Liquidity Crisis, Runs, and Security Design - Lessons from the Collapse of the Auction Rate Securities Market

Abstract:     
We use the recent collapse of the ARS market to study the fragility of financial innovations and systemic risks. We find strong evidence of investor runs and coordination failure among major broker-dealers in providing liquidity support. The two forces amplified each other dynamically, resulting in the market's collapse. The likelihood of auction failure and ARS reset rates depend significantly upon both the level of maximum auction rates and the rule used to calculate them. As predicted by auction theories, there is also strong evidence of underpricing after dealers withdrew their liquidity support. Finally, we find that liquidity in the non-auction secondary market may encourage aggressive bidding in the auctions, which leads to higher interest rates. All of these revealed flaws in the design of ARS.

Number of Pages in PDF File: 53

Keywords: Auction rate securities, liquidity crisis, uniform-price auctions, underpricing, security design, market microstructure, municipal bond pricing

JEL Classification: G12, G24, D44, H74

working papers series