November 2, 2012
Carola Frydman, Boston University and NBER; Eric Hilt, Wellesley College and NBER; and Lily Zhou, Federal Reserve Bank of New York
Frydman, Hilt, and Zhou use the unique circumstances that led to the Panic of 1907 to analyze its consequences for non-financial corporations. The panic was triggered by fears that the directors of trust companies were involved in a scandal that had no connection to any major corporation affiliated with those institutions. Using newly collected data, the authors find that corporations with close ties to the trust companies that faced severe runs experienced an immediate decline in their stock price, and performed worse in the years following the panic: they earned fewer profits and paid fewer dividends, and faced higher interest rates on their debt. Consistent with the notion that information asymmetries aggravated the consequences of the contraction of credit intermediation, these effects were largest for smaller firms and for industrials, whose collateral was more difficult to value than that of railroads.
Sumit Agarwal, National University of Singapore; Itzhak Ben-David, Ohio State University; and Vincent Yao, Fannie Mae
Borrowers who are financially-constrained have the incentive to influence the valuation process (for example, conditioning the transaction to go through at a high valuation) in order to borrow a larger loan amount or reduce the interest rate. Agarwal, Ben-David, and Yao show that the average valuation bias in refinance transactions is +3.6 percent. The bias is higher for highly-leveraged transactions (for example, +6.5 percent for cash-out transactions with leverage >95 percent), and for transactions mediated through a broker (by about +2.2 percent). Mortgages with inflated valuations are more likely to default, however lenders account for the valuation bias through pricing. Valuation inflation patterns became more severe in the run-up to the crisis and in bubble cities. In practice, the flexibility that appraisers have in determining valuation allows borrowers and lenders to circumvent the securitized risk criteria.
Kingsley Fong, University of New South Wales; Harrison Hong, Princeton University and NBER; Marcin Kacperczyk, New York University and NBER; and Jeffrey Kubik, Syracuse University
Fong, Hong, Kacperczyk, and Kubik test the hypothesis that security analysts discipline credit rating agencies. After all, analyst reports about a firm's equity likely would be informative about its debt-default probability and would calibrate its credit ratings. The authors follow Hong and Kacperczyk (2010) in using brokerage house mergers, which eliminate redundant analysts, to "shock" analyst following in order to identify the causal effect of coverage on credit ratings. They find that a drop in one analyst covering increases the subsequent ratings of a company by around a significant half-rating notch. This effect comes largely from firms with low initial analyst coverage and thus where the loss of one analyst represents a sizeable percentage drop in market discipline. The effect is stronger for firms close to default and therefore where firm debt trades more like equity. The higher ratings of having fewer analysts following also result in lower bond yields.
Anil Kashyap, University of Chicago and NBER, and Natalia Kovrijnykh, Arizona State University
Kashyap and Kovrijnykh analyze a model where investors use a credit rating to decide whether to finance a firm. The rating quality depends on the credit rating agency's (CRA) effort, which is unobservable. The authors analyze optimal compensation contracts for the CRA that dffier depending on whether the firm, investors, or a social planner orders the rating. They find that rating errors are larger when the firm orders it than when investors do. However, investors ask for ratings inefficiently often. Which arrangement leads to a higher social surplus depends on the agents' prior beliefs about the project quality. They also show that competition among CRAs causes them to reduce their fees, put in less effort, and thus leads to less accurate ratings. Rating quality also tends to be lower for new securities. Finally, they find that optimal contracts that provide incentives for both initial ratings and their subsequent revisions can lead the CRA to be slow to acknowledge mistakes.
Victoria Ivashina and David Scharfstein, Harvard University and NBER, and Jeremy Stein, Federal Reserve Board of Governors
A large share of dollar-denominated lending is done by non-U.S. banks, particularly European banks. Ivashina, Scharfstein, and Stein present a model in which such banks cut dollar lending more than euro lending in response to a shock to their credit quality. Because these banks rely on wholesale dollar funding, while raising more of their euro funding through insured retail deposits, the shock leads to a greater withdrawal of dollar funding. Banks can borrow in euros and swap into dollars to make up for the dollar shortfall, but this may lead to violations of covered interest parity (CIP) when there is limited capital to take the other side of the swap trade. In this case, synthetic dollar borrowing becomes expensive, which causes cuts in dollar lending. The authors test the model in the context of the Eurozone sovereign crisis, which escalated in the second half of 2011 and resulted in U.S. money-market funds sharply reducing the funding provided to European banks. Coincident with the contraction in dollar funding, there were significant violations of euro-dollar CIP. Moreover, dollar lending by Eurozone banks fell relative to their euro lending in both the U.S. and Europe; this was not the case for U.S. global banks. Finally, European banks that were more reliant on money funds experienced bigger declines in dollar lending.
Gregor Matvos, University of Chicago and NBER
Covenants allow firms to write more complete debt contracts. Matvos estimates the distribution of benefits that accrue to firms from their ability to write covenants into debt contracts. He shows that firms' surpluses from increased contractual completeness reduce to the same sufficient statistic across a wide variety of covenant models. This sufficient statistic can be estimated using covenant prices and firms' covenant choices, and is identified using revealed preference. Firms earn large surpluses when covenants can be written into debt contracts. For the average firm, the surplus exceeds the spread paid on a loan. The variety of covenant types significantly contributes to the large firm benefits. Restricting the ability to fine-tune individual covenants decreases gains from covenant contracting by at most 15 percent. These estimates suggest that if the intermediation sector can offer more complete debt contracts, ones that contain covenants, then substantial benefits can accrue to the non-financial sector.
Frederic Panier and Pablo Villanueva, Stanford University; Francisco Perez-Gonzalez, Stanford University and NBER
Panier, Perez-Gonzalez, and Villanueva show that capital structure significantly responds to changing tax incentives. To identify the effect of taxes, they exploit the introduction of a novel tax provision (the notional interest deduction, or NID) as an arguably exogenous source of variation to the cost of using equity financing. The NID, introduced in Belgium in 2006, drastically reduces the tax-driven distortions that favor the use of debt financing by allowing firms to deduct from their taxable income a notional interest charge that is a function of equity. The main findings here are: first, the NID led to a significant increase in the share of equity in the capital structure. Second, both incumbent and new firms increase their equity ratios after the NID is introduced. Third, the largest responses to these changing tax incentives are among large and new firms. Fourth, the increase in equity ratios is explained by higher equity levels and not by a reduction in other liabilities. These results are robust to using data from neighboring countries as a control group, as well as relying on a battery of tests aimed at isolating the effect of other potential confounding variables. Overall, the evidence demonstrates that tax policies designed to encourage the use of equity financing are likely to lead to more capitalized firms.