The Pricing of Investment Grade Credit Risk
Joshua D. Coval, Jakub W. Jurek, and Erik Stafford
March 30, 2009
Our analysis suggests that the dramatic recent widening of credit spreads is highly consistent with the decline in the equity market, the increase in its long-term volatility, and an improved investor appreciation of the risks embedded in structured products.
In contrast to the main argument in favor of using government funds to help purchase structured credit securities, we find little evidence that suggests these markets are experiencing fire sales.
[McAuley's World: This finding directly challenges the veracity of Treasury Secretary Geitner's claims and the necessity for additional Government intervention - later the report confirms that investors are being unjustly enriched at taxpayor expense]
On March 23, 2009, the Treasury announced that the TALF plan will commit up to $1 trillion to purchase legacy structured credit products. The government’s view is that a disappearance of liquidity has caused credit market prices to no longer reflect fundamentals: Many analysts appear to be looking at large recent price changes and concluding that we must be witnessing distressed pricing and widespread market failure. This conclusion is based on intuition. Our analysis suggests that the dramatic recent widening of credit spreads is highly consistent with the decline in the equity market, the increase in its volatility, and an improved investor appreciation of the risks embedded in these securities.
Our results suggest changes in fundamentals, as reflected in the equity market, account for a large portion of the repricing of credit that has occurred. In particular, the dramatic increase in the price of low cash flow states can account for most, if not all, of the rise in credit spreads for cash bonds. The spreads on credit default swaps, which currently trade at a large and negative basis relative to the underlying bonds, appear too low relative to risk-matched alternatives in the equity market.
We also find that the repricing of the investment grade structured credit securities suggests a correction of an ex ante failure of investors to appropriately charge for systematic risk.“An initial fundamental shock associated with the bursting of the housing bubble and deteriorating economic conditions generated losses for leveraged investors including banks … The resulting need to reduce risk triggered a wide-scale deleveraging in these markets and led to fire sales … [The Public-Private Investment Program] should facilitate price discovery and should help, over time, to reduce the excessive liquidity discounts embedded in current legacy asset prices.”
Policymakers are rapidly moving towards using TARP money to purchase toxic assets primarily tranches of collateralized debt obligations (CDOs) from banks, with the aim of supporting secondary markets and increasing bank lending. The key premise of current policies is that the prices for these assets have become artificially depressed by banks and other investors trying to unload their holdings in an illiquid market, such that they no longer reflect their true hold-to-maturity value. By purchasing or insuring a large quantity of bank assets, the government can restore liquidity to credit markets and solvency to the banking sector.
The analysis of this paper suggests that recent credit market prices are actually highly consistent with fundamentals. A structural framework confrms that bonds and credit derivatives should have experienced a significant repricing in 2008 as the economic outlook darkened and volatility increased.
The analysis also confirms that severe mispricing existed in the structured credit tranches prior to the crisis and that a large part of the dramatic rise in spreads has been the elimination of this mispricing.
If prices currently coming out of credit markets are actually correct, and not reflecting fire sales,this has several important implications. First, correct prices in the secondary market for these assets essentially imply that many major US banks are now legitimately insolvent. This insolvency can no longer be viewed as an artifact of bank assets being marked to artificially depressed prices coming out of an illiquid market. It means that bank assets are being fairly priced at valuations that sum to less than bank liabilities. In turn, any positive valuation assigned by shareholders to their equity claim arises solely from their anticipation of value transfer from firm debtholders or resource transfers from US taxpayers.
Similarly, using government resources to support these markets by insuring assets against furtherl osses amounts to providing insurance at premia that are significantly below what is fair for the risks that the US taxpayer will now bear.
Third, while the pricing of these securities is dramatically different from the way it was a year or two ago, this is because it was wrong then, not now. Efforts to restart this market are focused on resuming the flawed pricing of the past, when there was no charge for risk and investors relied on the accuracy of ratings. Investors have learned from their mistakes and now seem to be pricing these securities in accordance with their true risks.
Second, if current market prices are fair, any taxpayer dollars allocated to supporting these markets will simply transfer wealth to the current owners of these securities. To the extent that these assets reside in banks that are now insolvent, the owners are essentially the bondholders of these banks. The reason their bonds are currently trading far below par is that the assets backing up their claim are just not worth enough (nor expected to become worth enough when their bonds mature) to repay them. And so while they will be cheered by any government overpayment for the toxic assets backing up their claims, their happiness will be at the taxpayer’s expense since – to the extent that current prices are fair – they will be receiving more than fair value for their investments.
The main objective of this paper is to determine whether fire sales are required to explain prices currently observed in credit markets.
Other potential sources of repricing include a correction of ex ante mispricing due to incorrect forecasts of expected losses (i.e. incorrect ratings – earnings expectation), a correction of ex ante mispricing arising from a failure of investors to charge for systematic risk, and rational change in prices reflective of a change in fundamentals.
A key distinction between the fire sale view and the other possibilities is that only the fire sale view requires that current prices are incorrect. (If the current prices are correct – massive Government spending will only serve to manipulate the market to reward investors at taxpayer expense – the market manipulation will create temporary gain – then the market will seek equilibrium again)
And given that fundamentals have changed dramatically during the past 2 years, and that ex ante mispricing was likely present in many of the structured credit markets, the conclusion that the large spread changes are evidence of fire sales is, at best, a premature one.
From this perspective, policies that attempt to prevent a widespread mark-down in the value of credit-sensitive assets are likely to only delay – and perhaps even worsen – the day of reckoning.
Read the full paper (with formulas & footnotes) here: http://www.anderson.ucla.edu/Documents/areas/fac/finance/CJS_2009_v1.pdf
Coval: Harvard Business School; firstname.lastname@example.org. Jurek: Bendheim Center for Finance, Princeton University ;email@example.com. Sta¤ord: Harvard Business School; esta¤firstname.lastname@example.org. We thank Stephen Blythe, Ken Froot,
WHAT FORMULA IS GEITNER USING FOR HIS “STRESS TESTS”? WHY IS IT A SECRET FORMULA? WHY DOES THE FORMULA CHANGE FROM BANK TO BANK?
Ask your Congressperson if they know the answer. Ask them if they have read this report: http://www.usa.gov/Contact.shtml
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