Auction Rate Securities

Auction Rate Securities

Auction rate securities are long-term investments that act as short-term investments due to periodic auctions that frequently reset the interest rate. When functioning efficiently, auction rate securities offer highly liquid short-term investments and the option for investors to sell their securities back at par value. Although, inefficiency of the ARS market subsequently led to demand not meeting supply. Thus, eventually leading to asymmetrical information, and a vastly uncertain liquidity risk, for brokers and investors alike. The development of ARS was largely in part due to a steeply increased inflation rate in the late 1970s and early 1980s.        

To reduce the high inflation of the late 1970s and early 1980s, the Federal Reserve raised the target Federal Funds rate. The Federal Funds Rate is the interest rate at which US depository institutions make overnight loans of deposits held at the Federal Reserve to other depository institutions (Smith 1). The inflation rate rose to almost 20% by the early 1980s (see Figure 1).  The sharply increasing rate resulted in a dramatic increase in borrowing costs for many institutions. In response, there was a high demand for variable-rate and potentially cheaper financing alternatives. Consequently, investment banks began devising new and complex financial instruments, such as Auction Rate Securities.  In 1984, Ronald Gallatin invented ARS while working at Lehmann Brothers. Initially known as “periodic auction asset securities”, auction rate securities were first introduced by Goldman Sachs in 1988.  ARS were marketed by broker-dealers as liquid investments, alternatives to money markets, and cash-equivalent investments, characteristics that allowed ARS to surge to a $330 billion dollar market by 2007 (Austin 1).  The ARS market was largely comprised of municipal bonds, student loan bonds, and closed end mutual funds. The two primary issuers were municipalities and student loans, making up over 50% of the market (shown in Figure 2).