Why do governments repay external sovereign borrowing? This is a question that has been central to discussions of sovereign debt capacity, yet the answer is still being debated. Models where countries service their external debt for fear of being excluded from capital markets for a sustained period (or some other form of harsh punishment such as trade sanctions or invasion) seem very persuasive, yet are at odds with the fact that defaulters seem to be able to return to borrowing in international capital markets after a short while. With sovereign debt around the world at extremely high levels, understanding why sovereigns repay foreign creditors, and what their debt capacity might be, is an important concern for policy makers and investors. In our paper, Sovereign Debt, Government Myopia, and the Financial Sector, forthcoming in the Review of Financial Studies, we attempt to address these issues.

…continue reading: Sovereign Debt, Government Myopia, and the Financial Sector

In the recent NBER working paper, my co-author, Guillermo Ordoñez of the University of Pennsylvania, and I develop a model to examine the important role collateral plays in the economy. Where do safe assets come from? Empirical evidence suggests that the private sector creates more near riskless assets when the supply of government debt is low and reduces privately-created near riskless assets when the supply of government debt is high. Krishnamurthy and Vissing-Jorgensen (2012) show that the net supply of government debt is strongly negatively correlated with the net supply of private near-riskless debt.

The substitution between public and private safe debt is also shown by Krishnamurthy and Vissing-Jorgensen (2012) who document that changes in the supply of outstanding U.S. Treasuries have large effects on the yields of privately created assets. Gorton, Lewellen, and Metrick (2010) also find this relationship between government debt and privately produced substitutes. They document that the share of safe assets in the U.S. economy, including both U.S. Treasury debt and privately created near-riskless debt has remained constant as a percentage of all U.S. assets since 1952. Xie (2012) shows that the issuance of asset-backed securities tends to occur when the outstanding government debt is low and Sunderam (2012) documents the same phenomenon with respect to asset-backed commercial paper.

By “safe assets,” we mean government debt and privately created high quality debt, in particular, asset-backed securities. Such safe assets are used to collateralize repo, derivative positions, and are needed as collateral in clearing and settlement. See IMF (2012). Further, because they are ”information-insensitive” (in the nomenclature of Dang, Gorton, and Holmstrom (2012)), they are highly liquid and hence can store value without fear of capital losses in times of stress, a form of private money.

…continue reading: The Supply and Demand for Safe Assets

Given that the conference theme is macro-finance linkages, I thought I would try to lay out a corporate finance perspective on large-scale asset purchases (LSAPs). I have found this perspective helpful in thinking both about the general efficacy of LSAPs going forward, and about the differential effects of buying Treasury securities as opposed to mortgage-backed securities (MBS). But before I get started, please note the usual disclaimer: The thoughts that follow are my own and do not necessarily reflect the views of other members of the Federal Open Market Committee (FOMC). I should also mention that these comments echo some that I made in a speech at Brookings last month. [1] As I noted in that speech, I support the Committee’s decision to purchase mortgage-backed securities (MBS) at a rate of $40 billion per month, in tandem with the ongoing maturity extension program in Treasury securities, and its plan to continue with asset purchases if the Committee does not observe a substantial improvement in the outlook for the labor market.

…continue reading: Corporate Finance Perspective on Large-Scale Asset Purchases

So, here we are in California — in beautiful San Francisco. For better and for worse, California municipal finance is national news.

As an SEC Commissioner, my job in general doesn’t get me involved in the specifics of the individual municipal finance debates covered in today’s news — at least not in my official capacity.

My job is to protect investors in the roughly $4 trillion municipal securities market, maintain fair, orderly and efficient markets, and facilitate capital formation.

And, as a member of the Commission that serves the public as the investor’s advocate, I want to remind everyone that, without the trust and willingness of investors, projects that are critical to our country’s infrastructure could suffer. These include vital projects such as water, schools, roads, hospitals, and many others.

I’d like to talk about the importance of better protection for muni investors and how the Commission under Chairman Schapiro’s leadership is enhancing investor protection. I’ll also share my personal observations on the “what now” question that follows the issuance of our recent Report on the Municipal Securities Market.

As I walk through this, I want to make it clear that your support in these efforts is critical — that whatever we do, it will be done better if we have your input and support.

…continue reading: Enhancing Disclosure in the Municipal Securities Market: What Now?

In the paper, Campaign Contributions and Governmental Financial Management: Evidence from State Bond Pricing, which was recently made publicly available on SSRN, I study campaign-finance agency costs related to pricing in the $2.9 trillion state and local government bond market. By selecting a contributing underwriter directly, the government could incur significant costs with respect to government bond underpricing. There is no comparable impact when an underwriter is chosen through an auction. Through the use of a control function approach, I show that the decision to select a contributing underwriter is endogenous to first-day returns. When underpricing is expected, the government’s propensity to choose a contributing underwriter decreases as expected underpricing increases. This evidence supports the idea that there are significant agency costs associated with campaign contributions and the evidence remains robust after a battery of checks.

This paper’s results lend support to the political agency cost model. Consistent with the common assertion that the election is the primary disciplining mechanism for political executives in a political agency cost model (Besley, 2006), the likelihood that a contributing underwriter is chosen is decreasing in the closeness to the next election. Consistent with the idea that laws can discipline politicians directly and through taxpayer monitoring, the likelihood that the government does not choose an auction to select an underwriter is decreasing in the quality of conflict-of-interest laws and freedom-of-information laws; the likelihood that the government chooses a contributing underwriter is decreasing in the quality of freedom-of-information laws.

…continue reading: Campaign Contributions and Governmental Financial Management

In our paper, Does It Matter Who Pays for Bond Ratings? Historical Evidence, forthcoming in the Journal of Financial Economics, we examine whether charging issuers for bond ratings is associated with higher credit ratings employing the historical setting wherein S&P switched from an investor-pay to an issuer-pay model in 1974, four years after Moody’s made the same switch.

Many commentators and policy makers claim that charging bond issuers for ratings introduces conflicts of interest into the rating process. For corporate bonds issued between 1971 and 1978, we find that, for the same bond, Moody’s rating is higher than S&P’s rating prior to 1974 when only Moody’s charges issuers. After S&P adopts the issuer-pay model in July 1974, the evidence indicates that S&P’s ratings increase to the extent that they no longer differ from Moody’s ratings. Because we use Moody’s ratings for the same bond as our benchmark, we can conclude that this increase in S&P’s ratings is not due to general changes affecting bond ratings.

…continue reading: Does It Matter Who Pays for Bond Ratings?

Credit default swaps (CDS) are term insurance contracts written on the notional value of an outstanding bond. In the paper, The Economics of Credit Default Swaps, forthcoming in the Annual Review of Financial Economics, I study the economics of CDS using the economics of insurance literature as a basis for analysis. The first CDS were traded by JP Morgan in 1995. Since that time, CDS trading has grown dramatically. CDS contracts trade in the over-the-counter derivatives markets which is only loosely regulated. The CDS market exhibited exponential growth between 2001 and 2007. At its 2007 peak, total outstanding notional for CDS was over 62 trillion dollars. After the crisis, however, these numbers have halved to just over 30 trillion dollars in 2009. Most of this change in outstanding notional has occurred through “portfolio compression” as demanded by the regulators where long and short credit derivative positions on the same underlying credit entity held by the same institution are netted. The reduction is not due to decreased trading activity in CDS. This assertion is supported by the relatively stable outstanding notional of equity and interest rate and currency derivatives over this same time span.

…continue reading: The Economics of Credit Default Swaps

On the heels of the Administration’s recently published report to Congress outlining its objectives for reforming the housing finance market, [1] new legislative action may come that would encourage the issuance of covered bonds. Secretary of the Treasury Timothy Geithner on March 1, 2011 in testimony before the House Committee on Financial Services (“Committee”) stated that the development of a legislative framework for a covered bond market should be included as part of the consideration of new means to provide mortgage credit. [2] Notwithstanding earlier delays in implementing reform for this industry, [3] proposals for legislative action addressing covered bonds are likely to be a focal point for the Committee [4] during this session of Congress. A discussion draft of a bill sponsored by Representative Scott Garrett (R-NJ), which aims to establish standards for covered bond programs and a covered bond regulatory oversight program, has been circulated to members of Congress and securitization market participants. The draft bill, if enacted in its current form, would (i) define the issuers and asset classes that would be subject to the oversight program; (ii) establish a framework for a federal regulatory oversight program for covered bonds; and (iii) implement a default and insolvency resolution process. This memorandum summarizes the February 2011 discussion draft, entitled the “United States Covered Bond Act of 2011” (the “Act”), which is expected to be introduced later this year.

…continue reading: Reform for the Covered Bond Industry on the Horizon

In the paper, Cyclicality of Credit Supply: Firm Level Evidence, which was recently made publicly available on SSRN, we study bank loan supply through the business cycle using firm level data from 1990 to 2009. It is well known that lending is cyclical. The contribution of our paper is to address two of the main empirical challenges in identifying whether this reflects the effects of bank credit supply. First, we focus on firms’ choice between two close forms of external debt financing: bank debt and public bonds. By conditioning the sample on firms raising new debt, we can rule out a demand explanation for the drop in bank borrowing which coincides with downturns. Second, by doing the analysis at the firm level, we can directly address how the composition of firms raising finance varies through time. This allows us to rule out compositional changes in the pool of firms seeking debt finance as an explanation of our findings.

…continue reading: Cyclicality of Credit Supply

In the paper, Convertible Bond Arbitrageurs as Suppliers of Capital, which is forthcoming in the Review of Financial Studies, we investigate the role of convertible bond arbitrageurs as suppliers of capital. Convertible bonds have been an important source of financing for a wide variety of firms and have been particularly popular among distressed firms with depressed equity prices. While much smaller than the market for straight debt, the convertible bond market has, at times, been comparable in size to the market for new equity issues. The convertible bond market provides a useful laboratory for studying the role of capital supply on issuance. One reason is that suppliers as a group are fairly well defined. Convertible bond arbitrage hedge funds are widely believed to purchase more than 75% of primary issues of convertible debt. By focusing on a market in which convertible bond arbitrage hedge funds account for such a large fraction of primary market activity, we are able to isolate important measures of capital supply (such as hedge fund flows).

…continue reading: Convertible Bond Arbitrageurs as Suppliers of Capital