Auction rate securities are a scam. There, I said it. It's a way to procure longterm financing with short term rates with the note holders assuming all of the auction failure risk. I've looked through auction rate contracts and they are very complicated and give little or no recourse to the note holder when an auction fails.
But let's step back a second and figure out how these beasts work. A company needs to raise capital. They decide to borrow money for a long term project but they want to borrow at the low one month rate rather than the expensive 10 year rate. One month rates can be 2% less than ten year rates, so who wouldn't want to do that. But there is a catch. If they borrow at the one month rate, they have to pay the money back, or refinance the debt in one month. Enter the auction rate note.
The auction rate note allows the borrower to pay a little more than the the one month rate but gets to keep the money for a longer term. A quick digression on why borrower pay more to borrow for a longer term. It's pretty simple. First suppose a co-worker comes to you and asks to borrow $20 until tomorrow ("I forgot my wallet"). If you have the money and you know the person, no problem. You'll see him tomorrow, and the next day so you can be pretty confident that you'll get your money back. If the same guy asks to borrow that same $20 but promises to pay you back in five years, you might have misgivings. Are you going to be able to find him in five years? where will you be then? And a whole lot of similar questions.
The same thing happens for corporations. Lending for a longer period is riskier. There is a good chance the company's financial health could be different, better or worse. Also, the longer you have until a bond matures, the more the price might move. Look at two extreme examples. In bond math, the duration of a bond is considered to be roughly speaking the time it takes to get your money back. For a short term bond the duration is really short, a long term bond the duration is much longer.
So now back to auction rate notes. The borrower and underwriter (investment bank) start the process like any long term note. Remember, that's where the risk is. Then they finance the transaction by issuing auction rate notes. The difference between these notes and other short term paper is that the borrower is not obligated to pay back the loan when the notes are "auctioned" each month.
When most people hear the word auction, we think of someone with a gavel selling Picassos. If the seller's minimum price is not met, then the piece isn't sold. When the financial community hears auction, it's in the context of highly liquid securities like US treasuries where everything always gets sold. Auction rate securities are like art auctions. People bring there bonds to the auction, the auctioneer (trader) sends around a marketing memo around and interested parties bid on the notes. No bids, then the owners go home with their bonds and try again next month.
But what happens now, the auction failed and the owner still wants to sell the bonds. The auction rate desk that runs the periodic auction says it's not their job so the security goes to the corporate desk who evaluates it like a longterm note, because that's what it is. And they will put a price in line with what comparable 10 year bonds are priced at.
In fixed income, prices work inversely to coupon. Suppose a company issues two bonds that are similar in every way except coupon. Bond one, H has a high coupon. Bond two L has a low coupon. The price of the bond H will be higher than bond L. So now the corporate trader will price the auction rate security (with a coupon 2% less than long term bonds) against a higher coupon long term bond and the price will be low. But the owner of the auction rate note was expecting par, and now suddenly they're getting 80-90% of par, a huge loss for a "riskless" investment.
So how did it go wrong? the problem is that the banks sold these securities with the assumption that market for these securities would remain liquid. That there would always be buyers and anytime someone wanted to sell, they could. The documents stipulate that when there are no buyers, the sellers keep the bonds and try again. There is no obligation from the borrower or the underwriter to either pay back the bonds or make a market in these securities. Also, most of these securities have a cap in the rate the borrower pays. This cap was set when times were sunnier and credit was easy.
And when these securities do trade, they trade as longer term rather than short term securities.
Leaving the owners holding the bag. A
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2 comments:
is it correct to say that the liquidity introduced with auction rate securities added value in proportion to the value received by the underwriter and borrower in the difference between borrowing costs? or is this totally off the wall..
The question is whether or not liquidity was introduced at all using auction rate securities. They were sold as short term securities, but they're really not. If you had money to invest for a 3 month period, you damn well want to get your money out at the end of the quarter. That didn't happen because there was no market maker behind the deals willing to step in and support the assets.
Now to your point, the added liquidity introduced with auction allowed these securities to be handled like short term debt, sold to people who could only invest in short term paper and from a risk perspective looked like short term paper. For the added complication of the product, the investor was paid a little more than if they invested in straight commercial paper.
For this feature, the borrower paid less in interest than if they borrowed it long term. The underwriter just got to sell the bonds.
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