 Firm and Guarantor Risk, Risk Contagion and the Interfirm Spread Among Insured DepositsDouglas Cook and Lewis Spellman Center for Financial Institutions Working Papers from Wharton School Center for Financial Institutions, University of Pennsylvania Abstract: The authors present a model and empirical evidence which indicate that in the market for guaranteed debet, the interfirm spread in rates can depend as much on the market's valuation of the guarantor's risk as on the riskiness of the firms issuing the debt. The authors suggest that increasing guarantor risk widens spreads in market rates on guaranteed debt while holding constant for differences in firm risk. The model is applied empirically to explain the level of rates and the spread in the rates on federally insured certificates of deposit (CDs). The authors state that there has been little investigation into the influences of guarantor risk as apart from firm risk in determining the interfirm rate spread. The emergence of elevated junk CD rates and the widening of the interfirm rate spreaders were associated with firm risk rather than guarantor risk. A related issues was the appropriateness of the public policy analysis and response.
The paper suggests that market rates reflect the risk of both the guarantor and the firm. If the market perceives greater risk associated with the credit quality of the guarantor, the existing differences in the firms' credit risks will be more transparently observed in the market pricing of CD rates because less credit reliance will be placed on the guarantor. The model shows that the same guarantee and guarantor only makes for perfect substitutability in the pricing of guaranteed debt under the limiting condition of a riskless guarantor. It shows that despite an effort by the deposit insurer to retire the junk CDs or resolve the institutions issuing these CDs, the higher yields were due to a deterioration in the market's view of the credit quality of the federal guarantor. The paper also presents a general model of rates on third party guaranteed debt.
The authors suggest that the policy implications of their findings is at odds with received thought at the time when it was believed that the junk firm needed to be resolved quickly in order to prevent the high premiums of the junk CDS from infecting the prime firms CDs. There was no evidence of a statistical relationship between the industry's junk probability of insolvency and the prime probability of insolvency. While contagion might occur in some circumstances and if the junk firms had not been resolved it might have led to contagion of other firms' premiums, the authors suggest their evidence does not reveal generalized contagion in the market's risk pricing among firms. Date: 1994-05 There are no downloads for this item, see the EconPapers FAQ for hints about obtaining it. Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: https://EconPapers.repec.org/RePEc:wop:pennin:94-18 Access Statistics for this paper More papers in Center for Financial Institutions Working Papers from Wharton School Center for Financial Institutions, University of Pennsylvania Contact information at EDIRC. |
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