An auction rate security is a type of bond where the interest rate is determined by a reverse auction. This means that the bond is purchased by whichever investor or investors are willing to pay the lowest rate. In theory, this helps the issuer avoid paying more in interest than is needed to borrow the money, given current demand. In 2008, some issuers began experiencing difficulty finding buyers for auction rate securities, leading to disputes and recriminations.
A traditional bond is a debt security issued by a government or corporation. The buyer pays money now and receives the money back on a set date, plus an agreed interest payment. In some cases, interest is paid at regular intervals, rather than only at the final repayment date. The buyer has the option of selling the bond on to another investor before it expires. The prices commanded by both newly issued bonds and those traded among investors are usually determined by a combination of the interest rate paid on the bond and the likelihood that the money will be repaid as promised. This is considered close to certain with a government bond, but with corporate bonds, it depends on the risk that the corporation will go out of business beforehand.
With traditional bonds, the issuer sets the interest rate and hopes to attract enough buyers. In an auction rate situation, potential investors say how much they are willing to pay and how many bonds they require. The issuer then processes these bids to find the lowest rate at which all the bonds will be taken. All successful bidders then get the bonds at this rate, even if it is higher than their own bid.
If there are not enough bidders to purchase all the bonds offered for issue, the situation is described as a failed auction. When this happens, all bidders get the bond at a fixed rate, defined in the conditions of the issue. This is usually set at a level higher than anyone is expected to bid and is thus very undesirable for the issuer.
Until 2008, failed auctions were relatively rare as the financial institutions handling the issue would, if necessary, make sufficient bids to be sure that all the bonds on issue would be taken. In 2008, several major US banks that had formally acted in this role began refusing to do so, through a combination of a lack of confidence in the auction rate market and a general move toward less risky investments by such banks. This has severely restricted the number and success of auction rate issues since then.