Internal Models, Make Believe Prices, and Bond Market Cornering - Ishita Sen

Finance

Speaker : Ishita Sen

Buil. T - Room T105

We show that U.S. life insurers used internal models to over-report the value of a large fraction of corporate bonds during the financial crisis. Reported credit spreads of bonds valued using internal models were substantially lower by 220 bps, as compared to bonds that are otherwise similar but valued using external sources. Misreporting is higher for bonds that are likely to be impaired and negatively affect regulatory ratios, for insurers that have low regulatory capital, and for bonds that are held by few insurers. Using novel data on U.S. state regulators, we document that misreporting is negatively correlated with the degree of supervision at the state level, but only within bonds held by multiple insurers. In contrast, supervision has limited impact on misreporting when a bond has a single owner, as the lack of reference prices increases the search cost for regulators. Consistent with these incentives, we show that insurers "corner the market" by holding a large fraction of a bond's issue, as this allows them to bypass regulatory scrutiny and limit trading, factors that enable misreporting with internal models. Our findings have implications for the micro-structure of a segment of the corporate bond market and for properly assessing the fragility of financial institutions in bad times.