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Discussion of “Liquidity, Runs, and Security Design”Song Han, Dan Li (BoG)

* Any views expressed represent those of the author only and not necessarily those of the Federal Reserve Bank of New York or the Federal Reserve System.

Til Schuermann*Federal Reserve Bank of New York

Day Ahead ConferenceSan Francisco, January 2, 2009

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ARS lessons: security design, innovation

Han and Li use the ARS market as their laboratory to look at security design, auction mechanisms, financial innovation, financial fragility

Arguably much in this crisis has been about cool, fancy, new instruments which work beautifully when all is well but turn out to be quite fragile

Han and Li’s study is very carefully done, well explained, with clever use of novel dataset

Now that we know how and why it (ARS) failed, need to know more about why it thrived to begin with

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ARS and ALM

ARS, like so many financial innovations of last 10yrs, is an ALM (asset-liability mgmt) play

– Underlying assets long-dated: avg. maturity in authors’ sample is 24 yrs!

– Auctions allow frequent reset: every 7, 28, 35 days

– Acts like a short term investment (“cash equivalent”)

– Rates were typically just above LIBOR– Relatively recent phenomenon: didn’t really take-

off until 2002

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Who gains?

Issuers (munis, student loans): long dated debt sold like short term paper

– Cheaper– Get access to a broader investor class

Investors: safe, “cash-equivalent” investment

Dealers: market making, dealer spread– Institutional/retail investor arb– Dealer gets to see all other bids (dealer is last to

bid)

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When it breaks, who loses?

Machine turns out to be fragile

Issuers: get stuck with having to pay high (up to 20%) maximum rate when auction fails

– Issuers couldn’t participate in auction so couldn’t influence the prob of auction failure

Investors: stuck with illiquid instrument– Though they are getting paid more to hold it– Enough?

Dealers: end of a franchise– But not obvious how they lose beyond that

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Bond data: who knows what

Authors have auction data from 3 dealers over about 1 yr, mostly muni ARS (MARS)

Bond characteristics from Bloomberg: bond type (general obligation, revenue), taxability, credit rating, credit enhancement (insurer), maturity, size, etc.

NB: info on maximum rate (in case of auction failure) “is not readily available from any data source”

– Authors went through elaborate and careful process by going back to bond prospectus

– How, then, is an investor to know or find out?– This lack of transparency seems key!

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My favorite chart: pseudo-failure rate

% of auctions where dealer “had to” buy– When all goes well, just an inventory mgmt tool

What should that rate be?– Don’t know for a “quiet” period (e.g. 2005) since

data starts in mid-2007– Pre Feb 11, 2008: >50% (!!)– Seems like a key barometer for health of this

market

Fig 4 from Han & Li ARS Dec2008.pdf

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Role of dealers

Auctions happen at pre-set intervals when dealers can increase inventory

– Sell continuously from inventory into secondary mkt, e.g. (especially?) to retail investors

Dealers were reducing inventory already in 2007Q2– So what happened to the pseudo-failure rate from Q1

Q2?

Withdrawal of support paid for with reputation capital– Well, sort of: paid only by the first mover, and only if there

is no second mover– If others follow, then everybody (nobody) pays that

reputation capital– So what did Goldman (first mover) know in early Feb

2008?– If many dealers were already reducing inventory nearly a

year earlier (so they knew something), why wait so long?

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Final comments

“Liquidity is not universally good”: authors show that distance to fundamental value larger for bonds with more liquidity in secondary mkt

Security design is very important: fixed supply single price auction market with no issuer participation was fragile

But auction literature knew that already: so why did the market evolve this way?

– I think: dealers gained a lot through their access to private information in auctions: they saw all the bids

– But, dealers (rationally?) underpriced the risk of fragility

I’d like to see authors think harder about the role of dealers: information access, profitability, risk mgmt

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Thank You!http://nyfedeconomists.org/schuermann/