Investment and Financing under Reverse Asset Substitution (Job Market Paper, To be presented at AFA 2010 Atlanta Meetings) I show that banks place borrowing and investment restrictions on firms in an attempt to enjoy exclusive lending relationships. This agency problem is more pronounced for firms that have larger information asymmetries with the credit market. I use the term Reverse Asset Substitution (RAS) to express this partial transfer of control that benefits debt holders at the expense of equity holders when firm is not in danger of bankruptcy. While making the trade-off against tax shielding benefits, equity holders take this agency problem into account. I find that firms in perfect competition can invest 2% more in their PP&E annually than firms facing a monopoly in credit supply by banks. When compared to the case where bankruptcy cost is the only concern, presence of RAS reduces firm growth (11% lower), leverage (24% lower) and firm value (23% lower).
The Hand of ARMs (and Others) in the Subprime Crisis (Draft available upon request) We investigate the role of financial innovation, specifically, the introduction of new types of mortgages, such as hybrid ARMS in the present crisis. We explore policy measures regarding specific mortgage types that can help avoid such a situation in the future. We find that the real values of new houses purchased are actually lower when Adjustable Rate Mortgages or Interest Only loans were used to finance the purchase. As the housing boom progressed, consumers and lenders exercised caution and contracted to buy houses that had lesser value in real terms, for all types of mortgage contracts. Using a house worth $200,000 in year 2000 as benchmark, we estimate that houses purchased in 2007 were in expectation 38% lesser in value by year 2000 prices. If all mortgage contracts were Fixed Rate mortgages, we estimate that the cumulative percentage of defaults would stand at 29% compared to 33% as observed in our sample.
Heterogeneity in Corporate Governance: Theory and Evidence (Presented at FMA 2009 Reno Meetings) Optimal contracts under information asymmetry require an amount of ownership that management needs to have for incentive compatibility, that is often not practical for large firms. I argue that corporate governance mechanisms help achieve second best control for the investor under such conditions. I propose that the amount of management autonomy in a firm is chosen as a best response to exogenous firm characteristics, such as output variance. Shareholders face a trade-off regarding autonomy as higher autonomy increases firm productivity but also leads to increased private benefits. Shareholders in firms with higher exogenous variance attempt to reduce the information disadvantage they face by reducing autonomy of management. Thus, in practice, I observe a range of governance control that is negatively correlated to the variance of firm output. In addition, I find that over time, this information gap has decreased in US capital markets, and since Sarbanes-Oxley the information asymmetry does not play a role in the choice of corporate governance mechanisms.