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Valuing Toxic Assets: An Analysis of CDO Equity

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  • Francis A. Longstaff
  • Brett Myers

Abstract

How does the market value complex structured-credit securities? This issue is central to understanding the current financial crisis and identifying effective policy measures. We study this issue from a novel perspective by contrasting the valuation of CDO equity with that of bank stocks. This is possible because both CDO equity and bank stock represent levered first-loss residual claims on an underlying portfolio of debt. There are strong similarities in the two types of equity investments. Using an extensive data set of CDX index tranche prices, we find that the discount rates applied by the market to bank and CDO equity are very comparable. In addition, a single factor explains more than 64 percent of the variation in bank and CDO equity returns. Although banks are presumably active credit-portfolio managers, we find that bank alphas are significantly negative during the sample period and comparable in magnitude to those of more-passively-managed CDO equity. Both banks and CDO equity display significant sensitivity to "shadow banking" factors such as counterparty credit risk, the availability of collateralized financing for debt securities, and the liquidity of the derivatives market. A key implication is that we may be able to value "toxic" assets using readily-available stock market information.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14871.

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Date of creation: Apr 2009
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Handle: RePEc:nbr:nberwo:14871

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  1. Jan Pieter Krahnen & Christian Wilde, 2008. "Risk Transfer with CDOs," Working Paper Series: Finance and Accounting 187, Department of Finance, Goethe University Frankfurt am Main.
  2. Guenter Franke & Jan Pieter Krahnen, 2005. "Default Risk Sharing Between Banks and Markets: The Contribution of Collateralized Debt Obligations," NBER Working Papers 11741, National Bureau of Economic Research, Inc.
  3. Efraim Benmelech & Jennifer Dlugosz, 2009. "The Alchemy of CDO Credit Ratings," NBER Working Papers 14878, National Bureau of Economic Research, Inc.
  4. Francis A. Longstaff, 2002. "The Flight-to-Liquidity Premium in U.S. Treasury Bond Prices," NBER Working Papers 9312, National Bureau of Economic Research, Inc.
  5. Francis A. Longstaff & Arvind Rajan, 2006. "An Empirical Analysis of the Pricing of Collateralized Debt Obligations," NBER Working Papers 12210, National Bureau of Economic Research, Inc.
  6. Duffie, Darrell & Huang, Ming, 1996. " Swap Rates and Credit Quality," Journal of Finance, American Finance Association, vol. 51(3), pages 921-49, July.
  7. Peter M. DeMarzo, 2005. "The Pooling and Tranching of Securities: A Model of Informed Intermediation," Review of Financial Studies, Society for Financial Studies, vol. 18(1), pages 1-35.
  8. Robert A. Jarrow, 2001. "Counterparty Risk and the Pricing of Defaultable Securities," Journal of Finance, American Finance Association, vol. 56(5), pages 1765-1799, October.
  9. Markus K. Brunnermeier & Lasse Heje Pedersen, 2007. "Market Liquidity and Funding Liquidity," NBER Working Papers 12939, National Bureau of Economic Research, Inc.
  10. Giesecke, Kay, 2004. "Correlated default with incomplete information," Journal of Banking & Finance, Elsevier, vol. 28(7), pages 1521-1545, July.
  11. Cooper, Ian A & Mello, Antonio S, 1991. " The Default Risk of Swaps," Journal of Finance, American Finance Association, vol. 46(2), pages 597-620, June.
  12. Joshua Coval & Jakub Jurek & Erik Stafford, 2009. "The Economics of Structured Finance," Journal of Economic Perspectives, American Economic Association, vol. 23(1), pages 3-25, Winter.
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Cited by:
  1. Mardi Dungey & Gerald P. Dwyer & Thomas Flavin, 2011. "Systematic and liquidity risk in subprime-mortgage backed securities," Working Paper 2011-15, Federal Reserve Bank of Atlanta.
  2. Christian Laux & Christian Leuz, 2009. "Did Fair-Value Accounting Contribute to the Financial Crisis?," NBER Working Papers 15515, National Bureau of Economic Research, Inc.

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