Bhanu Balasubramnian Emporia State University Ken Cyree The University of Mississippi

1. Why Are Yield Spreads on Bank-Issued Subordinated Notes and Debentures Not Sensitive to Bank Risks? Bhanu Balasubramnian Emporia State University Ken Cyree The University of Mississippi

2. Debt Market Signals • Yield Spread = f (Term-structure, Default risk, Maturity Risk, Taxes, Liquidity Risk, Systematic Risk, Unknown factors) • Yield Spread on Bonds = YTM of a risky bond - YTM of a risk-free bond of similar characteristics • When leverage (or any other risk measure) decreases, default risk decreases. In turn, yield spread should decrease and vice versa • Change in yield spreads acts as signal for market perception of change in firm risk or default risk

3. Debt Market Signals – Empirical Evidence • SND spreads are less risk sensitive during the 1993-97 period and market discipline is weak - Board of Governors (1999) • Changes in yield spreads are not related to changes in firm-specific risk of banks during 1994-99 - Krishnan, Ritchken, and Thomson (2005) • Default risk component is large in money-market securities– Covitz and Downing (2007) • Are the long-term debt markets sensitive to all non-credit risks but not sensitive to credit risks?

4. Research Questions • Is lack of default risk sensitivity due to omitted credit risk factors? • Omitted factors of credit risk • Trust-Preferred Securities (TPS) • Too Big To Fail (TBTF) effect after LTCM crisis • Idiosyncratic Volatility • Omitted factors in decomposition of yield spreads • Tax effects – Elton, Gruber, Agrawal, and Mann (2001) • Whether or not TPS yield spreads can be used for market monitoring?

5. Data Sources • National Association of Insurance Commissioners (NAIC) database for bond transactions for the years 1994 – 1999 • SDC Platinum database - bond issue characteristics • FR Y-9C reports for banks • CRSP for stock market data • H-15 Reports from St. Louis Fed for daily Treasury rates

6. Sample Selection • Select fixed-rate, U.S. dollar, plain-vanilla bonds with investment grade credit ratings • No put or call options, collateral, sinking fund • Should not be convertible, Yankee, global, serial, LBO • Only bank-issued SND transactions • With at least two years of remaining maturity • At least 10 transactions per SND issue • 6620 buys and 4072 sell transactions • 300 SND issues by 71 BHCs

7. Decomposition of Yield Spreads YS (i, t) = α + β (F, k) F (i, t-1) + β (M, k) M( t) + β (L, k) L( t) + β (X, k) X (i, t) + ε (i, t) (1) • YS (i, t) = Yield spread of bond i at time t • F (i, t-1) = Vector of firm-level default risk variables • M (t) = Vector of market variables • L (t) = Vector of liquidity variables • X (i, t) = Vector of other control variables • Non-linear GMM estimation with Newey -West (1987) correction for autocorrelation and heteroskedasticity with five lags

9. Results – Full Sample • Yield Spread Levels are sensitive to firm-specific default risk variables • Tax Effects are significant • Idiosyncratic volatility measure (σ) captures default risks better than Market volatility measure (VIX) • Discount for size – TBTF discount • Exception - ROA is positively related to yield spreads

10. LTCM Crisis and TBTF Effect • January 1994 - June 1998 -Pre-LTCM bailout period • July 1998 – December 1999- Post-LTCM period • Important dates – July 20, 1998, Aug 17, 1998, September 02, 1998, September 24, 1998 • Major Crises - Mexican (Dec 94), Asian (June 97), Russian and LTCM (Aug 98),Brazilian (Nov 98)

11. Paradigm Shift in Firm-specific Default Risk Proxies and TBTF Effect

12. Default Risk Reduction Due to TPS • SND issued by all banks as at the end of 1998 $102.8 billion, of which, $100 billion was issued by the top 50 banks • TPS is the least expensive source of external Tier 1 capital • Over 800 banks have issued TPS for a total of $85 billion between 1996 and 2004; $28 billion between 1996 and 1999 by the top 50 banks

13. Leverage is not a significant determinant of yield spread even prior to LTCM bailout but after TPS issuance

14. TPS Spreads are sensitive to on-balance sheet default risk proxies

15. Changes in Determinants of Yield Spreads • To trace the changes in determinants of yield spreads – Analyze four sub-periods around LTCM crisis • August 97 – February 98 - tranquil period • March 98 – June 98, the period when bond market volatility increased • July 98 – September 98, the period when bond markets became extremely volatile • October 98 - December 99, the post-LTCM bailout period

16. Leverage is irrelevant; ROA is a risk proxy; Markets recognize off-balance sheet risks; TBTF Discount increases

18. WSJ 04/17/2008–Ahead of the Tape

19. Results • Yield spread levels on SND are sensitive to conventional risk measures prior to TPS issuance by banks • Risk sensitivity of conventional risk measures decrease after the introduction of TPS • No TBTF effect before the LTCM bailout but size discount doubles after the LTCM bailout • Idiosyncratic volatility is a better proxy for firm-specific risks • Omitting the tax effects in yield spreads leads to measurement errors • Yield spreads on TPS provide market signals

20. Results • Bond markets are sensitive to default risks, but paradigm changes in the determinants of yield spreads after LTCM bailout • Default risk proxies vary with time and available information • Leverage is not a proxy • ROA is a proxy for changes in risk-taking • Off-balance sheet items is a proxy

21. Policy Implications • Implicit guarantees and market discipline • Can TPS provide better market signals? – Needs further investigation after TARP • Disclosure Levels of off-balance sheet items • Can TPS and SND be capital securities without risk of capital loss? • Risk-weighting of earnings for CAMELS

22. Thank You Questions? Suggestions?