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© 2010 Thomas a Jacobs THREE ESSAYS in EMPIRICAL ASSET PRICING © 2010 Thomas A Jacobs THREE ESSAYS IN EMPIRICAL ASSET PRICING BY THOMAS A JACOBS DISSERTATION Submitted in partial fulfillment of the requirements for the degree of Doctor of Philosophy in Finance in the Graduate College of the University of Illinois at Urbana-Champaign, 2010 Urbana, Illinois Doctoral Committee: Professor George G Pennacchi, Chair and Director of Research Professor Charles M Kahn Professor Neil D Pearson Associate Professor Timothy C Johnson ABSTRACT The financial crisis of 2007-2008 led to extraordinary government intervention in firms and markets. The scope and depth of government action rivaled that of the Great Depression. Many traded markets experienced dramatic declines in liquidity leading to the existence of conditions normally assumed to be promptly removed via the actions of profit seeking arbitrageurs. These extreme events motivate the three essays in this work. The first essay seeks and fails to find evidence of investor behavior consistent with the broad 'Too Big To Fail' policies enacted during the crisis by government agents. Only in limited circumstances, where government guarantees such as deposit insurance or U.S. Treasury lending lines already existed, did investors impart a premium to the debt security prices of firms under stress. The second essay introduces the Inflation Indexed Swap Basis (IIS Basis) in examining the large differences between cash and derivative markets based upon future U.S. inflation as measured by the Consumer Price Index (CPI). It reports the consistent positive value of this measure as well as the very large positive values it reached in the fourth quarter of 2008 after Lehman Brothers went bankrupt. It concludes that the IIS Basis continues to exist due to limitations in market liquidity and hedging alternatives. The third essay explores the methodology of performing debt based event studies utilizing credit default swaps (CDS). It provides practical implementation advice to researchers to address limited source data and/or small target firm sample size. ii To Louis, Loretta, Marty and a lifelong love of learning. iii ACKNOWLEDGMENTS I could not have completed this project without the guidance, help and sup- port of many people. First of all I would like to recognize Neil Pearson for the, no doubt, exhausting effort in responding to all of my queries over the many years it took me to formulate and execute this project. Next, I would like to thank my adviser, George Pennacchi, for the many suggestions and critical feedback he provided. I would also thank the remaining members of my doctoral committee, Charlie Kahn and Tim Johnson. Charlie repeatedly offered me support when the outcome looked grim. I would like to recog- nize the remaining members of the Illinois finance department for critical feedback and advice they provided during the six seminars I gave during my lengthy tenure there as a graduate student. In particular, I would like to recognize Jeff Brown, Roger Cannaday, Murillo Campello, and Dave Iken- berry for individual advice and guidance. From the graduate college I would like to thank Rebecca Bryant for helpful guidance and support. Outside of the University of Illinois, I would like to recognize Adam Ashcraft, Brian Henderson, John Hund, Bob Taggart, and Michael Waldron for advice and feedback. There were a number of industry practitioners I also relied upon for help and guidance, Michael Ashton, Jim Goodwin, Renee Nadler, Russell Pemberton, and Doug Stalker. Finally, as I struggled to complete this pro- cess I relied upon the support of friends and family. In particular, I would like to thank Martin Albert, Sue Anderson, Mark Andrews, Joseph Cortese, Roger DeNiscia III, Joan DeNiscia, Dan Gallagher, John Jelinek, Elaine Rae, Doug Schmitt, Shamel Shawki, and my wife, Loretta. iv TABLE OF CONTENTS CHAPTER 1 INTRODUCTION . 1 CHAPTER 2 CHANGING MARKET PERCEPTIONS OF WHO IS TOO BIG TO FAIL DURING THE FINANCIAL CRISIS OF 2007-2008 . 3 2.1 Too Big To Fail . 6 2.2 The Events, Methodology and Data . 19 2.3 Results and Discussion . 27 2.4 Conclusion . 40 2.5 Tables and Figures . 43 CHAPTER 3 LIMITS TO ARBITRAGE IN THE U.S. MAR- KETS FOR INFLATION . 66 3.1 Inflation Markets . 69 3.2 Data and Methodology . 74 3.3 Results . 81 3.4 Conclusion . 87 3.5 Tables and Figures . 89 CHAPTER 4 CREDIT DEFAULT SWAPS IN THE PERFOR- MANCE OF EVENT STUDIES . 109 4.1 Existing CDS Event Study Approaches . 110 4.2 Data and Methodology . 113 4.3 Results . 124 4.4 Conclusion . 129 4.5 Tables and Figures . 131 CHAPTER 5 CONCLUSION . 142 APPENDIX A MODELING GOVERNMENT GUARANTEES . 145 APPENDIX B THE EVENTS . 149 APPENDIX C DETERMINATION OF VARIANCE ADJUST- MENT FOR PREDICTION ERROR . 163 v APPENDIX D MEASURING CREDIT DEFAULT SWAP (CDS) RETURNS . 164 REFERENCES . 168 AUTHOR'S BIOGRAPHY . 181 vi CHAPTER 1 INTRODUCTION This work is motivated by the financial crisis of 2007-2008 and its implications for financial institutions and markets. The three essays contained herein examine large financial institutions and the U.S. markets for inflation indexed securities and derivatives. The last essay is a methodological examination of the performance of event studies using credit default swaps. In essay 1, I consider the moral hazard mechanism of government 'Too Big To Fail' support of large financial institutions. This government support, through direct assistance and programs to improve market liquidity, during the worldwide financial crisis of 2007-2008 is unprecedented since the Great Depression. Whether a given firm is ex-ante 'Too Big To Fail' in the mind of government agents is not the principal issue for moral hazard, however. It is investor perception of 'Too Big To Fail' that drives the economically inefficient reduced funding cost for the firm. This essay examines the U.S. government's crisis actions as well as two international bank bailouts in a series of event studies employing both debt and equity returns. I conclude that only the largest of the banks and the government sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, already perceived to be recipients of explicit or implicit government guarantees, experienced any 'Too Big To Fail' premiums in their debt securities. There is no evidence that these premiums extended to other large financial firms such as broker dealers, insurers or surety firms, in spite of the bailout of Bear Stearns. There is no evidence that letting Lehman Brothers fail was a surprise to investors. In addition, there is no evidence that AIG's large derivative exposures and their associated losses prior to and during the crisis led investors to infer it would be rescued. Federal Reserve programs to improve liquidity and extend lending to non- banks did not lead to 'Too Big To Fail' premiums for firms. Essay 2 introduces inflation linked securities and derivatives in the U.S., where government debt markets represent the most liquid in the world. The 1 extension in 1997 of Treasury instruments to inflation protected securities (TIPS) provided investors with a truly risk free security. It also helped spur the growth of over-the-counter (OTC) traded inflation derivative markets in the U.S. As TIPS may be combined with nominal Treasury securities to produce similar positions in inflation to that of OTC inflation swaps, one would expect them to have very close values for priced future inflation. However, this is not the case. I examine the difference between said markets and taking a cue from corporate markets create the Inflation Indexed Swap Basis (IIS Basis) measure. I find it to be positive at all liquid tenors over a recent five year period including before, during and after the financial crisis. I explore the IIS Basis in time series and cross section finding it to be related to debt market funding, liquidity, and inflation. I conclude that it continues to exist for either of two reasons, supply limitations in the OTC derivative market or imperfect hedging opportunities, particularly given the lack of zero coupon TIPS of any size and depth. Essay 3 introduces credit default swaps (CDS) and their potential for use in debt based event studies. The market for CDS has continued to grow each year both in the total transaction amount and in the scope of firms traded. Given their constant tenor and improved liquidity, CDS present a compelling alternative to bond prices for the performance of debt based event studies over daily time intervals. However, there is no methodology guidance for the performance of event studies utilizing CDS spreads. I carry out Monte Carlo experiments similar to Brown and Warner (1985) to rectify this situation. I examine a range of performance measures to include those used in the empirical event studies completed to date. I undertake tests of size and power on these performance measures under varying portfolio sample size and differing models of daily spread change. I provide implementation guidance to researchers including how to proceed in cases where they need to rely on a market index due to limited source data and/or their study entails a small portfolio of sample firms. 2 CHAPTER 2 CHANGING MARKET PERCEPTIONS OF WHO IS TOO BIG TO FAIL DURING THE FINANCIAL CRISIS OF 2007-2008 In the introduction to their text 'Too Big To Fail', Stern and Feldman (2004) describe the lack of consensus among researchers and policymakers to the following two issues:1 1. Does 'Too Big To Fail' remain a problem for financial firms within the United States given the existing legal and regulatory structure?2;3 2. If so, is there a meaningful cost to 'Too Big To Fail' support policies? The credit crisis of 2007-2008 definitively provided an affirmative answer to the first question.4;5 Further, it confirmed the predictions of Stern and Feld- man (2004) as to which firms would be considered for 'Too Big To Fail' 1As defined in Stern and Feldman (2004), an institution is 'Too Big To Fail' if its uninsured creditors receive discretionary government support when said creditors are not automatically entitled to said support.
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