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Why Did Auction Rate Bond Auctions Fail During 2007-2008?

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  • Baixiao Liu
  • John J. McConnell
  • Alessio Saretto
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    Abstract

    The auction rate bond market grew from inauspicious beginnings in 1985 to representing a significant fraction of the municipal bond market in 2007 with a total of 603 issuances that year raising more than $35 billion in capital. Since March of 2008 not a single auction rate bond has been issued. The last issuance coincided with a wave of “failures” of auction rate bond auctions during the early winter of 2008. Pundits have attributed the auction failures to a “frozen” market and hint that irrationality on the part of investors precipitated the auction failures. Missing from the headlines is that all auction rate bonds have interest rate caps that limit their yields. We find that, contrary to the impression given by news headlines, not all auctions failed and that investors rationally discriminated among bonds such that it was primarily those with low caps that experienced high failure rates. We further conclude that, in the absence of such caps, few if any, auctions would have failed.

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    Bibliographic Info

    Paper provided by Purdue University, Department of Economics in its series Purdue University Economics Working Papers with number 1245.

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    Length: 54 pages
    Date of creation: Jul 2010
    Date of revision:
    Handle: RePEc:pur:prukra:1245

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