With risk-averse arbitrageurs and an effective lower bound (ELB) on nominal rates, nonlinear interactions among short-rate expectations, bond supply, and term premia emerge in equilibrium. These interactions, which are absent from affine models, help explain the observed behavior of the yield curve near the ELB, including evidence about unconventional monetary policy. The impact of both short-rate expectations and bond supply are attenuated at the ELB. However, in simulations of the post-crisis experience in the U.S., shocks to investors’ duration-risk exposures have much smaller effects than shocks to the anticipated path of short rates. The latter shocks matter, in part, because of the reduction in interest-rate volatility associated with a longer expected stay at the ELB—a novel channel of unconventional policy.

This paper documents that complex financial innovations like collateralized debt obligations (CDOs) enabled informed parties in the commercial mortgage-backed securitization pipeline to reduce their skin-in-the-game in a way not observable to other market participants. This reduction in first-loss security retention significantly impacted the probability that more senior tranches ultimately defaulted. We show that this performance is entirely driven by the amount of first-loss sold to (affiliated) CDOs within 12 months of the commercial mortgage-backed securities (CMBS) deal. Our result is robust to using the differential access of first-loss investors to CDO funding as an instrument to identify exogenous variations in the retention of first-loss securities.