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

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Abstract

We estimate the option value of municipal liquidity by studying bond market activity and public sector hiring decisions when government budgets are severely distressed. Using a regression discontinuity (RD) design, we exploit lending eligibility population cutoffs introduced by the federal sector’s Municipal Liquidity Facility (MLF) to study the effects of an emergency liquidity option on yields, primary debt issuance, and public sector employment. We find that while the announcement of the liquidity option improved overall municipal bond market functioning, lower-rated issuers additionally benefited from direct access to the facility—their bonds traded at higher prices and were issued more frequently, suggesting a potential credit-risk sharing channel on top of the Fed’s role as liquidity-provider of last resort. Local governments, by contrast, responded to emergency liquidity measures by recalling a greater share of service-providing government employees (mostly educational institution workers), but recalls were only sustained for higher-rated municipalities. This hiring responsiveness is consistent with the hypothesis that large government furloughs might have over-weighted the worst possible outcomes based on past experience. Together, the results suggest that municipalities would likely have been more distressed absent the emergency liquidity.

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  • Andrew F. Haughwout & Benjamin Hyman & Or Shachar, 2021. "The Option Value of Municipal Liquidity: Evidence from Federal Lending Cutoffs during COVID-19," Staff Reports 988, Federal Reserve Bank of New York.
  • Handle: RePEc:fip:fednsr:93156
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    References listed on IDEAS

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    8. Marco Cipriani & Andrew F. Haughwout & Benjamin Hyman & Anna Kovner & Gabriele La Spada & Matthew Lieber & Shawn Nee, 2020. "Municipal Debt Markets and the COVID-19 Pandemic," Liberty Street Economics 20200629, Federal Reserve Bank of New York.
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    Cited by:

    1. W. Blake Marsh & Padma Sharma, 2021. "Government Loan Guarantees during a Crisis: The Effect of the PPP on Bank Lending and Profitability," Research Working Paper RWP 21-03, Federal Reserve Bank of Kansas City.
    2. Robert Bernhardt & Stefania D'Amico & Santiago I. Sordo Palacios, 2021. "The Impact of Covid-19 Related Policy Responses on Municipal Debt Markets," Working Paper Series WP-2021-14, Federal Reserve Bank of Chicago.
    3. Andrew F. Haughwout & Benjamin Hyman & Or Shachar, 2021. "COVID Response: The Municipal Liquidity Facility," Staff Reports 985, Federal Reserve Bank of New York.
    4. Grey Gordon & Pablo Guerrón-Quintana, 2021. "Public Debt, Private Pain: Regional Borrowing, Default, and Migration," Working Paper 21-13, Federal Reserve Bank of Richmond.

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    More about this item

    Keywords

    municipal debt; state and local governments; COVID-19; Federal Reserve lending facilities;
    All these keywords.

    JEL classification:

    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • H74 - Public Economics - - State and Local Government; Intergovernmental Relations - - - State and Local Borrowing

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