Knowledge that Transforms

We present an information-based explanation for spinoffs. When the various divisions of a firm are spun off into several firms that have separate stock market listings, the number of traded securities increases. This makes the price system more informative. It improves the quality of the investment decisions made by managers and reduces uninformed investors' uncertainty about the value of the divisions. Both effects serve to increase the sum total of the market values of the spun-off divisions above the market value of the original firm.Journal of Economic LiteratureClassification Numbers: G14, G34.

Violations of the absolute priority rule (APR) are commonplace in private workouts, formal business reorganizations, and personal bankruptcies. While some theorists suggest they may arise endogenously, they are clearly magnified by the institutional structure of the bankruptcy code. This paper shows that APR violations exacerbate credit rationing problems by reducing the payment lenders receive in default states. Furthermore, APR violations make default more likely to occur, thereby making debt financing more costly. Together, these results support the view that APR violations create an impediment to efficient financial contracting.Journal of Economic LiteratureClassification Numbers: G33, G38, K20.

This paper presents a model of large institutional and small individual investors choosing stocks. Dividend policy of firms is determined by the preferences of the resulting stockholders. Large investors choose to invest in large corporations because it lowers their transaction costs. Since these institutions prefer dividends, the large corporations choose to pay dividends, while the small corporations, owned by individuals, do not. The results show that firm size and liquidity explain the decision ofwhetherto pay dividends well, whereas existing informational explanations (such as monitoring and signaling) explain thelevelof dividends well.Journal of Economic LiteratureClassification Numbers: G32, G35, G11.

We consider the design of securities that govern the distribution of cash flows and control rights for an investment project. An entrepreneur, endowed with managerial talent, contracts with an outside investor for required capital. Optimal contracts stipulate that the ownership of control and the distribution of cash flows are specified on a state contingent basis to manage the distortions that develop from the use of outside financing and so make the best use of the advantage in project management enjoyed by insiders. Our results illustrate that the use of warrants and convertible securities, which transfer control of the firm to outsiders in good states, and bankruptcy, which transfers control to outsiders in bad states, are related features of optimal contracts. Our model also indicates that firms will benefit from direct access to two types of bankruptcy processes resembling Chapter 7 and Chapter 11 (including deviations from absolute priority) of the bankruptcy code. This results differs from observed practices since stockholders cannot waive their rights for protection under Chapter 11. We show that when direct access to Chapter 7 is highly valuable, market participants have found clever ways to obtain it.Journal of Economic LiteratureClassification Numbers: G32 and G33.

This paper investigates the empirical significance of underwriter reputation capital by analyzing the impact of initial returns of IPOs on lead-underwriter market value. Consistent with reputation costs, overpriced offerings are associated with a decrease in lead-underwriter market value significantly in excess of estimated direct costs. For moderately underpriced offerings, however, underwriter wealth effects are positive. Consistent with higher reputation costs, these wealth effects are insignificant when the IPO underpricing is more extreme. In jointly managed offerings, it is lead-underwriters that are primarily affected by IPO initial performance.Journal of Economic LiteratureClassification Numbers: G24, G32.

This paper tries to explain why the issuers of an asset would restrict what information is available about their asset. In a world where knowledge is valued, market forces should induce disclosure, but we often see markets (such as the market for mortgage-backed securities) where assets' issuers refuse to release valuable information. We present a model of market liquidity and find that market liquidity can both rise and fall with the quantity of released information. More information may increase asymmetries of information and “lemons” style breakdowns. We find that asset bundling is more advantageous when private information is more accurate, which may be the case in the mortgage-backed securities market.Journal of Economic LiteratureClassification Numbers: G14, G32.

I address the “decimalization” debate, i.e., whether trading on cent ticks rather than fractions of a dollar reduces trading costs without diminishing liquidity. I use Toronto Stock Exchange data following their switch to decimal trading on April 15, 1996. For stocks whose minimum tick was reduced from one-eighth of a dollar to five cents, decimalization reduced spreads, while liquidity was not adversely affected. Investors' trading costs and liquidity providers' profits declined on average, but trading volume did not increase. For stocks whose minimum tick size declined from 5 cents to 1 cent, decimalization had little impact on market quality.Journal of Economic LiteratureClassification Numbers: G12, G15

A model of asymmetric asset value information and nonverifiability of liquidation motives is developed to examine the optimal design and governance of asset-backed securities. Because of adverse selection risk, the liquidation option of whole loan sale results in external price discounting of composite cash flows. The alternative liquidation option of senior/subordinated security design is shown to dominate whole loan sale, since cash flow splitting allows the issuer to internalize some or all of the lemons-related liquidation costs. Security subordination levels must increase relative to full information levels, however, to protect uninformed outside investors. Pool diversification and loan bundling are shown to be packaging strategies that can soften the lemons-related subordination effect and therefore increase liquidation proceeds. With respect to security governance, we show that it is the junior securityholder who should control the debt renegotiation process with pooled debt structures. Better asset value information and a first loss position are the reasons for junior securityholder control in our model. Numerous empirical implications of the model are also identified and discussed.Journal of Economic LiteratureClassification Numbers: D46, D81, D82, G13, G21, G24, G32, G33.