Lehman Default Research Articles

The real effects of relationship lending✰

This paper studies the real effects of relationship lending on firm activity in Italy following Lehman Brothers’ default shock and Europe's sovereign debt crisis, two different crisis situations where in the latter, bank solvency was at the centre of the economic shock while being more peripheral in the former. We use a large data set that merges the comprehensive Italian Credit and Firm Registers. We find that following Lehman's default, banks offered more favourable continuation lending terms to firms with which they had stronger relationships. Such favourable conditions enabled firms to maintain higher levels of investment and employment. The insulation effects of tighter bank-firm relationships were still present during the European sovereign debt crisis, especially for firms tied to well capitalised banks.

What Can Macro-Active Bond Funds Tell Us About Monetary Policy Changes?

We document significant outperformance by government bond funds on important macro announcement days such as FOMC and GDP. Attributing the macro-day alpha to fund managers' macro-timing skills, we provide evidence that fund managers do actively trade on their predictions of macro news, their ability to time the level factor is positive on both FOMC and GDP announcements and they can time the slope factor on GDP announcements, and their correct macro-day prediction does lead to higher macro-day alpha. Exploring its variation, we find the macro-day alpha to be larger during times of high macro disagreement and macro surprise, and stronger for more active funds with larger idiosyncratic volatility. Revealing their macro activeness, such active funds suffered the largest losses on the FOMC day of September 16, 2008, when, counter to their prediction, the Fed kept the rate unchanged despite the Lehman default. Finally, we find the macro-day outperformance to be persistent – past macro-day outperformers continue to outperform on future macro days.

Neglected Risk in Financial Innovation: Evidence from Structured Product Counterparty Exposure

AbstractWe investigate the compensation of counterparty exposure in the prices of structured products. Our analysis reveals that product issuers did not compensate retail investors for counterparty exposure before the Lehman default. Post‐Lehman, retail prices have no longer neglected this risk. We also measure retail investor attention towards issuer credit risk. For a given level of issuer credit risk, counterparty exposure is compensated more when attention is higher. Furthermore, issuers tend to construct products with larger counterparty exposure. Overall, our results shed light on the conditions under which financial engineering generates neglected risk.

Explaining CDS prices with Merton’s model before and after the Lehman default

We examine whether CDS prices around the Credit Crisis can be explained with Merton’s model. First we invert the model with market prices to reveal skewed volatility smiles over the whole 2005–2012 period. Then we calibrate the model to pre-Crisis data in two novel ways that allow for skewness, one based on equity-index options (MEIV) and the other on the sensitivity of CDS prices to equity volatility (MSKEW). In out-of-sample forecasts both calibrations match the in-Crisis peak of prices, but the second is better at capturing the systematic component of prices thereafter. Average CDS prices remain at twice their pre-Crisis level long after that event; the MSKEW calibration demonstrates that this is due to extra idiosyncratic risks, which are important for some firms but have negligible impact on others.

Investment banking, the certification effect and M&A deals: An event study approach

Several studies have found the existence of a relationship between the role of investment banks appointed as advisors in M&A deals and the yields earned by their clients. Traditionally this relationship is fostered by the ability of the leading investment banks to arrange and structure the best deals – i.e. the Superior Deal Hypothesis – and by the “certification effect”, namely that their presence provides assurance to the capital markets where are traded the companies involved– i.e. the Certification Effect. Our study also investigates the strength and direction of this relationship before and after Lehman Brothers collapse. The analysis, which uses an original composite metric in order to measure the reputation variable, is focused on the transactions that took place between listed companies in two time frames specifically pre and post the Lehman Brothers bankruptcy. The total sample is composed of 229 transactions, divided into 161 and 68 observations, pre and post Lehman respectively. The analysis conducted allows us to separate the Superior Deal Hypothesis from Certification Effect. On evidence, after the Lehman default, the wealth of shareholders involved (both relating to the targets and acquirers) is significantly influenced by the reputation of the investment banks which acted as advisors. Conversely, before the start of the financial turmoil in September 2008, no significant evidence has been found. The analysis conducted suggests that subsequent to the Lehman Brothers collapse, the certification effect has been playing a crucial role in shareholders’ choice.

The Real Effects of Relationship Lending

This paper studies the real consequences of relationship lending on firm activity in Italy following Lehman Brothers' default shock and Europe's sovereign debt crisis. We use a large data set that merges the comprehensive Italian Credit and Firm Registers. We find that following Lehman's default, banks offered more favourable continuation lending terms to firms with which they had stronger relationships. Such favourable conditions enabled firms to maintain higher levels of investment and employment. The insulation effects of tighter bank-firm relationships was still present during the European sovereign debt crisis, especially for firms tied to well capitalised banks.

Collateral and PDE

After Lehman default (credit crisis 2007), practitioners considered the default risk as a major risk. The regulators pushed the industry to use collateral in order to reduce the risk. In this new world, we want to see how this new considerations affect the theory related to the Partial Differential Equation (PDE) pricing methodology. First, we consider a theoretical framework introduced by Piterbarg, then we relax the perfect collateralisation assumption and establish the correct derivation of the hedgingportfolio.We do not intent to offense anyone and recognise fully the work done in the building of the Post Lehman Theory.We establish different PDE forms dependent of the treasury management strategy and also retrieve Kamtchueng results for the Funding Valuation Adjustment. Indeed there are differences between Funding charge coming from the cash flows due and the funding cost strategy resulting of cash and trading desks.

RELATIONSHIP LENDING DURING A FINANCIAL CRISIS

This paper studies whether relationship lending mitigates the transmission of the Lehman default shock to the supply of credit in Italy. Exploiting the presence of multiple banking relationships, we control for banks' and firms' unobserved characteristics. Results show that the growth of credit itself is higher and its cost lower the shorter the distance between the bank and the firm, the longer the relationship, and the higher the share of credit held by the bank. Credit growth by relationship lenders is 4.6% higher than that by transactional lenders; the increase in the cost of credit is 50 basis points lower. The positive effect of relationship lending on credit supply increased during the crisis, compared to a pre-crisis period. The beneficial effect of relationship lending is weaker if the relationship lender is more exposed to the financial crisis, especially when lending to weaker borrowers.

Corporate liquidity and the contingent nature of bank credit lines: Evidence on the costs and consequences of bank default

I study the impact of Lehman Brothers' bankruptcy and resultant inability to honor its obligations as a lender under committed credit lines. Firms that lost access to a credit line committed by Lehman Brothers experienced abnormal stock returns of −3%, on average, on the day of and day after Lehman's bankruptcy filing, amounting to roughly $5.7 billion in aggregate, risk-adjusted losses. These losses were significantly larger for firms that were more financially constrained, firms with less cash, firms for whom Lehman was a lead-bank, and firms that lost access to larger amounts of committed credit. During the four quarters immediately following Lehman's collapse, firms that lost access to a credit line cut their investment spending significantly while simultaneously hoarding more cash than comparable firms. Overall, these findings indicate that firms that lost access to a credit line incurred economically significant costs and real-side consequences as a result of Lehman's default on its loan commitments.

Bailouts and Moral Hazard: How Implicit Government Guarantees Affect Financial Stability

The recent crisis has shown that systemically relevant banks in distress are likely to benefit from governmental support. This reduces their downside risk and leads to moral hazard, i.e. to incentives for these banks to assume excessive risks. In this paper we show empirically that implicit guarantees lead to more leverage and to a lower quality of bank capital; furthermore, we investigate which institutional characteristics are associated with a reduction in moral hazard. Our analysis combines bank balance sheet information from 92 countries with Fitch Support Ratings and World Bank survey data on governance and regulation. We find that a higher likelihood of being bailed out is associated with higher leverage and with lower levels of common equity. We find that external auditing, regulating the range of banks’ activities, and restricted access to Lender-of-Last-Resort facilities reduce moral hazard; financial sophistication, instead, appears to be conducive to risk-taking. We also find the moral hazard effect to be stronger after the Lehman default.

Identifying risks in emerging market sovereign and corporate bond spreads

This paper investigates the systematic risk factors driving emerging market (EM) credit risk by jointly modeling sovereign and corporate credit spreads at a global level. We use a multi-regional Bayesian panel VAR model, with time-varying betas and multivariate stochastic volatility. This model allows us to decompose credit spreads and build indicators of EM risks. A key result is that indices of EM sovereign and corporate credit spreads differ because of their specific reactions to global risks (risk aversion, liquidity and US corporate risk). For example, following Lehman's default, EM sovereign spreads ‘decoupled’ from the US corporate market, whereas EM corporates ‘recoupled.’

Explaining CDS Prices Before and After the Lehman Default with a Simple Structural Model

We examine what determines CDS prices over 2005-2012. To do this, we calibrate Merton’s model in a novel way that allows for deviations from lognormality. The model works well in cross-section and time-series, both within and out-of sample. It conrms that systematic equity volatility is the major determinant of CDS prices. Before the Lehman default, all rms have CDS prices that are close to those set by the model (with small variations due to illiquidity and earnings-uncertainty). After the default,

Pay Attention or Pay Extra: Evidence on the Compensation of Investors for the Implicit Credit Risk of Structured Products

This paper investigates neglected risk in structured products. We compare retail prices of structured products with prices available to institutional investors to replicate the same products. Issuers do not compensate retail investors for counterparty exposure before the Lehman default even when replication prices reflect this risk. After Lehman, retail investors no longer neglect issuer credit risk, and issuers compensate counterparty exposure. Retail investor attention crucially determines the occurrence of neglected risk. Additionally, issuers have a propensity to construct products with larger counterparty exposure. Overall, our results shed light on the conditions under which financial engineering generates neglected risk.

Structure in the Italian overnight loan market

We analyze the Italian interbank loan market from 1999 until 2010. The analysis of net trade flows shows a high imbalance caused by a few large net borrowers in the market. The trading volume shows a significant drop starting in 2007, which accelerates with the Lehman default in late 2008. The interbank loan network is very dense. Hence, we try to identify strong links by looking for preferential lending relationships expressed by discounts in the loan rate. Furthermore, we estimate the dynamics of credit spreads for each bank and find that economically significant spreads for the overnight market developed only in 2010. The analysis of preferential loan relationships reveals that in the pre-Lehman era large net borrowers used to borrow at a slight discount. In the post-Lehman era borrowers with large net exposures paid more than the average market rate, which shows that the risk evaluation of market participants has changed considerably.

Fully Liquidity Adjusted CVA

After Lehman default (credit crisis which started in 2007), practitioners considered the default risk as a major risk. The Industry began to charge for the default risk of any derivatives. In this article we defined a methodology in order to fully adjusted the close out premium used to compute the CVA according to the Liquidity Risk. It is the first time that the CVA is adjusted taking into account the Liquidity Market Risk.We innovate market liquidity risk methodologies, in order to quantify this risk in the future to the close out premium. Therefore the CVA or Exposure will be function of our risk view or apetite.

Central Bank Liquidity Provision, Risk-Taking and Economic Efficiency

After the Lehman default, but also during the euro area sovereign debt crisis, central banks have tended to extend the ability of banks to take recourse to central bank credit operations through changes of the collateral framework (e.g. CGFS, 2008 – in consistence with previous narratives, such as Bagehot, 1873). We provide a simple four sector model of the economy in which we illustrate the relevant trade-offs, derive optimal central bank collateral policies, and show why in a financial crisis, in which liquidity shocks become more erratic and the total costs of defaults increase, central banks may want to allow for greater potential recourse of banks to central bank credit. The model also illustrates that the credit riskiness of counter parties and issuers is endogenous to the central bank's credit policies and related risk control framework. Finally, the model allows identifying the circumstances under which the counter intuitive case arises in which a relaxation of the central bank collateral policy may reduce its expected losses.

Financial Contagion During Lehman Default and Sovereign Debt Crisis: An Empirical Analysis on Euro Area Bond and Equity Markets

The recent Euro area crisis, which has originally been driven mainly by macroeconomic factors, has had a strong impact also on financial markets leading internationally to what is referred as contagion, that is co-movements among asset prices which have been excessive respect to fundamentals. The term “contagion,” generally used in contrast to “interdependence,” conveys the idea that during financial crisis there might be breaks or anomalies in the international transmission mechanism, arguably reflecting switches across multiple equilibria, market panics unrelated to fundamentals, investors’ herding and the like. Although there is still wide disagreement among economists about what contagion is exactly and how it should be tested empirically, a common approach consists of identifying breaks in the international transmission of shocks indirectly, inferring them from a significant rise in the correlation of asset returns across markets and countries. Our study extends on this conventional measures of contagion by directly investigating changes in the existence and the directions of causality among a sample of Euro area countries during the recent Lehman default and sovereign debt crisis. To test for contagion, we apply a three steps Granger causality/VECM methodology on sovereign bond spreads and stock returns as measures of perceived country risk. Results highlight the fact that the causality patterns have changed during the “crisis” periods compared to the pre-crisis “tranquil” periods, thus pointing out the occurrence of contagion phenomenon among Euro area countries during the last two international financial crises.

FVA, Modelling and Netting Arbitrage - Introduction

After Lehman default and the Euro Crisis (crisis which started mid-2007), the industry started to consider the funding risk as a major risk. The practitioners began to charge for their funding cost. In this stressed context, the FVA has been the subject of intense debate, even its definition is not well established. In this article we follow the footsteps of Kamtchueng by establishing netting arbitrage in the FVA framework relative to our hedging strategy. It is the first time that the FVA is related to another funding spread.

The CVA, Premium or Charge? CVA Call Hedging

After Lehman default (credit crisis 2007), Market participants started to consider the default risk as a major one. It became vital to charge the default risk at the trading level. The CVA became rapidly a standard when two institutions want to trade derivatives. The main task of this paper is to determine efficient hedging strategy of the CVA call. Indeed the litterature becomes to be hudge concerning this term without a clear definition. Is it a risk value or an actual premium? �The opinions of this article are those of the author and do not reflect in any way the views or business of his employer.

Fire Sales Forensics: Measuring Endogenous Risk

We propose a tractable framework for quantifying the impact of fire sales on the volatility and correlations of asset returns in a multi-asset setting. Our results enable to quantify the impact of fire sales on the covariance structure of asset returns and provide a quantitative explanation for spikes in volatility and correlations observed during liquidation of large portfolios. These results allow to estimate the impact and magnitude of fire sales from observation of market prices: we give conditions for the identifiability of model parameters from time series of asset prices, propose an estimator for the magnitude of fire sales in each asset class and study the consistency and large sample properties of the estimator. We illustrate our estimation methodology with two empirical examples: the hedge fund losses of August 2007 and the Great Deleveraging following the Lehman default.