Showing papers on "Leverage (finance) published in 2010"

House Prices, Home Equity-Based Borrowing, and the U.S. Household Leverage Crisis

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 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 cents for every dollar increase in home equity. Home equity-based borrowing is stronger for younger households, households with low credit scores, and households with high initial credit card utilization rates. 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. Lower credit quality households living 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 conservative estimates suggest that home equity-based borrowing added $1.25 trillion in household debt, and accounts for at least 39% of new defaults from 2006 to 2008.

Overconfidence and Early-life Experiences: The Impact of Managerial Traits on Corporate Financial Policies

Abstract: We show that measurable managerial characteristics have significant explanatory power for corporate financing decisions beyond traditional capital-structure determinants First, managers who believe that their firm is undervalued view external financing as overpriced, especially equity Such overconfident managers use less external finance and, conditional on accessing risky capital, issue less equity than their peers Second, CEOs with Depression experience are averse to debt and lean excessively on internal finance Third, CEOs with military experience pursue more aggressive policies, including heightened leverage Complementary measures of CEO traits based on press portrayals confirm the results

Sudden Stops, Financial Crises, and Leverage

Abstract: The evidence from Sudden Stops in emerging economies shows that financial crashes are generally followed by major economic crises. This paper explains this phenomenon as an equilibrium outcome of a business cycle model with an endogenous collateral constraint that induces amplification and asymmetry in the responses of macro-aggregates to shocks. Cyclical dynamics produce economic expansions during which the ratio of debt to asset values raises enough to hit the constraint, triggering a Fisherian deflation that causes a spiraling decline in credit and in the price and quantity of collateral assets. Output and factor allocations also fall because the collateral constraint cuts access to working capital financing. In the long run, precautionary saving makes Sudden Stops low probability events nested within normal cycles, as observed in the data.

Capital structure, equity ownership and firm performance

Abstract: This paper investigates the relationship between capital structure, ownership structure and firm performance using a sample of French manufacturing firms. We employ non-parametric data envelopment analysis (DEA) methods to empirically construct the industry’s ‘best practice’ frontier and measure firm efficiency as the distance from that frontier. Using these performance measures we examine if more efficient firms choose more or less debt in their capital structure. We summarize the contrasting effects of efficiency on capital structure in terms of two competing hypotheses: the efficiency-risk and franchise-value hypotheses. Using quantile regressions we test the effect of efficiency on leverage and thus the empirical validity of the two competing hypotheses across different capital structure choices. We also test the direct relationship from leverage to efficiency stipulated by the Jensen and Meckling (1976) agency cost model. Throughout this analysis we consider the role of ownership structure and type on capital structure and firm performance.

Did Fair-Value Accounting Contribute to the Financial Crisis?

Abstract: In its pure form, fair-value accounting involves reporting assets and liabilities on the balance sheet at fair value and recognizing changes in fair value as gains and losses in the income statement. When market prices are used to determine fair value, fair-value accounting is also called mark-to-market account ing. Some critics argue that fair-value accounting exacerbated the severity of the 2008 financial crisis. The main allegations are that fair-value accounting contrib utes to excessive leverage in boom periods and leads to excessive write-downs in busts. The write-downs due to falling market prices deplete bank capital and set off a downward spiral, as banks are forced to sell assets at "fire sale" prices, which in turn can lead to contagion as prices from asset fire sales of one bank become relevant for other banks. These arguments are often taken at face value, but evidence on problems created by fair-value accounting is rarely provided. We discuss these arguments and examine descriptive and empirical evidence that sheds light on the role of fair-value accounting for U.S. banks in the crisis. While large losses can clearly cause problems for banks and other financial institu tions, the relevant question for our article is whether reporting these losses under fair-value accounting created additional problems. Similarly, it is clear that deter mining fair values for illiquid assets in a crisis is very difficult, but did reporting fair values of illiquid assets make matters worse? Would the market have reacted dif ferently if banks had not reported their losses or used a different set of accounting

An International Comparison of Capital Structure and Debt Maturity Choices

Abstract: This study examines the influence of institutional environment on capital structure and debt maturity choices by examining a cross-section of firms in 39 developed and developing countries. We find that a country's legal and tax system, the level of corruption and the preferences of capital suppliers explain a significant portion of the variation in leverage and debt maturity ratios. Our evidence indicate that firms in countries that are viewed as more corrupt tend to use less equity and more debt, especially short-term debt, while firms operating within legal systems that provide better protection for financial claimants tend to have capital structures with more equity, and relatively more long-term debt. In addition, the existence of an explicit bankruptcy code and/or deposit insurance is associated with higher leverage and more long-term debt. We also find that firms tend to use more debt in countries where there is a greater tax gain from leverage, while firms in countries with larger government bond markets have lower leverage, suggesting that government bonds tend to crowd out corporate debt. Countries with more extensive defined benefit pension funds have higher debt ratios and longer debt maturities, whereas those with more extensive defined contribution fund activities have lower debt ratios. In addition, debt ratios are lower in countries that limit the bond holdings of pension funds. Finally, we do not find a significant association between financing choices and the size of the insurance industry.

The determinants of corporate sustainability performance

Abstract: This paper investigates the factors that drive high levels of corporate sustainability performance (CSP), as proxied by membership of the Dow Jones Sustainability World Index. Using a stakeholder framework, we examine the incentives for US firms to invest in sustainability principles and develop a number of hypotheses that relate CSP to firm-specific characteristics. Our results indicate that leading CSP firms are significantly larger, have higher levels of growth and a higher return on equity than conventional firms. Contrary to our predictions, leading CSP firms do not have greater free cash flows or lower leverage than other firms.

The Determinants of Bank Capital Structure

Abstract: The paper shows that mispriced deposit insurance and capital regulation were of second-order importance in determining the capital structure of large U.S. and European banks during 1991 to 2004. Instead, standard cross-sectional determinants of non-financial firms' leverage carry over to banks, except for banks whose capital ratio is close to the regulatory minimum. Consistent with a reduced role of deposit insurance, we document a shift in banks' liability structure away from deposits towards non-deposit liabilities. We find that unobserved time-invariant bank fixed-effects are ultimately the most important determinant of banks' capital structures and that banks' leverage converges to bank specific, time-invariant targets. Copyright 2010, Oxford University Press.

The Response of Corporate Financing and Investment to Changes in the Supply of Credit

Abstract: We examine how shocks to the supply of credit impact corporate financing and investment using the collapse of Drexel Burnham Lambert, Inc.; the passage of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989; and regulatory changes in the insurance industry as an exogenous contraction in the supply of below-investment-grade credit after 1989. A difference-in-differences empirical strategy reveals that substitution to bank debt and alternative sources of capital (e.g., equity, cash balances, and trade credit) was limited, leading to an almost one-for-one decline in net investment with the decline in net debt issuances. Despite this sharp change in behavior, corporate leverage ratios remained relatively stable, a result of the contemporaneous decline in debt issuances and investment. Overall, our findings highlight how even large firms with access to public credit markets are susceptible to fluctuations in the supply of capital.

Employee Treatment and Firm Leverage: A Test of the Stakeholder Theory of Capital Structure

Abstract: We investigate the stakeholder theory of capital structure from the perspective of a firm’s relationships with its employees. We find that firms that treat their employees fairly (as measured by high employee-friendly ratings) maintain low debt ratios. This result is robust to a variety of model specifications and endogeneity issues. The negative relation between leverage and a firm’s ability to treat employees fairly is also evident when we measure its ability by whether it is included in the list of Fortune Magazine’s “100 Best Companies to Work For.” These results suggest that a firm’s incentive/ability to offer fair employee treatment is an important determinant of its financing policy.

Seeking Shelter: Empirically Modeling Tax Shelters Using Financial Statement Information

Abstract: Using confidential tax shelter and tax return data obtained from the Internal Revenue Service, this study develops and validates an expanded model for inferring the likelihood that a firm engages in a tax shelter. Results show that tax shelter likelihood is positively related to subsidiaries located in tax havens, foreign-source income, inconsistent book-tax treatment, litigation losses, use of promoters, profitability, and size, and negatively related to leverage. Supplemental tests show that total book-tax differences (BTDs) and the contingent tax liability reserve are significantly related to tax shelter usage, while discretionary permanent BTDs and long-run cash effective tax rates are not. Finally, the model is weaker, yet still significant, in the FIN 48 disclosure environment. This research provides investors and policymakers with an extended, validated measure to calculate the presence of extreme cases of corporate tax aggressiveness. Such information could also aid analysts and other ta...

Leverage, Moral Hazard and Liquidity

Abstract: We build a model of the financial sector to explain why adverse asset shocks in good economic times lead to a sudden drying up of liquidity. Financial firms raise short-term debt in order to finance asset purchases. When asset fundamentals worsen, debt induces firms to risk-shift; this limits their funding liquidity and their ability to roll over debt. Firms may de-lever by selling assets to better-capitalized firms. Thus the market liquidity of assets depends on the severity of the asset shock and the system-wide distribution of leverage. This distribution of leverage is, however, itself endogenous to future prospects. In particular, short-term debt is relatively cheap to issue in good times when expectations of asset fundamentals are benign, resulting in entry to the financial sector of firms with less capital or high leverage. Due to such entry, even though the incidence of financial crises is lower in good times, their severity in terms of de-leveraging and evaporation of market liquidity can in fact be greater.

Hedge Fund Contagion and Liquidity Shocks

Abstract: Defining contagion as correlation over and above that expected from economic fundamentals, we find strong evidence of worst return contagion across hedge fund styles for 1990 to 2008. Large adverse shocks to asset and hedge fund liquidity strongly increase the probability of contagion. Specifically, large adverse shocks to credit spreads, the TED spread, prime broker and bank stock prices, stock market liquidity, and hedge fund flows are associated with a significant increase in the probability of hedge fund contagion. While shocks to liquidity are important determinants of performance, these shocks are not captured by commonly used models of hedge fund returns. USING MONTHLY HEDGE FUND INDEX DATA for the period January 1990 to October 2008, we find that the worst hedge fund returns, defined as returns that fall in the bottom 10% of a hedge fund style’s monthly returns, cluster across styles. Further, using both parametric and semi-parametric analyses, we show that this clustering cannot be explained by risk factors commonly used to explain hedge fund performance. Bekaert, Harvey, and Ng (2005 p. 40) define contagion as “correlation over and above what one would expect from economic fundamentals.” With this definition, the clustering we observe is contagion. To our knowledge, this is the first study to test for and document the existence of hedge fund contagion. To understand the determinants of hedge fund contagion, we turn to a recent paper by Brunnermeier and Pedersen (2009) for theoretical motivation. In their model, an adverse shock to speculators’ funding liquidity (the availability of funding) forces them to reduce their leverage and provide less liquidity to the markets, which reduces asset liquidity (the ease with which assets trade). When the impact of the funding liquidity shock on asset liquidity is strong enough, the decrease in asset liquidity makes funding even tighter for speculators, causing a self-reinforcing liquidity spiral in which both funding liquidity and asset liquidity continue to deteriorate. An important implication of their

The Net Benefits to Leverage

Abstract: I estimate the market's valuation of the net benefits to leverage using panel data from 1994 to 2004, identified from market values and betas of a company's debt and equity. The median firm captures net benefits of up to 5.5% of firm value. Small and profitable firms have high optimal leverage ratios, as predicted by theory, but in contrast to existing empirical evidence. Companies are on average slightly underlevered relative to the optimal leverage ratio at refinancing. This result is mainly due to zero leverage firms. I also look at implications for financial policy.

Household Leverage and the Recession of 2007 to 2009

Abstract: This paper shows that household leverage as of 2006 is a powerful statistical predictor of the severity of the 2007–09 recession across U.S. counties. Those counties 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 the official beginning of the recession in the fourth quarter of 2007. 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, the statistical model shows that household leverage growth and dependence on credit card borrowing as of 2006 explain a large fraction of the overall consumer default, house price, unemployment, residential investment, and durable consumption patterns during the recession. The findings suggest that a focus on household finance may help elucidate the sources of macroeconomic fluctuations.

Limits of Arbitrage: The State of the Theory

Abstract: We survey theoretical developments in the literature on the limits of arbitrage. This literature investigates how costs faced by arbitrageurs can prevent them from eliminating mispricings and providing liquidity to other investors. Research in this area is currently evolving into a broader agenda emphasizing the role of financial institutions and agency frictions for asset prices. This research has the potential to explain so-called "market anomalies" and inform welfare and policy debates about asset markets. We begin with examples of demand shocks that generate mispricings, arguing that they can stem from behavioral or from institutional considerations. We next survey, and nest within a simple model, the following costs faced by arbitrageurs: (i) risk, both fundamental and non-fundamental, (ii) short-selling costs, (iii) leverage and margin constraints, and (iv) constraints on equity capital. We finally discuss implications for welfare and policy, and suggest directions for future research.

Employee well-being, firm leverage, and bankruptcy risk.

Abstract: Employees of liquidating firms are likely to lose income and non-pecuniary benefits of working for the firm, which makes bankruptcy costly for employees. This paper examines whether firms take these costs into account when deciding on the optimal amount of leverage. We find that firms with leading track records in employee well-being significantly reduce the probability of bankruptcy by operating with lower debt ratios. Moreover, we observe that firms with better employee track records have better credit ratings, even when we control for differences in firm leverage.

Overborrowing, Financial Crises and 'Macro-prudential' Taxes

Abstract: An equilibrium model of financial crises driven by Irving Fisher's financial amplification mechanism features a pecuniary externality, because private agents do not internalize how the price of assets used for collateral respond to collective borrowing decisions, particularly when binding collateral constraints cause asset fire-sales and lead to a financial crisis. As a result, agents in the competitive equilibrium borrow "too much" ex ante, compared with a financial regulator who internalizes the externality. Quantitative analysis calibrated to U.S. data shows that average debt and leverage are only slightly larger in the competitive equilibrium, but the incidence and magnitude of financial crises are much larger. Excess asset returns, Sharpe ratios and the price of risk are also much larger, and the distribution of returns displays endogenous fat tails. State-contingent taxes on debt and dividends of about 1 and -0.5 percent on average respectively support the regulator's allocations as a competitive equilibrium.

Lending Relationships and Information Rents: Do Banks Exploit Their Information Advantages?

Abstract: In the process of lending to a firm, a bank acquires proprietary firm-specific information that is unavailable to nonlenders. This asymmetric evolution of information between lenders and prospective lenders grants the former an information monopoly. This article empirically investigates whether relationship banks exploit this advantage by charging higher interest rates than those that would prevail were all banks symmetrically informed. My identification strategy hinges on the notion that large information shocks that level the playing field among banks erode the relationship bank's information monopoly. I use the borrower's initial public offering (IPO) as such an information-releasing event, and build a panel dataset in which the unit of observation is a firm's lending relationships before and after its IPO. Prior to a firm's IPO, I find a U-shaped relation between borrowing rates and relationship intensity. After the IPO, interest rates are decreasing in relationship intensity. Furthermore, mean interest rates drop after an IPO. The results are robust to firm and loan-year fixed effects, and to controls for firm leverage pre- and post-IPO. Thus, the reported interest rate pattern is clean of any confounding effects that might arise from changes in financial risk. The Author 2009. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org, Oxford University Press.

Correlation Risk and Optimal Portfolio Choice

Abstract: We develop a new framework for multivariate intertemporal portfolio choice that allows us to derive optimal portfolio implications for economies in which the de gree of correlation across industries, countries, or asset classes is stochastic. Optimal portfolios include distinct hedging components against both stochastic volatility and correlation risk. We find that the hedging demand is typically larger than in univari ate models, and it includes an economically significant covariance hedging compo nent, which tends to increase with the persistence of variance-covariance shocks, the strength of leverage effects, the dimension of the investment opportunity set, and the presence of portfolio constraints. This paper develops a new multivariate modeling framework for intertempo ral portfolio choice under a stochastic variance-covariance matrix. We consider an incomplete market economy, in which stochastic volatilities and stochastic correlations follow a multivariate diffusion process. In this setting, volatili ties and correlations are conditionally correlated with returns, and optimal portfolio strategies include distinct hedging components against volatility and correlation risk. We solve the optimal portfolio problem and provide simple closed-form solutions that allow us to study the volatility and covariance hedg ing demands in realistic asset allocation settings. We document the importance of modeling the multivariate nature of second moments, especially in the con text of optimal asset allocation, and find that the optimal hedging demand can be significantly different from the one implied by more common models with constant correlations or single-factor stochastic volatility. An important thread within the asset pricing literature has documented the characteristics of the time variation in the covariance matrix of asset

Do Peer Firms Affect Corporate Financial Policy

Abstract: We show that corporate financial policies are highly interdependent; firms make financing decisions in large part by responding to the financing decisions of their peers, as opposed to changes in firm-specific characteristics. On average, a one standard deviation change in peer firms' leverage ratios is associated with an 11% change in own firm leverage ratios --- a marginal effect that is significantly larger than that of any other observable determinant and one that is driven by interdependencies among debt and equity issuance decisions. Consistent with information-based theories of learning and reputation, we find that smaller, more financially constrained firms with lower paid and less experienced CEOs are more likely to mimic their peers. Additionally, we quantify the externalities engendered by these peer effects, which can amplify the impact of changes in exogenous determinants on leverage by almost 70%.

The Aggregate Dynamics of Capital Structure and Macroeconomic Risk

Abstract: We study the impact of time-varying macroeconomic conditions on optimal dynamic capital structure for a cross-section of firms. Our structural-equilibrium framework embeds a contingent-claim corporate financing model within a consumption-based asset-pricing model. We investigate the effect of macroeconomic conditions on asset valuation and optimal corporate policies, and of preferences on capital structure. While capital structure is pro-cyclical at dates when firms re-lever, it is counter-cyclical in aggregate dynamics, consistent with empirical evidence. We also find that financially constrained firms choose more pro-cyclical policies and that leverage accounts for most of the macroeconomic risk relevant for predicting defaults, but is a poor measure of how preferences impact capital structure. The Author 2010. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org., Oxford University Press.

The Role of Private Equity Group Reputation in LBO Financing

Abstract: This paper investigates whether the reputation of acquiring private equity groups (PEGs) is related to the financing structure of leveraged buyouts (LBOs). Using a sample of 180 public-to-private LBOs in the US between January 1, 1997 and August 15, 2007, we find that reputable PEGs are more active in the LBO market when credit risk spreads are low and lending standards in the credit markets are lax. We also find that reputable PEGs pay narrower bank and institutional loan spreads, have longer loan maturities, and rely more on institutional loans. In addition, while we find that PEG reputation is positively related to buyout leverage (i.e., LBO debt divided by pre-LBO earnings before interest, taxes, and amortization (EBITDA) of the target), and leverage is significantly positively related to buyout pricing, we do not find any direct relation between PEG reputation and buyout valuations. The evidence suggests that PEG reputation is related to LBO financing structure not only because reputable PEGs are more likely to take advantage of market timing in credit markets and but also because PEG reputation reduces agency costs of LBO debt.

Financial Flexibility, Investment Ability and Firm Value: Evidence from Firms with Spare Debt Capacity

Abstract: We demonstrate that a conservative leverage policy directed at maintaining financial flexibility can enhance investment ability. Our analysis reveals that following a period of low leverage, firms make larger capital expenditures and increase abnormal investment. We find that these new investments are financed through new issues of debt. The impact of financial flexibility is both statistically significant and economically sizeable. Further, long run performance tests reveal that financially flexible firms not only invest more, but also invest better. Our results are consistent with the view that financial flexibility in the form of untapped reserves of borrowing power is a crucial missing link in capital structure theory.

Continuous-time models, realized volatilities, and testable distributional implications for daily stock returns

Abstract: We provide an empirical framework for assessing the distributional properties of daily speculative returns within the context of the continuous-time jump diffusion models traditionally used in asset pricing finance. Our approach builds directly on recently developed realized variation measures and non-parametric jump detection statistics constructed from high-frequency intra-day data. A sequence of simple-to-implement moment-based tests involving various transformations of the daily returns speak directly to the importance of different distributional features, and may serve as useful diagnostic tools in the specification of empirically more realistic continuous-time asset pricing models. On applying the tests to the 30 individual stocks in the Dow Jones Industrial Average index, we find that it is important to allow for both time-varying diffusive volatility, jumps, and leverage effects to satisfactorily describe the daily stock price dynamics. Copyright © 2009 John Wiley & Sons, Ltd.

Inequality, Leverage and Crises

Abstract: The paper studies how high leverage and crises can arise as a result of changes in the income distribution. Empirically, the periods 1920-1929 and 1983-2008 both exhibited a large increase in the income share of the rich, a large increase in leverage for the remainder, and an eventual financial and real crisis. The paper presents a theoretical model where these features arise endogenously as a result of a shift in bargaining powers over incomes. A financial crisis can reduce leverage if it is very large and not accompanied by a real contraction. But restoration of the lower income group's bargaining power is more effective.

Financial Flexibility, Investment Ability, and Firm Value: Evidence from Firms with Spare Debt Capacity

Abstract: We document, for the first time, that a conservative leverage policy directed at maintaining financial flexibility can enhance investment ability. Our analysis reveals that following a period of low leverage, firms make larger capital expenditures and increase abnormal investment. We find that these new investments are financed through new issues of debt. The impact of financial flexibility is both statistically significant and economically sizable. Further, long-run performance tests reveal that financially flexible firms not only invest more but also invest better. Our results are consistent with the view that financial flexibility in the form of untapped reserves of borrowing power is a crucial missing link in capital structure theory. There is a puzzling empirical regularity in the capital structure literature. Many firms appear to borrow less than the dominant theories predict. In his influential paper, Graham (2000) finds, “Paradoxically, large, liquid, profitable firms with low expected distress costs use debt conservatively.” He also reports that this conservative behavior appears to be persistent. Similar issues are discussed, among others, by Minton and Wruck (2001) and Strebulaev and Yang (2008). Recent survey evidence has shed some light on this matter (Bancel and Mittoo, 2004; Brounen, De Jong, and Koedijk, 2004; Graham and Harvey, 2001; Pinegar and Wilbricht, 1989). These studies suggest that it is financial flexibility that primarily drives chief finance officers’ leverage choices. Respondents say that flexibility is very important in enabling their companies to undertake investment in the future, when asymmetric information and contracting problems might otherwise force them to forego profitable growth opportunities. In other words, companies may adopt a conservative leverage policy to maintain “substantial reserves of untapped borrowing