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The Value of Implicit Guarantees

by Zoe Tsesmelidakis, University of Oxford, U.K. & Robert C Merton, MIT Sloan

Discussion by: Paul Kupiec, the American Enterprise Institute


Southern Finance Association Meetings, November 2013

Overview
Paper estimates the government subsidy that accrued to financial firms during the financial crisis
$365bn TBTF implicit insurance benefit transfer to financial firms Evidence banks shifted funding toward short-term instruments to benefit from low policy rates and special facilities

Many papers are doing this.why is this paper different?


Use Credit Grades CDS pricing model to estimate uninsured fair market spreads from pre-crisis periods Uses CDS model fair market spread estimates to calculate financing costs savings on actual debt issued by financial firms during the financial crisis

CDS Spread Model


Uses Credit Grades model
Finger, Finkelstein, Lardy, Pan, Ta, Tierney (2002)

Implementation of a Black and Cox (1976) model with stochastic default boundary
Lognormal boundarymean of process is calibrated endogenously Asset volatility is derived from option implied volatility and default boundary volatility

Calibrate the model on all financials with active CDS prior to the crisis
January 2002-August 2007 pre crisis
Model under-predicts actual spreads by 7 bps on average during this period

September 2007-September 2010 crisis period


Model over predicts spreads by 183bps on average; banks over-predicted by 350bps on average Time profile of wedge varies over the crisis (wedge looks like it should be highly correlated with VIX)

Total sample= 74 companies; 108,488 daily CDS spreads

Counterparty Risk Adjustment


Counterparty risk not an issue for CDS spreads issue pre-crisis In crisis, CDS spreads would decline because CDS writers are banks/Ibanks with newly-elevated risk of default
So spreads should tighten from counterparty credit risk effecthow much?
Create primary dealer CDS index Calculate individual banks CDS spread betas on this index to fit time-varying counterparty risk discount

Funding advantage calculated using adjusted wedge


Model CDS-counterparty risk adjustment-actual observed bond yield

Evidence of Govt Guarantee?


When CDS model is calibrated using data prior to 2007, the model suggests that bonds that were actually issued during the crisis should have had higher current coupons (higher yields) Basically, the CDS model, calibrated pre-crisis, no longer fits well the data after August 2007---the model predicts much higher yields Reduction in investors required bond yields is taken as evidence that government support (government guarantee) lowered inventors required yields
But Lehman failed? And implied vol is very high throughout 2008 into first quarter 2009
PD must still be very high Perhaps investors believe government would support recovery rates?

Evidence of Govt Guarantee -2-?


How is the government support reflected in the model?....Lower PD? Higher recovery?
What would a CDS model with an implicit government guarantee look like

Wedge estimate is largest in 1st quarter 2009

Maybe add a chart w/ actual CDS spreads, VIX and the wedge over the crisis period to help reader understand possible dynamics So PD would not seem to be reduced by guarantee until maybe late October 2008, when TARP finally passed And implied volatility is extremely high throughout fall 2008 into 2009 ---so, to get the model to fit the data, the default barrier would have to be lower? ---perhaps a different default boundary volatility parameter? But WAMU holding company bondholders lost bigvirtually everything

September 2008--Lehman failed. So did WAMU. And effectively so did Wachovia and Merrill Lynch

Are investors counting on the government to support recovery rates?

Evidence of Govt Guarantee -3-?


Why not estimate the model over 2008-2010 and give results?
Can the model fit the data if it is estimated over this period? Is so, which parameters change to make the model fit better?

My recollection is that, during the crisis period, many studies show model-indicated arbitrages that investors did not exploit and close Maybe absence of arbitrage pricing did not hold during the crisis?
If so, the CDS models underlying assumptions would not be valid during this period and the model specification for the spread would not fit the data.

So, how can we be sure the difference between actual and projected yields reflect a conjectural government guarantee?

Benefit of guarantee when Bond is issued


Stockholders get to issue more debt than they would have because a given amount of debt has a lower coupon payment
Change in PV assuming bonds issued had higher current coupon consistent with CDS model estimate (less counterparty risk adjustment)

Bond subsidy value-guaranteed bonds sell for more because the required yield is lower with the guarantee.
Change in PV assume bonds issued have the higher required yield consistent with CDS model estimate (less counterparty risk adjustment)

Use bond issuance data and re-price each issue using pre-crisis CDS model-based yield estimates

Estimated Total Benefit of Guarantees at Issuance 2007-2010


This is the guarantee benefit that accrues to the issuing institution
lower coupon lower yield total share banks 121.29 91.55 212.84 93.68% insurance 5.42 4.3 9.72 4.28% real estate 1.32 1.21 2.53 1.11% others 1.14 0.98 2.12 0.93% total 129.17 98.04 227.21 100.00%

Estimated Guarantee to Bondholders After Issuance


After bonds are issuedbenefits from changes in investors conjectural guarantee will accrue to those who purchased bonds Paper finds the day on which each companys spread between the CDS model estimate and the actual secondary market spread is the largest
If a bond is issued with a 0 or + subsidy, and the implied subsidy gets bigger as the crisis unfolds
the paper calculates the capital gain that would be generated by the increase in the wedge

These subsidies accrue to the owners of the bondsnot to the issuing corporation
Estimated to be 236 billion

Total subsidy estimate = Issuance Subsidy + Secondary Market subsidy


Total estimate=$365.2 billion

Commentary
Maybe model approach does not work in the crisis because there are arbitrages all over the place
because of illiquidity, investors cannot take advantage of price discrepancies and eliminate them If so, evidence that model does not fit during crisis may not be direct evidence that the unexplained residual reflects a government guarantee

Why not do the same exercise for non-financials?


Does the CDS model track for non-financials during the crisis? Try out CDS model crisis fit on Australian-Asian banks.
These banks had no exposure, no guarantee.does the pre-2007 calibration fit for them?

Commentary -2 Why would real estate firms get any guarantee benefit?
Didnt home builders got some type of special bailout from congressmaybe talk about this to motivate.

Headline loss number is misleading


TBTF subsidy should just measure benefits gained by financial institutions
Headline number mixes apples and oranges Including secondary market capital gains made by bond owners overstates the TBTF subsidy to the banks .only makes a bigger headline number

Epilogue
It turns out the authors have re-fit the model for the crisis period and will probably include results in updated paper drafts
The average default boundary estimate over this period is close to zero--much lower than the pre-crisis estimate

The authors have estimated the crisis wedge for non-financials


I did not see the numbers, but I think they claim there is a small wedge, but nothing close to the financial sector wedge they estimate

These additional results help make the case that the wedge is related to an implicit insurance guarantee