VALUING TOXIC ASSETS: AN ANALYSIS OF CDO EQUITY
Francis A. Longstaff, UCLA Anderson School , and NBER
Brett Myers, Krannert School of Management, Purdue University, and Research Affiliates, LLC
This paper studies this issue from a novel perspective by contrasting the valuation of CDO equity with that of bank stocks. This is possible because both CDO equity and bank stock represent levered first-loss residual claims on an underlying portfolio of debt. There are strong similarities in the two types of equity investments. Using an extensive data set of CDX index tranche prices, we find that the discount rates applied by the market to bank and CDO equity are very comparable. In addition, a single factor explains more than 64 percent of the variation in bank and CDO equity returns. Although banks are presumably active creditportfolio managers, we find that bank alphas are significantly negative during the sample period and comparable in magnitude to those of more-passively-managed
CDO equity. Both banks and CDO equity display significant sensitivity to “shadow banking” factors such as counterparty credit risk, the availability of collateralized financing for debt securities, and the liquidity of the derivatives market. A key implication is that we may be able to value “toxic” assets using readily-available
stock market information.