21/4/17: Millennials, Property ‘Ladders’ and Defaults

In a recent report, titled “Beyond the Bricks: The meaning of home”, HSBC lauded the virtues of the millennials in actively pursuing purchases of homes. Mind you - keep in mind the official definition of the millennials as someone born  1981 and 1998, or 28-36 years of age (the age when one is normally quite likely to acquire a mortgage and their first property).

So here are the HSBC stats:

As the above clearly shows, there is quite a range of variation across the geographies in terms of millennials propensity to purchase a house. However, two things jump out:

1. Current generation is well behind the baby boomers (when the same age groups are taken for comparatives) in terms of home ownership in all advanced economies; and
2. Millennials are finding it harder to purchase homes in the countries where homeownership is seen as the basic first step on the investment and savings ladder to the upper middle class (USA, Canada, UK and Australia).

All of which suggests that the millennials are severely lagging previous generations in terms of both savings and investment. This is especially true as the issues relating to preferences (as opposed to affordability) are clearly not at play here (see the gap between ‘ownership’ and intent to own).

That point - made above - concerning the lack of evidence that millennials are not purchasing homes because their preferences might have shifted in favour of renting and way from owning is also supported by a sky-high proportions of millennials who go to such lengths as borrow from parents and live with parents to save for the deposit on the house:

Now, normally, I would not spend so much time talking about property-related surveys by the banks. But here’s what is of added interest here. Recent evidence suggests that millennials are quite different to previous generations in terms of their willingness to default on loans. Watch U.S. car loans (https://www.ft.com/content/0f17d002-f3c1-11e6-8758-6876151821a6 and https://www.experian.com/blogs/insights/2017/02/auto-loan-delinquencies-extending-beyond-subprime-consumers/) going South and the millennials are behind the trend (http://newsroom.transunion.com/transunion-auto-loan-growth-driven-by-millennial-originations-auto-delinquencies-remain-stable) on the origination side and now on the default side too (http://www.zerohedge.com/news/2017-04-13/ubs-explains-whos-behind-surging-subprime-delinquencies-hint-rhymes-perennials).

Which, paired with the HSBC analysis that shows significant financial strains the millennials took on in an attempt to jump onto the homeownership ‘ladder’, suggests that we might be heading not only into another wave of high risk borrowing for property purchases, but that this time around, such borrowings are befalling and increasingly older cohort of first-time buyers (leaving them less time to recover from any adverse shock) and an increasingly willing to default cohort of first-time buyers (meaning they will shit some of the burden of default onto the banks, faster and more resolutely than the baby boomers before them). Of course, never pay any attention to the reality is the motto for the financial sector, where FHA mortgages drawdowns by the car loans and student loans defaulting millennials (https://debtorprotectors.com/lawyer/2017/04/06/Student-Loan-Debt/Student-Loan-Defaults-Rising,-Millions-Not-Making-Payments_bl29267.htm) are hitting all time highs (http://www.heraldtribune.com/news/20170326/kenneth-r-harney-why-millennials-are-flocking-to-fha-mortgages)

Good luck having a sturdy enough umbrella for that moment when that proverbial hits the fan… Or you can always hedge that risk by shorting the millennials' favourite Snapchat... no, wait...

8/5/16: Leverage and Management: Twin Risks or Separate Risks?

A new paper “How Management Risk Affects Corporate Debt” by Yihui Pan, Tracy Yue Wang, and Michael S. Weisbach (NBER Working Paper No. 22091 March 2016) looks at the role management risk (uncertainty about future managerial decisions) plays in increasing overall firm-wide default risk.

Specifically, the paper argues that “management risk is an important yet unexplored determinant of a firm’s default risk and the pricing of its debt. CDS spreads, loan spreads and bond yield spreads all increase at the time of CEO turnover, when management risk is highest, and decline over the first three years of CEO tenure, regardless of the reason for the turnover.”

The authors also show that a “similar pattern but of smaller magnitude occurs around CFO turnovers.”

Overall, “the increase in the CDS spread at the time of the CEO departure announcement, the change in the spread when the incoming CEO takes office, as well as the sensitivity of the spread to the new CEO’s tenure, all depend on the amount of prior uncertainty about the new management.”

Which means that leverage risk and management turnover risk can be paired.


In some detail, as authors note, “firm’s default risk reflects not only the likelihood that it will have bad luck, but also the risk that the firm’s managerial decisions will lead the firm to default”. In other words, while leverage risk matters on its own (co-determining overall firm risk), it also runs coincident and is possibly correlated with management turnover risk. “Management risk occurs when the impact of management on firm value is uncertain, and, in principle, could meaningfully affect the firm’s overall risk.”

This is not new. Empirically, we know that management risk is “an important factor affecting a firm’s risk. However, the academic literature on corporate default risk and the pricing of corporate debt has largely ignored management risk. This paper evaluates the extent to which uncertainty about management is a factor that affects a firm’s default risk and the pricing of its debt.”

Using a sample of primarily S&P 1500 firms between 1987 and 2012, the authors “characterize the way that the risk of a firm’s corporate debt varies with the uncertainty the market likely has about its management. The basic pattern is depicted in [the chart above]… The announcement of a CEO’s departure is associated with an increase in the firm’s CDS spread, reflecting an increased market assessment of the firm’s default risk. The CDS spread declines at the announcement of the successor, and further declines during the new CEO’s time in office, approximately back to the pre-turnover level after about three years.”

Quantitatively, the effect is sizeable: “the 5-year CDS spread is about 35 basis points (22% relative to the sample mean) higher when a new CEO takes office than three years into his tenure. Spreads on shorter-term CDS contracts exhibit an even larger sensitivity to CEO turnover and tenure. Spreads on loans and bond yield spreads also decline following CEO turnovers. These patterns occur regardless of the reason for the turnover; changes in spreads following turnovers that occur because of the death or illness of the outgoing CEO are not economically or statistically significantly different from changes in spreads in the entire sample.”

Dynamically, the results are also interesting: the process of risk pricing post-CEO exits is consistent with information updating / learning by markets. “The observed decline in default risk over tenure potentially reflects the resolution of uncertainty about management and hence a decline in management risk. …Bayesian learning models imply that if the changes in spreads around CEO turnover occur because of changes in management risk, then when ex ante uncertainty about management is higher, spreads should increase more around management turnover and decline faster subsequently. Consistent with this prediction, our estimates suggest that the increase in the CDS spread at the time of the CEO departure announcement, the change in the spread when the incoming CEO takes office, as well as the sensitivity of the spread to the new CEO’s tenure, all depend on the amount of uncertainty there is about the new management. For example, the increase in CDS spreads at the announcement of a CEO departure when the firm does not have a presumptive replacement is almost three times as high as when there is such an “heir apparent.” The revelation of the new CEO’s identity leads to smaller declines in spreads prior to the time when he takes over if the new CEO is younger than if he is older; presumably less is known about the young CEOs ex ante so less uncertainty is resolved when they are appointed. But once a younger CEO does take over, the market learns more about his ability from observing his performance, so the spreads decline faster.”

Fundamentals that may signal CEO quality ex ante also matter: “…when the CEO has an existing relationship with a lender before he takes his current job, the lender is likely to know more about the CEO’s ability and future actions, leading to lower management risk. Consistent with this argument, we find that the sensitivity of interest rates to the CEO’s time in office is 39-57% lower for loans in which the CEO has a prior relationship with the lender compared to those without such a relationship. This relation holds even if the CEO is an outsider and the relationship was built while he worked at a different firm, so the existence of the relationship is exogenous to the credit condition of the current firm.”

What about cost of debt and risk pricing? Some nice result here too: “Since uncertainty about management is likely to be idiosyncratic rather than systematic, it theoretically should not affect a firm’s cost of debt (i.e., the expected return on debt). Accordingly, firms should not adjust the cost of capital they use for capital budgeting purposes because of management-related uncertainty. In addition, since variation in management risk appears to be relatively short-term, it is unlikely to affect firms’ long-term capital structure targets. However, since management risk increases the volatility of cash flows, it should increase the demand for precautionary savings. Consistent with this idea, we find that firms facing higher management risk tend to have higher cash holdings. In particular, cash holdings decline with executive tenure, but only for firms for which management risk is likely to be high.”


Overall, an interesting set of results - highly intuitive and empirically novel. One thing that is missing is control for quality of governance within the firms, e.g.
- CSR
- ERM
- Board and C-level quality metrics
Avenue for future extension of the study…