Narrow Results

The deterioration in credit quality of General Motors (GM) and Ford to junk status in the spring of 2005 caused a wide-spread sell-off in their corporate bonds. Using a novel dataset, we document that this sell-off appears to have generated significant liquidity risk for market-makers, as evidenced by a significant imbalance in their quotes towards sales. We find that simultaneously there was a substantial increase in the co-movement between innovations in the credit default swap (CDS) spreads of GM and Ford and those of firms in all other industries, the increase being the greatest during the period surrounding the actual downgrade and reversing sharply thereafter. We show that the corporate bond market makers' imbalance towards sales in GM and Ford bonds explains a significant portion of this co-movement. These results linking liquidity risk and correlation risk are consistent with models in which market prices are episodically determined by the limited risk-bearing capacity of financial intermediaries.

We assess benefits and costs of the Troubled Asset Relief Program (TARP) based on theory, data, and empirical research to date. TARP was intended to attenuate systemic risk and improve the real economy, and we focus on these as the most important potential effects of the program. Evidence suggests mostly short-term social benefits in reducing systemic risk and improving the real economy. However, long-term evidence is limited — suggesting relatively long-lasting real economic improvements that might be offset by long-term increases in systemic risk. We give TARP a grade of “incomplete,” pending further research, and suggest some directions for this research.

Real estate booms have regularly occurred throughout the world, leaving painful busts and financial crises in their wake. Real estate is a natural investment for more passive debt investors, including banks, because real estate's flexibility makes it a better source of collateral than production facilities built for a specific purpose. Consequently, passive capital may flow disproportionately into real estate and help generate real estate bubbles. The preference of banks for more fungible real estate assets also explains why real estate is so often the source of a financial crisis. Real estate bubbles can be welfare enhancing if cities would otherwise be too small, either because of agglomeration economies or building restrictions. But given reasonable parameters, the large welfare costs of any financial crisis are likely to be higher than the modest benefits of extra building. The benefits of real estate bubbles are welfare “triangles,” while the costs of widespread default are welfare “rectangles.”