State and Local Financial Instruments

State and Local Financial Instruments

Policy Changes and Management

Studies in Fiscal Federalism and State–local Finance series

Craig L. Johnson, Martin J. Luby and Tima T. Moldogaziev

The ability of a nation to finance its basic infrastructure is essential to its economic well-being in the 21st century. This book covers the municipal securities market in the United States from the perspective of its primary capital financing role in a fiscal federalist system, where subnational governments are responsible for financing the nation’s essential physical infrastructure.

Chapter 11: Lessons learned from the birth, growth and collapse of the municipal auction rate securities (MARS) market

Craig L. Johnson, Martin J. Luby and Tima T. Moldogaziev

Subjects: economics and finance, public finance, politics and public policy, public administration and management, public policy


Municipal auction rate securities (MARS) were increasingly utilized by subnational governments to raise capital over the last few decades and improve the efficiency of their capital financing activities. MARS were developed as a means of reducing borrowing costs vis-à-vis long-term fixed rate and traditional variable rate demand bonds. However, the recent Financial Crisis which extended into the municipal securities market in 2007 and 2008 severely impacted the MARS market to the detriment of many state and local debt issuers. We critique this subnational government financial innovation by analyzing the birth, growth and collapse of the MARS market, primarily from the seller side, highlighting what we have learned over the global Financial Crisis. The chapter continues by providing a descriptive analysis of the important characteristics of the auction rate market including size of issues, bond insurance, credit ratings, underwriters, uses of proceeds, and default rates. Then, the chapter proceeds with a detailed exposition of the borrowing cost motivations that led to the explosive growth in the MARS market in recent years. This section utilizes a matched pair analysis to empirically examine expected borrowing cost benefits to debt issuers. Next, we analyze the impact of the recent Financial Crisis on the efficacy of MARS and the various responses by state and local governments to the disruption in the MARS market. Finally, we conclude with specific ‘lessons learned’ for subnational government debt issuers.

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