Notes from the Vault
Bin Wei and Vivian Yue
June 2015
An important form of bank lending is credit lines and other liquidity commitments, which serve as liquidity backstops to businesses. The recent financial crisis of 2007–09 demonstrated that liquidity backstops have important implications for financial stability. For example, concerns about provision of liquidity backstops by banks contributed to runs on asset-backed commercial paper programs in the summer of 2007. These runs together with those in several other markets (for example, markets for repo, money market funds) tightened credit going to firms and households and inflicted widespread damage to the U.S. and global economy. The following questions arise. What is the role of liquidity backstops in mitigating runs (or, conversely, the role of the lack of liquidity backstops in exacerbating runs)? How valuable is a liquidity backstop?
This Notes from the Vault analyzes these important liquidity questions in the context of the municipal bond markets for variable rate demand obligations (VRDOs) and auction rate securities (ARS). As we will describe shortly, the differential experiences of these markets during the financial crisis provide an ideal laboratory to identify and quantify the value of a liquidity backstop in mitigating runs.
What are VRDOs and ARS?
VRDOs and ARS are nominally long-term municipal bonds with floating interest rates that are reset on a periodic basis (typically weekly). The average maturity of these securities is about 25 years. The periodic rate resets make them essentially short-term securities so that they could be held by money market funds. The VRDO and ARS markets are significant components of the $3.7 trillion municipal bond market, with sizes of about $200 billion and $500 billion in 2008 at their peak time, respectively. The markets were an attractive financing venue for municipal issuers because they allow for the issuance of long-term obligations using short-term interest rates that are typically lower than long-term interest rates. For investors, these securities were also attractive because they offered better returns than traditional money market investments.
Both VRDOs and ARS securities are made to look like short-term securities through the periodic resale of the securities to new investors but the process by which they do so is very different. With VRDOs, the interest rate is reset by a remarketing agent who is responsible for reselling the bond to investors whereas ARS securities are resold via a Dutch auction process.
The difference in the resale procedures between the two securities becomes especially important when there is insufficient investor demand for the securities. VRDOs have an explicit liquidity backstop facility whereby a liquidity provider (usually large banks) acts as "buyer of last resort." The liquidity facilities are usually in the form of a direct letter of credit or a standby bond purchase agreement. Regardless of which structure is used, the liquidity provider is the ultimate source of liquidity. As a result, the VRDO instrument carries the short-term rating of its liquidity provider.
In contrast, ARS auction agents may serve as buyers of last resort if the auction fails, but they are not legally committed to providing liquidity. When there are insufficient bids at an auction and the auction agent decides not to intervene to provide liquidity, the auction will fail. In the case of auction failure, a pre-specified maximum interest rate (often shortened to "max rate" in Wall Street parlance) is imposed, and selling creditors will be stuck with their holdings until the next successful auction. Until the ARS market froze in mid-February 2008, auction failures were extremely rare—only 13 auctions failed between 1984 and 2006.1 Partly as a result of the rare auction failures, prior to the financial crisis ARS investors had the flawed perception that auction agents would always provide liquidity to prevent ARS auctions from failing. In fact, as shown in Figure 1, before the end of 2007, the average ARS and VRDO interest rates were very close, suggesting that market participants viewed both ARS and VRDOs as almost identical securities. However, after the financial crisis broke out, a tidal wave of auction failures hit the market.
The figure below plots the average interest rates in percent on the indexes of weekly resettable high-grade ARS (solid line) and VRDO (dashed line) between May 2006 and December 2009, maintained by the Securities Industry and Financial Markets Association (SIFMA).
What happened in the markets for VRDOs and ARS during the financial crisis?
The ARS market encountered significant problems in early 2008. Since mid-2007, the disruption in the subprime mortgage market spread to the monoline insurance market, where several major municipal bond insurers (for example, Ambac and MBIA) were downgraded because of their exposure to subprime mortgage debt. These downgrades resulted in increased selling pressure in ARS. On the other hand, the subprime mortgage meltdown also significantly strained balance sheets of auction agents (such as Citibank, Goldman Sachs, Lehman Brothers, UBS, Royal Bank of Canada, and JP Morgan) to the extent that they decided not to intervene and let the auctions fail in mid-February 2008.2 Reportedly, about 60 percent to 80 percent of auctions failed in the second half of February in 2008. The wave of auction failures drove up the ARS rate to as high as 6.6 percent around mid-February 2008, as figure 1 shows. The sheer volume of failed auctions and fear of future auction failures propelled more investors to run on ARS.
The run on ARS highlighted the implicitness of the liquidity provision in the ARS market. Although in less tumultuous times prior to 2007, auction agents had almost always stepped in to buy some of these securities to help keep the market functioning, they had no contractual obligations to do so. During the financial crisis, major auction agents indeed chose to no longer be "buyers of last resort." By contrast, the VRDO market was not affected as much in early 2008 due to the explicit structure of its liquidity facility.
However, later in 2008 the VRDO (as well as ARS) market experienced a run as a result of the bankruptcy of Lehman Brothers declared on September 15, 2008, and the subsequent panic in the market of money market mutual funds such as runs on Reserve Primary Fund—which "broke the buck"—and other money market funds. Investors worried about whether banking institutions that explicitly provided liquidity facility would be able to meet their obligations. The run on VRDO is evident in the spike of 7.96 percent of the average VRDO rate on September 24, 2008, as figure 1 shows.
The runs on ARS and VRDO in 2008 allow us to distinguish the differential effects of explicit and implicit liquidity provisions on the running decision of investors.
Why does the lack of a liquidity backstop exacerbate runs?
Runs on VRDO or ARS are ultimately driven by the "maturity-mismatch" problem; that is, short-term securities (for example, ARS or VRDOs) are issued to finance illiquid longer-term assets. The short-term financing leads to the rollover risk because creditors may refuse to roll over their debt (in other words, creditors decide to run).
Absent a liquidity backstop, liquidity may evaporate unexpectedly, especially at times when it is needed most. In the context of the ARS market, potential investors in the current auction recognize the risk that next auction might fail as well as the resulting loss: when the auction failure happens, it is usually the time when they also need to liquidate the bonds. The failure of the next auction forces these potential investors to hold the bonds and suffer possible losses. If current investors view this risk as too high, they will not choose to roll over. In economics jargon, the risk of illiquidity in the future causing current illiquidity is called dynamic debt runs as first studied in Zhiguo He and Wei Xiong (2012).
How valuable are liquidity backstops in mitigating runs?
The value of a liquidity backstop can now be conceptualized in the following thought experiment. As argued above, the lack of a liquidity backstop in the ARS market leads to a higher likelihood of runs relative to the VRDO market. Hypothetically, if we can permanently increase the interest rate of ARS at each point of time, the higher interest rate gives more compensation to investors and thus reduces the run likelihood in the ARS market. If we make the permanent increase large enough, the run likelihood in the ARS market can be reduced to the same likelihood in the VRDO market. In equilibrium, the amount of such permanent increase in the ARS rate should be the same as the fee of acquiring liquidity backstops in the VRDO market, which thus measures the value of a liquidity backstop. In our paper, we develop a theoretical model of the pricing of VRDO and ARS securities. We then estimate the model using the data of historical interest rates in the VRDO and AS markets. We find the value of a liquidity backstop is about 14.5 basis points per annum.
Liquidity backstops and the fragility in the shadow banking system
Although we focus on the municipal bond markets for VRDOs and ARS, we believe that our main results have broader implications—for example, on the shadow banking system. Many shadow banks finance longer-term assets with short-term debt, creating a sort of "shadow money." However, unlike the claims issued by commercial banks, the debt issued by these shadow banks is not backstopped by the federal safety net (for example, federal deposit insurance and the central bank's lender-of-last-resort capacity). In effect, shadow money or claims issued by shadow banks are more like ARS securities whereas claims issued by commercial banks are more like VRDO securities. The lack of public liquidity backstops make shadow money runnable. In fact, the recent financial crisis can be considered a modern bank run on the shadow banking system (see research by Gary Gorton and Andrew Metrick published in 2010 and 2012. For example, Federal Reserve Board Governor Daniel K. Tarullo (2012) pointed out such fragility in the shadow banking system:
"[s]shadow banking also refers to the creation of assets that are thought to be safe, short-term, and liquid, and as such, "cash equivalents" similar to insured deposits in the commercial banking system. Of course, as many financial market actors learned to their dismay, in periods of stress these assets are not the same as insured deposits."
The stabilizing role of liquidity backstops studied in this note helps us better understand the fragility in the shadow banking system.
Conclusion
We use the municipal bond markets for ARS and VRDOs as a laboratory to identify and quantify the value of a liquidity backstop in terms of its run-mitigating role. ARS were considered almost identical to VRDOs prior to the financial crisis. However, investors started to recognize the lack of a liquidity backstop in the ARS market at the onset of the crisis. The structural change in investors' beliefs drove a wedge in the experiences of these two markets during the crisis: the liquidity-backstop-lacking ARS market was more susceptible to runs and collapsed, but the liquidity-backstop-possessing VRDO market survived.
Note that our main results have broad applications beyond these municipal bond markets studied here, such as the run on money market funds. We focus on the markets for ARS and VRDOs that allow for such identification in a spirit similar to the "difference-in-difference" approach. Through structural estimation of the model, we are able to quantify the value of a liquidity backstop as about 14 basis points per annum.
As another application, the value of a liquidity backstop studied here speaks to the central difference between the shadow banking system and the traditional banking system. Consistent with the literature on the "neglected risk" view of shadow banking, "shadow money" (for example, ARS in this paper, or money market fund shares) can stop being liquid or safe once investors take account of tail risks that are previously neglected. We further demonstrate possible amplifying effects of neglecting tail risks in a dynamic setting. One particular implication is that the possibility of shadow money becoming illiquid in the future prompts investors to run more often, ex ante.
References
Gorton, Gary, and Andrew Metrick, 2010, Regulating the shadow banking system, Brookings Papers on Economic Activity, 261–97.
Gorton, Gary, and Andrew Metrick, 2012, Securitized banking and the run on repo, Journal of Financial Economics 104, 425–51.
He, Zhiguo, and Wei Xiong, 2012, Dynamic debt runs, Review of Financial Studies 25, 1799–1843.
Bin Wei is a financial economist and associate policy adviser at the Atlanta Fed, and Vivian Yue is associate professor of economics at Emory University and a senior research fellow in the Center for Quantitative Economic Research at the Atlanta Fed. The authors thanks Larry Wall for helpful comments on the paper. The views expressed here are the author’s and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. If you wish to comment on this post, please e-mail Bin Wei directly at bin.wei@atl.frb.org or Vivian Yue directly at vyue@emory.edu or send an email to atl.nftv.mailbox@atl.frb.org.
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1 "Prolonged disruption of the auction rate market could have negative impact on some ratings," Special Report, Moody's Investors Service, February 20, 2008.
2 See "Breakdown of auction rate securities markets," congressional testimony by Leslie Norwood, September 18, 2008.