Auction Failures and the Market for Auction Rate Securities

Abstract

The market for Auction Rate Securities (ARS) made headlines during the second week of February 2008 when auctions, at which the bonds interest rates are reset, experienced a wave of “failures.” Contrary to headlines that attribute the failures to a “frozen” market and/or to “irrationality” on the part of market participants, we find that (1) even at their height, less than 50% of ARS bonds experienced auction failures, (2) the likelihood of auction failure was directly related to the level of the bonds ”maximum auction rates” that cap the bond yields, and (3) using an empirical model of market clearing yields, the implied market clearing yields of bonds with failed auctions were significantly above their maximum auction rates. We interpret this evidence to mean that auctions failed because investors rationally declined to bid for bonds for which required market yields exceeded their maximum auction rates. We further find that ARS yields were generally higher than yields of various cash equivalent investment alternatives including treasury bills (T-bill), certificates of deposits (CD), money market funds (MMF), and Variable Rate Demand Obligations (VRDO). We interpret this latter evidence to mean that investors priced the possibility of auction failure into ARS yields.