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

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. JEL Classifications: G12, G24, D44, H74