Governance and Capital Structure: Theory and Evidence from the CMBS Market

Abstract

Theory and evidence are presented on how governance structure affects security design. Two types of frictions are isolated as they affect agent incentives to resolve financial distress: moral hazard in costly effort provision and risk-shifting incentives. A tension is shown to exist between the two effects, favoring a focus on one or the other depending on asset resale market conditions anticipated at the time of securities issuance. We show that, although effort provision is efficient with direct subordinate securityholder control over loan modification, there exist market conditions when concerns over risk-shifting costs predominate. As a result, governance mechanisms that limit risk shifting can be value enhancing. Empirical analysis of two distinct samples of commercial mortgage-backed securities issuances supports many of the model predictions, including the relative efficiency of junior security control over the workout specialist. We also empirically isolate the value-enhancing properties of specific governance mechanisms, the relative effects of which are time and market dependent.

Keywords: Structured Finance, Security Governance, Security Design, Special servicer, CMBS

JEL Classification: G21, G14