Corporate Finance

April 23, 2010
Efraim Benmelech, NBER and Harvard University, and Nittai Bergman, NBER and MIT, Organizers

Martin Oehmke, Columbia University, and Patrick Bolton, Columbia University and NBER
Credit Default Swaps and the Empty Creditor Problem

A number of commentators have raised concerns about the empty creditor problem that arises when a debtholder has obtained insurance against default but otherwise retains control rights in and outside bankruptcy. Bolton and Oehmke analyze this problem from an ex-ante and ex-post perspective in a formal model of debt with limited commitment, by comparing contracting outcomes with and without credit default swaps (CDS). They show that CDS, and the empty creditors they give rise to, have important ex-ante commitment benefits: by strengthening creditors' bargaining power, they raise the debtor' pledgeable income and help to reduce the incidence of strategic defaults. However, the researchers also show that lenders will over-insure in equilibrium, giving rise to an inefficiently high incidence of costly bankruptcy. They discuss a number of remedies that have been proposed to overcome the inefficiency resulting from excess insurance.

Ali Hortacsu and Chad Syverson, University of Chicago and NBER; Gregor Matvos, University of Chicago; and Sriram Venkataraman, Emory University
Are Consumers Affected by Durable Good Makers' Financial Distress? The Case of Auto Manufacturers

Theory suggests the financial decisions of durable goods makers can impose externalities on their consumers. Namely, the consumption stream that durable goods provide frequently depends on services provided by the manufacturer itself (for example, warranties, spare parts availability, maintenance, and upgrades). Manufacturer bankruptcy, or even the possibility thereof, threatens this service provision and as a result can substantially reduce the value of its products to their current owners. Hortacsu, Matvos, Syverson, and Venkataraman test whether this hypothesis holds in one of the largest durable goods markets, automobiles. They use data on prices of millions of used cars sold at wholesale auctions around the United States during 2006-8. They find that an increase in an auto manufacturer's financial distress (as measured by an increase in its CDS spread) does result in a contemporaneous drop in the prices of its cars at auction, controlling for a host of other influences on price. The estimated effects are statistically and economically significant. Furthermore, cars with longer expected service lives (those within manufacturer warranty, having lower mileage, or in better condition) see larger price declines than those with shorter remaining lives. These patterns do not seem to be driven solely by reduced demand from auto dealers affiliated with the troubled manufacturers. These estimates also imply a potentially large indirect cost of financial distress on car manufacturers.

Gara Afonso and Anna Kovner, Federal Reserve Bank of New York, and Antoinette Schoar, MIT and NBER
Stressed, not Frozen: The Federal Funds Market in the Financial Crisis

Afonso, Kovner, and Schoar examine the impact of the financial crisis of 2008, specifically the bankruptcy of Lehman Brothers, on the federal funds market. Rather than a complete collapse of lending in the presence of a market wide shock, they see that banks become more restrictive in which counterparties they lend to. After Lehman Brothers, amounts and spreads become more sensitive to borrower bank characteristics. While the market does not contract dramatically, lending rates do increase. Further, the market does not seem to expand to meet the increased demand predicted by the drop in other bank funding markets. The researchers examine discount window borrowing as a proxy for unmet fed funds demand and find that the fed funds market is not indiscriminate. As expected, borrowers who access the discount window have lower ROA. When looking at the lender side, they do not find that the characteristics of the lending bank importantly affect the amount of interbank loans a bank makes. In particular, they do not find that worse performing banks start hoarding liquidity and indiscriminately reduce their lending.

Jeremy C. Stein, Harvard University and NBER
Monetary Policy as Financial-Stability Regulation

Stein develops a model that speaks to the goals and methods of financial stability policies. From a normative perspective, the model defines the fundamental market failure to be addressed, namely that unregulated private money creation can lead to an externality in which intermediaries issue too much short-term debt and leave the system excessively vulnerable to costly financial crises. Second, in a simple economy where commercial banks are the only lenders, conventional monetary-policy tools -- such as open-market operations -- can be used to regulate this externality; in more advanced economies, it may be helpful to supplement monetary policy with other measures. Third, from a positive perspective, the model provides an account of how monetary policy can influence bank lending and real activity, even in a world where prices adjust without friction and other transactions media exist, in addition to bank-created money, which are outside the control of the central bank.

Douglas W. Diamond, University of Chicago and NBER, and Zhiguo He, University of Chicago
A Theory of Debt Maturity: The Long and Short of Debt Overhang

Maturing risky short-term debt can impose a stronger debt overhang effect than long-term debt does, distorting the firm's investment decisions. Diamond and He derive the optimal maturity structure based on the trade-off between long-term overhang in good times and (stronger) short-term overhang in bad times. The theory has implications for empirical studies of debt maturity structure, understanding the excessive defaults and underinvestment during recessions, market-based pricing of credit lines, and firms' cash holdings.

Viral V. Acharya, New York University and NBER; Philipp Schnabl, New York University; and Gustavo Suarez, Federal Reserve Board
Securitization without Risk Transfer

Acharya, Schnabl, and Suarez analyze asset-backed commercial paper conduits which played a central role in the early phase of the financial crisis of 2007-9. They document that commercial banks set up conduits to securitize assets worth $1.3 trillion while insuring the newly securitized assets using guarantees. The guarantees were structured to reduce bank capital requirements while providing recourse to bank balance sheets for outside investors. Consistent with such recourse, the researchers find, during the first year of the crisis, asset-backed commercial paper issuance fell and spreads increased, especially for conduits with weaker guarantees, riskier banks, and lower quality assets. Furthermore, banks with more exposure to conduits had lower stock returns, and losses from conduits remained with banks rather than outside investors. These results suggest that banks used this form of securitization to concentrate, rather than to disperse, financial risks in the banking sector, all the while reducing their capital requirements.

Nicola Gennaioli, CREI; Andrei Shleifer, Harvard University and NBER; and Robert C. Vishny, University of Chicago and NBER
Financial Innovation and Financial Fragility

Gennaioli, Shleifer, and Vishny present a standard model of financial innovation in which intermediaries engineer securities with cash flows that investors seek, but the researchers modify two assumptions. First, investors (and possibly intermediaries) neglect certain unlikely risks. Second (less crucially), investors demand securities with safe cash flows. In the model, security issuance is excessive, and financial markets become extremely fragile. As the previously-unattended-to risks are recognized, investors fly to safety, and the excessive volume of innovation accelerates this flight. Financial innovation can make both investors and intermediaries worse off, and lead to instability even without leverage or fire sales. The model mimics several facts from recent historical experiences, and points to new avenues for possible financial reform.

Shawn Cole and Thomas Sampson, Harvard University, and Bilal Zia, The World Bank
Prices or Knowledge? What Drives Demand for Financial Services in Emerging Markets?

Financial development is critical for growth, but its micro-determinants are not well understood. Cole, Sampson, and Zia test competing theories of low demand for financial services in emerging markets, combining novel survey evidence from Indonesia and India with a field experiment. They find a strong correlation between financial literacy and behavior. However, a financial education program has modest effects, increasing demand for bank accounts only for those with low levels of education or financial literacy. In contrast, small subsidies greatly increase demand. A follow-up two years later confirms these findings, and demonstrates that financial literacy combined with subsidies led to greater savings.