Research Highlights
How Investors Interpreted Government Bailout Guarantees
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Our evidence implies that the financial sector equity holders enjoyed a sizable government subsidy in the form of free insurance against a collapse in bank stock prices.
When the US government pledged to bail out the nation’s biggest banks during the 2008 financial crisis, its ostensible aim was to back up debt holders. But in effect, the government offered free insurance to equity holders of banking stocks, according to new research by NYU Stern Professor Stijn Van Nieuwerburgh.
In “Too Systemic-to-Fail: What Option Markets Imply about Sector-Wide Government Guarantees,” Finance Professor Van Nieuwerburgh, Stern alumnus Bryan Kelly (PhD ’10) and Hanno Lustig analyzed the prices of options contracts during the 2007-2009 financial crisis from several different directions. They determined that shareholders understood that the government’s bailout program might not protect every individual bank, but would cap losses across the financial sector. This inference on the part of shareholders was reflected in the price behavior of put options (i.e., the option to sell assets at an agreed price on or before a particular date), which acts as insurance against losses.
The authors studied the financial sector basket-index put spread – that is, the difference between the prices of individual bank options and the financial sector index option. They found that the spread between financial sector put options and the puts on the basket of individual banks did not move as expected. They then determined that this unusual movement was best explained by a model utilizing a truncated downside risk in the financial sector. Further analysis showed that the basket-index put spread increased an average of 31 percent in the first five days after government announcements that made a bailout more likely. Announcements that indicated the reverse resulted in the put spread decreasing by an average of 38 percent.
“Our evidence implies that the financial sector equity holders enjoyed a sizable government subsidy in the form of free insurance against a collapse in bank stock prices,” the authors conclude. “We estimate that the insurance provided to financial sector equity investors was worth on average $282 billion during the financial crisis. This finding has implications for the measurement of systemic risk, which often relies on equity and equity option prices. Our results show that these prices are contaminated by the government guarantee, and that this contamination can be dramatic.” They suggest that policy makers might want to consider that presumably unintended result the next time a financial crisis looms.
In “Too Systemic-to-Fail: What Option Markets Imply about Sector-Wide Government Guarantees,” Finance Professor Van Nieuwerburgh, Stern alumnus Bryan Kelly (PhD ’10) and Hanno Lustig analyzed the prices of options contracts during the 2007-2009 financial crisis from several different directions. They determined that shareholders understood that the government’s bailout program might not protect every individual bank, but would cap losses across the financial sector. This inference on the part of shareholders was reflected in the price behavior of put options (i.e., the option to sell assets at an agreed price on or before a particular date), which acts as insurance against losses.
The authors studied the financial sector basket-index put spread – that is, the difference between the prices of individual bank options and the financial sector index option. They found that the spread between financial sector put options and the puts on the basket of individual banks did not move as expected. They then determined that this unusual movement was best explained by a model utilizing a truncated downside risk in the financial sector. Further analysis showed that the basket-index put spread increased an average of 31 percent in the first five days after government announcements that made a bailout more likely. Announcements that indicated the reverse resulted in the put spread decreasing by an average of 38 percent.
“Our evidence implies that the financial sector equity holders enjoyed a sizable government subsidy in the form of free insurance against a collapse in bank stock prices,” the authors conclude. “We estimate that the insurance provided to financial sector equity investors was worth on average $282 billion during the financial crisis. This finding has implications for the measurement of systemic risk, which often relies on equity and equity option prices. Our results show that these prices are contaminated by the government guarantee, and that this contamination can be dramatic.” They suggest that policy makers might want to consider that presumably unintended result the next time a financial crisis looms.