Current Landscape

Temasek Holdings as well as several other sovereign wealth funds such as Qatar Investment Authority have invested in troubled financial service firms such as Merrill Lynch and Barclays. One of the important aspects of this crisis is the claim by many banks that their credit portfolios are trading at ‘fire sale’ prices or at steep discounts relative to their true value, which in turn results in their stock prices also being below its fundamental value. Is this justified? Can assets trade below true value?

Several financial crises including the current one are often accompanied by adverse economic circumstances. For example, the current crisis was triggered by loose lending standards. Thus, the current reduction in value of banks could be a downward correction of correct magnitude to account for earlier over pricing resulting from inadequate recognition of risk. On the other hand, finance research has documented many cases where the market overreacts to current events. Many previous financial crises have been accompanied by a ‘flight to quality’ where investors shun all risky assets in an indiscriminate fashion.

If the market has overreacted in the current credit crisis, then investors such as Temasek, who are buying into troubled banks, are getting a good deal by investing in cheap assets at fire sale prices. On the other hand, if the reduction in the value banks is solely attributable to loose lending standards and other adverse economic circumstances, then such fire sale investments should not be expected to yield higher returns relative to returns realised by investing in normal times. To the extent that the overpricing due to loose lending standards has not fully corrected, such investment in troubled companies may even result in lower than normal returns.

Current Research

This paper focuses on two things, both of which are very relevant to the current credit crisis. In particular, it studies the determinants of recovery rates (and loss given default) for a set of bank loans and public debt of US companies over a time period of 18 years from 1980 to 1999. It finds that industry distress has a strong impact on recovery rates, with recoveries being around 20% lower if a firm defaults when its industry peers are also experiencing distress.

A second important focus of this paper is to study the impact of fire sales on the market value of defaulted debt and defaulted bank loans.  We found strong evidence in favour of fire sales. In particular, market values of bank loans and publicly traded debt are very negatively impacted by the possibility of fire sales. There is also evidence to show that that fire sale effects are larger when the industry peers of the defaulted firm are also experiencing financial difficulties, something quite similar to the current status of the banking industry. Further, the magnitude of the loss in value due to fire sales is exacerbated when the defaulted firm has assets that are highly specific to the industry, i.e., the assets have few alternative uses outside the industry. For example, a real estate firm has assets that have many alternative uses. A financial service firm’s assets (example: loans) cannot be used outside of this industry.  Thus, real estate firms should be less impacted by fire sales than banks.

Implications

The study has several important implications. In particular, to the extent that financial buyers such as sovereign investment funds and other buyers with deep pockets can identify fire sales, they can profit by buying these assets cheaply and sell them when the industry returns to a normal state from its current distressed state.

A second important implication of this research is that several of the current credit risk models used in banks assumed constant recovery rates (or LGD). To the extent that recovery rates vary systematically with industry conditions, this suggests that Value at Risk (VAR) is measured incorrectly. The next generation of credit risk models would have to take into account the time varying nature of recovery rates, its correlation with the state of the industry as well as the its correlation with the default rate.

This paper was published in the Journal of Financial Economics in 2007 and took first runner-up place for the FAMA-DFA Best Paper Award. It was co-written with Prof Viral Acharya at the London Business School and Prof Sreedhar Bharath at the University of Michigan. Adapted by Tanmay Satpathy.