Credit risk and asymmetric information: A simplified approach

We present a simple model for risky, corporate debt. Debtholders and equityholders have incomplete information about the financial state of the debt issuing company. Information is incomplete because it is delayed for all agents, and it is asymmetrically distributed between debtholders and equityholders. We solve for the equityholders' optimal default policy and for the credit spreads required by debtholders. Delayed information accelerates the equityholders' optimal decision to default. Interestingly, this effect is small, implying only a small impact on credit spreads. Asymmetric information, however, has a major impact on credit spreads. Our model predicts high credit spreads for short-term debt, as observed empirically in credit markets.     

Forecasting and explaining aggregate consumer credit delinquency behaviour

We model aggregate delinquency behaviour for consumer credit (including credit card loans and other consumer loans) and for residential real estate loans using data up until 2008. We test for cointegrating relationships and then estimate short run error correction models. We find evidence to support the portfolio explanations of declines in credit quality for consumer and for real estate loans, but support for the reduced stigma explanation was restricted to real estate loans. Evidence supportive of household-level explanations of irrational borrowing and unexpected net income shocks was found for consumer and real estate loans, but evidence of strategic default was restricted to the volume of consumer loans and real estate loans, and not for credit cards. We also found that the error correction model gave forecasts of the volume of delinquent consumer debt which were of an accuracy comparable to that of an ARIMA model.     

Information transmission between sovereign debt CDS and other financial factors ⿿ The case of Latin America

This paper extends previous research by investigating the intertemporal causality relationships between daily Latin America sovereign credit default swap (CDS) returns and other financial sovereign debt spread determinants. The empirical results indicate that information in sovereign CDS can both lead and lag these financial determinants. Specifically, country financial variables, including exchange rates and lending spreads, and global financial variables including 10-U.S. Treasury yields, VIX and TED spreads, are important determinants for future sovereign CDS price movements. The findings provide investment implications for international financial markets.     

Stability in consumer credit scores: Level and direction of FICO score drift as a precursor to mortgage default and prepayment

This article represents an extension of the expansive credit risk and credit migration literature, prominent in the corporate bond and securities risk pricing literature, to an analysis of the drift of consumer credit scores. A rich data set of residential mortgages is used to observe credit score migration post loan origination and in a test of the ability of credit score transition to serve as a precursor to potential default and prepayment. The results indicate credit scores provide signals and information to investors and servicing agents in a fashion similar to credit ratings on commercial paper as to default potential.     

Macroeconomic factors, consumer behavior, and bankcard default rates

Over the period from 1981 through 1999, we investigate the relationship between bankcard delinquencies and key macroeconomic variables. Changes in the proportion of accounts in default are statistically related to the consumer debt ratio. When the delinquency rate is calculated based on the number of dollars outstanding, it is related to the total amount of revolving debt. We also find evidence consistent with a pattern of selective default behavior, in which consumers will default on bankcard debt before defaulting on other types of installment loans.     

Learning and the dynamics of consumer unsecured debt and bankruptcies

During the Great Moderation, the consumer unsecured debt-to-income ratio nearly doubled and the personal bankruptcy filing rate more than quadrupled. This historically tranquil period ended in 2008 with a severe recession and a protracted credit crunch. We develop a theory of learning in which consumers and lenders adjust their beliefs about the riskiness of the economic environment over time in response to the realized sequence of aggregate shocks and then embed it into an otherwise standard quantitative model of consumer default. Simulations of the model suggest that learning can explain as much as half of the recent boom and bust cycle in consumer unsecured debt and a modest fraction of the rise in bankruptcy filings prior to 2005.     

Credit default swaps and sovereign debt markets

This study investigates the link between the price discovery dynamics in sovereign credit default swaps (CDS) and bond markets and the degree of financial integration of emerging markets. Using CDS and sovereign bond spreads, the price discovery mechanism was tested using a vector error correction model. Financial integration is measured using news-based methods. We find that sovereign CDS and bond markets are co-integrated. In five out of seven sovereigns (71%), the bond market leads in price discovery by adjusting to new information regarding credit risk before CDS. In 29% of times, CDS markets are the source of price discovery. We also find a positive correlation of 0.67 between the degree of financial integration and the bond market information share. The evidence suggests that changes in sovereign credit risk and bond yields are significantly influenced by common external (global) factors, while country-specific factors play an insignificant role.     

The optimal capital structure of the firm with stable Lévy assets returns

This article builds a new structural default model under the assumption that a firm’s assets return follows a dynamics displaying jumps of both signs. In essence, we expand the work of Hilberink and Rogers (itself an extension of the Leland and Toft framework), which deals only with negative jumps. In contrast, we make use of stable Lévy processes, and we compute the values of the firm, debt and equity under this assumption. Theoretical credit spreads can also be obtained in our framework. They prove to be consistent with the empirical credit spreads observed in financial markets.      

Borrowing Constraints and Credit Demand in a Developing Economy

This paper investigates the determinants of credit demand in the presence of borrowing constraints in a developing economy. We model the determinants of observed debt for Chilean households while accounting for selection bias and the endogeneity of their income and specific household assets. Using a novel Chilean dataset, we estimate the relationship between household characteristics and consumer and mortgage debt. We find substantial differences in the nature of these relationships across the types of debt. For example, we find that the income elasticity for consumer debt is greater than 1 whereas for mortgage debt it is not. The results suggest the increased availability of credit, combined with the aging of the Chilean population, is likely to drastically change the distribution and level of Chilean debt. These findings are particularly relevant for other developing economies currently experiencing rapid income and debt growth. Copyright © 2015 John Wiley & Sons, Ltd.     

The integration of international financial markets: an attempt to quantify contagion in an input–output-type analysis

ABSTRACT

The increasing integration of international financial markets means that credit defaults in one country have to be covered by creditors in other countries. If the principle of creditor liability were applied systematically, the financial losses incurred by the financial institution that provided the credit and is thus directly affected by the default would be ‘passed on’ through its domestic and foreign shareholders and debt holders, as well as their creditors, to the original savers. In this paper, this contagion effect will be estimated by taking international capital linkages into account. Analogously to an input–output analysis of inter-industry linkages, savings used for investments in one country are traced back to the countries from which the funds originated. This also reveals the important role of international financial centers, which essentially serve as distributors of investment risks, while the financial losses are ultimately borne by larger countries with higher levels of savings.     

Optimal bankruptcy code: A fresh start for some

What is the optimal consumer bankruptcy law? I answer this question using an incomplete markets life-cycle model with a planner who can choose state-contingent bankruptcy costs. I develop two main theoretical characterizations. First, whenever debt discharge is allowed, it should occur without cost. Second, bankruptcy should always be allowed for highly-indebted households. Quantitatively, the optimal policy can generate a welfare gain as large as 11.6%. However, attractive informal default, asymmetric information, and moral hazard can reduce the welfare gain to as little as 0.7%.     

UK Household Debt: A Threat to Growth or Stability?

The liberalisation of credit constraints in the 1970s for UK consumers has had important implications for the housing market and consumer spending. This paper by John Muellbauer¹ examines the factors that have driven soaring consumer debt and house price levels; in particular those observed since the mid-1990s. By relying on recent econometric evidence and trends in credit availability, real income per head, nominal and real after tax mortgage rates, measures of perceived risk and broad demographic trends, it also analyses the prospects for house prices, mortgage debt and unsecured debt over the coming years. The outlook is for a 'soft landing' in the housing market and associated declines in the rate of growth of consumer debt, which, although probably not smooth, does suggest the underlying situation is more benign and less crisis-prone than it was in 1988–89.     

Market perception of sovereign credit risk in the euro area during the financial crisis

We study market perception of sovereign credit risk in the euro area during the financial crisis. In our analysis we use a parsimonious CDS pricing model to estimate the probability of default (PD) and the loss given default (LGD) as perceived by financial markets. In our empirical results the estimated LGDs perceived by financial markets stay comfortably below 40% in most of the samples. Global financial indicators are positively and strongly correlated with the market perception of sovereign credit risk; whilst macroeconomic and institutional developments were at best only weakly correlated with the market perception of sovereign credit risk.     

Fiscal retrenchments and the transmission mechanism of the sovereign risk channel for highly indebted countries

We formalize sovereign and private sector default probabilities into a monetary model in order to test the hypothesis, which recently appeared in the literature, of whether the consideration of a sovereign risk channel affects the sign and size of output fiscal multipliers. The model is estimated for the most vulnerable Eurozone countries-characterized by high debt-to-GDP ratio-and stochastically simulated conditional on expenditure and revenue policy measures. We show that, conditional on specific fiscal shocks, the risk channel can operate in a pro-cyclical direction, amplifying the temporary contractionary effects of fiscal retrenchments. We show that both the relations between economic fundamentals and sovereign debt spreads and that between sovereign and credit spreads are weak. Therefore, the effectiveness of the risk channel for fiscal consolidations is small, irrespective of the direction of change in the sovereign default probability.     

The great rotation in global credit risks

• ? The pattern of global credit risks looks very different today than in 2007. Risks are now mostly centred in China and emerging markets. “Excess” private debt in China is as high as $3 trillion compared with $1.7 trillion in the US a decade ago. Yet some pockets of significant risk still exist in advanced economies, which not only implies vulnerability to rising interest rates, but also that the scope for rate rises may be limited.
• ? With policy normalisation underway in the US and the scaling back of asset purchases expected to start soon in the Eurozone, we focus on assessing vulnerabilities across global credit markets. This article explores the topic using a top‐down, cross‐country approach. We find that although private debt and debt service ratios look more benign in advanced economies than a decade ago, they have deteriorated markedly in many emerging markets in recent years.
• ? Based on a measure of excess private debt – comparing private credit‐to‐GDP ratios with their trend – China, Hong Kong and Canada are the riskiest. When comparing debt service ratios relative to their long‐term averages, risks are also mainly concentrated in emerging countries. But Canada, Australia and some smaller European countries also have high debt service ratios that have failed to drop since 2007, despite the slump in global interest rates.
• ? Overall, aggregate private debt indicators look less worrying than in 2007. We would also argue that the concentration of excess private debt levels in China reduces the risk of a sudden financial crisis based on massive credit losses, such as the one in 2007–2010. But with corporate debt levels in the US, Canada and some other G7 countries above their long‐term trend, investors need to be attentive to these considerable pockets of risk.

     

Commercial mortgage underwriting: How well do lenders manage the risks?

Loan-to-value ratio and debt service coverage ratios have long been viewed as the two most important quantitative measures of the default risk of commercial mortgages. Option-based models of default provide strong theoretic support for the importance of original loan-to-value ratio. The same theoretical predictions have found strong empirical support in residential single-family mortgage analyses. However, recent empirical studies of commercial mortgage default have raised questions about the role of loan-to-value ratio in assessing the riskiness of commercial mortgages. These studies generally either find no relationship or a puzzling negative relationship between loan-to-value ratio and default. This paper uses a very large database of commercial loan histories to thoroughly investigate this issue. It finds strong evidence that loan-to-value and debt service coverage ratios are endogenous to the underwriting process. Lenders react to other—unmeasured—risk factors with credit rationing and pricing. As a result, unusually low loan-to-value ratio loans appear to have above average risk in other dimensions and their default probabilities are equal to or higher than average. The results show that the pricing spread that lenders establish as part of the underwriting process serves as an excellent summary measure of the riskiness of the loan. A test of lenders’ ability to appropriately price loan-to-value risk finds that, while there is some unpriced effect of loan-to-value ratio after controlling for the lender’s pricing, introducing lender pricing into the model removes the otherwise puzzling negative loan-to-value and default relationship previously observed in the literature.     

The (Un-) importance of Chapter 7 wealth exemption levels

This paper examines the effects of the Chapter 7 wealth exemption level on welfare, bankruptcy filings, debt, and on asset holdings. I build a heterogeneous agent life cycle model which features uninsurable income and expense shocks. Moreover, households can borrow and save simultaneously. When a borrower defaults on her debt by filing for Chapter 7 bankruptcy, she can keep her assets up to the wealth exemption level. Wealth exemption levels are important for two reasons. First, they explain the extensive and intensive margin of the credit card debt puzzle. Around thirty percent of borrowers, both in the model and in the data, who borrow at high interest rates simultaneously save at low interest rates. However, these borrowers borrow and save only relatively small amounts, a few thousand U.S. Dollars. Second, ignoring the exemption level biases results because it overstates the costs of defaulting. The welfare gains from Chapter 7 compared to the European system, where debt is not discharged, are twice as high when exemption levels are positive compared to when they are ignored. At the same time, wealth exemption levels are unimportant in the sense that they have an impact only at low exemption levels. The effects of increases in the exemption level fade out very quickly. There is no strong positive relationship between exemption levels, which vary across U.S. states, and default rates in the model. This is in contrast to the previous literature, but consistent with the data. The reason is that those borrowers who might default do not own much wealth. Therefore, only very few households are affected by increases in the exemption level.     

Endogenous trading in credit default swaps

We introduce a real options model in order to quantify the moral hazard impact of credit default swap (CDS) positions on the corporate default probabilities. Moral hazard is widely addressed in the insurance literature, where the insured agent may become less cautious about preventing the risk from occurring. Importantly, with CDS the moral hazard problem may be magnified since one can buy multiple protections for the same bond. To illustrate this issue, we consider a firm with the possibility of switching from an investment to another one. An investor can influence the strategic decisions of the firm and can also trade CDS written on the firm. We analyze how the decisions of the investor influence the firm value when he is allowed to trade credit default contracts on the firm’s debt. Our model involves a time-dependent optimal stopping problem, which we study analytically and numerically, using the Longstaff–Schwartz algorithm. We identify the situations where the investor exercises the switching option with a loss, and we measure the impact on the firm’s value and firm’s default probability. Contrary to the common intuition, the investors’ optimal behavior does not systematically consist in buying CDSs and increase the default probabilities. Instead, large indifference zones exist, where no arbitrage profits can be realized. As the number of the CDSs in the position increases to exceed several times the level of a complete insurance, we enter in the zone where arbitrage profits can be made. These are obtained by implementing very aggressive strategies (i.e., increasing substantially the default probability by producing losses to the firm). The profits increase sharply as we exit the indifference zone.     

Credit Default Swaps: Risk Hedge or Financial Weapon of Mass Destruction?

Credit default swaps (CDSs) are contracts between buyers and sellers of protection against default. They are a form of debt insurance, or more precisely derivatives contracts that investors buy to either insure against or profit from a default. In this way CDS contracts act as a form of debt insurance in that they provide a means of protection against credit risk. In the aftermath of the global financial crisis, the CDS earned the reputation of a ‘financial weapon of mass destruction’. Why? Is this charge justified? This paper shows that the reality is more complex: CDSs carry benefit as well as costs, and the risks associated with them can be mitigated through prudent supervision.     

Spillover effects on government bond yields in euro zone. Does full financial integration exist in European government bond markets?

This paper examines the time varying nature of European government bond market integration by employing multivariate GARCH models. We state that unlike other bond markets, in euro markets the default(credit) risk factor and other macroeconomic and fiscal indicators are not able to explain the sovereign bond yields after the beginning of monetary union. This fact might be counted as a signal for perfect financial integration. However, we also find that the global shocks affect Germany and the rest of euro bond markets in various levels, creating particular discrepancies in asset prices even we take into account the market specific factors. Different level responses of each euro market to the global shocks reveal that euro bond markets are not fully integrated with each other unlike the recent literature claimed. Besides, we explore that the global factors are effective for the volatility of yield differentials among euro government bonds.