Perceived guarantees, investor protection and bailout. The case of government‐sponsored mortgage institutions
| DOI | https://doi.org/10.1108/14635781211256729 |
| Pages | 435-457 |
| Date | 03 August 2012 |
| Published date | 03 August 2012 |
| Author | Patrick Trutwein,Dirk Schiereck,Matthias Thomas |
| Subject Matter | Property management & built environment |
Perceived guarantees, investor
protection and bailout
The case of government-sponsored mortgage
institutions
Patrick Trutwein, Dirk Schiereck and Matthias Thomas
Department of Finance, Accounting and Real Estate,
European Business School, Wiesbaden, Germany
Abstract
Purpose – This 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/approach – By 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.
Findings – The 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 implications – Investors 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/value – There 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.
Keywords United Statesof America, Real estate, Loans, Bonds,Financial institutions, Mortgages,
Credit risk, Creditdefault swaps, Equity returns, FannieMae, Freddie Mac, Financial crises
Paper type Research paper
1. Introduction
Standard theoretical models on the link of equity and debt markets predict a clear
linkage between equity and credit claims of any given corporation (Merton, 1974;
Black and Cox, 1976). The value of debt and equity is expected to move simultaneously
in the same direction as the overall enterprise value (of which credit default risk
is a key component) changes. Likewise, the relationship between the return on equity
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1463-578X.htm
Perceived
guarantees
and bailout
435
Journal of Property Investment &
Finance
Vol. 30 No. 5, 2012
pp. 435-457
qEmerald Group Publishing Limited
1463-578X
DOI 10.1108/14635781211256729
and credit spreads should be inverse (Hull and White, 2001; Kwan, 1996)[1]. Further,
this relationship between equity and credit spreads should intensify in case of lower
overall underlying credit quality or heightened idiosyncratic risk (also indicated by the
rating). However, empirical research on the relationship between equity and credit
markets does not always fully support these theoretical predictions.
There 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[2] (Trutwein et al., 2011; Trutwein and Schiereck, 2011; Norden and
Weber, 2009; Berndt and Ostrovnaya, 2008; Acharya and Johnson, 2007; Jorion and
Zhang, 2007; Longstaff et al., 2005). Yet, to our 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. What are the lessons learnt from the 2008 financial crisis about
investor protection in quasi guaranteed financial institutions?
This paper concentrates on examining the relationship between equity returns and
credit prices for Fannie Mae and Freddie Mac during the financial crisis of 2008. These
two government sponsored entitie (GSEs) are dominant players in the US credit and
mortgage market which is today in the focus of current US-legislation. Additionally
(foreign) investors intensely follow the restructuring of the GSEs against the
background of the cataclysmic events in debt and equity markets of 2008. Fannie Mae
and Freddie Mac are also deemed highly suitable as research object. They exhibit the
following traits which were relevant for capital markets during the financial crisis:
.The banks had considerable US-mortgage exposure (with portfolios in excess of
$5.3trn) which played a central role in the financial crisis of 2007-2008.
.Both institutions had public missions and were deemed “too big to fail”, so that
expectations around government support played a key role amid the crisis.
.The bailout affected bond and stockholders very differently: bond investors were
benefitting from the government stepping in, while stock holders lost their
investment in the process (Fender and Gyntelberg, 2008).
Besides the cheer size and importance of these entities for the US economy (DeGennaro,
2008) and the ongoing focus of the current administration in terms of retrospective
analysis and prospective policy (Swagel, 2011), make it worthwhile to explore the
relationship between equity and credit markets for Fannie Mae and Freddie Mac.
Before and at the beginning of the crisis from an investors perspective government
support put the two GSEs in an advantageous position with positives for equity and
debt alike (Angelides, 2011). However, as the crisis deepened and investor confidence
eroded, Fannie Mae and Freddie Mac were eventually taken into state conservatorship
in September 2008, which coincided with a severe decoupling of equity and credit
values. These phenomena underpin the importance of a detailed analysis in form of a
focused study, taking external effects and a staggered timeline into account, when it
comes to testing models on the equity-credit relationship.
By examining Fannie Mae and Freddie Mac during 2007 and 2008 this study
extends existing research on the link between equity and credit markets. We employ
univariate time series regression and vector autoregressive models to analyze the
JPIF
30,5
436
To continue reading
Request your trial