Download - corporate risk and credit risk
-
7/29/2019 corporate risk and credit risk
1/78
Massachusetts Institute of TechnologySloan School of Management
Course 15.415: Finance Theory I
Class Notes #25
Nonlinearities, Skewness and the Credit Option:
Corporate Bonds, Bank Loans and Bank Stocks
Douglas T. Breeden*August, 2012
Several slides are from D. T. Breeden, Bank Risk Management, Chapter 34 in The
Handbook of Modern Finance, Dennis Logue, Editor, 1989.
-
7/29/2019 corporate risk and credit risk
2/78
U.S. Bond Market:Governments, Corporates, Mortgages,
Consumer Credit and Municipals ($Trillions)Source: Federal Reserve Board Q1 2011 (solid), Q4 2008 (pattern)
02
468
101214161820
Treasurys,Agencies
Corporate &ForeignBonds
Mortgages ConsumerCredit
Municipals
2
-
7/29/2019 corporate risk and credit risk
3/78
I. Bank Loans and Corporate Bonds
in an Option Context
3
-
7/29/2019 corporate risk and credit risk
4/78
Black-Scholes-Merton (1973, 1974)Debt and Equity as Options
In their pathbreaking, Nobel Prize winningworks, Black and Scholes in 1973 and Merton in1974 showed that equity is like a call option on
the value of the firms assets.
They also showed that the debt of a firm is likeowning the firm and having written a call to the
shareholders. Option formulae can help pricecorporate bonds.
4
-
7/29/2019 corporate risk and credit risk
5/78
5
Bank Loans In An Option Context
Douglas T. Breeden
1. Bank Loans and Their Credit Options.
2. Hedging Bank Loans with options andFutures.
3. Pricing Bank Loans for Credit Risk.
5
-
7/29/2019 corporate risk and credit risk
6/78
6
Bank Loans In an Option Context
Crude Oil: A firm owns a crude oil storage facilitythat currently contains 1 million barrels of oil. At theJune, 2011 price of $100.00 per barrel, this oil isworth $100 million.
A bank lends $66.67 million (Loan/Value = 2/3) tothe firm for one year at an interest rate of 5.00%(3.25% prime + 1.75%) using the oil as collateral,
which results in a promised payment of $70 millionin one year ($66.67 x 1.05). The current 1-yearfutures price is $99.85.
6
-
7/29/2019 corporate risk and credit risk
7/78
Loan Risk Exposure To Commodity PricesValue of Firm Payment to Bank Shareholders Equity
Crude Oil Price ($MM) ($MM) ($MM)$40.00 $40.0 mln $40.0 $0.0
$50.00 $50.0 $50.0 $0.0
$60.00 $60.0 $60.0 $0.0
$70.00 $70.0 $70.0 $0.0
$80.00 $80.0 $70.0 $10.0
$90.00 $90.0 $70.0 $20.0
$100.00 $100.0 $70.0 $30.0
$110.00 $110.0 $70.0 $40.0
$120.00 $120.0 $70.0 $50.0$130.00 $130.0 $70.0 $60.0
$140.00 $140.0 $70.0 $70.0
$150.00 $150.0 $70.0 $80.0
$160.00 $160.0 $70.0 $90.0
Mathematically: V B + E 7
-
7/29/2019 corporate risk and credit risk
8/78
8
$70
70 million
-
7/29/2019 corporate risk and credit risk
9/78
9$70
-
7/29/2019 corporate risk and credit risk
10/78
10
10 20 30 40 50 60 70 80 90 100 110 120 130
35
70
105
140
175
-
7/29/2019 corporate risk and credit risk
11/78
Hedging Loans With Put OptionsCrude Oil Value Payment Put X=70 Put Net
Price of Firm to Bank Payoff Cost Cash
($/Barrel) ($Mln) ($Mln) ($Mln) ($Mln) ($Mln)$40.00 $40.0 $40.0 $30.0 $-2.32 $67.68
$50.00 $50.0 $50.0 $20.0 $-2.32 $67.68$60.00 $60.0 $60.0 $10.0 $-2.32 $67.68
$70.00 $70.0 $70.0 $ 0.0 $-2.32 $67.68
$80.00 $80.0 $70.0 $ 0.0 $-2.32 $67.68
$90.00 $90.0 $70.0 $ 0.0 $-2.32 $67.68
$100.00 $100.0 $70.0 $0.0 $-2.32 $67.68
$110.00 $110.0 $70.0 $0.0 $-2.32 $67.68$120.00 $120.0 $70.0 $0.0 $-2.32 $67.68
$130.00 $130.0 $70.0 $0.0 $-2.32 $67.68
$140.00 $140.0 $70.0 $0.0 $-2.32 $67.68
$150.00 $150.0 $70.0 $0.0 $-2.32 $67.68
$160.00 $160.0 $70.0 $0.0 $-2.32 $67.6811
-
7/29/2019 corporate risk and credit risk
12/78
12
-
7/29/2019 corporate risk and credit risk
13/78
13
-
7/29/2019 corporate risk and credit risk
14/78
Hedging Loan: Short Futures, Long Call OptionCrude Oil Value Payment Short Call X-=70 Call Net
Price of Firm to Bank Futures Gain Payoff Cost Cash
($/Barrel) ($Mln) ($Mln) ($Mln) ($Mln) ($Mln) ($Mln)$40.00 $40.0 $40.0 $59.85 $ 0.0 $-32.17 $67.68
$50.00 $50.0 $50.0 $49.85 $ 0.0 $-32.17 $67.68
$60.00 $60.0 $60.0 $39.85 $ 0.0 $-32.17 $67.68
$70.00 $70.0 $70.0 $29.85 $ 0.0 $-32.17 $67.68
$80.00 $80.0 $70.0 $19.85 $10.0 $-32.17 $67.68$90.00 $90.0 $70.0 $ 9.85 $20.0 $-32.17 $67.68
$100.00 $100.0 $70.0 $- 0.15 $30.0 $-32.17 $67.68
$110.00 $110.0 $70.0 $-10.15 $40.0 $-32.17 $67.68$120.00 $120.0 $70.0 $-20.15 $50.0 $-32.17 $67.68
$130.00 $130.0 $70.0 $-30.15 $60.0 $-32.17 $67.68
$140.00 $140.0 $70.0 $-40.15 $70.0 $-32.17 $67.68
$150.00 $150.0 $70.0 $-50.15 $80.0 $-32.17 $67.68
$160.00 $160.0 $70.0 $-60.15 $90.0 $-32.17 $67.6814
-
7/29/2019 corporate risk and credit risk
15/78
15
Example: Option Adjusted Spread on BankLoan (OAS)
Terms: 1-year loanPrincipal: $66.67 million
Repayment: $70.00 million in 1 year
Interest =Interest Rate = 5.00%
= Prime + 1.75%
(Prime = 3.25%)
Collateral: 1 million barrels of oil
Current value = $100.00/barrel
Loan-to-value ratio = = 66.7%
Million
Million
67.66$
33.3$
MillionMillion
00.100$67.66$
15
-
7/29/2019 corporate risk and credit risk
16/78
16
Option-Adjusted Return Calculation1-Year Put option on crude oil with strike price of $70/barrel
insures this loans payoff risk.
Put cost = $2,320,000 ( = 35%) or $2.32 per barrel.
Banks total cash out = + =
Cash received back = Loan payoff + Put = $70,000,000
with credit risk Payoff
Hedged or risk-adjusted return = - 1 =
Hedged
Loan = Weak risk-adjusted return
Return
Loan
000,670,66$
stPutHedgeCo
000,320,2$
utTotalCashO
000,990,68$
000,990,68$
000,000,70$
1.47%
Prime - 1.78%
16
~ ~
-
7/29/2019 corporate risk and credit risk
17/78
17
Effects of Option Volatilityon Cost of Put Hedge for Loan
Put Options Implied Volatility = 45% 25% =
Put Option Cost ($70 strike, 1 year) = $4,490,000 $720,000 = P
17
-
7/29/2019 corporate risk and credit risk
18/78
18
Option-Adjusted Loan Return With = 25%
Banks total cash out = $66,670,000 + $720,000
= $67,390,000
Banks cash received back = $70,000,000
Hedged or risk-adjusted return = - 1=
= risk-adjusted
= High risk adjustedreturn
000,390,67$000,000,70$
3.87%
Prime + 0.62%
18
-
7/29/2019 corporate risk and credit risk
19/78
19
Option-Adjusted Loan Return With = 45%
Banks Cash Out = $66,670,000 + $4,490,000 = $71,160,000
Banks Cash Back = $70,000,000
Hedged Return = - 1 =
=
= Very poor return (unprofitable)
000,160,71$000,000,70$
-1.63%
Prime - 4.88%
19
-
7/29/2019 corporate risk and credit risk
20/78
20
Computing The Interest RateThat Gives A Desired OAS
Assume:
Cost of Funds (LIBOR) = 0.5% = COF
Desired hedged profit = 1.5% =
Desired hedged return = 2.0% = HR
20
-
7/29/2019 corporate risk and credit risk
21/78
21
Computing The Interest RateThat Gives A Desired OAS
Analysis: Let the amount loaned be variable =
Put hedge cost = P
Total proceeds from risky loan and hedge = L
Pricing Formula: = 1 +
Solve for :
RH
PL
= - P
HR
L
1
21
C ti Th I t t R t
-
7/29/2019 corporate risk and credit risk
22/78
Computing The Interest RateThat Gives A Desired OAS
In the example: = - $4,490,000( = 45%)
= $64,137,500
Loan interest rate = -1
( = 45%) = - 1 =
=
Note: If = 25%, P = $720,000, then =
=
23
020.1
000,000,70$
Prime +5.90%
L
R500,137,64$000,000,70$
9.15%
LR 3.07%
Prime - 0.18%
LRL 1
-
7/29/2019 corporate risk and credit risk
23/78
Summary of Fair Interest Rates on 1-Year OilLoans Hedged with Put Options (Oil Price=$100)
PromisedPaymentin 1 Year
Loan/ValueRatio
Put Option Costs
Millions of dollars
Interest Rate for Bank toEarn Hedged Spread of 1.5%(Prime=3.35%, LIBOR=0.5%)
= 45% =35% = 25% = 45% =35% = 25%
$75 million approx70%
$6.05 $3.46 $1.33 11.14% 7.03% 3.88%
$70 million 65% $4.49 $2.32 $0.72 9.15% 5.57% 3.07%
$65 million 60% $3.21 $1.46 $0.34 7.41% 4.40% 2.55%
$60 million 55% $2.18 $0.86 $0.14 5.93% 3.51% 2.25%
23
-
7/29/2019 corporate risk and credit risk
24/78
24
-
7/29/2019 corporate risk and credit risk
25/78
Junk Bonds: Market Adjusted Debt Ratio (Quasi-Debt Ratio)vs. Yield to Worst Call 5 Yr Treasury
(.10 interval MAD1 bucket Averages from 1800 bonds sampled)MAD1= Face Val Debt/(Face Debt + Mkt Equity) Merton (1974, J. Finance)
25Source: Douglas T. Breeden and John B. Sprow, Smith Breeden Associates, 1989
-
7/29/2019 corporate risk and credit risk
26/78
26
-
7/29/2019 corporate risk and credit risk
27/78
27
-
7/29/2019 corporate risk and credit risk
28/78
28
-
7/29/2019 corporate risk and credit risk
29/78
29
Main Point:
The fair rate on a loan depends on the cost of the
options required to cover the banks credit risks. Ifoption costs are high (as with high volatility), thenloan rates must be high. Correspondingly, lowoption costs permit low loan rates.
The loan to value ratio affects the exercise prices ofthe options purchased. Intuitively, a lower loan tovalue ratio reduces the credit risk and the cost ofoption coverage.
29
B k C dit Ri k F P ti ll H d d Fi
-
7/29/2019 corporate risk and credit risk
30/78
30
Bank Credit Risks For a Partially Hedged FirmOld Example with $11 mln promised debt payment (Fut=$14.82)
Oil Unhedged Futures Hedge Gains Bank Receipt on Loan
Prices Firm Value H=25% H=50% H=75% H=0% H=25% H=50% H=75%
$8.00 $8.0 m $1.71 $3.41 $5.12 $8.00 $9.71 $11.00 $11.00
$9.00 $9.0 m $1.46 $2.91 $4.37 $9.00 $10.46 $11.00 $11.00
$10.00 $10.0 m $1.21 $2.41 $3.62 $10.00 $11.00 $11.00 $11.00
$11.00 $11.0 m $0.96 $1.91 $2.87 $11.00 $11.00 $11.00 $11.00
$12.00 $12.0 m $0.71 $1.41 $2.12 $11.00 $11.00 $11.00 $11.00
$13.00 $13.0 m $0.46 $0.91 $1.37 $11.00 $11.00 $11.00 $11.00
$14.00 $14.0 m $0.21 $0.41 $0.62 $11.00 $11.00 $11.00 $11.00
$15.00 $15.0 m ($0.04) ($0.09) ($0.13) $11.00 $11.00 $11.00 $11.00
$16.00 $16.0 m ($0.29) ($0.59) ($0.88) $11.00 $11.00 $11.00 $11.00
$17.00 $17.0 m ($0.54) ($1.09) ($1.63) $11.00 $11.00 $11.00 $11.00
$18.00 $18.0 m ($0.79) ($1.59) ($2.39) $11.00 $11.00 $11.00 $11.00
$19.00 $19.0 m ($1.05) ($2.09) ($3.14) $11.00 $11.00 $11.00 $11.00
$20.00 $20.0 m ($1.30) ($2.59) ($3.89) $11.00 $11.00 $11.00 $11.00
Note: Loan promises payment of $11 million in one year;
H = Percent of oil risk hedged; V = Total firm value
30
H d i S b di t d D bt With S d f P t O ti
-
7/29/2019 corporate risk and credit risk
31/78
Hedging Subordinated Debt With Spread of Put Option
Oil Payment to Subordinated Buy Put Write Put Hedged
Price Firm Value Senior Debt Debt Payoff X = $11 X = $10 Sub. Debt
$8.00 $8.0 m $8.0 m $0.0 m $ 3.0 m $-2.00 m $1.00 m
$9.00 $9.0 m $9.0 m $0.0 m $ 2.0 m $-1.00 m $1.00 m
$10.00 $10.0 m $10.0 m $0.0 m $ 1.0 m $-0.00 m $1.00 m
$11.00 $11.0 m $10.0 m $1.0 m $ 0.0 m $-0.00 m $1.00 m
$12.00 $12.0 m $10.0 m $1.0 m $ 0.0 m $-0.00 m $1.00 m$13.00 $13.0 m $10.0 m $1.0 m $ 0.0 m $-0.00 m $1.00 m
$14.00 $14.0 m $10.0 m $1.0 m $ 0.0 m $-0.00 m $1.00 m
$15.00 $15.0 m $10.0 m $1.0 m $ 0.0 m $-0.00 m $1.00 m
$16.00 $16.0 m $10.0 m $1.0 m $ 0.0 m $-0.00 m $1.00 m
$17.00 $17.0 m $10.0 m $1.0 m $ 0.0 m $-0.00 m $1.00 m
$18.00 $18.0 m $10.0 m $1.0 m $ 0.0 m $-0.00 m $1.00 m
$19.00 $19.0 m $10.0 m $1.0 m $ 0.0 m $-0.00 m $1.00 m
$20.00 $20.0 m $10.0 m $1.0 m $ 0.0 m $-0.00 m $1.00 m
31
Old Example with $11 mln promised debt payments,$10 mln senior debt, $1 mln subordinated
C fli t f I t t
-
7/29/2019 corporate risk and credit risk
32/78
32
Conflicts of InterestBetween Bondholders and Stockholders
Once debt is outstanding, stockholders have theincentives to take actions that benefit themselves at theexpense of the bondholders.
With debt outstanding, the objectives of maximizing thevalue of the firm and the value of the equity are notidentical.
Examples of bondholdersstockholder conflicts Claim dilution
Dividend payout
Asset substitution32
-
7/29/2019 corporate risk and credit risk
33/78
33
Types of Bond Covenants
Restrictions on production and investment policy
Mergers Financial assets
Sale of assets
Line of business
Restrictions on financial policy
Dividend payouts Priority
Total debt
Provisions for auditing
Bond Covenants reduce but do not eliminate agency costs
Components of Agency Costs
Monitoring costs
Bonding costs
Residual loss
33
-
7/29/2019 corporate risk and credit risk
34/78
II. Risk and Return inCorporate Bonds and Bank Loans
Quarterly Data: 1926-2011 Q3
34
-
7/29/2019 corporate risk and credit risk
35/78
35
Empirical Duration/Price Elasticity Estimates
-
7/29/2019 corporate risk and credit risk
36/78
Empirical Duration/Price Elasticity Estimatesfor Treasuries and Corporates
(Monthly Data 1989-2010)
Quarterly returns regressed on 3-month changes in thecorresponding 5, 10, 30-Year Treasury Rates:
Slope R-Squared
5-Year Treasury -4.4 0.97
10-Year Treasury -7.6 0.98
30-Year Treasury -13.9 0.97
Quarterly returns regressed on 3-month changes in the
10-Year Treasury Rate:
AAA Corporate -4.8 0.77 A Corporate -4.0 0.41
BBB Corporate -3.1 0.23
Junk Corporate(ex 07-10) -1.3 0.02
Mortgage Master -3.0 0.7136
-
7/29/2019 corporate risk and credit risk
37/78
Bond Ratings
37
Moodys S&P Quality of IssueInvestment-grade bonds:
Aaa AAA Highest quality. Very small risk of default.Aa AA High quality. Small risk of default.A A High-Medium quality. Strong attributes, but potentially vulnerable.Baa BBB Medium quality. Currently adequate, but potentially unreliable.
High-yield (Junk) bonds:Ba BB Some speculative element. Long-run prospects questionable.B B Able to pay currently, but at risk of default in the future.
Caa CCC Poor quality. Clear danger of default.Ca CC High speculative quality. May be in default.C C Lowest rated. Poor prospects of repayment.D - In default.
-
7/29/2019 corporate risk and credit risk
38/78
38
-
7/29/2019 corporate risk and credit risk
39/78
39
-
7/29/2019 corporate risk and credit risk
40/78
40
Moodys Average Cumulative Issuer-WeightedGlobal Default Rates by Alphanumeric Rating, 1998-2007
Rating Year 1 Year 10
Aaa 0.00 0.00
Aa 0.00 0.00
Aa2 0.00 0.00Aa3 0.00 0.17
A1 0.00 0.06
A2 0.05 0.52
A3 0.05 0.54
Baa1 0.20 1.66
Baa2 0.19 2.57
Baa3 0.39 4.49
4040
Rating Year 1 Year 10Ba1 0.42 3.68Ba2 0.77 10.16Ba3 1.05 17.79
B1 1.70 28.37B2 3.89 32.41B3 6.18 51.10Caa1 10.54 50.51Caa2 18.98 46.83Caa3 25.54 54.38
Ca-C 38.27 65.63Investment-Grade 0.10 1.13Speculative-Grade 4.69 27.38All Rated 1.78 9.28
-
7/29/2019 corporate risk and credit risk
41/78
41
Global Corporate Default Rates By Rating Category (source: S&P)
(%) AAA AA A BBB BB B CCC/C
1981 0.00 0.00 0.00 0.00 0.00 2.27 0.00
1982 0.00 0.00 0.21 0.34 4.22 3.13 21.43
1983 0.00 0.00 0.00 0.32 1.16 4.55 6.67
1984 0.00 0.00 0.00 0.66 1.14 3.39 25.00
1985 0.00 0.00 0.00 0.00 1.48 6.44 15.38
1986 0.00 0.00 0.18 0.33 1.31 8.33 23.08
1987 0.00 0.00 0.00 0.00 0.37 3.08 12.28
1988 0.00 0.00 0.00 0.00 1.04 3.62 20.37
1989 0.00 0.00 0.00 0.60 0.71 3.37 31.58
1990 0.00 0.00 0.00 0.58 3.55 8.54 31.25
1991 0.00 0.00 0.00 0.55 1.67 13.84 33.87
1992 0.00 0.00 0.00 0.00 0.00 6.99 30.19
1993 0.00 0.00 0.00 0.00 0.69 2.62 13.33
1994 0.00 0.00 0.14 0.00 0.27 3.08 16.671995 0.00 0.00 0.00 0.17 0.98 4.58 28.00
1996 0.00 0.00 0.00 0.00 0.67 2.89 4.17
1997 0.00 0.00 0.00 0.25 0.19 3.47 12.00
1998 0.00 0.00 0.00 0.41 0.96 4.59 42.86
1999 0.00 0.17 0.18 0.19 0.94 7.28 32.35
2000 0.00 0.00 0.26 0.37 1.24 7.73 34.12
2001 0.00 0.00 0.35 0.33 3.22 11.23 44.55
2002 0.00 0.00 0.00 1.00 2.78 8.10 44.12
2003 0.00 0.00 0.00 0.22 0.56 3.97 33.13
2004 0.00 0.00 0.08 0.00 0.52 1.55 15.11
2005 0.00 0.00 0.00 0.07 0.20 1.71 8.87
2006 0.00 0.00 0.00 0.00 0.29 0.80 13.08
2007 0.00 0.00 0.00 0.00 0.19 0.24 14.81
2008 0.00 0.38 0.38 0.47 0.76 3.82 26.53
Source: Standard & Poors Global Fixed Income Research and Standard a& Poors Credit Pro.
-
7/29/2019 corporate risk and credit risk
42/78
Default Rates on Corporate Bonds andChargeoffs on Bank Loans 1920-2009e
0
2
4
6
8
10
12
14
16
18
1920
1924
1928
1932
1936
1940
1944
1948
1952
1956
1960
1964
1968
1972
1976
1980
1984
1988
1992
1996
2000
2004
2008
SpecGradeBondD
efaultRate
-0.5
0
0.5
1
1.5
2
2.5
3
3.5
4
LoanCharge
off%
Moody Spec Grade Default Rate Bank Chargeoff %
42
-
7/29/2019 corporate risk and credit risk
43/78
43
-
7/29/2019 corporate risk and credit risk
44/78
44
-
7/29/2019 corporate risk and credit risk
45/78
45
-
7/29/2019 corporate risk and credit risk
46/78
46
-
7/29/2019 corporate risk and credit risk
47/78
47
-
7/29/2019 corporate risk and credit risk
48/78
48
-
7/29/2019 corporate risk and credit risk
49/78
49
-
7/29/2019 corporate risk and credit risk
50/78
50
-
7/29/2019 corporate risk and credit risk
51/78
51
Corporate Bonds Have Major Nonlinearities:
-
7/29/2019 corporate risk and credit risk
52/78
Corporate Bonds Have Major Nonlinearities:Stock Market Betas Increase in Risky Times
Quarterly Data: 1926-2011
Junk Bond Spread 500 bp(123 Observations in risky times)
vs5-YrGovt
t-stat vsS&P500
t-stat
Corr.RSQ
vs5-YrGovt
t-stat vsS&P500
t-stat Corr.RSQ
InvestmtGrade(Aaa,Aa)
1.4835.5
0.096.1 0.86
1.109.4
0.052.8 0.43
Baa
RatedBonds
1.07
23.7
0.11
7.1 0.75
0.94
7.8
0.27
15.8 0.71
JunkBonds
-
7/29/2019 corporate risk and credit risk
53/78
Nonlinearity: Banks Loan Betas and Stock Equity
Betas Change with Changing Credit Quality
CorporateBondRating
Junk Bond Spread 500 bp(123 Observs in risky times)
Loan PortfolioBeta vs. SP500
Bank EquityLevered 10/1
Loan PortfolioBeta vs. SP500
Bank EquityLevered 10/1
Aaa 0.09 0.90 0.05 0.50
Aa 0.09 0.90 0.10 1.00
A 0.10 1.00 0.15 1.50
Baa 0.11 1.10 0.27 2.70
Junk(
-
7/29/2019 corporate risk and credit risk
54/78
54
-
7/29/2019 corporate risk and credit risk
55/78
55
-
7/29/2019 corporate risk and credit risk
56/78
The Financial Panic of 2008/2009 and
the Tepid Recovery in 2010-2011
56
Six Sigma Drop In Real Estate Prices
-
7/29/2019 corporate risk and credit risk
57/78
5757
Six Sigma Drop In Real Estate Pricesand Loan Delinquencies Soar
Real estate prices have dropped by amounts thatwere truly unmeasured previously. Recent movesreflect many (6?) standard deviation events.
We tend to gauge what is a bad scenario bylooking at historical data to see how bad situationscan be. We need to think out of the box toworlds and equilibria that have not been seen, but
are possible.
Doug, the recent Turner report in the UK suggests that one problem was that the historyUsed in the empirical analysis, often just 5-6 years, was insufficient. JWPayne
D.T. Breeden, January 2011
F f H i P i 4Q % Ch
-
7/29/2019 corporate risk and credit risk
58/78
Frequency of Housing Price 4Q % ChangesCase Shiller 1987-2009: 6 Sigma Event.
58
0
2
4
6
810
12
14
16
18
20
D.T. Breeden, January 2011
Housing Price Percentage Declines By Metro
-
7/29/2019 corporate risk and credit risk
59/78
59
Area to 2009/2010 Lows from 2006-2007 PeaksSource: S&P Case Shiller
-60 -50 -40 -30 -20 -10 0
PhoenixLas Vegas
MiamiSan Diego
San Francisco
Los AngelesDetroitTampa
Washington, D.C.Composite 10 MktsComposite 20 Mkts
Minneapolis
ChicagoBoston
New YorkAtlantaSeattle
ClevelandPortland
DenverCharlotte
Dallas
-
7/29/2019 corporate risk and credit risk
60/78
60
2008
-
7/29/2019 corporate risk and credit risk
61/78
61
-
7/29/2019 corporate risk and credit risk
62/78
62
Leverage Matters And if you are levered and
-
7/29/2019 corporate risk and credit risk
63/78
63
Leverage Ratios (Assets/Equity) for Bear Stearns,Goldman, Morgan Stanley and Lehman 1996-2007
15.0
20.0
25.0
30.0
35.0
40.0
Dec-96
Dec-97
Dec-98
Dec-99
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
BSC GS MS LEH
Leverage Matters. And if you are levered andCorrelations go to 1.0 in extreme markets
63
Financial Panic of 2008/2009:Bank Stocks Fell 80% as Much As In the Great Depression
-
7/29/2019 corporate risk and credit risk
64/78
Bank Stocks Fell 80%, as Much As In the Great DepressionEnd of Month, June 2007- Jan 2010 vs. Aug 1929- Aug1933
Fin
0
10
20
30
40
50
60
70
80
90
100
110
6/30/2007
8/31/2007
10/31/2007
12/31/2007
2/29/2008
4/30/2008
6/30/2008
8/31/2008
10/31/2008
12/31/2008
2/28/2009
4/30/2009
6/30/2009
8/31/2009
10/31/2009
12/31/2009
Bank Stocks: Great Depression 8/1929-12/1932 KBW Bank Stock Index (12/31/06=100) to 2/20/2009
64
Stock Price Falls of Big 5 Investment Banks
-
7/29/2019 corporate risk and credit risk
65/78
Stock Price Falls of Big 5 Investment Banksin the Financial Panic of 2008/2009
Price
12/31/2006
2008
LowPrice
2009
Low Price
Feb 2010 June 30
2012
Bear Stearns $162.78 $ 4.81 Sold toJPM for
$10
GoldmanSachs
$199.35 $ 78.20 $47.41 $156.70 $95.86
Lehman
Brothers
$ 78.12 $ 0.05 Bankrupt
Merrill Lynch $ 93.10 $ 13.10 Sold toBAC
(For $27?)
MorganStanley
$ 67.20 $ 9.58 $ 6.71 $ 27.15 $14.5965
Stock Price Falls of Commercial Banks
-
7/29/2019 corporate risk and credit risk
66/78
Stock Price Falls of Commercial Banksin the Financial Panic of 2008/2009
12/31/2006
2008 Low 2009 Low Feb 2010 June 302012
Bank ofAmerica
$53.39 $18.52 $ 2.53 $15.94 $8.18
Citigroup $55.70 $11.52 $ 0.97 $ 3.35 ($27.41/10
)= $2.74
JP Morgan $48.30 $31.02 $14.96 $39.88 $35.73
National City $36.56 $ 1.36 Sold toPNC nr 0
Wachovia $56.95 $ 1.84 Sold toWFC nr 0
Wells Fargo $35.56 $20.51 $ 7.80 $27.29 $33.4466
Stock Price Falls of Insurers and Thrifts
-
7/29/2019 corporate risk and credit risk
67/78
Stock Price Falls of Insurers and Thriftsin the Financial Panic of 2008/2009
Price12/31/2006
2008Low Price
2009Low Price
Feb 2010 November2011
Fannie Mae $59.39 $0.43 $0.30 $ 0.96
Freddie
Mac
$67.90 $0.26 $0.25 $ 1.18
WashingtonMutual
$45.49 $0.03 Bankrupt
AIG $71.66 $1.35 $0.33 $ 1.21 ($23.91/20?)= $1.19
Ambac $89.07 $1.16 $0.35 $ 0.69
MBIA $73.06 $3.90 $2.17 $ 4.93 $8.32
67
-
7/29/2019 corporate risk and credit risk
68/78
68
-
7/29/2019 corporate risk and credit risk
69/78
69
Nonlinear Risks in Corporate Bonds In the Financial
-
7/29/2019 corporate risk and credit risk
70/78
Panic of 2008/2009: Betas Increase in Bad Times Junk Bond Return 10 Year Treasury Return vs. S&P 500 Stock
Return:
1989-2006 Data: -0.05 + 0.20 SP500
t=-0.3 t=4.7 RSQ=0.09
2007-2009 Data: 0.16 + 0.74 SP500
t=0.2 t=5.1 RSQ=0.45------------------------------------------------------------------------------------------
Baa Bond Return 10 Year Treasury Return vs. S&P 500 StockReturn:
1989-2006 Data: 0.02 + 0.06 SP500
t=0.3 t=3.4 RSQ=0.05
2007-2009 Data: 0.12 + 0.36 SP500
t=0.2 t=3.7 RSQ=0.31
70
Nonlinear Credit Option Risks in Bank Stocks:
-
7/29/2019 corporate risk and credit risk
71/78
Nonlinear Credit Option Risks in Bank Stocks:2002-2006 Growth Period Betas vs. Betas in the
Financial Panic and Great Recession of 2007-2011
Betas Increase in Bad Times
Bank Stock Return (KBW Bank Stock Index, BKX) regressed onS&P 500 Stock Return, Monthly data:
2002-2006 Data (N=60): 0.42 + 0.88 SP500
t= 2.0 t=15.3 RSQ=0.80
2007-2011 Data (N=57): -1.26 + 1.33 SP500
t=0.2 t=15.3 RSQ=0.81
And Value Lines beta estimates for many troubled banks went to
2.0 to 3.0 in the financial crisis (Citigroup, Wachovia, Bank ofAmerica and the investment banks, insurers and others). 71
-
7/29/2019 corporate risk and credit risk
72/78
72
-
7/29/2019 corporate risk and credit risk
73/78
73
-
7/29/2019 corporate risk and credit risk
74/78
Goldman Sachs
50
100
150
200
250
300
350
5/16/2008
4/18/2008
3/21/2008
2/22/2008
1/25/2008
12/28/2007
11/30/2007
11/2/2007
10/5/2007
9/7/2007
8/10/2007
7/13/2007
6/15/2007
5/18/2007
140
160
180
200
220
240
260
(18) GOLDMAN SACHS GROUP INC Bond Spread (right axis)
Equity Prices
74
-
7/29/2019 corporate risk and credit risk
75/78
Citigroup Corporate Bond Spreads vs. Equity Prices
-50
0
50
100
150
200
250
300
350
400
15 20 25 30 35 40 45 50 55 60
Stock Price
BondSpreadtoUS
t-stat: 19.4
R2: 0.54
75
-
7/29/2019 corporate risk and credit risk
76/78
Bear Stearns
0
100
200
300400
500
600
700
800
9001000
5/16/
2008
4/18/
2008
3/21/
2008
2/22/
2008
1/25/
2008
12/28/
2007
11/30/
2007
11/2/
2007
10/5/
2007
9/7/
2007
8/10/
2007
7/13/
2007
6/15/
2007
5/18/
2007
0
20
40
60
80
100
120
140
160180
(1) BEAR STEARNS CO INC Bond Spread (right axis) Equity Price
76
Black-Scholes-Merton Theory?
-
7/29/2019 corporate risk and credit risk
77/78
Black-Scholes-Merton Theory?Bear Stearns Stock vs. Bond Price
0
20
40
60
80
100
120
140
9/28/2007 '10/31/07 '11/30/08 '12/31/07 '1/31/08 '2/29/08 '3/31/08 '4/30/08
Stock
Price
75
80
85
90
95
100
105
Bond
Price
Stock Bond 5.55 17 Bond 6.4
77
Summary of the Main Results
-
7/29/2019 corporate risk and credit risk
78/78
Summary of the Main Results1. The credit put option in corporate bonds and bank loans is apparent
in their returns. Returns on corporate bonds, bank loans and bankstocks (which contain portfolios of bank loans) have negative convexity,written options, and negative skewness. The Financial Panic of2008/2009 gave a dramatic demonstration of these points.
2. Risks (betas) of corporate bonds, bank loans and bank stocks allincrease in times of economic stress such as recession or whendefault fears are so great that the yield spread on junk bonds is 500basis points over Treasury. Risks are not stable on theseinvestments.
3. Merton, Black and Scholes Nobel Prize winning option insights arevery helpful in understanding the nature of proper pricing of bankloans and corporate bonds. Exact pricing of actual loans andbonds is so complex that precise formulae do not exist for all loans