The Impact of Government Interventions on CDS and Equity Markets

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1 The Impact of Government Interventions on CDS and Equity Markets Frederic Schweikhard Zoe Tsesmelidakis Goethe University Frankfurt, House of Finance 8th Annual Credit Risk Conference Moody s and NYU Stern School of Business, May 2012

2 1. Introduction actual spreads Average CDS levels in the U.S. banking sector Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 2

3 1. Introduction actual spreads Average CDS levels in the U.S. banking sector Perfect guarantee Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 2

4 1. Introduction actual spreads Average CDS levels in the U.S. banking sector No guarantee Perfect guarantee Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 2

5 1. Introduction actual spreads Average CDS levels in the U.S. banking sector No guarantee Perfect guarantee Sources of imperfection: Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 2

6 1. Introduction actual spreads Average CDS levels in the U.S. banking sector No guarantee Perfect guarantee Sources of imperfection: Explicit vs. (probability of existence of) implicit guarantees Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 2

7 1. Introduction actual spreads Average CDS levels in the U.S. banking sector No guarantee Perfect guarantee Sources of imperfection: Explicit vs. (probability of existence of) implicit guarantees Maximum loss coverage Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 2

8 1. Introduction actual spreads Average CDS levels in the U.S. banking sector No guarantee Perfect guarantee Sources of imperfection: Explicit vs. (probability of existence of) implicit guarantees Maximum loss coverage Creditworthiness of guarantor Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 2

9 1. Introduction actual spreads Average CDS levels in the U.S. banking sector? No guarantee Perfect guarantee Sources of imperfection: Explicit vs. (probability of existence of) implicit guarantees Maximum loss coverage Creditworthiness of guarantor Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 2

10 1. Introduction Why do we care? Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 3

11 1. Introduction Why do we care? Crisis management: Bailouts and guarantees vs. free market economy Crisis prevention: Regulatory approaches Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 3

12 1. Introduction Why do we care? Crisis management: Bailouts and guarantees vs. free market economy Moral hazard Reduced funding costs bear negative incentives to higher leverage and excessive risk-taking Crisis prevention: Regulatory approaches Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 3

13 1. Introduction Why do we care? Crisis management: Bailouts and guarantees vs. free market economy Moral hazard Reduced funding costs bear negative incentives to higher leverage and excessive risk-taking Market value and social costs of guarantees Wealth transfer from taxpayers to creditors Crisis prevention: Regulatory approaches Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 3

14 1. Introduction Why do we care? Crisis management: Bailouts and guarantees vs. free market economy Moral hazard Reduced funding costs bear negative incentives to higher leverage and excessive risk-taking Market value and social costs of guarantees Wealth transfer from taxpayers to creditors Disruption of equity and debt markets Structural change in which default is no longer perceived as the same event across debt and equity markets Crisis prevention: Regulatory approaches Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 3

15 1. Introduction Why do we care? Crisis management: Bailouts and guarantees vs. free market economy Moral hazard Reduced funding costs bear negative incentives to higher leverage and excessive risk-taking Market value and social costs of guarantees Wealth transfer from taxpayers to creditors Disruption of equity and debt markets Structural change in which default is no longer perceived as the same event across debt and equity markets Crisis prevention: Regulatory approaches Standalone credit risk Better gauge of financial health than observed CDS price (cf. Hart and Zingales, 2009) Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 3

16 1. Introduction The questions Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 4

17 1. Introduction The questions Q. Have default risks reflected by CDS and stock markets diverged? Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 4

18 1. Introduction The questions Q. Have default risks reflected by CDS and stock markets diverged? Q. Which companies are perceived as TBTF, when, and to what extent? Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 4

19 1. Introduction The questions Q. Have default risks reflected by CDS and stock markets diverged? Q. Which companies are perceived as TBTF, when, and to what extent? Q. How much are the pecuniary subsidies large financial institutions enjoy? Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 4

20 1. Introduction Preview of the results Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 5

21 1. Introduction Preview of the results Our findings point to a structural break in the pricing assumptions for U.S. bank debt Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 5

22 1. Introduction Preview of the results Our findings point to a structural break in the pricing assumptions for U.S. bank debt Under the pre-crisis regime, stock-implied default risk estimates exceed their CDS counterparts during the crisis Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 5

23 1. Introduction Preview of the results Our findings point to a structural break in the pricing assumptions for U.S. bank debt Under the pre-crisis regime, stock-implied default risk estimates exceed their CDS counterparts during the crisis Effect is transitory and prices tend to converge after 2008 Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 5

24 1. Introduction Preview of the results Our findings point to a structural break in the pricing assumptions for U.S. bank debt Under the pre-crisis regime, stock-implied default risk estimates exceed their CDS counterparts during the crisis Effect is transitory and prices tend to converge after 2008 Deviations are related to proxies of systemic risk and TBTF like size, default correlation, high ratings, and TARP participation Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 5

25 1. Introduction Preview of the results Our findings point to a structural break in the pricing assumptions for U.S. bank debt Under the pre-crisis regime, stock-implied default risk estimates exceed their CDS counterparts during the crisis Effect is transitory and prices tend to converge after 2008 Deviations are related to proxies of systemic risk and TBTF like size, default correlation, high ratings, and TARP participation Capitalized subsidies calculated from bond offerings over the period amount to USD billion Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 5

26 2. Setup Linking credit and equity markets Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 6

27 2. Setup Linking credit and equity markets Merton (1974) views equity and debt as contingent claims on the asset value and models the dependence between default risk and equity Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 6

28 2. Setup Linking credit and equity markets Merton (1974) views equity and debt as contingent claims on the asset value and models the dependence between default risk and equity Empirical literature confirms that default risk is indeed implicitly valued in stock prices (e.g., Vassalou and Xing, 2004) Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 6

29 2. Setup Linking credit and equity markets Merton (1974) views equity and debt as contingent claims on the asset value and models the dependence between default risk and equity Empirical literature confirms that default risk is indeed implicitly valued in stock prices (e.g., Vassalou and Xing, 2004) Use the link between equity and debt markets that structural credit pricing models establish, i.e., calculate theoretical, stock-implied CDS spreads Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 6

30 2. Setup Linking credit and equity markets Merton (1974) views equity and debt as contingent claims on the asset value and models the dependence between default risk and equity Empirical literature confirms that default risk is indeed implicitly valued in stock prices (e.g., Vassalou and Xing, 2004) Use the link between equity and debt markets that structural credit pricing models establish, i.e., calculate theoretical, stock-implied CDS spreads Contrast default risk as explicitly priced in the CDS market to the default risk as it is implicitly priced in the stock market Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 6

is only revealed at default Schweikhard/Tsesmelidakis The

31 2. Setup Default barrier Distinctive features: Default may occur at any time Stochastic default barrier, which is only revealed at default Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 7

32 2. Setup Data Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 8

33 2. Setup Data Model input factors: Stock prices (from CRSP) Option implied volatilities (from OptionMetrics) Total liabilities from quarterly reports (from Compustat) Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 8

34 2. Setup Data Model input factors: Stock prices (from CRSP) Option implied volatilities (from OptionMetrics) Total liabilities from quarterly reports (from Compustat) CDS prices (from Markit) Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 8

35 2. Setup Data Model input factors: Stock prices (from CRSP) Option implied volatilities (from OptionMetrics) Total liabilities from quarterly reports (from Compustat) CDS prices (from Markit) Sample Composition Firms Observations Total Sectors Consumer Disc 96 5,861 10,597 15,342 19,256 20,656 22,230 20,830 18,682 13, ,870 Consumer Staples 37 2,258 4,340 5,977 7,981 8,055 8,662 8,774 7,907 5,691 59,645 Energy 41 1,474 3,123 5,134 6,774 7,832 9,352 9,717 9,696 6,955 60,057 Financials 74 4,297 7,935 11,412 14,602 15,333 16,218 15,511 13,146 9, ,448 Banks 27 2,530 4,004 4,953 5,503 6,075 6,088 5,489 4,123 3,026 41,791 Insurance 24 1,571 2,885 4,088 5,179 4,986 5,389 5,274 4,534 3,406 37,312 Real Estate ,725 2,851 3,279 3,801 3,848 3,596 2,886 22,866 Others , ,479 Health Care 42 1,672 3,814 6,099 8,107 8,631 9,562 9,111 8,699 5,796 61,491 Industrials 68 4,194 7,513 10,907 12,802 13,575 14,383 14,591 13,984 10, ,424 IT 34 2,001 3,308 4,844 6,128 6,533 7,222 7,158 6,583 5,138 48,915 Materials 52 2,258 4,805 7,273 9,471 10,059 11,317 11,165 9,940 7,695 73,983 Telecom Svcs ,038 1,605 1,972 2,583 3,122 2,926 2,486 1,532 17,797 Utilities 41 1,833 4,411 6,055 8,270 8,504 8,962 9,125 8,131 6,057 61,348 Total ,381 50,884 74,648 95, , , ,908 99,254 72, ,978 Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 8

36 3. Model estimations Constant default barrier Determine L i by minimizing the sum of squared errors between model (ĈDS) and market spreads (CDS) over a number of observations N in the period 01/ /2007: min L i N (ĈDS i,n ( L i ) CDS i,n ) 2 n=1 Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 9

37 3. Model estimations Constant default barrier Determine L i by minimizing the sum of squared errors between model (ĈDS) and market spreads (CDS) over a number of observations N in the period 01/ /2007: min L i N (ĈDS i,n ( L i ) CDS i,n ) 2 n=1 Whole Sample Period Pre-Crisis Period Crisis Period Post-Crisis Period Ival N L crmse ME RMSE ME RMSE ME RMSE ME RMSE Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 9

38 3. Model estimations Constant default barrier Determine L i by minimizing the sum of squared errors between model (ĈDS) and market spreads (CDS) over a number of observations N in the period 01/ /2007: min L i N (ĈDS i,n ( L i ) CDS i,n ) 2 n=1 Whole Sample Period Pre-Crisis Period Crisis Period Post-Crisis Period Ival N L crmse ME RMSE ME RMSE ME RMSE ME RMSE Results very robust to choice of grid density. Reducing the interval from 50 to 10 slightly improves the estimates, therefore, focus on an interval of 10 in the following. Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 9

39 3. Model estimations Constant default barrier Determine L i by minimizing the sum of squared errors between model (ĈDS) and market spreads (CDS) over a number of observations N in the period 01/ /2007: min L i N (ĈDS i,n ( L i ) CDS i,n ) 2 n=1 Whole Sample Period Pre-Crisis Period Crisis Period Post-Crisis Period Ival N L crmse ME RMSE ME RMSE ME RMSE ME RMSE Results very robust to choice of grid density. Reducing the interval from 50 to 10 slightly improves the estimates, therefore, focus on an interval of 10 in the following. In the pre-crisis period the model underpredicts observed spreads due to nondefault components, like illiquidity, in line with the literature (Eom, Helwege, and Huang (2004), Longstaff (2004), Tang and Yan (2007)). Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 9

40 3. Model estimations Constant default barrier Predicted vs. observed CDS spreads Firm-level results Citigroup model spread market spread Goldman Sachs model spread market spread JPMorgan Chase model spread market spread Morgan Stanley model spread market spread Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 10

41 3. Model estimations Constant default barrier Predicted vs. observed CDS spreads Aggregate results Financials avg. model spreads avg. market spreads Nonfinancials avg. model spreads avg. market spreads Banks avg. model spreads avg. market spreads Nonbank financials avg. model spreads avg. market spreads Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 11

42 3. Model estimations Constant default barrier Predicted vs. observed CDS spreads Relative deviations Banks Other financials Other sectors Relative deviations Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 12

43 3. Model estimations Constant default barrier Predicted vs. observed CDS spreads Relative deviations Banks Other financials Other sectors Relative deviations (a) (b) (c) (a) Acquisition of Bear Stearns by JPMorgan (b) TARP (c) Rescue package for Bank of America Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 12

44 3. Model estimations Constant default barrier Predicted vs. observed CDS spreads Sector results Pre-Crisis Period Crisis Period Post-Crisis Period Mean Std Mean Std Mean Std Market Model Dev Dev Market Model Dev Dev Market Model Dev Dev Consumer Disc Consumer Staples Energy Financials Banks Insurance Real Estate Others Health Care Industrials IT Materials Telcom Svcs Utilities Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 13

45 3. Model estimations Constant default barrier Predicted vs. observed CDS spreads Sector results Pre-Crisis Period Crisis Period Post-Crisis Period Mean Std Mean Std Mean Std Market Model Dev Dev Market Model Dev Dev Market Model Dev Dev Consumer Disc Consumer Staples Energy Financials Banks Insurance Real Estate Others Health Care Industrials IT Materials Telcom Svcs Utilities Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 13

46 3. Model estimations Constant default barrier Predicted vs. observed CDS spreads Sector results Pre-Crisis Period Crisis Period Post-Crisis Period Mean Std Mean Std Mean Std Market Model Dev Dev Market Model Dev Dev Market Model Dev Dev Consumer Disc Consumer Staples Energy Financials Banks Insurance Real Estate Others Health Care Industrials IT Materials Telcom Svcs Utilities Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 13

47 3. Model estimations Constant default barrier Predicted vs. observed CDS spreads Sector results Pre-Crisis Period Crisis Period Post-Crisis Period Mean Std Mean Std Mean Std Market Model Dev Dev Market Model Dev Dev Market Model Dev Dev Consumer Disc Consumer Staples Energy Financials Banks Insurance Real Estate Others Health Care Industrials IT Materials Telcom Svcs Utilities Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 13

48 4. Explaining the divergence Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 14

49 4. Explaining the divergence ĈDS i,t CDS i,t CDS i,t Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 14

50 4. Explaining the divergence ĈDS i,t CDS i,t CDS i,t = c + β mmacro i,t + ɛ i,t Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 14

51 4. Explaining the divergence ĈDS i,t CDS i,t CDS i,t = c + β mmacro i,t + β f Firm i,t + ɛ i,t Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 14

52 4. Explaining the divergence Predictions of regressors ĈDS i,t CDS i,t CDS i,t = c + β mmacro i,t + β f Firm i,t + ɛ i,t Pre-Crisis Crisis Post-Crisis Mean Std Min Max Mean Std Min Max Mean Std Min Max Macrofinancial Variables Business Climate S&P 500 Return rs&p500 (%) VIX Interest Rate Term Structure Treasury Rate ± Term Spread ± Illiquidity On/Off Spread LOn/Off Refcorp Spread LRef Firmspecific Variables Ratings S&P Issuer Ratings + Firm Condition Stock Return rs (%) Stock Volatility σs Size Total Assets (bn) Total Liab. + Market Cap. (bn) TARP + Default Correlation βr DF S Counterparty Risk βr PD CDS For robustness see also dynamics of relative price deviations, alternative subsamples, and determinants of changes. Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 14

53 4. Explaining the divergence Determinants of relative deviations (4) (5) (6) (7) (8) Coef. t Coef. t Coef. t Coef. t Coef. t rs&p *** *** *** *** *** Treasury Rate *** *** Term Spread *** LRef *** *** *** *** *** Rating (AAA) *** *** *** *** Rating (AA) *** *** *** *** Rating (A) *** *** *** *** Rating (BBB) *** *** *** *** Rating (BB) *** *** *** *** Rating (B) *** *** *** *** Rating (CCC) *** *** *** *** Rating (CC) rs *** *** *** *** *** σs *** *** *** Size ** ** * Size rs&p *** βr DF IFin S *** TARP ** MES *** Constant *** *** *** *** Adj.R Observations 524, , , ,868 64,143 Coef. Estimates OLS OLS OLS OLS OLS Standard Errors CL-F CL-F CL-F CL-F CL-F For robustness see also dynamics of relative price deviations, alternative subsamples, and determinants of changes. Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 15

54 4. Explaining the divergence Determinants of relative deviations (4) (5) (6) (7) (8) Coef. t Coef. t Coef. t Coef. t Coef. t rs&p *** *** *** *** *** Treasury Rate *** *** Term Spread *** LRef *** *** *** *** *** Rating (AAA) *** *** *** *** Rating (AA) *** *** *** *** Rating (A) *** *** *** *** Rating (BBB) *** *** *** *** Rating (BB) *** *** *** *** Rating (B) *** *** *** *** Rating (CCC) *** *** *** *** Rating (CC) rs *** *** *** *** *** σs *** *** *** Size ** ** * Size rs&p *** βr DF IFin S *** TARP ** MES *** Constant *** *** *** *** Adj.R Observations 524, , , ,868 64,143 Coef. Estimates OLS OLS OLS OLS OLS Standard Errors CL-F CL-F CL-F CL-F CL-F For robustness see also dynamics of relative price deviations, alternative subsamples, and determinants of changes. Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 15

55 4. Explaining the divergence Determinants of relative deviations (4) (5) (6) (7) (8) Coef. t Coef. t Coef. t Coef. t Coef. t rs&p *** *** *** *** *** Treasury Rate *** *** Term Spread *** LRef *** *** *** *** *** Rating (AAA) *** *** *** *** Rating (AA) *** *** *** *** Rating (A) *** *** *** *** Rating (BBB) *** *** *** *** Rating (BB) *** *** *** *** Rating (B) *** *** *** *** Rating (CCC) *** *** *** *** Rating (CC) rs *** *** *** *** *** σs *** *** *** Size ** ** * Size rs&p *** βr DF IFin S *** TARP ** MES *** Constant *** *** *** *** Adj.R Observations 524, , , ,868 64,143 Coef. Estimates OLS OLS OLS OLS OLS Standard Errors CL-F CL-F CL-F CL-F CL-F For robustness see also dynamics of relative price deviations, alternative subsamples, and determinants of changes. Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 15

56 4. Explaining the divergence Determinants of relative deviations (4) (5) (6) (7) (8) Coef. t Coef. t Coef. t Coef. t Coef. t rs&p *** *** *** *** *** Treasury Rate *** *** Term Spread *** LRef *** *** *** *** *** Rating (AAA) *** *** *** *** Rating (AA) *** *** *** *** Rating (A) *** *** *** *** Rating (BBB) *** *** *** *** Rating (BB) *** *** *** *** Rating (B) *** *** *** *** Rating (CCC) *** *** *** *** Rating (CC) rs *** *** *** *** *** σs *** *** *** Size ** ** * Size rs&p *** βr DF IFin S *** TARP ** MES *** Constant *** *** *** *** Adj.R Observations 524, , , ,868 64,143 Coef. Estimates OLS OLS OLS OLS OLS Standard Errors CL-F CL-F CL-F CL-F CL-F For robustness see also dynamics of relative price deviations, alternative subsamples, and determinants of changes. Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 15

57 4. Explaining the divergence Determinants of relative deviations (4) (5) (6) (7) (8) Coef. t Coef. t Coef. t Coef. t Coef. t rs&p *** *** *** *** *** Treasury Rate *** *** Term Spread *** LRef *** *** *** *** *** Rating (AAA) *** *** *** *** Rating (AA) *** *** *** *** Rating (A) *** *** *** *** Rating (BBB) *** *** *** *** Rating (BB) *** *** *** *** Rating (B) *** *** *** *** Rating (CCC) *** *** *** *** Rating (CC) rs *** *** *** *** *** σs *** *** *** Size ** ** * Size rs&p *** βr DF IFin S *** TARP ** MES *** Constant *** *** *** *** Adj.R Observations 524, , , ,868 64,143 Coef. Estimates OLS OLS OLS OLS OLS Standard Errors CL-F CL-F CL-F CL-F CL-F For robustness see also dynamics of relative price deviations, alternative subsamples, and determinants of changes. Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 15

58 4. Explaining the divergence Determinants of relative deviations (4) (5) (6) (7) (8) Coef. t Coef. t Coef. t Coef. t Coef. t rs&p *** *** *** *** *** Treasury Rate *** *** Term Spread *** LRef *** *** *** *** *** Rating (AAA) *** *** *** *** Rating (AA) *** *** *** *** Rating (A) *** *** *** *** Rating (BBB) *** *** *** *** Rating (BB) *** *** *** *** Rating (B) *** *** *** *** Rating (CCC) *** *** *** *** Rating (CC) rs *** *** *** *** *** σs *** *** *** Size ** ** * Size rs&p *** βr DF IFin S *** TARP ** MES *** Constant *** *** *** *** Adj.R Observations 524, , , ,868 64,143 Coef. Estimates OLS OLS OLS OLS OLS Standard Errors CL-F CL-F CL-F CL-F CL-F For robustness see also dynamics of relative price deviations, alternative subsamples, and determinants of changes. Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 15

59 4. Explaining the divergence Determinants of relative deviations (4) (5) (6) (7) (8) Coef. t Coef. t Coef. t Coef. t Coef. t rs&p *** *** *** *** *** Treasury Rate *** *** Term Spread *** LRef *** *** *** *** *** Rating (AAA) *** *** *** *** Rating (AA) *** *** *** *** Rating (A) *** *** *** *** Rating (BBB) *** *** *** *** Rating (BB) *** *** *** *** Rating (B) *** *** *** *** Rating (CCC) *** *** *** *** Rating (CC) rs *** *** *** *** *** σs *** *** *** Size ** ** * Size rs&p *** βr DF IFin S *** TARP ** MES *** Constant *** *** *** *** Adj.R Observations 524, , , ,868 64,143 Coef. Estimates OLS OLS OLS OLS OLS Standard Errors CL-F CL-F CL-F CL-F CL-F For robustness see also dynamics of relative price deviations, alternative subsamples, and determinants of changes. Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 15

60 4. Explaining the divergence Determinants of relative deviations (4) (5) (6) (7) (8) Coef. t Coef. t Coef. t Coef. t Coef. t rs&p *** *** *** *** *** Treasury Rate *** *** Term Spread *** LRef *** *** *** *** *** Rating (AAA) *** *** *** *** Rating (AA) *** *** *** *** Rating (A) *** *** *** *** Rating (BBB) *** *** *** *** Rating (BB) *** *** *** *** Rating (B) *** *** *** *** Rating (CCC) *** *** *** *** Rating (CC) rs *** *** *** *** *** σs *** *** *** Size ** ** * Size rs&p *** βr DF IFin S *** TARP ** MES *** Constant *** *** *** *** Adj.R Observations 524, , , ,868 64,143 Coef. Estimates OLS OLS OLS OLS OLS Standard Errors CL-F CL-F CL-F CL-F CL-F For robustness see also dynamics of relative price deviations, alternative subsamples, and determinants of changes. Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 15

61 5. Subsidies Capitalized subsidies in the primary bond market Estimate implicit subsidies by interpreting the wedge as a funding cost advantage for debt financing. Implicit but reasonable assumption: Negative CDS-bond basis (due to illiquidity and counterparty risk) stays fixed as default risk increases. Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 16

62 5. Subsidies Capitalized subsidies in the primary bond market Estimate implicit subsidies by interpreting the wedge as a funding cost advantage for debt financing. Implicit but reasonable assumption: Negative CDS-bond basis (due to illiquidity and counterparty risk) stays fixed as default risk increases. using detailed characteristics of public bond offerings between 2007 and 2010 for our financial subsample (source: FISD). Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 16

63 5. Subsidies Capitalized subsidies in the primary bond market Estimate implicit subsidies by interpreting the wedge as a funding cost advantage for debt financing. Implicit but reasonable assumption: Negative CDS-bond basis (due to illiquidity and counterparty risk) stays fixed as default risk increases. using detailed characteristics of public bond offerings between 2007 and 2010 for our financial subsample (source: FISD). revaluing the offering prices given a change in the YTM. How much less debt would a bank have been able issue? Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 16

64 5. Subsidies Capitalized subsidies in the primary bond market Estimate implicit subsidies by interpreting the wedge as a funding cost advantage for debt financing. Implicit but reasonable assumption: Negative CDS-bond basis (due to illiquidity and counterparty risk) stays fixed as default risk increases. using detailed characteristics of public bond offerings between 2007 and 2010 for our financial subsample (source: FISD). revaluing the offering prices given a change in the YTM. How much less debt would a bank have been able issue? revaluing the offering prices given a change in the coupon rate. How much more would a bank have to pay (in PV terms) to raise the debt? Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 16

65 5. Subsidies Capitalized subsidies in the primary bond market Panel A Offering amounts Total Banks Insurance Real Estate Others Total Panel B Subsidies calc. by increasing YTMs Total Banks Insurance Real Estate Others Total Panel C Subsidies calc. by increasing coupon rates Total Banks Insurance Real Estate Others Total *All values are in billion U.S. dollars. Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 17

66 5. Subsidies Capitalized subsidies in the primary bond market Panel A Offering amounts Total Banks Insurance Real Estate Others Total Panel B Subsidies calc. by increasing YTMs Total Banks Insurance Real Estate Others Total Panel C Subsidies calc. by increasing coupon rates Total Banks Insurance Real Estate Others Total *All values are in billion U.S. dollars. Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 17

67 5. Subsidies Capitalized subsidies in the primary bond market Panel A Offering amounts Total Banks Insurance Real Estate Others Total Panel B Subsidies calc. by increasing YTMs Total Banks Insurance Real Estate Others Total Panel C Subsidies calc. by increasing coupon rates Total Banks Insurance Real Estate Others Total *All values are in billion U.S. dollars. Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 17

68 5. Subsidies Capitalized subsidies in the primary bond market Panel A Offering amounts Total Banks Insurance Real Estate Others Total Panel B Subsidies calc. by increasing YTMs Total Banks Insurance Real Estate Others Total Panel C Subsidies calc. by increasing coupon rates Total Banks Insurance Real Estate Others Total *All values are in billion U.S. dollars. Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 17

69 6. Conclusion Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 18

70 6. Conclusion The problem Misalignment between stock and CDS markets due to government guarantees Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 18

71 6. Conclusion The results Misalignment between stock and CDS markets due to government guarantees CDS spread divergence is most pronounced for banks and peaks at 1000 bps on average in fall 2008 Capitalized subsidies amount to $129.2 billion Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 18

72 6. Conclusion The policy implication Misalignment between stock and CDS markets due to government guarantees CDS spread divergence is most pronounced for banks and peaks at 1000 bps on average in fall 2008 Capitalized subsidies amount to $129.2 billion CDS prices are biased to the downside and thus unreliable to monitor the health of the financial system Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 18

74 A. Appendix Macrofinancial variables usiness Climate S&P 500 Return r S&P500 (%) VIX nterest Rate Term Structure Treasury Rate Term Spread lliquidity On/Off Spread L On/Off Refcorp Spread L Ref TBTF guarantees become particularly valuable in times of crises, when default probabilities jump up and expected recovery rates decline. Average daily return of the S&P 500 index over the past six months + Model-free volatility forecast for the next 30-day period implied from index options The effect of a rise in the spot rate is ambiguous: First, it lowers the a firm s PD by increasing the risk-neutral drift of its asset value process. Second, it can be associated with a tightened monetary policy and higher PDs. A steeper slope of the yield curve is similarly ambiguous: First, it may be associated with the expectation of a recovering economy. Second, it can accompany rising inflation and corresponding monetary countermeasures. ± Three-month Treasury rate ± Slope between the ten-year and the three-month Treasury rates Since illiquidity drives up market prices while model estimates remain unaffected, it should reduce price deviations. Five-year Treasury yield is compared to its less frequently traded off-the-run counterpart Yield difference between less frequently traded five-year bonds issued by the Resolution Funding Corporation and Treasury bonds Schweikhard/Tsesmelidakis The Impact of Government Interventions on CDS and Equity Markets 20

The Financing and Growth of Firms in China and India: Evidence from Capital Markets

The Financing and Growth of Firms in China and India: Evidence from Capital Markets Tatiana Didier Sergio Schmukler Dec. 12-13, 2012 NIPFP-DEA-JIMF Conference Macro and Financial Challenges of Emerging