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(originally published by Booz & Company)


Efraim Benmelech on Financial Contagion

Now there is a disruption within the industry: Airline One files for bankruptcy. As it quickly attempts to restructure to a scaled-down enterprise, Airline One’s managers begin to sell off aircraft. When you sell a lot of assets on short notice, the prices are going to drop. Hence, this is going to affect Airline Two. For the bonds issued by Airline Two that were secured by Boeing and, thus, overlapped with the aircraft of Airline One, we will see the credit spreads grow. But we won’t see a change in the credit spreads of Airline Two’s other bonds, which were secured by Airbus, the aircraft not used by Airline One.

So how do we know that the effect on Airline Two is driven by Airline One and not by an industry-wide shock? Because only the bonds secured by the same aircraft as those being sold by Airline One have seen their credit spreads increasing.

In our analysis, we look at the two types of aircraft bonds that were issued by Airline Two. We differentiate between how much each bond overlaps with the fleet of Airline One. There we can identify contagion. If both types of Airline Two’s bonds were similarly affected, it would be an indication that larger forces were causing the industry disruption and that Airline One’s distress was not the cause of Airline Two’s.

S+B: Does the airline analogy map onto other kinds of contagion?
We believe so. We used the airline industry because we wanted to have precise estimates and it’s such a clean test. We can classify individual aircraft and we can look at the overlap between different types of collateral, so this facilitates the study. But the methods of the study should not be confined to the airline industry. We can extend the argument to housing markets, which are incredibly important. We can extend the argument to sovereign debt, and we can extend the argument to other types of corporate debt.

S+B: Are there particular sectors in which we’re more likely to see contagion occur?
Industries in which there are a lot of networks and industries that share the same types of assets are industries in which you might have contagion. The more connections—the more business that occurs within the industry, the more the firms depend on one another—the more potential for contagion you have.

S+B: The 2008 crisis is still very much on people’s minds.  Would you say that’s a clear example of contagion in the banking sector?
The whole reason that people are concerned about banking is contagion. Banks make loans to one another, and if one bank collapses it could lead to the collapse of another bank and potentially the collapse of the sector. This is why people were so worried about the collapse of Lehman Brothers. Other financial institutions had made loans to Lehman Brothers or had securities insured with Lehman. Once the value declined, they had to sell them, and then the value of the collateral fell further and then more banks failed.

In the Great Depression, many banks failed, and they failed in a domino pattern. In 2008, banks were failing, but the domino effect was smaller because we had more regulation and more intervention in place. But it’s still a major concern.

S+B: If contagion spreads across industries like a disease in the body, can a company immunize itself against it?
It’s not exactly that a company can immunize itself completely, but it can definitely take steps to avoid having a weak immune system. The strength of a company’s immune system is directly tied to the amount of debt it has.

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