Knowledge that Transforms

We develop a model of the joint capital structure decisions of banks and their borrowers. Bank leverage of 85% or higher emerges because bank seniority both dramatically reduces bank asset volatility and incentivizes risk-taking by producing a skewed return distribution. Nonfinancial firms choose low leverage to protect their banks, presenting a partial resolution to the low-leverage puzzle. Our setup naturally extends to include government actions as we model bank assets using a modified Basel framework. Deposit insurance and bailout expectations lead banks and borrowers to take on more risk. Capital regulation lowers bank leverage but can increase bank risk due to a compensating increase in borrower leverage. Despite this, doubling current capital requirements reduces bank default risk by up to 90%, with only a small increase in loan interest rates.

How should regulators design effective emergency lending facilities to mitigate stigma during a financial crisis? I explore this question using data from an unexpected disclosure of partial lists of banks that secretly borrowed from the lender of last resort during the Great Depression. I find evidence of stigma in that depositors withdrew more deposits from banks included on the lists in comparison with banks left off the lists. Overall, the results suggest that an emergency lending facility that never reveals bank identities would mitigate stigma.

Did securitization exacerbate the foreclosure crisis by altering mortgage servicing practices? I exploit the unanticipated freeze of private mortgage securitization in 2007 to provide new evidence that securitization increases foreclosure probability and decreases modification probability. These effects are economically large and persist over time even after implementation of the Home Affordable Modification Program (HAMP) in 2009. Using hand-collected data on the contractual terms of servicing agreements, I show that servicers typically have broad discretion to modify loans but face significant incentives favoring foreclosure. The evidence implies that securitization significantly increased foreclosure rates during and after the crisis.

This paper studies the pricing of volatility risk using the first-order conditions of a long-term equity investor who is content to hold the aggregate equity market instead of overweighting value stocks and other equity portfolios that are attractive to short-term investors. We show that a conservative long-term investor will avoid such overweights to hedge against two types of deterioration in investment opportunities: declining expected stock returns and increasing volatility. We present novel evidence that low-frequency movements in equity volatility, tied to the default spread, are priced in the cross section of stock returns.

We show that inflation disagreement, not just expected inflation, has an impact on nominal interest rates. In contrast to expected inflation, which mainly affects the wedge between real and nominal yields, inflation disagreement affects nominal yields predominantly through its impact on the real side of the economy. We show theoretically and empirically that inflation disagreement raises real and nominal yields and their volatilities. Inflation disagreement is positively related to consumers’ cross-sectional consumption growth volatility and trading in fixed income securities. Calibrating our model to disagreement, inflation, and yields reproduces the economically significant impact of inflation disagreement on yield curves.

This paper contrasts the investment behavior of different financial institutions in debt securities as a response to past returns. For identification, I use unique security-level data from the German Microdatabase Securities Holdings Statistics. Banks and investment funds respond in a procyclical manner to past security-specific holding period returns. In contrast, insurance companies and pension funds act countercyclically; they buy when returns have been negative and sell after high returns. The heterogeneous responses can be explained by differences in their balance sheet structure. I exploit within-sector variation in the financial constraint to show that tighter constraints are associated with relatively more procyclical investment behavior.

I show that patents are pledged as collateral to raise significant debt financing, and that the pledgeability of patents contributes to the financing of innovation. In 2013, 38% of US patenting firms had previously pledged patents as collateral, and these firms performed 20% of research and development expense and patenting in Compustat. Employing court decisions as a source of exogenous variation in creditor rights, I show that patenting companies raised more debt, and spent more on R&D, when creditor rights to patents strengthened. Subsequently, these companies exhibited a gradual increase in patenting output and the use of patents as collateral.

Identifying the effects of “flights to safety” on asset prices using pure time-series methods is difficult because crises are infrequent. We develop a new cross-sectional identification approach, motivated by the insight that investors may differ in their “preferred habitats” within a broad asset class. We apply the method to the question of whether foreign capital is responsible for residential real estate price movements in global cities such as London and New York, especially during crises. Using large data sets of housing transactions, we find that foreign risk strongly affects London house prices. The effects are long-lasting, and are associated with both safe-haven effects and immigration.

Exploiting portfolio data and repeated surveys of an Italian bank's clients, we test whether investors’ risk aversion increases following the 2008 crisis. We find that, after the crisis, both qualitative and quantitative measures of risk aversion increase substantially and that affected individuals divest more stock. We investigate four explanations: changes in wealth, expected income, perceived probabilities, and emotion-based changes of the utility function. Our data are inconsistent with the first two channels, while they suggest that fear is a potential mechanism underlying financial decisions, whether by increasing the curvature of the utility function or the salience of negative outcomes.