Working Papers and Publications by GCFP Affiliates

Retire on the House: The Use of Reverse Mortgages to Enhance Retirement Security by Mark J. Warshawsky & Tatevik Zohrabyan
Working Paper – July, 2016
Category: Other Work on Policy and Finance

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Credit Policy as Fiscal Policy by Deborah Lucas
Draft of forthcoming Brookings Papers on Economic Activity – March 2016
Category: Evaluation and Management of Government Financial Institutions

With the notable exception of Gale (1991), federal credit policies have been largely overlooked in analyses of the macroeconomic effects of fiscal policies. In this paper I make the case that the amount of fiscal stimulus to the U.S. economy has in recent times been seriously underestimated because of this omission. In general, the error is likely to be particularly severe during downturns that are accompanied by major disruptions in private credit markets, as occurred during the Great Recession of 2007-9 and in its aftermath. The estimates here for 2010 suggest that the stimulus effects of federal credit programs were likely to have been similar in magnitude to those of the American Recovery and Reinvestment Act of 2009 (ARRA), which provided about $392 billion of additional spending and tax cuts that year (CBO, 2011). I also find that federal credit subsidies had a big “bang-for-the-buck”—a large amount of stimulus per dollar of taxpayer cost. Furthermore, government credit programs acted as automatic stabilizers because participation rates and loan amounts could increase during the downturn without legislative action.

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Crowd-sourcing a better definition of a SIFI by Doug Criscitello
Brief – March, 2016
Category: Measurement and Control of Systemic Risk

The MIT Center for Finance and Policy recently announced the winners of its first crowd-sourced contest, “What is a Systemically Important Financial Institution?” A collaboration between the MIT Center for Finance and Policy and the Harvard Crowd Innovation Laboratory, the contest was launched to generate new proposals to specify sets of criteria that regulators should apply to designate a financial institution as systemically important.

This brief provides some background on the contest and summarizes the ideas that were generated.

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China’s Growing Local Government Debt Levels by Xun Wu
Policy Brief – January 2016
Category: Evaluation and Management of Government Financial Institutions

Local governments across China have borrowed substantially in recent years to fund public infrastructure improvements and other capital investments. Local indebtedness has increased dramatically since the global financial crisis of 2008, reaching 40 percent of GDP or RMB 24.0 trillion ($3.8 trillion) in 2014. With an economy growing at its slowest pace since the economic reforms of the 1980s, local debt levels have become a policy concern both within China and internationally. While policymakers have taken steps to mitigate the risks to China’s financial and fiscal systems, further measures may be necessary. Local debt, however, could return to more sustainable levels if the pace of infrastructure investment slows or if more stable funding sources are made available to local government.

While China’s more affluent eastern provinces have the greatest levels of debt in absolute terms, their burden is likely manageable and small as a share of local GDP compared with the poorer western provinces. While not yet severe, the fiscal outlook will be less benign in the future without significant policy changes by the central government. With a number of policy and regulatory reforms underway, some of the risky and opaque financing channels and operations that facilitated the explosion of local debt after 2008 are intended to be shut down. Moreover, the central government is taking measures to restructure local debt—pointing to the possibility, and perhaps likelihood, of a larger bailout should debt levels become unmanageable.

A structural imbalance between local government spending and access to tax revenues remains a fundamental tension, as the ability to meet debt service obligations is dependent on the power to raise revenues. Under China’s fiscal and tax system, local governments receive about 50 percent of taxes collected but are responsible for about 80 percent of expenditures—with a resulting gap that has to be filled from other sources, such as land sales and bank loans. Successful reform will require more stable and transparent financing channels for local governments.

The local government debt problem is set against a backdrop of economic change, as China attempts to turn its government-dominated economic growth model into a market-oriented one. From that perspective, how it manages its local fiscal conditions will be telling about the commitment to and speed of those larger changes.

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Hacking Reverse Mortgages by Deborah Lucas
Working Paper – revised September, 2016
Category: Evaluation and Management of Government Financial Institutions

Reverse mortgages hold the promise of unlocking home equity to help meet retirees’ spending needs while allowing them to age in place. Despite the product’s potential as significant source of liquidity and insurance, the reverse mortgage market has been slow to take off. In the U.S., the HECM–a product designed and administered by the federal government—dominates the market. We develop a valuation model for HECMs and use it to suggest an answer to the reverse mortgage puzzle: why is it that a seemingly useful and subsidized product is so unpopular? The analysis suggests a financial explanation may be an important component of the answer: The loans are expensive for borrowers. There is a government subsidy, but the benefits are largely captured by the guaranteed private lenders. Structural changes to the program are proposed that could lower cost and improve the product’s functionality and appeal.

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Customers and Investors: A Framework for Understanding Financial Institutions by Robert C. Merton & Richard T. Thakor
Customers and Investors: A Framework for Understanding Financial Institutions (Short Version) by Robert C. Merton & Richard T. Thakor
Working Paper – June, 2015
Category: Regulation of Financial Markets and Institutions

Financial institutions have both investors and customers. Investors, such as those who invest in stocks and bonds or private/public-sector guarantors of institutions, expect an appropriate risk-adjusted return in exchange for the financing and risk-bearing that they provide. Customers of a financial intermediary, in contrast, provide financing in exchange for a specific set of services, and do not want the fulfillment of these services to be contingent on the credit risk of the intermediary, even when they are not small, uninformed agents lacking in sophistication. This paper develops a framework that defines the roles of customers and investors in intermediaries, and uses the framework to provide an economic foundation for the aversion to intermediary credit risk on the part of its customers. It further explores the implications of this customer-investor nexus for a host of issues related to how contracts between financial intermediaries and their customers are structured and how risks are shared between them, as well as the consequences of (unexpected) deviations from the ex ante optimal contractual arrangement. We show that the optimality of insulating the customer from the credit risk of the intermediary explains various contractual arrangements, institutions, and regulatory practices observed in practice. Moreover, customers and investors are often intertwined in practice, and so this intertwining provides insights into the adoption of “too-big-to-fail” policies and bailouts by regulators in general. Finally, the approach taken here shows that financial crises may be a consequence of observed but unexpected deviations from the ex ante optimal risk-sharing arrangement between financial intermediaries and their customers.

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On Latency and Volatility by Andrei Kirilenko and Richard Sowers
Working Paper – June, 2015
Category: Regulation of Financial Markets and Institutions

Deformation in the clock links latency to fluctuations in volatility; so, latency should be in some way related to the volatility of volatility. A standard way to characterize the volatility of volatility, however, hinges upon first estimating volatility at an intermediate fixed time scale, and then looking at the fluctuations of volatility. This is going to miss the effect of latency. Instead, we define a volatility of instantaneous volatility (VIV), which pushes the notion of the volatility of volatility down to a microscopic level and enables us to link volatility to latency. We demonstrate the link between the VIV and latency first for a fixed latency and then suggest how to generalize it to stochastic, evolving latency.

While the intuition that latency ends up in the volatility of volatility is simple, the math quickly gets out of hand as we need to keep track of many moving parts inside deformed clocks. We go through all this math because we believe that with the continuing automation of the trading process, latency itself has become a market factor which should be explicitly modeled and then – when the models become robust like those for volatility – traded. Traders who wish to hedge their exposure to or speculate on marketwide latency can take positions in something akin to the VIX; we call the LIX – the Latency Index. This could help price the latency risk and allocate it around.

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Liquidity Trap and Excessive Leverage by Anton Korinek and Alp Simsek
Working Paper – February, 2015
Category: Other Work on Policy and Finance

In recent years, the US economy experienced a deleveraging episode in which the household debt declined. Deleveraging also coincided with a liquidity trap in which the conventional monetary policy was constrained and the economic activity remained below its potential. In this paper, we investigate the role of macroprudential policies in mitigating deleveraging episodes that coincide with liquidity traps. In these environments, households’ ex-ante leverage insurance decisions are associated with aggregate demand externalities. The unregulated equilibrium allocation is inefficient, and welfare can be improved by macroprudential policies such as debt limits and insurance subsidies. The size of the optimal intervention depends on the differences in marginal propensity to consume between constrained and unconstrained households during the deleveraging episode. Contractionary monetary policy is inferior to macroprudential policy in addressing excessive leverage, and it can even have the unintended consequence of increasing leverage.

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Latency and Asset Prices by Andrei Kirilenko and Gui Lamacie
Working Paper – January, 2015
Category: Regulation of Financial Markets and Institutions

We measure message processing time or latency inside an automated trading platform. We show that latency is a random variable that has a strong predictive power over both volatility and the volatility of volatility of a highly liquid asset over and above changes in message traffic. We argue that in automated markets, processing time contains valuable nontrade information about the price formation process. We recommend that automated trading platforms improve pre-trade price transparency by reporting characteristics of latency to market participants on an ongoing basis along with order book events, transaction prices, and trading volume.

How does latency affect the dynamics of asset prices in modern markets? In this paper, we present a simple model of latency. In our model, latency is a delay between the observed asset price and its true, but latent fundamental price. Because of latency, the observed asset price shadows the true price at some deformed distance away. In other words, latency leads to the deformation in the clock of an asset’s evolution.

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Evaluating the Cost of Government Credit Support: The OECD Context by Deborah Lucas
Economic Policy – 2014
Category: Evaluation and Management of Government Financial Institutions

Governments throughout the OECD allocate a large share of societies’ capital and risk through their credit-related activities. Hence, accurate cost estimates for credit support programmes are a prerequisite for efficient resource allocation, transparency, effective management and public oversight. I find that OECD governments generally take their cost of capital to be their own borrowing rate, rather than using a weighted-average cost of capital that includes the cost of risk borne by taxpayers and the general public in their role as equity holders. That practice, which is institutionalized in government accounting and budgetary rules, results in cost estimates for credit support that are significantly downwardly biased relative to a fair-value metric that recognizes the full cost of risk. The size and possible real consequences of those distortions are illustrated with analyses of the European Bank for Reconstruction and Development, the European Stability Mechanism, and the Tennessee Valley Authority.

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Evaluating the Government as a Source of Systemic Risk by Deborah Lucas
Working Paper – June, 2014
Category: Measurement and Control of Systemic Risk

In the wake of the financial crisis, the Dodd-Frank Act established the Financial Stability Oversight Council (FSOC) and the Office of Financial Research (OFR) to address the concern that policymakers lacked sufficient data to anticipate emerging threats to financial stability. Although most discussions about systemic risk have focused on the private-sector, the U.S. federal government is the world’s largest and most interconnected financial institution, and through its activities—as a banker, rule-maker, and regulator—represents a major source of systemic risk. This paper makes the qualitative and quantitative case that the government is a significant source of such risks, discusses the nature of the risks, and offers suggestions for how the OFR, through its data initiatives and analyses, could help to illuminate and mitigate the those risks.

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Valuation, Adverse Selection, and Market Collapses by Michael J. Fishman & Jonathan A. Parker
Working Paper – April, 2014
Category: Regulation of Financial Markets and Institutions

We study equilibria and policy in a market for external financing of real investment projects in which unsophisticated and sophisticated investors compete. A limited set of investors can choose to pay a cost and become sophisticated, allowing them to evaluate an additional dimension of projects before choosing whether or not to fund them. Because the valuation of a particular project is unobserved by all other investors, such valuation creates information on which adverse selection can occur. Unlike in previous models, higher amounts of valuation are associated with lower market prices and so greater returns to valuation, and this strategic complementarity in the capacity to do valuation generates multiple equilibria. From a social perspective, in this region of multiplicity the equilibrium without valuation is always more efficient despite funding projects that valuation would reveal as unprofitable and despite first-order benefits to the information. Valuation equilibria have low investment and low prices (high interest rates) and ex post high profits by sophisticated investors. A shift in equilibrium to a valuation equilibrium can be interpreted as a valuation run causing a credit crunch. In terms of policy, a large investor (such as a GSE) can ensure the efficient equilibrium only if it can pre-commit to a price (committing to lose money if need be) and, for some parameters, can lead to a strict gain in welfare if also subsidized.

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Rebutting Arrow and Lind: why governments should use market rates for discounting by Deborah Lucas
Journal of Natural Resources Policy Research – January 15, 2014
Category: Evaluation and Management of Government Financial Institutions

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On a New Approach for Analyzing and Managing Macrofinancial Risks by Robert C. Merton, Monica Billio, Mila Getmansky, Dale Gray, and Andrew W. Lo Financial Analysts Journal – 2013
Category: Measurement and Control of Systemic Risk

At the fifth annual CFA Institute European Investment Conference on 19 October 2012 in Prague, Robert C. Merton gave a presentation on analyzing and managing macrofinancial risk. This article is based on his talk and on the research he carried out with his coauthors.

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Systemic Risk and the Refinancing Ratchet Effect by Amir E. Khandani and Andrew W. Lo
Journal of Financial Economics – 2013
Category: Measurement and Control of Systemic Risk

The combination of rising home prices, declining interest rates, and near-frictionless refinancing opportunities can create unintentional synchronization of homeowner leverage, leading to a ‘‘ratchet’’ effect on leverage because homes are indivisible and owner-occupants cannot raise equity to reduce leverage when home prices fall. Our simulation of the U.S. housing market yields potential losses of $1.7 trillion from June 2006 to December 2008 with cash-out refinancing vs. only $330 billion in the absence of cash-out refinancing. The refinancing ratchet effect is a new type of systemic risk in the financial system and does not rely on any dysfunctional behaviors.

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Do Labyrinthine Legal Limits on Leverage Lessen by Andrew W. Lo and Thomas J. Brennan
Texas Law Review – 2012
Category: Regulation of Financial Markets and Institutions

A common theme in the regulation of financial institutions and transactions is leverage constraints. Although such constraints are implemented in various ways-from minimum net capital rules to margin requirements to credit limits-the basic motivation is the same: to limit the potential losses of certain counterparties. However, the emergence of dynamic trading strategies, derivative securities, and other financial innovations poses new challenges to these constraints. We propose a simple analytical framework for specifying leverage constraints that addresses this challenge by explicitly linking the likelihood of financial loss to the behavior of the financial entity under supervision and prevailing market conditions. An immediate implication of this framework is that not all leverage is created equal, and any fixed numerical limit can lead to dramatically different loss probabilities over time and across assets and investment styles. This framework can also be used to investigate the macroprudential policy implications of microprudential regulations through the general-equilibrium impact of leverage constraints on market parameters such as volatility and tail probabilities.

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Valuation of Government Policies and Projects by Deborah Lucas
Annual Review of Finance and Economics – 2012
Category: Evaluation and Management of Government Financial Institutions

Governments play a central role in the allocation of capital and risk in the economy. Evaluating the cost to taxpayers of government investments requires an assumption about the government’s cost of capital. Governments often take their borrowing rate to be their cost of capital, which implicitly treats the market risk associated with their activities as having no cost to taxpayers. This article reviews the theoretical and practical rationale for treating market risk as a cost to governments, presents an interpretive review of the growing literature that applies the concepts and tools of modern finance to evaluating the costs of government policies and projects, and suggests directions for future research. Examples considered include deposit insurance, Fannie Mae and Freddie Mac, the Federal Reserve’s emergency lending facilities, student loans, real infrastruc- ture investments, and public pension plans.

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Econometric Measures of Connectedness and Systemic Risk in the Finance and Insurance Sectors by Monica Billio, Mila Getmansky, Andrew W. Lo, and Loriana Pelizzon
Journal of Financial Economics – 2012
Category: Measurement and Control of Systemic Risk

We propose several econometric measures of connectedness based on principal-components analysis and Granger-causality networks, and apply them to the monthly returns of hedge funds, banks, broker/dealers, and insurance companies. We find that all four sectors have become highly interrelated over the past decade, likely increasing the level of systemic risk in the finance and insurance industries through a complex and time-varying network of relationships. These measures can also identify and quantify financial crisis periods, and seem to contain predictive power in out-of-sample tests. Our results show an asymmetry in the degree of connectedness among the four sectors, with banks playing a much more important role in transmitting shocks than other financial institutions.

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A Survey of Systemic Risk by Dimitrios Bisias, Mark Flood, Andrew W. Lo, and Stavros Valavanis
Annual Review of Financial Economics – 2012
Category: Measurement and Control of Systemic Risk

We provide a survey of 31 quantitative measures of systemic risk in the economics and finance literature, chosen to span key themes and issues in systemic risk measurement and management. We motivate these measures from the supervisory, research, and data perspectives in the main text, and present concise definitions of each risk measure—including required inputs, expected outputs, and data requirements—in an extensive appendix. To encourage experimentation and innovation among as broad an audience as possible, we have developed open-source Matlab code for most of the analytics surveyed, which can be accessed through the Office of Financial Research (OFR) at http://www.treasury.gov/ofr.

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The National Transportation Safety Board: A Model for Systemic Risk Management by Eric Fielding, Andrew W. Lo, and Jian Helen Yang
Journal of Investment Management – 2011
Category: Measurement and Control of Systemic Risk

We propose the National Transportation Safety Board (NTSB) as a model organization for addressing systemic risk in industries and contexts other than transportation. When adopted by regulatory agencies and the transportation industry, the safety recommendations of the NTSB have been remarkably effective in reducing the number of fatalities in various modes of transportation since the NTSB’s inception in 1967 as an independent agency. The NTSB has no regulatory authority and is solely focused on conducting forensic investigations of transportation accidents and proposing safety recommendations. With only 400 full-time employees, the NTSB has a much larger network of experts drawn from other government agencies and the private sector who are on call to assist in accident investigations on an as-needed basis. By allowing the participation in its investigations of all interested parties who can provide technical assistance to the investigations, the NTSB produces definitive analyses of even the most complex accidents and provides actionable measures for reducing the chances of future accidents. It is possible to create more efficient and effective systemic-risk management processes in many other industries, including financial services, by studying the organizational structure and functions of the NTSB.

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An Evaluation of Large-Scale Mortgage Refinancing Programs by Mitchell Remy, Deborah Lucas, and Damien Moore Working Paper Series Congressional Budget Office – September, 2011
Category: Evaluation and Management of Government Financial Institutions

We analyze a stylized large-scale mortgage refinancing program that would relax current income and loan-to-value restrictions for borrowers who wish to refinance and whose mortgages are currently insured by Fannie Mae, Freddie Mac, or the Federal Housing Administration. The analysis relies on an estimate of the volume of incremental refinancing that would occur and an estimate of how future default and prepayment behavior would be affected by such refinancing. Relative to the status quo, the specific program analyzed here is estimated to cause an additional 2.9 million mortgages to be refinanced, resulting in 111,000 fewer defaults on those loans and estimated savings for the GSEs and FHA of

$3.9 billion on their credit guarantee exposure, measured on a fair-value basis. Offsetting those savings, federal investors in MBSs, including the Federal Reserve, the GSEs, and the Treasury, would experience an estimated fair-value loss of $4.5 billion. Therefore, on a fair-value basis, the specific program analyzed here would have an estimated cost to the federal government of $0.6 billion. (The proposal analyzed here is a stylized one, and the estimated costs are not reported entirely according to the rules governing federal budget accounting; the figures in this paper do not represent a CBO cost estimate of a legislative proposal.) Because the estimated gains and losses are small relative to the size of the housing market, the mortgage market, and the overall economy, the effects on those markets and the economy would be small as well. We also discuss the impact of this program on various stakeholders, including homeowners, non- federal mortgage investors, mortgage lenders, mortgage service providers, private mortgage insurers, and subordinated mortgage holders. For example, non-federal investors would experience an estimated fair- value loss of $13 to $15 billion; most of that wealth would be transferred to borrowers.

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Complexity, Concentration, and Contagion: A Comment by Andrew W. Lo
Journal of Monetary Economics – June, 2011
Category: Measurement and Control of Systemic Risk

Although the precise origins of the term “complex adaptive system” are unclear, nevertheless, the hackneyed phrase is now firmly ensconced in the lexicon of biologists, physicists, mathematicians, and, most recently, economists. However, as with many important ideas that become clichés, the original meaning is often obscured and diluted by popular usage. But thanks to the fascinating article by Gai, Haldane, and Kapadia (hereafter GHK), we have a concrete and practical instantiation of a complex adaptive system in economics, one that has real relevance to current policy debates regarding financial reform. Since there is very little to criticize in GHK’s compelling article, I will seek to amplify their results and place them in a broader context in my comments below.