Knowledge that Transforms

We develop a multiasset trading model to examine the closed-end fund discount. The model shows that the discount can arise if the quality of private information in the underlying assets is sufficiently better than in the fund. The model also indicates that a discount (premium) can arise if the excessive volatility of the fund dominates (is dominated by) the fund's diversification benefit. Moreover, the model predicts a negative relation between the discount and the institutional ownership differential, as arbitrageurs prefer funds with large discounts. Using a sample of U.S. equity closed-end funds, we test these predictions and find supporting evidence. Journal of Economic Literature Classification Numbers: D82, G10, G12, G14.

This study analyzes effects on debt and equity claimants of asset sales into securitizations. Shareholders' returns are increasing in shareholder capitalization. Average losses to shareholders in mortgage-backed securities issuers are explained historically. First time issuance and increased securitization frequency are shareholder-wealth-increasing. Securitizers with actively traded bonds enjoy substantial and significant shareholder gains, which are greater the poorer the creditworthiness of the seller. Wealth transfer from bondholders to shareholders occurs in asset-backed securities among sellers with low credit ratings. Banks' claimants have benefited significantly more than other FIs' claimants, suggesting that securitization can alleviate regulatory burden. Journal of Economic Literature Classification Number: G14, G21.

This paper develops a framework for analyzing tradeoffs between policies for cleaning banks' balance sheets of bad debt when asymmetric information exists between banks and regulators regarding the amount of bad debt. The framework consists of a two-tier hierarchy composed of a regulator, banks, and firms. Hidden information and moral hazard are present at each tier of the hierarchy. The analysis identifies two types of effects of the regulator's policy choice: a direct effect on a bank's willingness to reveal its bad loans versus hiding them via loan rollovers, and an indirect effect on firm behavior as a function of the bank's response. The framework is applied to analyze tradeoffs between three policies: a laissez-faire policy, transfer of debt to an asset management company, and cancellation of debt inherited from a previous regime. Journal of Economic Literature Classification Numbers: G21; G28; G30; P34.

We examine the survival of nonrational investors in an evolutionary game model with a population dynamic for a large economy. The dynamic indicates that the growth rate of wealth accumulation drives the evolutionary process. We focus our analysis on the survival of overconfidence and investor sentiment. We find that underconfidence or pessimism cannot survive, but moderate overconfidence or optimism can survive and even dominate, particularly when the fundamental risk is large. These findings provide new empirical implications for the survivability of active fund management. Our results lend support to the relevance of the psychology of investors in studying financial markets. Journal of Economic Literature Classification Numbers: G10, G14.

We construct a degree-of-total-leverage framework to test whether and how shifts in product mix affect earnings volatility at 472 U.S. commercial banks between 1988 and 1995. Our framework, which accounts for cost and revenue synergies not captured in most previous studies, conceptually links earnings volatility to revenue volatility, expense fixity, and product mix. We find that replacing traditional lending activities with fee-based activities—an ongoing trend that may be strengthened by recent financial modernization—is associated with both higher revenue volatility and higher total leverage, which in this framework implies higher earnings volatility. Journal of Economic Literature Classification Numbers: G21, G32, D24.

We explore the optimal financial contract for a large investor with potential control over a firm's investment decisions. An optimal menu of claims resembles a U.S. version of lender liability doctrine—equitable subordination. This doctrine permits the court to subordinate a controlling investor's claim in bankruptcy, but only under well-specified conditions. It allows a firm to strike an efficient balance between: (i) inducing the large investor to monitor, and (ii) limiting the influence costs that arise when claimants can challenge existing contracts. We provide a partial rationale for a financial system in which powerful creditors do not hold blended debt and equity claims. Journal of Economic Literature Classification Numbers: G20, G33, K22.

This paper provides a detailed analysis of the call auction procedure on the Frankfurt Stock Exchange. We develop a direct measure of execution costs in a call auction that is comparable to the bid–ask spread in a continuous market. We find that transaction costs for small transactions in the call market are lower than the quoted spread in the continuous market, whereas transaction costs for large transactions in the call market are higher than the spread in the continuous market. An analysis of specialist (Makler) participation shows that Maklers provide a valuable service to the market. On average, their compensation is restricted to commission income rather than trading profits. Journal of Economic Literature Classification Number: G10.