The Impact of Liquidity on Senior Credit Spreads During the Subprime Crisis
65 Pages Posted: 30 Mar 2013 Last revised: 8 Jul 2013
Date Written: May 23, 2013
This paper examines the effects of liquidity during the 2007-09 crisis, focussing on the senior tranche of the CDX.NA.IG Index and on Moody's AAA Corporate Bond Index. The aim is to understand whether these senior credit indices were discounted below fair value and to what extent this discount reflects a lack of depth in the relevant markets, scarcity of risk-capital, and liquidity preference exhibited by investors. Using cointegration analysis, the paper shows that during the crisis lower market and funding liquidity and higher investors' risk-aversion are important drivers of the increase in the spread of triple-A structured securities, while they are less significant to explain the spread of a portfolio of unstructured credits. Looking at the experience of the subprime crisis, the study explores the pitfalls of securitization when the conditions under which it can work properly (transparency and tradability) suddenly disappear; leaving investors highly exposed to systemic risk factors.
Keywords: Credit Default Swap Index, Structural Model, Crisis, Market Liquidity, Funding Liquidity, Systemic Risk
JEL Classification: G01, G10, G12, G13
Suggested Citation: Suggested Citation