Insufficient funds
Subprime Mortgage Defaults and Credit Default Swaps
Eric Arentsen et al.
Journal of Finance, forthcoming
Abstract:
We offer the first empirical evidence on the adverse effect of credit default swap (CDS) coverage on subprime mortgage defaults. Using a large database of privately securitized mortgages, we find that higher defaults concentrate in mortgage pools with concurrent CDS coverage, and within these pools the loans originated after or shortly before the start of CDS coverage have an even higher delinquency rate. The results are robust across zip code and origination quarter cohorts. Overall, we show that CDS coverage helped drive higher mortgage defaults during the financial crisis.
----------------------
The failure of models that predict failure: Distance, incentives, and defaults
Uday Rajan, Amit Seru & Vikrant Vig
Journal of Financial Economics, forthcoming
Abstract:
Statistical default models, widely used to assess default risk, fail to account for a change in the relations between different variables resulting from an underlying change in agent behavior. We demonstrate this phenomenon using data on securitized subprime mortgages issued in the period 1997–2006. As the level of securitization increases, lenders have an incentive to originate loans that rate high based on characteristics that are reported to investors, even if other unreported variables imply a lower borrower quality. Consistent with this behavior, we find that over time lenders set interest rates only on the basis of variables that are reported to investors, ignoring other credit-relevant information. As a result, among borrowers with similar reported characteristics, over time the set that receives loans becomes worse along the unreported information dimension. This change in lender behavior alters the data generating process by transforming the mapping from observables to loan defaults. To illustrate this effect, we show that the interest rate on a loan becomes a worse predictor of default as securitization increases. Moreover, a statistical default model estimated in a low securitization period breaks down in a high securitization period in a systematic manner: it underpredicts defaults among borrowers for whom soft information is more valuable. Regulations that rely on such models to assess default risk could, therefore, be undermined by the actions of market participants.
----------------------
Consumer Credit: Too Much or Too Little (or Just Right)?
Jonathan Zinman
Journal of Legal Studies, June 2014, Pages S209-S237
Abstract:
The intersection of research and policy on consumer credit often has a Goldilocks feel. Some researchers and policy makers posit that consumer credit markets produce too much credit. Other researchers and policy makers posit that markets produce too little credit. I review theories and evidence on inefficient consumer credit supply. For each of eight classes of theories I sketch some of the leading models and summarize any convincing empirical tests of those models. I also discuss more circumstantial evidence that does not map tightly onto a particular model but has the potential to shed light on, or obscure, answers to key questions. Overall there is a lack of convincing evidence on whether markets err and in which direction. We do not yet understand whether and under what conditions markets oversupply or undersupply credit, much less why.
----------------------
Xiumin Martin & Sugata Roychowdhury
Journal of Accounting and Economics, forthcoming
Abstract:
This paper investigates whether the initiation of trading in credit default swaps (CDSs) on a borrowing firm's outstanding debt is associated with a decline in that firm's reporting conservatism. CDS investments can modify lenders’ payoffs on their loan portfolios by providing insurance on negative credit outcomes. The onset of CDS trading reduces lenders’ incentives to continuously monitor borrowers and also their demand that borrowers report conservatively. Additionally, borrowers expect CDS-insured lenders to be more intransigent in renegotiations triggered by defaults and covenant violations. Since conservatism can trigger earlier covenant violations, borrowers have heightened incentives to report less conservatively in the post-CDS period. Using a differences-in-differences research design, we observe a decline in borrowing firms’ reporting conservatism after CDS trade initiation. This effect is more pronounced when reputation costs lenders face from reducing monitoring are lower, when debt contracts outstanding at the time of CDS trade initiation have more financial covenants, and when lenders who monitor borrowers more regularly in the pre-CDS period enter into CDS contracts to hedge their credit exposures.
----------------------
Managing markets for toxic assets
Christopher House & Yusufcan Masatlioglu
Journal of Monetary Economics, March 2015, Pages 84–99
Abstract:
A model in which banks trade toxic assets to raise funds for investment is analyzed. Toxic assets generate an adverse selection problem and, consequently, the interbank asset market provides insufficient liquidity. Investment is inefficiently low because acquiring funding requires banks to sell high-quality assets for less than their “fair” value. Equity injections reduce liquidity and may be counterproductive as a policy for increasing investment. Paradoxically, if it is directed to firms with the greatest liquidity needs, an equity injection will reduce investment further. Asset purchase programs, like the Public-Private Investment Program, often have favorable impacts on liquidity, investment and welfare.
----------------------
Systemic Risk and Stability in Financial Networks
Daron Acemoglu, Asuman Ozdaglar & Alireza Tahbaz-Salehi
American Economic Review, forthcoming
Abstract:
This paper argues that the extent of financial contagion exhibits a form of phase transition: as long as the magnitude of negative shocks affecting financial institutions are sufficiently small, a more densely connected financial network (corresponding to a more diversified pattern of interbank liabilities) enhances financial stability. However, beyond a certain point, dense interconnections serve as a mechanism for the propagation of shocks, leading to a more fragile financial system. Our results thus highlight that the same factors that contribute to resilience under certain conditions may function as significant sources of systemic risk under others.
----------------------
Financial Education, Financial Competence, and Consumer Welfare
Sandro Ambuehl, Douglas Bernheim & Annamaria Lusardi
NBER Working Paper, October 2014
Abstract:
We introduce the concept of financial competence, a measure of the extent to which individuals' financial choices align with those they would make if they properly understood their opportunity sets. Unlike existing measures of the quality of financial decision making, the concept is firmly rooted in the principles of choice-based behavioral welfare analysis; it also avoids the types of paternalistic judgments that are common in policy discussions. We document the importance of assessing financial competence by demonstrating, through an example, that an educational intervention can appear highly successful according to conventional outcome measures while failing to improve the quality of financial decision making. Specifically, we study a simple intervention concerning compound interest that significantly improves performance on a test of conceptual knowledge (which subjects report operationalizing in their decisions), and appears to counteract exponential growth bias. However, financial competence (welfare) does not improve. We trace the mechanisms that account for these seemingly divergent findings.
----------------------
Do rating agencies cater? Evidence from rating-based contracts
Pepa Kraft
Journal of Accounting and Economics, forthcoming
Abstract:
I examine whether rating agencies cater to borrowers with rating-based performance-priced loan contracts (PPrating firms). I use data from Moody's Financial Metrics on its quantitative adjustments for off-balance-sheet debt and qualitative adjustments for soft factors. In the cross-section and for borrowers experiencing adverse economic shocks, I find that these adjustments are more favorable for PPrating firms than for other firms, consistent with rating agencies catering to the PPrating borrowers. I find that this catering is muted in two circumstances when rating agencies' reputational costs are higher than usual: (1) near the investment grade and prime short-term rating thresholds and (2) when Fitch Ratings also provides a rating.
----------------------
The Futility of Cost-Benefit Analysis in Financial Disclosure Regulation
Omri Ben-Shahar & Carl Schneider
Journal of Legal Studies, June 2014, Pages S253-S271
Abstract:
What would happen if cost-benefit analysis (CBA) were applied to disclosure regulations? Mandated disclosure has largely escaped rigorous CBA because it looks so plausible: disclosure seems rich in benefits and low in cost. This article makes two arguments. First, it previews our thesis in More Than You Wanted to Know that disclosure laws do not deliver their anticipated benefits and thus cannot easily pass quantified CBA. Second, it describes a previously unrecognized cost of disclosure, one arising from lawmakers’ collective-action problem. With the proliferation of disclosures, each new mandate diminishes the attention that people can give to other information, including all other disclosures. The problem for CBA is lawmakers’ inability to coordinate laws across different fields and jurisdictions. This article illustrates this regulatory failure by examining the rigorous cost-effectiveness analysis conducted by the Consumer Financial Protection Bureau for its recent mortgage disclosure regulation.
----------------------
Lindsay Owens
Social Forces, forthcoming
Abstract:
Social class confers a bundle of capabilities, practices, and beliefs that are conventionally assumed to be hierarchical, rigid, and self-perpetuating. However, this framework often belies the fact that these qualities needn't be necessarily or exhaustively advantageous. In particular, social change may render obsolete class-linked characteristics that were advantageous in previous periods. Drawing on interviews with homeowners at risk of foreclosure and a yearlong ethnography of a housing counseling organization, I find that although the housing crisis of the “Great Recession” affected both working- and middle-class homeowners alike, the practices of working-class borrowers better positioned them to exploit a number of informational advantages in the rapidly changing mortgage modification setting. My findings are a departure from existing research that treats middle-class capabilities and practices as intrinsically advantageous.
----------------------
The Political Economy of Regulation in Markets with Naïve Consumers
Patrick Warren & Daniel Wood
Journal of the European Economic Association, forthcoming
Abstract:
In a model of a competitive industry selling base goods and add-ons, we investigate the conditions under which citizen-consumers will support policies that eliminate behavioral inefficiencies induced by naïve consumers. Unregulated competitive markets have two effects: they produce deadweight losses, and they redistribute income away from biased consumers. Both unbiased and naïve consumers believe that they benefit from this redistribution (the naïve consumers are wrong), so support for efficiency-improving regulation is limited. Extending our model to consumers with partial sophistication about their naïveté, we predict patterns of regulation consistent with the form and timing of the Credit Card Accountability Responsibility and Disclosure (CARD) Act of 2009.
----------------------
Strategic or Nonstrategic: The Role of Financial Benefit in Bankruptcy
Shuoxun Zhang, Tarun Sabarwal & Li Gan
Economic Inquiry, forthcoming
Abstract:
A partial test for strategic behavior in bankruptcy filing may be formulated by testing whether consumers manipulate their debt and filing decision jointly, or not: that is, testing for endogeneity of financial benefit and the bankruptcy filing decision. Using joint maximum likelihood estimation of an extended discrete choice model, test results are consistent with nonstrategic filing: financial benefit is exogenous to the filing decision. This result is confirmed in two different datasets (Panel Study of Income Dynamics and Survey of Consumer Finances). This result is consistent with an ex ante low net gain from a bankruptcy filing; a type of “rational inattention” to rare events such as bankruptcy.
----------------------
Payday Lending Regulation and the Demand for Alternative Financial Services
Roman Galperin & Andrew Weaver
Johns Hopkins University Working Paper, September 2014
Abstract:
In this paper we use a novel empirical strategy to estimate the net benefit of regulatory restrictions on the supply of fringe credit products. Our estimation measures the effect of strict regulation and prohibition of one such product — payday loans — on demand for another product — refund anticipation loans (RALs). Using a policy discontinuity at state border approach with zip-code-level panel data, we find an economically and statistically significant negative effect of strict regulation of payday loans on demand for RALs. A state ban on payday lending results in about five percent reduction in demand for RALs. We interpret this effect as evidence that the behavioral component is stronger than the rational-strategic component of demand for payday loans, indicating that strict regulation of payday loans may benefit households on net. We conclude with a discussion of implications for policy.
----------------------
Securitization and the Fixed-Rate Mortgage
Andreas Fuster & James Vickery
Review of Financial Studies, forthcoming
Abstract:
Fixed-rate mortgages (FRMs) dominate the U.S. mortgage market, with important consequences for monetary policy, household risk management, and financial stability. We show that the FRM market share is sharply lower when mortgages are difficult to securitize, exploiting plausibly exogenous variation in access to liquid securitization markets generated by a regulatory cutoff and time variation in private securitization activity. We interpret our findings as evidence that lenders are reluctant to retain the prepayment and interest rate risk embedded in FRMs. The form of securitization (private versus government backed) has little effect on FRM supply during periods in which private securitization markets are well functioning.
----------------------
New Evidence on the Impact of Financial Crises in Advanced Countries
Christina Romer & David Romer
University of California Working Paper, October 2014
Abstract:
This paper revisits the aftermath of financial crises in advanced countries in the decades before the Great Recession. We construct a new series on financial distress in 24 OECD countries for the period 1967–2007. The series is based on narrative assessments of the health of countries’ financial systems that were made in real time; and it classifies financial distress on a relatively fine scale, rather than treating it as a 0-1 variable. We find little support for the conventional wisdom that the output declines following financial crises are uniformly large and long-lasting. Rather, the declines are highly variable, on average only moderate, and often temporary. One important driver of the variation in outcomes across crises appears to be the severity and persistence of the financial distress itself: when distress is particularly extreme or continues for an extended period, the aftermath of a crisis is worse.
----------------------
The Evolution of Bank Supervision: Evidence from U.S. States
Kris James Mitchener & Matthew Jaremski
NBER Working Paper, October 2014
Abstract:
We use a novel data set spanning 1820-1910 to examine the origins of bank supervision and assess factors leading to the creation of formal bank supervision across U.S. states. We show that it took more than a century for the widespread adoption of independent supervisory institutions tasked with maintaining the safety and soundness of banks. State legislatures initially pursued cheaper regulatory alternatives, such as double liability laws; however, banking distress at the state level as well as the structural shift from note-issuing to deposit-taking commercial banks and competition with national banks propelled policymakers to adopt costly and permanent supervisory institutions.