Center for Financial Research
CFR Working Paper Series 2010
The CFR sponsors original research on issues associated with deposit insurance, banking performance, risk measurement and management, corporate finance, and financial policy and regulation. The results of CFR-sponsored research, FDIC staff research, and other invited papers on these CFR research lines appear in the CFR Working Paper Series.
FDIC Center for Financial Research Working Paper No. 2010-11
Kristina Minnick, Haluk Unal, Liu Yang
We examine how managerial incentives affect acquisition decisions in the banking industry. We find that higher pay-for-performance sensitivity (PPS) leads to value-enhancing acquisitions. Banks whose CEOs have higher PPS have significantly better abnormal stock returns around the acquisition announcements. On average, acquirers in the High-PPS group outperform their counterparts in the Low-PPS group by 1:4% in a three-day window around the announcement. Ex ante, higher PPS helps to reduce the incentives to make value-destroying acquisitions, while at the same time promote value-enhancing acquisitions. The positive market reaction can be rationalized by post-merger performance. Following acquisitions, banks with higher PPS experience greater improvement in their operating performance. We show that the effect of PPS is mainly driven by small and medium-sized banks, but is not present in large banks.
FDIC Center for Financial Research Working Paper No. 2010-10
This paper demonstrates that liquidity risk as measured by the covariation of fund returns with unexpected changes in aggregate liquidity is an important determinant in the cross-section of hedge-fund returns. The results show that funds that significantly load on liquidity risk subsequently outperform low-loading funds by about 6% annually, on average, over the period 1994-2008, while negative performance is observed during liquidity crises. The returns are independent of the liquidity a fund provides to its investors as measured by lockup and redemption notice periods, and they are also robust to commonly used hedge-fund factors. These findings highlight the importance of understanding systematic liquidity variations in the evaluation of hedge-fund performance.
JEL Classification: G12, G14, G23.
Keywords: Liquidity risk, Hedge funds, Price impact, Asset pricing.
FDIC Center for Financial Research Working Paper No. 2010-09
Sudheer Chava and Amiyatosh Purnananda
We provide causal evidence that adverse capital shocks to banks affect their borrowers' performance negatively. We use an exogenous shock to the U.S. banking system during the Russian crisis of Fall 1998 to separate the effect of borrowers' demand of credit from the supply of credit by the banks. Firms that primarily relied on banks for capital suffered larger valuation losses during this period and subsequently experienced a higher decline in their capital expenditure and profitability as compared to firms that had access to the public-debt market. Consistent with an adverse shock to the supply of credit, crisis-affected banks decreased the quantity of their lending and increased loan interest rates in the post-crisis period significantly more than the unaffected banks. Our results suggest that the global integration of the financial sector can contribute to the propagation of financial shocks from one economy to another through the banking channel.
JEL Classification: G21, G32, D82.
Keywords: Banking Crisis, Russian Default, Bank Loans, Credit Crunch.
FDIC Center for Financial Research Working Paper No. 2010-08
An originate-to-distribute (OTD) model of lending, where the originator of a loan sells it to various third parties, was a popular method of mortgage lending before the onset of the subprime mortgage crisis. We show that banks with high involvement in the OTD market during the pre-crisis period originated excessively poor quality mortgages. This result is not explained away by differences in observable borrower quality, geographical location of the property or the cost of capital of high and low OTD banks. Instead, our evidence supports the view that the originating banks did not expend resources in screening their borrowers. The effect of OTD lending on poor mortgage quality is stronger for capital-constrained banks. Overall, we provide evidence that lack of screening incentives coupled with leverage induced risk-taking behavior significantly contributed to the current sub-prime mortgage crisis.
JEL Classification: G11, G12, G13, G14.
FDIC Center for Financial Research Working Paper No. 2010-07
Carlos D. Ramirez
Using a newly constructed database of bank failures for the period 1900 to 1930, this paper estimates a dynamic regression model to examine the extent to which banking instability at the state level affects the proportion of state deposits relative to national deposits. The main results indicate that banking failures reduce the proportion of state deposits by approximately 0.04 percent in the short run and by nearly 1 percent in the long run. In the eight states that adopted deposit insurance systems during the late 1910s and the 1920s, however, I find no evidence that banking crises affected deposit growth. Furthermore, I find no evidence that the banking crisis of the 1980s and 1990s had any significant effect on state deposit growth. These results suggest that deposit insurance may have lessened the effects of banking instability on deposit growth.
JEL Classification: K42
Keywords: JEL classification:
FDIC Center for Financial Research Working Paper No. 2010-06
J. Michael Collins and Maximilian D. Schmeiser
Starting in 2008, the number of homeowners losing their homes to foreclosure began increasing dramatically. Given that troubled borrowers may not fully understand their options for modifying their mortgage, lenders and policymakers have reacted to rising foreclosure filings by increasing the use of third-party default counseling programs. However, the existing literature on mortgage default counseling provides little convincing evidence on the effectiveness of counseling on borrower outcomes. This study employs multiple identification strategies to assess the impacts of counseling on receipt of loan modifications and keeping one�s home. We find evidence of negative selection into counseling; however, once this negative selection is controlled for, counseling is consistently found to increase the probability that borrowers will receive a modification. We also find some evidence that counseling reduces the probability that a borrower will lose his or her home to foreclosure. Moreover, among borrowers who received a loan modification, those who were counseled were less likely to subsequently default. Lastly, we consistently find that when a homeowner receives counseling is an important determinant of his or her final outcome: those who receive counseling when current or in the early stages of default are much more likely to receive a modification or keep their homes than those who receive counseling when seriously delinquent.
JEL Classification: K42
Keywords: Jel Codes
FDIC Center for Financial Research Working Paper No. 2010-05
Ryan M. Goodstein and Yan Y. Lee
We measure the causal impact of foreclosures on crime. Using a novel national county-level panel dataset, we find robust evidence that foreclosures increase burglary. Our baseline OLS estimate indicates that a one percentage point increase in foreclosure rates increases burglary rates by 2.1 percent. This estimate increases to roughly 10 percent when we use an IV strategy to addresses potential bias in OLS due to measurement error in foreclosure rates. Sensitive to specification, we also find positive effects of foreclosures on larceny and aggravated assault. Our estimates indicate that foreclosures do not have an effect on motor vehicle theft, robbery, rape, or murder.
JEL Classification: K42
Keywords: Crime, Foreclosures, Instrumental Variables
FDIC Center for Financial Research Working Paper No. 2010-04
Gergana Jostova, Stanislava Nikolova, Alexander Philipov and Christof W. Stahel
This paper documents significant price momentum in US corporate bonds over the period from 1973 to 2008. Results are based on close to 3 million bondmonth return observations (on average about 7,200 bonds per month issued by 2,000 companies), compiled from two transaction (Mergent's FISD/NAIC and TRACE) and three dealer-quote (Lehman Brothers, DataStream, and Bloomberg) databases. As with equities, momentum profits derive from the highest credit risk securities. However, contrary to equities, bond momentum strategies derive their profitability primarily from winners. Hence, short-sale constraints are unlikely to explain the persistent profitability of bond momentum. Bond momentum profits are robust to risk, liquidity, and transaction costs considerations, and are prevalent in both quote-based and trade-based datasets.
JEL Classification: G10, G12, G14
Keywords: Bond Market; Price Momentum; Credit Risk
FDIC Center for Financial Research Working Paper No. 2010-03
Ethan Cohen-Cole and Jonathan Morse
This paper presents evidence that precautionary liquidity concerns lead many individuals to pay credit card bills even at the cost of mortgage delinquencies and foreclosures. While the popular press and some recent literature have suggested that this choice may emerge from steep declines in housing prices, we find evidence that individual-level liquidity concerns are more important in this decision. That is, choosing credit cards over housing suggests a precautionary liquidity preference.
By linking the mortgage delinquency decisions to individual-level credit conditions, we are able to assess the compound impact of reductions in housing prices and retrenchment in the credit markets. Indeed, we find the availability of cash-equivalent credit to be a key component of the delinquency decision. We find that a one standard deviation reduction in available credit elicits a change in the predicted probability of mortgage delinquency that is similar in both direction and nearly double in magnitude to a one standard deviation reduction in housing price changes (the values are -25% and -13% respectively). Our findings are consistent with consumer finance literature that finds individuals have a preference for preserving liquidity - even at significant cost.
JEL Classification: D14, G20
Keywords: consumer finance, delinquency, payment priority
FDIC Center for Financial Research Working Paper No. 2010-02
Wei Jiang, Kai Li, and Pei Shao
This paper provides a comprehensive analysis of a new and increasingly important phenomenon: the simultaneous holding of both equity and debt claims of the same company by noncommercial-banking institutions ("dual holders"). The presence of dual holders offers a unique opportunity to assess the existence and magnitude of shareholder-creditor conflicts. We find that syndicated loans with dual holder participation have loan yield spreads that are 18-32 basis points lower than those without. The difference remains economically significant after controlling for the selection effect. Further investigation of dual holders' investment horizons and changes in borrowers' credit quality lends support to the hypothesis that incentive alignment between shareholders and creditors plays an important role in lowering loan yield spreads.
JEL Classification: G20, G32
Keywords: shareholder-creditor conflicts, dual holding, syndicated loans
FDIC Center for Financial Research Working Paper No. 2010-01
Kyung So Im, Junsoo Lee, Margie Tieslau
This paper proposes a new Lagrange multiplier (LM) based unit root test for panel data allowing for heterogeneous structural breaks in both the intercept and slope of each cross-section unit in the panel. We note that panel unit root tests allowing for breaks in the slope will critically depend on the nuisance parameters indicating the size and location of breaks. Any panel tests that ignore this dependency on the nuisance parameter will be subject to serious size distortions. To address this problem, our test employs a method that renders the asymptotic distribution of the panel tests invariant to nuisance parameters. We derive the asymptotic properties of our test and also examine its finite-sample properties. In addition, our test easily can be modified to correct for the presence of cross-correlations in the innovations of the panel. We illustrate this by applying the cross-sectionally augmented ADF (CADF) procedure of Pesaran (2007) to our test statistic.
JEL Classification: C12, C15, C22
Keywords: Panel Unit Root Tests, LM Test, Structural Breaks, Trend Breaks