Leverage and Liquidity: Evidence from the Closed-End Fund Industry

This paper uses the February 2008 auction rate security (ARS) market freeze to examine the spillover effects of an exogenous funding liquidity shock on the underlying asset markets. Consistent with theory, I find that the stocks held by closed-end funds (CEFs) that borrow from the ARS market experience larger declines in market liquidity and lower returns than other stocks after the ARS market freeze. These effects are more pronounced when (i) these ARS-levered CEFs hold a larger fraction of shares outstanding, (ii) the borrowing level from the ARS market is higher, and (iii) the stocks are less liquid before the ARS market freeze. The spillover effects of the ARS market freeze are temporary and diminish during the next 12 months. Further investigation shows that the spillover effects are indeed associated with the heavy selling behavior of the ARS-levered CEFs after experiencing the ARS market shock. Overall, this study provides evidence that a funding liquidity shock to financial institutions can cause a decline in both market liquidity and the prices of the underlying assets