Perceived guarantees, investor protection and bailout

Abstract

PurposeThis paper investigates the link between equity and credit markets for the government‐sponsored mortgage institutions, Fannie Mae and Freddie Mac, during the period from January 2007 until December 2008. Before the financial crisis, investors perceived these real estate finance institutions as quasi state guaranteed.Design/methodology/approachBy examining Fannie Mae and Freddie Mac during 2007 and 2008, this study extends existing research on the link between equity and credit markets. The authors employ univariate time series regression and vector autoregressive models to analyze the comovements over time and the lead‐lag relationship for equity returns, CDS spread changes, and bond spread changes.FindingsThe results provide evidence for equity returns and credit spreads of CDS and bonds being inversely related and adjusting simultaneously. The relationship between equity and credit markets intensifies during periods of heightened risks. The link between equity returns and bond spread changes is more robust in an environment of slightly elevated risk, while the relationship between equity and CDS markets intensifies during times of extreme stress. It was also found that the link between equity and credit markets completely breaks down as government intervention in the form of regulatory changes and ultimately, conservatorship, materializes.Practical implicationsInvestors active in equity and credit markets need to be aware of the relevance of the prevailing capital market regime and the role of external effects such as government support and bailout.Originality/valueThere is a growing body of empirical research employing event studies and regression analyses on the firm level to examine the link between equity and credit default swaps. Yet, to the authors' knowledge this relationship has not been explored specifically for quasi guaranteed institutions. However, given the growing number of at least partly state owned real estate finance institutions, this specific focus is important to understand future expected risk compensation of equity and credit investors. The paper ask what lessons are to be learnt from the current financial crisis about investor protection in quasi guaranteed financial institutions.