Working Papers

The Art of Timing: Managing Sudden Stop Risk in Corporate Credit Markets,

with Lin Ma and Daniel Streitz; June 2023

Abstract: High yield firms aggressively exercise the call option embedded in their bonds. We construct a new measure of option moneyness and show that firms efficiently exercise the interest rate and spread option implicit in these contracts. Controlling for moneyness, firms frequently prepay bonds and issue new debt if rollover risk is high. We develop and estimate a structural model to quantify the costs and benefits of dynamically managing this risk. The ability to use callable debt almost entirely dissipates dead-weight losses from rollover risk. Creditor-shareholder conflicts reduce the effectiveness of this dynamic hedging strategy for highly levered firms.

Refinancing Frictions, Mortgage Pricing and Redistribution

with David Berger, Konstantin Milbradt and Joe Vavra; April 2023

Internet appendix
Abstract: There are large cross-sectional differences in how often US borrowers refinance mortgages. In this paper, we develop an equilibrium mortgage pricing model that allows us to explore the consequences of this heterogeneity. We show that equilibrium forces imply important cross subsidies from borrowers who rarely refinance to those who refinance often. Mortgage reforms can potentially reduce these regressive cross-subsidies, but the equilibrium effects of these reforms can also have important distributional consequences. For example, many policies which lead to more frequent refinancing lead to higher equilibrium mortgage rates and reduce residential mortgage credit access for a large number of borrowers.

Sovereign Debt Ratchets and Welfare Destruction,

with Peter DeMarzo and Zhiguo He; July 2022; Journal of Political Economy, accepted

Internet appendix
Abstract: We model an impatient, risk-neutral government that cannot commit to a particular fiscal path, financed by competitive lenders. In equilibrium, debt adjusts slowly towards a target debt-to-income level, exacerbating booms and busts. Strikingly, gains from trade dissipate when trading is continuous, leaving the government no better off than in financial autarky, due to a “sovereign debt ratchet effect.” Moreover, citizens who are more patient than their government are strictly harmed. We characterize equilibrium debt dynamics, ergodics, and comparative statics when income follows a geometric Brownian motion, and analyze commitment devices that allow the sovereign to recapture some gains from trade.

Can the Cure Kill the Patient? Corporate Credit Interventions and Debt Overhang,

with Nicolas Crouzet; May 2021; Revise and resubmit at the Journal of Finance

Abstract: Interventions in corporate credit markets were a major innovation in the policy response to the 2020 recession. This paper develops and estimates a model to quantify their impact on borrowing and investment. Even during downturns, credit interventions can be a bad policy idea, because they exacerbate debt overhang and depress investment in the long run. However, if the downturn is accompanied by financial market disruptions, they initially help forestall inefficient liquidations. These short term benefits quantitatively dominate the long run overhang costs. Additionally, constraining shareholder distributions, and targeting high-leverage firms substantially increases the “bang for the buck” of credit interventions.

Comparative Valuation Dynamics in Models with Financing Restrictions,

with Lars P. Hansen and Paymon Khorrami


Rigid Wages, Seniority Rules, and Unemployment Duration,

with Fernando Alvarez and Rob Shimer

Abstract: This paper examines the impact of unions on unemployment and wages in a dynamic equilibrium search model. We model a union as imposing a minimum wage and rationing jobs to ensure that the union’s most senior members are employed. This generates rest unemployment, where following a downturn in their labor market, unionized workers are willing to wait for jobs to reappear rather than search for a new labor market. Introducing unions into a dynamic equilibrium model has two implications, which others have argued are features of the data: the hazard of exiting unemployment at long durations is very low when the union-imposed minimum wage is high; and a high union-imposed minimum wage generates a compressed wage distribution and a high turnover rate of jobs.

A Macro-Finance Approach to Sovereign Debt Spreads and Returns,

Abstract: Foreign currency sovereign bond spreads tend to be higher than historical sovereign credit losses, and cross-country spread correlations are larger than their macro-economic counterparts. Foreign currency sovereign debt exhibits positive and time-varying risk premia, and standard linear asset pricing models using US-based factors cannot be rejected. The term structure of sovereign credit spreads is upward sloping, and inverts when either (a) the country’s fundamentals are bad or (b) measures of US equity or credit market stress are high. I develop a quantitative and tractable continuous-time model of endogenous sovereign default in order to account for these stylized facts. My framework leads to semi-closed form expressions for certain key macro-economic and asset pricing moments of interest, helping disentangle which of the model features influences credit spreads, expected returns and cross-country correlations. Standard pricing kernels used to explain properties of US equity returns can be nested into my quantitative framework in order to test the hypothesis that US-based bond investors are marginal in sovereign debt markets. I show how to leverage my model to study the early 1980’s Latin American debt crisis, during which high short term US interest rates and floating rate dollar-denominated debt led to a wave of sovereign defaults.

Empirical Appendix to: A Macro-Finance Approach to Sovereign Debt Spreads and Returns

Abstract: This Internet appendix contains a detailed empirical discussion on sovereign credit spreads and returns. While past empirical work on this topic has leveraged sovereign bond price data, I instead use credit default swap data to provide additional support for several known facts. First, I show that investors in hard currency sovereign debt markets do not behave in a risk-neutral fashion. I then provide suggestive evidence that investors’ level of risk-aversion is time-varying, and is positively correlated with measures of US credit or equity market risk. Finally, I provide evidence on the term structure of sovereign credit spreads and returns, which inform the construction, estimation and validation of the model developed in the main paper.

Refereed Publications

Mortgage Prepayment and Path-Dependent Effects of Monetary Policy,

with David Berger, Konstantin Milbradt and Joseph Vavra; September 2021; American Economic Review

Internet appendix
Abstract: How much ability does the Fed have to stimulate the economy by cutting interest rates? We argue that the presence of substantial debt in fixed-rate, prepayable mortgages means that the ability to stimulate the economy by cutting interest rates depends not just on their current level but also on their previous path. Using a household model of mortgage prepayment matched to detailed loan-level evidence on the relationship between prepayment and rate incentives, we argue that recent interest rate paths will generate substantial headwinds for future monetary stimuli.