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1 April 2014 CFA Institute Journal Review

The Financial Crisis and Temporary Liquidity Guarantee Program: Their Impact on Fixed-Income Markets (Digest Summary)

  1. Nicholas Tan, CFA

The Federal Deposit Insurance Corporation created the Temporary Liquidity Guarantee Program in October 2008 to boost liquidity and confidence in the banking system, which had been in turmoil since 2007. By providing a guarantee for newly issued senior unsecured bank debt, this program aimed to attract risk-averse investors back into the corporate bond market by offering a temporary funding channel to banks and, in turn, encouraging the banks in the program to lend to corporations.

What’s Inside?

The authors study the effectiveness of the Temporary Liquidity Guarantee Program (TLGP) as a solution to the banking crisis. In particular, they quantify the market value of the program’s guarantee, which is similar to the guarantee on US Treasury debt, and study the program’s impact on liquidity and the credit crisis in debt markets.

How Is This Research Useful to Practitioners?

The results of the authors’ study demonstrate the positive effect of the TLGP on the liquidity and credit problems of AAA rated financial debt. The program helped lower borrowing costs of participating banks.

The authors posit that because bonds backed by the Federal Deposit Insurance Corporation (FDIC) carry the same implied level of guarantee as Treasuries, they should be similarly priced as risk free. But they find that the FDIC-backed bond issues yield 66 bps more than comparable Treasuries. Average yield spreads versus Treasuries are lower for commercial banks than investment banks, which the authors surmise is the result of commercial banks being subject to closer regulatory oversight.

They also find that banks that issued FDIC-backed debt experienced negative stock price reactions around the announcement date of the debt issue—a –1.53% abnormal return with a (–1, 0) window. However, the bond market reaction to the debt issuance was positive—a 0.32% abnormal return with a (–1, 0) window—indicating a pessimistic view by stockholders and an overall positive liquidity and credit view by bondholders. There also seems to be positive spillover from the TLGP into the overall AAA rated financial debt market, where an average 78 bp drop is observed in average AAA yields during the five-month window surrounding TLGP announcements.

FDIC-backed debt is found to trade at a significant yield advantage relative to non-FDIC-backed debt, with an average of a 132 bp difference, which indicates the premium the market was willing to pay for this guarantee.

How Did the Authors Conduct This Research?

More than 90% of the FDIC-backed debt issues were medium-term notes, most of which were issued in $100,000 minimums and with maturities between one and three years. At the height of the TLGP, there were 101 guaranteed issues with a combined amount of $345.8 billion.

The authors collect data from Bloomberg on all FDIC-backed, medium-term fixed-rate notes and debt with a minimum original maturity of one year from November 2008 to July 2009, which includes 70 issues by 25 banks after removing those with incomplete issue information.

The yield spreads of FDIC-backed debt are compared with those of Treasury debt by contrasting the daily bid yields of both on similar durations, with the yield spread calculated as the yield on FDIC-backed debt minus the yield of the T-note in the matched pair. Yield differentials of AAA debt and FDIC-backed debt are compared to examine the impact of the TLGP on the AAA debt market as a whole.

Using standard event-study methodology, the authors examine issuing banks’ stock returns surrounding the issue date of FDIC-backed debt over two standard event windows to gauge stockholders’ reactions to the TLGP. The issuing banks’ daily bond returns surrounding the issue date of FDIC-backed debt are also examined. To calculate abnormal bond returns, the authors use the bonds’ raw returns minus the return on Datastream indices.

To explore the liquidity and credit impact of the TLGP on the yield of the AAA debt market and the program’s effects on the overall AAA debt market against variables consisting of bond features and interest rates, the authors run regressions on percentage-of-yield changes of the market (excluding FDIC-backed debt). The regressions are run to examine both FDIC-backed debt issuance and the initiation of the TLGP.

The authors measure the value of the FDIC guarantee by regressing the yield differentials of non-FDIC-backed debt and FDIC-backed debt against bond issue and macroeconomic variables.

Abstractor’s Viewpoint

Liquidity crunches seem to be one of the major precursors of banking crises in recent years—for example, the recent financial crisis in the United States and Europe and just last year in China, where short-term liquidity issues led to sizeable spikes in interbank lending rates, freezing funding for some smaller banks. It has become evident that the latest episodes of liquidity crunches require tools more varied than the ones used traditionally by central banks to free up access to capital and that reassurances of action by main liquidity providers and a readiness to step in should be made the mainstays of financial markets going forward.

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