Explaining the Decline in the Auction Rate Securities Market

Until recently, the market for auction rate securities (ARSs) was a thriving, if little-known, segment of the capital markets. Auction rate securities are long-term securities, but with time-varying interest rates that are reset periodically via an auction process. As U.S. financial markets have struggled to absorb the problems of subprime mortgages and tightened credit conditions, the ARS market has attracted a good deal of negative attention. Auctions to reset the rates of these instruments repeatedly failed, resulting in numerous lawsuits in which ARS investors claimed that the nature of the risks of these securities had been misrepresented. The U.S. Securities and Exchange Commission (SEC) and several state attorneys general have also initiated investigations of several major underwriters of ARSs. These developments are but one example of a relatively obscure portion of the capital markets falling victim to the recent credit crisis. In this article, the authors describe these securities and the market in which they operate. The authors then examine the collapse of this market, starting in February of 2008, and the after-effects that are still being felt.