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by Zoe Tsesmelidakis, University of Oxford, U.K. & Robert C Merton, MIT Sloan
Overview
Paper estimates the government subsidy that accrued to financial firms during the financial crisis
$365bn TBTF implicit insurance benefit transfer to financial firms Evidence banks shifted funding toward short-term instruments to benefit from low policy rates and special facilities
Implementation of a Black and Cox (1976) model with stochastic default boundary
Lognormal boundarymean of process is calibrated endogenously Asset volatility is derived from option implied volatility and default boundary volatility
Calibrate the model on all financials with active CDS prior to the crisis
January 2002-August 2007 pre crisis
Model under-predicts actual spreads by 7 bps on average during this period
Maybe add a chart w/ actual CDS spreads, VIX and the wedge over the crisis period to help reader understand possible dynamics So PD would not seem to be reduced by guarantee until maybe late October 2008, when TARP finally passed And implied volatility is extremely high throughout fall 2008 into 2009 ---so, to get the model to fit the data, the default barrier would have to be lower? ---perhaps a different default boundary volatility parameter? But WAMU holding company bondholders lost bigvirtually everything
September 2008--Lehman failed. So did WAMU. And effectively so did Wachovia and Merrill Lynch
My recollection is that, during the crisis period, many studies show model-indicated arbitrages that investors did not exploit and close Maybe absence of arbitrage pricing did not hold during the crisis?
If so, the CDS models underlying assumptions would not be valid during this period and the model specification for the spread would not fit the data.
So, how can we be sure the difference between actual and projected yields reflect a conjectural government guarantee?
Bond subsidy value-guaranteed bonds sell for more because the required yield is lower with the guarantee.
Change in PV assume bonds issued have the higher required yield consistent with CDS model estimate (less counterparty risk adjustment)
Use bond issuance data and re-price each issue using pre-crisis CDS model-based yield estimates
These subsidies accrue to the owners of the bondsnot to the issuing corporation
Estimated to be 236 billion
Commentary
Maybe model approach does not work in the crisis because there are arbitrages all over the place
because of illiquidity, investors cannot take advantage of price discrepancies and eliminate them If so, evidence that model does not fit during crisis may not be direct evidence that the unexplained residual reflects a government guarantee
Commentary -2 Why would real estate firms get any guarantee benefit?
Didnt home builders got some type of special bailout from congressmaybe talk about this to motivate.
Epilogue
It turns out the authors have re-fit the model for the crisis period and will probably include results in updated paper drafts
The average default boundary estimate over this period is close to zero--much lower than the pre-crisis estimate
These additional results help make the case that the wedge is related to an implicit insurance guarantee