Macroeconomic Conditions and the Puzzles of Credit Spreads and Capital Structure Hui Chen

This paper addresses two puzzles about corporate debt: the “credit spread puzzle”—why yield spreads between corporate bonds and treasuries are high and volatile—and the “under-leverage puzzle” —why firms use debt conservatively despite seemingly large tax benefits and low costs of financial distress. I propose a unified explanation for both puzzles: investors demand high risk premia for holding defaultable claims, including corporate bonds and levered firms, because (i) defaults tend to concentrate in bad times when marginal utility is high; (ii) default losses are also higher during such times. I study these comovements in a structural model, which endogenizes firms' financing and default decisions in an economy with business-cycle variation in expected growth rates and economic uncertainty. These dynamics coupled with recursive preferences generate countercyclical variation in risk prices, default probabilities, and default losses. The credit risk premia in my calibrated model are large enough to account for most of the high spreads and low leverage ratios. Relative to a standard structural model without business-cycle variation, the average spread between Baa and Aaa-rated bonds rises from 48 bp to around 100 bp, while the average optimal leverage ratio of a Baa-rated firm drops from 67% to 42%, both close to the U.S. data.

 

Modeling the Effect of Macroeconomic Factors on Corporate Default and Credit Rating Transitions Stephen Figlewski, Halina Frydman, Weijian Liang

In credit modeling, default intensity is known to depend on firm-specific factors, notably credit rating, but variation in aggregate default rates over time presumably reflects changes in general economic conditions also. We fit Cox intensity models for defaults, as well as major upgrades and downgrades in credit rating, with both firm-specific factors and a broad range of macroeconomic variables. The sample covers all corporate issuers in Moody's corporate bond Default Research Database over the period 1981 - 2002. We find credit events are strongly influenced by ratings related factors, and also significantly affected by macroeconomic factors. Interestingly, while the coefficients on specific macro variables vary widely depending on which other variables are included in a specification, the estimated effects of the ratings-related factors are largely unchanged by the addition of macroeconomic variables to the model.

 

Liquidity Risk of Corporate Bond Returns Viral V. Acharya, Sreedhar Bharath, Yakov Amihud

We examine the unconditional and conditional sensitivity of monthly U.S. corporate bond returns to liquidity risk factors over the period 1973 to 2003. On average, both investment grade and sub-investment grade bond returns are exposed to both stock- as well as treasury bond-market illiquidity. However, the magnitudes exhibit substantial differences. The stock-market liquidity risk of sub-investment grade bonds is about ten times higher than that of investment-grade bonds, and the factor is around four for bond-market liquidity risk. Furthermore, investment grade and sub-investment grade bonds behave in a fundamentally different way during recessions: Investment grade bond returns’ exposure to liquidity risk is little affected during recessions; in contrast, sub-investment grade bonds’ exposure to liquidity risk arises almost entirely due to recessions, the recession effect being twice as large as the unconditional effect. The results, especially the conditional effects during recession, are robust to controlling
for other systematic risks (term and default) in corporate bond returns as well as to controlling for changes in expected loss and VIX.

 

Hedging Credit: Equity Liquidity Matters Sanjiv R. Das, Paul Hanouna

Credit default swap (CDS) spreads are directly related to equity market liquidity in the Merton (1974) model via hedging. Empirical tests confirm this relationship. This relationship is monotone increasing when credit quality worsens. We theorize and confirm this new channel by means of which liquidity costs are embedded in CDS spreads.

 

Did Securitization Lead to Lax Screening? Evidence from Subprime Loans 2001-2006 Benjamin J. Keys, Tanmoy Mukherjee, Amit Seru, Vikrant Vig

Theories of financial intermediation suggest that securitization, the act of converting illiquid loans into liquid securities, could reduce the incentives of financial intermediaries to screen borrowers. We empirically examine this question using a unique dataset on securitized subprime mortgage loan contracts in the United States. We exploit a specific rule of thumb in the lending market to generate an instrument for ease of securitization and compare the composition and performance of lenders’ portfolios around the ad-hoc threshold. Conditional on being securitized, the portfolio that is more likely to be securitized defaults by around 20% more than a similar risk profile group with a lower probability of securitization. Crucially, these two portfolios have similar observable risk characteristics and loan terms. We use variation across lenders (banks vs. independents), state foreclosure laws, and the timing of passage of anti-predatory laws to rule out alternative explanations. Our results suggest that securitization does adversely affect the screening incentives of lenders.

 

The Consequences of Mortgage Credit Expansion: Evidence from the 2007 Mortgage Default Crisis Atif Mian, Amir Sufi

We demonstrate that a rapid expansion in the supply of mortgages driven by disintermediation explains a large fraction of recent U.S. house price appreciation and subsequent mortgage defaults. We identify the effect of shifts in the supply of mortgage credit by exploiting within county variation across zip codes that differed in latent demand for mortgages in the mid 1990s. From 2001 to 2005, high latent demand zip codes experienced large relative decreases in denial rates, increases in mortgages originated, and increases in house price appreciation, despite the fact that these zip codes experienced significantly negative relative income and employment growth over this time period. These patterns for high latent demand zip codes were driven by a sharp relative increase in the fraction of loans sold by originators shortly after origination, a process which we refer to as “disintermediation.” The increase in disintermediation-driven mortgage supply to high latent demand zip codes from 2001 to 2005 led to subsequent large increases in mortgage defaults from 2005 to 2007. Our results suggest that moral hazard on behalf of originators selling mortgages is a main culprit for the U.S. mortgage default crisis.

 

Innovations in Credit Risk Transfer: Implications for Financial Stability Darrell Duffie

Banks and other lenders often transfer credit risk in order to liberate capital for further loan intermediation. Beyond selling loans outright, lenders are increasingly active in the markets for syndicated loans, collateralized loan obligations (CLOs), credit default swaps, credit derivative product companies, "specialty finance companies," and other financial innovations designed for credit risk transfer. My purpose here is to explore the design, prevalence, and effectiveness of credit risk transfer. My focus will be the costs and benefits for the efficiency and stability of the financial system.

 

How Sovereign is Sovereign Credit Risk? Francis A. Longstaff, Jun Pan, Lasse H. Pedersen, Kenneth J. Singleton

The benefits from diversifying equity portfolios internationally are well established in the literature. We study whether diversifying sovereign credit portfolios across countries has similar benefits. The evidence suggests that the benefits are likely to be much smaller for two reasons. First, sovereign credit is more correlated across countries than are equity returns. In fact, just three principal components account for more than 50 percent of the variation in sovereign credit spreads. Furthermore, sovereign credit spreads are more related to the U.S. stock and high-yield bond markets, global risk premia, and international trading and liquidity patterns than they are to local economic measures. Second, we find that excess returns from investing in sovereign credit are largely compensation for bearing global risk. In particular, there is little or no country-specific credit risk premium after adjusting for global risk factors, and a significant amount of the variation in sovereign credit returns can be forecast using U.S. equity, volatility, and bond market risk premia.

 

Liquidity Risk and Correlation Risk: A Clinical Study of the General Motors and Ford Downgrade of May 2005 Viral V. Acharya, Stephen Schaefer, Yili Zhang

The GM and Ford downgrade to junk status during May 2005 caused a wide-spread sell-off in their corporate bonds. Using a novel dataset, we document that this sell-off appears to have generated significant liquidity risk for market-makers, as evidenced in the significant imbalance in their quotes towards sales. We also document that simultaneously, there was excess co-movement in the fixed-income securities of all industries, not just in those of auto firms. In particular, using credit-default swaps (CDS) data, we find a substantial increase in the co-movement between innovations in the CDS spreads of GM and Ford and those of firms in all other industries, the increase being greatest during the period surrounding the actual downgrade and reversing sharply thereafter. We show that a measure of liquidity risk faced by corporate bond market-makers – specifically, the imbalance towards sales in the volume and frequency of quotes on GM and Ford bonds – explains a significant portion of this excess co-movement. Additional robustness checks suggest that this relationship between the liquidity risk faced by market-makers and the correlation risk for other securities in which they make markets was likely causal. Overall, the evidence is supportive of theoretical models which imply that funding liquidity risk faced by financial intermediaries is a determinant of market prices during stress times.