The Option Value of Municipal Liquidity: Evidence from Federal Lending Cutoffs during COVID-19

57 Pages Posted: 16 Feb 2021

See all articles by Andrew Haughwout

Andrew Haughwout

Federal Reserve Bank of New York

Benjamin Hyman

Federal Reserve Bank of New York

Or Shachar

Federal Reserve Bank of New York

Date Written: February 5, 2021

Abstract

We estimate the option value of municipal liquidity by studying bond market behavior and public sector hiring decisions when government budgets are severely distressed. Using a regression discontinuity (RD) design, we exploit lending eligibility cutoffs introduced by the Federal sector’s Municipal Liquidity Facility (MLF) in April 2020 to study the effect of an emergency liquidity option on yields, primary issuance, credit downgrade probability, and public sector employment. We find that while the announcement of the liquidity option improved overall municipal bond market functioning across the board, low-rated issuers additionally benefited from direct access: low-rated government bonds traded at higher prices and were issued more frequently on private markets with facility access. This suggests the presence of a credit-risk sharing channel on top of the Fed’s role as liquidity-provider of last resort. In contrast to investors, local governments responded to the liquidity option by retaining a greater share of public sector employees across the entire ratings distribution.The results imply municipal debt markets and employment outcomes would likely have been more distressed absent the MLF, and are consistent with the view that large government furloughs might have over-weighted the worst possible outcomes based on past experience.

Keywords: Municipal Liquidity, Municipal Bond Markets, State and Local Goverment Employment, Federal Facilities

JEL Classification: G18, J23, G12, H74, E50

Suggested Citation

Haughwout, Andrew F. and Hyman, Benjamin and Shachar, Or, The Option Value of Municipal Liquidity: Evidence from Federal Lending Cutoffs during COVID-19 (February 5, 2021). Available at SSRN: https://ssrn.com/abstract=3785577 or http://dx.doi.org/10.2139/ssrn.3785577

Andrew F. Haughwout

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States
212-720-2685 (Phone)
212-720-1844 (Fax)

Benjamin Hyman (Contact Author)

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY NY 10045
United States

Or Shachar

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States
(212) 720-6974 (Phone)
(212) 720-1582 (Fax)

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