Auction Rate Securities (ARS) are security instruments, underwritten by UBS, a financial services firm. These instruments are used by customers as cash alternatives. Amidst the financial crisis, UBS is in a dilemma whether to continue supporting the ARS market.
Daniel B. Bergstresser, Shawn Cole, and Siddharth Shenai
Harvard Business Review (209119-PDF-ENG)
March 05, 2009
Case questions answered:
- What is Auction Rate Securities (ARS)? Describe some of the main features of these securities (characteristics, risk profile, etc.) and briefly explain the auction process underlying ARS.
- Why did issuers find ARS attractive to issue? Why did investors find them attractive (who are those investors?)? What was the appeal for brokers/underwriters such as UBS?
- Why did liquidity dry up and auctions started to fail? Be sure to elaborate a bit on the sources of those determinants.
- Should UBS continue to support the auctions for the ARS that it has underwritten? Be sure to state and trade-off potential reasons that would make a case for/against supporting auctions before making a recommendation. Be sure to take a position, explain why you choose that position, and comment on potential consequences your decision may have.
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Case answers for UBS and Auction Rate Securities (A)
1. What is Auction Rate Securities (ARS)? Describe some of the main features of these securities (characteristics, risk profile, etc.) and briefly explain the auction process underlying ARS.
Auction Rate Securities are typically long date debt-instruments issued by municipalities or structured finance entities. These are held by investors who sought relatively liquid instruments that offered higher returns than government securities.
These securities were deemed highly liquid as they could be sold to other investors at auctions conducted at frequent periods. The coupon rate would be determined based on the demand and supply of these securities at the auctions. Investors could place 4 types of orders before the auction – hold, hold-at-rate, buy and sell.
The lowest rate at which the supply and demand are satisfied (buy orders = sell orders) would be the market-clearing rate. If the demand fell short of the supply, the auction would fail, and the notes would remain with the initial investors while the coupon rate would be set at a specified cap for the next period.
Though these auctions technically ran the risk of failure, the risk-profile was relatively low because the broker-dealers would ensure that an auction would not fail by buying any unsold notes.
In this case, Investor 1 ($100 million) and Investor 3 ($40 million) will be able to complete their demand fully. In comparison, Investor 4 will be able to fulfill 60% ($60 million) of the initial demand, with the total adding to $200 million.
The lowest rate at which the demand can be fulfilled is 5.5%.
Therefore, Investor 1 holds $100 million, Investor 3 holds $40 million, and Investor 4 holds $60 million at 5.5% each.
As per the prospectus, the Auction Rate Securities is specified to have a max interest rate of 10%. Therefore, Investor 4 and Investor 5 will not get their bids rejected.
Since the other investors have a combined demand of only $180 million, the auction will be deemed to have failed. The current holders of the note will continue to hold the ARS and will not sell their portions until the next auction. They may choose to go for a trade-in in a secondary market, but these were not developed back.
This sets up the stage for a broker-dealer like UBS to intervene as UBS can buy the remaining $20 million of the ARS at the market-clearing rate which will now be 8.5%.
Therefore, if UBS intervenes by buying the remaining $20 million at 8.5%, Investor 1 will hold $100 million, Investor 2 will hold $50 million and Investor 3 will hold $30 million at 8.5% each. If UBS intervenes in this way, then the auction will now be successful.
One of the main reasons for UBS intervention would be to…