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Abstract:
We demonstrate that a rapid expansion in the supply of mortgages driven by disintermediation explains a large fraction of recent U.S. house price appreciation and subsequent mortgage defaults. We identify the effect of shifts in the supply of mortgage credit by exploiting within-county variation across zip codes that differed in latent demand for mortgages in the mid 1990s. From 2001 to 2005, high latent demand zip codes experienced large relative decreases in denial rates, increases in mortgages originated, and increases in house price appreciation, despite the fact that these zip codes experienced significantly negative relative income and employment growth over this time period. These patterns for high latent demand zip codes were driven by a sharp relative increase in the fraction of loans sold by originators shortly after origination, a process which we refer to as "disintermediation." The increase in disintermediation-driven mortgage supply to high latent demand zip codes from 2001 to 2005 led to subsequent large increases in mortgage defaults from 2005 to 2007. Our results suggest that moral hazard on behalf of originators selling mortgages is a main culprit for the U.S. mortgage default crisis.

Abstract:
We conduct a within-county analysis using detailed zip code level data to document new findings regarding the origins of the biggest financial crisis since the Great Depression. The recent sharp increase in mortgage defaults is significantly amplified in subprime zip codes, or zip codes with a disproportionately large share of subprime borrowers as of 1996. Prior to the default crisis, these subprime zip codes experience an unprecedented relative growth in mortgage credit. The expansion in mortgage credit from 2002 to 2005 to subprime zip codes occurs despite sharply declining relative (and in some cases absolute) income growth in these neighborhoods. In fact, 2002 to 2005 is the only period in the last eighteen years when income and mortgage credit growth are negatively correlated. We show that the expansion in mortgage credit to subprime zip codes and its dissociation from income growth is closely correlated with the increase in securitization of subprime mortgages. Finally, we show that all of our key findings hold in markets with very elastic housing supply that have low house price growth during the credit expansion years.

subprime, sub-prime, mortgages, default crisis, disintermediation, defaults, consumer credit, credit supply, credit expansion

Abstract:
Using individual-level data on homeowner debt and defaults from 1997 to 2008, we show that borrowing against the increase in home equity by existing homeowners is responsible for a significant fraction of both the sharp rise in U.S. household leverage from 2002 to 2006 and the increase in defaults from 2006 to 2008. Employing land topology-based housing supply elasticity as an instrument for house price growth, we estimate that the average homeowner extracts 25 to 30 cents for every dollar increase in home equity. Money extracted from increased home equity is not used to purchase new real estate or pay down high credit card debt, which suggests that real outlays (i.e., consumption or home improvement) are likely uses of borrowed funds. Home equity-based borrowing is stronger for younger households, households with low credit scores, and households with high initial credit card utilization rates. Homeowners in high house price appreciation areas experience a relative decline in default rates from 2002 to 2006 as they borrow heavily against their home equity, but experience very high default rates from 2006 to 2008. Our estimates suggest that home equity-based borrowing is equal to 2.8% of GDP every year from 2002 to 2006, and accounts for 34% of new defaults from 2006 to 2008.

subprime, mortgage, home equity, household leverage, house prices, consumption, wealth effect

Abstract:
We examine the effects of constituent interests, special interests, and politician ideology on congressional voting behavior on two of the most significant pieces of legislation in U.S. economic history: the American Housing Rescue and Foreclosure Prevention Act of 2008 and the Emergency Economic Stabilization Act of 2008. Representatives from districts experiencing an increase in mortgage default rates are more likely to vote in favor of the AHRFPA, and the response is stronger in more competitive districts. Representatives only respond to mortgage related defaults (not non-mortgage defaults), and are more sensitive to defaults of their own-party constituents. Higher campaign contributions from the financial services industry are associated with an increased likelihood of voting in favor of the EESA, a bill which transfers wealth from tax payers to the financial services industry. Examining the trade-off between ideology and economic incentives, we find that conservative politicians are less responsive to both constituent and special interests. This latter finding suggests that politicians, through ideology, can commit against intervention even during severe crises.

Abstract:
We show that incentive conflicts between firms and their creditors have a large impact on corporate debt policy. Net debt issuing activity experiences a sharp and persistent decline following debt covenant violations, when creditors use their acceleration and termination rights to increase interest rates and reduce the availability of credit. The effect of creditor actions on debt policy is strongest when the borrower's alternative sources of finance are costly. In addition, despite the less favorable terms offered by existing creditors, borrowers rarely switch lenders following a violation.

Capital Structure, Financial Policy, Debt, Control Rights, Optimal Contracting

Abstract:
Using a novel data set that records individual debt issues on the balance sheet of a large sample of rated public firms, we show that recognition of debt heterogeneity leads to new insights into the determinants of corporate capital structure. We first demonstrate that traditional capital structure studies that ignore debt heterogeneity miss a substantial fraction of capital structure variation. We then show that relative to high credit quality firms, low credit quality firms are more likely to have a multi-tiered capital structure consisting of both secured bank debt with tight covenants and subordinated non-bank debt with loose covenants. Further, while high credit quality firms enjoy access to a variety of sources of discretionary flexible sources of finance, low credit quality firms rely on tightly monitored secured bank debt for liquidity. The findings are similar when we focus on plausibly exogenous credit quality variation in a sample of "fallen angels," which are firms that are downgraded from investment grade to speculative grade by Moody's Investors Services. We discuss the extent to which these findings are consistent with existing theoretical models of debt structure in which firms simultaneously use multiple debt types to reduce incentive conflicts.

debt structure, bank debt, monitoring, credit ratings, private placements, commercial paper, convertible debt

Abstract:
We present novel empirical evidence that conflicts of interest between creditors and their borrowers have a significant impact on firm investment policy. We examine a large sample of private credit agreements between banks and public firms and find that 32% of the agreements contain an explicit restriction on the firm's capital expenditures. Creditors are more likely to impose a capital expenditure restriction as a borrower's credit quality deteriorates, and the use of a restriction appears at least as sensitive to borrower credit quality as other contractual terms, such as interest rates, collateral requirements, or the use of financial covenants. We find that capital expenditure restrictions cause a reduction in firm investment and that firms obtaining contracts with a new restriction experience subsequent increases in their market value and operating performance.

Control Rights, Investment Policy, Financial Contracting, Financial Covenants, Capital Expenditures, Creditor Control

Abstract:
Using a large sample of private credit agreements between US publicly traded firms and financial institutions, we show that over 90% of long-term debt contracts are renegotiated prior to their stated maturity. Renegotiations result in large changes to the amount, maturity, and pricing of the contract, occur relatively early in the life of the contract, and are rarely a consequence of distress or default. Our analysis of the determinants of renegotiation reveal that the accrual of new information concerning the credit quality, investment opportunities, and collateral of the borrower, as well as macroeconomic fluctuations in credit and equity market conditions, are the primary determinants of renegotiation and its outcomes. The terms of the initial contract (e.g., contingencies) also play an important role in renegotiations; by altering the structure of the contract in a state contingent manner, renegotiation is partially controlled by the contractual assignment of bargaining power.

Renegotiation, Bargaining, Incomplete Contracts, Security Design, Bank Loans

Abstract:
I empirically examine the factors that determine whether firms use bank lines of credit or cash in corporate liquidity management. I find that bank lines of credit, also known as revolving credit facilities, are a viable liquidity substitute only for firms that maintain high cash flow. In contrast, firms with low cash flow are less likely to obtain a line of credit, and they rely more heavily on cash in their corporate liquidity management. An important channel for this correlation is the use of cash flow-based financial covenants by banks that supply credit lines. I find that firms must maintain high cash flow to remain compliant with covenants, and banks restrict firm access to credit facilities in response to covenant violations. Using the cash-flow sensitivity of cash as a measure of financial constraints, I provide evidence that lack of access to a line of credit is a more statistically powerful measure of financial constraints than traditional measures used in the literature.

Abstract:
I empirically examine the factors that determine whether firms use bank lines of credit or cash in corporate liquidity management. Bank lines of credit, also known as revolving credit facilities, are a viable liquidity substitute only for firms that maintain high cash flow. Firms with low cash flow are less likely to obtain a line of credit, and rely more heavily on cash in their corporate liquidity management. An important channel for this correlation is the use of cash flow-based financial covenants by banks that supply credit lines. Firms must maintain high cash flow to remain compliant with covenants, and banks restrict firm access to credit facilities in response to covenant violations. Using the cash flow sensitivity of cash as a measure of financial constraints, I provide evidence that lack of access to a line of credit is a more statistically powerful measure of financial constraints than traditional measures used in the literature.

Bank Debt, Lines of Credit, Revolving Credit Facilities, Flexibility, Leverage, Corporate Liquidity, Cash-flow sensitivity of cash, Financial covenants, Covenant violations

Abstract:
We provide evidence that creditors play an active role in the governance of corporations well outside of payment default states. Using a large sample of covenant violations reported by U.S. public firms, we show that violations are followed immediately with an increase in CEO turnover, an increase in the incidence of corporate restructurings and hiring of turnaround specialists, a decline in acquisitions and capital expenditures, and a reduction in debt usage and shareholder payouts. The changes in the investment and financing behavior of violating firms coincide with amended credit agreements that contain stronger restrictions on firm decision making. Changes in the management of violating firms suggest that creditors exert considerable behind the scenes influence on governance in addition to contractual control. We also show that firm operating and stock price performance improve following a violation, suggesting that actions taken by creditors benefit shareholders.

covenants, covenant violations, corporate governance, creditors, control rights, CEO turnover, acquisition

Abstract:
We review recent evidence and future directions for empirical research on financial contracting in the context of corporate finance. Specifically, we survey evidence pertaining to incentive conflicts, control rights, collateral, renegotiation, and interactions between financial contracts and other governance mechanisms. We also discuss directions for future research, concluding that the financial contracting approach offers a potentially fruitful perspective for empirical researchers seeking to better understand a variety of issues in corporate finance including capital structure, investment policy, payout policy, and corporate governance.

Financial Contracting, Security Design, Control Rights, Renegotiation

Abstract:
We show that household leverage is an early and powerful predictor of the 2007 to 2009 recession. Counties in the U.S. that experienced a large increase in household leverage from 2002 to 2006 showed a sharp relative decline in durable consumption starting in the third quarter of 2006 – a full year before any significant change in unemployment. Similarly, counties with the highest reliance on credit card borrowing reduced durable consumption by significantly more following the financial crisis of the fall of 2008. Overall, our estimates show that household leverage growth and dependence on credit card borrowing explain a large fraction of the overall consumer default, house price, unemployment, residential investment, and durable consumption patterns during the recession. Our findings suggest that a focus on household finance may help elucidate the sources macroeconomic fluctuations.

household finance, economic fluctuations, recession, household leverage, housing crisis, mortgage defaults, unemployment, auto sales, durable consumption, residential investment

Abstract:
This paper examines the consequences of the Financial Services Modernization Act of 1999 for the structure of the U.S. financial services industry. We ask how the industry may evolve as this new legislation interacts with the consolidation trend already under way, what types of mergers are most likely to occur, and how profitable and risky the resulting firms might be.

Gramm Leach Bliley, Financial Services Modernization Act, bank consolidation, financial services consolidation

Abstract:
I examine the introduction of syndicated bank loan ratings by Moody's and Standard & Poor's in 1995 to evaluate whether third-party rating agencies affect firm financial and investment policy. The introduction of bank loan ratings leads to an increase in the use of debt by firms that obtain a rating, and also increases in firms' asset growth, cash acquisitions, and investment in working capital. Consistent with a causal effect of the ratings, the increase in debt usage and investment is concentrated in the set of borrowers who are of lower credit quality and do not have an issuer credit rating before 1995. A loan-level analysis demonstrates that previously unrated borrowers who obtain a loan rating gain increased access to the capital of less-informed investors. The results suggest that third-party debt certification has real effects on firm investment policy.

G31, G32, G34, G21

Abstract:
I examine the introduction of syndicated bank loan ratings by Moody's and Standard & Poor's in 1995 to evaluate whether third-party rating agencies affect firm financial and investment policy. I find that the introduction of bank loan ratings leads to an increase in the use of debt by firms that obtain a rating, and in increases in firms' asset growth, cash acquisitions, and investment in working capital. A loan level analysis demonstrates that borrowers that obtain a loan rating gain increased access to the capital of less informed investors such as foreign banks and non-bank institutional investors. The effects of the loan rating are strongest among firms that are of lower credit quality and do not have an existing public bond rating before bank loan ratings are introduced. This pattern suggests that third-party debt certification expands the supply of available debt financing, which leads to real effects on firm investment policy.

syndicated loans, loan ratings, credit ratings, certification, capital structure, asset growth, acquisitions

Abstract:
The relaxation of restrictions on commercial bank underwriting, culminated in the passage of the Financial Services Modernization Act of 1999, has initiated a major change in debt underwriting markets facing borrowing firms, as financial institutions are now able to jointly produce private lending and corporate debt underwriting services. Using fixed effects regressions on a panel of 4553 debt issues by 509 firms from 1990 to 2003, I find that issuing firms receive a 10 to 15 percent reduction in underwriting fees, which is driven by commercial banks jointly offering lending and underwriting services. I show firms are no more locked in to financial relationships after deregulation than before, and that issuing firms add multiple lead managers to prevent a lending commercial bank underwriter from gaining too much power over the firm. While a number of papers analyze commercial bank entry, this paper is the first to use the effect of exogenous deregulation on within-firm variation over time to estimate key parameters. This methodological contribution is important; I show that cross section (or pooled) regressions produce biased and inconsistent estimates of the effect of commercial banks on yield spreads. The fixed effects strategy employed here calls into question the result in previous research that commercial banks obtain lower yield spreads for borrowing firms.

Universal banking, debt underwriting

Abstract:
While trends in college enrollment for blacks and whites have been the subject of study for a number of years, little attention has been paid to the variation in college enrollment by socioeconomic status (SES). It is well documented that, controlling for family background, blacks are more likely to enroll in college than whites. This relationship is somewhat deceptive, however. Upon closer examination, we find that blacks are more likely to enroll in college than their white counterparts only among low-SES individuals. Among high SES individuals, this pattern is reversed. We also find that this relationship is strongest in the 1970s and appears to disappear over time; by the 1990s, blacks are no more likely to attend college than whites at any end of the SES distribution. This paper first documents this phenomenon and then attempts to understand what is driving these differences across the distribution of family background characteristics and why the relationship is changing over time. Although they have a significant impact on college enrollment behavior, tuition costs and local labor markets explain very little of racial differences in college entry. We do uncover different responses to tuition and labor markets by individuals from different ends of the SES distribution, an important consideration for policies targeted at improving college enrollment for low-SES individuals.

Abstract:
Using a novel data set that records individual debt issues on the balance sheet of a large random sample of rated public firms, we show that a recognition of debt heterogeneity leads to new insights into the determinants of corporate capital structure. We first demonstrate that traditional capital structure studies that ignore debt heterogeneity miss a substantial fraction of capital structure variation. We then show that relative to high credit quality firms, low credit quality firms are more likely to have a multi-tiered capital structure consisting of both secured bank debt with tight covenants and subordinated non-bank debt with loose covenants. Further, while high credit quality firms enjoy access to a variety of sources of discretionary flexible sources of finance, low credit quality firms rely on tightly monitored secured bank debt for liquidity. We discuss the extent to which these findings are consistent with existing theoretical models of debt structure in which firms simultaneously use multiple debt types to preserve manager and creditor incentives.

Abstract:
We examine the determinants of congressional voting behavior on two of the most significant pieces of federal legislation in U.S. economic history: the American Housing Rescue and Foreclosure Prevention Act of 2008 and the Emergency Economic Stabilization Act of 2008. We find evidence that constituent interests and special interests influence voting patterns during the crisis. Representatives from districts experiencing an increase in mortgage default rates are significantly more likely to vote in favor of the AHRFPA. They are precise in responding only to mortgage related constituent defaults, and are significantly more sensitive to defaults of their own-party constituents. Increased campaign contributions from the financial services industry is associated with a higher likelihood of voting in favor of the EESA, a bill which transfers wealth from tax payers to the financial services industry. We also examine the trade-off between politician ideology and constituent and special interests, and find that conservative politicians are less responsive to constituent and special interest pressure. This latter finding suggests that politicians, through ideology, can commit against intervention even during severe crises.

Abstract:
We examine whether unregulated, private insurance markets efficiently provide insurance against reclassification risk (the risk of becoming a bad risk and facing higher premiums). To do so, we examine the ex-post risk type of individuals who drop their long-term care insurance contracts relative to those who are continually insured. Consistent with dynamic inefficiencies, we find that individuals who drop coverage are of lower risk ex-post than individuals who were otherwise-equivalent at the time of purchase but who do not drop out of their contracts. These findings suggest that dynamic market failures in private insurance markets can preclude the efficient provision of insurance against reclassification risk.

Abstract:
Using individual-level data on homeowner debt and defaults from 1997 to 2008, we show that borrowing against the increase in home equity by existing homeowners is responsible for a significant fraction of both the sharp rise in U.S. household leverage from 2002 to 2006 and the increase in defaults from 2006 to 2008. Employing land topology-based housing supply elasticity as an instrument for house price growth, we estimate that the average homeowner extracts 25 to 30 cents for every dollar increase in home equity. Money extracted from increased home equity is not used to purchase new real estate or pay down high credit card balances, which suggests that borrowed funds may be used for real outlays (i.e., consumption or home improvement). Home equity-based borrowing is stronger for younger households, households with low credit scores, and households with high initial credit card utilization rates. Homeowners in high house price appreciation areas experience a relative decline in default rates from 2002 to 2006 as they borrow heavily against their home equity, but experience very high default rates from 2006 to 2008. Our estimates suggest that home equity-based borrowing is equal to 2.8% of GDP every year from 2002 to 2006, and accounts for at least 34% of new defaults from 2006 to 2008.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
I empirically explore the syndicated loan market, with an emphasis on how information asymmetry between lenders and borrowers influences syndicate structure and on which lenders become syndicate members. Consistent with moral hazard in monitoring, the lead bank retains a larger share of the loan and forms a more concentrated syndicate when the borrower requires more intense monitoring and due diligence. When information asymmetry between the borrower and lenders is potentially severe, participant lenders are closer to the borrower, both geographically and in terms of previous lending relationships. Lead bank and borrower reputation mitigates, but does not eliminate, information asymmetry problems.

Syndicated loans, information asymmetry, distance, Dealscan, syndicate structure, bank choice