We evaluate the effect of the Federal Reserve’s purchase of long-term Treasuries and other long-term bonds ("QE1" in 2008-2009 and "QE2" in 2010-2011) on interest rates.  Using an event-study methodology that exploits both daily and intra-day data, we find a large and significant drop in nominal interest rates on long-term safe assets (Treasuries, Agency bonds, and highly-rated corporate bonds).  This occurs mainly because there is a unique clientele for long-term safe nominal assets, and the Fed purchases reduce the supply of such assets and hence increase the equilibrium safety-premium.  We find only small effects on nominal (default-adjusted) interest rates on less safe assets such as Baa corporate rates. The impact of quantitative easing on MBS rates is large when QE involves MBS purchases, but not when it involves Treasury purchases, indicating that a second main channel for QE is to affect the equilibrium price of mortgage-specific risk. Evidence from inflation swap rates and TIPS show that expected inflation increased due to both QE1 and QE2, implying that reductions in real rates were larger than reductions in nominal rates. Our analysis implies that (a) it is inappropriate to focus only on Treasury rates as a policy target because QE works through several channels that affect particular assets differently, and (b) effects on particular assets depend critically on which assets are purchased.

 

This paper measures how securitized assets, including mortgage-backed securities and other asset-backed securities, have shifted across financial institutions during this crisis and how the availability of financing has accommodated such shifts. Sectors that substantially use repo financing—in particular, the hedge fund and broker-dealer sector—have reduced asset holdings, while the commercial banking sector, which has had access to more stable funding sources, has increased asset holdings. The banking sector also increased its leverage dramatically during this crisis. These findings are important to understand the role played by the government during the crisis as well as to understand the factors determining asset prices and liquidity during the crisis. [JEL: G01, G21, G28, E5]

I describe two amplifications mechanisms that operate during liquidity crises and discuss the scope for
central bank policies during crises as well as preventive policies in advance of crises. The first mechanism
works through asset prices and balance sheets. A negative shock to the balance sheets of asset-holders
causes them to liquidate assets, lowering prices, further deteriorating balance sheets, culminating in a
crisis. The second mechanism involves investors’ Knightian uncertainty. Unusual shocks to untested
financial innovations lead agents to become uncertain about their investments causing them to disengage
from markets and increase their demand for liquidity. This behavior leads to a loss of liquidity and a
crisis.

Severe flight to quality episodes involve uncertainty about the environment, not only risk about asset payoffs. The uncertainty is triggered by unusual events and untested financial innovations that lead agents to question their worldview. We present a model of crises and central bank policy that incorporates Knightian uncertainty. The model explains crisis regularities such as market-wide capital immobility, agents' disengagement from risk, and liquidity hoarding. We identify a social cost of these behaviors, and a benefit of a lender of last resort facility. The benefit is particularly high because public and private insurance are complements during uncertainty-driven crises.

Uncertainty that is, a rise in unknown and immeasurable risk rather than the measurable risk that the financial sector specializes in managing is at the heart of the recent liquidity crisis. The financial instruments and derivative structures underpinning the recent growth in credit markets are complex. Because of the rapid proliferation of these instruments, market participants cannot refer to a historical record to measure how these financial structures will behave during a time of stress. These two factors, complexity and lack of history, are the preconditions for rampant uncertainty. We explain how a rise in uncertainty can cause a liquidity crisis and discuss central bank policies in this context.

``Limits of Arbitrage" theories require that the marginal investor in a particular asset market be a specialized arbitrageur. Then the constraints faced by this arbitrageur (i.e. capital constraints) feed through into asset prices. We examine the mortgage-backed securities (MBS) market in this light, as casual empiricism suggests that investors in the MBS market do seem to be very specialized. We show that risks that seem relatively minor for aggregate wealth are priced in the MBS market. A simple pricing kernel based on the aggregate value of MBS securities prices risk in the MBS market. The evidence suggests that limits of arbitrage theories can explain the cross-sectional and time-series behavior of spreads in this market.

Emerging market economies are fertile ground for the development of real estate and other financial bubbles. Despite these economies’ significant growth potential, their corporate and government sectors do not generate the financial instruments to provide residents with adequate stores of value. Capital often flows out of these economies seeking these stores of value in the developed world. Bubbles are beneficial because they provide domestic stores of value and thereby reduce capital outflows while increasing investment. But they come at a cost, as they expose the country to bubble-crashes and capital flow reversals. We show that domestic financial underdevelopment not only facilitates the emergence of bubbles, but also leads agents to undervalue the aggregate risk embodied in financial bubbles. In this context, even rational bubbles can be welfare reducing. We study a set of aggregate risk management policies to alleviate the bubble-risk. We show that prudential banking regulation, sterilization of capital inflows and structural policies aimed at developing public debt markets and property rights, all have a high payoff in this environment.

 

We integrate a widely accepted version of the separation of ownership and control—Michael Jensen's (1986) free cash flow theory—into a dynamic equilibrium model, and study the effect of imperfect corporate control on asset prices and investment. Aggregate free cash flow of the corporate sector is an important state variable in explaining asset prices, investment, and the cyclical behavior of interest rates and the yield curve. The financial friction causes cash-flow shocks to affect investment, and causes otherwise i.i.d. shocks to be transmitted from period to period. The shocks propagate through large firms and during booms.

Firms in emerging markets are exposed to severe financial frictions and credit constraints, that are exacerbated by the sudden stop of capital inflows. Can monetary policy offset this external credit squeeze? We show that although this may be the case during moderate contractions (or in partial equilibrium), the expansionary effect of monetary policy vanishes during severe external crises. The exchange rate jumps to reduce the dollar value of domestic collateral until equilibrium in domestic financial markets is consistent with the external constraint. An expansionary monetary policy in this context raises the value of domestic collateral but it exacerbates the exchange rate depreciation (beyond the standard interest parity effect) and has little effect on aggregate activity. However there is a dynamic linkage between monetary policy and sudden stops. The anticipation of a dogged defense of the exchange rate worsens the consequences of sudden stops by distorting the private sector incentive to take precautions against these shocks. For similar general equilibrium reasons, dollarization of liabilities has limited impact during a sudden stop, but it has significant underinsurance consequences.

Emerging economies are exposed to severe and sudden shortages of international financial resources. Yet domestic agents seem not to undertake enough precautions against these sudden stops. Following our previous work, we highlight in this paper the central role played by limited domestic development in ex-ante (insurance) and ex-post (spot) financial markets in generating this collective undervaluation of external resources and insurance. Within this structure, this paper studies several canonical policies to counteract the external underinsurance. We do this by first solving for the optimal mechanism given the constraints imposed by limited domestic financial development, and then considering the main -- in terms of the model and practical relevance -- implementations of this mechanism.

We study optimal enforcement in credit markets in which the only threat facing a defaulting borrower is restricted access to financial markets. We solve for the optimal level of exclusion, and link it to observed institutional arrangements. Regulation in this environment must accomplish two objectives. First, it must prevent borrowers from defaulting on one bank and transferring their resources to another bank. Second, and less obviously, it must give banks the incentive to make sizeable loans, and to honor their promises of future credit. We establish that the optimal regulation resembles observed laws governing default on debt. Moreover, if debtors have the right to a “fresh start” after bankruptcy then this must be balanced by enforceable provisions against fraudulent conveyance. Our optimal regulation is robust, in that it can be implemented in a way that does not require the regulator to have information about either the borrower or lender. Finally, restricting the availability of credit to a defaulted borrower is not a threat, in and of itself, that motivates borrowers to repay loans.

Macroeconomic models of credit market imperfections have been offered as a theory for how common shocks to the balance sheets of credit constrained firms are amplified through changes in the value of collateral and transmitted as fluctuations in output. This paper clarifies and extends these models by first showing that they are not robust to the introduction of markets which allow these firms to hedge against common shocks. A theory of incomplete hedging is then proposed in which the supply of hedging available in the economy is constrained by the aggregate value of collateral. In aggregate, the capacity of banks and other financial intermediaries to provide finance is limited by the aggregate collateral constraint. We find that the constraint introduces a skewed response of the economy to shocks. While the constraint may not affect activity in many states of the world, if shocks are sufficiently adverse, the constraint binds and financial market imperfections amplify the downturn.

We propose that the limited financial development of emerging markets is a significant factor behind the large share of dollar-denominated external debt present in these markets. We show that when financial constraints affect borrowing and lending between domestic agents, agents undervalue insuring against an exchange rate depreciation. Since more of this insurance is present when external debt is denominated in domestic currency rather than in dollars, this result implies that domestic agents choose excessive dollar debt. We also show that limited financial development reduces the incentives for foreign lenders to enter emerging markets. The retarded entry reinforces the underinsurance problem.

This very short paper presents a simple version of our ideas in a Mundell-Fleming framework. Our purpose is to illustrate why a dual liquidity model is useful for thinking about emerging markets' issues, and how its policy prescriptions may differ from other models.

This paper studies the spread between the newly issued 30 year Treasury bond and the old 30 year bond. The spread follows a systematic pattern over the auction cycle: it begins high at an auction date, and converges toward zero by the next auction date. I document the profits on establishing a long old bond/ short new bond convergence trade and rolling this over every auction cycle, over a period from 6/95 to 11/99. Despite the systematic convergence, the average profits are close to zero, and profits covary with the stock market in a manner resembling a short put option position. The difference in repo market financing rates between the two bonds is an important component of the costs in carrying the position. I then ask what economic factors account for the level and time variation in the spread. Using the spread between commercial paper and T-Bills to identify changes in investor preference for liquid assets, I establish that aggregate factors affecting liquidity preference plays an important role in the variation of the bond/old-bond spread. The evidence also establishes that new bonds are imperfect substitutes for other bonds, and therefore changes in the supply of new bonds, such as in recent Treasury buybacks, will have important effects on bond market spreads.

We build a model of emerging markets crises which features two types of collateral constraints. Firms in a domestic economy have limited borrowing capacity from international investors. They also have limited borrowing capacity with respect to each other. We study how the presence of and changes in these collateral constraints affect financial and real variables. A binding international constraint in the aggregate leads to a sharp rise in interest rates and fire sales of domestic assets, while limited domestic collateral can lead to wasted international collateral. These two collateral constraints can interact in important ways. The first is disintermediation: a fire sale of domestic assets causes banks to fail in their function of reallocating resources across the economy leading to wasted international collateral. The second is a dynamic effect. We show that firms in an economy with limited domestic collateral and a binding international collateral constraint will not adequately precaution against adverse shocks, increasing the severity of these shocks. Our approach is distinctive in that, while much of the literature on the role of financial constraints in macroeconomics draws their insights within either of these collateral deficiencies, we argue that their static and dynamic interactions have important consequences for emerging markets' performance.

The aim of this paper is to conceptualize and design a risk topography that outlines a data acquisition and dissemination process that informs policy makers, researchers and market participants about systemic risk. Our approach emphasizes that systemic risk (i) typically builds up in the background before materializing in a crisis and (ii) is determined by market participants' response to various shocks. To this end we propose a two-step approach: First, regulators elicit from market participants their (partial equilibrium) risk as well as liquidity sensitivities with respect to major risk factors and liquidity scenarios. By doing so, one takes advantage of private sector internal risk models and over time an informative panel data set is obtained. Second, general equilibrium responses and economy-wide system effects are calibrated using this panel data set.

We measure the repo funding extended by money market funds and securities lenders to the shadow banking system, including quantities, haircuts, and repo rates sorted by the type of underlying collateral. Both the quantity and price data suggest that there was a run on repo backed by non-Agency MBS/ABS collateral, while the repo market for Treasury and Agency collateral was not significantly affected. However, to gauge the consequences of such a run one must also take into account that prior to the financial crisis only about 3% of outstanding non-Agency MBS/ABS is financed with repo from money market funds and securities lenders. A more sizeable contraction in short-term debt financing of non-Agency MBS/ABS occurs with the contraction in asset-backed commercial paper. While the contraction in aggregate repo funding with non-Agency MBS/ABS was small relative to the outstanding stock of non-Agency MBS/ABS, dealer banks with a larger exposure to private debt securities were affected more strongly and resorted to the Fed's emergency lending programs for funding.

We show that the US Debt/GDP ratio is negatively correlated with the spread between corporate bond yields and Treasury bond yields. The result holds even when controlling for the default risk on corporate bonds. We argue that the corporate bond spread reflects a convenience yield that investors attribute to Treasury debt. Changes in the supply of Treasury debt trace out the demand for convenience by investors. We show that the aggregate demand curve for the convenience provided by Treasury debt is downward sloping and provide estimates of the elasticity of demand. We analyze disaggregated data from the Flow of Funds Accounts of the Federal Reserve and show that individual groups of Treasury holders also have downward sloping demand curves. Groups for whom the liquidity of Treasuries is likely to be more important have steeper demand curves. The results have bearing for important questions in finance and macroeconomics. We discuss implications for the behavior of corporate bond spreads, interest rate swap spreads, the riskless interest rate, and the value of aggregate liquidity. We also discuss the implications of our results for the financing of the US deficit, Ricardian equivalence, and the effects of foreign central bank demand on Treasury yields.

We present a model to study the dynamics of risk premia during crises in asset markets where the
marginal investor is a financial intermediary. Intermediaries face a constraint on raising equity capital.
When the constraint binds, so that intermediaries’ equity capital is scarce, risk premia rise to reflect the
capital scarcity. We calibrate the model and show that it does well in matching two aspects of crises:
the nonlinearity of risk premia during crisis episodes; and, the speed of adjustment in risk premia from a
crisis back to pre-crisis levels. We use the model to quantitatively evaluate the effectiveness of a variety
of central bank policies, including reducing intermediaries’ borrowing costs, infusing equity capital, and
directly intervening in distressed asset markets. All of these policies are effective in aiding the recovery
from a crisis. Infusing equity capital into intermediaries is particularly effective because it attacks the
equity capital constraint that is at the root of the crisis in our model.

We develop a model in which the capital of the intermediary sector plays a critical role in
determining asset prices. The model is cast within a dynamic general equilibrium economy, and
the role for intermediation is derived endogenously based on optimal contracting considerations.
Low intermediary capital reduces the risk-bearing capacity of the marginal investor. We show
how this force helps to explain patterns during …nancial crises. The model replicates the observed
rise during crises in Sharpe ratios, conditional volatility, correlation in price movements of assets
held by the intermediary sector, and fall in riskless interest rates. In a dynamic context, we show
that aversion to drops in intermediary capital can generate a two-factor asset pricing model with
a role for both a market factor and a liquidity factor.

We present a model of flight to quality episodes that emphasizes financial system risk and the Knightian uncertainty surrounding these episodes. In the model, agents are uncertain about the probability distribution of shocks in markets different from theirs, treating such uncertainty as Knightian. Aversion to this uncertainty generates demand for safe financial claims. It also leads agents to require financial intermediaries to lock-up capital to cover their own market shocks in a manner that is robust to uncertainty over other markets. These actions are wasteful in the aggregate and can trigger a financial accelerator. A lender of last resort can unlock private collateral and stabilize the economy during negative shocks by committing to intervene should conditions worsen.

During the booms that precede crises in emerging economies, policymakers often struggle to limit capital flows and their expansionary consequences. The main policy tool for this task is a sterilization of capital inflows --essentially a swap of international reserves for public bonds. Despite its widespread use, sterilization is often criticized for its ineffectiveness and, in extreme cases, its potential backfiring. We argue that these concerns are justified when countries experience occasional external crises and domestic financial markets are illiquid. In this context, while standard Mundell-Fleming considerations may determine the impact of the sterilization on short term peso interest rates, a potentially more powerful and offsetting mechanism is triggered by the anticipated reversal of this policy in the event of an external crisis. If the instruments used in the sterilization are illiquid or result in fiscal deficits that reduce the liquidity of the private sector, then the effective dollar cost of capital, which considers the whole path of expected future rates, may be lowered rather than raised by this policy. Most importantly, this dollar cost of capital reduction does not reflect a true increase in the country's international liquidity during the external crisis and reversal, as would be the case with a successful sterilization, but just a decline in domestic private liquidity. The impact of the latter on relative asset prices creates a sort of ``international liquidity illusion" which fosters rather than depress aggregate demand, and exacerbates short term capital inflows.

Emerging economies experience sudden stops in capital inflows. As we have argued in Caballero and Krishnamurthy (2002), having access to monetary policy during these sudden stops is useful, but mostly for ``insurance'' rather than aggregate demand reasons. In this environment, a central bank that cannot commit to monetary policy choices will ignore the insurance aspect and follow a procyclical rather than the optimal countercyclical monetary policy. It will also intervene excessively to support the exchange rate. These inefficiencies are exacerbated by the presence of an expansionary bias. In order to solve these problems, we propose modifying the central bank's objective to (i) include state-contingent inflation targets, (ii) target a measure of inflation that overweights non-tradable inflation, and (iii) weigh reserves holdings.