Knowledge that Transforms

This paper investigates the risk structure of interest rates using pure discount bonds. The most striking feature of our estimates of default-risk premia is the resemblance of their time profile to the theoretical time profile obtained by Merton (1974).

When the S&L crisis finally boiled over, one-quarter of the Savings and Loan Associations in the country were already insolvent, and the losses embedded in the long-standing insurance guarantees were at least $100 billion. This book shows that serious problems had plagued the industry for 20 before the crisis, and the information was there to signal that trouble was brewing. It also shows that perverse incentives in the system made it worthwhile for financially weak S&Ls, the federal deposit insurers, the regulators, and the Congress to ignore the danger signs?everyone, in fact, except the taxpayers who had to foot the bill.

This paper finds that, for the 1935–1986 period, the market's risk-return relation does not have a January seasonal. The findings differ from those of other studies due to the use of value-weighted, rather than equally weighted, portfolios. Inferences are sensitive to the weighting procedure because of the small-firm return patterns in January. In particular, even in those Januaries for which the market return is negative, small-firm returns are positive, and they are more positive the higher is beta. This is consistent with the portfolio rebalancing explanation of the turn-of-the-year effect.

Firms and institutions are monitored and controlled through a complex set of implicit and explicit contractual relations. Because of these agency theoretic relations, institutional behavior in financial markets is not a simple reflection of the preference structures of individuals. Institutional preferences give rise to a demand for new financial instruments and innovations, even when the returns on these instruments are “spanned” in the sense of complete pricing. The innovations can be thought of as solving moral hazard problems. An agency theoretic example serves to illustrate the demand, supply, and financial marketing of stripped securities. In short, institutions matter.