Liquidity and Fire Sale Risk: Pricing and Implications

1. VikasMehrotra University of Alberta Investment Commonality across Insurance Companies: Fire Sale Risk and Corporate Yield Spreads Vikram Nanda, Wei Wu and Alex Zhou UT Dallas, CSPU Pomona and Fed Res BOG

2. Keynes on Liquidity: Two Dimensions Liquid assets are “more certainly realisable at short notice without loss” • Liquidity is about the length of time it takes to realize an asset’s valuewithout loss. • If immediacy is desired, the transaction price will deviate from fundamentals.

3. Background Insurance companies are huge buyers of corporate bonds. When these bonds are downgraded, there is a common shock to all holders who now find it more costly to keep the downgraded bonds on their books due to higher capital requirement for lower rated bonds. There is a temporary logjam at the bond exit door. None of this ought to be a surprise to other (non-insurer) bond holders.

4. Questions in the study#1 Sir John R Hicks “…liquidity preference is the reason why ready money commands a premium over bills or bonds- is the cause, therefore, of the existence of a rate of interest. ” A worse than "expected" outcome must be dreaded more than a better than “expected” outcome is desired. This is not because of any abstract "law of diminishing marginal utility"; it is because of the impact which such unfavourable outcomes may have upon the non-liquid elements in the situation (things that may happen on the side of liabilities or on the side of other, non-liquid, assets). Is illiquidity priced? Yes, but we already knew this at least from the time of Hicks (1962, pp. 789):

5. Questions in the study:#2 Within the class of illiquid assets, is fire-sale risk priced? Define fire-sale as an order imbalance where sellers vastly outnumber buyers at the moment of the fire-sale. Even if the long-run demand for the asset is highly elastic, in the short-run – at the time of the fire-sale – inducements must be offered to attract buyers with successively lower reservation prices. With sufficient time, additional buyers do emerge, and prices revert to fundamental levels. But the hall mark of a fire-sale is a discounted price relative to fundamental value. Or to paraphrase the authors, Are market participants cognizant of such risks? The answer in this study is a strong YES.

6. Should we be surprised?

7. Results and Implications Simply showing that liquidity in general and fire-sale risk in particular is priced in the bond market is perhaps unsurprising, but the results here go beyond that for at least two reasons. First, the results here shed light on how liquidity is fundamentally a dis-equilibrium phenomenon, best thought of in quantized form. (Even Brownian motion cannot arise without granularity…). That is, liquidity is essentially about order imbalances. Perfect liquidity implies an exact match of buy and sell orders at all times. In reality, the length of time it takes to clear the imbalance is not zero; government bonds are more liquid than van Gogh paintings because there are more potential buyers and sellers in the government bond market.

8. Results and Implications Agree with the first claim. In rational markets, this is to be expected because of the risk fire-sale induced by correlated selling. Re negative externality, it all depends on whether the risk was priced in, and whether non-insurer bondholders are compensated for providing liquidity in a fire-sale situation. Bonds for most of us, including our MBA textbooks, are colorless securities whose yields are substitutable across bonds of similar characteristics. This assumes that when a bond is brought to the market for selling, a large number of buyers stands on the ready. In this study, Nanda et al contend that “… the substantial and correlated bond holdings by insurance companies can exacerbate price risk and impose a negative externality on other bond investors.”

9. Investment Commonality… What is interesting is that this sweetener is priced in at the time the insurance firms collectively march into the bond fields. A corollary is that a wholesale exit by insurance firms would eventually, and perhaps paradoxically, raise the bond’s liquidity, though at the time of the exit, there would be a price decline to clear the imbalance. An implication is that the fire-sale discount is transient. Once the buy orders come in at a lower price, and the order imbalance is cleared, prices ought to revert to fundamental values to compensate the liquidity suppliers (buyers). Is this observed in the data?

10. What we know from Ellul et al (2011 JFE) Fire sale of downgraded bonds by insurance companies.  Price pressure on downgraded bonds that is proportional to the size of order imbalance (which in turn depends on the financial constraints faced by the insurers). Price decline in response to the shock is fast.  However, the price pressure induced decline is transient. Price recovery follows – its speed being a function of the search costs for finding the counterparties (typically non-insurance buyers).  This is all very consistent with the Presidential Address by Duffie (2000, JF) where he discusses the role of “slow moving capital” in restoring equilibrium prices. As an example, he cites index deletions. The effect of deletions on indexers is similar to bond downgrades for insurers – they sell en masse. Have a look at the price impact.

11. Fig 1: Duffie (2010 JF)

12. Spill-over risk? If the price discount is reversed, is the spill-over arrested? Specifically, is there any need to mark to market an asset whose price is depressed temporarily?

13. More questions What happens when a bond is put on a Negative Credit Watch? Split-ratings? Instead of PCT Held by Insurers, could you look at the Number of Insurers? Or do a Concentration Index of bond holdings? On the liquidity supply side, do we know who the bond-holders are?

14. Instrument Variables IV estimation – why are we doing this? Precisely what is the nature of endogeneity here? One possibility is that that insurers chase yields. An easy way to check for this is to examine the NAIC 1 category bonds held by insurers. This category stipulates the same capital requirement for AAA, AA and A rated bonds. Yield chasing implies that insurers will gravitate towards A rated bonds vis-à-vis AAA or AA bonds. Table 3 provides some clues. On the right, we have the fraction of outstanding bonds held by insurance firms.

15. Chasing Yields A similar picture emerges when we look at the number of insurer-year observations for holdings in each of the three rating classes under NAIC 1 class for determining capital requirements. Not surprisingly, insurers go for maximum yield within a capital requirement class. Other bond holders not subject to NAIC capital requirements can also chase yields, but that would come with more risk without any attendant regulatory arbitrage.

16. Investment Commonality… How do the two instruments address this endogeneity? All we are doing is predicting PCT Holdings based on instruments that leave open the possibility of yield chasing. For instance, take IV#1, FY2005. Katrina-related losses led insurers to sell a some of their bond holdings. Does this instrument meet the exclusion criterion? I can think of at least one channel through which FY2005 directly affects the Yield Spread. Consider an insurer that responds to the losses by selling its higher priced (more liquid) bond holdings. The remaining bonds therefore have a higher yield. In Stage 2, the fraction held by insurer would show up with a positive coefficient, but this is not via a clean exogenous liquidity channel. It is rather a direct impact of the Katrina related sell-off of higher priced bonds.

17. Additional curiosities It would be very interesting to see if (i) Bonds held by insurers are more likely to be downgraded or put on credit watch vis-à-vis bonds held by other institutions; (ii) there were changes to the NAIC capital requirement tables and how insurers responded to them; and (iii) how holdings by other financial institutions (potential counter-parties) vary with capital requirements.

18. Investment Commonality… IV – 2nd instrument. How does this instrument meet the exclusion criterion? Specifically, the instrument is defined as Holdings reaching maturity in the quarter scaled by New Issues. I had a hard time following how this instrument met the exclusion criterion. Specifically, consider the denominator. Suppose that bond markets are pro-cyclical, in the sense that more bonds are issued when bond yields are low. In the first stage, the paper shows that the coef on the instrument is positive – this can arise from PCT HELD declining in new issues, hardly a surprise. More critically, in the second stage, the coef on the predicted PCT HELD is seen as positive. But we haven’t ruled out the possibility that a smaller new issue market is directly associated with higher yields.

19. Back of the envelope From Ellul et al, the average trading per bond per week by an insurance company at the time of a downgrade is $2.5 million. The price impact is around 0.5% per million $. Nanda et al, pp. 35: In particular, for our full sample of investment-grade corporate bonds, a one-standard deviation increase of 22.50% in the percentage held by insurance companies is associated with a 1.61% increase in the yield spread. With an average duration of 7 years, the price impact is 7 x 1.61% ≈ 11%. This seems to suggest that the association between higher yields and insurance holdings cannot entirely be explained by the risk of fire sale. Enough doubt remains that insurer firms are chasing yields.

20. Investment Commonality… Also look at Diamond and Rajan (2011, QJE): The prospect of a future fire sale of a bank's assets can depress its current value…  Anticipating a fire-sale, non-insurers can sit it out till the price dips sufficiently. This dries up liquidity precisely when the financially constrained insurers need it the most.

21. Thanks! Enjoyed the paper and learned something that I didn’t know before!