Knowledge that Transforms

This article integrates the problem of designing corporate bankruptcy rules into a theory of optimal debt structure. We show that, in an optimal contracting framework with imperfect renegotiation, having multiple creditors increases a firm’s debt capacity while increasing its incentives to default strategically. The optimal debt contract gives creditors claims that are jointly inconsistent in case of default. Bankruptcy rules are therefore a necessary part of the overall financing contract, to make claims consistent and to prevent a value-reducing run for the assets of the firm. We characterize these rules, with predictions about the allocation of security rights, the right to trigger bankruptcy, and the symmetry of treatment of creditors in default.

This article examines the effect of household debt on investment decisions. We alter a simple portfolio choice model to allow households to retire outstanding debt and realize a risk-free rate of return equal to the interest rate on that debt. Using the Survey of Consumer Finances, we find that households with mortgage debt are 10 % less likely to own stocks and 37 % less likely to own bonds compared to similar households with no mortgage debt. We calculate the costs of nonoptimal investment in the presence of various forms of household debt. We find that 26 % of households should forgo equity market participation on account of the high interest rates they pay on their debt. (JEL D03, D12, D14, G11, G12) This article examines the effect of debt on the household portfolio. Whereas standard portfolio choice models focus primarily on the asset side of the house-hold balance sheet, we examine the effects of liabilities on investment deci-sions. Throughout the life cycle, many households accumulate debt from a variety of sources including mortgages, student loans, and consumer debt. Re-tirement of this debt offers households a return equal to the interest rate on their loan, which is almost always greater than the return to investing in the

We study a demand-and-supply model of judicial discretion in corporate bankruptcy. On the supply side, we assume that bankruptcy courts may be biased for debtors or creditors, and subject to career concerns. On the demand side, we assume that debtors (and creditors) can engage in forum shopping at some cost. A key finding is that stronger creditor protection in reorganization improves judicial incentives to resolve financial distress efficiently, preventing a “race to the bottom” toward inefficient uses of judicial discretion. The comparative statics of our model shed light on a lot of evidence on U.S. bankruptcy and yield novel predictions on how bankruptcy codes should affect firm-level outcomes.

We theoretically and empirically investigate firm-level risk dynamics around seasoned equity offerings (SEOs). Empirically, beta increases before SEOs and decreases gradually thereafter. Using real options theory, commitment-to-invest generates a gradual post-issuance beta decline whereas instantaneous investment and time-to-build do not. In a behavioral theory, systematic mispricing can cause increasing pre-issuance and decreasing post-issuance risk but idiosyncratic mispricing cannot. In the empirical cross-section, investment, own-firm runup, SEO proceeds, and primary issuance--associated with the real options theory--predict beta declines. Sentiment proxies have weaker effects in the full sample, but are significant in a post-1996 subsample. SEOs coincide with low firm- and market-volatility, suggesting volatility-timing in corporate decisions. The Author 2010. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: [email protected]., Oxford University Press.

This article examines how price risk affects housing demand. It identifies two relevant channels: a financial risk effect that reduces demand, and a hedging effect that increases demand since current homes may hedge future housing costs. The latter dominates when hedging incentives are strong, namely when the likelihood of moving up the housing ladder is high and the tendency to move across markets is low. For households with weak hedging incentives, the article finds negative effects of price risk on the timing and size of home purchases, but positive effects for households with strong hedging incentives. The Author 2010. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: [email protected]., Oxford University Press.

We provide direct evidence on the impact of asymmetric information on both financing and operating activities through a study of credit evaluations of microfinance institutions (MFIs). We employ a regression discontinuity model that exploits the eligibility criteria of an evaluation subsidy offered by a nonprofit consortium. Evaluations dramatically cut the cost of financing. This effect is strongest for commercial lenders and for short-term MFI–lender relationships. The impact of evaluations on the supply of finance is mixed. Evaluated MFIs lend more efficiently, extending more loans per employee.

There is a strong inverse relation between insider trading and institutional demand the same quarter and over the previous year. Our analysis suggests a combination of factors contribute to this relation. First, institutional investors are more likely to provide the liquidity necessary for insiders to trade. Second, insiders are more likely to buy low valuation and low lag return stocks while institutions are attracted to the opposite security characteristics. Last, the results are consistent with the hypothesis that insiders are more likely to view their securities as overvalued (undervalued) following a period when institutions were net buyers (sellers).

Information on borrower quality is a fundamental issue in debt contracting, corporate and consumer finance, and financial intermediation. We investigate the link between account activity and information production on borrower risk. Based on a unique data set, we find that credit line usage, limit violations, and cash inflows exhibit abnormal patterns approximately 12 months before default events. Measures of account activity substantially improve default predictions and are especially helpful for monitoring small businesses and individuals. Furthermore, early warning indications result in higher loan spreads, and in a higher likelihood of limit reductions and complete write-offs. Our study shows that account activity provides a real-time window into the borrower's cash flows, thus explaining why banks have an advantage in providing certain types of debt financing.

We provide new evidence linking board characteristics and performance. We employ a sample of index funds to isolate the operational component of performance, thereby minimizing investment policy effects in our performance measures. Using manually collected governance data from the mutual fund industry covering the period from 1998 to 2007, we find an inverse relation between board size and fund performance. We also find evidence supporting our hypotheses that organizational form (whether the fund sponsor is publicly or privately held) plays an important role in determining operational performance. Specifically, we find that board size, the presence of fund sponsor officers, and boards comprised of all independent directors are related to operational performance when the sponsor is publicly held. For privately held firms, board structure is insignificantly related to performance. Overall, the results are consistent with the notion that there may not be a single optimal board structure that is applicable to all funds, attempts to regulate board attributes should be considered with caution, and sponsor level factors are important board structure considerations. (JLE G34, G32, G20)

We examine situations where the same fund manager simultaneously manages mutual funds and hedge funds. We refer to this as side-by-side management. We document 344 such cases involving 693 mutual funds and 538 hedge funds. Proponents of this practice argue that it is essential to hire and retain star performers. Detractors argue that the temptation for abuse is high, and the practice should be banned. Our analysis based on various performance metrics shows that side-by-side mutual fund managers significantly outperform peer funds, consistent with this privilege being granted primarily to star performers. Interestingly, side-by-side hedge fund managers are at best on par with their style category peers, casting further doubt on the idea that conflicts of interest undermine mutual fund investors. Thus, we find no evidence of welfare loss for mutual fund investors due to exploitation of conflicts of interest.