Massachusetts Institute of Technology

Sloan School of Management

Course 15.415: Finance Theory I

Class Notes #25

Nonlinearities, Skewness and the Credit Option:

Corporate Bonds, Bank Loans and Bank Stocks

Douglas T. Breeden*
August, 2012
Several slides are from D. T. Breeden, Bank Risk Management, Chapter 34 in The
Handbook of Modern Finance, Dennis Logue, Editor, 1989.

U.S. Bond Market:

Governments, Corporates, Mortgages,
Consumer Credit and Municipals ($Trillions)
Source: Federal Reserve Board Q1 2011 (solid), Q4 2008 (pattern)
20
18
16
14
12
10
8
6
4
2
0
Treasurys,
Agencies

Corporate &
Foreign
Bonds

Mortgages

Consumer
Credit

Municipals

I. Bank Loans and Corporate Bonds

in an Option Context

Black-Scholes-Merton (1973, 1974)

Debt and Equity as Options
In their pathbreaking, Nobel Prize winning
works, Black and Scholes in 1973 and Merton in
1974 showed that equity is like a call option on
the value of the firms assets.
They also showed that the debt of a firm is like
owning the firm and having written a call to the
shareholders. Option formulae can help price
corporate bonds.

Bank Loans In An Option Context

Douglas T. Breeden

1. Bank Loans and Their Credit Options.

2. Hedging Bank Loans with options and
Futures.
3. Pricing Bank Loans for Credit Risk.
5

Bank Loans In an Option Context

Crude Oil: A firm owns a crude oil storage facility
that currently contains 1 million barrels of oil. At the
June, 2011 price of $100.00 per barrel, this oil is
worth $100 million.
A bank lends $66.67 million (Loan/Value = 2/3) to
the firm for one year at an interest rate of 5.00%
(3.25% prime + 1.75%) using the oil as collateral,
which results in a promised payment of $70 million
in one year ($66.67 x 1.05). The current 1-year
futures price is $99.85.
6

Loan Risk Exposure To Commodity Prices

Crude Oil Price
$40.00
$50.00
$60.00
$70.00
$80.00
$90.00

Value of Firm
($MM)
$40.0 mln
$50.0
$60.0
$70.0
$80.0
$90.0

Payment to Bank
($MM)
$40.0
$50.0
$60.0
$70.0
$70.0
$70.0

Shareholders Equity
($MM)
$0.0
$0.0
$0.0
$0.0
$10.0
$20.0

$100.00

$100.0

$70.0

$30.0

$110.00
$120.00
$130.00
$140.00
$150.00
$160.00
Mathematically:

$110.0
$120.0
$130.0
$140.0
$150.0
$160.0
V

$70.0
$70.0
$70.0
$70.0
$70.0
$70.0
B

$40.0
$50.0
$60.0
$70.0
$80.0
$90.0
E

70 million

$70
8

$70

175
140
105
70

35

10

20

30

40

50

60

70

80

90 100

110

120 130

10

Hedging Loans With Put Options

Crude Oil
Price
($/Barrel)
$40.00
$50.00
$60.00
$70.00
$80.00
$90.00

Value
of Firm
($Mln)
$40.0
$50.0
$60.0
$70.0
$80.0
$90.0

Payment
to Bank
($Mln)
$40.0
$50.0
$60.0
$70.0
$70.0
$70.0

$100.00

$100.0

$70.0

$110.00
$120.00
$130.00
$140.00
$150.00
$160.00

$110.0
$120.0
$130.0
$140.0
$150.0
$160.0

$70.0
$70.0
$70.0
$70.0
$70.0
$70.0

Put X=70
Payoff
($Mln)
$30.0
$20.0
$10.0
$ 0.0
$ 0.0
$ 0.0

Put
Cost
($Mln)
$-2.32
$-2.32
$-2.32
$-2.32
$-2.32
$-2.32

Net
Cash
($Mln)
$67.68
$67.68
$67.68
$67.68
$67.68
$67.68

$0.0

$-2.32

$67.68

$0.0
$0.0
$0.0
$0.0
$0.0
$0.0

$-2.32
$-2.32
$-2.32
$-2.32
$-2.32
$-2.32

$67.68
$67.68
$67.68
$67.68
$67.68
$67.68
11

12

13

Hedging Loan: Short Futures, Long Call Option

Crude Oil Value
Payment
Short
Call X-=70
Price
of Firm to Bank Futures Gain Payoff
($/Barrel) ($Mln)
($Mln)
($Mln)
($Mln)
$40.00
$40.0
$40.0
$59.85
$ 0.0
$50.00
$50.0
$50.0
$49.85
$ 0.0
$60.00
$60.0
$60.0
$39.85
$ 0.0
$70.00
$70.0
$70.0
$29.85
$ 0.0
$80.00
$80.0
$70.0
$19.85
$10.0
$90.00
$90.0
$70.0
$ 9.85
$20.0

Call
Cost
($Mln)
$-32.17
$-32.17
$-32.17
$-32.17
$-32.17
$-32.17

Net
Cash
($Mln)
$67.68
$67.68
$67.68
$67.68
$67.68
$67.68

$100.00

$100.0

$70.0

$- 0.15

$30.0

$-32.17

$67.68

$110.00
$120.00
$130.00
$140.00
$150.00
$160.00

$110.0
$120.0
$130.0
$140.0
$150.0
$160.0

$70.0
$70.0
$70.0
$70.0
$70.0
$70.0

$-10.15
$-20.15
$-30.15
$-40.15
$-50.15
$-60.15

$40.0
$50.0
$60.0
$70.0
$80.0
$90.0

$-32.17
$-32.17
$-32.17
$-32.17
$-32.17
$-32.17

$67.68
$67.68
$67.68
$67.68
$67.68
$67.68
14

Example: Option Adjusted Spread on Bank

Loan (OAS)
Terms: 1-year loan
Principal:
$66.67 million
Repayment: $70.00 million in 1 year
3.33Million

Interest = $$66
.67Million
Interest Rate = 5.00%
= Prime + 1.75%
(Prime = 3.25%)
Collateral:
1 million barrels of oil
Current value = $100.00/barrel
$66.67Million
Loan-to-value ratio = $100.00Million
= 66.7%
15

Option-Adjusted Return Calculation

1-Year Put option on crude oil with strike price of $70/barrel
insures this loans payoff risk.
Put cost = $2,320,000 ( = 35%) or $2.32 per barrel.
,670,000
Banks total cash out = $66
+
Loan

$2,320
,000

PutHedgeCost

,990,000
= $68

TotalCashOut

Cash received back = Loan payoff + Put = $70,000,000

with credit risk
Payoff
,000,000
Hedged or risk-adjusted return = $$70
68,990,000 - 1 =

Hedged
Loan =
Return

Prime - 1.78%

1.47%

Weak risk-adjusted return

16

Effects of Option Volatility

on Cost of Put Hedge for Loan
Put Options Implied Volatility

45%

25%

Put Option Cost ($70 strike, 1 year) = $4,490,000 $720,000 = P

17

Option-Adjusted Loan Return With = 25%

Banks total cash out = $66,670,000 + $720,000
= $67,390,000
Banks cash received back = $70,000,000

Hedged or risk-adjusted return =

$70,000,000
$67,390,000 -

1= 3.87%

= Prime + 0.62% risk-adjusted

= High risk adjusted return
18

Option-Adjusted Loan Return With = 45%

Banks Cash Out = $66,670,000 + $4,490,000 = $71,160,000
Banks Cash Back = $70,000,000
Hedged Return

$70,000,000 - 1 =
$71,160,000

-1.63%

Prime - 4.88%
= Very poor return (unprofitable)
19

Computing The Interest Rate

That Gives A Desired OAS
Assume:

Cost of Funds (LIBOR) =

0.5%

COF

Desired hedged profit

1.5%

Desired hedged return =

2.0%

RH

20

Computing The Interest Rate

That Gives A Desired OAS
Analysis: Let the amount loaned be variable =
Put hedge cost = P
Total proceeds from risky loan and hedge = L

Pricing Formula:
Solve for :

L
P =

RH

1 +

L
1 RH

P
21

Computing The Interest Rate

That Gives A Desired OAS
= $70,000,000 - $4,490,000
1.020

In the example:
( = 45%)

= $64,137,500
Loan interest rate

( = 45%)

L 1 R
-1 L

RL = $70,000,000 - 1 = 9.15%
$64,137,500
= Prime +5.90%

Note: If = 25%, P = $720,000, then RL = 3.07%

= Prime - 0.18%
23

Summary of Fair Interest Rates on 1-Year Oil

Loans Hedged with Put Options (Oil Price=$100)
Promised
Payment
in 1 Year

Loan/
Value
Ratio

Put Option Costs

Millions of dollars
= 45% =35%

Interest Rate for Bank to

Earn Hedged Spread of 1.5%
(Prime=3.35%, LIBOR=0.5%)

= 25% = 45%

=35%

= 25%

$75 million approx

70%

$6.05

$3.46

$1.33

11.14%

7.03%

3.88%

$70 million

65%

$4.49

$2.32

$0.72

9.15%

5.57%

3.07%

$65 million

60%

$3.21

$1.46

$0.34

7.41%

4.40%

2.55%

$60 million

55%

$2.18

$0.86

$0.14

5.93%

3.51%

2.25%
23

24

Junk Bonds: Market Adjusted Debt Ratio (Quasi-Debt Ratio)

vs. Yield to Worst Call 5 Yr Treasury
(.10 interval MAD1 bucket Averages from 1800 bonds sampled)
MAD1= Face Val Debt/(Face Debt + Mkt Equity) Merton (1974, J. Finance)

25
Source: Douglas T. Breeden and John B. Sprow, Smith Breeden Associates, 1989

26

27

28

Main Point:
The fair rate on a loan depends on the cost of the
options required to cover the banks credit risks. If
option costs are high (as with high volatility), then
loan rates must be high. Correspondingly, low
option costs permit low loan rates.
The loan to value ratio affects the exercise prices of
the options purchased. Intuitively, a lower loan to
value ratio reduces the credit risk and the cost of
option coverage.

29

Bank Credit Risks For a Partially Hedged Firm

Old Example with $11 mln promised debt payment (Fut=$14.82)
Oil
Prices
$8.00
$9.00
$10.00
$11.00
$12.00
$13.00

Unhedged
Firm Value
$8.0 m
$9.0 m
$10.0 m
$11.0 m
$12.0 m
$13.0 m

Futures
H=25%
$1.71
$1.46
$1.21
$0.96
$0.71
$0.46

$14.00

$14.0 m

$0.21

$15.00
$16.00
$17.00
$18.00
$19.00
$20.00

$15.0 m
$16.0 m
$17.0 m
$18.0 m
$19.0 m
$20.0 m

($0.04)
($0.29)
($0.54)
($0.79)
($1.05)
($1.30)

Hedge Gains
H=50% H=75%
$3.41 $5.12
$2.91 $4.37
$2.41 $3.62
$1.91 $2.87
$1.41 $2.12
$0.91 $1.37
$0.41

$0.62

($0.09)
($0.59)
($1.09)
($1.59)
($2.09)
($2.59)

($0.13)
($0.88)
($1.63)
($2.39)
($3.14)
($3.89)

Note: Loan promises payment of $11 million in one year;

H = Percent of oil risk hedged; V = Total firm value

H=0%
$8.00
$9.00
$10.00
$11.00
$11.00
$11.00

Bank Receipt on Loan

H=25% H=50% H=75%
$9.71 $11.00 $11.00
$10.46 $11.00 $11.00
$11.00 $11.00 $11.00
$11.00 $11.00 $11.00
$11.00 $11.00 $11.00
$11.00 $11.00 $11.00

$11.00

$11.00

$11.00

$11.00

$11.00
$11.00
$11.00
$11.00
$11.00
$11.00

$11.00
$11.00
$11.00
$11.00
$11.00
$11.00

$11.00
$11.00
$11.00
$11.00
$11.00
$11.00

$11.00
$11.00
$11.00
$11.00
$11.00
$11.00
30

Hedging Subordinated Debt With Spread of Put Options

Old Example with $11 mln promised debt payments,
$10 mln senior debt, $1 mln subordinated
Oil
Price
$8.00
$9.00
$10.00
$11.00
$12.00
$13.00

Firm Value
$8.0 m
$9.0 m
$10.0 m
$11.0 m
$12.0 m
$13.0 m

Payment to
Senior Debt
$8.0 m
$9.0 m
$10.0 m
$10.0 m
$10.0 m
$10.0 m

Subordinated
Debt Payoff
$0.0 m
$0.0 m
$0.0 m
$1.0 m
$1.0 m
$1.0 m

Buy Put
X = $11
$ 3.0 m
$ 2.0 m
$ 1.0 m
$ 0.0 m
$ 0.0 m
$ 0.0 m

Write Put
X = $10
$-2.00 m
$-1.00 m
$-0.00 m
$-0.00 m
$-0.00 m
$-0.00 m

Hedged
Sub. Debt
$1.00 m
$1.00 m
$1.00 m
$1.00 m
$1.00 m
$1.00 m

$14.00

$14.0 m

$10.0 m

$1.0 m

$ 0.0 m

$-0.00 m

$1.00 m

$15.00
$16.00
$17.00
$18.00
$19.00
$20.00

$15.0 m
$16.0 m
$17.0 m
$18.0 m
$19.0 m
$20.0 m

$10.0 m
$10.0 m
$10.0 m
$10.0 m
$10.0 m
$10.0 m

$1.0 m
$1.0 m
$1.0 m
$1.0 m
$1.0 m
$1.0 m

$ 0.0 m
$ 0.0 m
$ 0.0 m
$ 0.0 m
$ 0.0 m
$ 0.0 m

$-0.00 m
$-0.00 m
$-0.00 m
$-0.00 m
$-0.00 m
$-0.00 m

$1.00 m
$1.00 m
$1.00 m
$1.00 m
$1.00 m
$1.00 m
31

Conflicts of Interest
Between Bondholders and Stockholders
Once debt is outstanding, stockholders have the
incentives to take actions that benefit themselves at the
expense of the bondholders.

With debt outstanding, the objectives of maximizing the

value of the firm and the value of the equity are not
identical.
Examples of bondholdersstockholder conflicts
Claim dilution
Dividend payout
Asset substitution
32

Types of Bond Covenants

Restrictions on production and investment policy

Mergers
Financial assets
Sale of assets
Line of business
Restrictions on financial policy
Dividend payouts
Priority
Total debt
Provisions for auditing
Bond Covenants reduce but do not eliminate agency costs
Components of Agency Costs
Monitoring costs
Bonding costs
Residual loss
33

II. Risk and Return in

Corporate Bonds and Bank Loans
Quarterly Data: 1926-2011 Q3

34

35

Empirical Duration/Price Elasticity Estimates

for Treasuries and Corporates
(Monthly Data 1989-2010)
Quarterly returns regressed on 3-month changes in the
corresponding 5, 10, 30-Year Treasury Rates:

Slope
R-Squared
5-Year Treasury
-4.4
0.97
10-Year Treasury
-7.6
0.98
30-Year Treasury
-13.9
0.97
Quarterly returns regressed on 3-month changes in the
10-Year Treasury Rate:
AAA Corporate
-4.8
0.77
A Corporate
-4.0
0.41
BBB Corporate
-3.1
0.23
Junk Corporate(ex 07-10) -1.3
0.02
Mortgage Master
-3.0
0.71

36

Bond Ratings
Moodys

S&P

Quality of Issue
Investment-grade bonds:

Aaa

AAA

Highest quality. Very small risk of default.

Aa

AA

High quality. Small risk of default.

High-Medium quality. Strong attributes, but potentially vulnerable.

Baa

BBB

Medium quality. Currently adequate, but potentially unreliable.

High-yield (Junk) bonds:

Ba

BB

Some speculative element. Long-run prospects questionable.

Able to pay currently, but at risk of default in the future.

Caa

CCC

Poor quality. Clear danger of default.

Ca

CC

High speculative quality. May be in default.

Lowest rated. Poor prospects of repayment.

In default.

37

38

39

Moodys Average Cumulative Issuer-Weighted

Global Default Rates by Alphanumeric Rating, 1998-2007

Rating Year 1 Year 10

Aaa
0.00
0.00
Aa
0.00
0.00
Aa2
0.00
0.00
Aa3
0.00
0.17
A1
0.00
0.06
A2
0.05
0.52
A3
0.05
0.54
Baa1
0.20
1.66
Baa2
0.19
2.57
Baa3
0.39
4.49

Rating
Ba1
Ba2
Ba3
B1
B2
B3
Caa1
Caa2
Caa3
Ca-C
Investment-Grade
Speculative-Grade
All Rated

Year 1
0.42
0.77
1.05
1.70
3.89
6.18
10.54
18.98
25.54
38.27
0.10
4.69
1.78

Year 10
3.68
10.16
17.79
28.37
32.41
51.10
50.51
46.83
54.38
65.63
1.13
27.38
9.28
40

(%)
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008

Global Corporate Default Rates By Rating Cate gory (source: S&P)

AAA
AA
A
BBB
BB
B
0.00
0.00
0.00
0.00
0.00
2.27
0.00
0.00
0.21
0.34
4.22
3.13
0.00
0.00
0.00
0.32
1.16
4.55
0.00
0.00
0.00
0.66
1.14
3.39
0.00
0.00
0.00
0.00
1.48
6.44
0.00
0.00
0.18
0.33
1.31
8.33
0.00
0.00
0.00
0.00
0.37
3.08
0.00
0.00
0.00
0.00
1.04
3.62
0.00
0.00
0.00
0.60
0.71
3.37
0.00
0.00
0.00
0.58
3.55
8.54
0.00
0.00
0.00
0.55
1.67
13.84
0.00
0.00
0.00
0.00
0.00
6.99
0.00
0.00
0.00
0.00
0.69
2.62
0.00
0.00
0.14
0.00
0.27
3.08
0.00
0.00
0.00
0.17
0.98
4.58
0.00
0.00
0.00
0.00
0.67
2.89
0.00
0.00
0.00
0.25
0.19
3.47
0.00
0.00
0.00
0.41
0.96
4.59
0.00
0.17
0.18
0.19
0.94
7.28
0.00
0.00
0.26
0.37
1.24
7.73
0.00
0.00
0.35
0.33
3.22
11.23
0.00
0.00
0.00
1.00
2.78
8.10
0.00
0.00
0.00
0.22
0.56
3.97
0.00
0.00
0.08
0.00
0.52
1.55
0.00
0.00
0.00
0.07
0.20
1.71
0.00
0.00
0.00
0.00
0.29
0.80
0.00
0.00
0.00
0.00
0.19
0.24
0.00
0.38
0.38
0.47
0.76
3.82

Source: Standard & Poors Global Fixed Income Research and Standard a& Poors Credit Pro.

CCC/C
0.00
21.43
6.67
25.00
15.38
23.08
12.28
20.37
31.58
31.25
33.87
30.19
13.33
16.67
28.00
4.17
12.00
42.86
32.35
34.12
44.55
44.12
33.13
15.11
8.87
13.08
14.81
26.53

41

16

3.5

14

12

2.5

10

Moody Spec Grade Default Rate

2008

2004

2000

1996

1992

1988

1984

1980

1976

1972

1968

1964

1960

-0.5

1956

1952

1948

1944

0.5

1940

1936

1932

1928

1.5

1924

Loan Chargeoff %

18

1920

Spec Grade Bond Default Rate

Default Rates on Corporate Bonds and

Chargeoffs on Bank Loans 1920-2009e

Bank Chargeoff %

42

43

44

45

46

47

48

49

50

51

Corporate Bonds Have Major Nonlinearities:

Stock Market Betas Increase in Risky Times
Quarterly Data: 1926-2011
Junk Bond Spread <500 bp

Junk Bond Spread >500 bp

(220 Observations in good times)

(123 Observations in risky times)

vs
5-Yr
Govt

vs
S&P tCorr.
500 stat RSQ

vs
5-Yr
Govt

vs
t-stat S&P
500

0.09

1.10

0.05

Investmt
Grade
1.48
(Aaa,Aa)
Baa
Rated
Bonds

1.07

Junk
Bonds
<Baa

0.73

t-stat

35.5

6.1

0.86

0.11
23.7

0.94
7.1

0.75

0.21
11.7

9.4

0.55

2.8

0.43

15.8

0.71

16.6

0.69

0.27
7.8

0.16
9.7

t-stat Corr.
RSQ

0.48
0.8

52

Nonlinearity: Banks Loan Betas and Stock Equity

Betas Change with Changing Credit Quality
Corporate
Bond
Rating

Junk Bond Spread <500 bp

(220 Observs in good times)

Junk Bond Spread >500 bp

(123 Observs in risky times)

Loan Portfolio Bank Equity

Beta vs. SP500 Levered 10/1

Loan Portfolio Bank Equity

Beta vs. SP500 Levered 10/1

Aaa

0.09

0.90

0.05

0.50

Aa

0.09

0.90

0.10

1.00

0.10

1.00

0.15

1.50

Baa

0.11

1.10

0.27

2.70

Junk
(<Baa)

0.21

2.10

0.48

4.80
53

54

55

The Financial Panic of 2008/2009 and

the Tepid Recovery in 2010-2011

56

Six Sigma Drop In Real Estate Prices

and Loan Delinquencies Soar
Real estate prices have dropped by amounts that
were truly unmeasured previously. Recent moves
reflect many (6?) standard deviation events.
We tend to gauge what is a bad scenario by
looking at historical data to see how bad situations
can be. We need to think out of the box to
worlds and equilibria that have not been seen, but
are possible.
Doug, the recent Turner report in the UK suggests that one problem was that the history
Used in the empirical analysis, often just 5-6 years, was insufficient. JWPayne

D.T. Breeden, January 2011

57

Frequency of Housing Price 4Q % Changes

Case Shiller 1987-2009: 6 Sigma Event.
20
18
16
14
12
10
8
6
4
2
0

D.T. Breeden, January 2011

58

Housing Price Percentage Declines By Metro

Area to 2009/2010 Lows from 2006-2007 Peaks
Source: S&P Case Shiller

-60

-50

-40

-30

-20

Dallas
Charlotte
Denver
Portland
Cleveland
Seattle
Atlanta
New York
Boston
Chicago
Minneapolis
Composite 20 Mkts
Composite 10 Mkts
Washington, D.C.
Tampa
Detroit
Los Angeles
San Francisco
San Diego
Miami
Las Vegas
Phoenix
-10

0
59

60

2008

61

62

Leverage Matters. And if you are levered and

Correlations go to 1.0 in extreme markets
Leverage Ratios (Assets/Equity) for Bear Stearns,
Goldman, Morgan Stanley and Lehman 1996-2007

40.0
35.0
30.0
25.0

BSC

GS

MS

Dec-07

Dec-06

Dec-05

Dec-04

Dec-03

Dec-02

Dec-01

Dec-00

Dec-99

Dec-98

Dec-97

15.0

Dec-96

20.0

LEH
63

Financial Panic of 2008/2009:

Bank Stocks Fell 80%, as Much As In the Great Depression
End of Month, June 2007- Jan 2010 vs. Aug 1929- Aug1933
110

Fin

100
90
80

70
60
50

40
30

20
10

Bank Stocks: Great Depression 8/1929-12/1932

12/31/2009

10/31/2009

8/31/2009

6/30/2009

4/30/2009

2/28/2009

12/31/2008

10/31/2008

8/31/2008

6/30/2008

4/30/2008

2/29/2008

12/31/2007

10/31/2007

8/31/2007

6/30/2007

KBW Bank Stock Index (12/31/06=100) to 2/20/2009

64

Stock Price Falls of Big 5 Investment Banks

in the Financial Panic of 2008/2009
Price
12/31/20
06

2008
Low
Price

2009
Feb 2010
Low Price

Bear Stearns

$162.78

$ 4.81

Sold to
JPM for
$10

Goldman
Sachs

$199.35

$ 78.20

$47.41

Lehman
Brothers

$ 78.12

$ 0.05

Bankrupt

Merrill Lynch

$ 93.10

$ 13.10

Sold to
BAC
(For $27?)

Morgan
Stanley

$ 67.20

$ 9.58

$ 6.71

June 30
2012

$156.70

$95.86

$ 27.15

$14.59
65

Stock Price Falls of Commercial Banks

in the Financial Panic of 2008/2009
12/31/
2006

2008 Low

2009 Low

Feb 2010

June 30
2012

Bank of
America

$53.39

$18.52

$ 2.53

$15.94

$8.18

Citigroup

$55.70

$11.52

$ 0.97

$ 3.35

($27.41/10
)
= $2.74

JP Morgan

$48.30

$31.02

$14.96

$39.88

$35.73

National City

$36.56

$ 1.36

Sold to
PNC nr 0

Wachovia

$56.95

$ 1.84

Sold to
WFC nr 0

Wells Fargo

$35.56

$20.51

$ 7.80

$27.29

$33.44
66

Stock Price Falls of Insurers and Thrifts

in the Financial Panic of 2008/2009
Price
12/31/2006

2008
Low Price

2009
Low Price

Feb 2010

Fannie Mae $59.39

$0.43

$0.30

$ 0.96

Freddie
Mac

$67.90

$0.26

$0.25

$ 1.18

Washington $45.49
Mutual

$0.03

Bankrupt

AIG

$71.66

$1.35

$0.33

$ 1.21

Ambac

$89.07

$1.16

$0.35

$ 0.69

MBIA

$73.06

$3.90

$2.17

$ 4.93

November
2011

($23.91/20?)
= $1.19

$8.32

67

68

69

Nonlinear Risks in Corporate Bonds In the Financial

Panic of 2008/2009: Betas Increase in Bad Times

Junk Bond Return 10 Year Treasury Return vs. S&P 500 Stock
Return:
1989-2006 Data: -0.05 + 0.20 SP500
t=-0.3 t=4.7
RSQ=0.09
2007-2009 Data: 0.16 + 0.74 SP500
t=0.2 t=5.1
RSQ=0.45
----------------------------------------------------------------------------------------- Baa Bond Return 10 Year Treasury Return vs. S&P 500 Stock
Return:
1989-2006 Data: 0.02 + 0.06 SP500
t=0.3 t=3.4
RSQ=0.05
2007-2009 Data: 0.12 + 0.36 SP500
t=0.2 t=3.7
RSQ=0.31
70

Nonlinear Credit Option Risks in Bank Stocks:

2002-2006 Growth Period Betas vs. Betas in the
Financial Panic and Great Recession of 2007-2011
Betas Increase in Bad Times
Bank Stock Return (KBW Bank Stock Index, BKX) regressed on
S&P 500 Stock Return, Monthly data:
2002-2006 Data (N=60):

0.42 + 0.88 SP500

t= 2.0 t=15.3
RSQ=0.80

2007-2011 Data (N=57): -1.26 + 1.33 SP500

t=0.2 t=15.3
RSQ=0.81

And Value Lines beta estimates for many troubled banks went to
2.0 to 3.0 in the financial crisis (Citigroup, Wachovia, Bank of
America and the investment banks, insurers and others).

71

72

73

6/15/2007

5/18/2007
(18) GOLDMAN SACHS GROUP INC Bond Spread (right axis)

5/16/2008

4/18/2008

3/21/2008

2/22/2008

1/25/2008

12/28/2007

11/30/2007

11/2/2007

10/5/2007

9/7/2007

8/10/2007

7/13/2007

Goldman Sachs

260
350

240
300

220
250

200
200

180
150

160
100

140
50

Equity Prices
74

Citigroup Corporate Bond Spreads vs. Equity Prices

400
350

t-stat: 19.4

Bond Spread to UST

300

R2: 0.54

250
200
150
100
50
0
-50

15

20

25

30

35

40

45

50

55

60

Stock Price

75

Bear Stearns
180

1000
900
800
700
600
500
400
300
200
100
0

160
140
120
100
80
60
40
20

(1) BEAR STEARNS CO INC Bond Spread (right axis)

5/16/2008

4/18/2008

3/21/2008

2/22/2008

1/25/2008

12/28/2007

11/30/2007

11/2/2007

10/5/2007

9/7/2007

8/10/2007

7/13/2007

6/15/2007

5/18/2007

Equity Price
76

Black-Scholes-Merton Theory?
Bear Stearns Stock vs. Bond Price
140

105

120

100

100

80
90
60

Bond Price

Stock Price

95

85
40
80

20

75
9/28/2007

'10/31/07

'11/30/08
Stock

'12/31/07

'1/31/08

Bond 5.55 17

'2/29/08

'3/31/08

'4/30/08

Bond 6.4

77

Summary of the Main Results

1. The credit put option in corporate bonds and bank loans is apparent
in their returns. Returns on corporate bonds, bank loans and bank
stocks (which contain portfolios of bank loans) have negative convexity,
written options, and negative skewness. The Financial Panic of
2008/2009 gave a dramatic demonstration of these points.
2. Risks (betas) of corporate bonds, bank loans and bank stocks all
increase in times of economic stress such as recession or when
default fears are so great that the yield spread on junk bonds is 500
basis points over Treasury. Risks are not stable on these
investments.
3. Merton, Black and Scholes Nobel Prize winning option insights are
very helpful in understanding the nature of proper pricing of bank
loans and corporate bonds. Exact pricing of actual loans and
bonds is so complex that precise formulae do not exist for all loans.
78