Auction Rate Securities Fraud Lawyer

ARS: Why Highly Rated Securities Lose Liquidity

Many investors were shocked when their AAA-rated auction rate securities (ARS) holdings suddenly lost liquidity in February 2008. Their surprise was partly caused by the misleading promises of safety and liquidity made by brokerage firms and partly caused by their own misunderstanding of the bond rating system used by Standard & Poor’s, Moody’s, Fitch, and other agencies.

In the minds of many investors, the AAA rating – the highest possible – held by their ARS was essentially a guarantee that a crisis like the one in February 2008 would not occur. How could such highly rated securities lose liquidity in such a catastrophic way?

One must understand that the bond rating system used by S&P , Fitch, and other firms is basically equivalent to the credit rating system used to grade the “credit-worthiness” of consumers. A consumer with a good credit rating is considered highly likely to repay debts on time and is thus more attractive to lenders.

The bond rating system works the same way; it is a measure of the “credit-worthiness” of a bond issuer (be it a corporation, municipal government, or non-profit organization) in terms of the likelihood that the full face value of the bond will be repaid as promised on the maturity date. An AAA-rated bond is one issued by an entity which is considered highly likely to fulfill its financial obligation when the bond comes due. For long-term bonds such as auction rate securities, this maturity date could be 20, 30, or 40 years in the future.

In other words, the rating of a bond has little to do with the liquidity of an investment in auction rate securities. Rather, it is concerned with the ability of a bond issuer to pay back its debt years down the line. The only way that a high rating benefits ARS in terms of liquidity is by potentially boosting demand for a particular bond.

For more information, contact an auction rate securities attorney at 800-220-9341 today.