Jefferson Duarte (Rice University)

Identifying the Portfolio Balance Mechanism

Abstract: The Portfolio Balance Mechanism (PBM) theorizes that reducing the supply of U.S. Treasuries (USTs) increases their prices and prompts the creation of similar assets for preferred-habitat investors. We identify the PBM using the suspension of 30-year UST bond auctions between 2002 and 2005. The suspension announcement resulted in a 5.1% daily return on the 30-year UST bond and prompted the issuance of safe, long-term collateralized mortgage obligations (CMOs), created by tranching mortgage pools to meet the demand of life insurers (habitat-preference investors). The heterogeneity of USTs, CMOs and insurer types results in an unusually clean identification of the PBM.

Joint work Tarik Umar.