Newer and Updated Working Papers:
“A Theory of Cash Flow Based Financing with Distress Resolution” with Simon Mayer and Konstantin Milbradt (September 2023). Accepted, Review of Economic Studies.
previously “A Theory of Asset and Cash Flow Based Financing”
abstract: We develop a dynamic contracting theory of asset- and cash flow-based financing that demonstrates how firm, intermediary, and capital market characteristics jointly shape firms' financing constraints. A firm with imperfect access to equity financing covers financing needs through costly sources: an intermediary and retained cash. The firm's financing capacity is endogenously determined by either the liquidation value of assets (asset-based) or the intermediary's going-concern valuation of the firm's cash flows (cash flow-based). The optimal contract is implemented with defaultable debt --- specifically unsecured credit lines and senior-secured debt --- and features risk-sharing via bankruptcy. When the firm does well, it repays its debt in full. When it does poorly, distress resolution mirrors U.S. bankruptcy procedures (Chapter 7 and 11). Secured and unsecured debt are complements because risk-sharing via unsecured debt increases secured debt capacity. Debt and equity are dynamic complements because future access to equity financing increases current debt capacity.
“Bank Fragility when Depositors are the Asset” with Valentin Haddad and Tyler Muir (April 2023)
abstract: Banks' relationships with their depositors are valuable when depositors remain sticky, but this value evaporates if they leave. This tension makes banks fragile when interest rates increase and long-term asset values are depressed. In this scenario, if all of its depositors leave, the bank fails, which justifies depositors' departure in the first place. Such failures can happen even when banks only invest in liquid assets and when deposits are insured, and they are more likely for banks with the most valuable relationships. This fragility leads to sharp changes in the exposure of bank values to interest rate risk: insensitive most of the time but highly responsive when asset losses are about to catch up with them. This non-linearity complicates the evaluation of capital adequacy, with neither mark-to-market nor hold-to-maturity providing an accurate picture of bank health. We find evidence consistent with these mechanisms during the rate increase of 2022 and 2023, culminating with the failure of Silicon Valley Bank.
“PE for the Public: The Rise of SPACs” with Sebastian Gryglewicz and Simon Mayer (Oct 2021).
[Slides]
abstract: A special purpose acquisition company (SPAC) allows sponsors to directly access public capital markets to raise funds to conduct acquisitions. Traditionally, such experts would raise capital for this activity by first tapping private markets to initiate a venture capital (VC) or private equity (PE) fund. We present a model that explains why SPAC financing has recently become attractive relative to the traditional PE-to-IPO approach. PE-to-IPO financing more efficiently separates high-quality from low-quality experts. SPAC financing more efficiently separates good acquisitions from bad acquisitions and therefore is the preferred mode of funding for firms subject to severe adverse selection. Thus, the increased use of SPAC financing is consistent with the recent rise of intangible assets and technology firms, which may have increased the severity of the adverse selection problem over firm acquisitions. The model explains several features of PE-to-IPO and SPAC financing.
Publications:
"Optimal Securitization with Moral Hazard" (DOI) with Tomasz Piskorski and Alexei Tchistyi (2012), Journal of Financial Economics, 104(1) 186-202
abstract: We consider the optimal design of mortgage-backed securities (MBS) in a dynamic setting in which a mortgage underwriter with limited liability can engage in costly hidden effort to screen borrowers and can sell loans to investors. We show that (i) the timing of payments to the underwriter is the key incentive mechanism, (ii) the maturity of the optimal contract can be short, and that (iii) bundling mortgages is efficient as it allows investors to learn about underwriter effort more quickly, an information enhancement effect. Finally, we demonstrate that the optimal contract can be closely approximated by the “first loss piece.”
"Reputation and Signaling in Asset Sales" (DOI) (2017), Journal of Financial Economics, 125(2) (2017) 245-265. Internet Appendix.
abstract: Static adverse selection models of security issuance show that informed issuers can perfectly reveal their private information by maintaing a costly stake in the securities they issue. This paper shows that allowing an issuer to both signal current security quality via retention and build a reputation for honesty leads that issuer to misreport quality even when owning a positive stake—the equilibrium is neither separating nor pooling. An issuer retains less as reputation improves and prices are more sensitive to retention when the issuer has a worse reputation.
"Are Lemons Sold First? Dynamic Signaling in the Mortgage Market" (DOI) with Manuel Adelino and Kris Gerardi (2019), Journal of Financial Economics, (Lead Article) 132(1) 1-25. Internet Appendix.
- Jensen Prize for Best Paper in Corporate Finance and Organizations in the Journal of Financial Economics, Second Place
abstract: A central result in the theory of adverse selection in asset markets is that informed sellers can signal quality by delaying trade. This paper uses the residential mortgage market as a laboratory to test this mechanism. Using detailed, loan-level data on privately securitized mortgages, we find a strong relation between mortgage performance and time-to-sale. Importantly, this finding is conditional on all observable information about the loans. This effect is strongest in the "Alt-A" segment of the market, where loans are often originated with incomplete documentation. The results provide some of the first evidence of a signaling mechanism through delay of trade.
"Capital Share Dynamics when Firms Insure Workers" (NBER Working Paper Version) (DOI) with Hanno Lustig and Mindy Zhang Xiaolan (2019), Journal of Finance, 74(4) 1707-1751. Internet Appendix.
abstract: Although the aggregate capital share for U.S. firms has increased, the firm-level capital share has decreased on average. The divergence is due to the largest firms. While these mega-firms now produce a larger output share, their labor compensation has not increased proportionately. We develop a model in which firms insure workers against firm-specific shocks. More productive firms allocate more rents to shareholders, while less productive firms endogenously exit. Increasing firm-level risk delays the exit of less productive firms and increases the measure of mega-firms, raising the aggregate capital share and lowering it on average. We present evidence supporting this mechanism.
"Investment Timing and Incentive Costs" (DOI) with Sebastian Gryglewicz (2020), Review of Financial Studies, 33(1) 309-357. Previously titled Dynamic Agency and Real Options.
abstract: We analyze how the costs of smoothly adjusting capital, such as incentive costs, affect in- vestment timing. In our model, the owner of a firm holds a real option to increase a lumpy form capital and can also smoothly adjust an incremental form of capital. Increasing the cost of incre- mental capital can delay or accelerate investment in lumpy capital. Incentive costs due to moral hazard are a natural source of costs for the accumulation of incremental capital. When moral hazard is severe, delaying investment in lumpy capital is costly and it is optimal to overinvest relative to the first-best case.
"The Insurance is the Lemon: Failing to Index Contracts" (DOI) with Benjamin Hebert (2020), Journal of Finance, 75(1) 463-506.
- Brattle Group Prize in Corporate Finance, First Place
abstract: We introduce a model to explain the widespread failure to index contracts to aggregate indices, despite the apparent risk-sharing benefits of indexation. Our model features these benefits, but demonstrates that asymmetric information about the ability of indices to measure underlying aggregate states can lead to risk-sharing failures and non-indexation. Suppose that a borrower receives an offer from a lender that features higher repayments in “good” states, in exchange for lower repayments in “bad” states. To make such an offer, a lender must ask for higher average repayments, because the lender is exposed to these aggregate risks. The borrower, however, is concerned that she is paying something for nothing; if the index is a poor measure of the true aggregate state, the cost of this contract might exceed its benefits. We provide conditions under which this effect is strong enough to cause the borrower to reject this contract, and choose a conventional, non-contingent contract instead. Under these conditions, many equilibria are possible, and they can be Pareto-ranked; the use of non-contingent contracts can be viewed as a coordination failure.
“Growth Options, Incentives, and Pay-for-Performance: Theory and Evidence" (DOI) with Sebastian Gryglewicz and Geoffery Zheng (2020), Management Science, 66(3), 1248-1277.
- Jacob Gold & Associates Best Paper Prize, ASU Sonoran Winter Finance Conference 2017
abstract: Pay-performance sensitivity is a common proxy for the strength of incentives. We show that growth options create a wedge between pay-effort sensitivity, which determines actual incentives, and pay-performance sensitivity, which is the ratio of pay-effort to performance-effort sensitivity. An increase in growth option intensity can increase performance-effort sensitivity more than pay-effort sensitivity, so that as incentives increase, pay-performance sensitivity decreases. We document empirical evidence consistent with this finding. Pay-performance sensitivity, measured by dollar changes in manager wealth over dollar changes in firm value, decreases with proxies for growth option intensity and increases with proxies for growth option exercise.
“Cash to Spend: IPO Wealth and House Prices” with Mark Thibodeau and Jiro Yoshida (2022). Forthcoming, Real Estate Economics
abstract: This study demonstrates the impact of initial public offerings (IPOs) on local house prices. Applying spatial difference-in-differences methods to IPOs in California from 1993 to 2017, we find house prices increase by 0.7% to 0.9% near an IPO firm's headquarters around filing and issuing dates. Upon lock-up expiration, price changes depend on post-issuance returns. Treating the San Francisco Bay as a commuting barrier, we identify sustained price increases after filings and temporary increases after issuing and lock-up expiration. We also confirm post-IPO price divergence between the treatment and synthetic control areas. Our findings indicate the effect of liquid wealth under mild financial constraints.
Older Working Papers:
"Collateral constraints, wealth effects, and volatility: evidence from real estate markets" with William Mann (2021). Revise and Resubmit, Review of Finance.
abstract: We document that, within-region, lower-income zip codes have more volatile returns to housing than do higher-income zip codes, without any corresponding higher returns. We rationalize this finding with a simple model that features a collateral constraint on borrowing and non-homothetic preferences over housing. Shocks to the representative household's marginal rate of substitution lead to volatility in the return to housing via the collateral constraint. We argue that lower-income households have a more volatile marginal rate of substitution, and thus more volatile returns to housing, consistent with our empirical findings. We provide further evidence for our mechanism using (1) variation in wealth induced by lagged housing returns; (2) cross-sectional data on the housing expenditure share; and (3) state-level non-recourse status, which instruments for the tightness of collateral constraints. Finally, we observe that endogenous volatility in housing returns may limit the available supply of housing, via producers' option to delay. Consistent with this hypothesis, the age of the housing stock is monotonically decreasing in local income levels.
“Corporate Liquidity Management under Moral Hazard” with Simon Mayer and Konstantin Milbradt (2020).
abstract: We present a model of liquidity management and financing decisions under moral hazard in which a firm accumulates cash to forestall liquidity default. When the cash balance is high, a tension arises between accumulating more cash to reduce the probability of default and providing incentives for the manager. When the cash balance is low, the firm hedges against liquidity default by transferring cash flow risk to the manager via high powered incentives. This risk transfer occurs even though the manager is risk averse and the firm’s owner’s are risk neutral because default is inefficient. Firms with more volatile cash flows transfer less risk to the manager and hold more cash. Agency conflicts lead to endogenous flotation costs related to the severity of the moral hazard problem. These flotation costs always reduce the funds raised during a refinancing round to below the no-moral-hazard benchmark.
"Mortgage Underwriting Standards in the Wake of Quantitative Easing" with Richard Stanton and Nancy Wallace (2014).
abstract: While the large-scale asset purchases (LSAPs) have funneled vast amounts of capital into the secondary market for mortgages, the direct effect of these programs on the primary mortgage market is not yet clear. We present evidence that while the LSAPs may have improved conditions for the least risky borrowers, they have not improved conditions for all borrowers. For example, the average FICO score of agency securitized mortgages increased from below 720 (low risk) in 2008 to above 760 (extremely low risk) in 2012. What explains this dramatic shift in the average quality of agency securitized mortgages, and why did it persist even with the flood of capital into the secondary mortgage market from the LSAPs? We argue that the change in the probability of buy back requests on Fannie and Freddie mortgage backed securities can explain the tightening of mortgage credit standards.
Work in Progress:
"A Theory of Optimal Capital Structure and Endogenous Bankruptcy" with Hengji Ai (2016).
“Bad Culture" with Mark Egan, Gregor Matvos, Amit Seru (2018).