“Liquidity Crisis, Runs, and Securities Design Lessons from the Collapse of the Auction Rate Securities Market” by Song Han
Federal Reserve Board
We use the recent collapse of the auction rate securities (ARS) market to study the fragility of financial innovations and systemic risks. We find strong evidence of investor runs and coordination failures among major broker-dealers providing liquidity support. The two forces amplified each other dynamically, resulting in the market's collapse. We also find that, after dealers withdrew their liquidity support, both the likelihood of auction failure and ARS reset rates depend significantly on maximum auction rates. In addition, as predicted by auction theories, there is strong evidence of underpricing. Finally, we find that liquidity in the non-auction secondary market may lead to more severe underpricing.