IDEAS home Printed from https://ideas.repec.org/p/nbr/nberwo/14871.html
   My bibliography  Save this paper

Valuing Toxic Assets: An Analysis of CDO Equity

Author

Listed:
  • 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.

Suggested Citation

  • Francis A. Longstaff & Brett Myers, 2009. "Valuing Toxic Assets: An Analysis of CDO Equity," NBER Working Papers 14871, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:14871
    Note: AP
    as

    Download full text from publisher

    File URL: http://www.nber.org/papers/w14871.pdf
    Download Restriction: no

    References listed on IDEAS

    as
    1. Markus K. Brunnermeier & Lasse Heje Pedersen, 2009. "Market Liquidity and Funding Liquidity," Review of Financial Studies, Society for Financial Studies, vol. 22(6), pages 2201-2238, June.
    2. Gunter Franke & Jan Pieter Krahnen, 2007. "Default Risk Sharing between Banks and Markets: The Contribution of Collateralized Debt Obligations," NBER Chapters,in: The Risks of Financial Institutions, pages 603-634 National Bureau of Economic Research, Inc.
    3. Francis A. Longstaff & Sanjay Mithal & Eric Neis, 2005. "Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market," Journal of Finance, American Finance Association, vol. 60(5), pages 2213-2253, October.
    4. 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.
    5. Giesecke, Kay, 2004. "Correlated default with incomplete information," Journal of Banking & Finance, Elsevier, vol. 28(7), pages 1521-1545, July.
    6. Francis A. Longstaff & Arvind Rajan, 2008. "An Empirical Analysis of the Pricing of Collateralized Debt Obligations," Journal of Finance, American Finance Association, vol. 63(2), pages 529-563, April.
    7. 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.
    8. 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.
    9. Francis A. Longstaff, 2004. "The Flight-to-Liquidity Premium in U.S. Treasury Bond Prices," The Journal of Business, University of Chicago Press, vol. 77(3), pages 511-526, July.
    10. Krahnen, Jan Pieter & Wilde, Christian, 2008. "Risk transfer with CDOs," CFS Working Paper Series 2008/15, Center for Financial Studies (CFS).
    11. Robert A. Jarrow & Fan Yu, 2008. "Counterparty Risk and the Pricing of Defaultable Securities," World Scientific Book Chapters,in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 20, pages 481-515 World Scientific Publishing Co. Pte. Ltd..
    12. Benmelech, Efraim & Dlugosz, Jennifer, 2009. "The alchemy of CDO credit ratings," Journal of Monetary Economics, Elsevier, vol. 56(5), pages 617-634, July.
    13. Duffie, Darrell & Huang, Ming, 1996. " Swap Rates and Credit Quality," Journal of Finance, American Finance Association, vol. 51(3), pages 921-949, July.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Christian Laux & Christian Leuz, 2010. "Did Fair-Value Accounting Contribute to the Financial Crisis?," Journal of Economic Perspectives, American Economic Association, vol. 24(1), pages 93-118, Winter.
    2. Mardi Dungey & Gerald Dwyer & Thomas Flavin, 2013. "Systematic and Liquidity Risk in Subprime-Mortgage Backed Securities," Open Economies Review, Springer, vol. 24(1), pages 5-32, February.

    More about this item

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:14871. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (). General contact details of provider: http://edirc.repec.org/data/nberrus.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.