CFI Working Paper
"Catastrophic Risk and Credit Markets"
Mark Garmaise (UCLA Anderson) and Tobias Moskowitz (University of Chicago)
Financial markets can play a key role in mitigating catastrophe risk by efficiently spreading the risks, as well as supplying capital. Catastrophes, such as Hurricane Andrew in Florida and the Northridge earthquake in California, have given rise to innovations in the market for catastrophe risk. Firms have developed complex statistical models to assess risk; they invest in buildings and structures that have lower expected losses from natural disasters, and they utilize the catastrophe risk securitization market.
How efficient and competitive the catastrophe insurance markets are is another question. A new working paper by Mark Garmaise and Tobias Moskowitz takes a fresh look at the catastrophe insurance market, its inefficiencies and spillover effect to credit markets. The authors develop a model of the pricing and financing of properties in the presence of catastrophe risk and test their theory using unique data on catastrophic earthquake risk and commercial property loan contracts and prices in the U.S. from 1992-99.
The empirical results support the model's predictions. Inefficiencies in the supply of catastrophe insurance lead to inefficiencies in bank credit markets. Banks are inefficient in financing properties facing catastrophic risk because they do not specialize in monitoring whether property owners are taking measures and making investments to ensure maximal safety. Insurers, on the other hand, are properly equipped to evaluate safety-enhancing investments, but due to insufficient capital and a relatively small number of providers, the catastrophe insurance market is also inefficient.
Garmaise and Moskowitz analyze the impact of earthquake risk specifically, and find that in Los Angeles county, the median quake risk reduces the probability of bank financing by over 20%. They examine a specific event, the Northridge earthquake, and find that in the immediate months after, properties with high earthquake risk were especially unlikely to be financed with bank loans, and bank-financed transactions were concentrated in lower risk properties while the relationship between cash-financed transactions and the catastrophic risk of a property remained unchanged. However, this effect lasted only for about three months and had no significant longer-term effects.
The paper presents a general framework for analyzing a broad set of catastrophic risks including hurricane, terrorism, and political perils. The main result, that inefficiencies in the supply of catastrophe insurance lead to distortions in credit markets, supports the contention that catastrophe risk, and in particular earthquake risk, may neither be optimally priced nor optimally allocated among market participants. In particular, inefficiencies in the supply of catastrophe insurance leads to less bank financing of catastrophe-susceptible properties, limited market participation by less wealthy investors and incomplete insurance coverage. - P. Yang >>READ PAPER, "Catastrophic Risk and Credit Markets" (PDF)
CFI Research Note
Real Interest Rates, Expected Inflation and Real Estate Returns: A Comparison of the U.S. and Canada
Richard Roll (UCLA Anderson) and Kuntara Pukthaunthong-Le (San Diego State University)
Belief in a negative relation between mortgage rates and real estate values is virtually ubiquitous among journalists, homeowners, and real estate brokers. It appears to be based on compelling logic: an increase in mortgage rates implies a higher monthly payment for new borrowers, who should thereafter be less able to afford a home. But empirical support for the above belief has not been overwhelming; house prices have often boomed in periods of high inflation and high nominal interest rates. Is there some reason why increases in mortgage rates should not bring lower housing values? The answer is yes.
The mortgage interest deduction in the United States effectively implies that homeowners in high inflation environments can deduct part of the real value of the principal of their mortgage loans over time. Nominal mortgage rates rise with inflation and are fully deductible for most homeowners while the real value of the outstanding principal declines over time. This suggests that increases in nominal interest rates could actually have a positive impact on house prices if those increases are induced by higher expected inflation.
In Canada, mortgage interest is not tax deductible, so increases in nominal interest rates caused by increased inflation brings no corresponding tax benefit to homeowners.
Higher interest rates induced by inflation should, however, also reduce the real returns for mortgage lenders in both countries, so nominal mortgage yields might rise by more than the expected inflation increase to compensate lenders for the added tax burden. But this supply consideration is the same in the two countries, so whatever the overall impact of inflation on house prices might be, it should be less in the United States than in Canada.We find empirical evidence that the effect of inflation on real house prices is indeed less in the U.S. We study real monthly returns on real estate investment trusts (REITs), which should be strongly correlated with real house prices because all types of real estate are substitutes. We impute real interest rates and expected inflation rates from nominal and indexed bonds in Canada and the U.S. and study the relation between REIT real returns and changes in these rates while controlling for broad equity movements.
Real interest rate changes have strongly negative and quite similar effects on REIT returns in both countries. In contrast, changes in expected inflation have very dissimilar effects; in Canada, increased inflation reduces REIT values significantly while the impact is not significantly different from zero in the U.S. Other empirical characteristics of REIT returns, such as the response to broad equity movements and explanatory power, are remarkably similar in the two countries, so we feel safe in concluding that some underlying genuine cause, possibly mortgage interest deductibility, is responsible for the striking dissimilarity in the impact of inflation. >>READ PAPER, "Real Interest Rates, Expected Inflation and Real Estate Returns: A Comparison of the U.S. and Canada" by Kuntara Pukthuanthong & Richard Roll
Managing Director, Barclays Capital
Matthew Barrett is a managing director and head of distressed debt and Special Situations Investing at Barclays Capital. Based in Los Angeles, Mr. Barrett is portfolio manager and is responsible for a team of professionals that invest proprietary capital in a wide range of assets, including distressed debt investments and other special situations. Prior to joining Barclays Capital in 2006, Mr. Barrett was at Oaktree Capital Management for 10 years as a Managing Director, Head of Analysis, and a leader of its Opportunities Funds -- one of the largest global distressed debt and special situations platforms. He received his MBA from the Anderson School in 1986.
Managing Director, Eureka Capital Markets, LLC
Stephen Greene is a senior managing director at Eureka. He has over 20 years of experience in mergers and acquisitions, financial restructuring and capital raising. Steve has played a meaningful role in closing over 70 transactions with an aggregate value in excess of $15 billion. Prior to Eureka, he established and led Andersen's Healthcare Corporate Finance practice in New York and was the co-founder and leader of Andersen's Western Region Corporate Finance practice. Before joining Andersen, he was a managing director with Houlihan, Lokey, Howard & Zukin, Inc. in charge of Houlihan's San Francisco office.
He received his M.B.A. in Finance from the Anderson School, U.C.L.A. He also holds an M.A. History (Fulbright/Hays fellowship) and a B.A. (Phi Beta Kappa and Honors in History), both from Stanford University. Steve is a Registered Securities Principal (Series 24) and a Registered Securities Representative (Series 7 and 63) through the NASD.
Hans Hufschmid is chief executive officer of GlobeOp and is based at the company's London office. Prior to becoming a founding partner in GlobeOp in 2000, Hufschmid was a principal at Long-Term Capital Management (LTCM) and co-head of its London office for five years, supervising traders, researchers, programmers and administration personnel.
He also served on the company's risk management and management committees. He previously spent 10 years with Salomon Brothers in London and New York, the last four as global head of foreign exchange sales and trading. A managing director, he was also a member of Salomon Brothers' credit committee. Hufschmid holds a B.S. in business administration from the University of Southern California and an MBA from the University of California, both in Los Angeles.
UCLA Anderson Ranked #1 in Publications Per Tenure-Track Finance Faculty in Top Four Finance Journals Over Past Five Years (Figures from W.P. Carey School of Business at A.S.U.)
- UCLA Anderson - 3.27
- Duke - 2.53
- Purdue - 2.50
- University of Chicago - 2.36
- Emory - 2.20
- Ohio State - 2.15
- Stanford - 2.13
- Harvard - 2.08
- M.I.T. - 1.95
- Utah - 1.92
Alternative Assets Conference Keynote Presentation
Larry Fink & Stephen Schwarzman
Compliance with FAS 123
Hybrid Funding Models for R&D