Valuing Toxic Assets: An Analysis of CDO Equity

Francis Longstaff and Brett Myers

No 14871, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: How does the market value complex structured-credit securities? This issue is central to understanding the current financial crisis and identifying effective policy measures. We study this issue from a novel perspective by contrasting the valuation of CDO equity with that of bank stocks. This is possible because both CDO equity and bank stock represent levered first-loss residual claims on an underlying portfolio of debt. There are strong similarities in the two types of equity investments. Using an extensive data set of CDX index tranche prices, we find that the discount rates applied by the market to bank and CDO equity are very comparable. In addition, a single factor explains more than 64 percent of the variation in bank and CDO equity returns. Although banks are presumably active credit-portfolio managers, we find that bank alphas are significantly negative during the sample period and comparable in magnitude to those of more-passively-managed CDO equity. Both banks and CDO equity display significant sensitivity to "shadow banking" factors such as counterparty credit risk, the availability of collateralized financing for debt securities, and the liquidity of the derivatives market. A key implication is that we may be able to value "toxic" assets using readily-available stock market information.

JEL-codes: G01 G12 G13 G21 (search for similar items in EconPapers)
Date: 2009-04
New Economics Papers: this item is included in nep-ban, nep-cfn and nep-fmk
Note: AP
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Citations: View citations in EconPapers (10)

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