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Finance and Economics Discussion Series

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Abstract: We use simulations of the Federal Reserve's FRB/US model to examine the efficacy of a number of proposals for reducing the consequences of the zero bound on nominal interest rates. Among the proposals are: a more aggressive monetary policy; promises to make up any shortfall in monetary ease during the zero-bound period by keeping interest rates lower in the future; and the adoption of a price-level target. We consider two assumptions about expectations formation. One assumption is fully model-consistent expectations (MCE)--a reasonable assumption when a policy has been in place for some time, but perhaps less so for a newly announced policy. We therefore also consider the possibility that only financial markets have MCE, and that other agents form their expectations using a small-scale VAR model estimated using historical data. All of the policies noted above are highly effective at reducing the adverse effects of the zero bound under MCE, but their efficacy drops considerably when households and firms base their expectations on the historical average behavior of the economy, and only investors fully recognize the economic implications of the various proposals.

Keywords: Zero bound, monetary policy, expectations formation, macroeconomic models

Abstract: This paper uses the response of investment to identified structural shocks to investigate some key issues, including the nature of adjustment costs and investment's responsiveness to user cost. In the estimation, the model parameters are chosen to match as closely as possible the impulse responses from an identified VAR. In the preferred results, both investment- and capital-stock adjustment costs are important; the size of the capital-stock adjustment costs is in line with estimates from firm-level studies; the investment-adjustment costs suggest rapid adjustment of investment to its desired level; and the estimated elasticity of substitution between capital and other inputs is considerably smaller than one. There is, however, an important sensitivity: The VAR's identified aggregate demand shock leads to a large crowding out effect--when output expands, investment falls. When this shock is included among those matched, the elasticity of substitution is near one and only investment adjustment costs are important.

Keywords: Investment, adjustment costs, identified VAR

Abstract: Furture old-age mortality is notoriously difficult to predict because it requires not only an understanding of the process of senescence, which is influenced by genetic, environmental and behavioral factors, but also a prediction of how these factors will evolve going forward. In this paper, I argue that individuals are uniquely qualified to predict their own mortality based on their own genetic background, as well as environmental and behavioral risk factors that are often known only to the individual. Using expectations data from the 1992 HRS, I construct subjective cohort life tables that are shown to predict the unusual direction of revisions to U.S. life expectancy by gender between 1992 and 2004; that is, the SSA revised up male life expectancy in 2004 and at the same revised down female life expectancy, narrowing the gender gap in longevity by 25 percent over this period. Further, the subjective expectations of women suggest that female life expectancies produced by the Social Security Actuary might still be on the high side, while the subjective life expectancies for men appear to be roughly in line with the 2004 life tables.

Keywords: Mortality risk, life tables, subjective expectations

Abstract: This paper explores how altruistic parents structure transfer rules in response to potential incentive problems and how the investment behavior of children is influenced by these transfer policies. To investigate these issues, I develop a dynamic model of altruistic transfers in which transfers can be tied to the purchase of human capital investment. Numerical solutions are examined to provide insight into the predictions of the model for transfer behavior and investment by family size. The dynamic framework developed in the paper is used to guide the interpretation of data on transfers and education investment by children in the Health and Retirement Survey. The data are consistent with the prediction of the model that children in larger families invest more in education conditional on initial transfers.

Keywords: Intergenerational transfers, altruism, education

Abstract: In recent years, a broad academic consensus has arisen around the use of rational expectations sticky-price models to capture inflation dynamics. These models are seen as providing an empirically reasonable characterization of observed inflation behavior once suitable measures of the output gap are chosen; and, moreover, are perceived to be robust to the Lucas critique in a way that earlier econometric models of inflation are not. We review the principal conclusions of this literature concerning: 1) the ability of these models to fit the data; 2) the importance of rational forward-looking expectations in price setting; and 3) the appropriate measure of inflationary pressures. We argue that existing rational expectations sticky-price models fail to provide a useful empirical description of the inflation process, especially relative to traditional econometric Phillips curves of the sort commonly employed for policy analysis and forecasting.

Keywords: New-Keynesian Phillips curve, sticky-price models

feds 2005-65
January 2006

Retail Deposit Fees and Multimarket Banking (PDF)

Timothy H. Hannan

Abstract: This paper reports a systematic examination of the determinants of deposit-related retail banking fees using a set of survey data that is unusual for its size, specificity, and sampling properties. The analysis focuses explicitly on six different fees associated with checking accounts and automated teller machine (ATM) usage. A preliminary analysis documents that, on average, multimarket banks charge substantially higher fees than do typically smaller, single-market banks. A more detailed econometric analysis yields results consistent with predictions of recent models. In particular, it finds that the greater the presence of multimarket banks in the local market, the higher are the retail deposit fees of single-market banks (except in highly concentrated markets) and the weaker is the positive relationship between those fees and market concentration.

Keywords: Banks, fees, competition

Abstract: In the early 1990s, nearly forty years after Brown v. the Board of Education, three Supreme Court decisions dramaically altered the legal environment for court-ordered desegregation. Lower courts have released numerous school districts from their desegregation plans as a result. Over the same period racial segregation increased in public schools across the country -- a phenomenon which has been termed resegregation. Using a unique dataset, this paper finds that dismissal of a court-ordered desegregation plan results in a gradual, moderate increase in racial segregation and an increase in black dropout rates and black private school attendance. The increased dropout rates and private school attendance are experienced only by districts located outside of the South Census region. There is no evidence of an effect on white student along any dimension.

Keywords: Desegregation, education, dropout, race

feds 2005-63
December 2005

Explaining Credit Default Swap Spreads with the Equity Volatility and Jump Risks of Individual Firms (PDF)

Benjamin Yibin Zhang, Hao Zhou, and Haibin Zhu

Abstract: A structural model with stochastic volatility and jumps implies specific relationships between observed equity returns and credit spreads. This paper explores such effects in the credit default swap (CDS) market. We use a novel approach to identify the realized jumps of individual equities from high frequency data. Our empirical results suggest that volatility risk alone predicts 50 percent of the variation in CDS spreads, while jump risk alone forecasts 19 percent. After controlling for credit ratings, macroeconomic conditions, and firms' balance sheet information, we can explain 77 percent of the total variation. Moreover, the pricing effects of volatility and jump measures vary consistently across investment-grade and high-yield entities. The estimated nonlinear effects of volatility and jumps are in line with the model-implied relationships between equity returns and credit spreads.

Keywords: Structural model, stochastic volatility, jumps, credit spread, nonlinear effect, high-frequency data

feds 2005-62
December 2005

An Inflation Goal with Multiple Reference Measures (PDF)

William Whitesell

Abstract: Most inflation-targeting central banks express their inflation objective in terms of a range for a single official inflation measure but generally have not clarified the meaning of the ranges and their implications for policy responses. In formulating policy, all central banks monitor multiple inflation indicators. This paper suggests an alternative approach to communicating an inflation goal: announcing point-values, rather than ranges, for a few key reference measures of inflation that are used in making policy. After reviewing and extending relevant theoretical and empirical studies, the paper argues that the alternative approach could more accurately reflect the concerns of policymakers and provide a better accountability structure for monetary policy performance.

Keywords: Inflation targeting, monetary policy regime

feds 2005-61
September 2008

How Did the 2003 Dividend Tax Cut Affect Stock Prices? (PDF)

Gene Amromin, Paul Harrison, and Steven Sharpe

Abstract: We test the hypothesis that the 2003 dividend tax cut boosted U.S. stock prices and thus lowered the cost of equity. Using an event-study methodology, we attempt to identify an aggregate stock market effect by comparing the behavior of U.S. common stock prices to that of European stocks and real estate investment trusts. We also examine the relative cross-sectional response of prices on high-dividend versus low-dividend paying stocks. We do not find any imprint of the dividend tax cut news on the value of the aggregate U.S. stock market. On the other hand, high-dividend stocks outperformed low-dividend stocks by a few percentage points over the event windows, suggesting that the tax cut did induce asset reallocation within equity portfolios. Finally, the positive abnormal returns on non-dividend paying U.S. stocks in 2003 do not appear to be tied to tax-cut news.

Keywords: Dividends, capital taxation

Full Paper (Screen Reader Version)
feds 2005-60
October 2008

The Sustainability of Health Spending Growth (PDF)

Glenn Follette and Louise Sheiner

Abstract: We evaluate the long-run sustainability of health spending growth. Under the criterion that non-health consumption does not fall, one percent excess cost growth appears to be an upper bound for the economy as a whole when the projection horizon extends over the century, although some groups would experience declines in non-health consumption. More generally, the increase in health spending as a share of income may lead to a significant expansion of public sector financing, as has been the case historically. Extrapolation of historical trends also suggests that higher health spending will lead to insurance contracts with lower out-of-pocket payment shares, putting further upward pressure on health care expenditures.

Keywords: Health spending, sustainability, Medicare, cost growth

feds 2005-59
December 2005

A No-Arbitrage Analysis of Economic Determinants of the Credit Spread Term Structure (PDF)

Liuren Wu and Frank Xiaoling Zhang

Abstract: This paper presents an internally consistent analysis of the economic determinants of the term structure of credit spreads across different credit rating classes and industry sectors. Our analysis proceeds in two steps. First, we extract three economic factors from 13 time series that capture three major dimensions of the economy: inflation pressure, real output growth, and financial market volatility. In the second step, we build a no-arbitrage model that links the dynamics and market prices of these fundamental sources of economic risks to the term structure of Treasury yields and corporate bond credit spreads. Via model estimation, we infer the market pricing of these economic factors and their impacts on the whole term structure of Treasury yields and credit spreads.

Estimation shows that positive inflation shocks increase both Treasury yields and credit spreads across all maturities and credit rating classes. Positive shocks on the real output growth also increase the Treasury yields, more so at short maturities than at long maturities. The impacts on the credit spreads are positive for high credit rating classes, but become negative and increasingly so at lower creditrating classes. The financial market volatility factor has small positive impacts on the Treasury yield curve, but the impacts are strongly positive on the credit spreads, and increasingly so at longer maturities and lower credit rating classes.

Finally, when we divide each rating class into two industry sectors: financial and corporate, we find that with in each rating class, the credit spreads in the financial sector are on average wider and more volatile than the spreads in the corporate sector. Estimation further shows that the term structure of credit spreads in the financial sector is more responsive to shocks in the economic factors.

Keywords: Credit spreads, term structure, interest rates, macroeconomic factors, financial leverage, volatility, dynamic factor mode, Kalman filter

feds 2005-58
December 2005

Robustifying Learnability (PDF)

Robert J. Tetlow and Peter von zur Muehlen

Abstract: In recent years, the learnability of rational expectations equilibria (REE) and determinacy of economic structures have rightfully joined the usual performance criteria among the sought-after goals of policy design. Some contributions to the literature, including Bullard and Mitra (2001) and Evans and Honkapohja (2002), have made significant headway in establishing certain features of monetary policy rules that facilitate learning. However a treatment of policy design for learnability in worlds where agents have potentially misspecified their learning models has yet to surface. This paper provides such a treatment. We begin with the notion that because the profession has yet to settle on a consensus model of the economy, it is unreasonable to expect private agents to have collective rational expectations. We assume that agents have only an approximate understanding of the workings of the economy and that their learning the reduced forms of the economy is subject to potentially destabilizing perturbations. The issue is then whether a central bank can design policy to account for perturbations and still assure the learnability of the model. Our test case is the standard New Keynesian business cycle model. For different parameterizations of a given policy rule, we use structured singular value analysis (from robust control theory) to find the largest ranges of misspecifications that can be tolerated in a learning model without compromising convergence to an REE.

Keywords: Monetary policy, learning, e-stability, learnability, robust control

Abstract: We examine the effects of the 2003 dividend tax cut on U.S. stock prices and corporate payout policies. First, using an event-study methodology, we compare the performance of U.S. stocks to that of other securities that should not have benefited from the tax change. We find that U.S. large-cap and small-cap indexes do not outperform their European counterparts, nor REIT stocks, over the event windows, suggesting little if any aggregate stock market effect from the tax change. In cross-sectional analysis, high-dividend stocks outperformed low-dividend stocks by a few percentage points over the event windows. On the other hand, non-dividend paying stocks are found to have outperformed the overall market by a small margin, but this result does not appear specific to the event windows, suggesting that non-tax factors were at play. Second, the tax change did appear to induce an increase in dividends, especially at firms where executive compensation was weighted more heavily toward stock than options. However, the effect on total payouts was more muted, as many firms scaled back share repurchases.

Keywords: Dividends, capital taxation, share repurchases, executive compensation

feds 2005-56
December 2005

Competition and Price Discrimination in the Market for Mailing Lists (PDF)

Ron Borzekowski, Raphael Thomadsen, and Charles Taragin

Abstract: This paper examines the relationship between competition and price discrimination in the market for mailing lists. More specifically, we examine whether sellers are more likely to segregate consumers by offering a menu of quality choices (second-degree price discrimination) and/or offering different prices to readily identifiable groups of consumers (third-degree price discrimination) in more competitive markets. We also examine how the fineness with which consumers are divided corresponds to the level of competition in the market.

The dataset includes information about all consumer response lists derived from mail order buyers (i.e. lists derived from catalogs) available for rental in 1997 and 2002. Using industry classifications, we create measures of competition for each list. We then use these measures to predict whether given lists utilize discriminatory pricing strategies.

Our results indicate that lists facing more competition are more likely to implement second-degree and third-degree price discrimination, and when implementing second-degree price discrimination, to offer menus with more choices.

Keywords: Price discrimination, information goods

Abstract: I explore alternative central bank policies for liquidity provision in a model of payments. I use a mechanism design approach so that agents' incentives to default are explicit and contingent on the credit policy designed. In the first policy, the central bank invests in costly enforcement and charges an interest rate to recover costs. I show that the second best solution is not distortionary. In the second policy, the central bank requires collateral. If collateral does not bear an opportunity cost, then the solution is first best. Otherwise, the second best is distortionary because collateral serves as a binding credit constraint.

Keywords: Payments systems, central banking, liquidity, collateral

feds 2005-54
November 2005

Can Financial Innovation Help to Explain the Reduced Volatility of Economic Activity? (PDF)

Karen E. Dynan, Douglas W. Elmendorf, and Daniel E. Sichel

Abstract: The stabilization of economic activity in the mid 1980s has received considerable attention. Research has focused primarily on the role played by milder economic shocks, improved inventory management, and better monetary policy. This paper explores another potential explanation: financial innovation. Examples of such innovation include developments in lending practices and loan markets that have enhanced the ability of households and firms to borrow and changes in government policy such as the demise of Regulation Q. We employ a variety of simple empirical techniques to identify links between the observed moderation in economic activity and the influence of financial innovation on consumer spending, housing investment, and business fixed investment. Our results suggest that financial innovation should be added to the list of likely contributors to the mid-1980s stabilization.

Keywords: Economic fluctuations, volatility, financial innovation, financial deregulation

Abstract: Affine term structure models in which the short rate follows a jump-diffusion process are difficult to solve, and the parameters of such models are hard to estimate. Without analytical answers to the partial difference differential equation (PDDE) for bond prices implied by jump-diffusion processes, one must find a numerical solution to the PDDE or exactly solve an approximate PDDE. Although the literature focuses on a single linearization technique to estimate the PDDE, this paper outlines alternative methods that seem to improve accuracy. Also, closed-form solutions, numerical estimates, and closed-form approximations of the PDDE each ultimately depend on the presumed distribution of jump sizes, and this paper explores a broader set of possible densities that may be more consistent with intuition, including a bi-modal Gaussian mixture. GMM and MLE of one- and two-factor jump-diffusion models produce some evidence for jumps, but sensitivity analyses suggest sizeable confidence intervals around the parameters.

Keywords: Jump-diffusion, term-structure models

Abstract: This paper analyzes the necessary and sufficient conditions for solving money-in-the-utility-function models when contemporaneous asset returns are uncertain. A unique solution to such models is shown to exist under certain measurability conditions. Stochastic Euler equations, whose existence is normally assumed in these models, are then formally derived. The regularity conditions are weak, and economically innocuous. The results apply to the broad range of discrete-time monetary and financial models that are special cases of the model used in this paper. The method is also applicable to other dynamic models that incorporate contemporaneous uncertainty.

Keywords: Money, asset pricing, dynamic programming, stochastic modelling, uncertainty

feds 2005-51
November 2005

Monetary Policy with Imperfect Knowledge (PDF)

Athanasios Orphanides and John C. Williams

Abstract: We examine the performance and robustness of monetary policy rules when the central bank and the public have imperfect knowledge of the economy and continuously update their estimates of model parameters. We find that versions of the Taylor rule calibrated to perform well under rational expectations with perfect knowledge perform very poorly when agents are learning and the central bank faces uncertainty regarding natural rates. In contrast, difference rules, in which the change in the interest rate is determined by the inflation rate and the change in the unemployment rate, perform well when knowledge is both perfect and imperfect.

Keywords: Natural rate of interest, natural rate of unemployment, rational expectations, learning, monetary policy rules

Abstract: Firms active in OTC derivative markets increasingly use margin agreements to reduce counterparty credit risk. Making several simplifying assumptions, I use both a quasi- analytic approach and a simulation approach to quantify how margining reduces counterparty credit exposure. Margining reduces counterparty credit exposure by over 80 percent, using baseline parameter assumptions. I show how expected positive exposure (EPE) depends on key terms of the margin agreement and the current mark-to-market value of the portfolio of contracts with the counterparty. I also discuss a possible shortcut that could be used by firms that can model EPE without margin but cannot achieve the higher level of sophistication needed to model EPE with margin.

Keywords: Counterparty risk, collateral, margin, derivatives

Abstract: Differences in the supply of housing generate substantial variation in housing prices across the United States. Because housing prices influence migration, the elasticity of housing supply also has an important impact on local labor markets. Specifically, an increase in labor demand will translate into less employment growth and higher wages in places where it is relatively difficult to build new houses. To identify metropolitan areas where the supply of housing is constrained, I assemble evidence on housing supply regulations from a variety of sources. In places with relatively few barriers to construction, an increase in housing demand leads to a large number of new housing units and only a moderate increase in housing prices. In contrast, for an equal demand shock, places with more regulation experience a 17 percent smaller expansion of the housing stock and almost double the increase in housing prices. Furthermore, I find that housing supply regulations have a significant effect on local labor market dynamics. Whereas a 1 percent increase in labor demand generally leads to a 1 percent increase in the long-run level of employment, the employment response is less than 0.8 percent in places where the housing supply is highly constrained.

Keywords: Housing supply, zoning regulations, local labor markets

Abstract: The estimation of dynamic no-arbitrage term structure models with a flexible specification of the market price of risk is beset by a severe small-sample problem arising from the highly persistent nature of interest rates. We propose using survey forecasts of a short-term interest rate as additional input to the estimation to overcome the problem. The three-factor pure-Gaussian model thus estimated with the U.S. Treasury term structure for the 1990-2003 period generates a stable estimate of the expected path of the short rate, reproduces the well-known stylized patterns in the expectations hypothesis tests, and captures some of the short-run variations in the survey forecast of the changes in longer-term interest rates.

Keywords: Dynamic term structure models, survey data, interest rate forecasts, term premia, expectations hypothesis

Abstract: Using data on corporate profits forecasts from the Survey of Professional Forecasters, I decompose real stock returns into a fundamental news component and a return news component and analyze the effects of the Great Moderation on each. Empirically, the response of each component of real stock returns to the Great Moderation has been quite different. The volatility of fundamental news shocks has declined by 50% since the onset of the Great Moderation, suggesting a strong link between underlying fundamentals and the broader macroeconomy. Alternatively, the volatility of return news shocks has remained stable over the Great Moderation period. Since the bulk of stock market volatility is attributable to return shocks, the Great Moderation has not had a significant effect on stock return volatility. These empirical findings are shown to be consistent with Campbell and Cochrane's (1999) habit formation asset pricing model. In the face of a large decline in consumption volatility, the volatility of fundamental news shocks declines while the volatility of return shocks stagnate. Ultimately, the effect of a Great Moderation in consumption volatility on overall stock return volatility in the habit formation model is slight.

Keywords: Great moderation, stock market volatility, fundamental news, return news

Abstract: It is frequently claimed that high ATM surcharges actually attract customers to the banks that impose them, particularly if they operate large ATM networks. By exploiting as "natural experiments" two events associated with the lifting of surcharge bans in Iowa and in the states that neighbor Iowa, this paper seeks to test for the implications of this phenomenon as it applies to the market shares of banking institutions and to several aspects of market structure. Consistent with these implications, results of "difference-in-difference" analyses suggest that the shares of larger market participants increase, the shares of smaller market participants decrease, market concentration increases, and the number of market competitors decreases after the lifting of surcharge bans.

Keywords: ATMs surcharge competition

Abstract: This paper examines how changes in tax policy, welfare programs, public health insurance, and economic conditions during the 1990s affected welfare use and employment among single mothers. Drawing on panel data from the Survey of Income and Program Participation, I give new estimates of the effects of specific policy changes and use those estimates to explain changes in economic behavior. The results suggest that Welfare Reform policies, the EITC, and improved economic conditions, in that order, were the primary determinants of changes in welfare use and employment between 1993 and 1999.

Keywords: Welfare reform, EITC, Medicaid, labor supply, single mothers

Abstract: We use anticipated changes in tax rates associated with changes in family composition to estimate intertemporal labor supply elasticities and elasticities of taxable income with respect to the net-of-tax wage rate. A number of provisions of the tax code are tied explicitly to child age and dependent status. Changes in the ages of children can thus affect marginal tax rates through phase-in or phase-out provisions of tax credits or by shifting individuals across tax brackets. We identify the response of labor and income to these tax changes by comparing families who experienced a tax rate change to families who had a similar change in dependents but no resulting tax rate change. A primary advantage of our approach is that the changes are anticipated and therefore should not cause re-evaluations of lifetime income. The estimates of substitution effects should consequently not be confounded by life-cycle income effects. The empirical design also allows us to compare similar families and can be used to estimate elasticities across the income distribution. In particular, we provide estimates for low and middle income families. Using data from the Survey of Income and Program Participation (SIPP), we estimate an intertemporal elasticity of family labor earnings close to one for families earning between $30,000 and $75,000. Our estimates for families in the EITC phase-out range are lower but still substantial. Estimates from the IRS-NBER individual tax panel are consistent with the SIPP estimates. Tests using alternate control groups and simulated "placebo" tax schedules support our identifying assumptions. The high-end estimates suggest substantial efficiency costs of taxation.

Keywords: Intertemporal labor supply, taxation

feds 2005-43
October 2005

The Effects of Mortgage Prepayments on M2 (PDF)

Yueh-Yun C. O'Brien

Abstract: Mortgage prepayments can contribute significantly to fluctuations in M2 growth rates. These mortgage prepayment effects are primarily driven by certain rules of mortgage-backed-security (MBS) insurers that require mortgage servicers to hold in M2-type deposits the prepayment proceeds due to MBS investors. This paper provides a methodology for estimating prepayment effects on M2. The effects are estimated separately for refinancing and home sales. The results indicate that excluding the mortgage prepayment effects from M2 produces smoother monthly growth rates. The stability of the relationship between money and GDP as measured by M2 velocity is also increased. Refinancing prepayments account for most of the prepayment effects on M2.

Keywords: Mortgage prepayments, M2, refinancing, home sales

Abstract: This paper formalizes the process of updating the nowcast and forecast on output and inflation as new releases of data become available. The marginal contribution of a particular release for the value of the signal and its precision is evaluated by computing "news" on the basis of an evolving conditioning information set. The marginal contribution is then split into what is due to timeliness of information and what is due to economic content. We find that the Federal Reserve Bank of Philadelphia surveys have a large marginal impact on the nowcast of both inflation variables and real variables, and this effect is larger than that of the Employment Report. When we control for timeliness of the releases, the effect of hard data becomes sizeable. Prices and quantities affect the precision of the estimates of inflation, while GDP is affected only by real variables and interest rates.

Keywords: Forecasting, monetary policy, factor model, real time data, large data sets, news

Abstract: Since 1997, when the Department of Housing and Urban Development discontinued its quarterly gross mortgage flow system, there has been no systematic attempt to disaggregate the net change in outstanding home mortgage debt into its constituent gross flows. Using a different approach, we have developed a system that reconciles the change in regular home mortgage debt with mortgage flows. The latter includes home purchase and refinance originations, and mortgage purchases, sales, and repayments for five types of mortgage originators and six categories of other mortgagees. In the process, we derive the sources of equity extraction from homes financed by mortgages.

Keywords: Mortgage originations, mortgage repayments, refinance originations, home equity extraction

feds 2005-40
September 2008

Risk, Uncertainty, and Asset Prices (PDF)

Geert Bekaert, Eric Engstrom, and Yuhang Xing

Abstract: We identify the relative importance of changes in the conditional variance of fundamentals (which we call "uncertainty") and changes in risk aversion in the determination of the term structure, equity prices and risk premiums. Theoretically, we introduce persistent time-varying uncertainty about the fundamentals in an external habit model. The model matches the dynamics of dividend and consumption growth, including their volatility dynamics and many salient asset market phenomena. While the variation in price-dividend ratios and the equity risk premium is primarily driven by risk aversion, uncertainty plays a large role in the term structure and is the driver of counter-cyclical volatility of asset returns.

Keywords: Equity premium, economic uncertainty, stochastic risk aversion, time variation in risk and return, excess volatility, external habit, term structure

Full paper (Screen Reader Version): Revised | Original

Original paper (PDF)

Abstract: We compile and analyzed detailed information on the debt structure and interest rate derivative positions of nonfinancial firms in 2000 and 2002. We find that differences in debt structure across firms and time tend to be counterbalanced by difference in derivative positions. In particular, among derivative users, smaller firms tend to have relatively more interest rate exposure from liabilities than larger firms and tend to use derivatives that offset these exposures. Larger firms also tend to limit their interest rate exposures, but they do so through their choice of debt structure rather than with derivatives. On the other hand, we find that a large fraction of the change in derivative positions over time cannot be explained by changes in debt structure. Finally, we find no evidence that nonfinancial firms hedge interest rate exposures from their operating assets, but do not see this as supporting the hypothesis that firms use derivatives to speculate.

Keywords: Derivatives, risk management, debt maturity

Abstract: The movement of hours worked over the business cycle is an important input into the estimation of many key parameters in macroeconomics. Unfortunately, the available data on hours do not correspond precisely to the concept required for accurate inference. We study one source of mismeasurement--that the most commonly used source data measure hours paid instead of hours worked--focusing our attention on salaried workers, a group for whom the gap between hours paid and hours worked is likely particularly large. We show that the measurement gap varies significantly and positively with changes in labor demand. As a result, we estimate that the standard deviations of the workweek and of total hours worked are 25 and 6 percent larger, respectively, than standard measures of hours suggest. We also find that this measurement gap is an unlikely source of the acceleration in published measures of productivity since 2000.

Keywords: Salaried workers, workweek, cyclical movements in hours worked

Abstract: This note presents a simple algorithm for characterizing the set of pure strategy Nash equilibria in a broad class of entry games. The algorithm alleviates much of the computational burden associated with recently developed econometric techniques for estimating payoff functions inferred from entry games with multiple equlibria.

Keywords: Entry games, multiple equilibria, incomplete models

Abstract: The growing share of financial assets that are held and managed by large institutional investors whose desired trades move asset prices is at odds with the traditional competitive assumption that investors are small and take prices as given. This paper relaxes the traditional price-taking assumption and instead presents a dynamic multiple asset model of imperfect competition in asset markets among large investors who differ in their risk aversion. The model is used to study asset price dynamics during an LTCM-like scenario in which market rumors of distressed asset sales are followed at a later date by the sales themselves. Using the model, it is shown that large investors front-run distressed sales; asset prices overshoot their long-run fundamentals; and asset pricing models experience temporary breakdown. During the period of model breakdown assets equilibrium returns are explained by the market portfolio and by transient liquidity factors.

Keywords: Strategic investors, contagion, Cournot competition

feds 2005-35
August 2005

Liquidity, Default, Taxes and Yields on Municipal Bonds (PDF)

Junbo Wang, Chunchi Wu, and Frank Zhang

Abstract: We examine the relative yields of Treasuries and municipals using a generalized model that includes liquidity as a state factor. Using a unique transaction dataset, we are able to estimate the liquidity risk of municipals and its effect on bond yields. We find that a substantial portion of the maturity spread between long- and short-maturity municipal bonds is attributable to the liquidity premium. Controlling for the effects of default and liquidity risk, we obtain implicit tax rates very close to the statutory tax rates of high-income individuals and corporations, and these tax rate estimates are remarkably stable over maturities.

Keywords: Municipal bond, liquidity risk, default, tax rate, yield spread

feds 2005-34
September 2005

Optimal Policy Projections (PDF)

Lars E.O. Svensson and Robert J. Tetlow

Abstract: We outline a method to provide advice on optimal monetary policy while taking policymakers' judgment into account. The method constructs optimal policy projections (OPPs) by extracting the judgment terms that allow a model, such as the Federal Reserve Board staff economic model, FRB/US, to reproduce a forecast, such as the Greenbook forecast. Given an intertemporal loss function that represents monetary policy objectives, OPPs are the projections---of target variables, instruments, and other variables of interest---that minimize that loss function for given judgment terms. The method is illustrated by revisiting the economy of early 1997 as seen in the Greenbook forecasts of February 1997 and November 1999. In both cases, we use the vintage of the FRB/US model that was in place at that time. These two particular forecasts were chosen, in part, because they were at the beginning and the peak, respectively, of the late 1990s boom period. As such, they differ markedly in their implied judgments of the state of the world in 1997 and our OPPs illustrate this difference. For a conventional loss function, our OPPs provide significantly better performance than Taylor-rule simulations.

Keywords: Optimal monetary policy, forecasts, judgment

Abstract: This paper reviews a simple three-factor arbitrage-free term structure model estimated by Federal Reserve Board staff and reports results obtained from fitting this model to U.S. Treasury yields since 1990. The model ascribes a large portion of the decline in long-term yields and distant-horizon forward rates since the middle of 2004 to a fall in term premiums. A variant of the model that incorporates inflation data indicates that about two-thirds of the decline in nominal term premiums owes to a fall in real term premiums, but estimated compensation for inflation risk has diminished as well.

Keywords: Forward rates, term-structure model, arbitrage-free pricing, term premiums

feds 2005-32
September 2005

The Household Spending Response to the 2003 Tax Cut: Evidence from Survey Data (PDF)

Julia Lynn Coronado, Joseph P. Lupton, and Louise M. Sheiner

Abstract: The Jobs and Growth Tax Relief and Reconciliation Act of 2003 has been described as textbook fiscal stimulus. Using household survey data on the self-reported qualitative response to the tax cuts, we estimate that the boost to aggregate personal consumption expenditures from the child credit rebate and the reduction in withholdings raised the average level of real GDP in the second half of 2003 by 0.2 percent and by 0.3 percent in the first half of 2004. We also show that households in the survey were well aware of their tax cuts and tended to spend equally out of the child credit rebate and the reduced withholdings, a result that is contrary to the conventional wisdom.

Keywords: JGTRRA, tax policy, consumer spending

Abstract: Several researchers have recently documented a large reduction in output volatility. In contrast, this paper examines whether output has become more predictable. Using forecasts from the Federal Reserve Greenbooks, I find the evidence is somewhat mixed. Output seems to have become more predictable at short horizons, but not necessarily at longer horizons. The reduction in unpredictability is much less than the reduction in volatility. Associated with this, recent forecasts had little predictive power.

Keywords: Predictability, variability, forecast errors, Greenbook

Abstract: Recent studies of crude oil price formation emphasize the role of interest rates and convenience yield (the adjusted spot-futures spread), confirming that spot prices mean-revert and normally exceed discounted futures. However, these studies don't explain why such "backwardation" is normal. Also, models derived in these studies typically explain only about 1 percent of daily returns, suggesting other factors are important, too. In this paper, I specify a structural oil-market model that links returns to convenience yield, inventory news, and revisions of expected production cost (growth of which is related to backwardation). Although its predictive power is only a marginal improvement, the model fits the data far better. In addition, I find reversion of spot to futures prices only when backwardation is severe. Convenience yield behaves nonlinearly, but price response to convenience yield is also nonlinear. Equivalently, futures are informative about future spot prices only when spot prices substantially exceed futures.

Keywords: Oil prices, oil futures, backwardation, convenience yield

Abstract: Federal funds futures are popular tools for calculating market-based monetary policy surprises. These surprises are usually thought of as the difference between expected and realized federal funds target rates at the current FOMC meeting. This paper demonstrates the use of federal funds futures contracts to measure how FOMC announcements lead to changes in expected interest rates after future FOMC meetings. Using several 'surprises' at different horizons, timing, level, and slope components of unanticipated policy actions are defined. These three components have differing effects on asset prices that are not captured by the contemporaneous surprise measure.

Keywords: Measuring monetary policy surprises, timing slope and level surprises, asset prices

Abstract: Regressions of investment on Tobin's Q are misspecified in the presence of capital gestation lags because they don't distinguish between the value of existing capital and the value of capital at a future date. Current investment should be determined by the anticipated shadow value of capital at the gestation horizon. Under homogeneity conditions analogous to Hayashi[1982], this value is equal to the forecast of an adjusted version of Q. This misspecification helps to explain many pathologies in the literature: attenuated estimates of the coefficient on Q, low R2, and serially-correlated errors. Regressions using aggregate data suggest that (1) endogeneity problems associated with the standard regression of investment on Q can can be eliminated by reversing the regression, (2) forecastable changes in Q provide additional information about investment not captured in current Q, and (3) specifications that explicitly account for gestation lags yield capital adjustment costs of a more reasonable magnitude.

feds 2005-27
May 2005

External Habit and the Cyclicality of Expected Stock Returns (PDF)

Thomas D. Tallarini, Jr. and Harold H. Zhang

Abstract: We estimate an equilibrium asset pricing model in which agents' preferences have an unobserved external habit using the efficient method of moments (EMM). Given the estimated structural parameters we examine the cyclical behavior of expected stock returns in the model. We find that the estimated structural parameters imply countercyclical expected stock returns as documented in existing empirical studies. The model, however, is still rejected at the one percent level. Detailed examination of the moment conditions in our estimation indicates that the model performs reasonably well in matching the mean of returns, but it fails to capture the higher order moments.

Keywords: External habit, expected returns, asset pricing, efficient method of moments

Abstract: We use data obtained from a series of Michigan Surveys of Consumer Attitudes to study stock market beliefs and portfolio choices of individual investors. We find that expected returns over the medium- and long-term horizon appear to be extrapolated from past realized returns. The findings also indicate that a more optimistic assessment of macroeconomic conditions coincides with higher expected returns and lower expected volatility, implying strongly procyclical Sharpe ratios. These results are given added credence by the empirical finding that reported portfolio concentrations in equities tend to be higher for respondents who anticipate higher returns and lower uncertainty. Overall, our empirical results lend support to the hypothesis that equity valuations are lower during recessions--and--subsequent returns are higher--because of undue pessimism about future returns, rather than high risk aversion.

Keywords: Equity premium, expected returns, behavioral finance

feds 2005-25
May 2005

Prices, Production, and Inventories over the Automotive Model Year (PDF)

Adam Copeland, Wendy Dunn, and George Hall

Abstract: This paper studies the within-model-year pricing and production of new automobiles. Using new monthly data on U.S. transaction prices, we document that for the typical new vehicle, prices typically fall over the model year at a 9.2 percent annual rate. Concurrently, both sales and inventories are hump shaped. To explain these time series, we formulate a market equilibrium model for new automobiles in which inventory and pricing decisions are made simultaneously. On the demand side, we use micro-level data to estimate time-varying aggregate demand curves for each vehicle. On the supply side, we solve a dynamic programming model of an automaker that, while able to produce only one vintage of a product at a time, may accumulate inventories and consequently sell multiple vintages of the same product simultaneously. The profit maximizing pricing and production strategies under a build-to-stock inventory policy imply declining prices and hump-shaped sales and inventories of the magnitudes observed in the data. Further, roughly half of the price decline is driven by inventory control considerations, as opposed to decreasing demand.

Keywords: Dynamic pricing, revenue management, discrete-choice demand estimation, build-to-stock inventory policy

Abstract: Investment models typically assume that capital becomes productive almost immediately after purchase and that there is no lead time needed to plan. In the case, marginal q is usually sufficient for investment. This paper develops a model of aggregate investment where competitive firms face no adjustment costs other than building and planning delays. In this context, both Tobin's Q and cash flow can be noisy indicators of investment because some shocks fail to outlast the combined gestation lag. The paper demonstrates some empirical facts that challenge prevailing theories of investment but are consistent with gestation requirements. Regressions using aggregate data suggest that it takes at least four quarters for investment to respond to technology shocks and as many as eight additional quarters before productive capacity is affected. Estimates from structural VARs show that only permanent shocks affect investment, but that cash flow and Q react to both permanent and transitory shocks.

Keywords: Investment, capital, time to build, Tobin's Q, temporary shocks

feds 2005-23
May 2005

Raising the Bar for Models of Turnover (PDF)

Erwan Quintin and John J. Stevens

Abstract: It is well known that turnover rates fall with employee tenure and employer size. We document a new empirical fact about turnover: Among surviving employers, separation rates are positively related to industry-level exit rates, even after controlling for tenure and size. Specifically, in a dataset with over 13 million matched employee-employer observations for France, we find that, all else equal, a 1 percentage point increase in exit rates raises separation rates by 1/2 percentage point on average. Among current year hires, the average effect is twice as large. This relationship between exit rates and separation rates is robust to a host of data and statistical considerations. We review several standard models of worker turnover and argue that a model with firm-specific human capital accumulation most easily accounts for this new empirical fact.

Keywords: Firm survival, employee turnover, human capital

Abstract: Labor market outcomes such as turnover and earnings are correlated with employer characteristics, even after controlling for observable differences in worker characteristics. We argue that this systematic relationship constitutes strong evidence in favor of models where workers choose how much to invest in future productivity. Because employer characteristics are correlated with firm survival, returns to these investments vary across firm types. We describe a dynamic general equilibrium model where workers employed in firms more likely to survive choose to devote more time to productivity enhancing activities, and therefore have a steeper earnings-tenure profile. Our model also predicts that quit rates should be lower in firms more likely to survive, and should tend to fall during slow times, while job destruction rates should rise. These predictions, we argue, are borne out by the existing empirical evidence.

Keywords: Firm survival, firm size, employee turnover, firm specific human capital

Abstract: This paper reviews a variety of backtests that examine the adequacy of Value-at-Risk (VaR) measures. These backtesting procedures are reviewed from both a statistical and risk management perspective. The properties of unconditional coverage and independence are defined and their relation to backtesting procedures is discussed. Backtests are then classified by whether they examine the unconditional coverage property, independence property, or both properties of a VaR measure. Backtests that examine the accuracy of a VaR model at several quantiles, rather than a single quantile, are also outlined and discussed. The statistical power properties of these tests are examined in a simulation experiment. Finally, backtests that are specified in terms of a pre-specified loss function are reviewed and their use in VaR validation is discussed.

Keywords: VaR, backtesting

feds 2005-20
May 2005

Branch Banking, Bank Competition, and Financial Stability (PDF)

Mark Carlson and Kris James Mitchener

Abstract: It is often argued that branching stabilizes banking systems by facilitating diversification of bank portfolios; however, previous empirical research on the Great Depression offers mixed support for this view. Analyses using state-level data find that states allowing branch banking had lower failure rates, while those examining individual banks find that branch banks were more likely to fail. We argue that an alternative hypothesis can reconcile these seemingly disparate findings. Using data on national banks from the 1920s and 1930s, we show that branch banking increases competition and forces weak banks to exit the banking system. This consolidation strengthens the system as a whole without necessarily strengthening the branch banks themselves. Our empirical results suggest that the effects that branching had on competition were quantitatively more important than geographical diversification for bank stability in the 1920s and 1930s.

Keywords: Branching banking, bank consolidation, financial stability, Great Depression

Abstract: This paper uses a dynamic general-equilibrium model with a nominal tax system to consider the effects of temporary partial expensing allowances on investment and other macroeconomic aggregates.

Keywords: Investment tax incentives, investment tax credit, expensing allowances

Abstract: This paper compares nominal price rigidity in retail stores during two 28-month periods: 1889-1891 and 1997-1999. The 1889-1891 microdata price quotes show: 1. a lower frequency of price changes; 2. a smaller average magnitude of price changes; 3. fewer "small" price changes; and, 4. fewer temporary price reductions. These differences are consistent with the 1889-1891 period having a higher cost of changing prices resulting in less adjustment to transitory price shocks. Changes in the retailing environment that may have led to a higher cost of changing prices in 1889-1891 are discussed.

Keywords: Nominal price rigidity, frequency of price change

Abstract: One of the most striking changes in the composition of household retirement savings over the past 20 years has been the shift from defined benefit to defined contribution pension plans. Understanding the factors underlying this shift is important for determining its impact on retirement saving adequacy. Yet previous research, which has mostly focused on factors affecting all firms, such as regulation or increased longevity, has yielded little consensus. In this study we estimate the contribution of changing workforce characteristics and production environments to the shift in pension coverage. Our findings suggest that, while aggregate factors explain a large part of the movement, changes in worker demand, due to evolving workforce characteristics, also contributed notably. On the supply side, we find support for the theory that technical change has reduced the value of DB plans. These supply and demand factors are particularly important for explaining the significant variation in cross-industry trends in pension coverage.

Keywords: Pensions, compensation, workforce trends, job turnover, technical change

Abstract: We study the relationship between banking competition and the transmission of monetary policy through the bank lending channel. Using business small loan origination data provided from the Community Reinvestment Act from 1996-2002 in our analysis, we are able to reaffirm the existence of the bank lending channel of monetary transmission. Moreover, we find that the impact of monetary policy on loan originations is weaker in more concentrated markets.

Keywords: Competition, monetary policy, lending channel

feds 2005-15
April 2005

The Effects of Competition from Large, Multimarket Firms on the Performance of Small, Single-Market Firms: Evidence from the Banking Industry (PDF)

Allen N. Berger, Astrid A. Dick, Lawrence G. Goldberg, and Lawrence J. White

Abstract: We offer and test two competing hypotheses for the consolidation trend in banking using U.S. banking industry data over the period 1982-2000. Under the efficiency hypothesis, technological progress improved the performance of large, multimarket firms relative to small, single-market firms, whereas under the hubris hypothesis, consolidation was largely driven by corporate hubris. Our results are consistent with an empirical dominance of the efficiency hypothesis over the hubris hypothesis-on net, technological progress allowed large, multimarket banks to compete more effectively against small, single-market banks in the 1990s than in the 1980s. We also isolate the extent to which technological progress occurred through scale versus geographic effects and how they affected the performance of small, single-market banks through revenues versus costs. The results may shed light as well on some of the research and policy issues related to community banking, and on the question of how community banks should be defined.

Keywords: Banks, community banking, bank size, multimarket banks, technological progress

Abstract: Recent papers by Kim and Nelson (1999) and McConnell and Perez-Quiros (2000) uncover a dramatic decline in the volatility of U.S. GDP growth beginning in 1984. Determining whether the source is good luck, good policy or better inventory management has since developed into an active area of research. This paper seeks to shed light on the source of the decline in volatility by studying the behavior of the U.S. automobile industry, where the changes in volatility have mirrored those of the aggregate data. We find that changes in the relative volatility of sales and output, which have been interpreted by some as evidence of improved inventory management, could in fact be the result of changes in the process driving automobile sales. We first show that the autocorrelation of sales dropped during the 1980s, and that the behavior of interest rates may be the force behind the change in sales persistence. A simulation of the assembly plants' cost function illustrates that the persistence of sales is a key determinant of output volatility. A comparison of the ways in which assembly plants scheduled production in the 1990s relative to the 1970s supports the intuition of the simulation.

Keywords: Automobiles, GDP volatility

Abstract: Many recent papers have claimed that when housing services are treated separately from other forms of consumption in utility, a wide range of economic puzzles such as the equity premium puzzle can be explained. Our paper challenges these claims. The key assumption embedded in this literature is that households are not very willing to substitute housing services for consumption. We show that housing services and consumption must be much more substitutable than has been assumed for a neoclassical consumption model to be consistent with U.S. house price data. Further, when forced to match both historical house prices and stock returns, the lowest risk-free rate the model can generate is 11 percent.

Keywords: House prices, housing, equity premium

Abstract: The cycle in output and hours worked is not symmetric: it behaves differently around recessions than in expansions. Similarly, the trend in multifactor productivity (MFP) seems to pass through different regimes; there was an extended period of slow MFP growth from about 1973 through 1995, and faster growth thereafter. Typical linear models and linear filters such as the Kalman filter deal poorly with asymmetry and regime changes. This paper attempts to determine more accurately and quickly any shifts in trend MFP growth, using a nonlinear Kalman/Markov filter with a model of the unobserved components of output and hours. This hybrid model incorporates regime-switching in the business cycle and in the trend growth of MFP. Estimation results are promising. The hybrid model and associated filter appear to be faster than the basic Kalman filter in detecting turning points in the smoothed conditional mean estimate of trend MFP growth; in addition, the hybrid model avoids some of the Kalman filter's biases in reconstructing historical business cycles and the MFP trend.

Keywords: Multifactor productivity, total factor productivity, regime switching, Markov switching

Abstract: In Silicon Valley's computer cluster, skilled employees are reported to move rapidly between competing firms. If true, this job-hopping facilitates the reallocation of resources towards firms with superior innovations, but it also creates human capital externalities that reduce incentives to invest in new knowledge. Outside of California, employers can use non-compete agreements to reduce mobility costs, but these agreements are unenforceable under California law. Until now, the claim of "hyper-mobility" of workers in Silicon has not been rigorously investigated. Using new data on labor mobility we find higher rates of job-hopping for college-educated men in Silicon Valley's computer industry than in computer clusters located out of the state. Mobility rates in other California computer clusters are similar to Silicon Valley's, suggesting some role for state laws restricting non-compete agreements. Outside of the computer industry, California's mobility rates are no higher than elsewhere.

Keywords: Silicon Valley, industrial cluster, mobility, non-compete, modularity, innovation

Abstract: A frictionless, structural view of default has the unrealistic implication that recovery rates on bonds, measured at default, should be close to 100 percent. This suggests that standard "frictions" such as default delays, corporate-valuation jumps, and bankruptcy costs may be important drivers of recovery rates. A structural view also suggests the existence of nonlinearities in the empirical relationship between recovery rates and their determinants. We explore these implications empirically and find direct evidence of jumps, and also evidence of the predicted nonlinearities. In particular, recovery rates increase as economic conditions improve from low levels, but decrease as economic conditions become robust. This suggests that improving economic conditions tend to boost firm values, but firms may tend to default during particularly robust times only when they have experienced large, negative shocks.

Keywords: Recovery rate, default, credit risk model

Abstract: This paper proposes a method for predicting the probability density of a variable of interest in the presence of model ambiguity. In the first step, each candidate parametric model is estimated minimizing the Kullback-Leibler 'distance' (KLD) from a reference nonparametric density estimate. Given that the KLD represents a measure of uncertainty about the true structure, in the second step, its information content is used to rank and combine the estimated models. The paper shows that the KLD between the nonparametric and the parametric density estimates is asymptotically normally distributed. This result leads to determining the weights in the model combination, using the distribution function of a Normal centered on the average performance of all plausible models. Consequently, the final weight is determined by the ability of a given model to perform better than the average. As such, this combination technique does not require the true structure to belong to the set of competing models and is computationally simple. I apply the proposed method to estimate the density function of daily stock returns under different phases of the business cycle. The results indicate that the double Gamma distribution is superior to the Gaussian distribution in modeling stock returns, and that the combination outperforms each individual candidate model both in- and out-of-sample.

Keywords: Density forecast comparison, kernel density estimation, entropy, model combination

feds 2005-08
January 2005

Does Trading Frequency Affect Subordinated Debt Spreads? (PDF)

Christopher Bianchi, Diana Hancock, and Laura Kawano

Abstract: Because illiquid bonds may be relatively poorly priced, the ability to infer investor perceptions of changes in a banking organization's financial health from such bonds may be obscured. To examine the time-series effect of trading frequency on subordinated debt spreads, we consider the liquidity of subordinated debt for large, complex U.S. banking organizations over the 1987:Q2 - 2002:Q4 period. Since trade volumes are unobservable, we construct various measures of weekly trading frequency from observed bond prices. Using these indirect liquidity measures, we find evidence that trading frequency does significantly affect observed subordinated debt spreads. We also provide estimates for the premium of illiquidity.

Keywords: Bond liquidity, pricing

Abstract: Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs) that purchase mortgages and issue mortgage-backed securities (MBS). In addition, the GSEs are active participants in the primary and secondary mortgage markets on behalf of their own portfolios of MBS. Because these portfolios have grown quite large, portfolio purchases as well as MBS issuance are likely to be important forces in the mortgage market. This paper examines the statistical evidence of a connection between GSE actions and the interest rates paid by mortgage borrowers. We find that both portfolio purchases and MBS issuance have negligible effects on mortgage rate spreads and that purchases are not any more effective than securitization at reducing mortgage interest rate spreads. We also examine the 1998 liquidity crisis and find that GSE portfolio purchases did little to affect interest rates paid by borrowers. These results are robust to alternative assumptions about causality and to model specification.

Keywords: Mortgage finance, government-sponsored enterprises, financial stability

Abstract: We derive a theoretical model of how jumbo and conforming mortgage rates are determined and how the jumbo-conforming spread might arise. We show that mortgage rates reflect the cost of funding mortgages and that this cost of funding can drive a wedge between jumbo and conforming rates (the jumbo-conforming spread). Further, we show how the jumbo-conforming spread widens when mortgage demand is high or core deposits are not sufficient to fund mortgage demand, and tighten as the mortgage market becomes more liquid and realizes economies of scale. Using MIRS data for April 1997 through May 2003, we estimate that the GSE funding advantage accounts for about seven basis points of the 15-18 basis point jumbo-conforming spread.

Keywords: Fannie Mae, Freddie Mac, GSEs, mortgages, MBS, securitization, mortgage rates

Abstract: The housing-related government-sponsored enterprises Fannie Mae and Freddie Mac (the "GSEs") have an ambiguous relationship with the federal government. Most purchasers of the GSEs' debt securities believe that this debt is implicitly backed by the U.S. government despite the lack of a legal basis for such a belief. In this paper, I estimate how much GSE shareholders gain from this ambiguous government relationship. I find that (1) the government's ambiguous relationship with Fannie Mae and Freddie Mac imparts a substantial implicit subsidy to GSE shareholders, (2) the implicit government subsidy accounts for much of the GSEs' market value, and (3) the GSEs would hold far fewer of their mortgage-backed securities in portfolio and their capital-to-asset ratios would be higher if they were purely private.

Keywords: Fannie Mae, Freddie Mac, GSEs, mortgages, subsidies, housing, mortgage rates, securitization

feds 2005-04
April 2011

Econometric Tests of Asset Price Bubbles: Taking Stock (PDF)

Refet S. Gurkaynak

Abstract: Can asset price bubbles be detected? This survey of econometric tests of asset price bubbles shows that, despite recent advances, econometric detection of asset price bubbles cannot be achieved with a satisfactory degree of certainty. For each paper that finds evidence of bubbles, there is another one that fits the data equally well without allowing for a bubble. We are still unable to distinguish bubbles from time-varying or regime-switching fundamentals, while many small sample econometrics problems of bubble tests remain unresolved.

Keywords: Asset price bubbles, econometric bubble detection

Abstract: Little empirical work exists on the substitutability of depository institutions. In particular, the willingness of consumers to substitute banks for thrifts and to switch between multimarket and single-market institutions (i.e., institutions with large vs. small branch networks) has been of strong interest to policymakers. We estimate a structural model of consumer choice of depository institutions using a panel data set that includes most depository institutions and market areas in the United States over the period 1990-2001. Using a flexible framework, we uncover utility parameters that affect a consumer's choice of institution and measure the degree of market segmentation for two institution subgroups. We use our estimates to calculate elasticities and perform policy experiments that measure the substitutability of firms within and across groupings. We find both dimensions--thrifts and banks, and single- and multimarket institutions--to be important market segments to consumer choice and, ultimately, to competition in both urban and rural markets.

Keywords: Depository institutions, product differentiation, discrete choice, demand estimation, antitrust, SSNIP

feds 2005-02
January 2005

The Reform of October 1979: How It Happened and Why (PDF)

David E. Lindsey, Athanasios Orphanides, and Robert H. Rasche

Abstract: This study offers a historical review of the monetary policy reform of October 6, 1979, and discusses the influences behind it and its significance. We lay out the record from the start of 1979 through the spring of 1980, relying almost exclusively upon contemporaneous sources, including the recently released transcripts of Federal Open Market Committee (FOMC) meetings during 1979. We then present and discuss in detail the reasons for the FOMC's adoption of the reform and the communications challenge presented to the Committee during this period. Further, we examine whether the essential characteristics of the reform were consistent with monetarism, new, neo, or old-fashioned Keynesianism, nominal income targeting, and inflation targeting. The record suggests that the reform was adopted when the FOMC became convinced that its earlier gradualist strategy using finely tuned interest rate moves had proved inadequate for fighting inflation and reversing inflation expectations. The new plan had to break dramatically with established practice, allow for the possibility of substantial increases in short-term interest rates, yet be politically acceptable, and convince financial markets participants that it would be effective. The new operating procedures were also adopted for the pragmatic reason that they would likely succeed.

Keywords: Federal Reserve, FOMC, Paul Volcker, monetary reform, operating procedures

Abstract: Tax efficiency is the dominant consideration in theoretical portfolio models that allow for both taxable and tax-deferred accounts (TDAs). Investors are advised to locate higher-tax assets in their tax-deferred accounts, which in the Unites States commonly translates into "holding bonds inside TDAs and holding equities outside." Yet, observed portfolio allocations are not tax efficient. This paper empirically evaluates the predictions of a recent model designed to bridge the existing gap by explicitly incorporating uninsurable labor income risk and limited accessibility of TDA assets in household decisions [Amromin, 2003]. Together, these elements create tension between household's desire to maintain tax efficient allocations and its concern over the need to make costly TDA withdrawals in the event of bad income draws. This leads some borrowing-constrained households facing labor income risk and TDA access penalties to forgo tax efficiency in favor of allocations that provide more liquidity in bad income states--an outcome labeled as "precautionary portfolio choice." The empirical results based on household-level portfolio data from the Survey of Consumer Finances provide evidence that both the choice of whether to hold a tax efficient portfolio and the degree of portfolio tax inefficiency are related to the presence and severity of precautionary motives.

Keywords: Tax efficiency, precautionary motives, portfolio choice, tax-deferred retirement savings

 

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