Financial Contagion in the Mutual Fund Industry - Closed-End Funds, Auction Rate Securities, and Fire-Sale Cascades
Final Report Abstract
An important question is whether financial contagion can arise not only in the bank sector but also in the non-bank financial sector. In this research project we document empirically one channel of financial contagion in the non-bank financial sector. In particular, we show that a liquidity shock, which affected levered closed-end mutual funds spilled over to openend mutual funds. This is significant because it highlights an example of financial contagion, where a liquidity shock spilled over from a relatively small sector of the non-bank financial sector (closed-end funds) to a much larger sector of the non-bank financial sector (open-end funds). Therefore, our results should be of high importance to regulators who need to better understand the various channels of financial contagion in order to take appropriate actions to minimize contagion. In early 2008, the market for Auction Rate Securities (ARS) failed because market makers were no longer willing to provide liquidity to this market. This led to a sudden and permanent increase in the cost of borrowing for levered closed-end funds, which had used ARS to lever their portfolios. Funds reacted to this cost increase by de-levering and selling stocks. We show that this resulted in temporary price pressure (fire-sales). Open-end equity funds that were holding stocks subject to these fire-sales realized low returns. Especially retail investors reacted to the poor performance of their open-end funds by liquidating their holdings. This resulted in cash outflows at these funds, which had to be financed by asset sales. We show that some of these asset sales resulted in additional price pressure (fire-sales). Taken together, we show that the ARS market failure in 2008 led to a fire-sale cascade.
Publications
- 2018, Three Essays on Mutual Funds, Doctoral Dissertation
L. Klipper
(See online at https://dx.doi.org/10.18452/19585)
