This article explores the effects of credit enhancement, and downgrades to credit enhancement providers, on the costs to municipal issuers for holding variable rate debt during the 2008—09 market crisis. Although municipal issuers were potentially subject to pressure on their debt issues due to credit contraction, the extent of the problem has not been well researched, especially regarding credit enhancement. This study empirically investigates whether liquidity providers affect the cost of municipal variable rate debt and whether the impact is affected by credit downgrades of liquidity providers. Several important contributions are made. First, this research emphasizes the role of liquidity provision as a form of credit enhancement. Second, the value of liquidity provision is examined in the environment of credit downgrades to liquidity providers. Third, the research tests capital market efficiency using variable, as opposed to fixed rate debt, which allows for the identification of liquidity risk and default risk.
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