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What Does the Failure of Silicon Valley Bank Say About the State of Finance?

Silicon Valley Bank wasn't ready for the Fed's interest rate hikes, but that's only part of the story. Victoria Ivashina and Erik Stafford probe the complex factors that led to the second-biggest bank failure ever.

Do Banks Have an Edge?

Reliance on high leverage is one distinctive component of the bank business model. This study suggests that the aggregate United States banking sector was relatively inefficient between 1960 and 2015. The falling costs of new production technologies in capital markets may further advantage capital markets over banks.

Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting

This paper studies the asset selection of private equity investors and the risk and return properties of passive portfolios with similarly selected investments in publicly traded securities. Results indicate that sophisticated institutional investors appear to significantly overpay for the portfolio management services associated with private equity investments.

The Cost of Capital for Alternative Investments

An accurate assessment of the cost of capital is fundamental to the efficient allocation of capital throughout the economy. Alternative investments are investments made by sophisticated individual and institutional investors in private investment companies like hedge funds and private equity funds. These investments are frequently combined with financial leverage to bear risks that may be unappealing to the typical investor or that require flexibility that public investment funds may not provide. Often there is a real possibility of a complete loss of invested capital. For this paper, Jakub W. Jurek and Erik Stafford study the required rate of return for a risk-averse investor allocating capital to alternative investments. They argue that the risks borne by hedge fund investors are likely to be positive net supply risks that are unappealing to average investors, such that they may earn a premium relative to traditional assets. Key concepts include: Even with direct knowledge of the underlying risks, the commonly used tools for asset allocation and determining required rates of return are inappropriate for these types of risk. A simple put writing strategy closely matches the risks observed in the time series of the aggregate hedge fund universe. Properly evaluating the risks of alternative investments is challenging. At the individual fund level, this will be especially difficult. The calibrations in this paper suggest that despite the seemingly appealing return history of alternative investments, many investors have not covered their cost of capital. Closed for comment; 0 Comments.

Crashes and Collateralized Lending

This paper presents a framework for understanding the contribution of systematic crash risk to the cost of capital for a variety of different types of securities. The framework isolates the systematic crash risk exposure of different collateral types (equities, corporate bonds, and CDO tranches), and provides a simple mechanism for allocating the cost of bearing this risk between a financing intermediary and investor. Research was conducted by Jakub W. Jurek (Bendheim Center for Finance, Princeton University) and Erik Stafford (Harvard Business School). Key concepts include: A typical loan extended by a broker to an investor for a purchase on margin is collateralized by the underlying security and protected by the investor's capital contribution (the collateral, margin, or "haircut"). The haircut protects the intermediary from changes in the liquidation value of the collateral. The researchers' focus is looking at haircuts as an effective protection against large market declines. They derive a schedule of haircuts and financing rates (spreads above the risk-free rate), which represents the intermediary's fair charge for providing leverage to the investor. The framework also can be used to stress test different types of collateral by examining the predicted financing terms as market conditions change. This systematic credit risk channel has not been explored in the banking literature, despite the growing role of collateralized borrowing in the economy (e.g. repo market) and the seeming relevance of ensuring collateral robustness in adverse economic states. Closed for comment; 0 Comments.

The Economics of Structured Finance

This paper investigates the spectacular rise and fall of structured finance. HBS professor Joshua Coval, Princeton professor Jakub Jurek, and HBS professor Erik Stafford begin by examining how the structured finance machinery works. They construct simple examples of collateralized debt obligations (CDOs) that show how pooling and tranching a collection of assets permits credit enhancement of the senior claims. They then explore the challenge faced by rating agencies, examining, in particular, the parameter and modeling assumptions that are required to arrive at accurate ratings of structured finance products. They conclude with an assessment of what went wrong and the relative importance of rating agency errors, investor credulity, and perverse incentives and suspect behavior on the part of issuers, rating agencies, and borrowers. Key concepts include: Small errors that would not be costly in the single-name market are significantly magnified by the collateralized debt obligation structure, and can be further magnified when CDOs are created from the tranches of other collateralized debt obligations, as was common in mortgage-backed securitizations. Explicitly acknowledging that parameters are uncertain would go a long way towards solving this problem. However, adopting this perspective on parameter uncertainty means far fewer AAA-rated securities can be issued and therefore present fewer opportunities to offer investors attractive yields. Investors need to recognize the fundamental difference between single name and structured securities in terms of exposure to systematic risk. Unlike traditional corporate bonds, whose fortunes are primarily driven by firm-specific considerations, the performance of securities created by tranching large asset pools is strongly affected by the performance of the economy as a whole. Senior structured finance claims have the features of economic catastrophe bonds, in that they are designed to default only in the event of extreme economic duress. Because credit ratings do not indicate conditions in which default is likely to happen, they do not capture exposure to systematic risks. The lack of consideration for certain types of exposure reduces the usefulness of ratings, no matter how precise they are made to be. Closed for comment; 0 Comments.

Economic Catastrophe Bonds

Pooling economic assets into large portfolios and tranching them into sequential cash-flow claims has become a big business, generating record profits for both the Wall Street originators and the agencies that rate these securities. This paper by business economics doctoral student Jakub Jurek and HBS professors Joshua Coval and Erik Stafford investigates the pricing and risks of instruments created as a result of recent structured finance activities. It demonstrates that senior collateralized debt obligation (CDO) tranches have significantly different systematic risk exposures than their credit rating-matched, single-name counterparts, and should therefore command different risk premia. Key concepts include: Investors in senior CDO tranches are grossly undercompensated for the highly systematic nature of the risks they bear. An investor willing to assume the economic risks inherent in senior CDO tranches can, with equivalent economic exposure, earn roughly 3 times more compensation by writing out-of-the-money put spreads on the market. Credit rating agencies do not provide customers with adequate information for pricing. They are willing to certify senior CDO tranches as "safe" when, from an asset pricing perspective, they are quite the opposite. Closed for comment; 0 Comments.

Pricing Liquidity: The Quantity Structure of Immediacy Prices

Researchers and participants in the market for securities have long been interested in the costs of transacting and the notion of liquidity as a performance measure of market structure. In real world capital markets, investors and corporations generally do not expect to transact at fundamental value. Rather, market participants face some degree of illiquidity, where they must sacrifice price, trade size, or speed of execution, forcing them to transact at prices away from fundamental value. The exact price of liquidity, however, is unknown. This paper develops an option-based model of the price of liquidity via the pricing of limit orders. Key concepts include: The model points to the competitiveness of market making as a potentially important driver of transaction prices. The model results in a simple formula that can be used to estimate transaction prices as a function of transaction size for individual securities, including very large transactions like corporate issues and takeovers. The uncertainty over transactable prices, relative to fundamental value, produces a liquidity risk. The model may be a useful step towards a new measure of liquidity risk. Closed for comment; 0 Comments.