Dynamic Debt Runs and the Market for Variable Rate Demand Obligations
Vivian Yue and
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Bin Wei: Federal Reserve Board
No 1308, 2013 Meeting Papers from Society for Economic Dynamics
A variable rate demand obligation (VRDO) is a tax-emept municipal bond whose interest rate resets on a periodic basis. In addition, its bondholders have a "tender" option to liquidate their positions at par, exposing the issuer to possible runs. The VRDO market experienced large-scale runs in 2008 during the financial crisis, which contributed to the largest municipal bankruptcy in history by Jefferson County in Alabama. In this paper we develop a dynamic model of VRDO and runs. In the model both the interest rate and the decision of creditors to run are endogenously determined in closed form. We show that a higher pre-specified maximum interest rate or a higher liquidity premium reduces the likelihood of run. We structurally estimate the model using the method of simulated maximum likelihood. The structural estimation allows us to compute the model-implied likelihood of run, to quantitatively assess different roles of liquidity and credit components, and to examine different contributing factors to the most recent episode of runs during the crisis.
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed013:1308
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