Tuesday, July 22, 2008

U.S. GSE Credit Default Swaps and Market Discipline

(OFHEO Working Paper) Financial regulators are interested in harnessing market information and market discipline to improve the supervision and performance of financial institutions. Recent growth in the market for credit default swaps (CDS), derivative instruments that allow for the trading of credit risk, presents the possibility of a new and important source of such information. The current paper explores the potential role of the rapidly expanding CDS market in providing market information relative to Fannie Mae and Freddie Mac (the Enterprises). Since there is an inherent link between CDS and bonds, a preliminary question is whether the CDS market provides information not captured in the bond market. With respect to the Enterprises, this question takes on added importance in light of the previous research that failed to find default risk signals in bond market and stock market information. Thus, if CDS markets only replicate bond market information, little reason exists to invest additional regulatory resources monitoring them. To explore this topic, the paper first summarizes theory and evidence linking CDS pricing and bond pricing. This summary focuses on reasons why and evidence that the information from these markets may differ. The paper then documents a CDS dataset purchased from Markit Group, noting certain data limitations, and explores the behavior of CDS prices for the Enterprises and for other large U.S. financial institutions. In the process, the paper explores the relationship between CDS and bond pricing for the Enterprises.

The evidence indicates that CDS market participants evaluate and price the credit risk associated with the Enterprises differently from bond market participants. In particular, CDS market participants do not always price the credit risk associated with the obligations of the Enterprises lower than the credit risk associated with other large financial firms. In addition, a significant amount of the variation in the price of credit risk on the Enterprises’ subordinated debt is not explained by the pricing of credit risk on their senior debt, a very different result than found in bond market data.

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