Author's Note: What is an Auction-Rate Security?

You may have never heard of auction rate securities (ARS). Until the ARS market crashed on February 13, 2008 most investors were unaware of these niche Wall Street products. They have since become iconic symbols of the biggest financial fraud in modern Wall Street history.

ARS are "debt obligations"—bonds that promise to pay back an investment with interest. They are issued mostly by municipal organizations in need of cheap funding—charities, universities, museums, student loan organizations, hospitals, and the like.

ARS are bonds with fluctuating interest rates. As the "market makers," Wall Street banks underwrote the bonds for the issuers and their brokerages managed the auctions at which they were sold to investors.

Unlike an ordinary U.S. Treasury bond with a fixed interest rate, or yield, the interest rates for ARS were reset at auctions every 7, 28, or 35 days. For example, a student loan ARS might yield 3 percent at one auction and wind up yielding 2 percent at another, depending on how many investors were willing to buy it.

Wall Street banks controlled the auctions and charged handsome fees for doing so. When things were running smoothly, the issuers received long-term financing at short-term rates. And investors received higher yields than plain vanilla money market funds, with no apparent risk to principal if interest rates spiked.

ARS auctions created a unique kind of money market. An ordinary money market is a mix of very short-term ...

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