Corporate Finance

April 19, 2013
Philipp Schnabl, Stern School of Business at New York University, and Zhiguo He, University of Chicago Booth School, Organizers

Rene Stulz, Ohio State University and NBER; Taylor Nadauld and Craig Merrill, Brigham Young University; and Shane Sherlund, Federal Reserve Board

Why Did Financial Institutions Sell RMBS at Fire Sale Prices During the Financial Crisis?

Much attention has been paid to the large decreases in value of non-agency residential mortgage-backed securities (RMBS) during the financial crisis. Many observers have argued that the fall in prices was partly caused by fire sales. Stulz, Nadauld, Merrill, and Sherlund use capital requirements and accounting rules to identify circumstances in which financial institutions had incentives to engage in fire sales and then they examine whether such sales occurred. For financial institutions subject to credit-sensitive capital requirements, capital requirements increase as an asset's credit becomes impaired. When accounting rules require such an asset's value to be marked-to-market and the fair value loss to be recognized in earnings, a capital-constrained firm can improve its capital position by selling the credit-impaired asset, even if it has to accept a liquidity discount to do so. In contrast, a financial firm whose fair value losses are not recognized in earnings for the purpose of calculating capital requirements, is more likely to satisfy capital requirements by selling liquid assets whose value has not fallen, and hence would be unlikely to engage in fire sales. Using a sample of 5,000 repeat transactions of non-agency RMBS by insurance companies from 2006 to 2009, the authors show that insurance companies that became more capital-constrained because of operating losses (uncorrelated with RMBS credit quality) and also recognized fair value losses sold comparable RMBS at much lower prices than other insurance companies during the crisis.

David Scharfstein, Harvard University and NBER, and Adi Sunderam, Harvard University

Concentration in Mortgage Lending, Refinancing Activity, and Mortgage Rates

Scharfstein and Sunderam present evidence that high concentration in local mortgage lending reduces the sensitivity of mortgage rates and refinancing activity to mortgage-backed security (MBS) yields. A decrease in MBS yields is typically associated with greater refinancing activity and lower rates on new mortgages. However, this effect is dampened in counties with concentrated mortgage markets. The authors isolate the direct effect of mortgage market concentration and rule out alternative explanations based on borrower, loan, and collateral characteristics in two ways. First, they use a matching procedure to compare high- and low-concentration counties that are very similar on observable characteristics and find similar results. Second, they examine counties where concentration in mortgage lending is increased by bank mergers. They show that within a given county, sensitivities to MBS yields decrease after a concentration-increasing merger. These results suggest that the strength of the housing channel of monetary policy transmission varies in both the time series and the cross-section. In the cross-section, increasing concentration by a single standard deviation reduces the overall impact of a decline in MBS yields by approximately 50 pecent. In the time series, a decrease in MBS yields today has a 40 percent smaller effect on the average county than it would have had in the 1990s because of higher concentration today.

William Fuchs and Aniko Oery, University of California at Berkeley, and Andrzej Skrzypacz, Stanford University

Transparency and Distressed Sales under Asymmetric Information

Fuchs and his co-authors analyze a dynamic market with short lived adverse selection and correlated values. Uninformed buyers compete inter- and intra-temporarily for a good that is sold by an informed seller who is suffering a liquidity shock. They contrast a transparent (public price offers) with an opaque (private price offers) information structure. First, they show that with private offers, a pure strategy equilibrium is not sustainable if the seller is patient enough. Moreover, they can fully characterize the equilibrium in both information structures in a three-period model if the buyers' valuations are a linear function of the seller's costs and if costs are uniformly distributed. Finally, they derive that in this setting, any equilibrium with private offers is weakly more efficient than the unique pure strategy equilibrium with public offers.

Bruno Biais and Augustin Landier, University of Toulouse

The (Ir)resistible Rise of Agency Rents

The rents that agents can extract from principals increase with the magnitude of incentive problems, which the literature usually takes as given. Biais and Landier endogenize it, by allowing agents to choose more or less opaque and complex technologies. In their overlapping generations model, agents compete with their predecessors. They study whether the presence of old-timers earning low rents can keep young managers' rent-seeking in check. With dynamic contracts, long horizons help principals to incentivize agents. Hence, old agents are imperfect substitutes for young ones. This mutes down competition between generations, especially if compensation deferral is strong. As a result, young managers can opt for more opaque and complex technologies, and therefore larger rents, than their predecessors. Thus, in equilibrium, complexity and rents rise over time.

Tobias Berg, Humboldt University; Manju Puri, Duke University and NBER; and Jorg Rocholl, ESMT

Loan Office Incentives and the Limits of Hard Information

Poor loan quality is often attributed to loan officers exercising poor judgment. A potential solution is to base loans on hard information alone. However, Berg, Puri, and Rocholl find other consequences of bypassing discretion stemming from loan officer incentives and limits of hard information verifiability. Using unique data where loans are based on hard information, and loan officers are volume-incentivized, they find that loan officers increasingly use multiple trials to move loans over the cut-off, both in a regression-discontinuity design and when the cut-off changes. Additional trials positively predict default suggesting strategic manipulation of information even when loans are based on hard information alone.

Daniel Paravisini, London School of Economics and NBER, and Antoinette Schoar, Massachusetts Institute of Technology and NBER

The Information and Agency Effects of Scores: Randomized Evidence from Credit Committees

Information technologies may affect productivity by reducing agents' information processing costs, and by making agents' private information easier to observe by the principal. Paravisini and Schoar distinguish these mechanisms empirically in the context of the randomized adoption of credit scoring in a bank that lends primarily to small businesses. They find that scores increase credit committees' effort and output on difficult-to-evaluate applications. Output also increases in a treatment where committees receive no new information about an applicant, but the score is expected to become available in the future. This effect is uniquely consistent with scores reducing asymmetric information problems inside credit committees and explains over 75 percent of the total output increase. Additional evidence suggests that scores improve productive efficiency by decentralizing decision-making and by equalizing the expected marginal returns across loans.

Kelly Shue, University of Chicago, and Richard Townsend, Dartmouth College

Swinging for the Fences: Executive Reactions o Quasi-Random Option Grants

The financial crisis renewed interest in the relation between compensation incentives and risk taking. Shue and Townsend examine whether paying top executives with options induces them to take more risk. To identify the causal effect of options, they exploit two distinct sources of variation in option compensation that arise from institutional features of multi-year grant cycles. They find that a 10 percent increase in the value of new options granted leads to a 3-6 percent increase in firm equity volatility. This increase in risk is primarily driven by an increase in leverage. They also find that an increase in stock options leads to lower dividend growth with mixed effects on investment and firm profitability.

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