Liquidity Crisis, Runs, and Security Design: Lessons from the Collapse of the Auction Rate Municipal Bond Market

58 Pages Posted: 10 Jan 2009 Last revised: 25 Apr 2013

See all articles by Song Han

Song Han

Board of Governors of the Federal Reserve System

Dan Li

Board of Governors of the Federal Reserve System

Date Written: January 15, 2008

Abstract

In this paper, we use the recent collapse of the ARS market as the laboratory to study issues on the fragility of financial innovations and systemic risks. We find strong evidence of investor runs for liquidity - partly caused by a self-fulfilling panic - and coordination failures among major broker-dealers in providing liquidity support. The two forces amplify each other dynamically, resulting in the market collapse. We also find that the likelihood of auction failures and ARS reset rates depend significantly on both the rule and the level of maximum auction rates; that, as predicted by auction theories, there is also strong evidence for underpricing after dealers withdrew their liquidity supports; and that liquidity in the non-auction secondary market may encourage aggressive bidding that increases the reset rates.

Keywords: Auction, auction rate securities, municipal bond pricing, liquidity crisis

JEL Classification: G12, G24, D44, H74

Suggested Citation

Han, Song and Li, Dan, Liquidity Crisis, Runs, and Security Design: Lessons from the Collapse of the Auction Rate Municipal Bond Market (January 15, 2008). Available at SSRN: https://ssrn.com/abstract=1325702 or http://dx.doi.org/10.2139/ssrn.1325702

Song Han (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
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202-736-1971 (Phone)
202-452-3891 (Fax)

Dan Li

Board of Governors of the Federal Reserve System ( email )

20th and C Streets, NW
Mail Stop 89
Washington, DC 20551
United States

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