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Why Are Yield Spreads on Bank- Issued Subordinated Notes and Debentures Not Sensitive to Bank Risks? Bhanu Balasubramnian Emporia State University Ken.

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Presentation on theme: "Why Are Yield Spreads on Bank- Issued Subordinated Notes and Debentures Not Sensitive to Bank Risks? Bhanu Balasubramnian Emporia State University Ken."— Presentation transcript:

1 Why Are Yield Spreads on Bank- Issued Subordinated Notes and Debentures Not Sensitive to Bank Risks? Bhanu Balasubramnian Emporia State University Ken Cyree The University of Mississippi

2 Debt Market Signals Yield Spread = f (Term-structure, Default risk, Maturity Risk, Taxes, Liquidity Risk, Systematic Risk, Unknown factors) Yield Spread on Bonds = YTM of a risky bond - YTM of a risk-free bond of similar characteristics When leverage (or any other risk measure) decreases, default risk decreases. In turn, yield spread should decrease and vice versa Change in yield spreads acts as signal for market perception of change in firm risk or default risk

3 Debt Market Signals – Empirical Evidence SND spreads are less risk sensitive during the 1993-97 period and market discipline is weak - Board of Governors (1999) Changes in yield spreads are not related to changes in firm-specific risk of banks during 1994-99 - Krishnan, Ritchken, and Thomson (2005) Default risk component is large in money-market securities– Covitz and Downing (2007) Are the long-term debt markets sensitive to all non-credit risks but not sensitive to credit risks?

4 Research Questions Is lack of default risk sensitivity due to omitted credit risk factors? –Omitted factors of credit risk –Trust-Preferred Securities (TPS) –Too Big To Fail (TBTF) effect after LTCM crisis –Idiosyncratic Volatility –Omitted factors in decomposition of yield spreads –Tax effects – Elton, Gruber, Agrawal, and Mann (2001) Whether or not TPS yield spreads can be used for market monitoring?

5 Data Sources National Association of Insurance Commissioners (NAIC) database for bond transactions for the years 1994 – 1999 SDC Platinum database - bond issue characteristics FR Y-9C reports for banks CRSP for stock market data H-15 Reports from St. Louis Fed for daily Treasury rates

6 Sample Selection Select fixed-rate, U.S. dollar, plain-vanilla bonds with investment grade credit ratings No put or call options, collateral, sinking fund Should not be convertible, Yankee, global, serial, LBO Only bank-issued SND transactions With at least two years of remaining maturity At least 10 transactions per SND issue 6620 buys and 4072 sell transactions 300 SND issues by 71 BHCs

7 Decomposition of Yield Spreads YS (i, t) = α + β (F, k) F (i, t-1) + β (M, k) M( t) + β (L, k) L( t) + β (X, k) X (i, t) + ε (i, t) (1) YS (i, t) = Yield spread of bond i at time t F (i, t-1) = Vector of firm-level default risk variables M (t) = Vector of market variables L (t) = Vector of liquidity variables X (i, t) = Vector of other control variables Non-linear GMM estimation with Newey -West (1987) correction for autocorrelation and heteroskedasticity with five lags

8 Table 4: Firm Specific Variables reflect default risks except ROA VariableEstimatep-value Loans / Total assets (LTA) %0.45510.0001 Non-performing loans / Total loans (NPA) %7.2025<.0001 Net charge-off / Loans (CHGOFF) %-9.20370.2752 Commercial loans / Total loans (CNI) %0.29730.0038 Off-bal. sheet items / Total assets (OFFBAL) %0.02000.0010 Log (Total Assets) (LNTA) %-0.1130<.0001 Total Assets / Total Equity (LEVERAGE) %0.18830.0179 Return on Assets (ROA) %7.60950.0198 Market value / Book value (MB) %-0.0853<.0001 Std. Dev. of stock returns (VOLATILITY) %0.88860.0116

9 Results – Full Sample Yield Spread Levels are sensitive to firm- specific default risk variables Tax Effects are significant Idiosyncratic volatility measure (σ) captures default risks better than Market volatility measure (VIX) Discount for size – TBTF discount Exception - ROA is positively related to yield spreads

10 LTCM Crisis and TBTF Effect January 1994 - June 1998 -Pre-LTCM bailout period July 1998 – December 1999- Post-LTCM period Important dates – July 20, 1998, Aug 17, 1998, September 02, 1998, September 24, 1998 Major Crises - Mexican (Dec 94), Asian (June 97), Russian and LTCM (Aug 98), Brazilian (Nov 98)

11 Paradigm Shift in Firm-specific Default Risk Proxies and TBTF Effect Table 5: Panel C: Firm Specific Variables Variable Pre-LTCM CrisisPost-LTCM Crisis Estimatep-valueEstimatep-value Loans / Total assets (LTA)31.79020.007625.56310.3441 Non-per. loans / Total loans (NPA)475.48820.00071759.25300.0215 Net charge-off / Loans (CHGOFF)123.53400.89242764.05800.1512 Commercial loans / Total loans (CNI)15.94580.134632.48290.1587 Off-bal. items / Total assets (OFFBAL)0.99690.15962.55810.0072 Log (Total Assets) (LNTA)-11.3074<.0001-23.2922<.0001 Assets / Equity (LEVERAGE)20.59500.01188.04600.6849 Return on Assets (ROA)277.37420.44061938.24100.0193 Market value / Book value (MB)-6.56260.0004-8.72710.0033 Std. Dev. of returns (VOLATILITY)94.82260.0570-60.85980.2945

12 Default Risk Reduction Due to TPS SND issued by all banks as at the end of 1998 $102.8 billion, of which, $100 billion was issued by the top 50 banks TPS is the least expensive source of external Tier 1 capital Over 800 banks have issued TPS for a total of $85 billion between 1996 and 2004; $28 billion between 1996 and 1999 by the top 50 banks

13 Leverage is not a significant determinant of yield spread even prior to LTCM bailout but after TPS issuance Variable Pre-TPSPost-TPS pre-LTCMPost-TPS post-LTCM Estimatep-valueEstimatep-valueEstimatep-value LTA52.10580.000564.76710.046713.73110.6362 NPA452.85390.0019262.92850.65402270.56700.0234 CHGOFF)-714.72700.5415-1001.81000.63882617.75700.2406 CNI2.02940.886744.95150.116940.38630.1372 OFFBAL1.38920.1068-0.35510.83222.37340.0153 LNTA-14.8392<.0001-12.41380.0357-28.3796<.0001 LEVERAGE35.72670.000827.30640.1117-3.11010.8850 ROA1082.27800.0178548.63160.54272215.36600.0125 MB-18.4576<.0001-5.86140.0717-8.17160.0118 VOLATILITY-8.20150.9096193.78060.0062-28.98540.6205

14 TPS Spreads are sensitive to on-balance sheet default risk proxies VariableEstimatep-value Intercept415.370.0648 Net charge-off / Loans (CHGOFF)10405.000.0646 Off-balance sheet items / Total assets (OFFBAL)-2.080.4007 Log (Total Assets) (LNTA)-5.020.5397 Total Assets / Total Equity (LEVERAGE)91.220.0128 Return on Assets (ROA)-4087.450.0521 No. of observations58 Adj. R-Sq.0.5238 F-Statistics5.18<.0001

15 Changes in Determinants of Yield Spreads To trace the changes in determinants of yield spreads – Analyze four sub-periods around LTCM crisis August 97 – February 98 - tranquil period March 98 – June 98, the period when bond market volatility increased July 98 – September 98, the period when bond markets became extremely volatile October 98 - December 99, the post-LTCM bailout period

16 Leverage is irrelevant; ROA is a risk proxy; Markets recognize off-balance sheet risks; TBTF Discount increases Variable Aug97-Feb98Mar98-June98July98-Sep98Oct98-Dec99 Estimatep-valueEstimatep-valueEstimatep-valueEstimatep-value LTA0.290.39831.320.11970.040.95400.350.2217 NPA-5.030.650529.840.0190-9.230.527921.990.0081 CHGOFF57.530.691542.450.567624.010.674354.060.0062 OFFBAL0.000.99750.010.56530.040.19160.020.0407 LNTA-0.070.4162-0.150.2262-0.280.0695-0.25<.0001 LEVERAGE0.240.2974-0.200.6847-0.710.07860.340.1263 ROA6.740.5700-15.230.0085-81.110.058817.800.0295 MB-0.100.01930.060.40680.120.1480-0.090.0090 VOLATILITY1.670.08021.950.03780.740.6524-0.320.5930

17

18 WSJ 04/17/2008–Ahead of the Tape

19 Results Yield spread levels on SND are sensitive to conventional risk measures prior to TPS issuance by banks Risk sensitivity of conventional risk measures decrease after the introduction of TPS No TBTF effect before the LTCM bailout but size discount doubles after the LTCM bailout Idiosyncratic volatility is a better proxy for firm-specific risks Omitting the tax effects in yield spreads leads to measurement errors Yield spreads on TPS provide market signals

20 Results Bond markets are sensitive to default risks, but paradigm changes in the determinants of yield spreads after LTCM bailout Default risk proxies vary with time and available information –Leverage is not a proxy –ROA is a proxy for changes in risk-taking –Off-balance sheet items is a proxy

21 Policy Implications Implicit guarantees and market discipline Can TPS provide better market signals? – Needs further investigation after TARP Disclosure Levels of off-balance sheet items Can TPS and SND be capital securities without risk of capital loss? Risk-weighting of earnings for CAMELS

22 Thank You Questions? Suggestions?

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