the order data described below.

The designation is the item an investor reads first. A rate marked as the maximum rate tells the reader that the auction failed; a rate marked as an all-hold rate tells the reader that no holder offered securities for sale.

The deadline is 6:30 p.m. Eastern Time on the day the auction occurs, if that day is an RTRS business day. If any item is not available by then, it must be provided as soon as it becomes available. If the auction takes place on a day that is not an RTRS business day, the information is due by 6:30 p.m. Eastern Time on the next RTRS business day. Changes to information already submitted must be made as soon as possible.

Auction Agents, Designated Agents and Reliance on Reported Data

A program dealer may designate an agent to report for it, and an auction agent may submit information on the program dealer's behalf even without being designated. The MSRB expected most auction information to come from auction agents. Where an auction agent submits the information and correctly identifies the program dealer, the program dealer need not submit it again; where the auction agent fails to submit, the program dealer must, and if several program dealers are involved, each is responsible for seeing that the information is provided on time. The failure of a designated agent to comply is treated as the program dealer's own failure.

Because many of the reported items are produced by the auction agent, dealers cannot always verify them. The rule therefore provides that if the auction agent has reported the information within the required time, the program dealer may rely on its accuracy, provided the program dealer makes a good faith and reasonable effort to have the auction agent correct any inaccuracies known to it. The SEC's approval order explained that the same reliance extends to a dealer that itself forwards to SHORT the information it received from the auction agent, so long as it corrects inaccuracies it knows of and introduces no errors of its own.

Where an auction has several program dealers, each reports the order data only as it reflects that dealer's own involvement in the auction. A designated agent reporting for several program dealers reports the aggregate of all their involvement. A program dealer may rely on an auction agent's reporting where the agent has undertaken to report the information for all program dealers in the auction and the dealer has no reason to believe the agent is reporting inaccurately.

Bidding Information and Orders From Issuers

The 2010 amendments added what the MSRB called bidding information: the rates and aggregate par amounts of orders to hold at a specific rate, orders to sell at any rate and orders to buy, with the amounts of each that were executed or successfully held. The MSRB explained that this information would show, for example, how the rate was determined in a successful auction. It had first proposed that the bidding information be filed as a word-searchable document, but in response to comments it required the items to be reported as individual data elements, because separate data elements make it possible to compute statistics, such as a bid-to-cover ratio, that give meaningful information about the demand for a particular auction rate security.

The amendments also require two kinds of order to be shown separately. A program dealer must report the rates, par amounts and type of its own orders for its own account, buy, sell or hold, and the amounts of each type executed. And the orders of the issuer or conduit borrower of the security must be reported as well.

The issuer orders raised a practical problem. Some issuers and conduit borrowers place their orders through a third party, such as an investment adviser or a registered representative, so the program dealer receiving the order may not know whose it is. The MSRB therefore added a requirement that any dealer submitting an order to a program dealer on behalf of an issuer or conduit borrower of the security must disclose that fact at the time it submits the order. It also dropped a proposed requirement to show whether issuer orders were executed, because a program dealer could not reliably know that where a third-party dealer had submitted several orders and only some were filled.

Auction Procedure Documents

Rule G-34(c)(i)(B) requires each program dealer to submit to the MSRB the current documents setting out the auction procedures and interest rate setting mechanisms for each outstanding auction rate security for which it acts, and to submit any new, amended or later versions no later than five business days after they are made available to it. The submissions are made electronically to SHORT in a designated electronic format.

The MSRB had first proposed a deadline of one business day for new or amended documents. An industry association argued that this was unduly burdensome for documents to which the dealer is not a party and which reach dealers in no uniform way, and the MSRB settled on five business days, consistent with the timeframe for submitting advance refunding documents to it. For documents on existing programmes the MSRB allowed ninety business days, citing the number of documents involved and the time dealers might need to obtain them from third parties, and the SEC found that period reasonable; the rule text now states a fixed date for those current documents, September 22, 2011.

Two practical rules accompanied the requirement as the MSRB described it in 2010. Where an auction had several program dealers and one had already submitted a document, the others could identify the document already in the system instead of filing a duplicate. And because many documents for outstanding securities were old and might not exist in electronic form, the requirement that documents be word-searchable files applied only to new or amended documents produced after the rule took effect. The obligation for auction documents is also stated without qualification: a remarketing agent for a demand obligation need only use best efforts to obtain its liquidity facility documents and file a notice when it cannot, but a program dealer carries no comparable best-efforts language for auction procedure documents.

Why Auction Rate Reporting Started First

The MSRB filed the SHORT proposal on November 18, 2008, and the SEC approved it on January 7, 2009. All three commenters asked for more time. The MSRB kept January 30, 2009 as the effective date for auction rate securities but moved the date for variable rate demand obligations to April 1, 2009.

Its reasons turned on the two markets' size and their investors. Because the number of auction rate issues was relatively small, dealers whose automated systems were not ready could report auction results manually through the SHORT web interface; and because auction rate securities are primarily a retail product, the MSRB considered it important to make them transparent as early as possible. Manual reporting was impractical for demand obligations, given their large number and how often their rates reset, so they were given more time to build automated submissions. The SEC agreed that no delay was warranted for auction rate securities, because the dislocations in that market made price transparency necessary as soon as possible.

Common Errors and Exam Traps

The first trap is to treat an auction rate security as a short-term security. Its maturity is long; only its rate is short-term. The second is to assume a holder can always get par. Par is available only when the auction clears; in a failed auction holders keep their securities and earn the maximum rate.

A third is to confuse the all-hold rate with the maximum rate. Both are fallback rates and both are often a multiple of an index, but the all-hold rate applies when no one sells and is designed to be low, while the maximum rate applies when bids are insufficient or the clearing rate would exceed it and is designed to be high. A fourth is to think the clearing rate is paid only to new buyers; it applies to every security in the issue for the next period.

A fifth is to attribute a put or a liquidity facility to an auction rate security. Those are the marks of a variable rate demand obligation. A sixth is to think that a firm becomes a program dealer by accepting a customer order for an auction; the definition turns on submitting orders directly to the auction agent.

Examination Relevance and Key Takeaways

Auction rate securities bring together several recurring examination themes: the difference between a security's maturity and its rate reset period, the mechanics of an auction that sets one rate for an entire issue, the meaning of liquidity for an investor whose exit depends on other people's bids, and the post-crisis transparency regime built around Rule G-34(c), SHORT and EMMA.

The key points to retain are these. The clearing rate is the lowest rate at which all securities offered for sale clear, and it applies to the whole issue. An all-hold rate applies when every holder holds at any rate; a failed auction leaves holders in place at the maximum rate. Auction rate securities generally have no put and no liquidity facility. Program dealers report each auction's results by 6:30 p.m. Eastern Time on an RTRS business day, may rely on an auction agent's timely report while correcting known errors, and file auction procedure documents no later than five business days after new or amended versions are made available to them.