Most home mortgages in the United States are fixed-rate loans with an embedded prepayment option. When long-term rates decline, the effective duration of mortgage-backed securities (MBS) falls due to heightened refinancing expectations. I show that these changes in MBS duration function as large-scale shocks to the quantity of interest rate risk that must be borne by professional bond investors. I develop a simple model in which the risk tolerance of bond investors is limited in the short run, so these fluctuations in MBS duration generate significant variation in bond risk premia. Specifically, bond risk premia are high when aggregate MBS duration is high. The model offers an explanation for why long-term rates could appear to be excessively sensitive to movements in short rates and explains how changes in MBS duration act as a positive-feedback mechanism that amplifies interest rate volatility. I find strong support for these predictions in the time series of US government bond returns.

We develop and test a model in which swap spreads are determined by end users' demand for and constrained intermediaries' supply of long-term interest rate swaps. Swap spreads reflect compensation both for using scarce intermediary capital and for bearing convergence risk—i.e., the risk spreads will widen due to a future demand-and-supply imbalance. We show that a proxy for the intermediated quantity of swaps—dealers' net position in Treasuries—flipped sign during the Global Financial Crisis when swap spreads turned negative and that this variable predicts the excess returns on swap spread trades. Exploiting our model's sign restrictions, we identify shifts in demand and supply and find that both contribute significantly to the volatility of swap spreads.

Many have argued that overoptimistic thinking on the part of lenders helps fuel credit booms. We use new micro-data on mutual funds’ holdings of securitizations to examine which investors are susceptible to such boom-time thinking. We show that firsthand experience plays a key role in shaping investors’ beliefs. During the 2003–2007 mortgage boom, inexperienced fund managers loaded up on securitizations linked to nonprime mortgages, accumulating twice the holdings of more seasoned managers. Moreover, inexperienced managers who personally experienced severe or recent adverse investment outcomes behaved more like seasoned managers. Training and institutional memory can serve as partial substitutes for personal experience.

We examine the business model of traditional commercial banks when they compete with shadow banks. While both types of intermediaries create safe “money-like” claims, they go about this in different ways. Traditional banks create money-like claims by holding illiquid fixed-income assets to maturity, and they rely on deposit insurance and costly equity capital to support this strategy. This strategy allows bank depositors to remain “sleepy”: they do not have to pay attention to transient fluctuations in the market value of bank assets. In contrast, shadow banks create money-like claims by giving their investors an early exit option requiring the rapid liquidation of assets. Thus, traditional banks have a stable source of funding, while shadow banks are subject to runs and fire-sale losses. In equilibrium, traditional banks have a comparative advantage at holding fixed-income assets that have only modest fundamental risk but are illiquid and have substantial transitory price volatility, whereas shadow banks tend to hold relatively liquid assets.