Corporate Finance

March 20, 2009
Francisco Perez-Gonzalez, Organizer

Elena Loutskina, University of Virginia, and Philip Strahan, Boston College and NBER
Informed and Uninformed Investment in Housing: The Downside of Diversification

Concentrated lending declined dramatically between 1992 and 2006. Loutskina and Strahan show that mortgage lenders that concentrate in a few markets behave like informed investors, while diversified lenders behave like uninformed investors. First, concentrated lenders accept and retain more mortgage applications than diversified lenders. Second, they have higher profits than diversified lenders, their profits vary less systematically, and their stock prices fell much less during the 2007-08 credit crisis. Third, when concentrated lenders retain more mortgages, future housing prices tend to appreciate, but retention rates of diversified lenders have no power to explain price changes. Both across markets and over time, the share of concentrated lending - that is, the share of informed lending - is negatively related to the recent housing price run-up. The researchers conclude that inadequate information production helps explain the 2001-8 real estate bubble and crash.

Rajkamal Iyer, University of Amsterdam,Asim Ijaz Khwaja, Harvard University and NBER,Erzo Luttmer, Harvard University and NBER, and Kelly Shue, Harvard University
Screening in Alternative Credit Markets: Can Individual Lenders’ Infer Borrower Credit-worthiness in Peer-to-Peer Lending?

The past few years have seen a large growth in online peer-to-peer credit markets. Yet the sustainability of these alternate credit markets depends crucially on the ability of lenders to infer borrowers’ creditworthiness. Iyer and his co-authors examine this ability using a methodology that takes advantage of lenders not observing a borrowers’ true credit score but only seeing an aggregate credit category in the particular market considered. The researchers find that lenders are able to use available information to infer up to a third of the relevant content in a borrower’s credit score. This is economically significant and allows creditors to lend at a 200-basis-points lower rate for borrowers with (unobserved to them) better credit scores within a category. While lenders infer the most from standard “hard” information that is traditionally used by banks for screening, they also use non-standard (subjective) information for inference. The methodology here shows that, without needing to code information contained in pictures or personal descriptions a borrower posts, lenders learn even from such “softer” information, particularly when it is likely to provide credible/costly signals regarding borrower creditworthiness. These findings highlight that peer-to-peer markets do show a degree of efficiency and suggest they may even provide advantages over traditional lending markets by extracting information from non-traditional sources.

Adriano Rampini and S. Viswanathan, Duke University
Collateral and Capital Structure

Rampini and Viswanathan develop a dynamic model of the capital structure based on the need to collateralize loans with tangible assets. The model provides a unified theory of optimal firm financing in terms of the optimal capital structure, investment, leasing, and risk management policy. Tangible assets are a key determinant of the cross section and dynamic behavior of the capital structure. Firms with low tangible capital are constrained longer, lease more of their physical capital, and borrow less. Leasing of tangible assets enables faster firm growth. The model helps explain the “zero debt puzzle” as well as other stylized facts about the capital structure. For risk management the model implies that incomplete hedging of net worth is optimal.

Alex Edmans, University of Pennsylvania,Xavier Gabaix, New York University and NBER, Tomasz Sadzik, New York University, and Yuliy Sannikov, Princeton University
Dynamic Incentive Accounts

Optimal contracts in a dynamic model must address a number of issues absent from static frameworks. The CEO can manipulate earnings in the short run; he may undo contracts through private saving; and shocks to firm value can weaken the incentive effect of securities over time. Edmans and his co-authors analyze the optimal compensation scheme in such a setting. The efficient contract takes a surprisingly simple form, and can be implemented by a “Dynamic Incentive Account.” The CEO’s expected pay is escrowed into an account, a fraction of which is invested in the firm’s stock and the remainder in cash. The account features state-dependent rebalancing and time-dependent vesting. It is constantly rebalanced so that the equity fraction remains above a certain threshold; this threshold sensitivity is typically increasing over time even in the absence of career concerns. The account vests gradually both during the CEO’s employment and after he quits, so as to deter short-termist actions before retirement.

Joshua Rauh, University of Chicago and NBER, and Amir Sufi, University of Chicago
Capital Structure and Debt Structure

Using a novel dataset that records individual debt issues on the balance sheet of a large sample of rated public firms, Rauh and Sufi show that recognizing debt heterogeneity leads to new insights into the determinants of corporate capital structure. They first demonstrate that traditional capital structure studies that ignore debt heterogeneity miss a substantial fraction of capital structure variation. They then show that, relative to high credit-quality firms, low credit-quality firms are more likely to have a multi-tiered capital structure consisting of both secured bank debt with tight covenants and subordinated non-bank debt with loose covenants. Further, while high credit-quality firms enjoy access to a variety of sources of discretionary flexible sources of finance, low credit-quality firms rely on tightly monitored secured bank debt for liquidity. The findings are similar when the authors focus on plausibly exogenous credit quality variation in a sample of “fallen angels,” which are firms that are downgraded from investment grade to speculative grade by Moody’s Investors Services. They discuss the extent to which these findings are consistent with existing theoretical models of debt structure in which firms simultaneously use multiple debt types to reduce incentive conflicts.

Armen Hovakimian, Baruch College,Ayla Kayhan, Securities and Exchange Commission, and Sheridan Titman, University of Texas, Austin and NBER
Crediting Rating Targets

Credit ratings can be viewed as a summary statistic that captures various elements of a firm’s capital structure. They incorporate a firm’s debt ratio, the maturity and priority structure of its debt, as well as the volatility of its cash flows. However, regressions of credit ratings on firm characteristics provide inferences that are not always consistent with the interpretations of extant regressions that include various debt ratios as independent variables. In particular, Hovakimian and his co-authors find, coefficients of variables that have been viewed as proxies for the uniqueness and the extent that assets can be redeployed, for example, R and D expenses and asset tangibility, have different effects in the credit rating regressions than in the debt ratio regressions. In addition, the researchers find that after controlling for whether or not firms have debt ratings, the extant evidence of a positive relation between debt ratios and size is reversed. Finally, using regression-based proxies for target ratings and debt ratios, they find that deviations from rating targets as well as debt ratio targets influence subsequent corporate finance choices. When observed ratings are below (above) the target, firms tend to make security issuance and repurchase decisions that reduce (increase) leverage. In addition, firms are more likely to decrease (increase) dividend payouts when they have below (above) target ratings and make more (fewer) acquisitions when they have above (below) target ratings.

Redouane Elkamhi, University of Iowa, Jan Ericsson, McGill University, and Christopher Parsons, University of North Carolina, Chapel Hill
The Cost of Financial Distress and the Timing of Default

At any point in time, most firms are not in financial distress. This implies that they must suffer value losses unrelated to their leverage -- economic shocks -- before becoming financially distressed. Elkamhi, Ericsson, and Parsons show that if estimates of ex-ante financial distress costs are not filtered from the effects of future economic shocks, they are biased upward by a factor of five on average, and up to an order of magnitude. Filtered from economic shocks, pure ex-ante distress costs average less than 1 percent of current firm value. The authors also estimate sensitivities of ex-ante distress costs to leverage that are generally far too small to offset the expected tax benefits. Extending their analysis to the cross-section and time series, they confirm that ex- ante distress costs are highest: 1) when the risk premium in debt markets is high, and 2) among firms with high systematic risk. Overall, their results suggest that most firms use debt too conservatively, but they characterize conditions under which they do not.

Isil Erel, Ohio State University, Brandon Julio, London Business School, and Michael Weisbach, Ohio State University and NBER (Joint with Woojin Kim)
Financial Market Conditions and the Structure of Securities

Economic theory, as well as commonly-stated views of practitioners, suggests that downturns in financial markets can affect both the ability and manner in which firms raise external financing. Theory suggests that downturns should be associated with a shift toward less information-sensitive securities, as well as a “flight to quality”, in which firms can issue high-rated securities but not low-rated ones. Erel and his co-authors evaluate these hypotheses on a large sample of publicly-traded debt issues, seasoned equity offers, and completed loans. They find that market downturns lead firms to use less information-sensitive securities. In addition, poor market conditions affect the structure of securities offered, shifting them towards shorter maturities and more security. Furthermore, market conditions affect the quality of securities offered, with worsening conditions substantially lowering the number of low-rated debt issues. Overall, these findings suggest that market-wide conditions are important factors in firms’ capital raising decisions.

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