Research articles for the 2020-08-28
Appraisal Inflation and Private Mortgage Securitization
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Lenders’ access to soft information on appraisal inflation could lead to adverse selection in private mortgage securitization. Combining a nationwide mortgage data with a real estate transaction data and using a difference-in-differences empirical design, we document that securitized refinance loans have more than 3% higher appraisal inflation than portfolio loans at key LTV notches. At those notches, securitized mortgages are more likely to default by 19 to 50% in relative terms. The additional credit risk associated with the appraisal inflation on sold notch loans does not seem to be priced in the mortgage rate. The results are robust after controlling for servicer and lender effects, and hold when we infer appraisal inflation from repeat sale transactions or hedonic price estimates. These findings indicate the existence of adverse selection in private securitization where lenders sell mortgages with higher appraisal inflation to MBS investors and keep mortgages with lower appraisal bias in their own portfolios, without compensating investors for the additional credit risk.
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Lenders’ access to soft information on appraisal inflation could lead to adverse selection in private mortgage securitization. Combining a nationwide mortgage data with a real estate transaction data and using a difference-in-differences empirical design, we document that securitized refinance loans have more than 3% higher appraisal inflation than portfolio loans at key LTV notches. At those notches, securitized mortgages are more likely to default by 19 to 50% in relative terms. The additional credit risk associated with the appraisal inflation on sold notch loans does not seem to be priced in the mortgage rate. The results are robust after controlling for servicer and lender effects, and hold when we infer appraisal inflation from repeat sale transactions or hedonic price estimates. These findings indicate the existence of adverse selection in private securitization where lenders sell mortgages with higher appraisal inflation to MBS investors and keep mortgages with lower appraisal bias in their own portfolios, without compensating investors for the additional credit risk.
COVID-19 and European Banks
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This paper shows how European banks responded to the initial COVID-19 outbreak by focusing on bank capital. Using a bank-level COVID-19 exposure measure, we show that worse-capitalized banks increased their lending whereas their better-capitalized peers decreased their lending. At the same time, only better-capitalized banks experienced an increase in their delinquent and restructured loans. These findings are in line with the zombie lending literature that banks with low capital have an incentive to increase their lending during contraction times to help their weaker borrowers so that they can avoid loan losses and write-offs on their capital.
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This paper shows how European banks responded to the initial COVID-19 outbreak by focusing on bank capital. Using a bank-level COVID-19 exposure measure, we show that worse-capitalized banks increased their lending whereas their better-capitalized peers decreased their lending. At the same time, only better-capitalized banks experienced an increase in their delinquent and restructured loans. These findings are in line with the zombie lending literature that banks with low capital have an incentive to increase their lending during contraction times to help their weaker borrowers so that they can avoid loan losses and write-offs on their capital.
Credit Market Imperfection, Lack of Entrepreneurs and Capital Outflow from a Developing Economy
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This paper explores the impact of credit market on the entrepreneurs and demand for credit in a credit constrained economy and the resultant impact on the capital flows. In standard trade models the capital flows across countries are explained as a result of the rate of return differentials due to presence/absence of capital among the countries whereby capital flows from the capital rich countries to capital poor countries. We show that the rate of return differentials could arise due to presence/absence of entrepreneurs, i.e., low price of capital in autarky may reflect lack of demand for credit due to scarcity of entrepreneurs and not capital abundance and eventually may lead to capital outflow from a capital scarce country. This is a different way of echoing the sentiment of the well-known “Lucas Paradox†which suggests that capital might flow from the poor to the rich countries. We also show the possibility of trade and capital flow being complements and not substitutes, as is usual in standard models.
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This paper explores the impact of credit market on the entrepreneurs and demand for credit in a credit constrained economy and the resultant impact on the capital flows. In standard trade models the capital flows across countries are explained as a result of the rate of return differentials due to presence/absence of capital among the countries whereby capital flows from the capital rich countries to capital poor countries. We show that the rate of return differentials could arise due to presence/absence of entrepreneurs, i.e., low price of capital in autarky may reflect lack of demand for credit due to scarcity of entrepreneurs and not capital abundance and eventually may lead to capital outflow from a capital scarce country. This is a different way of echoing the sentiment of the well-known “Lucas Paradox†which suggests that capital might flow from the poor to the rich countries. We also show the possibility of trade and capital flow being complements and not substitutes, as is usual in standard models.
Creditor Rights and Borrowers' Accounting Conservatism: Evidence from Anti-recharacterization Laws
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Using the staggered adoption of anti-re-characterization laws (ARL) as an exogenous shock to creditor rights, we study the causal effects of creditor rights on borrowers’ accounting conservatism. ARL precludes the re-characterization of securitized assets which otherwise can be re-characterized as collateral of secured loans, thus these laws protect securitization investors at the expense of debt-holders’ rights. Consistent with debt-holders’ demand for conservative accounting, we find an increase in reporting conservatism following the adoption of ARL. To further support the channel of debt-holders’ demand, we document that the effect of ARL on accounting conservatism is stronger for firms with higher credit risk. In addition, we document a stronger effect of ARL on accounting conservatism for firms with better corporate governance, suggesting that these firms are more likely to meet debt-holders’ demand. Overall, our study establishes a causal link between creditor rights and accounting conservatism, and adds to the literature by offering new insights from both perspectives of demand and supply.
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Using the staggered adoption of anti-re-characterization laws (ARL) as an exogenous shock to creditor rights, we study the causal effects of creditor rights on borrowers’ accounting conservatism. ARL precludes the re-characterization of securitized assets which otherwise can be re-characterized as collateral of secured loans, thus these laws protect securitization investors at the expense of debt-holders’ rights. Consistent with debt-holders’ demand for conservative accounting, we find an increase in reporting conservatism following the adoption of ARL. To further support the channel of debt-holders’ demand, we document that the effect of ARL on accounting conservatism is stronger for firms with higher credit risk. In addition, we document a stronger effect of ARL on accounting conservatism for firms with better corporate governance, suggesting that these firms are more likely to meet debt-holders’ demand. Overall, our study establishes a causal link between creditor rights and accounting conservatism, and adds to the literature by offering new insights from both perspectives of demand and supply.
Does Borrowing from the Private Bond Market Cost More than Borrowing from the Public Bond Market?
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We investigate the pricing of private versus public placement bonds, using a novel data set, and test the effect of covenants on yield spreads in the primary market. The observed yield spread premium of 116 basis points is partially explained by credit risk but equally important, by the use of covenants. We provide evidence of a U-shape effect of covenant intensity on spread, the downward sloping part explained by investment covenants, the upward sloping part by financing covenants. The use of covenants has as much explanatory power beyond credit risk as liquidity and market conditions together, providing direct evidence of firm’s willingness to pay for options providing renegotiation flexibility.
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We investigate the pricing of private versus public placement bonds, using a novel data set, and test the effect of covenants on yield spreads in the primary market. The observed yield spread premium of 116 basis points is partially explained by credit risk but equally important, by the use of covenants. We provide evidence of a U-shape effect of covenant intensity on spread, the downward sloping part explained by investment covenants, the upward sloping part by financing covenants. The use of covenants has as much explanatory power beyond credit risk as liquidity and market conditions together, providing direct evidence of firm’s willingness to pay for options providing renegotiation flexibility.
Evaluating the Impact of Export Finance Support on Firm-Level Export Performance: Evidence from Pakistan
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This paper evaluates the impact of two export finance support schemes: The Export Finance Scheme (EFS) and the Long-Term Finance Facility for Plant & Machinery (LTFF) on firm-level export performance. These policies offer loans to exporters at concessionary interest rates to finance short-term working capital and long-term investment in machinery and equipment respectively. To do so, we combine customs data with information about which firms participate in each scheme and the value of the loans they obtain between 2015 and 2017. We find that EFS and LTFF increased the growth rate of exports sales by 7 and 8-11 percentage points respectively. Neither policy exerts a significant impact on the number of products that a firm exports or the number of foreign countries it sells to. Our analysis indicates that facilitating long-term investment in physical capital is more cost effective to raise exports than subsidizing exporters’ working capital needs.
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This paper evaluates the impact of two export finance support schemes: The Export Finance Scheme (EFS) and the Long-Term Finance Facility for Plant & Machinery (LTFF) on firm-level export performance. These policies offer loans to exporters at concessionary interest rates to finance short-term working capital and long-term investment in machinery and equipment respectively. To do so, we combine customs data with information about which firms participate in each scheme and the value of the loans they obtain between 2015 and 2017. We find that EFS and LTFF increased the growth rate of exports sales by 7 and 8-11 percentage points respectively. Neither policy exerts a significant impact on the number of products that a firm exports or the number of foreign countries it sells to. Our analysis indicates that facilitating long-term investment in physical capital is more cost effective to raise exports than subsidizing exporters’ working capital needs.
Financial Stability, Resolution of Systemic Banking Crises and COVID-19: Toward an Appropriate Role for Public Support and Bailouts
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A wide range of approaches has been applied to address banking and other financial crises. The nature of the approach depends on the nature of the crisis, its origins, evolution and context. Systemic banking crises are among the most common and costly to address. The experiences of the three major international financial crises of the past 25 years â€" the Asian Financial Crisis, the Global Financial Crisis, and the European Debt Crisis â€" offer critical lessons regarding the most effective approaches in tackling bank solvency during a systemic crisis. One of the most common and also effective methods has been the transfer of non-performing loans (NPLs) to an Asset Management Company (AMC) that performs workouts or liquidates stressed loan portfolios at a more opportune time to amortize losses. In most cases the use of AMCs has delivered positive results for the taxpayer. Contemporary consensus as regards tackling bank solvency during a systemic financial crisis focuses heavily on prevention of government bailouts in order to protect state finances and curb moral hazard. However, an overly dogmatic focus on preventing public financial support in the context of a systemic bank solvency crisis may place insurmountable obstacles to the use of state-backed AMCs and other forms of resolution of NPLs and bank recapitalization. This paper provides a new perspective on the common belief that public support in the context of systemic bank insolvency â€" i.e. bank bailouts â€" is an inefficient use of public funds or conducive to moral hazard. Our study finds that state-backed AMCs can be effective in recapitalizing banking systems, depending on the modus operandi of the restructuring, funding and the conditions attached to the fiscal backstop. With respect to systemic banking crises or those caused by exogenous factors, such as the unprecedented disruption of economic activity due the COVID-19 pandemic, preservation of financial stability and not containment of moral hazard should be policy-makers’ predominant goal. Thus, we suggest that a combination of balance sheet restructuring and the use of AMCs to manage NPLs is the optimal approach.
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A wide range of approaches has been applied to address banking and other financial crises. The nature of the approach depends on the nature of the crisis, its origins, evolution and context. Systemic banking crises are among the most common and costly to address. The experiences of the three major international financial crises of the past 25 years â€" the Asian Financial Crisis, the Global Financial Crisis, and the European Debt Crisis â€" offer critical lessons regarding the most effective approaches in tackling bank solvency during a systemic crisis. One of the most common and also effective methods has been the transfer of non-performing loans (NPLs) to an Asset Management Company (AMC) that performs workouts or liquidates stressed loan portfolios at a more opportune time to amortize losses. In most cases the use of AMCs has delivered positive results for the taxpayer. Contemporary consensus as regards tackling bank solvency during a systemic financial crisis focuses heavily on prevention of government bailouts in order to protect state finances and curb moral hazard. However, an overly dogmatic focus on preventing public financial support in the context of a systemic bank solvency crisis may place insurmountable obstacles to the use of state-backed AMCs and other forms of resolution of NPLs and bank recapitalization. This paper provides a new perspective on the common belief that public support in the context of systemic bank insolvency â€" i.e. bank bailouts â€" is an inefficient use of public funds or conducive to moral hazard. Our study finds that state-backed AMCs can be effective in recapitalizing banking systems, depending on the modus operandi of the restructuring, funding and the conditions attached to the fiscal backstop. With respect to systemic banking crises or those caused by exogenous factors, such as the unprecedented disruption of economic activity due the COVID-19 pandemic, preservation of financial stability and not containment of moral hazard should be policy-makers’ predominant goal. Thus, we suggest that a combination of balance sheet restructuring and the use of AMCs to manage NPLs is the optimal approach.
Firm-Level Risk Disclosures: Effects on the Market Value of Firms during the Risk Materialization in the Case of the COVID-19 Crisis
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How does the stock market react to risk disclosures in annual reports of firms? Various studies investigated the reactions to the information at the time of disclosure. Still, there is little evidence about the differences between the market reaction to firms disclosing the risks and firms without disclosure when the risks indeed materialize. By using the COVID-19 pandemic, we are able provide empirical evidence about the effect of a disclosed systematic risk on the stock market returns across a broad set of industries. Our data consists of 3,433 annual reports from firms listed on US stock exchanges filed in 2019, from which only 652 firms (19%) disclosed the risk of a pandemic or epidemic. We find a significant increase in the stock return volatility for disclosing firms during the pandemic. Furthermore, the stock returns of disclosing firms fell significantly more at the start of the pandemic, but also increased more during the initial recovery phase than non-disclosing firms. Additionally, our study indicates that the importance of the risk disclosure in annual reports decreases with a growing market value.
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How does the stock market react to risk disclosures in annual reports of firms? Various studies investigated the reactions to the information at the time of disclosure. Still, there is little evidence about the differences between the market reaction to firms disclosing the risks and firms without disclosure when the risks indeed materialize. By using the COVID-19 pandemic, we are able provide empirical evidence about the effect of a disclosed systematic risk on the stock market returns across a broad set of industries. Our data consists of 3,433 annual reports from firms listed on US stock exchanges filed in 2019, from which only 652 firms (19%) disclosed the risk of a pandemic or epidemic. We find a significant increase in the stock return volatility for disclosing firms during the pandemic. Furthermore, the stock returns of disclosing firms fell significantly more at the start of the pandemic, but also increased more during the initial recovery phase than non-disclosing firms. Additionally, our study indicates that the importance of the risk disclosure in annual reports decreases with a growing market value.
Incentives in Blockchain Design and Applications
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Since Bitcoin’s invention in 2009, permissionless blockchain technology has gone through several waves of interest and development. While applications related to payments have advanced at breakneck speed, progress in financial and nonmonetary applications have largely failed to live up to initial excitement. This chapter considers the incentives facing network participants in light of the fundamental problem of signal verification. Doing so can account for both the successes and the failures: first, why are payments a particularly suitable problem to be solved by blockchain technology? And second, what additional problems do financial and nonmonetary applications pose?
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Since Bitcoin’s invention in 2009, permissionless blockchain technology has gone through several waves of interest and development. While applications related to payments have advanced at breakneck speed, progress in financial and nonmonetary applications have largely failed to live up to initial excitement. This chapter considers the incentives facing network participants in light of the fundamental problem of signal verification. Doing so can account for both the successes and the failures: first, why are payments a particularly suitable problem to be solved by blockchain technology? And second, what additional problems do financial and nonmonetary applications pose?
International Real Estate Investments
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Cross-border real estate investing offers opportunities for enhanced diversification. Investors often begin real estate investing domestically because local opportunities are more familiar and easier to undertake than cross-border (international) investments. As investors gain experience investing in a variety of domestic real estate projects, they often look to other countries for new opportunities. Institutional investors pursuing direct access to real estate assets often begin investing abroad by becoming a limited partner in an international project somewhat similar to the domestic opportunities with which they are already familiar and experienced.
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Cross-border real estate investing offers opportunities for enhanced diversification. Investors often begin real estate investing domestically because local opportunities are more familiar and easier to undertake than cross-border (international) investments. As investors gain experience investing in a variety of domestic real estate projects, they often look to other countries for new opportunities. Institutional investors pursuing direct access to real estate assets often begin investing abroad by becoming a limited partner in an international project somewhat similar to the domestic opportunities with which they are already familiar and experienced.
Limited Attention Bias and Institutional Investor Characteristics
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We test for limited attention bias in institutional investor trading. We use the universe of transaction-level data of institutional investors trading in the U.S. corporate bond market. Results show that trading volume abnormally increases in subsamples of uninformative rating actions. We also find abnormal bond returns associated with uninformative rating actions. We then zero in on transaction-level data of the largest domestic institutional investor, an approach that allows us to match investor characteristics to individual transactions. We document an association between restatements and abnormal trading on uninformative news. These results provide supportive evidence that limited attention bias affects institutional investors.
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We test for limited attention bias in institutional investor trading. We use the universe of transaction-level data of institutional investors trading in the U.S. corporate bond market. Results show that trading volume abnormally increases in subsamples of uninformative rating actions. We also find abnormal bond returns associated with uninformative rating actions. We then zero in on transaction-level data of the largest domestic institutional investor, an approach that allows us to match investor characteristics to individual transactions. We document an association between restatements and abnormal trading on uninformative news. These results provide supportive evidence that limited attention bias affects institutional investors.
Listed versus Unlisted Real Estate Investments
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This chapter examines the main unlisted real estate funds available (openend funds and closed-end funds), as well as the most important listed real estate funds (REITs and ETFs based on real estate indices). The chapter also analyzes the extent to which analysis of publicly traded real estate may be used to provide information on the risks and returns of private real estate, and offers an empirical analysis of the differences between the returns of listed (market-based) real estate and those of private (appraisal-based) real estate.
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This chapter examines the main unlisted real estate funds available (openend funds and closed-end funds), as well as the most important listed real estate funds (REITs and ETFs based on real estate indices). The chapter also analyzes the extent to which analysis of publicly traded real estate may be used to provide information on the risks and returns of private real estate, and offers an empirical analysis of the differences between the returns of listed (market-based) real estate and those of private (appraisal-based) real estate.
Pension Funds and Private Equity Real Estate: History, Performance, Pathologies, Risks
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I study the history and performance of commercial real estate (CRE) in the pension fund portfolio, showing how many plan sponsors fundamentally changed their approach to CRE investment once underfunding gaps began to emerge in the early and middle 2000s. Several new empirical facts are presented, including pension fund share ownership estimates of private equity real estate (PERE) in excess of 50%, reconfirmation of underperformance of Value-add and Opportunity PERE funds, and the apparent existence of an illiquidity price premium paid by pension funds for the “volatility veil†that PERE fund investment provides. Three types of concentration risks are identified, including high geographical ownership concentrations. The risks that pension funds and their investment in PERE funds pose to economic and financial stability have been exacerbated by the negative aftershocks of the COVID-19 pandemic.
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I study the history and performance of commercial real estate (CRE) in the pension fund portfolio, showing how many plan sponsors fundamentally changed their approach to CRE investment once underfunding gaps began to emerge in the early and middle 2000s. Several new empirical facts are presented, including pension fund share ownership estimates of private equity real estate (PERE) in excess of 50%, reconfirmation of underperformance of Value-add and Opportunity PERE funds, and the apparent existence of an illiquidity price premium paid by pension funds for the “volatility veil†that PERE fund investment provides. Three types of concentration risks are identified, including high geographical ownership concentrations. The risks that pension funds and their investment in PERE funds pose to economic and financial stability have been exacerbated by the negative aftershocks of the COVID-19 pandemic.
Regulatory Stress Tests and Bank Responses
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In this paper, we investigate how the regulatory stress test framework in the European Union affects banks’ investment decisions and portfolio choices. Using the causal inference and event study methodology, we document a substantial impact of EU-wide stress tests in 2011, 2014 and 2016 on the banks’ portfolio strategies. The banks subject to regulatory stress tests tend to structure their portfolios with lower risk assets that is reflected in a decline in risk-weighted assets as compared to the control group. At the same time, the dynamic of realized risk that is measured by the proportion of non-performing exposure in portfolios remains unaffected. The estimates based on two alternative subsamples indicate that the magnitude of such effect rise with the increase in the size of the bank´s assets.
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In this paper, we investigate how the regulatory stress test framework in the European Union affects banks’ investment decisions and portfolio choices. Using the causal inference and event study methodology, we document a substantial impact of EU-wide stress tests in 2011, 2014 and 2016 on the banks’ portfolio strategies. The banks subject to regulatory stress tests tend to structure their portfolios with lower risk assets that is reflected in a decline in risk-weighted assets as compared to the control group. At the same time, the dynamic of realized risk that is measured by the proportion of non-performing exposure in portfolios remains unaffected. The estimates based on two alternative subsamples indicate that the magnitude of such effect rise with the increase in the size of the bank´s assets.
Stoxx Europe Indices and Index Premium
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With their transparent and rules-based index review policy and surging popularity, Stoxx Europe indices provide an excellent opportunity to study the index inclusion effect in a pan-European setting. Using a dataset spanning the period from 1999 to 2019, we find sizable positive abnormal returns for additions to Euro Stoxx 50. CARs averaged 7% from thirty days before the announcement to the effective inclusion date. No such effects have been observed for Stoxx Europe 600. We find evidence for both downward-sloping demand curves and investor awareness hypotheses.
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With their transparent and rules-based index review policy and surging popularity, Stoxx Europe indices provide an excellent opportunity to study the index inclusion effect in a pan-European setting. Using a dataset spanning the period from 1999 to 2019, we find sizable positive abnormal returns for additions to Euro Stoxx 50. CARs averaged 7% from thirty days before the announcement to the effective inclusion date. No such effects have been observed for Stoxx Europe 600. We find evidence for both downward-sloping demand curves and investor awareness hypotheses.
The Effect of Macroprudential Policies on Credit Developments in Europe 1995-2017
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The paper inspects the credit impact of policy instruments that are commonly applied to contain systemic risk. It employs detailed information on the use of capital-based, borrower-based and liquidity-based instruments in 28 European Union countries in 1995â€"2017 and a macroeconomic panel setup. The paper finds a significant impact of capital buffers, profit distribution restrictions, specific and general loan-loss provisioning regulations, sectoral risk weights and exposure limits, borrower-based measures, caps on long-term maturity and exchange rate mismatch, and asset-based capital requirements on credit to the non-financial private sector. Furthermore, the business cycle and monetary policy influence the effectiveness of most of the macroprudential instruments. Therein, capital buffers and sectoral risk weights act countercyclically irrespectively of the prevailing monetary policy stance, while a far richer set of policy instruments can act countercyclically in combination with the appropriate monetary policy stance.
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The paper inspects the credit impact of policy instruments that are commonly applied to contain systemic risk. It employs detailed information on the use of capital-based, borrower-based and liquidity-based instruments in 28 European Union countries in 1995â€"2017 and a macroeconomic panel setup. The paper finds a significant impact of capital buffers, profit distribution restrictions, specific and general loan-loss provisioning regulations, sectoral risk weights and exposure limits, borrower-based measures, caps on long-term maturity and exchange rate mismatch, and asset-based capital requirements on credit to the non-financial private sector. Furthermore, the business cycle and monetary policy influence the effectiveness of most of the macroprudential instruments. Therein, capital buffers and sectoral risk weights act countercyclically irrespectively of the prevailing monetary policy stance, while a far richer set of policy instruments can act countercyclically in combination with the appropriate monetary policy stance.
The Political Economy of the G20 Agenda on Financial Regulation
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The paper empirically examines the implementation record of international financial regulation of the banking sector. The study finds that the size of the banking sector and the presence of global systemically important banks (G-SIBs) are positively associated with a stronger implementation record. These results suggest that cooperative motives of internalising externalities, creating a level playing field and preserving financial stability play a role in explaining the implementation record. We find evidence that this cooperative behaviour may be driven by the self-interest of global players as the positive record is particularly strong in countries where large banking sectors and big banks are both present, and where regulation only applies to large players. Sectoral concentration, bank health and the share of foreign ownership yield more mixed results as regards their impact on implementation.
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The paper empirically examines the implementation record of international financial regulation of the banking sector. The study finds that the size of the banking sector and the presence of global systemically important banks (G-SIBs) are positively associated with a stronger implementation record. These results suggest that cooperative motives of internalising externalities, creating a level playing field and preserving financial stability play a role in explaining the implementation record. We find evidence that this cooperative behaviour may be driven by the self-interest of global players as the positive record is particularly strong in countries where large banking sectors and big banks are both present, and where regulation only applies to large players. Sectoral concentration, bank health and the share of foreign ownership yield more mixed results as regards their impact on implementation.
Transmission of Market Orders Through Communication Line With Relativistic Delay
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The notion of “relativistic finance†became ingrained in public imagination and has been asserted in many mass-media reports. Yet, despite an observed drive of the most reputable Wall Street firms to establish their servers ever closer to the trading hubs, there is surprisingly little “hard†information related to relativistic delay of the trading orders. In this paper, the author uses modified M/M/G queue theory to describe propagation of the trading signal with finite velocity.
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The notion of “relativistic finance†became ingrained in public imagination and has been asserted in many mass-media reports. Yet, despite an observed drive of the most reputable Wall Street firms to establish their servers ever closer to the trading hubs, there is surprisingly little “hard†information related to relativistic delay of the trading orders. In this paper, the author uses modified M/M/G queue theory to describe propagation of the trading signal with finite velocity.
