The Journal of Finance

Credit Rationing, Income Exaggeration, and Adverse Selection in the Mortgage Market

Published: 05/23/2016   |   DOI: 10.1111/jofi.12426

BRENT W. AMBROSE, JAMES CONKLIN, JIRO YOSHIDA

We examine the role of borrower concerns about future credit availability in mitigating the effects of adverse selection and income misrepresentation in the mortgage market. We show that the majority of additional risk associated with “low‐doc” mortgages originated prior to the Great Recession was due to adverse selection on the part of borrowers who could verify income but chose not to. We provide novel evidence that these borrowers were more likely to inflate or exaggerate their income. Our analysis suggests that recent regulatory changes that have essentially eliminated the low‐doc loan product would result in credit rationing against self‐employed borrowers.

TOWARD A WORLD PAYMENTS SYSTEM: A REVIEW ARTICLE

Published: 03/01/1967   |   DOI: 10.1111/j.1540-6261.1967.tb01654.x

Anthony Y. C. Koo

Stochastic Dominance: A Note

Published: 06/01/1982   |   DOI: 10.1111/j.1540-6261.1982.tb02229.x

YORAM KROLL, HAIM LEVY

Optimal Bank Behavior under Uncertain Inflation

Published: 09/01/1985   |   DOI: 10.1111/j.1540-6261.1985.tb02369.x

YORAM LANDSKRONER, DAVID RUTHENBERG

In this paper, we derive a model of the individual banking firm facing stochastic inflation. The bank is considered as a depository financial intermediary operating in the primary market as a multiproduct price discriminating firm. A secondary market is also considered where liquidity surpluses and deficits are traded. Two types of assets and liabilities are assumed: deposits and loans linked to a general price level and nonlinked instruments. Effects of changes in the parameters such as inflation rate and variability, reserve requirements are analyzed.

The Effects of Different Taxes on Risky and Risk‐free Investment and on the Cost of Capital

Published: 03/01/1986   |   DOI: 10.1111/j.1540-6261.1986.tb04491.x

YU ZHU, IRWIN FRIEND

This paper analyzes the major factors which determine the effects of taxation on the value of risky assets and on the cost of capital, and shows how the magnitudes and even the signs of these effects depend on the values assumed for a few key parameters in the model. Using plausible values for these parameters, it is shown that the results obtained are frequently counter‐intuitive.

Mean Reversion across National Stock Markets and Parametric Contrarian Investment Strategies

Published: 12/17/2002   |   DOI: 10.1111/0022-1082.00225

Ronald Balvers, Yangru Wu, Erik Gilliland

For U.S. stock prices, evidence of mean reversion over long horizons is mixed, possibly due to lack of a reliable long time series. Using additional cross‐sectional power gained from national stock index data of 18 countries during the period 1969 to 1996, we find strong evidence of mean reversion in relative stock index prices. Our findings imply a significantly positive speed of reversion with a half‐life of three to three and one‐half years. This result is robust to alternative specifications and data. Parametric contrarian investment strategies that fully exploit mean reversion across national indexes outperform buy‐and‐hold and standard contrarian strategies.

MEASURING THE IMPACT OF CONSUMER CREDIT CONTROLS ON SPENDING*

Published: 05/01/1952   |   DOI: 10.1111/j.1540-6261.1952.tb01543.x

Clarke L. Fauver, Ralph A. Young

Inflation, Uncertainty, and Investment

Published: 07/01/1986   |   DOI: 10.1111/j.1540-6261.1986.tb04528.x

CARLISS Y. BALDWIN, RICHARD S. RUBACK

This paper investigates the effect of inflation on a firm's investments in fixed assets. When future prices are certain, inflation affects the present value of depreciation tax shields, and the impact of inflation on the choice between different lived assets is nonmonotonic. Future asset price uncertainty creates a valuable switching option and benefits shorter‐lived assets.

Did Subjectivity Play a Role in CDO Credit Ratings?

Published: 07/19/2012   |   DOI: 10.1111/j.1540-6261.2012.01748.x

JOHN M. GRIFFIN, DRAGON YONGJUN TANG

Analyzing 916 collateralized debt obligations (CDOs), we find that a top credit rating agency frequently made positive adjustments beyond its main model that amounted to increasingly larger AAA tranche sizes. These adjustments are difficult to explain by likely determinants, but exhibit a clear pattern: CDOs with smaller model‐implied AAA sizes receive larger adjustments. CDOs with larger adjustments experience more severe subsequent downgrading. Additionally, prior to April 2007, 91.2% of AAA‐rated CDOs only comply with the credit rating agency's own AA default rate standard. Accounting for adjustments and the criterion deviation indicates that on average AAA tranches were structured to BBB support levels.

Private and Public Merger Waves

Published: 04/12/2013   |   DOI: 10.1111/jofi.12055

VOJISLAV MAKSIMOVIC, GORDON PHILLIPS, LIU YANG

We document that public firms participate more than private firms as buyers and sellers of assets in merger waves and their participation is affected more by credit spreads and aggregate market valuation. Public firm acquisitions realize higher gains in productivity, particularly for on‐the‐wave acquisitions and when the acquirer's stock is liquid and highly valued. Our results are not driven solely by public firms' better access to capital. Using productivity data from early in the firm's life, we find that better private firms subsequently select to become public. Initial size and productivity predict asset purchases and sales 10 and more years later.

Idiosyncratic Cash Flows and Systematic Risk

Published: 05/01/2015   |   DOI: 10.1111/jofi.12280

ILONA BABENKO, OLIVER BOGUTH, YURI TSERLUKEVICH

We show that unpriced cash flow shocks contain information about future priced risk. A positive idiosyncratic shock decreases the sensitivity of firm value to priced risk factors and simultaneously increases firm size and idiosyncratic risk. A simple model can therefore explain book‐to‐market and size anomalies, as well as the negative relation between idiosyncratic volatility and stock returns. Empirically, we find that anomalies are more pronounced for firms with high idiosyncratic cash flow volatility. More generally, our results imply that any economic variable correlated with the history of idiosyncratic shocks can help to explain expected stock returns.

Is Proprietary Trading Detrimental to Retail Investors?

Published: 02/02/2018   |   DOI: 10.1111/jofi.12609

FALKO FECHT, ANDREAS HACKETHAL, YIGITCAN KARABULUT

We study the conflict of interest that arises when a universal bank conducts proprietary trading alongside its retail banking services. Our data set contains the stock holdings of every German bank and those of their corresponding retail clients. We investigate (i) whether banks sell stocks from their proprietary portfolios to their retail customers, (ii) whether those stocks subsequently underperform, and (iii) whether retail customers of banks engaging in proprietary trading earn lower portfolio returns than their peers. We present affirmative evidence for all three questions and conclude that proprietary trading can, in fact, be detrimental to retail investors.

The Causal Effect of Limits to Arbitrage on Asset Pricing Anomalies

Published: 05/21/2020   |   DOI: 10.1111/jofi.12947

YONGQIANG CHU, DAVID HIRSHLEIFER, LIANG MA

We examine the causal effect of limits to arbitrage on 11 well‐known asset pricing anomalies using the pilot program of Regulation SHO, which relaxed short‐sale constraints for a quasi‐random set of pilot stocks, as a natural experiment. We find that the anomalies became weaker on portfolios constructed with pilot stocks during the pilot period. The pilot program reduced the combined anomaly long–short portfolio returns by 72 basis points per month, a difference that survives risk adjustment with standard factor models. The effect comes only from the short legs of the anomaly portfolios.

Looking for Someone to Blame: Delegation, Cognitive Dissonance, and the Disposition Effect

Published: 08/06/2015   |   DOI: 10.1111/jofi.12311

TOM Y. CHANG, DAVID H. SOLOMON, MARK M. WESTERFIELD

We analyze brokerage data and an experiment to test a cognitive dissonance based theory of trading: investors avoid realizing losses because they dislike admitting that past purchases were mistakes, but delegation reverses this effect by allowing the investor to blame the manager instead. Using individual trading data, we show that the disposition effect—the propensity to realize past gains more than past losses—applies only to nondelegated assets like individual stocks; delegated assets, like mutual funds, exhibit a robust reverse‐disposition effect. In an experiment, we show that increasing investors' cognitive dissonance results in both a larger disposition effect in stocks and a larger reverse‐disposition effect in funds. Additionally, increasing the salience of delegation increases the reverse‐disposition effect in funds. Cognitive dissonance provides a unified explanation for apparently contradictory investor behavior across asset classes and has implications for personal investment decisions, mutual fund management, and intermediation.

Managerial Entrenchment and Capital Structure Decisions

Published: 04/18/2012   |   DOI: 10.1111/j.1540-6261.1997.tb01115.x

PHILIP G. BERGER, ELI OFEK, DAVID L. YERMACK

We study associations between managerial entrenchment and firms' capital structures, with results generally suggesting that entrenched CEOs seek to avoid debt. In a cross‐sectional analysis, we find that leverage levels are lower when CEOs do not face pressure from either ownership and compensation incentives or active monitoring. In an analysis of leverage changes, we find that leverage increases in the aftermath of entrenchment‐reducing shocks to managerial security, including unsuccessful tender offers, involuntary CEO replacements, and the addition to the board of major stockholders.

Pledgeability, Industry Liquidity, and Financing Cycles

Published: 07/04/2019   |   DOI: 10.1111/jofi.12831

DOUGLAS W. DIAMOND, YUNZHI HU, RAGHURAM G. RAJAN

Why do firms choose high debt when they anticipate high valuations, and underperform subsequently? We propose a theory of financing cycles where the importance of creditors’ control rights over cash flows (“pledgeability”) varies with industry liquidity. The market allows firms take on more debt when they anticipate higher future liquidity. However, both high anticipated liquidity and the resulting high debt limit their incentives to enhance pledgeability. This has prolonged adverse effects in a downturn. Because these effects are hard to contract upon, higher anticipated liquidity can also reduce a firm's current access to finance.

How Risky Are U.S. Corporate Assets?

Published: 12/11/2022   |   DOI: 10.1111/jofi.13196

TETIANA DAVYDIUK, SCOTT RICHARD, IVAN SHALIASTOVICH, AMIR YARON

We use market data on corporate bonds and equities to measure the value of U.S. corporate assets and their payouts to investors. In contrast to equity dividends, total corporate payouts are highly volatile, turn negative when corporations raise capital, and are acyclical. At the same time, corporate asset returns are similar to returns on equity, and both are exposed to fluctuations in economic growth. To reconcile this evidence, we argue that acyclical but volatile net repurchases mask the exposure of total payouts' cash components to economic growth risks. We develop an asset pricing framework to quantitatively illustrate this economic channel.

Investor Protection and Firm Liquidity

Published: 03/21/2003   |   DOI: 10.1111/1540-6261.00551

Paul Brockman, Dennis Y. Chung

The purpose of this study is to investigate the relation between investor protection and firm liquidity. We posit that less protective environments lead to wider bid‐ask spreads and thinner depths because they fail to minimize information asymmetries. The Hong Kong equity market provides a unique opportunity to compare liquidity costs across distinct investor protection environments, but still within a common trading mechanism and currency. Our empirical findings verify that firm liquidity is significantly affected by investor protection. Regression and matched‐sample results show that Hong Kong‐based equities exhibit narrower spreads and thicker depths than their China‐based counterparts.

ON SOME DEFINITIONAL PROBLEMS WITH THE METHOD OF CERTAINTY EQUIVALENTS

Published: 12/01/1977   |   DOI: 10.1111/j.1540-6261.1977.tb03366.x

Sasson Bar‐Yosef, Roger Mesznik

Optimal Security Design and Dynamic Capital Structure in a Continuous‐Time Agency Model

Published: 01/11/2007   |   DOI: 10.1111/j.1540-6261.2006.01002.x

PETER M. DeMARZO, YULIY SANNIKOV

We derive the optimal dynamic contract in a continuous‐time principal‐agent setting, and implement it with a capital structure (credit line, long‐term debt, and equity) over which the agent controls the payout policy. While the project's volatility and liquidation cost have little impact on the firm's total debt capacity, they increase the use of credit versus debt. Leverage is nonstationary, and declines with past profitability. The firm may hold a compensating cash balance while borrowing (at a higher rate) through the credit line. Surprisingly, the usual conflicts between debt and equity (asset substitution, strategic default) need not arise.