TAILIEUCHUNG - Rollover Risk and Credit Risk

Before discussing our methodology, we motivate our study with a table illustrating bank adaptation and soft credit at work. The data are from a large Greek bank, covering tens of thousands applications by individuals for credit products. 4 Columns 1 and 2 show the monthly declared income and monthly payments on household credit products for self-employed individuals across di§erent industries, and column 3 presents the ratio of payments-to-income. On average, self-employed Greeks spend 82% of their monthly reported income servicing debt. To put this number in perspective, the standard practice in consumer Önance (in the United States as well as Greece) is to never lend to borrowers such. | The Journal of FINANCE The Journal of THE AMERICAN FINANCE ASSOCIATION THE JOURNAL OF FINANCE VOL. LXVII NO. 2 APRIL 2012 Rollover Risk and Credit Risk ZHIGUO HE and WEI XIONG ABSTRACT Our model shows that deterioration in debt market liquidity leads to an increase in not only the liquidity premium of corporate bonds but also credit risk. The latter effect originates from firms debt rollover. When liquidity deterioration causes a firm to suffer losses in rolling over its maturing debt equity holders bear the losses while maturing debt holders are paid in full. This conflict leads the firm to default at a higher fundamental threshold. Our model demonstrates an intricate interaction between the liquidity premium and default premium and highlights the role of short-term debt in exacerbating rollover risk. The yield spread of a firm s bond relative to the risk-free interest rate directly determines the firm s debt financing cost and is often referred to as its credit spread. It is widely recognized that the credit spread reflects not only a default premium determined by the firm s credit risk but also a liquidity premium due to illiquidity of the secondary debt market . Longstaff Mithal and Neis 2005 and Chen Lesmond and Wei 2007 . However academics and policy makers tend to treat both the default premium and the liquidity premium as independent and thus ignore interactions between them. The financial crisis of 2007 to 2008 demonstrates the importance of such an interaction deterioration in debt market liquidity caused severe financing difficulties for many financial firms which in turn exacerbated their credit risk. In this paper we develop a theoretical model to analyze the interaction between debt market liquidity and credit risk through so-called rollover risk when debt market liquidity deteriorates firms face rollover losses from issuing new bonds to replace maturing bonds. To avoid default equity holders need to bear the rollover losses while maturing debt .

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