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

The 2008 auction rate securities market collapse and US nonprofit health systems

“…Both McConnell and Sarretto (2010) and Han and Li (2008) found that failed auctions were much more likely to occur for ARS bonds with floating rate caps than those with fixed rate caps. Nevertheless, auction failures had become much more likely for ARS bonds regardless of the nature of its imbedded interest rate cap.…”

“…Considerable fee revenues and generous bonuses accrued to the investment banking firms and their creative professionals for developing and promoting new financing and risk management instruments. The existent literature (McConnell and Sarretto, 2010; D'Silva et al , 2008; Han and Li, 2008) of this event has focused on the impact of these events on investors. The 2008 global financial crisis triggered a sequence of events that uncovered the hitherto for latent risk of widespread ARS auction failure and the concurrent devaluation of fixed payer swaps on the various nonprofit educational institutions, health systems, and governmental organizations that relied on ARS for long term debt financing.…”

“…Although the underwriting broker/dealers are not required to do so, they can provide a “clearing bid” and purchase any “excess” bonds to avert an auction failure (Schwartz, 2009). The liquidity provided by the interest rate reset auction mechanism in conjunction with the bonds' federal income tax‐exempt status helps explain the popularity of ARS bonds as a short term investment for high net worth individuals, corporate treasurers, and mutual funds (Han and Li, 2008). In fact, many corporate investors classified their ARS investments as cash equivalents.…”