Knowledge that Transforms

We provide estimates of holdings of highly rated securitization tranches of U.S. bank holding companies before the credit crisis and evaluate hypotheses that have been advanced to explain them. Whereas holdings exceeded Tier 1 capital for some large banks, they were economically trivial for the typical bank. Banks with high holdings were not riskier before the crisis using conventional measures, but they performed poorly during the crisis. We find that holdings of highly rated tranches were correlated with a bank's securitization activity. Theories unrelated to the securitization activity, such as "bad incentives" or "bad risk management," are not supported in the data.

We study capital structure choices that entrepreneurs make in their firms' initial year of operation, using restricted-access data from the Kauffman Firm Survey. Firms in our data rely heavily on external debt sources, such as bank financing, and less extensively on friends-and-family-based funding sources. Many startups receive debt financed through the personal balance sheets of the entrepreneur, effectively resulting in the entrepreneur holding levered equity claims in their startups. This fact is robust to numerous controls, including credit quality. The reliance on external debt underscores the importance of credit markets for the success of nascent business activity.

We study how firms allocate cash flow by estimating the cash-flow sensitivities of various uses of cash flow. We decompose cash flow into a transitory and a permanent component and focus on the allocation of the transitory component, which by construction contains little information about future growth opportunities. We find that more financially constrained firms allocate more transitory cash flow to cash savings and direct less toward investment than do less constrained firms, consistent with constrained firms accumulating liquidity to buffer against future financial constraints. We also illustrate several methodological advantages of our approach over alternative methods in previous studies.

We study how a firm's decision to offer bonds of various maturities affects the portfolio allocations of institutional investors. We argue that because of lower information-collection costs, institutional investors tilt their portfolios towards firms that offer bonds of various maturities. We show that this translates into lower bond yields, both in the primary and in the secondary bond markets.

Because of limited liability, insolvent banks have an incentive to continue lending to insolvent borrowers, in order to hide losses and gamble for resurrection, even though this is socially inefficient. We suggest a scheme that regulators could use to solve this problem. The scheme would induce banks to reveal their bad loans, which can then be dealt with. Bank participation in the scheme would be voluntary. Even though banks have private information on the quantity of bad loans on their balance sheets, the scheme avoids creating windfall gains for bank equity holders. In addition, some losses can be imposed on debt holders.

This paper considers the optimal joint decision on firm organization and capital structure under a tax-bankruptcy trade-off, stressing the role of guarantees against default. Conditional guarantees, which are embedded in parent-subsidiary structures, increase joint value and joint debt relative to unguaranteed stand-alone firms. Such guarantees, that are unilateral rather than mutual for moderate default costs, may dominate the unconditional mutual guarantees built in mergers. We study the optimal characteristics of both guarantors and beneficiaries, as well as their impact on the self-enforcement potential of conditional guarantees.

We analyze a model in which traders have different trading opportunities and learn information from prices. The difference in trading opportunities implies that different traders may have different trading motives when trading in the same market—some trade for speculation and others for hedging—and thus they may respond to the same information in opposite directions. This implies that adding more informed traders may reduce price informativeness and therefore provides a source for learning complementarities leading to multiple equilibria and price jumps. Our model is relevant to various realistic settings and helps to understand a variety of modern financial markets.

We study the impact of nationalism and interstate frictions on international economic relations by analyzing market reaction to adverse shocks to Sino-Japanese relations in 2005 and 2010. Japanese companies with high China exposure suffer relative declines during each event window; a symmetric effect is observed for Chinese companies with high Japanese exposure. The effect on Japanese companies is more pronounced for those operating in industries dominated by Chinese state-owned enterprises, whereas firms with high Chinese employment experience lower declines. These results emphasize the role of countries' economic and political institutions in mediating the impact of interstate frictions on firm-level outcomes.

We hypothesize that poor country-level governance, which makes public information less reliable, induces fund managers to increase their use of semipublic information. Utilizing data from international mutual funds and stocks over the 2000–2009 period, we find that semipublic information-related stock rebalancing can be five times higher in countries with the worst quality of governance than in countries with the best. The use of semipublic information increases price informativeness but also increases information asymmetry and reduces stock liquidity. It also intensified the price impact and liquidity crunch during the recent global financial crisis.

We show that wrongful discharge laws—laws that protect employees against unjust dismissal—spur innovation and new firm creation. Wrongful discharge laws, particularly those that prohibit employers from acting in bad faith ex post, limit employers' ability to hold up innovating employees after the innovation is successful. By reducing the possibility of holdup, these laws enhance employees' innovative efforts and encourage firms to invest in risky but potentially mould-breaking projects. We develop a model and provide supporting empirical evidence of this effect using the staggered adoption of wrongful discharge laws across U.S. states.