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William C. Dudley, Jennifer Roush, and Michelle Steinberg Ezer

The Case for TIPS:
An Examination of the Costs
and Benefits
• Some studies suggest that the issuance of
Treasury Inflation-Protected Securities (TIPS)—
inflation-indexed debt—has not been as costeffective for the Treasury as the issuance of
nominal securities.

• The studies base their conclusions on ex post
analysis, that is, they look back from the actual
inflation outcome to determine whether TIPS
issuance costs exceeded the costs of nominal
Treasury issuances of similar durations.

• This article argues that the ex post approach
has drawbacks when it comes to assessing the
costs and benefits of TIPS over the long run;
instead, an ex ante approach is recommended.

• A comprehensive analysis of TIPS should also
consider the program’s other, more difficultto-quantify, benefits—especially when cost
analysis shows that TIPS are only marginally
more expensive or about as expensive as
nominal issuances.
• The ex ante costs of TIPS issuance are found to
be about equal to the costs of nominal Treasury
issuance; moreover, TIPS provide meaningful
benefits to investors and policymakers.
William C. Dudley, president and chief executive officer of the Federal Reserve
Bank of New York, was executive vice president and head of the Bank’s
Markets Group at the time this article was written; Jennifer Roush is chief
of the Monetary and Financial Market Analysis Section of the Board of
Governors of the Federal Reserve System; Michelle Steinberg Ezer is
a senior trader/analyst in the Markets Group.
Correspondence: <jennifer.e.roush@frb.gov> <michelle.ezer@ny.frb.org>

1. Introduction

lightly more than a decade has passed since the inaugural
issuance of inflation-indexed debt by the U.S. Treasury
Department. Eleven years and thirty issues later, we are at a
good vantage point from which to evaluate the successes and
failures of the Treasury Inflation-Protected Securities (TIPS)
program.
From a purely financial perspective, a number of recent
studies have suggested that the program has been a
disappointment. After calculating the direct costs of TIPS
issuance relative to issuance of nominal Treasury securities, the
studies show that the first ten years of the TIPS program have
cost the Treasury billions of dollars (Sack and Elsasser 2004;
Roush 2008).
Importantly, these studies rely entirely on ex post analysis.
In other words, the studies ask, Given the actual inflation
outcome, did the costs of TIPS issuances exceed the costs of
nominal Treasury issuances of similar durations? This
approach depends on the actual inflation outcome, which may
differ from expectations at the time the TIPS investment was
made because investors do not have perfect foresight of
inflation. If investors underpredict actual inflation when
purchasing TIPS at auction, then these positive forecast errors
would increase the payments that the Treasury has to make to

The authors thank James Clouse, Joshua Frost, Joseph Gagnon, Kenneth
Garbade, Warren Hrung, Lorie Logan, Simon Potter, Anthony Rodrigues,
Brian Sack, and Jonathan Wright for thoughtful comments and Brian Sack
for the data in Chart 5. The views expressed are those of the authors and do
not necessarily reflect the position of the Federal Reserve Board, the Federal
Reserve Bank of New York, or the Federal Reserve System.

FRBNY Economic Policy Review / July 2009

TIPS holders to compensate them for realized inflation.1, 2
Upside inflation surprises tend to increase the ex post cost of
issuing TIPS compared with nominal Treasuries.
While inflation forecast errors are relevant for calculating
the actual costs incurred over the first ten years of the TIPS
program, we believe they are irrelevant in assessing the
expected benefits or costs of the program over the long run—a
theme we explore in this article. In other words, current ex post
analysis suffers from the problem of small sample size,
particularly since most of the issues have overlapping lifetimes
and therefore are not necessarily independent of each other. In
the long run, investors learn from their mistakes, and inflation
shocks tend to average out. When investors make a particular
forecast error, they adapt their future expectations accordingly

While inflation forecast errors are relevant
for calculating the actual costs incurred
over the first ten years of the TIPS
program, we believe they are irrelevant in
assessing the expected benefits or costs
of the program over the long run.
so they do not persistently make the same error. This means
that eventually, amid shifting economic conditions, their
accumulated forecast errors will average to zero. Similarly, over
time, the amount of upside and downside inflation surprises
should average to zero. The implication of this process for the
TIPS program is that, in the long run, factors other than
inflation forecast errors will determine its cost relative to the
cost of nominal Treasury issuance (Table 1).
What are these other factors? Two primary factors are the
compensation investors require to hold a security that is less
liquid than its nominal counterpart, termed the illiquidity
premium, and the insurance value they attach to obtaining
protection against inflation risk, known as the inflation risk
premium.3 With regard to the first factor, when investors are
worried about their ability to resell TIPS in a liquid secondary
market, they require compensation for holding the securities
compared with more liquid alternatives. This illiquidity
premium tends to drive up TIPS yields and increase the
Treasury’s borrowing costs. The second factor works in the
1

Conversely, negative inflation forecast errors decrease the inflation payments
by the Treasury relative to the amount it received for providing investors with
protection against inflation.
2
As we discuss, there are other factors that also help determine whether an
issue brings in more revenue than it generates, including illiquidity and
inflation risk premiums.

The Case for TIPS

Table 1

Impact of Changes in Factors on TIPS
Break-Even Inflation

Factor
Inflation expectations
Illiquidity premium
Inflation risk premium

Impact on TIPS Break-Even
if Factor Increases
Increase
Decrease
Increase

Source: Authors’ calculations.

opposite direction. To the extent that investors are willing to
pay for inflation protection, they would purchase TIPS at a
price above that implied by their expected payment stream.
As such, inflation risk premiums result in lower expected
borrowing costs for the government and savings for the TIPS
program compared with nominal issuance.
To determine which factor has been historically dominant,
we conduct an ex ante cost analysis: We compare the amount
that the Treasury received for inflation compensation at
auction with an observable measure of contemporaneous
inflation expectations.4 The difference between these series
yields a measure of the net savings or loss incurred by the
Treasury that is independent of inflation forecast errors. It is
also equal to the net value of the illiquidity and inflation risk
premiums associated with each TIPS issue. We find that prior
to 2004, the break-even inflation rate is below a survey measure
of inflation expectations.5 This indicates that the illiquidity
premium exceeded the inflation risk premium over this period.
Since 2004, however, we find that break-even rates were
approximately equal to expected inflation, indicating that the
two factors were roughly in balance.
3

In addition to these primary factors, TIPS yields also reflect the taxation
difference between TIPS and nominal issuances, the convexity difference
between real and nominal yields, and the price of the embedded deflation floor.
Regarding the tax differential, because an investor has to pay taxes currently on
the accrual of the principal amount payable at maturity on inflation-protected
issues, non–tax-exempt investors may require a higher yield on TIPS (a lower
TIPS break-even) than what would be associated with their true inflation
expectations. As a result, it may be more difficult for the Treasury to capture
investors’ full inflation expectations and inflation risk premiums. In contrast,
the attractiveness of TIPS may be enhanced as a result of the fact that, at
maturity, TIPS holders receive the higher of the inflation-adjusted principal
amount or the par amount.
4
The measure of contemporaneous inflation expectations may differ from that
embedded in TIPS break-evens at TIPS auctions because the subset of investors
is slightly different. Primary dealers, which have been awarded an average of
54 percent of the competitive bids accepted at TIPS auctions since mid-2003,
are not the end-users of TIPS, and likely put in an underwriting bid at auction.
That said, because the Treasury is paid at the auction stop-out rate, we believe
this measure is most appropriate for our analysis.
5
The break-even inflation rate is the spread between a TIPS yield and a
nominal yield with a similar maturity. It is the inflation rate that will equate
the return on a TIPS with the return on a nominal security.

There are two possible reasons for the change in fortune
for TIPS issued after 2004. Over time, as the TIPS market
developed, the illiquidity risk premium shrank and/or inflation
risk premiums increased. Evaluating the two components
independently, we conclude that a decline in the illiquidity
premium is the more convincing explanation. In particular,
our review of the evidence shows a downward secular trend in
the TIPS illiquidity premium. In contrast, the inflation risk
premiums appear to have remained relatively low and stable
in recent years.
These findings have important implications for assessing
the benefits and costs of future TIPS issuances. The TIPS
illiquidity that persisted during the first several years of the
program and that appears to explain much of the cost of past
issuances no longer seems to be an important factor.6 As a
result, as long as the illiquidity premium and inflation
premiums do not shift in systematic ways, future TIPS
issuances should be much more cost-effective for the Treasury.
A second theme of this article is that relative cost
calculations, on either an ex ante or ex post basis, are just one
aspect of a comprehensive analysis of the costs and benefits of
the TIPS program. We believe that TIPS issuance provides the
taxpayer with other benefits that should be taken into account
when evaluating the program—especially when cost analysis

As long as the illiquidity premium and
inflation premiums do not shift in
systematic ways, future TIPS issuances
should be much more cost-effective
for the Treasury.
shows that TIPS are either only marginally more expensive or
about as expensive to issue as nominals. Some of these benefits,
such as a broadening of the Treasury’s investor base and a
diversification of its funding sources, were cited by Treasury
Deputy Assistant Secretary for Federal Finance Timothy S.
Bitsberger as a way for the Treasury to “reduce our borrowing
costs over time.”7 As such, some of the difficult-to-measure
benefits of the TIPS program are consistent with the Treasury’s
current debt management objectives. In a November 2001
speech, Under Secretary of the Treasury for Domestic Finance
Peter Fisher emphasized that “The debt management strategy
of Treasury has been to strive to be regular and predictable in
the issuance of debt while minimizing borrowing costs over
6

Roush (2008) finds that outstanding TIPS issuances under the counterfactual
assumption that there was no illiquidity premium imply significant cost
savings.
7
See Bitsberger (2002).

many years and interest rate cycles.”8 This strategy has meant
issuing and paying down debt in a manner that promotes
market liquidity and obtains financing across the yield curve.
To assess the net benefits and costs of the TIPS program
more fully, we discuss other benefits that we believe are central
to a complete evaluation of the program. Although these
benefits are not easily measured, they may be considerable. For
example, we describe how the program provides important
advantages for investors with real saving objectives as well as
valuable information for policymakers whose directive is to
contain inflation.
The remainder of this article is organized as follows. The
next section examines the ex ante costs of TIPS issuance.
Measures of illiquidity and inflation risk premiums embedded
in TIPS are reviewed in Section 3. In Section 4, we discuss other
economic benefits of inflation-indexed debt that are not
captured in relative cost measures. Section 5 summarizes our
main conclusions.

2. Ex Ante Cost Analysis
Studies that have evaluated the issuance costs of TIPS
compared with nominal Treasuries have typically compared
ex post costs. These studies usually show that TIPS issuance has
resulted in a higher net cost to the Treasury. For example,
Sack and Elsasser (2004) find a net cost to the Treasury from
the start of the program through early 2004 of slightly less
than $3 billion. Roush (2008) finds that total ex post costs of
TIPS through March 2007 were in the range of $5 billion to
$8 billion.9
A problem with current ex post analysis, however, is that it
depends upon the performance of inflation over a relatively
short period of time. If inflation proves to be meaningfully
different than what was expected at the time of TIPS issuance,
then this difference—the “inflation surprise”—affects the costs
of TIPS relative to nominal Treasuries. For instance, if inflation
turns out to be higher than expected, then TIPS issuance
becomes more expensive relative to nominal Treasury
issuance. If inflation turns out to be lower, however, an ex post
analysis would show higher savings (lower costs) from the TIPS
program.
The importance of the inflation surprise in determining
ex post costs can be seen in other developed countries with
8

See Fisher (2001). See Gensler (1998) and Stigum and Crescenzi (2007)
for an overview of Treasury debt management.
9
To put the range in perspective, we note that the average annual increase in
publicly held outstanding Treasury marketable debt since 2002 is approximately $227 billion. Furthermore, $5 billion to $8 billion represents
0.1 to 0.2 percent of total outstanding Treasury marketable debt held by
the public as of June 2008.

FRBNY Economic Policy Review / July 2009

similar programs of inflation-linked sovereign debt issuance.
In fact, several other developed countries’ inflation surprises
have resulted in lower costs of inflation-linked debt issuance
compared with the costs of nominal debt issuance. For
example, in its 2000-01 Annual Review, the United Kingdom
Debt Management Office notes that the “significant reduction
in the cost of funding [from the inflation-linked debt program]
… has partly been due to the reduction of inflation risk but
more importantly because of the fact market expectations of
inflation have exceeded the inflation outturn (‘outcome’) for
much of the last twenty years.”10 Similarly, a 2006 ex post cost

A problem with current ex post analysis . . .
is that it depends upon the performance
of inflation over a relatively short period of
time. If inflation proves to be meaningfully
different than what was expected at the
time of TIPS issuance, then this difference—
the “inflation surprise”—affects the costs
of TIPS relative to nominal Treasuries.
study by the Agency France Trésor finds that its inflationlinked debt program saved the government ¤120 million
between 1998 and 2004.11 In that study, the authors observe
that any analysis of this type is difficult because it does not
include some of the hard-to-measure benefits of the program,
such as the diversification of the government’s debt portfolio,
and it only applies in retrospect. In other words, if actual
inflation turns out to be higher than expected, the inflationlinked program could instead appear costly.
Over the long run, however, inflation surprises should not
matter. This is because investors are likely to learn from their
mistakes and not repeat their forecast errors indefinitely.
If investors incorporate all known information into their
predictions, inflation surprises should be unbiased, with as
many downward surprises in inflation performance as upward
surprises.
When considering the performance of TIPS over the
expected life of the program, we believe this longer term
perspective is most relevant. If an experiment were to be run
thousands of times drawing from the underlying distribution
of possible inflation outcomes, would the Treasury’s costs have
been lower, on average, with TIPS or with nominal Treasuries?
10
11

United Kingdom Debt Management Office (2001, p. 39).
Coeuré and Sagnes (2005).

The Case for TIPS

Alternatively, we can ask whether the Treasury obtained the
financing it needed at a low cost on an ex ante basis—that is,
independent of inflation forecast errors.
To answer this question, we apply a concept that TIPS
analysts call the break-even inflation rate. Essentially, this is a
value that makes the marginal investor indifferent between
buying TIPS or nominal securities. It includes investors’
expectations about the amount of inflation they will be
compensated for as well as any premium they are willing to pay
for protection against inflation. It also includes the component
of the TIPS yield that investors require as compensation for any
deficiency in TIPS market liquidity relative to market liquidity
for nominal Treasury securities.
We conduct an ex ante analysis by comparing the auction
break-even rate with a measure of inflation expectations.12
Ideally, we would like to use a measure of inflation expected by
TIPS investors at the time of the auction. Unfortunately, such
a measure is not available. Instead, as an approximation, we use
real-time estimates of expected inflation from the Survey of
Professional Forecasters (SPF), conducted by the Federal
Reserve Bank of Philadelphia.13 Although the survey’s median
estimate of the CPI inflation rate over the next ten years
is available only quarterly,14 it is unlikely that inflation
expectations are very volatile at a high frequency, leading us to
expect that the SPF measure may be a reasonable gauge of
market expectations.15
Chart 1 compares the auction break-even rate at the tenyear maturity point with the SPF long-run estimate of CPI
inflation. It shows that during the early years of the TIPS
12

We apply the same methodology as Roush (2008) to calculate the auction
break-even rate. In particular, we estimate the break-even rate received at
auction to be the implied inflation rate that equates the price of the TIPS at
auction to a hypothetical on-the-run nominal security with the same real
payment stream as the TIPS issue. For further details on the calculation,
see Roush (2008).
13
The SPF is conducted on a quarterly basis. Survey respondents are
professional economic forecasters in business and on Wall Street.
14
We use the median ten-year-ahead CPI inflation forecast, which represents
the median expectations of respondents for the average annual headline CPI
inflation rate over the next ten years. As such, this forecast is for a similar
inflation index and an almost similar time period as a newly issued ten-year
TIPS. The SPF forecast is based on the seasonally adjusted headline CPI; if it
were based on a non–seasonally-adjusted CPI, there should be no difference
between the two because they would be forecasts of average annual rates, and
therefore assumptions about seasonality over the year would be irrelevant.
The time period of the survey is slightly off, given that TIPS are linked to
non–seasonally-adjusted CPI lagged by approximately 2.5 months.
15
Although there are no direct measures of inflation expectations, we believe
that the Survey of Professional Forecasters is a good proxy. An alternative
survey is the University of Michigan’s Survey of Consumers, which is a median
long-term (five-year) inflation expectations measure. The Michigan measure is
based on the forecasts of consumers, as opposed to professional economists.
A similar analysis using this measure shows a comparable pattern, where the
early years of the TIPS program appear more costly.

Chart 1

Ten-Year TIPS Auction Break-Even Minus SPF
Median Consumer Price Index over Next Ten Years
Basis points

100
50
0
-50

the inflation risk premium, then the break-even rate will be
below the expected rate of inflation and the ex ante cost of TIPS
issuance will be greater. The fact that break-even rates were
below expected inflation during the first several years of the
program indicates that the illiquidity premium must have been
a dominant influence on ex ante costs over this period.17 More
recently, however, break-even rates and inflation expectations
appear to be approximately equal, implying that the two factors
more or less cancel each other out. This shift could be
attributable to a decline in the illiquidity premium in TIPS
yields and/or an increase in the inflation risk premium.

-100
Treasury first announces
commitment to program

-150
-200
1997 98 99 00 01 02

3. TIPS Illiquidity Premiums
and Inflation Risk Premiums

Sources: Federal Reserve Bank of Philadelphia, Survey of Professional
Forecasters (SPF); Board of Governors of the Federal Reserve System.

program, the auction break-even inflation rate was lower than
median inflation expectations of professional forecasters. This
indicates that the ex ante cost of ten-year TIPS issuances was
higher than the cost of nominal ten-year Treasury issuances.
As of June 2008, however, the break-even inflation rate at
the ten-year maturity point was about 2.50 percent, which is
equal to the most recent SPF long-run estimate of 2.50 percent
CPI inflation. If we assume that the SPF fairly represents the
expectations of investors, then the current constellation of data
indicates that on an ex ante basis, it appears that the cost of
issuing TIPS is currently about equal to the cost of issuing
nominal Treasuries.16 From this perspective, there appears to
be little net benefit or cost from TIPS in terms of expected
financing expenses.
The break-even inflation rate obtained from a comparison
of TIPS yields and nominal Treasury yields includes two other
key elements beyond expectations about the future inflation
rate: the inflation risk premium that investors pay for inflation
protection and the illiquidity premium associated with TIPS
compared with nominal Treasuries. If the insurance value of
inflation protection exceeds the illiquidity premium, then the
break-even rate will be greater than expected inflation and the
ex ante cost of TIPS will be lower than it is for nominal
Treasuries. If, however, the illiquidity premium is greater than

There is no direct evidence on the illiquidity premiums in TIPS
yields and on inflation risk premiums, so we rely on indirect
evidence and model-based estimates. In this section, we
consider several approaches to modeling both types of
premiums as well as review observable evidence on changes
in TIPS market liquidity.

3.1 Illiquidity Premiums
Over the past decade, TIPS issuance has grown nearly five times
as quickly as nominal issuance, to where it now represents
almost 10 percent of the Treasury’s marketable debt

Over the past decade, TIPS issuance has
grown nearly five times as quickly as
nominal issuance, to where it now
represents almost 10 percent of the
Treasury’s marketable debt portfolio.
portfolio.18 During this period, the TIPS investor base appears
to have widened and, according to Federal Reserve 2004 data—
information on market activity collected by the Federal Reserve

Although the sample size is limited, the median ten-year-ahead CPI inflation
rate forecasted by the SPF has typically overpredicted actual ten-year CPI
inflation for the forecasts made between 1979 and 1997. If, in a longer sample
period, the SPF proves to always overpredict ten-year-ahead CPI inflation, then
the ex ante cost estimates in our analysis may be overstated. That said, we
believe that over a longer sample period, the forecast errors of the SPF should
net out to zero.

17
Roush (2008) finds that the illiquidity premium in TIPS accounts for most
of the ex post cost of TIPS during this period.
18

This estimate does not account for the current principal inflation accretion
on TIPS issues. If that amount is included, the share increases to 11.9 percent
(U.S. Treasury Department, Bureau of the Public Debt, Monthly Statement of
the Public Debt of the United States, January 2008).

FRBNY Economic Policy Review / July 2009

Chart 2

Chart 3

Average Daily Secondary-Market Trading Volume
in TIPS

Assets under Management in Inflation-Protected
Bond Funds

Twelve-Week Moving Average

Billions of dollars

900
TIPS outstanding
(inflation-adjusted par)

80
70

800
700

Scale

8
60

600

40
4

500

Total assets under
management

400

Scale

300

200

100
0

0
2002

0
1998 99

07 08
Sources: Investment Company Institute; U.S. Treasury Department.

Source: Board of Governors of the Federal Reserve System, FR 2004
reporting forms.
Note: Figures reflect interdealers and customers; interdealer volumes
represent one side of a trade.

from primary dealers in U.S. government securities—trading
volume among primary dealers in the secondary market has
increased ten-fold (Chart 2).19
While data on the distribution of TIPS holders are not
available, there are some signs that TIPS market participation
has increased and that the market has become less concentrated. For example, in our conversations with TIPS investors
about TIPS market liquidity, they noted the ability to execute
trades with a larger number of primary dealers compared with
five to ten years earlier. Similarly, a review of the Federal
Reserve 2004 data reveals that primary dealer trading in TIPS
has become somewhat less concentrated across institutions.20
For example, the top quintile (by volume) of primary dealers
was responsible for an average of 68 percent of total TIPS
volume in 2007, 10 percentage points lower than the 2001
average.21, 22 In addition, there has been a notable increase in
the size of mutual funds that hold inflation-indexed securities.
According to the Investment Company Institute, assets under
management in inflation-protected mutual funds have grown
712 percent over the past five years (Chart 3).
19

The increase in average daily trading volumes exceeds the increase in TIPS
outstanding over the same period. Over the past ten years, the inflationadjusted par amount of TIPS outstanding has increased almost six-fold.
20
The TIPS traders and the representatives of one electronic brokerage firm
with whom we spoke observed that a large majority of trading in TIPS occurs
through the primary dealer community.
21
By comparison, the nominal total transaction volume among the top
quintile of primary dealers averaged 44 percent and 49 percent in 2007 and
2001, respectively.

The Case for TIPS

TIPS traders and investors have reported increased
confidence in the longevity of the program and the ability to
execute transactions in the secondary market over the past ten
years.23 Of note, volume in TIPS was sufficient to support the
expansion of electronic trading platforms—such as BrokerTec,
Bloomberg, and TradeWeb—to enable TIPS electronic trading
in 2003, 2001, and 2003, respectively. Furthermore, a review of
bid-ask spreads reveals that TIPS liquidity appears to have
improved somewhat in longer term markets since 2003, and is
roughly the same in the five- and ten-year sectors. For example,
according to Fleming and Krishnan (2008),24 when there were
bid and ask quotes in the interdealer broker market, bid-ask
spreads averaged approximately 2/32s, 3/32s, and 7/32s in the
five-, ten-, and twenty-year benchmark issues, respectively,

According to Federal Reserve 2004 data on primary dealers, the breakdown
of total TIPS transaction volume between the interdealer market and the
dealer-to-customer market has also changed since 2001. Trading between
primary dealers and customers accounted for 78.4 percent of total primary
dealer transaction volume in 2001. In 2007, this percentage declined to
73.4 percent, while interdealer trading increased.
23
Most notably, TIPS market participants cited the Treasury’s 2002 public
affirmation of its commitment to the program (<http://treas.gov/press/
releases/po3149.htm>), which it has reaffirmed in public statements as recently
as the August 2008 refunding (<http://www.treas.gov/press/releases/
hp1095.htm>).
24
Fleming and Krishnan note that a drawback of using the bid-ask spread to
analyze TIPS market liquidity is that there is not always a two-sided market. For
example, they estimate that between March 2005 and March 2008, there was a
two-sided market in the on-the-run ten-year TIPS approximately 60 percent of
the time in the interdealer broker market. As such, information on the extent
to which there is a two-sided market complements the bid-ask spread when
analyzing liquidity. Unfortunately, a longer time series of these data is not
available.

Chart 4

Illiquidity Premium in Ten-Year TIPS Yield
Percent
2.5

2.0

1.5

1.0

0.5

0
1999

Source: D’Amico, Kim, and Wei (2008).

between March 2005 and March 2008.25 Although figures are
not directly comparable given the different data sources, Sack
and Elsasser (2004) estimate bid-ask spreads of 2/32s for TIPS
maturing between five and ten years and between 4/32s and

The important question concerning future
issuances is not whether TIPS liquidity
has improved, but whether TIPS liquidity
has improved enough to shrink the
illiquidity premium sufficiently to make
TIPS issuance cost-effective from
the perspective of the Treasury.
16/32s for TIPS maturities beyond ten years in 2003. Our
discussions with TIPS market participants also suggest that
secondary-market liquidity has improved over the past five
years.
Even if TIPS liquidity has improved, it undoubtedly remains
below that of on-the-run nominal securities. Daily trading
volumes in on-the-run nominal securities far exceed those
described for TIPS (Fleming and Mizrach 2008). The
important question concerning future issuances is not whether
TIPS liquidity has improved, but whether TIPS liquidity has

improved enough to shrink the illiquidity premium sufficiently
to make TIPS issuance cost-effective from the perspective of the
Treasury. More precisely, are investors currently demanding
substantial compensation in order to hold TIPS relative to a
more liquid security? The larger such premiums are going
forward, the greater the costs to the Treasury of future
issuances, all else equal.
D’Amico, Kim, and Wei (2008) estimate the illiquidity
premium in TIPS yields compared with off-the-run nominal
securities from a no-arbitrage latent-factor model of the real
and nominal term structure. The authors derive this measure
by comparing observed TIPS yields with predictions based on
an affine model of nominal term structure and an estimated
process for inflation.26
D’Amico, Kim, and Wei estimate that the liquidity
premium in the ten-year TIPS yield was as large as 200 basis
points in the early years of the program (Chart 4). Since then,
however, the premium has trended down, and within the last
six months has fluctuated below 50 basis points. The fact that
the premium is positive for most of the sample indicates that
TIPS have remained illiquid relative to off-the-run nominal
securities, and thus even more so compared with their on-therun counterparts. Nonetheless, the fact that the premium
investors demand in compensation for this illiquidity has
shrunk to lower levels in recent years suggests that TIPS market
liquidity has improved enough to have a dramatic effect on the
cost-effectiveness of TIPS issuance. Indeed, as we discuss

Bid-ask spreads are measured in 1/32s of a point, where a point roughly
equals 1 percent of the security’s par value.

See the appendix for more details on the D’Amico, Kim, and Wei model.

FRBNY Economic Policy Review / July 2009

Chart 5

Sack Measure of the TIPS Liquidity Premium
since 1999
Five-Year Five-Year-Forward Rate
Percent

0.75

0.50

0.25

0
1998

Treasury relatively less to issue TIPS than nominal securities.
This raises an important question about the size of the
illiquidity premiums vis-à-vis the size of the inflation risk
premiums.
To better estimate the size of the inflation risk premiums, we
consider several models. A simple measure of the inflation risk
premium can be calculated based on the term structure of
forward inflation compensation rates at distant horizons, as
described in Sack (2007a). The rationale is that most factors
affecting movements in inflation tend to die out after a few
years, so that investors are unlikely to expect inflation to be
different at adjacent forward rates, for example, at nine and ten
years ahead.28 Thus, the spread between one-year-forward
inflation ending in nine and in ten years is likely to be driven
mostly by inflation risk premiums.29
Chart 6 presents a time series of the inflation risk premium
from nine to ten years ahead measured according to this
approach.30 The estimates in the chart are based on smoothed

Source: Macroeconomic Advisers.

below, it now compares favorably with estimates of the size of
the inflation risk premium.
Sack (2007b) provides an alternative measure of the
illiquidity premium in five-year-forward TIPS yields beginning
in five years. His measure is derived from a regression of TIPS
yields on a variety of macroeconomic variables as well as the
secondary-market turnover in TIPS.27 Consistent with
D’Amico, Kim, and Wei (2008), Sack finds that the TIPS yields
in the early years of the program were above the level predicted
by macroeconomic fundamentals alone, and interprets the part
of the TIPS yield that is predicted by TIPS turnover as a proxy
for the illiquidity premium. This measure, shown in Chart 5,
also points to a notable improvement in TIPS liquidity during
the 2001-04 period. Of note, the level of Sack’s illiquidity
measure is different from the D’Amico, Kim, and Wei estimate
because Sack measures the illiquidity premium indirectly
through a multifactor regression.

3.2 Inflation Risk Premiums
The notable declines in estimates of the illiquidity premiums
in TIPS yields in recent years suggest that it now costs the
27

In his regression, Sack includes a measure of the difference between
the unemployment rate and the Non-Accelerating Inflation Rate of
Unemployment, expected real GDP over the subsequent year, the spread
between West Texas Intermediate (WTI) futures and spot prices, lagged WTI
oil price inflation, the three-month moving average of correlation between
daily changes in the stock market and break-even rates, and the squared
difference between TIPS volume at each point in the sample with the end
period volume.

The Case for TIPS

The notable declines in estimates of the
illiquidity premiums in TIPS yields in
recent years suggest that it now costs
the Treasury relatively less to issue TIPS
than nominal securities.
zero-coupon yield curves for real and nominal bonds
(Gürkaynak, Sack, and Wright 2006, 2008). The inflation risk
premium has varied between 0 and 25 basis points since 1999,
with an average value of 11 basis points.
Another method for estimating the inflation term premium
embedded in nominal Treasury yields is the no-arbitrage
model used by D’Amico, Kim, and Wei (2008). Chart 7
presents a time series of the inflation risk premium for ten-year
zero-coupon inflation compensation from their model. This
measure of the inflation risk premium varies between 40 and
120 basis points over the history of the TIPS program. The
levels of the two measures of inflation risk premiums are not
directly comparable because one is a short-term far forward
rate and one is long-term spot rate. However, it is useful to note
that the correlation between the two measures is positive and
28

This simplifying assumption ignores factors that affect the level of long-run
inflation expectations. However, these factors are likely to occur infrequently.
29
Although this approach does not explicitly account for liquidity effects, the
fact that the illiquidity premium at nine years is unlikely to be very different
from the premium at ten years signifies that, in essence, liquidity effects are
more or less excluded by taking the spread at these adjacent horizons.
30
We use a smoothed spline to abstract from small deviations in yields based
on liquidity. Furthermore, we believe that any differences between our
estimates, which are derived from a smoothed spline, and those derived from
a bid, ask, or mid-spline would be small.

Chart 6

Inflation Risk Premium at Ten Years from Term Structure of Forward Inflation Compensation
Basis points
25
20
15
10
5
0
-5
-10
1999

Source: Gürkaynak, Sack, and Wright (2008).

Chart 7

Ten-Year Risk Premium
Basis points
140
120
100
80
60
40
20
0
1999

Source: D’Amico, Kim, and Wei (2008).

statistically significant, albeit at only 0.28. More importantly,
although the D’Amico, Kim, and Wei measure exhibits
somewhat different variation, particularly in the first half of the
sample, both series generally declined between 2004 and 2008,
before picking up recently. This provides further evidence that
the recent improvement in the cost of TIPS issuance was
associated with a decline in TIPS illiquidity premiums rather
than an increase in inflation risk premiums.

3.3 The Inflation Risk Premium Earned
by the Treasury at Auction
We conclude this section by explicitly decomposing our ex ante
cost analysis into the components associated with illiquidity in
TIPS and inflation risk premiums. We again compare the
break-even rate of inflation with a measure of expected
inflation from the Survey of Professional Forecasters. However,

FRBNY Economic Policy Review / July 2009

Chart 8

Inflation Risk Premiums at Historical TIPS Auctions
Basis points

250
200
150
100
50
0
-50
1997

Source: Authors’ calculations, based on data from the U.S. Treasury Department and the Board of Governors of the Federal Reserve System.

we now exclude the illiquidity premium in TIPS yields
estimated in D’Amico, Kim, and Wei (2008) before computing
the break-even rate.31 A comparison of this break-even rate
with inflation expectations yields an estimate of the premium
investors were willing to pay for inflation protection at
previous TIPS auctions.
Chart 8 uses this method to present estimates of the
inflation risk premium on TIPS auction days.32 The average
risk premium over the sample is within the range of the other
estimates, at 47 basis points. Furthermore, this measure of
auction inflation risk premiums appears to have decreased over
time. This may indicate that the initial purchasers of inflationindexed bonds were also those investors who put the highest
value on inflation protection.33 An alternative explanation is
that as inflation has stayed low, inflation expectations have
31

D’Amico, Kim, and Wei calculate the liquidity component for five- and tenyear TIPS yields, which we use to adjust the auction prices of five- and ten-year
TIPS issues. For twenty- and thirty-year TIPS issues, we assume that the
liquidity component is equal to the component for a ten-year security, which
in the event that these securities are less liquid than the ten-year note,
understates this effect and thus underestimates the risk premium at this
horizon. D’Amico, Kim, and Wei also do not calculate liquidity yield
components before 1999, because there were too few TIPS issues to construct
a zero-coupon yield curve. For auctions occurring between 1997 and 1999,
we assume that the liquidity yield component is equal to its value at the start
of 1999.
32
Note that the maturity of TIPS changes at each auction in the chart,
complicating comparison with the time series of the inflation risk premiums.
Put another way, the inflation risk premiums presented in the chart are not for
a constant time horizon, but vary between five, ten, twenty, and thirty years,
depending on the maturity of the TIPS being auctioned on a given date.

The Case for TIPS

become better anchored. As this has occurred, the inflation risk
premium that investors have been willing to pay for inflation
protection has diminished somewhat over time.34
Table 2 presents the average inflation risk premium by
maturity of the securities auctioned. Although the size of the
premium does not appear to increase consistently with
maturity, this result may be misleading as it is attributable, at
least in part, to changing issuance patterns. For example, with
the exception of the July 2002 TIPS, five-year TIPS have only
been issued during the past three years—a period in which oil
prices increased more than 175 percent. This could contribute
to the high estimate of the inflation risk premium for five-year
TIPS. In contrast to the relatively limited issuance of five-,
33

The fact that the inflation risk premiums by this measure are sometimes
negative suggests possible measurement error in the estimation of inflation
expectations. Furthermore, except for the two recent negative estimates of
inflation risk premiums, the other negative estimates are not significantly
different from zero.
34
The -32.3 basis point estimate of the inflation risk premium at the April 2008
five-year TIPS auction may reflect market conditions at the time of the auction
as opposed to the actual value investors placed on inflation protection. In
particular, the historically low level of five-year TIPS yields (and the low
expected coupon rate) reportedly may have deterred some investors from
participating in the auction. Of note, the pre–auction-day yield of the five-year
TIPS, at 0.53 percent, was the lowest pre–auction-day level compared with
prior five-year TIPS auctions and was notably below the 1.79 percent average
five-year TIPS yield since the Treasury brought back the five-year maturity
point in 2004. In addition, part of the negative inflation risk premium may also
reflect the flight-to-quality bid in the nominal market at the time. When we
calculate the inflation risk premium that assumes that TIPS are as liquid as an
on-the-run security (instead of an off-the-run security), the premium increases
to -10.3 basis points.

4. Other Benefits of InflationIndexed Debt

Table 2

Estimate of Inflation Risk Premium by Maturity
of Issue
Maturity
Five-year
Ten-year
Twenty-year
Thirty-year

Premium (Basis Points)
52.0
41.0
37.5
83.0

Source: Authors’ calculations.

twenty-, and thirty-year TIPS, ten-year TIPS were issued
throughout the sample and thus may provide the best overall
estimate that is also maturity-constant. According to this
estimate, a typical risk premium over this period has been
about 40 basis points.
The fact that investors appear willing to pay about 40 basis
points for inflation protection indicates that the TIPS program
does satisfy a real demand that is not met by nominal

The fact that investors appear willing to
pay about 40 basis points for inflation
protection indicates that the TIPS
program does satisfy a real demand
that is not met by nominal Treasuries.
It also suggests a potential for significant
gains to the Treasury from enhanced
secondary-market trading liquidity.
Treasuries. It also suggests a potential for significant gains to
the Treasury from enhanced secondary-market trading
liquidity. For example, if the TIPS market were as liquid as the
market for off-the-run Treasuries, the Treasury would have
realized a total cost savings from the TIPS program of
$22 billion to $32 billion.35, 36

We estimate the ex ante cost of the TIPS program as the present discounted
value of the difference in the payment stream paid by the Treasury to TIPS
holders from the expected payment embedded in TIPS prices, assuming that
actual inflation equals the SPF measure of expected inflation and that no
illiquidity premium exists.
36
Similarly, if the TIPS market were as liquid as the market for on-the-run
Treasuries, the Treasury would have realized a total cost savings from the TIPS
program of $28 billion to $37 billion.

The Treasury’s ability to issue TIPS at lower inflation-adjusted
yields because of a significant inflation risk premium is one of
several benefits that inflation-linked debt issuance provides to
investors and monetary policymakers. Other benefits of the
TIPS program, although difficult to quantify, are potentially
considerable. We now discuss how some of these benefits may
make TIPS issuance more favorable to the Treasury and U.S.
taxpayers than additional issuances of nominal securities.

4.1 Inflation Hedge for Households
Economist James Tobin made one of the most convincing
arguments in favor of inflation-indexed debt on behalf of
households with real saving objectives:
“… markets do not provide, at any price, a riskless way of
accumulating purchasing power for the future, whether
for old age, or for college education or for heirs….
Meanwhile we force savers to take risk, even if they would
gladly pay for the privilege of avoiding it…. No private
institution can fill this gap. No insurance company or
pension fund could assume the risk of offering purchasing
power escalation to its creditors without similarly
(inflation) escalated securities in which to invest at least
some of their funds.”37, 38
The key point of this argument is that even if nominal bond
yields are high enough on average to compensate investors for
the expected rate of inflation, an individual investor at any time
may be overcompensated or undercompensated vis-à-vis the
realized rate of inflation. By providing individuals with a way to
insure against inflation risk, TIPS embed less risk than any
other asset class. With virtually no credit risk or inflation risk,
TIPS are one of the safest investments.39 Equities or other assets
with uncertain nominal returns provide only an imperfect
hedge depending on their correlation vis-à-vis inflation
(Chu, Lee, and Pittman 1995).

Tobin (1963, pp. 204, 206).
While investors could purchase short-term debt and renegotiate the interest
rate every three months, they would be exposed to roll-over risk.
39
There is some inflation basis risk in that TIPS are based on the non–
seasonally-adjusted consumer price index, and a household’s expenditure
basket might differ from the basket in the CPI. Also, pension and endowment
liabilities may be more closely related to other inflation or wage measures than
the CPI.
38

FRBNY Economic Policy Review / July 2009

This benefit has implications for individual investors as well
as for the broader economy.40 By enabling investors to insure
against inflation risk, the government allows them to choose
the amount of inflation risk they hold, resulting in a more
optimal allocation of risk among investors with different
tolerances (Campbell and Shiller 1996). In addition, as Tobin
(1963) argues, the existence of a risk-free inflation hedge may
in turn encourage saving behavior by households.

4.2 Improved Monetary Policy
The existence of TIPS helps to improve the conduct of
monetary policy in a number of ways. Foremost, the program
provides up-to-date information about the evolution of
inflation expectations and real ex ante interest rates,41 which

provide an alternative market source of daily information on
inflation expectations, these securities are much less liquid than
TIPS (Beechey and Femia 2007).43 Moreover, it is unclear
whether the U.S. inflation swaps market would exist without
the TIPS market because TIPS provide a benchmark security
that can be used to hedge the inflation payments on swaps.
TIPS are also valuable in helping economists and
policymakers understand the forces that influence inflation
expectations. For example, minute-by-minute data on
inflation compensation from financial markets provide a gauge
of the effects of monetary policy actions and macroeconomic
data releases on inflation expectations. In this way, TIPS help
inform macroeconomic models that are important in the
policymaking process.

4.3 Improved Fiscal Policy
The existence of TIPS helps to improve
the conduct of monetary policy in a
number of ways. Foremost, the program
provides up-to-date information about the
evolution of inflation expectations and real
ex ante interest rates, which are important
inputs to monetary policy decisions.

TIPS may also offer incentives for improved fiscal policy. They
provide an explicit incentive for the fiscal (as well as monetary)
authorities to conduct policy with an eye toward the consequences for inflation. Recognition by the public that the
government is accountable for higher inflation in the form of

are important inputs to monetary policy decisions. Because
increases in inflation expectations are often difficult to predict
and to reverse, up-to-date information from TIPS about
expectations may be important in helping monetary policymakers keep inflation expectations in check. This is critical
because inflation expectations are a major element influencing
the inflation process.42 In this role, TIPS are particularly useful
because survey measures of inflation expectations, such as
those from the University of Michigan and the Survey of
Professional Forecasters, are available only with a lag and are
updated much less frequently. Although inflation swaps

higher inflation payments to TIPS holders may help hold down
inflation expectations and cause inflation expectations to be
more firmly anchored, that is, less responsive to inflation shocks.
Moreover, TIPS can help improve the management of the
national debt. Because payments on TIPS are tied to realized
inflation, the receipts and expenditures of the Treasury

It should be noted that there are potential income distribution effects if TIPS
are more expensive to issue than nominal securities and TIPS holders are not
evenly distributed across income groups. We do not address these effects here,
however.
41
Raw inflation compensation rates are not pure measures of inflation
expectations because they contain inflation risk premiums and, potentially,
distortions attributable to illiquidity. However, estimates of expected inflation
can be derived using measures of these later components, as demonstrated by
D’Amico, Kim, and Wei (2008). Furthermore, significant changes in TIPS
liquidity tend to be slow compared with inflation expectations; as a result, over
short periods of time, changes in inflation compensation rates can reflect a
change in inflation expectations and/or inflation risk premiums.

The Case for TIPS

If long-run inflation expectations become less anchored, shocks to inflation
may result in a larger effect on inflation expectations and trend inflation.
Consistent with this idea, Mishkin (2007) notes that “because long-run
inflation expectations are a key driver of trend inflation, monetary authorities
monitor long-run inflation expectations closely. If they find that they are losing
credibility with the markets, so that inflation expectations begin to drift and
rise above (or fall below) a desired level, they will take actions to restore their
credibility.”
43
Trading in CPI futures, which provides another financial market read on
inflation expectations, was introduced on the Chicago Board of Exchange in
March 2004; however, market liquidity had declined to nearly zero by the
summer of 2005.

Department are (all else equal) likely to be better matched—
since tax receipts are also nominal and likely to rise and fall
with shifts in the underlying inflation rate. Thus, TIPS issuance
may help reduce the overall volatility of the Treasury’s
financing needs.44 A reduction in volatility helps promote the

Because payments on TIPS are tied to
realized inflation, the receipts and
expenditures of the Treasury Department
are (all else equal) likely to be better
matched—since tax receipts are also
nominal and likely to rise and fall with
shifts in the underlying inflation rate. Thus,
TIPS issuance may help reduce the overall
volatility of the Treasury’s financing needs.
regularity and predictability of the issuance calendar, which
increases the liquidity of outstanding Treasury securities and
helps to foster demand at Treasury auctions.
In addition, as noted by Timothy S. Bitsberger, Treasury
Deputy Assistant Secretary for Federal Finance, TIPS may give
the Treasury access to a broader investor base,45 which may
reduce the Treasury’s overall funding costs. Bitsberger further
observes that “by diversifying our [the Treasury’s] borrowing,
we reduce exposure to a single adverse shock and both lower
and smooth our borrowing costs.” The comparison between
the prevailing interest rates on TIPS and on nominal Treasuries
provides insight into the relative costs associated with issuing
the last dollar of debt. However, just as important is the answer
to the question whether TIPS issuance, by displacing nominal
Treasury issuance, reduces the level of interest rates that the
Treasury pays on its nominal issuances. In principle, a
substantial shift in the composition of Treasury issuance into
TIPS from nominal Treasuries could lead to lower interest rates
paid on the remaining nominal Treasury issuance. This would
occur if TIPS were not perfect substitutes for nominal Treasury
securities and if the demand for nominal Treasuries was
downward-sloping—that is, not completely elastic.
The first condition almost certainly holds given the different
attributes of TIPS and nominal Treasuries. If they were perfect
44
Since payments on nominal Treasury debt are tied to expected inflation at
the time of the security’s auction, differences in Treasury assets and liabilities
can arise from divergences between realized and expected inflation.
45
Presentation by Bitsberger to the Bond Market Association’s InflationLinked Securities Conference, June 26, 2003 (<http://treas.gov/press/releases/
js505.htm>).

substitutes, there would not be a liquidity premium for
nominal Treasuries relative to TIPS. The second condition
seems likely to hold, as evidenced by a number of studies
finding that an increase in the net amount of Treasury
borrowing leads to higher expected borrowing costs for the
Treasury.46
While it is very difficult to estimate the effect that additional
supply would have on Treasury yields, a few studies have
touched upon the subject. Fleming (2002) suggests that a
$1 billion increase in issuance size for the most recently issued
three- or six-month bill raises its yield, relative to neighboring
bill yields, by approximately 0.35 basis point. At the longer end,
Krishnamurthy (2002) finds that a $1 billion increase in bond
supply would raise the bond yield, relative to the yield on the
previously issued bond, by 0.2 basis point. These results suggest
that by issuing securities in a segmented TIPS market, the
Treasury may keep realized yields on bill and nominal coupon
securities lower than they otherwise would have been.

5. Conclusion
This article offers an in-depth evaluation of the Treasury
Inflation-Protected Securities program. Our investigation
reaches several important conclusions.
First, a decision on whether the continued issuance of TIPS
is beneficial to U.S. taxpayers should be based on a comparison
of the ex ante costs of TIPS and nominal Treasury issuance and,
especially when these costs are negligible, on a consideration of
the more difficult-to-measure benefits TIPS issuance provides
taxpayers and policymakers. This decision should not be based
on an ex post cost analysis because such analysis depends on
the realized inflation rate over a relatively short history, which
is irrelevant in assessing the expected costs of TIPS issuance
compared with nominal Treasury issuance on a prospective
basis.
Second, on an ex ante basis, the cost of TIPS issuance is
about equal to or less than the cost of nominal Treasury
issuance. The reason is that the value of inflation protection—
the implicit premium that investors are willing to pay in terms
46

Tests of market segmentation of different types of Treasury debt have yielded
mixed results (Fleming 2002; Krishnamurthy 2002; Laubach 2003). However,
this work is generally limited to consideration of different maturities of
nominal debt and does not consider segmentation of real versus nominal debt.
That there might be more evidence for the latter is suggested by conventional
wisdom that TIPS market participants tend to be buy-and-hold investors,
including institutions such as pension funds. The Treasury auction allotment
data consistently show that pension funds and investment funds have taken
down an average of 30 percent of the amount issued at TIPS auctions since
2000. In contrast, these investors have taken down only 10 percent of the
amount offered at nominal coupon auctions over the same period.

FRBNY Economic Policy Review / July 2009

of lower TIPS yields—is now greater than or equal to the yield
premiums investors demand for holding relatively illiquid
TIPS compared with nominal Treasuries.
Third, although the costs of TIPS issuance over the life of the
program appear to have exceeded the costs of comparable
nominal issuance, these costs were concentrated during the
early years of the program, when the illiquidity premium
associated with TIPS was large. That premium has shrunk
significantly as the TIPS program has matured. Therefore,
these early costs are “sunk” and should not be used to
determine whether TIPS issuance is costly on an ongoing basis.
Fourth, TIPS issuance has other significant benefits that are
not captured by an analysis of net issuance costs. These include

The Case for TIPS

the value to investors of having a risk-free asset that offers
protection against inflation, the value to the monetary authority
of having a real-time guide to shifts in inflation expectations,
and the fact that a TIPS program likely displaces nominal debt
issuance to some degree, allowing for a reduction in the average
cost of nominal issuance as that supply is reduced.
Finally, our analysis of the ex ante costs of the TIPS program
and the more difficult-to-measure benefits suggests at least a
modest net benefit to the Treasury. Because TIPS issuance
appears to be attractive from the Treasury’s standpoint, a
natural next step is answering the question, What is the optimal
allocation of the Treasury’s liability portfolio between TIPS and
nominal Treasury securities?

Appendix: Estimation of the Illiquidity Premium

We briefly describe how D’Amico, Kim, and Wei (2008)
estimate the illiquidity premium in yields on Treasury
Inflation-Protected Securities (TIPS). Their first step is to
estimate yields on hypothetical real bonds that have the same
liquidity as nominal Treasury securities, using a joint model of
nominal yields and inflation. Intuitively, the authors are constructing these yields by considering the time-series properties
of nominal Treasury yields and inflation, but they do so in a
coherent asset pricing framework that rules out the possibility
that investors are leaving arbitrage opportunities unexploited.
Modern asset pricing theory starts from the premise that the
absence of arbitrage implies the existence of a pricing kernel, m t + 1 ,
such that the price of any asset satisfies the relationship
Pt = E t ( Pt + 1 m t + 1 ). Because bond prices are not complicated by
uncertain cash flows, the price of an n-period nominal zerocoupon bond is given just by E t ( m t + 1 m t + 2 …
…mt +n ) . This
imposes tight restrictions on the relationship between the timeseries and cross-sectional properties of these bond prices.
Following many researchers in the finance literature, D’Amico,
Kim, and Wei assume that the pricing kernel, m t + 1, depends on
the short-term interest rate, ys ( t ) , and prices of risk, λ ( t ). If
investors were risk-neutral, then λ ( t ) would be zero, but the
authors make no such assumption. The short-term interest rate
and prices of risk are assumed to be “affine” (linear plus a
constant) functions of three unobserved factors, represented
by X ( t ) ,
ys ( t ) = δ 0 + δ 1 X ( t )

λ ( t ) = v 0 + v1 X ( t ) .
In turn, these factors are assumed to follow a vector
autoregression of the form
X ( t + 1 ) = μ +Φ X ( t ) + ε ( t + 1 ) .

This implies that the yield on an n-period zero-coupon bond is
given by an affine function of the factors
yn ( t ) = a n + bn 'X (t ),

where a ( n ) and b (n ) are functions of the parameters of the
model including μ , Φ , δ 0 , δ 1, v 0 , and v1. Finally, a novel
feature of the D’Amico, Kim, and Wei study is its assumption
that expected inflation is also an affine function of the same
factors, X ( t ) ,
e

π (t ) = φ 0 + φ 1 X ( t ) .

Because it jointly models the nominal term structure and
inflation, the model can be used to price a hypothetical real
bond, the yield on which also turns out to be an affine function
of the factors
real

real

yn ( t ) = an

real

+ bn

X ( t ).

The model is estimated using data on nominal Treasury
yields, CPI inflation, and survey forecasts of nominal shortterm interest rates and inflation.47 The survey forecasts are
treated as noisy measures of true expectations of future rates
and inflation. In addition, substituting the parameter estimates
into the last equation gives the estimated real yields.

Estimating the Illiquidity Premium
in TIPS Yields
Because D’Amico, Kim, and Wei derive estimated real yields
from the nominal off-the-run term structure rather than
directly from TIPS themselves, the resulting estimated real
yields implicitly embody the same liquidity characteristics as
nominal off-the-run securities. Thus, by differencing these
estimated real yields and observed TIPS yields, the authors
obtain an estimate of the portion of observed real yields that
owes to differences in nominal and real bond liquidity. A
positive difference results when TIPS are less liquid than the
nominal off-the-run securities, since in this case TIPS investors
require a yield premium for holding the less liquid securities.
Chart 4 in the text shows that this difference series is indeed
positive throughout its history. It also exhibits a secular decline,
which is consistent with improved liquidity as one would
expect from a developing financial market. It also shows a small
amount of variation around its downward trend. This may
reflect high-frequency changes in the liquidity premium, but it
is probably also importantly influenced by model fitting error,
as the model-implied nominal yields are close—but not
identical—to the actual observed yields.

TIPS are not included directly in the version of the D’Amico, Kim, and Wei
model discussed here because the sample of available TIPS is too short. Instead,
the authors model inflation and use it to price synthetic real bonds. The
authors also estimate a version of the model that incorporates TIPS; however,
the shortness of the available TIPS sample means that their estimates are likely
associated with greater estimation error.

FRBNY Economic Policy Review / July 2009

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The Case for TIPS

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Krishnamurthy, A. 2002. “The Bond/Old-Bond Spread.” Journal
of Financial Economics 66, no. 2-3 (November): 463-506.
Laubach, T. 2003. “New Evidence on the Interest Rate Effects of
Budget Deficits and Debt.” Board of Governors of the Federal
Reserve System Finance and Economics Discussion Series,
no. 2003-12, April.
Mishkin, F. S. 2007. “Inflation Dynamics.” NBER Working Paper
no. 13147, June.
Roush, J. E. 2008. “The ‘Growing Pains’ of TIPS Issuance.” Board
of Governors of the Federal Reserve System Finance and
Economics Discussion Series, no. 2008-08, February.
Sack, B. 2006. “Treasury Saves a Billion on January 2007 TIPS.”
Macroeconomic Advisers Monetary Policy Insights, Fixed
Income Focus, December 15.
———. 2007a. “How Low Is the Inflation Risk Premium?”
Macroeconomic Advisers Inflation-Linked Analytics, May 9.
———. 2007b. “Are Long-Term Real Yields Now Attractive?”
Macroeconomic Advisers Inflation-Linked Analytics, June 28.
Sack, B., and R. Elsasser. 2004. “Treasury Inflation-Indexed Debt:
A Review of the U.S. Experience.” Federal Reserve Bank of
New York Economic Policy Review 10, no. 1 (May): 47-63.

References (Continued)

Stigum, M., and A. Crescenzi. 2007. Stigum’s Money Market. 4th ed.
New York: McGraw-Hill.

Tzucker, R., and M. Islam. 2005. “A Pension Reform Primer.” In
Barclays Capital Fixed Income Rates Strategy, November 22.

Tobin, J. 1963. “Essays on Principles of Debt Management.”
In Commission on Money and Credit, Fiscal and Debt
Management Policies. Englewood Cliffs, N.J.: Prentice-Hall.

United Kingdom Debt Management Office. 2001. DMO Annual
Review 2000-01, September 7.
———. 2007. DMO Annual Review 2006-07, August 2.

Treasury Borrowing Advisory Committee. 2008. “Minutes of the
Meeting of the Treasury Borrowing Advisory Committee of the
Securities Industry and Financial Markets Association, July 29,
2008.” Available at <http://www.treas.gov/press/releases/
hp1095.htm>.

The views expressed are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York,
the
Reserve Board,
or the
Federal
Reserve
System.
The Federal
Reserve
Bank of New
provides
no warranty,
TheFederal
views expressed
are those
of the
authors
and do
not necessarily
reflect
the position
of theYork
Federal
Reserve
Board, theexpress
Federalor
implied,
as
to
the
accuracy,
timeliness,
completeness,
merchantability,
or
fitness
for
any
particular
purpose
of
any
information
Reserve Bank of New York, or the Federal Reserve System.
contained in documents produced and provided by the Federal Reserve Bank of New York in any form or manner whatsoever.
FRBNY Economic Policy Review / July 2009

William L. Silber

Why Did FDR’s Bank Holiday
Succeed?
• After a month-long run on banks, on March 5,
1933, President Franklin Delano Roosevelt
declared a nationwide Bank Holiday that shut
down the banking system.

• The following week, in his first Fireside Chat,
Roosevelt appealed directly to Americans to
prevent a resumption of bank withdrawals; when
the banks reopened on March 13, depositors
stood in line to return their hoarded cash.

• The success of the Bank Holiday and the
turnaround in public confidence can be
attributed to the Emergency Banking Act
of 1933, passed by Congress on March 9.

• The President used the emergency currency
provisions of the Act to encourage the Federal
Reserve to create de facto 100 percent deposit
insurance in the reopened banks.

• The Bank Holiday and the Emergency Banking
Act reestablished the integrity of the
U.S. payments system and demonstrated the
power of credible regime-shifting policies.

William L. Silber is the Marcus Nadler Professor of Finance and Economics
at New York University’s Stern School of Business.
<wsilber@stern.nyu.edu>

1. Introduction

n Sunday, March 5, 1933, after a month-long run on
American banks, the newly inaugurated President of the
United States, Franklin Delano Roosevelt, proclaimed a fourday suspension of all banking transactions, beginning the
following day. The nation’s stock exchanges also closed, even
though they were not mentioned in the President’s executive
order. On Thursday, March 9, Roosevelt did not reopen the
banks as planned; rather, he extended the closure for three
days. Americans should have reacted in horror to the
President’s proclamation and his decision to abandon his
original schedule. Instead, they waited to hear his plan.
Roosevelt’s fifteen-minute radio address to the American
people on Sunday evening, March 12—his first Fireside Chat—
informed the public that only sound banks would be licensed
to reopen by the U.S. Treasury: “I can assure you that it is safer
to keep your money in a reopened bank than under the
mattress.”1 Much to everyone’s relief, when the institutions
reopened for business on March 13, depositors stood in line to
return their hoarded cash to neighborhood banks. Within two
weeks, Americans had redeposited more than half of the
currency that they had squirreled away before the suspension.
1

New York Times, March 13, 1933, p. 1 cont.

The author acknowledges helpful comments from an anonymous referee and
from Stephen Cecchetti, Hugh Rockoff, Anna Schwartz, Richard Sylla, George
Tavlas, Paul Wachtel, Eugene White, and Lawrence J. White. He extends special
thanks to Kenneth Garbade and Thomas Sargent for encouragement and advice;
to Rik Sen for excellent research assistance; and to Joseph Komljenovich and
Marja Vitti, archivists at the Federal Reserve Bank of New York, for their help.
The views expressed are those of the author and do not necessarily reflect the
position of the Federal Reserve Bank of New York or the Federal Reserve System.
FRBNY Economic Policy Review / July 2009

The market registered its approval as well. On March 15, 1933,
the first day of trading after the extended closure, the New York
Stock Exchange recorded the largest one-day percentage price
increase ever.2 With the benefit of hindsight, the nationwide
Bank Holiday in March 1933 ended the bank runs that had
plagued the Great Depression.
How, then, did Roosevelt manage to accomplish in one
week what Herbert Hoover failed to do in three years?
Contemporary observers consider the Bank Holiday and the
Fireside Chat a one-two punch that broke the back of the Great
Depression. According to Beard and Smith (1940, p. 78), “the
sudden nationwide holiday performed the same function for
the bank panic as may a slap in the face for a person gripped by
unreasoning hysteria.” Allen (1939, p. 111) notes that the bank
reopening succeeded because “the people had been catapulted
and persuaded by a president who seemed to believe in them
and was giving them action. . . .” Alter (2006, p. 269) confirms
the importance of Roosevelt’s communication skills by quoting
Will Rogers on the President’s description of the reopening:
“He made everyone understand it, even the bankers.”
Roosevelt’s oratory certainly played an important role, but
only the financially naive would have believed that the
government could examine thousands of banks in one week to
identify those that should survive. According to Wigmore
(1987, p. 752), “The federal review procedure for reopening
banks also had too many weaknesses to create much
confidence, given the number of banks reopened, the speed
with which they opened, and the lack of current information
on them. There were no standards for judging which banks

Contemporary observers consider
the Bank Holiday and the Fireside Chat
a one-two punch that broke the back
of the Great Depression.
should reopen.” Thus, Temin and Wigmore (1990, p. 491)
dismiss the importance of the Bank Holiday: “The value of
stocks . . . rose sharply from its trough in March—at the time
of the Bank Holiday—to a peak in July. . . . This abrupt
turnaround was hardly the result of the interregnum or the
Bank Holiday itself. They contained bad news about the health
of the economy. Only after Roosevelt’s commitment to
inflationary policies became clear during the Hundred Days
did the value of stocks rise. The stock market rose and fell with
the value of the dollar during 1933, illustrating dramatically the
link between devaluation and expectations for the economy.”
2

See Siegel (1998, p. 183).

Why Did FDR’s Bank Holiday Succeed?

Temin and Wigmore (pp. 488-9) ignore the March 15, 1933,
stock price increase in their assessment of the Bank Holiday.
They go further to state: “For the first month the administration
was absorbed with the Bank Holiday and preparing for action.
Stock, bond, foreign exchange, and commodities markets were
quiet and little changed” [italics added].
This article demonstrates that the Bank Holiday that began
on March 6, 1933, marked the end of an old regime, and the
Fireside Chat a week later inaugurated a new one. The
Emergency Banking Act of 1933, passed by Congress on
March 9—combined with the Federal Reserve’s commitment
to supply unlimited amounts of currency to reopened banks—

People . . . believed the President on
March 12, 1933, when he said that the
reopened banks would be safer than the
proverbial “money under the mattress.”
created de facto 100 percent deposit insurance. Moreover, the
evidence shows that people recognized this guarantee and, as a
result, believed the President on March 12, 1933, when he said
that the reopened banks would be safer than the proverbial
“money under the mattress.” Confirmation of the turnaround
in expectations came in two parts: the Dow Jones Industrial
Average rose by a statistically significant 15.34 percent on
March 15, 1933 (taking into account the two-week trading halt
during the Bank Holiday), and by the end of the month, the
public had returned to the banks two-thirds of the currency
hoarded since the onset of the panic.
Together, the Emergency Banking Act and the de facto
100 percent deposit insurance created a safety net for banks
and produced a regime shift with instantaneous results, similar
to Sargent’s (1986) description of “The Ends of Four Big
Inflations.” This result would come as no surprise to Friedman
and Schwartz (1963, p. 434), who observe that “Federal
insurance of bank deposits was the most important structural
change in the banking system to result from the 1933 panic,
and . . . the structural change most conducive to monetary
stability since state bank notes were taxed out of existence
immediately after the Civil War.”3 However, Friedman and
Schwartz (pp. 421-2) simply review the provisions of the
3

The Banking Act of 1933, which included a provision for creating the Federal
Deposit Insurance Corporation (FDIC), was passed on June 13, 1933. FDIC
insurance, which was not retroactive, became effective on January 1, 1934.
Although Roosevelt himself opposed deposit insurance legislation (Calomiris
and White 2000, p. 193), as we discuss, the President’s opposition did not
interfere with his commitment to the success of de facto depositor protection
that began with the earlier Emergency Banking Act of 1933.

Emergency Banking Act of 1933 and do not recognize the
implicit guarantee for deposits in the reopened banks. Both
Meltzer (2003, p. 423) and Wicker (1996, p. 146) maintain that
the government understood the need to guarantee deposits in
reopened banks, but they do not show that the public
recognized this new policy and acted accordingly.
Friedman and Schwartz correctly praise the stabilizing role
of deposit insurance, but they do not distinguish between a
100 percent guarantee and the insurance program created by
the FDIC that began on January 1, 1934. FDIC insurance caps
its guarantee at a maximum dollar amount for each deposit
account, initially set at $2,500. Small depositors with FDIC
insurance did not have to worry about their accounts, but large
depositors, who were only partially insured, could still be
panicked into a run. Roosevelt’s implicit 100 percent guarantee
on March 12, 1933, convinced all depositors to trust the
reopened banks.
The nationwide Bank Holiday in March 1933 was a unique
event in American financial history. In the past, banks had
suspended the convertibility of deposits into currency, but
never had there been a complete stoppage of the entire
U.S. payments system. The evidence presented here on the
speed with which the Bank Holiday and the Emergency
Banking Act of 1933 reestablished the integrity of the payments
system demonstrates the power of credible regime-shifting
policies.
The article is organized as follows. Section 2 describes the
February 1933 banking system crisis that culminated in the
formal suspension of all banking transactions upon Roosevelt’s
proclamation of a nationwide Bank Holiday. Section 3 reviews
the reasons for the suspension, and Section 4 describes the

The nationwide Bank Holiday in March
1933 was a unique event in American
financial history. In the past, banks had
suspended the convertibility of deposits
into currency, but never had there been
a complete stoppage of the entire
U.S. payments system.
solution to the crisis: the Emergency Banking Act of 1933.
Evidence from the contemporary press confirms that an
important segment of the American public understood the
implicit federal guarantee for all deposits of reopened banks.
Section 5 shows that people responded by redepositing the
currency they had withdrawn and by bidding up stock prices.

2. The Collapse
“The straw that broke the camel’s back occurred in Detroit,
Michigan,” in February 1933, according to Acting Comptroller
of the Currency Francis Awalt.4 Michigan Governor William A.
Comstock declared a statewide banking holiday on
February 14, 1933, to prevent the failure of the Union
Guardian Trust Company of Detroit, a bank with close ties to
Henry Ford. The story of the battle between Ford—Union
Guardian’s largest depositor—and Under Secretary of the
Treasury Arthur Ballantine over how to save the bank from
insolvency has been told many times (Kennedy 1973; Wigmore
1985; Wicker 1996). The failure of Ford and Ballantine to arrive
at a mutually agreeable solution forced the governor to suspend
banking operations in the entire state. The fallout from that
decision gave new meaning to the law of unintended
consequences. Instead of preventing a panic, the Michigan
bank holiday precipitated one. The suspension confirmed the
public’s worst fears—that the banks were unsafe—and sparked
a nationwide rush to cash.
The damage from the February 14 Michigan proclamation
came from contagion. According to Wicker (1996, p. 121), the
Michigan bank holiday “spread fear and uncertainty quickly to
the contiguous states of Ohio, Indiana, and Illinois.” The
contemporary press suggests, however, that those states
recognized the danger of imitating the Michigan example. On
February 17, the office of Ohio Governor George White issued
this statement: “There is no occasion for a proclamation by
Governor White of a banking holiday in the state of Ohio.”5
On February 23, the New York Times reported that Indiana
Governor Paul McNutt declared that there would be “no bank
moratorium in Indiana” in order to quiet “unwarranted
reports from Chicago that there would be [one].”6
Unlike Michigan’s Midwestern neighbors, Maryland failed
to hold the line. On February 24, Governor Albert Ritchie
remarked: “I attended the meeting of bankers this evening with
the idea of doing whatever is best for the depositors. . . . I
believe there is no justification for the withdrawals which have
recently been taking place. But to protect the property and
saving[s] of the people of the city [of Baltimore] and the State
these large withdrawals should stop. It was the consensus of
opinion that a bank holiday should be declared tomorrow.”7
In the weeks following the Michigan moratorium, there
were large increases in the demand for currency (Table 1). For
the six weeks ending February 8, 1933, currency in circulation
was quite stable, averaging $5.36 billion. After February 8,
4

Awalt (1969, p. 349).
New York Times, February 18, 1933, p. 5.
6
February 23, 1933, p. C31.
7
New York Times, February 24, 1933, p. 21.
5

FRBNY Economic Policy Review / July 2009

Table 1

Currency in Circulation, January-July 1933

Date
January
4
11
18
25
February
1
8
15
22
March
1
8
15
22
29
April
5
12
19
26
May
3
10
17
24
31
June
7
14
21
28
July
5
12
19
26

Amount
(Billions of Dollars)
5.38
5.30
5.32
5.32
5.37
5.47
5.56
5.70
6.43
7.25
6.98
6.32
6.07
5.97
5.86
5.78
5.71
5.67
5.67
5.57
5.51
5.53
5.48
5.44
5.41
5.39
5.47
5.38
5.35
5.31

Source: Board of Governors of the Federal Reserve System, Banking and
Monetary Statistics (1943, p. 387).

currency held by the public rose steadily, reaching $7.25 billion
in the week ending March 8, 1933. The $1.78 billion jump in
currency held by the public between February 8 and March 8—
an increase of more than 30 percent—confirms the hoarding of
cash.8 Almost all of the increase occurred after February 15.
8

The weekly data in Table 1 are not seasonally adjusted, but monthly seasonal
factors show that virtually no adjustment is required for February and March
(see Banking and Monetary Statistics, Table 111, Board of Governors of the
Federal Reserve System, 1943).

Why Did FDR’s Bank Holiday Succeed?

The rush to cash during the weeks following the Michigan bank
holiday triggered bank closures or deposit restrictions in every
state, even before Roosevelt’s proclamation of March 5, 1933
(Wicker 1996, p. 128). According to the New York Times, “A bank
holiday ‘until further notice’ was declared tonight [March 4] in
Delaware, the last of the forty-eight states in which restrictions
have been made.”9 However, there is disagreement over the
precise number of bank holidays in force before Roosevelt’s
presidential decree. According to Friedman and Schwarz (1963,
p. 325), “By March 3, holidays in about half the states had been
declared”; Meltzer (2003, p. 382) indicates “By inauguration day
[March 4], thirty-five states had declared bank holidays”; and
Alter (2006, p. 190) maintains “By the early evening of Friday
March 3, banks in thirty-two of forty-eight states were closed.”
Why is there such confusion? To some extent, the
disagreement stems from the use of different sources or time
periods; only Wicker (1996) provides a reference for his
discussion (the New York Times). The more likely source of
confusion is that some states went to great lengths to avoid a
de jure holiday. For example, the Chicago Tribune reported that
“Indiana Governor Paul V. McNutt today informed state
officials . . . [that] Indiana banks, under the new bank code law
recently rushed through the state legislature, have the power to
limit withdrawals to one-tenth of one percent. Therefore, no
state-wide bank moratorium will be declared in Indiana.”10
A detailed examination of the Associated Press list of
banking restrictions by state (including the District of
Columbia) as of the close of business on March 4, 1933, reveals
that “Banks in 28 states are ‘closed’; Banks in 10 states are ‘some
or mostly closed’; Banks in 11 states have deposits that are
‘restricted to withdrawals of 5 (or some unspecified)
percent.’”11 The Associated Press characterized Indiana as:
“About half [of the banks] restricted to 5 percent [withdrawals]
indefinitely.” If the term bank holiday means an unqualified
shutdown of banking transactions by state governments, then
the Associated Press limited the number to twenty-eight.12
As these accounts suggest, Franklin Delano Roosevelt did
not invent the bank holiday. So why is his March 5
proclamation credited with launching a process that was
crucial to restoring confidence in America’s banking system?
The answer is that Roosevelt’s initiative turned a maze of state
restrictions into a uniform national policy. This action was the
key first step to resolving the banking crisis: It shifted the
9

March 5, 1933, p. F24.
March 5, 1933, p. A5.
11
New York Times, March 5, 1933, p. F24.
12
Although the Associated Press listed New York as “closed,” the New York
Times (March 5, 1933, p. 23) reported that “At least two banks in New York
City did not avail themselves of the banking holiday proclaimed yesterday by
Governor Lehman. They were the Sterling National Bank, 1410 Broadway and
the National Bank of Far Rockaway.”
10

responsibility for the integrity of the payments system to the
federal government, where it belonged.

3. The Challenge
Roosevelt’s challenge was to figure out how to reopen the banks
without triggering a resumption of the deposit withdrawals
that led to the suspensions. His solution—the Bank Holiday—
was a more extensive form of bank suspension that had last
occurred in the United States in 1907 under the national
banking system. Indeed, Congress had established the Federal
Reserve System in 1913 precisely to prevent banks from
suspending the convertibility of deposits into currency.
Friedman and Schwartz (1963, p. 330) compare the Bank
Holiday with earlier restrictions: “One would be hard put to . . .
find a more dramatic example of how far the result of
legislation can deviate from intention.”
Why did the national banking system fail in 1933? Friedman
and Schwartz (p. 330) acknowledge that, even with the benefit
of hindsight, “the answer is by no means clear.” However, a
number of points are worth considering.13 First, the weakened
capital position of the commercial banks made them
vulnerable to even minor drains.14 Second, the public’s
demand for currency during February and March 1933 was
exacerbated by a demand for gold.15 Third, although the
Federal Reserve Act provided for an elastic currency by
allowing a Reserve Bank to discount eligible commercial paper
and ship currency in the form of Federal Reserve Notes to a
commercial bank, the Act also imposed a reserve requirement
of 40 percent gold backing for Federal Reserve Notes
outstanding. Finally, by March 3, 1933, the gold drain at the
Federal Reserve Bank of New York reduced its gold reserve
ratio to 24 percent. Meltzer (2003, p. 387) states that the
Federal Reserve Board then suspended the gold reserve
requirement, but quotes Federal Reserve Bank of New York
Governor George Harrison, saying that “he would not take the
responsibility of running [the] bank with deficient reserves”
(p. 386). Perhaps Wicker (1996, p. 145) sums up the situation
best: “[Using] the pre-1914 remedy of suspension of cash
payments can be explained quite easily. Bold and courageous
13

See Meltzer (2003, pp. 381-9) and Friedman and Schwartz (1963, pp. 324-32).
Friedman and Schwartz (1963, p. 330) emphasize that “The recorded capital
figures were widely recognized as overstating the available capital because assets
were being carried on the books at a value higher than their market value.”
15
According to Wigmore (1987, p. 744), weekly data show a $1.8 billion
increase in currency in circulation and a gold drain of $563 million from the
Federal Reserve System. Wigmore also provides daily data showing a larger
gold outflow from the Federal Reserve Bank of New York during the first few
days of March.
14

leadership was absent. Neither the Fed nor the RFC
[Reconstruction Finance Corporation] was willing to accept
lender of last resort responsibilities.”
The absence of leadership created a vacuum filled with fear
and uncertainty, making the reopening of banks a precarious
undertaking. According to Acting Comptroller of the Currency
Awalt, “No one knew how the public would react when the
banks reopened. If they demanded their money they either had
to have it or the reopening would be a failure.”16
To prevent a resumption of bank withdrawals, the President
appealed directly to the people on March 12, 1933, in his first
Fireside Chat.17 His opening words set the tone: “My friends, I
want to talk for few minutes with the people of the United
States about banking—with the comparatively few who
understand the mechanics of banking, but more particularly
with the overwhelming majority of you who use banks for the
making of deposits and the drawing of checks. I want to tell you
what has been done in the last few days, and why it was done,

Roosevelt’s challenge was to figure out how
to reopen the banks without triggering a
resumption of the deposit withdrawals that
led to the suspensions. His solution—the
Bank Holiday—was a more extensive form
of bank suspension that had last occurred in
the United States in 1907 under the national
banking system.

and what the next steps are going to be.” In clear and simple
terms, Roosevelt explained the procedure for reopening the
banks and claimed that only sound banks would be reopened.
The novelty of this event is captured by the description, the
day after the talk, in the Christian Science Monitor: “He speaks
to the nation over the radio in what is quite possibly the most
remarkable address ever made by any President. In man-toman fashion, in words of only one syllable, he uses the tones of
a friend on the inside to assure a people . . . that the bank
situation is sound. He recites the problems [and] explains the
remedy: ‘when people find they can get their money when they
want it the phantom of fear will soon be laid [to rest]. . . . It was
the government’s job to straighten out this situation and the
job is being performed.’”18
16

Awalt (1969, p. 368).
The text of the Fireside Chat, and the excerpts that follow, can be found in
the New York Times (March 13, 1933, p. 1).
18
March 13, 1933, p. 1.
17

FRBNY Economic Policy Review / July 2009

Frederick Lewis Allen, the contemporary social historian,
confirmed the power of the President’s oratory (Allen 1939,
p. 110): “Roosevelt’s first Fireside Chat was perfectly attuned.
Quiet, uncondescending [sic], clear, and confident, it was an
incredibly skillful performance.” However, Allen also
emphasized that most people did not understand how the
government could accomplish its objective: “The banks opened
without any such renewed panic as had been feared. They
might not have done so had the people realized that it was
impossible, in a few days, to separate the sound banks from the
unsound” (p. 110).
Allen suggests that most people did not care what the
President said—only the way he said it. But the President’s
opening words identified two groups of people: the
“comparatively few who understand the mechanics of banking
. . . [and] the overwhelming majority.” How did the President
assure the more sophisticated public—and a skeptical press—
who could blow the whistle if there was no substance to his
promises?
Roosevelt, in fact, delivered a double-barreled message
during his Fireside Chat—one for the general public and one
for the financiers. To those who understood the mechanics of
banking, he said, “Last Thursday [March 9] was the legislation
promptly and patriotically passed by the Congress . . . [that]
gave authority to develop a program of rehabilitation of our
banking facilities. . . . The new law allows the twelve Federal
Reserve Banks to issue additional currency on good assets and
thus the banks that reopen will be able to meet every legitimate

Roosevelt . . . delivered a doublebarreled message during his Fireside
Chat—one for the general public and
one for the financiers.
call. The new currency is being sent out by the Bureau of
Engraving and Printing to every part of the country.”
The Emergency Banking Act, passed by Congress on March 9,
1933, gave the President the backing that he needed to ensure the
safety of the reopened banks.19 Without that legislation, the
President’s words could not have carried the day.

4. The Emergency Banking Act of 1933
The key provision of the Emergency Banking Act, mentioned
by Roosevelt, allowed the Federal Reserve Banks to issue
emergency currency, similar to that issued in 1914 under the
Aldrich-Vreeland Act. According to the New York Times: “To
many of the President’s closest advisors the Aldrich-Vreeland
Act, repealed when the Federal Reserve Act came into effect,
provides the model scheme for the projected expansion of
currency through Federal Reserve Notes.”20 Titles I through IV
of the Emergency Banking Act went much further, however,
granting the President near dictatorial powers.
Title I of the Act approved the President’s declaration of
the Bank Holiday and allowed the President, during the
period of emergency, to regulate all banking functions,

The key provision of the Emergency
Banking Act . . . allowed the Federal
Reserve Banks to issue emergency
currency, similar to that issued in 1914
under the Aldrich-Vreeland Act.

including “any transactions in foreign exchange, transfers of
credit between or payments by banking institutions as
defined by the President, and export, hoarding, melting, or
earmarking of gold or silver coin.” Title II gave the
Comptroller of the Currency the power to restrict the
operations of a bank with impaired assets and to appoint a
conservator, who “shall take possession of the books,
records, and assets of every description of such bank, and
take such action as may be necessary to conserve the assets
of such bank pending further disposition of its business.”
Title III allowed the Secretary of the Treasury to determine
whether a bank needed additional funds to operate and
“with the approval of the President request the
Reconstruction Finance Corporation to subscribe to the
preferred stock in such association, State bank or trust
company, or to make loans secured by such stock as
collateral.” Title IV provided for issuance by the Federal
Reserve Banks of emergency currency, called Federal
20

The text of the Emergency Banking Act of 1933 appears in its entirety in
the New York Times (March 10, 1933, p. 2).

Why Did FDR’s Bank Holiday Succeed?

March 9, 1933, p. 2. The emergency currency provision of the AldrichVreeland Act, passed in May 1908 to prevent a replay of the Panic of 1907, had
been scheduled to expire by legislative design on June 30, 1914. The Federal
Reserve Act, passed in December 1913, extended the expiration date for one
year, until June 30, 1915, to provide protection against panics while the Federal
Reserve System was being organized. The extension allowed Treasury Secretary
William McAdoo to invoke the Aldrich-Vreeland Act to prevent a panic in
August 1914 at the outbreak of the Great War (see Silber [2007b]).

Reserve Bank Notes, backed either by “(A) any direct
obligations of the United States or (B) any notes, drafts, bills
of exchange, or bankers’ acceptances, acquired under the
provisions of this act.” Federal Reserve Bank Notes would
circulate alongside normal Federal Reserve Notes, even
though they were not backed by gold, because the Act
provided that the new notes “shall be receivable at par in all
parts of the United States . . . and shall be redeemable in
lawful money of the United States on presentation at the
United States Treasury.”
Title I of the Emergency Banking Act conferred on the
President considerable power to deal with the crisis. The
Administration did not shy away from using that power. In his
Fireside Chat on Sunday night, March 12, Roosevelt ordered
banks to be opened sequentially: “First in the Twelve Reserve
Bank cities—those banks which on first examination by the
Treasury have been already found to be all right . . . followed on
Tuesday . . . by banks already found to be sound in cities where
there are recognized clearing houses . . . [and] on Wednesday
and succeeding days, banks in smaller places . . . subject, of
course to the government’s physical ability to complete its
survey.”21 The Treasury issued emergency regulations designed
to prevent runs on the reopened banks, including: “No banking
institution shall permit any withdrawal by any person when
such institution, acting in good faith, shall deem that the
withdrawal is intended for hoarding.”22
Roosevelt recognized that the restoration of confidence was
the most important ingredient for a successful reopening:
“Confidence and courage are the essentials of success in
carrying out our plan.”23 Friedman and Schwartz (1963,
p. 440) confirm the role of confidence: “Panics arose out of or
were greatly intensified by a loss of confidence in the ability of
banks to convert deposits into currency.” However, Roosevelt
did not inspire great confidence when he said the first banks to
be reopened were those that “on first examination by the
Treasury have been already found to be all right.” Nor did
regulations against hoarding assure people that the banks were
sound; if anything, the reverse was more likely. The key to
creating confidence in the reopened banks rested with Titles III
and IV of the Emergency Banking Act.
Title IV gave the Federal Reserve the flexibility to issue
emergency currency—Federal Reserve Bank Notes—backed by
any assets of a commercial bank. The contemporary press
recognized the power of the emergency currency provision:
“The new currency feature of the law is one of the most
important of the many extraordinary powers given to this
administration . . . which stem from the Aldrich-Vreeland Act
21

New York Times, March 13, 1933, p. 1 cont.
New York Times, March 13, 1933, p. 2.
23
New York Times, March 13, 1933, p. 1 cont.
22

. . . invoked in 1914 for the issuance of about $386,000,000 in
emergency currency.”24 The link to Aldrich-Vreeland
currency, which succeeded in defusing the financial crisis at the
outbreak of World War I, conferred credibility on the power of
Title IV of the Emergency Banking Act of 1933.25 The Wall
Street Journal wrote: “Banks which are believed to be 100%
sound would be reopened as soon as their condition could be
checked. . . . All banks so reopened, it was pointed out, could
under Title 4 and under machinery already in existence obtain
the cash resources necessary from the Federal Reserve banks.”26
Title IV of the Emergency Banking Act promised more than
just the availability of cash to reopened banks. It also created
the expectation that the government would guarantee all
depositors against loss, without limit. As the New York Times
reported: “Some bankers who were here today . . . interpreted
the emergency banking act as a measure under which the
government practically guarantees, not officially but morally,

Roosevelt recognized that the
restoration of confidence was the most
important ingredient for a successful
reopening [of banks].

the deposits in the banks which it permits to reopen. This point
of view was based on the fact that banks permitted to open are
characterized as 100 per cent sound and assured of sufficient
currency to meet all obligations” [italics added].27
Title III of the Emergency Banking Act added to the public’s
perception of a guarantee, according to the New York Times:
“The privilege to be extended to banks to issue preferred stock
to be taken over by the Reconstruction Finance Corporation
when they are in need of funds for capital purposes or
reorganization, is also pointed to as another feature of the
governmental program which fits in with the theory that a
virtual guarantee is extended to depositors.”28 Two days earlier,
a New York Times headline had announced: “Deposit
Guarantee Seen in Bank Law,” and the newspaper attributed
the view to “an interpretation of the measure . . . by some
officials in one of the government departments it concerns.”29
The availability of capital funds through the Reconstruction
Finance Corporation would certainly help a bank’s balance
24

New York Times, March 10, 1933, p. 3.
See Silber (2007a) for a discussion of the 1914 financial crisis.
26
March 10, 1933, p. 1 cont.
27
March 13, 1933, p. 1 cont.
28
March 13, 1933.
29
March 11, 1933, p. 2.
25

FRBNY Economic Policy Review / July 2009

sheet, but only the Federal Reserve could provide unlimited
currency to banks to meet a run on deposits. Acting
Comptroller of the Currency Awalt confirmed the implicit
guarantee many years later, but also hinted at concern over
Federal Reserve support: “It was felt that the various Federal
Reserve Banks must back the reopened banks to the hilt, and
that it was no time for any conservative head of a Federal
Reserve Bank to exercise his conservatism, should demand be
made for currency. We reasoned, therefore, that if the Federal
Reserve agreed to a reopening of a particular bank, it would
necessarily be forced to back it one hundred percent” [italics
added].30
How could a conservative Federal Reserve throttle the
guarantee? A bank in need of cash could get the new Federal
Reserve Bank Notes, according to Title IV of the Emergency
Banking Act, by discounting with its regional Federal Reserve
Bank “(A) any direct obligations of the United States or (B) any
notes, drafts, bills of exchange, or bankers’ acceptances,
acquired under the provisions of this act.” However, an
individual Federal Reserve Bank could refuse to accept a bank’s
assets as collateral if the assets were considered too risky.
Central bankers are always concerned with credit risk. The
Federal Reserve Banks may have been especially sensitive
because they are private corporations owned by the
commercial banks that are members of the System. In a
discussion titled “Tragic Interlude in March, 1933,”
Emanuel A. Goldenweiser, Director of Research and Statistics
at the Federal Reserve Board from 1926 through 1945, wrote:
“The Federal Reserve Banks and their management were still
under the spell of commercial banking practice and theory and
were dominated by the concept of liquidity as protection to a

An agreement to indemnify the Federal
Reserve Banks against losses ensured
their cooperation in lending freely to
banks in need of cash.
bank. They were also concerned about protecting the liquidity
and solvency of the Federal Reserve Banks themselves as
custodians of the country’s ultimate reserves.”31
An agreement to indemnify the Federal Reserve Banks
against losses ensured their cooperation in lending freely to
banks in need of cash. The promise to protect the Reserve
Banks came in the form of a telegram, dated March 11, 1933,
30
31

Awalt (1969, p. 368).
Goldenweiser (1951, p. 165).

Why Did FDR’s Bank Holiday Succeed?

from Roosevelt’s Treasury Secretary, William Woodin, to
Governor George Harrison of the Federal Reserve Bank of
New York, quoting President Roosevelt: “It is inevitable that
some losses may be made by the Federal Reserve banks in loans
to their member banks. The country appreciates, however, that
the 12 regional Federal Reserve Banks are operating entirely
under Federal Law and the recent Emergency Bank Act greatly
enlarges their powers to adapt their facilities to a national

The key question is: When the banks
reopened, did the public behave as
though it believed in the newly guaranteed
safety of the banking system?

emergency. Therefore, there is definitely an obligation on the
federal government to reimburse the 12 regional Federal
Reserve Banks for losses which they may make on loans made
under these emergency powers. I do not hesitate to assure you
that I shall ask the Congress to indemnify any of the 12 Federal
Reserve banks for such losses. I am confident that Congress will
recognize its obligation to these Federal Banks should the
occasion arise, and grant such request.”32 Roosevelt clearly
went out on a limb to ensure the Federal Reserve’s cooperation.
Congress understood the role of emergency currency in
guaranteeing bank deposits. As the New York Times observed:
“the framing and adoption of the emergency banking law . . .
went far to offset demands in Congress for a separate guarantee
bill.”33 Of course, the public did not know the details of the
Federal Reserve’s reluctance to lend, nor did it know of
Roosevelt’s indemnification scheme.34 Most Americans, in
fact, did not read the New York Times, so they were unaware of
the publicity accorded the implicit guarantee.
32

Federal Reserve Bank of New York Archives, Central Files Unit, 017.1. The
Honorable Ogden Mills, outgoing Treasury secretary, was invited to the Board
of Directors meeting of the Federal Reserve Bank of New York to read the
telegram and to brief the Directors on “recent discussions of the problems
involved in reopening the banks of the country which have taken place in
Washington, D.C.” (Minutes, March 11, 1933, p. 179, Federal Reserve Bank of
New York Archives). William Woodin, incoming Treasury secretary, had asked
Mills to stay on and help draft the Emergency Banking Act. Also see
Alter (2006) and Meltzer (2003) for discussions of the role that Mills played.
33
March 13, 1933, p. 1 cont.
34
The Directors of the Federal Reserve Bank of New York were sufficiently worried
about the riskiness of loans to reopened banks that they transmitted the following
resolution to the Treasury secretary: “Pending the legal assumption of the
responsibility of the government [to indemnify the Reserve Banks] . . . we believe
that banks should be licensed to reopen only with our approval, as the principal
burden of taking care of such banks as are reopened will be ours” (Minutes,
March 12, 1933, p. 189, Federal Reserve Bank of New York Archives).

Perhaps the articles in the New York Times reflected the
strategy outlined by Raymond Moley, a member of
Roosevelt’s brain trust. Moley had worked with Treasury
Secretary William Woodin to formulate the Emergency
Banking Act and had helped draft the March 12 Fireside Chat.
He stated: “Those who conceived and executed . . . the policies
which vanquished the bank crisis . . . were intent upon
rallying the confidence, first, of the conservative business and
banking leaders of the country and then, through them, of the
public generally” (Moley 1939, p. 155).
Indicative evidence of the strategy described by Moley
comes from comparing the Minutes of the Board of Directors
of the Federal Reserve Bank of New York with comments in the
New York Times. On March 10, 1933, the following entry
appeared in the Minutes: “Under this law, enacted as a part of
the program for reopening the banks, the Federal Reserve
Banks become in effect guarantors of the deposits of the
reopened banks. While they are not legally bound there is a
large moral responsibility” [italics added].35 Two days later, the
New York Times echoed precisely that sentiment: “Some
bankers who were here today . . . interpreted the emergency
banking act as a measure under which the government
practically guarantees, not officially but morally, the deposits in
the banks which it permits to re-open” [italics added].36 There
is no evidence of a purposeful leak, but Treasury Secretary
William Woodin had been a member of the Board of Directors
of the Federal Reserve Bank of New York until March 3, 1933,
and could have easily arranged a discreet disclosure.37
In sum, the contemporary commentary suggests that
Roosevelt’s rhetoric in his first Fireside Chat gave the public
confidence in the opened banks. Business and banking
leaders—and the press—could rely on the Emergency Banking
Act to deliver on the government’s moral obligation to
guarantee all deposits. The key question is: When the banks
reopened, did the public behave as though it believed in the
newly guaranteed safety of the banking system?

5. The Evidence
On the very first day that the banks reopened, the press
described depositors anxious to redeposit their cash. A front
35

Minutes, March 11, 1933, p. 172, Federal Reserve Bank of New York
Archives.
36
March 13, 1933, p. 1 cont.
37
This tactic is consistent with the approach of the new Administration. Alter
(2006, pp. 179-81) confirms Roosevelt’s Machiavellian side by documenting
his failure to cooperate with Hoover in the month before the election. He
suggests that “It is hard to avoid the conclusion that [Roosevelt] intentionally
allowed the economy to sink lower so that he could enter the presidency in a
more dramatic fashion.”

page headline in the Chicago Tribune read: “City Recovers
Confidence as 34 Banks Open.”38 The front page of the
New York Times carried similar news: “Rush to Put Money
Back Shows Restored Faith as Holiday Ends.”39 The Times
article explained: “The public plainly showed that it recovered
from the fear and hysteria which characterized the last few days
before the banking holiday was proclaimed. It was obvious that
the people had full confidence in the banks which received
licenses to reopen from the Federal Reserve Bank . . . there was

On the very first day that the banks
reopened, the press described depositors
anxious to redeposit their cash.

a general ‘run’ yesterday [March 13] to deposit or redeposit
money. . . . Conditions in New York were duplicated in each of
the other Federal Reserve cities throughout the country where
full banking facilities were restored.”40 The process continued
the following day, according to the Times: “With the reopening
of the banks in clearing house centers . . . currency poured in
from private hoards and from the tills of business houses to be
deposited in the banks.”41
The success of the reopening had the somewhat anomalous
result of making the emergency currency appear redundant. On
March 15, a Times headline announced: “New Currency Put at
$2,000,000,000: Bureau made first Delivery of Money 24 Hours
after Receiving Order.”42 The newspaper then concluded: “If this
movement [of returning currency] keeps up, bankers remarked,
only a comparatively small amount of the new Federal Reserve
Bank Notes will be needed to supplement the existing supplies of
regular currency.” The public’s behavior supports the old banker
adage: “When they know they can get their money, they are not
so eager to have it.”43
The data on currency in circulation in Table 1 support the
descriptive comments in the press. Currency held by the public
had increased by $1.78 billion in the four weeks ending
March 8, 1933. The public returned two-thirds of the
increase—$1.18 billion—by the end of the month.44 This
remarkable turnaround is all the more impressive considering
that when the government’s initial licensing program ended on
38

March 14, 1933.
March 14, 1933.
40
March 14, 1933.
41
March 15, 1933, p. 5.
42
March 15, 1933, p. 5.
43
The quote comes from the Wall Street Journal (September 15, 1914, p. 5).
It refers to British investors not liquidating their American investments as the
crisis of 1914 came under control. See Silber (2007a, p. 128).
39

FRBNY Economic Policy Review / July 2009

Table 2

Significance Tests for Stock Returns: March 3-15, 1933
Dow Jones Industrial Average

S&P 500 Index

14.27

15.37

18.48

14.41

2.48

2.45

1.81

1.94

2.03
—

2.22
—

—
3.23

—
2.35

Return over Bank Holiday (percent)
Post-election standard deviation
of returns (percent)
t-statistic (with eight trading days)
t-statistic (with ten trading days)

CRSP Equally Weighted Index CRSP Value-Weighted Index

Source: University of Chicago, Booth School of Business, Center for Research in Security Prices (CRSP).
Note: All data are continuously compounded.

April 12, 1933, a total of 4,215 banks, with deposits of nearly
$4 billion, remained closed (Wicker 1996, pp. 146-7).45
The stock market provides a second assessment of the events
from March 3, 1933 (the last trading day before the Bank
Holiday), to March 15, 1933 (the day the New York Stock
Exchange resumed trading). The Dow Jones Industrial Average
increased by a record 15.34 percent on March 15, 1933—the
largest one-day percentage price increase ever recorded,
according to Siegel (1998, p. 183). However, Siegel omits this
day from his ranking of largest daily stock price increases,
presumably because trading had been suspended for almost
two calendar weeks. Recall that Temin and Wigmore (1990,
p. 488) dismiss entirely the March 15 price increase,
maintaining that the market was quiet and little changed.
Is the 15.34 percent jump in the Dow Jones Industrial
Average significant after accounting for the trading
suspension? A simple t-test on the continuously compounded
return of 14.27 percent on March 15, 1933, can determine
whether this increase is statistically significant. The relevant
daily standard deviation of returns is 2.48 percent.46 Allowing
for eight regular trading days between March 3, 1933, and
March 15, 1933, the t-statistic has a value of 2.03, which is
significant at conventional levels.47 Table 2 presents the same
set of statistics for three other stock market indexes: the
S&P 500 Index (which consisted of ninety stocks at that time);
44

The weekly data are not seasonally adjusted, but the monthly seasonal
adjustments for March are minimal (see footnote 8). Moreover, the changes in
currency in circulation for the corresponding weeks in each of the three
previous years are small and show no pattern. In 1932, currency in circulation
declined from $5.26 billion in the second week of March to $5.15 billion in the
last week of March; in 1931, it grew from $4.27 billion to $4.33 billion; in 1930,
it rose from $4.21 billion to $4.23 billion (source: Banking and Monetary
Statistics, pp. 384-7, Board of Governors of the Federal Reserve System, 1943).
45
The history of bank suspensions provides some perspective. Over the
1930-32 period, bank suspensions averaged 1,699 per year; from 1934 through
1940, they averaged 45 per year (source: Banking and Monetary Statistics,
Table 66, Board of Governors of the Federal Reserve System, 1943).

Why Did FDR’s Bank Holiday Succeed?

the Chicago Booth Center for Research in Security Prices
(CRSP) equally weighted index; and the CRSP value-weighted
index. The t-statistics for the Bank Holiday returns using the
CRSP indexes allow for ten trading days between the two dates
because, unlike the Dow Jones Industrial Average and the
S&P 500 Index, the CRSP data include abbreviated Saturday
sessions.48 All of the t-statistics are significant.
Stock prices fluctuate for many reasons—and sometimes for
no reason at all—but the magnitude of the favorable response
on March 15, 1933, implies that the successful reopening of the
banking system cannot be ignored. The contemporary press
confirms the connection. The day after the market reopened,
the New York Times observed: “The robust advance in stocks
and bonds was interpreted—and correctly so—as Wall Street’s
mark of approval of the steps taken by the President and
Congress in the interval to end the financial disorder.”49 The
Wall Street Journal added: “The emergency banking act lifted
46

To measure the normal variability of returns during this period, we first
calculate the daily standard deviation of returns (continuously compounded)
on the Dow Jones Industrial Average from January 4, 1932, through March 3,
1933. We then split the sample on November 8, 1932, the date of Roosevelt’s
election, and perform an F-test to determine whether the pre-election
(January 4, 1932, through November 7, 1932) daily standard deviation of
3.45 percent equals the post-election (November 9, 1932, through March 3,
1933) daily standard deviation of 2.48 percent. The F-statistic equals 2.03, with
213 and 77 degrees of freedom, implying a p-value of .001. Thus, we reject the
hypothesis of equality for the pre- and post-election standard deviation of
returns. Daily data on the Dow Jones Industrial Average (and the estimate of
the daily standard deviation) did not include the abbreviated Saturday trading
sessions.
47
The eight trading days between March 3 and March 15 exclude Saturdays.
Recognition that variance over nontrading days is lower than variance over
trading days (see French and Roll [1986] and Lockwood and Linn [1990])
would increase the t-statistic.
48
The reduced daily standard deviations for the CRSP indexes compared with
the S&P 500 Index and the Dow Jones Industrial Average are due, in part, to
the lower standard deviation of returns on the abbreviated Saturday sessions
compared with the rest of the week.
49
March 16, 1933, p. 25.

from security and commodity markets an enormous weight of
potential liquidation.”50And the Chicago Tribune waxed
eloquent in its assessment: “The zooming upward of prices on
the reopened stock markets today is regarded as barometrical
indication of the economic weather test that is settling in. . . .
The courage, determination, and resourcefulness of the new
President have apparently taken the country by storm. The
reopening of the banks with deposits everywhere exceeding
withdrawals crowned with success the first action taken by the
administration.”51

6. Conclusion
A number of forces contributed to the success of the Bank
Holiday declared by Franklin Delano Roosevelt in 1933.
The President placed the responsibility for safeguarding the
integrity of the payments system with the federal government.
Congress passed the Emergency Banking Act of 1933, giving
the President the power to restore confidence in the banking
system by establishing 100 percent guarantees for bank
deposits. And Roosevelt did not hesitate to use that power to
end the banking crisis.
We can draw three main conclusions from this event. First,
management of the banking crisis required bold and decisive
action. Second, rhetoric alone did not solve the crisis; a
substantive component was required to restore the banking
system to normal operations. Finally, the speed with which the
Bank Holiday and the Emergency Banking Act reestablished
the integrity of the payments system demonstrates the power of
credible regime-shifting policies.

March 16, 1933, p. 6.

March 16, 1933, p. 1. The press cited a second factor buoying stock prices:
favorable Congressional legislation giving Roosevelt the power to reduce
veterans’ benefits and federal salaries. According to the Chicago Tribune
(March 16, 1933, p. 1): “What the country is witnessing is a president doing
swiftly and certainly what the overwhelming majority of the people
demanded. . . . No sooner had he ended the bank panic than Mr. Roosevelt
began pushing through Congress the bill for a 500 million dollar reduction in
the cost of the federal government and the bill to legalize and tax beer.”

FRBNY Economic Policy Review / July 2009

References

Allen, F. L. 1939. Since Yesterday: The 1930s in America. New
York: Harper & Row. Reprinted: First Perennial Library (1972).

Meltzer, A. H. 2003. A History of the Federal Reserve, Volume I:
1913-1951. Chicago: University of Chicago Press.

Alter, J. 2006. The Defining Moment: FDR’s Hundred Days and
the Triumph of Hope. New York: Simon & Schuster.

Moley, R. 1939. After Seven Years. New York: Harper & Brothers.
Reprinted: De Capo Press, New York (1972).

Awalt, F. G. 1969. “Recollections of the Banking Crisis in 1933.”
Business History Review 43, no. 3 (autumn): 347-71.

Sargent, T. J. 1986. “The Ends of Four Big Inflations.” In Rational
Expectations and Inflation. New York: Harper & Row.

Beard, C. A., and G. H. E. Smith. 1940. The Old Deal and the New.
New York: Macmillan.

Siegel, J. J. 1998. Stocks for the Long Run. 2nd ed. New York:
McGraw-Hill.

Calomiris, C. W., and E. White. 2000. “The Origins of Federal Deposit
Insurance.” In Charles Calomiris, ed., U.S. Bank Deregulation
in Historical Perspective, 164-211. Cambridge: Cambridge
University Press.

Silber, W. L. 2007a. When Washington Shut Down Wall Street:
The Great Financial Crisis of 1914 and the Origins of
America’s Monetary Supremacy. Princeton, N.J.: Princeton
University Press.

French, K. R., and R. Roll. 1986. “Stock Return Variances: The Arrival
of Information and the Reaction of Traders.” Journal of
Financial Economics 17, no. 1 (September): 5-26.

———. 2007b. “The Great Financial Crisis of 1914: What Can We
Learn from Aldrich-Vreeland Emergency Currency?” American
Economic Review 97, no. 2 (May): 285-9.

Friedman, M., and A. J. Schwartz. 1963. A Monetary History of the
United States. Princeton, N.J.: Princeton University Press.

Temin, P., and B. Wigmore. 1990. “The End of One Big Deflation.”
Explorations in Economic History 27, no. 4 (October): 483-502.

Goldenweiser, E. A. 1951. American Monetary Policy. New York:
McGraw-Hill.

Wicker, E. 1996. The Banking Panics of the Great Depression.
Cambridge: Cambridge University Press.

Kennedy, S. E. 1973. The Banking Crisis of 1933. Lexington, Ky.:
University Press of Kentucky.

Wigmore, B. 1985. The Crash and Its Aftermath: A History of
Securities Markets in the United States, 1929-1933.
Westport, Conn.: Greenwood Press.

Lockwood, L. J., and S. C. Linn. 1990. “An Examination of Stock
Market Return Volatility during Overnight and Intraday Periods,
1964-1989.” Journal of Finance 45, no. 2 (June): 591-601.

———. 1987. “Was the Bank Holiday of 1933 Caused by a Run on the
Dollar?” Journal of Economic History 47, no. 3 (September):
739-55.

The views expressed are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York,
the Federal Reserve Board, or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty, express or
implied, as to the accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of any information
contained in documents produced and provided by the Federal Reserve Bank of New York in any form or manner whatsoever.
30

Why Did FDR’s Bank Holiday Succeed?

Andrew F. Haughwout and Ebiere Okah

Below the Line: Estimates
of Negative Equity
among Nonprime
Mortgage Borrowers
• Evidence from the current downturn suggests
that declines in borrower equity are fundamental
contributors to the rise in delinquencies and
defaults on nonprime mortgage loans.
• Measures of housing units with negative
equity—in which the mortgage balance
exceeds the value of the collateral property—
have become a key component in crafting
policies to address the foreclosure crisis.
• An analysis of the prevalence and magnitude
of negative equity in the U.S. nonprime
mortgage market finds that negative equity
is closely associated with the time and place
of mortgage origination and with the existence
of subordinate liens against the property.
• Borrowers in negative equity are twice as
likely as those in positive equity to be
seriously delinquent, or in default, on their
first-lien mortgage.

Andrew F. Haughwout is an assistant vice president and Ebiere Okah
an assistant economist at the Federal Reserve Bank of New York.
Correspondence: <andrew.haughwout@ny.frb.org>

1. Introduction

he boom in nonprime mortgage lending that occurred in
the United States between 2004 and 2006 was quickly
followed by rapid increases in the rate of delinquencies and
foreclosures on these loans.1 This pronounced deterioration
alarmed investors, the public, and policymakers.2 Significantly,
uncertainty about the source of the decline in loan quality has
played a key role in the credit crunch that began in mid-2007.
Nonprime loan originations rose sharply after 2003 (Chart 1),
and these loans became delinquent far more quickly than had
earlier vintages. Indeed, loans originated in 2004 performed
poorly compared with earlier vintages, and the 2005 and
2006 vintages became seriously delinquent within a year of
origination at rates that the 2003 vintage took twenty and thirty
months to reach, respectively.3
1

In this article, the nonprime market consists of subprime and alt-A loans.
Compared with prime mortgage loans, subprime mortgages are typically of
smaller value and made to borrowers with some blemish on their credit history.
Alt-A, or “near-prime,” mortgages are typically larger value loans made to
borrowers who, for a variety of reasons, may not choose to provide the
documentation of income or assets typically required to obtain a prime
mortgage.
2
As reported, for example, at CNNMoney.com (<http://money.cnn.com/
2007/11/04/news/companies/citigroup_prince/index.htm>) and BBC News
(<http://news.bbc.co.uk/2/hi/business/7070935.stm>). See also Bernanke
(2008).

The views expressed are those of the authors and do not necessarily reflect the
position of the Federal Reserve Bank of New York or the Federal Reserve
System.

FRBNY Economic Policy Review / July 2009

Chart 1

Chart 2

Nonprime Loan Originations by Year

Mean FICO Score by Vintage

Percentage of sample

Score

680

660

640

620

600

580
560

0
Pre2000

2000

2001

2002 2003

2004

2005

2006

2007

Source: FirstAmerican CoreLogic, LoanPerformance data.

The mortgage industry’s standard view of default risk has
historically focused on four underwriting characteristics at
mortgage origination: borrower credit rating, loan-to-value
(LTV) ratio, debt-to-income (DTI) ratio, and the extent of
third-party income and asset verification. However, changes in
these characteristics alone seemed insufficient to explain the
severe and rapid erosion in the status of nonprime loans
(Demyanyk and van Hemert 2008; Haughwout, Peach, and
Tracy 2008). While some underwriting criteria deteriorated as
the nonprime market share expanded, others changed little or
even improved. For example, mean credit bureau (FICO)
scores of nonprime borrowers increased steadily after 2001
(Chart 2), largely as a result of a shift in the composition of the
nonprime pool to alt-A loans.
In light of these mixed developments, some analysts turned
to the economy to explain the poor mortgage performance.
However, because economic growth between 2005 and 2007
was fairly steady—real GDP expanded 3.1, 2.9, and 2.2 percent,
respectively, in those three years while the unemployment rate
fell below 5 percent—sharp income declines seemed to be an
unlikely source of the widespread increases in nonprime
delinquencies and foreclosures.
To be sure, aggregate statistics may mask changes in
individual circumstances. When a borrower experiences a
deterioration in personal finances, the borrower’s amount of
home equity largely influences his or her course of action. One
underlying economic factor that did deteriorate concurrently
with mortgage performance was house price appreciation.
After peaking at an annual growth rate of 12.1 percent in
3

These figures include loans that are at least ninety days delinquent, are in
foreclosure, or are Real-Estate-Owned (REO)—that is, ownership of the
collateral has been transferred to the lender.

Below the Line

Pre- 2000 2001
2000

2002

2003 2004

2005 2006

2007

Source: FirstAmerican CoreLogic, LoanPerformance data.

the second quarter of 2005, the Office of Federal Housing
Enterprise Oversight’s (OFHEO) national house price index
began to slow, and ultimately declined. By the fourth quarter
of 2008, the annual growth rate of the index was -4.5 percent
(Chart 3), and the reversal was even sharper in certain areas
of the country.
Observers in the popular media and in the research
community quickly pointed to the confluence of house price
declines and mortgage defaults as more than coincidence

Measures of housing units with negative
equity . . . have become a necessary
component in crafting policies to address
the current foreclosure crisis.

(Gerardi, Shapiro, and Willen 2007; Haughwout, Peach, and
Tracy 2008; Demyanyk and van Hemert 2008). Indeed, a large
body of research on mortgage defaults indicates that declines in
house prices—or, more precisely, reductions in borrower
equity—are fundamental contributors to default (see, for
example, Vandell [1995] and Elul [2006]); evidence from the
current downturn, although limited, confirms this hypothesis
(see, for example, Foote, Gerardi, and Willen [2008]).4
For this reason, measures of housing units with negative
equity—that is, homes whose mortgage balance exceeds the
value of the collateral housing unit—have become a necessary
component in crafting policies to address the current
foreclosure crisis. In this article, we estimate negative equity in

2. Data and Methods

Chart 3

Home Price Indexes
Comparison of OFHEO and S&P/Case-Shiller
Year-over-year
percentage change

20
10
OFHEO
0
S&P/Case-Shiller
-10
-20
2000

We combine information from several sources to obtain our
estimates of negative equity nonprime mortgages in the United
States. Our primary source of information on individual loans
is FirstAmerican CoreLogic’s LoanPerformance data set. As
of February 2009, the data set provided monthly loan-level
information on approximately 4.8 million active, securitized
subprime and alt-A loans with total balances of more than
$1 trillion. While LoanPerformance captures more than
90 percent of securitized nonprime loans after 1999 and nearly
100 percent of the crucial 2003-05 vintages, it excludes all loans
held in bank portfolios (Mayer and Pence 2008). PenningtonCross (2002) argues that securitized subprime mortgages differ
systematically from those retained in portfolios; loans held in

Sources: Office of Federal Housing Enterprise Oversight (OFHEO);
Standard and Poor’s.

the U.S. nonprime mortgage market for 2008-09, and beyond,
with the goal of describing the sources of the problem and the
characteristics of borrowers in a negative equity position. Our
results suggest that the prevalence and magnitude of negative
equity are closely associated with the time and place of mortgage
origination and with the existence of subordinate liens against
the property. In addition, borrowers in negative equity are
much more likely to be seriously delinquent, or in default, on
their first-lien mortgage than borrowers in positive equity.
Our study is organized as follows. Section 2 describes our
sample of mortgage data and our methods as well as discusses
how changes in mortgage underwriting and house price
dynamics can affect borrower equity. In Section 3, we present
estimates of negative equity mortgages as well as examine the
static relationship between negative equity and mortgage
default. In Section 4, we discuss our results and use
information from other studies and from housing price futures
contracts to examine the relationship between borrower equity
and house price dynamics. Section 5 summarizes our key
findings.

We define equity as the book equity of a loan, where the mortgage balance is
subtracted from the home’s value. This definition is not to be confused with the
difference between mortgage value and home value. Because the market value
of the mortgage will neither be larger than its balance (since the loan is
discounted for risk) nor greater than the underlying asset of the home, it is
possible to have both positive equity and negative book equity. While market
equity is an important concept, we focus on the difference between the balance
on the mortgage and the value of the house; thus, we refer to book equity
simply as “equity.”

We rely on two sources of house price
growth to estimate negative equity: the
widely used [Office of Federal Housing
Enterprise Oversight] house price index and
the S&P/Case-Shiller home price index.

bank portfolios may look substantially different. Because our
data are limited to securitized loans, any inferences should be
limited to this set of loans.
The LoanPerformance data set offers a rich source of
information on the characteristics of securitized nonprime
loans, such as the date of loan origination, the Zip code in
which the collateral property is located, details of the mortgage
contract, and underwriting information. Also included are
monthly updates of dynamic information such as current
interest rates, mortgage balances, and the borrower’s payment
record.
We analyze a 1 percent random sample of the first-lien
subprime and alt-A loans reported in the data set as of
December 1, 2008.5 Our data include more than 49,000 active,
or not yet repaid, loans. We combine the loan-level data with
aggregate data on house price dynamics for each metropolitan
statistical area (MSA) in the sample. Because our data set is a
sample, it is subject to sampling variation, but for ease of
exposition we report only point estimates, not standard errors.
5

Because observations in the LoanPerformance data set are loans coded to
Zip code, we choose our data set from the universe of first-lien loans only. This
approach avoids the possibility of double counting subordinate-lien loans
on the same property. While the LoanPerformance data set also includes
information on nonprime subordinate liens, it is impossible to match these
loans to the first liens. Nonetheless, as we discuss, we do observe the balance
on subordinate liens at origination of the first lien.

FRBNY Economic Policy Review / July 2009

We rely on two sources of house price growth to estimate
negative equity: the widely used OFHEO house price index and
the S&P/Case-Shiller home price index.6 Although both
indexes are based on repeat transactions on the same property
over time, they differ in important ways. OFHEO, which
provides separate indexes for 381 MSAs, enables us to estimate
house price changes for the great majority of properties in our
loan-level data set. However, the OFHEO index is based on the
sale price or appraisal value of homes with prime, conforming
mortgages, that is, those securitized by government-sponsored
enterprises.7 Because the properties we study are by definition

Chart 4

Combined Loan-to-Value Ratios by Vintage
140
120
100
80
60
40
Pre- 2000 2001 2002 2003 2004 2005 2006 2007
2000

An interesting feature revealed by the data
is that while first-lien loans remained at
relatively stable [loan-to-value ratios]
throughout the 2000-08 period,
subordinate liens became more common
and rose in value as a percentage
of house value.

financed with a nonprime mortgage, OFHEO’s focus on these
government-sponsored mortgages introduces the possibility of
measurement error in our estimate of house price appreciation,
with the sign and magnitude of the error depending on how
appreciation varies across market segments.
The S&P/Case-Shiller index addresses this problem in two
ways. First, it covers all sales, not just those in the prime market
segment. Second, it provides supplementary indexes for three
tiers in each of the markets it covers. The tiers divide each
market into thirds—low, middle, and high—based on area
house prices as of December 2008. For example, Los Angeles
MSA properties with prices under $309,184 are in the low tier,
prices between $309,184 and $470,182 make up the middle tier,
and prices above $470,182 are considered high tier. Inspection
of the house price dynamics in these tiers indicates that they
indeed differ from the composite measure, suggesting that,
for our purposes, measurement error using the OFHEO index
is likely nontrivial. This suspicion is confirmed by Leventis
(2008), who finds that differences between the two indexes
6

For more details, see <http://www.fhfa.gov/Default.aspx?Page=14> and
<http://www2.standardandpoors.com/spf/pdf/index/SP_CS_Home_Price_
Indices_Factsheet.pdf>. In July 2008, OFHEO became the Federal Housing
Finance Agency, but we continue to refer to the index as the OFHEO index.
7
Concerns have been raised that appraisals during the “boom” years of
nonprime lending were biased upward. OFHEO does publish a national
“purchase-only” index that incorporates data only from actual sales, but
this index is not available for individual MSAs.

Below the Line

Sources: FirstAmerican CoreLogic, LoanPerformance data; authors’
calculations.
Notes: For each year, the shaded box indicates the middle 50 percent of
the data. Thus, the top of each box represents the 75th percentile value
and the bottom the 25th. The line intersecting each box shows the median
value. The thin lines extending from the boxes represent the upper and
lower adjacent ranges, which extend at most 1.5 times the interquartile
range in both directions.

are influenced importantly by the treatment of lower priced
houses. Using the S&P/Case-Shiller price parameters as a guide,
we determined that its middle- and high-tier indexes best
estimate house prices for subprime and alt-A loans,
respectively.8
To estimate equity in properties, we perform a series of
basic calculations. First, we use data from LoanPerformance
to calculate the borrower’s net equity in the property at the
origination of each first-lien loan. This measure captures
both the balance of the first lien as well as the balances of all
subordinate liens, if any exist. An interesting feature revealed
by the data is that while first-lien loans remained at relatively
stable LTVs throughout the 2000-08 period, subordinate
liens became more common and rose in value as a percentage
of house value. Chart 4 plots combined (all liens) LTV ratios
by vintage. It shows that until 2003, LTVs were fairly steady,
with a median of 80; after 2003, however, the median LTV
began climbing. By 2006, the median origination LTV of
nonprime loans was 89.3, and fully 25 percent of the loans
had an LTV of at least 100. That is, a quarter of borrowers
who took nonprime mortgages in 2006 had no equity at
origination.
We calculate origination equity, which is house value of
the first-lien loan ( HV0 ) minus total balances on all L liens
ΣL M l at origination. Equity at time t is then simply initial
l =1
0

∑

In each S&P/Case-Shiller MSA, the mean price of a home collateralizing a
subprime mortgage was in the middle tier, while alt-A home prices were in
the high tier.

equity plus any house price appreciation, minus any increase in
mortgage balances after origination:
Et =

∑

L
l
HV0 – Σl = 1 M 0

Table 1

OFHEO-Based Negative Equity Estimates
December 1, 2008

∑

L
l
+ Δ HVt – Σ l = 1 Δ M 0 .

Net equity can change in three distinct ways:
First lien
All liens
Total loans

• principal amount on the first-lien mortgage changes
1
Δ M t ≠ 0 (typically, mortgage balances will decline
1
over time, meaning that Δ M t < 0 ),

∑

21
29
100

sluggish growth: the city’s peak growth year was 2003, when
prices rose just 5.4 percent.9
The combination of a falling housing market and a large
number of homeowners holding little or no equity at mortgage
origination created a perfect storm for generating negative
equity. Note that for a mortgage with an apparently safe
origination LTV ratio of around 80, a 20 percent decline in
house value—not uncommon in many metro areas in 2007—
could potentially erase essentially all of the homeowner’s
equity. One should not be surprised, therefore, to find that the

The combination of a falling housing
market and a large number of
homeowners holding little or no equity
at mortgage origination created a perfect
storm for generating negative equity.

3. Negative Equity among
Nonprime Borrowers
Two developments important for understanding homeowner
equity occurred after 2002. First, full loan-to-value ratios rose
sharply as junior liens became more common and larger. This
change is present throughout the post-2002 period, but it is
especially significant in 2006—when more than 25 percent of
nonprime originations had initial LTV ratios of 100 or more
(Chart 4).
Second, starting in 2005, the house price environment,
whether measured by the OFHEO or the S&P/Case-Shiller
index, became much less favorable for building borrower
equity (Chart 3). This reversal was especially sharp in some
areas that had experienced the highest growth prior to 2005.
The Las Vegas MSA, for instance, saw its house price growth
rate, measured by the S&P/Case-Shiller index, decline from
more than 42 percent in 2003 to -15 percent in 2007. Parts of
the Midwest experienced a similar phenomenon, but it resulted
from a different set of dynamics. In Cleveland, for example,
the S&P/Case-Shiller index declined just 1.7 percent in 2007.
However, the decline followed a long period of relatively

10,144
13,766
47,876

Note: House value changes are estimated using the Office of Federal
Housing Enterprise Oversight (OFHEO) indexes for individual
metropolitan statistical areas.

• house value changes ΔHVt ≠ 0 .

∑

Negative Equity
(Percent)

Source: FirstAmerican CoreLogic, LoanPerformance data.

• principal amount(s) on subordinate liens changes
ΣL Δ M l ≠ 0 ,
l=2
0
We have direct, micro-level evidence on only the first
component, because LoanPerformance tracks monthly
balances on each first-lien loan we observe. We use each MSA’s
OFHEO and S&P/Case-Shiller indexes to estimate changes in
house values since loan origination. For balances on
subordinate liens, we assume that the borrower makes regular
interest payments, but that principal amounts remain
unchanged. Note that this is somewhat of a “middle-ground”
assumption: borrowers may either make progress reducing
L
l
the balances on subordinate liens ( Σ l = 2 Δ M t < 0) or they
may layer additional liens on top of those we observe
L
l
( Σ l = 2 Δ M t > 0).

Number of Loans

incidence of negative equity grew substantially in 2006 and
2007. What we now consider is exactly how large and how
common nonprime negative equity mortgages have become,
where they are concentrated, and their consequences for
borrower behavior.
Our December 1, 2008, OFHEO-based estimates indicate
that 21 percent of borrowers were in negative equity on
their first lien while 29 percent were in negative equity when
junior liens were included (Table 1). By comparison, the
percentage of nonprime borrowers facing negative equity was
3 percent and 13 percent in April 2008, calculated using first
and combined liens, respectively. At that time, borrowers
9

Growth rates in this discussion are measured as December-over-December
percentage growth.

FRBNY Economic Policy Review / July 2009

Table 2

Chart 5

Comparison of S&P/Case-Shiller and OFHEO
Indexes

Negative Equity by Origination Year
Percent

December 1, 2008

70
Number Negative Equity
of Loans
(Percent)
a

S&P/Case-Shiller negative equity estimates
First lien
All liens
Total loans
OFHEO negative equity estimates
First lien
All liens
Total loans

60
50
40

7,150
9,989
21,164

34
47
100

4,945
7,367
21,164

23
35
100

30
20
10

Source: FirstAmerican CoreLogic, LoanPerformance data.

0
Pre2000

2000

2001 2002

2003

2004

2005

2006

2007

Source: FirstAmerican CoreLogic, LoanPerformance data.

House value changes are estimated using the S&P/Case-Shiller high- and
medium-tier indexes for individual metropolitan statistical areas.
b
House value changes are estimated using the Office of Federal Housing
Enterprise Oversight (OFHEO) indexes for individual metropolitan
statistical areas.

with junior liens were more than four times as likely to be
in negative equity, an incidence that demonstrates the
importance of second liens in determining negative equity.
However, home prices have dropped markedly since then,
placing many more borrowers in negative equity—even those
who had made a sizable down-payment or had just a single
lien on their property.
Limiting our analysis to the seventeen cities covered by
the S&P/Case-Shiller tiered indexes paints a bleaker picture
(Table 2). Using this measure of house price changes, we
estimate that 47 percent of housing units with nonprime
mortgages—nearly 1 million households in these seventeen
cities alone—are in a negative equity position. However,
application of the OFHEO index to this restricted set of cities
produces a lower estimate of 35 percent, or 736,700 mortgages,
in negative equity.10
This disparity highlights the difference in market segments
tracked by both indexes. While neither measure exactly
captures the nonprime securitized market, the S&P/CaseShiller index includes properties covered by these loans, while
the OFHEO’s reliance on conforming mortgages prevents it
from doing so. However, OFHEO’s national coverage offers
an enormous advantage when estimating the prevalence of
negative equity in aggregate. We have opted to concentrate on
what we consider the more accurate data set available for a
10

These figures are population estimates based on the sample information
reported in Table 2.

Below the Line

restricted set of cities; thus, we focus on the seventeen cities
for which we have S&P/Case-Shiller tiered information.
Nonetheless, we also report OFHEO results—especially when
analyzing the entire United States—to provide a broader view
of nonprime mortgages.
Recall that the time of loan origination is important for
determining negative equity because the two determinants of
negative equity—the value of the home and the ratio of the

The importance of vintage suggests that
one would expect areas that experienced
housing booms during 2004-06,
especially locations where borrowers took
loans with small down-payments, to have
the highest prevalence of negative equity.
Our data support this hypothesis.
loan to the initial value of the home—both correlate with
vintage. Increases in full LTV ratios at origination, combined
with the sharp reversal in home prices in 2006, suggest that
borrowers who took mortgages later in the period would be
more likely to find themselves with no equity in their property.
As Chart 5 shows, very small shares of nonprime mortgages
that originated before 2003 were in negative equity by
December 2008, but negative equity rates were sharply higher
in subsequent vintages. All told, we estimate that the difference
between house values and nonprime balances in these cities
totals more than $58 billion (Table 3).

Table 3

Negative Equity by Metropolitan Statistical Area

Area
Atlanta
Boston
Chicago
Cleveland
Denver
Las Vegas
Los Angeles
Miami
Minneapolis
New York
Phoenix
Portland
San Diego
San Francisco
Seattle
Tampa
Washington, D.C.
Seventeen-area composite

Negative Equity
(Percent)

Average Difference between Mortgage Balance
and House Value (Dollars)

Total Amount in Negative Equity
(Thousands of Dollars)

45
21
35
32
33
89
52
69
61
13
80
24
61
39
21
60
47
47

18,016
17,156
18,201
9,865
12,607
83,654
80,484
68,357
32,839
22,119
73,314
18,676
84,371
65,986
17,125
37,110
52,113
58,496

983,660
202,440
964,670
114,440
267,280
7,871,870
13,593,690
10,417,590
1,155,940
822,840
9,024,990
190,500
4,496,990
2,830,800
236,330
1,888,910
3,397,760
58,460,690

Source: FirstAmerican CoreLogic, LoanPerformance data.
Notes: House value changes are estimated using the S&P/Case-Shiller high- and medium-tier indexes for individual metropolitan statistical areas.
Mortgage balances on junior and senior liens are combined. The last column represents the population counts.

The importance of vintage suggests that one would expect
areas that experienced housing booms during 2004-06,
especially locations where borrowers took loans with small
down-payments, to have the highest prevalence of negative
equity. Our data support this hypothesis. Almost a quarter of
the negative equity properties in the seventeen S&P/CaseShiller cities are in one of the three California MSAs, with more
than 15 percent in Los Angeles alone (Table 3). In addition,
negative equity is much larger in the California (and to a lesser
extent Florida) cities than elsewhere in the country. The
California cities saw relatively large declines in housing prices
and had larger than average mortgages—factors that led to
a greater prevalence and intensity of negative equity. Thus,
borrowers who received high LTV loans in 2006-07 in areas
that experienced sharp house price reversals are very likely to
find themselves in a negative equity position.

average initial LTVs are significantly higher on negative equity
loans (Table 4; Table 5 provides the same information for
states, using the OFHEO index). Debt-to-income ratios are
typically higher among negative equity borrowers as well.
Interestingly, credit bureau scores are generally higher among
the negative equity borrowers.11 The fact that “borrower
quality” at origination is roughly the same for positive and
negative equity loans is a relevant consideration when
interpreting default behavior.
To gain an understanding of mortgage repayments, it is
crucial to analyze the relationship between equity status and
default behavior. Recent research on defaults has shown the
importance of house price appreciation in influencing
nonprime mortgage outcomes (Demyanyk and van Hemert
2008; Gerardi, Shapiro, and Willen 2007). Demyanyk and
van Hemert (2008) find that borrowers whose houses have
11

3.1 Borrower Characteristics and Behavior
An examination of borrower and loan characteristics by equity
status shows that, not surprisingly, the most striking difference
between positive and negative equity loans is the combined
(senior plus junior) LTV ratio at origination; in each MSA,

Table 5 reports these results using the OFHEO index of the broader set of
states. While the estimated shares in negative equity in the broader sample are
consistently lower than the shares in Table 4’s more narrow sample of
seventeen MSAs, they demonstrate similar spatial patterns—with the bulk of
negative equity properties concentrated in boom states, especially California.
In addition, the broader sample’s concentration of negative equity loans
among borrowers with relatively high credit scores, high DTI ratios, and high
combined LTV ratios at origination is similar to the more narrow sample’s
concentration. Neither sample demonstrates a clear relationship between
equity and documentation level.

FRBNY Economic Policy Review / July 2009

Table 4

Underwriting Characteristics by Equity Status and Metropolitan Statistical Area
Area
Seventeen-area composite
Positive equity
Negative equity
Atlanta
Positive equity
Negative equity
Boston
Positive equity
Negative equity
Chicago
Positive equity
Negative equity
Cleveland
Positive equity
Negative equity
Denver
Positive equity
Negative equity
Las Vegas
Positive equity
Negative equity
Los Angeles
Positive equity
Negative equity
Miami
Positive equity
Negative equity
Minneapolis
Positive equity
Negative equity
New York
Positive equity
Negative equity
Phoenix
Positive equity
Negative equity
Portland
Positive equity
Negative equity
San Diego
Positive equity
Negative equity
San Francisco
Positive equity
Negative equity
Seattle
Positive equity
Negative equity
Tampa
Positive equity
Negative equity
Washington D.C.
Positive equity
Negative equity

Equity Status
(Percent)

Debt-to-Income Ratio

FICO Score

Loan-to-Value Ratio

Fully Documented
(Percent)

53
47

38
40

673
678

73
91

43
36

55
45

35
40

673
668

80
98

56
61

79
21

39
42

662
678

72
98

42
42

65
35

39
42

641
667

80
97

53
40

68
32

37
41

636
646

82
97

62
78

67
33

38
42

675
671

82
99

57
61

11
89

34
39

689
683

65
88

39
33

48
52

38
41

692
690

63
89

35
22

31
69

38
39

654
667

67
88

42
33

39
61

36
41

673
668

76
95

52
54

87
13

40
42

663
686

75
98

38
22

20
80

35
39

693
673

70
87

48
41

76
24

37
41

685
691

79
98

47
44

39
61

36
40

703
699

60
88

33
26

61
39

36
40

716
693

65
91

32
24

79
21

39
39

678
694

81
97

50
44

40
60

35
39

659
666

73
90

49
40

53
47

39
41

675
677

71
94

44
38

Below the Line

Table 5

Underwriting Characteristics by Equity Status and State
Equity Status
(Percent)

Debt-to-Income Ratio

FICO Score

Loan-to-Value Ratio

Fully Documented
(Percent)

91
9

38
42

655
672

83
98

55
44

Arizona
Positive equity
Negative equity

57
43

37
40

674
676

75
93

46
40

California
Positive equity
Negative equity

43
57

37
40

695
685

64
88

37
28

Florida
Positive equity
Negative equity

51
49

38
39

657
666

75
91

46
35

Nevada
Positive equity
Negative equity

20
80

37
39

687
683

69
89

39
34

Indiana
Positive equity
Negative equity

98
2

37
40

640
623

87
98

70
79

Michigan
Positive equity
Negative equity

47
53

37
40

637
646

77
93

65
65

Ohio
Positive equity
Negative equity

89
11

38
41

638
645

86
99

67
76

State
Non-boom and non-bust states
Forty-three-state composite
Positive equity
Negative equity
Boom states

Bust states

Source: FirstAmerican CoreLogic, LoanPerformance data.
Notes: House value changes are estimated using the Office of Federal Housing Enterprise Oversight indexes for individual states. Mortgage balances
on junior and senior liens are combined. Details may not sum to totals because of rounding.

appreciated less, or depreciated more, tend to default more, all
else equal. In much of this work, borrower default is treated as
a continuous function of house value; in contrast, we analyze a
sharp break at zero equity. The idea that borrower behavior
might change markedly as properties pass into negative equity
is supported by both theory and empirical evidence. Theory
predicts that borrowers with positive equity will rarely default,
but those with little or no equity will sometimes determine that
default is the best option. When equity declines by a particular
amount—that is, if house values fall enough after loan
origination—borrowers reach a critical value where they are
certain to default (Vandell 1995).

Haughwout, Peach, and Tracy (2008) study the probability
that a borrower will fall at least ninety days behind on
scheduled payments within the first year of a nonprime
mortgage. The authors report very large ceteris paribus jumps
in this probability as LTV ratios rise above 100, particularly
among borrowers who are not owner-occupants. They find
that negative equity adds approximately 7 percentage points to
default probability for owner-occupants and between 15 and
20 percentage points for investors, compared with similar
owners with slightly positive equity in their properties (that is,
those with LTV ratios between 95 and 100).

FRBNY Economic Policy Review / July 2009

Table 6

Loan Status by Borrower Equity
Percent
Days Delinquent
Thirty

Sixty

Ninety or More

Foreclosure

Real-Estate-Owned

First lien
Positive equity
Negative equity

8
9

4
6

8
12

8
17

4
9

All liens
Positive equity
Negative equity

7
8

4
5

7
11

7
16

3
9

Source: FirstAmerican CoreLogic, LoanPerformance data.
Note: House value changes are estimated using the S&P/Case-Shiller high- and medium-tier indexes for individual metropolitan statistical areas.

In related work, Foote, Gerardi, and Willen (2008) study
ownership experiences of prime and nonprime borrowers in
Massachusetts beginning in the late 1980s. They produce two
findings of relevance for our analysis: subprime borrowers are
much more likely to default in general than those holding
conforming mortgages, and borrowers with negative equity are
more likely to default after five years (and are less likely to sell
their properties) than those with positive equity.
As expected, we find that the share of positive equity loans
ninety or more days delinquent is a little more than half the rate
for loans with negative equity (Table 6). However, borrowers
with negative equity are just as likely to be thirty days
delinquent—but twice as likely to be in foreclosure and three

We find that the share of positive equity
loans ninety or more days delinquent is a
little more than half the rate for loans with
negative equity.

times as likely to have passed through the foreclosure process
and be in REO by the lender. Thus, a fall in home prices may
not precipitate initial delinquency, but it may encourage
default by a homeowner who is already having difficulty
making payments. This outcome is consistent with results from
a model in which some borrowers experience shocks to their
income and fall a month or two behind on their mortgages,
then decide whether to prepay (sell or refinance) or default.
When their equity is below zero, the tendency to default is
relatively strong.
While only 10 percent of positive equity homes are in foreclosure or REO on all liens, we estimate that 31 percent of
40

Below the Line

properties in foreclosure or REO are in a positive equity
position (Table 6). This conclusion may appear to contradict
the argument that negative equity is a necessary condition for
default. The high number of positive equity properties in
foreclosure may reflect mismeasurement of housing equity or

Our foreclosure rates . . . reflect not only
the prevalence of entering foreclosure,
which itself is influenced by both borrower
and lender behavior, but also the time
that a property in default spends in
foreclosure.
the presence of transaction costs that make default a better
option than continuing to make payments on the loan.12
We find that our estimates of borrower equity are lower for
those properties that are delinquent ninety days or more, in
foreclosure, or in REO (Table 7). When prepayment penalties
and the possibility of mismeasurement of house values are
considered, these borrowers may perceive themselves to be in
negative equity on their mortgages, a factor that helps explain
their behavior.
Although these results are qualitatively consistent with those
of Foote, Gerardi, and Willen (2008) and Haughwout, Peach,
and Tracy (2008), a direct comparison is difficult. In particular,
because our mortgage data set consists entirely of nonprime
loans, we observe the effect of negative equity on that subsample
12

Recall that we describe negative book equity. It is possible that many of the
loans that we measure as having positive equity have prepayment fees or other
features that put the default option “in the money.” It is also possible that we
underestimate house price declines for some of these loans.

Table 7

Loan Status among Positive Equity Borrowers
Days Delinquent

Average difference between mortgage balance
and house value (dollars)
Average difference as a percentage of house value

Current

Thirty

Sixty

Ninety or More

Foreclosure

Real-Estate-Owned

137,610
28

86,294
22

71,683
20

76,291
17

59,898
15

42,954
13

of the Foote, Gerardi, and Willen population. In addition, we
observe a single cross-section of properties in foreclosure at a
point in time, as opposed to the Foote, Gerardi, and Willen
approach of observing the timing of entry into default and the
Haughwout, Peach, and Tracy analysis of delinquency within
the first year of origination. Our foreclosure rates thus reflect
not only the prevalence of entering foreclosure, which itself is
influenced by both borrower and lender behavior, but also the
time that a property in default spends in foreclosure.

contracts expiring in November 2009 had a combined negative
equity rate of 45 percent, very near the average rate of 47 percent for the seventeen cities tracked by the S&P/Case-Shiller
index. We estimate that the trajectories implied by the futures
contracts would increase the negative equity rate to 61 percent
by late 2009 and add 135,500 borrowers to the ranks of those
whose homes are worth less than their mortgage balances in

Negative equity’s important effect on
borrower default underscores the value
of understanding the potential future path
of negative equity.

4. Looking Ahead
Negative equity’s important effect on borrower default
underscores the value of understanding the potential future
path of negative equity. Accordingly, we look at two possible
relationships between negative equity and nonprime
borrowing going forward.
We begin by using the S&P/Case-Shiller home price index.
The index has the advantage of covering a large number of
homes in the small number of markets for which it is available.
Another advantage is that futures contracts on the index trade
on the Chicago Mercantile Exchange.13 As a result, the path of
the indexes in individual MSAs can be predicted. The futures
contracts currently provide estimates of house price
appreciation in several cities for various months through
November 2012.14
Our examination of futures contracts on S&P/Case-Shiller
indexes points to further deterioration in home prices in the
cities covered. As of December 2008, the five cities with
13

See <http://housingrdc.cme.com/index.html> for more information.
The cities are Boston, Denver, Las Vegas, Los Angeles, New York, San Diego,
San Francisco, and Washington, D.C.; futures prices for Miami are available
only through November 2010. While these markets are relatively thinly traded,
activity picks up following release of the S&P/Case-Shiller home price index.
We thus use the futures prices for contracts that had “open interest” on March 31,
2009: the release date for the January 2009 S&P/Case-Shiller index.

these five cities. The contracts forecast the percentage of
borrowers with negative equity in their homes to decrease
by the end of 2010 (Chart 6). These calculations are derived
using the percentage changes in home prices predicted for the
S&P/Case-Shiller composite index and applying the changes to
its high- and medium-tier indexes, assuming that borrowers
fall no further behind on their mortgages.
A second potential relationship between negative equity
and house prices is somewhat more general. Chart 7 presents
the number of borrowers in various equity categories as of
December 2008, where equity is expressed as a percentage of
house value. Here we use the OFHEO index, which offers the
broadest coverage. Assuming that no changes in mortgage
balances occur, one can estimate the number of new negative
equity borrowers by moving the chart’s “zero line.”15 For
example, the effect of a 10 percent decline in house prices
can be estimated by moving this line two bars to the right.
According to this scenario, approximately 1.5 million (719,600
plus 770,000) new nonprime borrowers would see their house
15

Alternatively, if one believes that the OFHEO index is 10 percent overvalued,
one might conduct a similar exercise to estimate current negative equity rates.

FRBNY Economic Policy Review / July 2009

Chart 6

Chart 7

Potential Path of Negative Equity

Ratio of Equity to House Prices
As of December 2008

Percent
100
90

December 1, 2008

November 2009
November 2010

Frequency (in thousands)

Density (percentage of sample)

880

18.4

770

16.1

660

13.8

550

11.5

440

9.2

330

6.9

220

4.6

110
0
-120 -100 -80 -60 -40 -20

2.3
0

70
60

20
10
0
s
ga

e
sV
La

s
ele

i
iam

rk
Yo

co
cis

n
Sa

Fra

gto

.
D.C

in
sh
Wa

Sources: FirstAmerican CoreLogic, LoanPerformance data;
Chicago Mercantile Exchange.

value fall below their current mortgage balance. This path of
house prices would raise our OFHEO-based estimate of the
negative equity share to roughly 45 percent. Conversely, a
turnaround in the housing market that resulted in a 10 percent
increase in house values would lift 729,200 borrowers into
positive equity, reducing the rate to just 14 percent.16
These arguably plausible changes in the value of the OFHEO
index have very large effects on the incidence of negative equity
among nonprime borrowers because, as Chart 7 shows, many
hundreds of thousands of borrowers are very near zero equity.
Relatively small changes in house prices from this point
forward can therefore have large influences on both the
incidence of negative equity and, by extension, the risk of
default by nonprime borrowers.

5. Conclusion
Recent declines in house values have put hundreds of
thousands of nonprime borrowers in a negative equity
position, that is, with a house value below the property’s
mortgage balance. Our study finds that nonprime borrowers in
negative equity share several characteristics: for example, they
took out loans near the peak of the housing market and their
loans had high LTV ratios usually achieved with subordinate
liens in addition to the first lien. We also find that while
negative equity loans exist in most U.S. metropolitan areas,
16

Note that these estimates are imprecise, as they do not account for changes
in mortgage balances over time.

Below the Line

80 100

Borrower equity as a percentage of house value

Sources: FirstAmerican CoreLogic, LoanPerformance data;
Office of Federal Housing Enterprise Oversight.

they are disproportionately concentrated in housing markets
that experienced especially large swings in house price
appreciation, particularly in California. We estimate that three
California metropolitan areas account for more than a quarter
of the negative equity mortgages in our sample. Moreover,
because of the higher balances on these mortgages, the loans
account for nearly half of the overall difference between house
values and mortgage balances.
Going forward, further house price declines will lead to
continued increases in the number of nonprime mortgages in
negative equity. If house prices fall an additional 10 percent
from their December 2008 levels, we estimate that approximately 1.5 million new mortgages nationwide will carry
balances that exceed the value of the collateral homes. The
aggregate difference between these balances and house values
could approach $135 billion.
Although negative equity is a necessary condition for default,
it does not always lead to default. As other studies, including
ours, have shown, borrowers do not automatically default when
their house value drops below their mortgage balance.
Nonetheless, research has demonstrated that negative equity
borrowers are far less likely to prepay their mortgages and
are more likely to become seriously delinquent and thus
default. We find that among nonprime borrowers, the default
probability of an outstanding negative equity mortgage is two to
three times as high as that of a positive equity borrower. In this
context, the future direction of house prices will be a critical
determinant of the payment behavior of nonprime borrowers.

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The views expressed are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York
or the Federal Reserve System. The Federal Reserve Bank of New York provides no warranty, express or implied, as to the
accuracy, timeliness, completeness, merchantability, or fitness for any particular purpose of any information contained in
documents produced and provided by the Federal Reserve Bank of New York in any form or manner whatsoever.
FRBNY Economic Policy Review / July 2009

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