Financial Economics, Asset Pricing
with Z. Tsesmelidakis
We investigate the impact of government guarantees on the pricing of default risk in credit and stock markets and, using a Merton-type structural credit model, provide evidence of a structural break in the valuation of U.S. bank debt in the course of the 2007-2009 financial crisis, manifesting in a lowered default boundary, or, under the pre-crisis regime, in higher stock-implied credit spreads. A possible explanation is the asymmetric treatment of debt and equity in rescue measures, which tend to favor creditors. The discrepancies are driven by several factors including firm size, default correlation, and high ratings, thus corroborating our too-big-to-fail hypothesis, and they largely persist after accounting for counterparty risk and illiquidity. The proposed methodology allows identifying (a) which companies are perceived as implicitly guaranteed by market participants, (b) at which point in time, and (c) how high a premium they enjoy. In an application of the concept to the pricing of offerings in the primary bond market, we find evidence of subsidies to thefinancial sector amounting to $129 billion over the period 2007-2010.
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The Internalization of Systemic Risk: An Analysis of Bank Levy Schemes
with M. Wahrenburg
The government actions during the 2007-09 financial crisis have demonstrated that large financial institutions benefit from implicit ``too-big-to-fail'' (TBTF) guarantees. This paper analyzes the effectiveness of the recent national bank levy schemes introduced in Germany, France, and the U.K. in reducing the social costs incurred by excessive (systemic) risk-taking. Based on a sample of 41 large European and U.S. banks, we compute the retrospective annual tax amounts as if a given levy had applied to all banks throughout the period 2007-10. The contributions are then contrasted to the cash value of the funding cost advantage, the TBTF premium, which is estimated both from rating-implied bond yields and a structural model of default risk. The results suggest that the U.K. and German levies perform similarly well, but that all schemes fail to match the amount required for the internalization of the externality. The discriminatory power of the French levy is the weakest.
An Event Study of Government Interventions
In the context of the 2007-09 financial crisis, this paper analyzes the direct impact of government intervention announcements on the evolution of CDS spreads, stock prices, and the value of implicit guarantees, or the CDS-equity ``wedge,'' estimated using a Merton-type structural pricing model. First, our results indicate that CDS spreads for banks narrowed, while stock prices did not show a clear, significant response in either direction, supporting the notion that the market perceives interventions as affecting the debt and the equity side asymmetrically. Second, the wedge reveals to be significantly and positively event-driven, which further corroborates its information value. Third, we show how the bailout effects vary with the types of actions applied, and they turn out to be especially pronounced after the announcement of comprehensive rescue programs entailing debt guarantees. Further, eliminating announcement days from the model and market price processes largely reduces the wedge.
How to Become Too-Big-to-Fail – The Impact of Mergers on Credit Risk
with Z. Tsesmelidakis
In this paper, we investigate the relationship between M&A activity in the financial sector and its impact on the evolution of the borrowing and credit insurance costs of firms involved in transactions. The study shows how mergers and acquisitions reduce credit spreads, thereby reflecting the growing "too big to fail" perception by the market.