Topic: Liquidity BackdropDynamic Debt Runs

Speaker: Bin Wei, Board of Governors of the Federal Reserve System

Date: June 25, 2013 (Tue.)

Time: 1:00-2:30pm

Location: Building 4, Room 101

Language: English

Abstract:

During the recent financial crisis of 2007-09, the markets for variable rate demand obligations (VRDO)auction rate securities (ARS) experienced severe runs, which contributed to the largest municipal bankruptcy in history. Both VRDOARS are long-term floating rate securities whose interest rates are reset periodically. However, unlike VRDO, ARS lack a liquidity backstop that can provide liquidity to its creditors whenever they want to liquidate their positions. The lack of a liquidity backstop, manifested by the wave of "auction failures" during the crisis, exacerbated the ARS runsled to the subsequent collapse of the ARS market. In this paper we develop a tractable model of dynamic debt runs on these securities, in which both the interest ratethe decision of creditors to run are endogenously determined in closed form. Theoretically we show that while the periodic interest rate resets help to mitigate runs in both markets, the lack of a liquidity backstop makes the ARS market more susceptible to runs than the VRDO market. We quantitatively evaluate the value of a liquidity backstop through a structural estimation of our model using the method of simulated maximum likelihood.

About the speaker:

Dr. Bin Wei is currently an Economist at Board of Governors of the Federal Reserve System. Before he joined the Federal Reserve Board, he had been an Assistant Professor of Finance at Baruch College, the City University of New York. Dr. Wei received his Ph.D. in Finance from the Fuqua School of Business at Duke University in 2007. His main research interests include contract theory, liquidity, fixed income securities, asset pricing,market microstructure. Dr. Wei has published in Review of Financial Studies, Management Science,Journal of Money, CreditBankingother leading journals.