Litmus Testing – Addressing Failed Auction Securities

Executive Summary

The auction market relies heavily on investor confidence. Once certain bonds were perceived to be troubled, similar securities, even those with well run programs, may see their auctions at risk.
The scenario of a bond ultimately curing itself with a successful auction is unlikely. It is unrealistic to assume that dealers will eventually buy investors out at par value.
We envision the following courses of action for failed auctions:

1. Waiting it out
2. Restructuring
3. Cutting losses

Impairment and “illiquid” asset classification may be issues to consider for corporations with failed auction bonds.
The mismatched funding model of “borrowing short, lending long” again failed the litmus test on auction rate securities.

Overview of The ARS Market

Auction rate securities (ARS) refer to a kind of debt security with nominally long-term maturities and variable coupon rates. Periodic Dutch auctions held by the underwriting dealer, often every 28 or 35 days, set the coupon rate for each period and allow bondholder redemptions in a successful auction. Municipal bonds, asset-backed securities and preferred stocks are several of the security types that use auctions to issue debt and set rates.
ARS are usually marketed and sold by a single bond dealer with no resale market other than a subsequent auction or a courtesy purchase by the underwriting dealer. Industry estimates place the size of the ARS market in the U.S. at between $250 billion and $360 billion.
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