I explore what U.S. state government bond prices imply about the relative recovery rates of pensioners and debtholders in a state default. Across U.S. states from 2005 to 2016, a one-standard-deviation increase in the ratio of unfunded pension liabilities to GDP is associated with a 27-32 basis point increase in bond spreads over the Treasury rate. Unfunded pensions cost U.S. states over $2 billion in lost bond issuance proceeds in 2016. Event study exercises examining the reactions of bond spreads to a pension reform in Illinois provide evidence that this relationship is causal. The effect of unfunded pension liabilities on bond spreads is stronger in states where pensioners are likely to have higher bargaining power or legal protection in a default. These facts are consistent with predictions from a structural model of municipal government credit, and model estimates reveal substantial cross-sectional variation in investor perceptions of pension seniority. These perceptions are related to state-level political and legal factors which may affect recovery rates of pensioners in a default.
There is a large degree of uncertainty regarding what would occur if a U.S. state government defaulted on its debt. The legal framework for state government default is non-existent, and there is no modern-day precedent for such an event. However, recent events in the Puerto Rican debt crisis may provide a blueprint for how a state default would play out. I find that state bond spreads over the Treasury rate react to various legal events and decisions related to the Puerto Rican bankruptcy. I also find that reactions are stronger in states with worse credit conditions. This suggests that markets may perceive these events and decisions as setting precedent for potential future state default events. Moreover, that precedent is likely more relevant for states that are closer to default. These findings provide unique evidence of the role legal uncertainty plays in asset markets.
Tail Risk and Asset Pricing Anomalies
I test whether various asset pricing anomalies can be explained through exposure to tail-risk. I find that asset pricing anomalies persist, in the sense of generating excess returns in relation to standard factor pricing models, when controlling for exposure to tail-risk. Thus, existing cross-sectional asset pricing anomalies are not proxies for underlying tail-risk. Results are similar for broader measures of systemic risk. Finally, I investigate firm-level tail-risk exposures and tail-risk pricing and provide evidence that previous cross-sectional evidence regarding the presence of tail-risk has been overstated or misidentified.
The Impact of the Shadow Banking Sector on Public Finance (with Kelly Posenau)
Money market mutual funds are a primary source of short-term financing for municipal governments. In response to the financial crisis, the SEC implemented a series of reforms in 2016 designed to make these funds more stable. We study the effects of the reforms on the U.S. municipal debt market. We show tax-exempt fund holdings of municipal variable rate demand notes (VRDN) dropped precipitously around implementation of the reform. Moreover, we observe an increase in VRDN interest rates. However, we do not observe any significant changes in issuance patterns around the reform. Our results suggest the reform may have increased short-term borrowing costs for municipal governments.