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Dynamic Debt Runs and the Market for Variable Rate Demand Obligations

Vivian Yue and Bin Wei
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Bin Wei: Federal Reserve Board

No 1308, 2013 Meeting Papers from Society for Economic Dynamics

Abstract: 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.

Date: 2013
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