Market Institutions and Financial Market Risk

June 17-18, 2010
Mark Carey of the Federal Reserve Board, and NBER Research Associates Anil K Kashyap and Raghuram Rajan, University of Chicago, and Rene Stulz, Ohio State University, Organizers

Alberto Manconi and Massimo Massa, INSEAD, and Ayako Yasuda, University of California, Davis
The Behavior of Intoxicated Investors: The Role of Institutional Investors in Propagating the Financial Crisis of 2007-2008

Using a novel dataset of institutional investors' bond holdings, Manconi, Massa, and Yasuda examine the transmission of the crisis of 2007-2008 from the securitized bond market to the corporate bond market via joint ownership of these bonds by investors. They posit that, corporate bonds held by investors with high exposure to securitized bonds and liquidity needs will experience greater selling pressure and price declines (yield increases) at the onset of the crisis. They further test predictions of a model of dynamic asset liquidation: investors with large enough future liquidity shocks will hold on to liquid assets, and instead sell assets that have relatively high temporary price impacts on trading. Mutual funds with higher sensitivity of pay-to-performance held higher portions of their portfolios in securitized bonds prior to the crisis. Post-crisis, these funds did not sell securitized bonds on average; instead they sold corporate bonds to meet their liquidity needs. Shorter-horizon mutual funds liquidated greater portions of their corporate bond holdings, especially lower-rated bonds. Furthermore, corporate bond yield spreads widened more for those bonds whose mutual fund holders' portfolios were more heavily exposed to securitized bonds, especially lower-rated bonds. Selling pressure on corporate bonds came primarily from mutual fund investors with high exposure; in contrast, insurance companies sold little, regardless of their exposure, as long as they were above the minimum capital ratio threshold. These findings suggest that performance-sensitive and short-horizon mutual funds played a role in transmitting the crisis from securitized bonds to corporate bonds.

Gary B. Gorton and Andrew Metrick, Yale University and NBER
Securitized Banking and the Run on Repo (NBER Working Paper No. 15223)

The Panic of 2007-2008 was a run on the sale and repurchase market (the "repo" market), which is a very large, short-term market that provides financing for a wide range of securitization activities and financial institutions. Repo transactions are collateralized, frequently with securitized bonds. Gorton and Metrick refer to the combination of securitization plus repo finance as "securitized banking,"and argue that these activities were at the nexus of the crisis. They use a novel dataset that includes credit spreads for hundreds of securitized bonds to trace the path of crisis from subprime-housing related assets into markets that had no connection to housing. They find that changes in the "LIB-OIS" spread, a proxy for counterparty risk, was strongly correlated with changes in credit spreads and repo rates for securitized bonds. These changes implied higher uncertainty about bank solvency and lower values for repo collateral. Concerns about the liquidity of markets for the bonds used as collateral led to increases in repo "haircuts": the amount of collateral required for any given transaction. With declining asset values and increasing haircuts, the U.S. banking system was effectively insolvent for the first time since the Great Depression.

Monica Billio and Loriana Pelizzon, University of Venice; Mila Getmansky, University of Massachusetts, Amherst; and Andrew W. Lo, MIT and NBER
Measuring Systemic Risk in the Finance and Insurance Sectors

A significant contributing factor to the financial crisis of 2007-2009 was the apparent interconnectedness among hedge funds, banks, brokers, and insurance companies, which amplified shocks into systemic events. Billio, Getmansky, Lo, and Pelizzon propose five measures of systemic risk based on statistical relations among the market returns of these four types of financial institutions: correlations, cross-autocorrelations, principal components analysis, regime-switching models, and Granger-causality tests. They find that all four sectors have become highly interrelated and less liquid over the past decade, increasing the level of systemic risk in the finance and insurance industries. These measures can also identify and quantify financial crisis periods, and seem to contain predictive power for the current financial crisis. The results suggest that while hedge funds can provide early indications of market dislocation, their contributions to systemic risk may not be as significant as those of banks, insurance companies, and brokers who take on risks more appropriate for hedge funds.

Franklin Allen, University of Pennsylvania; Ana Babus, University of Cambridge; and Elena Carletti, European University Institute
Financial Connections and Systemic Risk

Overlapping portfolio exposures among financial institutions is an important source of systemic risk. Allen, Babus, and Carletti develop a model where institutions form connections through swaps of projects in order to diversify their individual risk. These connections lead to two different network structures. In a clustered network, groups of financial institutions within a cluster will hold identical portfolios. Defaults occur together, but the number of states where this happens is small. In an unclustered network, defaults are more dispersed, but they occur in more states. With long-term finance, there is no difference between the two structures in terms of total defaults and welfare. In contrast, with short-term finance, the network structure matters. Upon the arrival of a signal about banks' future defaults, investors update their expectations of the ability of financial institutions to repay them. If their updated expectations are low, then they do not to roll over the debt and there is systemic risk in that all institutions are liquidated early.

Nicola Gennaioli, CREI; Andrei Shleifer, Harvard University and NBER; and Robert W. Vishny, University of Chicago and NBER
Financial Innovation and Financial Fragility (NBER Working Paper No. 16068)

Gennaioli, Shleifer, and Vishny present a standard model of financial innovation, in which intermediaries engineer securities with cash flows that investors seek, but they modify two assumptions. First, investors (and possibly intermediaries) neglect certain unlikely risks. Second, investors demand securities with safe cash flows. Financial intermediaries cater to these preferences and beliefs by engineering securities perceived to be safe but exposed to neglected risks. Because the risks are neglected, security issuance is excessive. As investors eventually recognize these risks, they fly back to the safety of traditional securities and markets become fragile, even without leverage, precisely because the volume of new claims is excessive. Financial innovation can make both investors and intermediaries worse off. The model mimics several facts from recent historical experiences and points to new avenues for financial reform.

Mark Mitchell and Todd Pulvino, CNH Partners
Arbitrage Crashes and the Speed of Capital

The imminent failure of large Wall Street prime brokerage firms during the 2008 financial crisis caused a sudden and dramatic decrease in the amount of financial leverage afforded hedge funds. This decrease in financing resulted from the ex post asymmetrical payoff to rehypothecation lenders - the ultimate providers of financing, through prime brokers, to hedge funds. A primary consequence of this withdrawal of financing was the inability of hedge funds involved in relative-value trades to maintain prices of substantially similar assets at substantially similar prices. According to Mitchell and Pulvino, the magnitudes of these mispricings, and the time required to correct them, provide an indication of the role played by arbitrageurs in maintaining rational prices during normal times.

Andrew Ellul and Vijay Yerramilli, Indiana University
Stronger Risk Controls, Lower Risk: Evidence from U.S. Bank Holding Companies

Ellul and Yerramilli investigate whether U.S. bank holding companies (BHCs) with strong and independent risk management functions had lower enterprise-wide risk. They hand-collect information on the organizational structure of the risk management function at the 74 largest publicly-listed BHCs, and use this information to construct a Risk Management Index (RMI) that measures the strength of organizational risk controls at these institutions. They find that BHCs with a high RMI in the year 2006 (that is, before the onset of the financial crisis) had lower exposure to private-label mortgage-backed securities, were less active in trading off-balance sheet derivatives, had a smaller fraction of non-performing loans, and had lower downside risk during the crisis years (2007 and 2008). In a panel spanning the 9 year period 2000-2008, the authors find that BHCs with higher RMIs had lower enterprise-wide risk, after controlling for size, profitability, a variety of risk characteristics, corporate governance, executive compensation, and BHC fixed effects. This result holds even after controlling for any dynamic endogeneity between risk and RMI. Overall, these results suggest that strong internal risk controls are effective in restraining risk-taking behavior at banking institutions.

Kalina Manova, Stanford University and NBER, and Davin Chor, Harvard University
Off the Cliff and Back: Credit Conditions and International Trade during the Global Financial Crisis

Manova and Chor study the collapse of international trade flows during the global financial crisis, using detailed data on monthly U.S. imports during this period. They show that adverse credit conditions were an important channel through which the crisis affected trade volumes. They identify the effects of credit tightening by exploiting the variation in the cost of capital across countries and over time, as well as the variation in financial dependence across sectors. They find that countries with higher interbank rates and thus tighter credit markets export less to the United States. These effects are especially pronounced in sectors that require extensive external financing, have few collateralizable assets, and can access limited trade credit. Exports of financially vulnerable industries are thus more sensitive to the cost of external capital than exports of less dependent industries, and this sensitivity rose during the financial crisis. Our estimates imply that the crisis would have reduced trade flows by 26 percent more if governments had not acted to lower lending rates, and by 30 percent less if policy interventions had had a more immediate effect on the cost of capital. These results provide new evidence on the effect of credit conditions on trade, while highlighting the large real effects of financial crises and the potential gains from policy intervention.

Edie Hotchkiss, Boston College; David C. Smith, University of Virginia; and Per Stromberg, Stockholm School of Economics and NBER
Private Equity and the Resolution of Financial Distress

In order to understand the role of private equity firms in the restructuring of financially distressed firms, Hotchkiss, Smith, and Stromberg examine the private equity ownership of 2,160 firms which obtained leveraged loan financing between 1997 and 2010. The economic downturn beginning in 2007 is associated with a marked increase in defaults of these highly leveraged companies; approximately 50 percent of defaults involve PE-backed companies. Defaulting firms that are private-equity backed spend less time in financial distress and are more likely to survive as an independent reorganized company versus being sold to a strategic buyer or liquidated. Recovery rates to junior creditors, however, are lower for PE-backed firms.

Ing-Haw Cheng, University of Michigan; and Harrison Hong and Jose A. Scheinkman, Princeton University and NBER
Yesterday's Heroes: Compensation and Creative Risk-Taking

Cheng, Hong, and Scheinkman investigate the link between compensation and risk-taking among finance firms during 1992-2008. First, there are substantial cross-firm differences in residual pay (defined as total executive compensation controlling for firm size). Second, residual pay is correlated with price based risk-taking measures, including firm beta, return volatility, the sensitivity of firm stock price to the ABX subprime index, and tail cumulative return performance. Third, these risk-taking measures are correlated with pay, even though executives are highly incentivized as measured by insider ownership. Finally, compensation and risk-taking are not related to governance variables, but they do co-vary with ownership by institutional investors who tend to have short-termist preferences and the power to influence firm management policies. These findings suggest that the residual pay measure here is picking up other important high-powered incentives not captured by insider ownership. They also point to substantial heterogeneity in both firm culture and investor preferences for short-termism and risk-taking.

Richard Stanton and Nancy Wallace, University of California, Berkeley
CMBS Subordination, Ratings Inflation, and the Crisis of 2007-2009

Stanton and Wallace analyze the performance of the commercial mortgage-backed security (CMBS) market before and during the recent financial crisis. Using a comprehensive sample of CMBS deals from 1996 to 2008, they show that (unlike the residential mortgage market) the loans underlying CMBS did not significantly change their characteristics during this period, commercial lenders did not change the way they priced a given loan, defaults remained in line with their levels during the entire 1970s and 1980s and overall, the CMBS and CMBX markets performed as normal during the financial crisis (at least by the standards of other recent market downturns). They further show that the recent collapse of the CMBS market was caused primarily by the rating agencies allowing subordination levels to fall to levels that provided insufficient protection to supposedly "safe" tranches.

Antje Berndt and Burton Hollifield, Carnegie Mellon University; and Patrik Sandas, University of Virginia
The Role of Mortgage Brokers in the Subprime Crisis

Berndt, Hollifield, and Sandas study the role of mortgage brokers in the subprime crisis using a detailed sample of loans funded by, formerly, one of the largest subprime lenders, New Century Financial Corporation. Prior to the subprime crisis, mortgage brokers originated about 65 percent of all subprime mortgages and yet little is known about their behavior and contribution to the subprime crisis. In 2005, brokers in the sample here earned an average of $5,600 or 2.8 percent on each originated loan, with $3,900 or 2.0 percent coming from direct fees, and $1,700 or 0.8 percent from indirect fees paid by New Century. The fees earned are different for different types of loans and vary with borrower, property, and neighborhood characteristics. The authors decompose the broker revenues into a cost and profit component and find evidence consistent with brokers having market power. They relate the broker profits to the subsequent performance of the loans and show that higher broker profits are associated with worse loan performance suggesting that brokers earned high profits on loans that turned out to be riskier ex post.

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