Asset reliability and security prices: evidence from credit markets

Abstract

We assess the relation between asset reliability and security prices. Concerns about asset reliability are increasing with the move to fair value accounting in general purpose financial reports. We provide pertinent evidence from credit markets. A key benefit of using credit market data to explore the capital market implications of asset reliability is the theoretical basis of Duffie and Lando (Econometrica 69(3):633–664, 2001). They show that asset reliability (measurement) concerns should be concentrated in short-term credit spreads. Thus a focus on credit term structure can facilitate a cleaner identification of the impact of asset reliability on security prices. We find that asset reliability issues, attributable to SFAS 157 disclosures of Level 2 and, especially, Level 3 financial assets for a set of US financial institutions over the period of August 2007 to March 2009, are a significant determinant of short-term credit spreads and the shape of the general credit term structure. Our findings are robust to a variety of control variables and research design choices.

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Acknowledgments

We thank seminar participants at Bocconi University, London Business School, London School of Economics, University of Sydney, and the MEAFA Conference. We also thank Darrell Duffie, Paul Dunmore, John Hand, Anya Kleymenova, S. P. Kothari, Francis Longstaff, Doron Nissim (editor), Stephen Penman, Stephen Schaefer, Lakshmanan Shivakumar, Kari Sigurdsson, Regina Wittenberg-Moerman, Fan Yu, Bin Zeng, and two anonymous referees for their useful comments. We are grateful to Feng Li for making available his measures of financial reporting transparency. We also thank Jing Zhang at Moody’s Analytics for providing us with EDF data. An earlier version of this paper was titled “Asset measurement uncertainty and credit term structure.” The views expressed here are those of the authors and do not reflect the views of Citadel LLC, its affiliates, or employees.

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Correspondence to Scott Richardson.

Appendices

Appendix 1: Variable definitions

CDS1Y/CDS5Y: The ratio of the spread on a 1-year CDS contract to the spread on a 5-year CDS contract. It measures the relative steepness of the front end of a given firm’s credit term structure.

CDS5Y/CDS10Y: The ratio of the spread on a five-year CDS contract to the spread on a 10-year CDS contract. It measures the relative steepness of the middle portion of a given firm’s credit term structure.

MCAP: The log of market capitalization.

MLEV: Market leverage, measured as the ratio of the sum of short-term and long-term debt to market capitalization.

DEPTH: The number of dealers providing quotes for the 5-year CDS contract as reported in the MarkIt database.

REFINANCE: The log ratio of short-term debt to long-term debt. It is a measure of companies’ need to access debt markets in the near term.

L23/TA: The ratio of financial assets marked to market as either Level 2 or Level 3 assets under FAS157 relative to total assets.

L2(3)/TA: The ratio of financial assets marked to market as Level 2 (3) assets under FAS157 relative to total assets.

L23/FA: The ratio of financial assets marked to market as either Level 2 or Level 3 assets under FAS157 relative to total financial assets.

L2(3)/FA: The ratio of financial assets marked to market as Level 2 (3) assets under FAS157 relative to total financial assets.

CDSJY: The quoted spread for a given firm’s credit default swap contract for J year maturity, where J = 1, 3, 5 or 10.

σ Assets : Our proxy for jump risk. It is the option-implied volatility of a liquid out-of-the-money put option with maturity of 90 days.

All variables are measured at the start of each month over the period August 2007 through March 2009. We stop our analysis at March 2009 due to the changes in the CDS market at that time.

We require at least three dealer quotes for a firm-month observation to be retained. We remove firm-month records where a given variable is in the extreme percentiles (i.e., delete top and bottom 1 percent).

We use US dollar-denominated CDS contracts with a modified restructuring (MR) clause.

Appendix 2: Sample firms

Banks
COUNTRYWIDE FINANCIAL CORP POPULAR INC
FANNIE MAE RADIAN GROUP INC
FEDERAL AGRICULTURE MT REGIONS FINANCIAL CORP
FEDERAL HOME LOAN MORT SUNTRUST BANKS INC
KEYCORP U S BANCORP
MGIC INVESTMENT CORP/W WACHOVIA CORP
NATIONAL CITY CORP WELLS FARGO & CO
PMI GROUP INC WMI HOLDINGS CORP
Diversified financials
AFFILIATED MANAGERS GR GOLDMAN SACHS GROUP IN
AMERICAN EXPRESS CO JANUS CAPITAL GROUP IN
AMERIPRISE FINANCIAL I JPMORGAN CHASE & CO
BANK OF AMERICA CORP LEGG MASON INC
BEAR STEARNS COMPANIES INC. LEHMAN BROTHERS HOLDINGS INC
CAPITAL ONE FINANCIAL MERRILL LYNCH & CO INC
CIT GROUP INC MORGAN STANLEY
DISCOVER FINANCIAL SVC SCHWAB (CHARLES) CORP
E TRADE FINANCIAL CORP SLM CORP
FRANKLIN RESOURCES INC STATE STREET CORP
Insurance
AFLAC INC LINCOLN NATIONAL CORP
ALLSTATE CORP LOEWS CORP
AMBAC FINANCIAL GROUP MARKEL CORP
AMERICAN FINANCIAL GROUP INC. MARSH & MCLENNAN COS
AMERICAN INTERNATIONAL GROUP MBIA INC
AON PLC METLIFE INC
ARCH CAPITAL GROUP LTD ODYSSEY RE HOLDINGS CO
ASSURANT INC PROGRESSIVE CORP-OHIO
BERKLEY (W R) CORP PRUDENTIAL FINANCIAL I
BERKSHIRE HATHAWAY REINSURANCE GROUP AMER INC.
CHUBB CORP RENAISSANCERE HOLDINGS
CNA FINANCIAL CORP SAFECO CORP
GENWORTH FINANCIAL INC TORCHMARK CORP
HARTFORD FINANCIAL SER TRAVELERS COS INC
HORACE MANN EDUCATORS CORP UNUM GROUP
KEMPER CORP/DE  
Real estate
AVALONBAY COMMUNITIES KIMCO REALTY CORP
BOSTON PROPERTIES INC MACK-CALI REALTY CORP
CAMDEN PROPERTY TRUST NATIONWIDE HEALTH PPTY
DDR CORP PROLOGIS INC
DUKE REALTY CORP RAYONIER INC
FIRST INDL REALTY TRUS SIMON PROPERTY GROUP I
GENERAL GROWTH PPTYS I UDR INC
HCP INC VORNADO REALTY TRUST
HEALTH CARE REIT INC WASHINGTON REIT
ISTAR FINANCIAL INC WEINGARTEN REALTY INVS

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Arora, N., Richardson, S. & Tuna, İ. Asset reliability and security prices: evidence from credit markets. Rev Account Stud 19, 363–395 (2014). https://doi.org/10.1007/s11142-013-9254-7

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Keywords

  • Credit markets
  • Asset reliability
  • Credit term structure
  • Value relevance

JEL Classification

  • G12
  • G14
  • M41