A market being replaced

Author: | Published: 17 Nov 2008

Since the mid-eighties, auction-rate securities (ARS) have been viewed by the market as a stable financing vehicle. They offered issuers cheap flexible financing and, afforded closed-end funds a means of leveraging their assets and reinvesting the proceeds in the funds' portfolios. Pension funds and other institutional investors considered ARS to be high-quality liquid investments.

ARS are short-term investments bearing interest rates tied to broad-based, short-term financial rates that reset periodically through an auction process. Before February 2008, the financial intermediaries that served as broker-dealers participated in the auction process, actively bidding on the securities being sold. Their bids supported the market and ensured successful auctions. However, the level of support provided by these broker-dealers was not understood by most market participants and few understood that if the broker-dealers stopped these activities, auctions would fail.

Beginning in February, as financial institutions started facing serious liquidity issues, broker-dealers stopped participating. Without their...