Assistant Professor of Finance
Director of Research
"Optimal Securitization with Moral Hazard" with Tomasz Piskorski and Alexei Tchistyi, Journal of Financial Economics, 104 (2012) 186-202
Abstract: We consider the optimal design of mortgage-backed securities (MBS) in a dynamic setting in which a mortgage underwriter with limited liability can engage in costly hidden effort to screen borrowers and can sell loans to investors. We show that (i) the timing of payments to the underwriter is the key incentive mechanism, (ii) the maturity of the optimal contract can be short, and that (iii) bundling mortgages is efficient as it allows investors to learn about underwriter effort more quickly, an information enhancement effect. Finally, we demonstrate that the optimal contract can be closely approximated by the “first loss piece.”
Abstract: Static adverse selection models of security issuance show that informed issuers can perfectly reveal their private information by maintaing a costly stake in the securities they issue. This paper shows that allowing an issuer to both signal current security quality via retention and build a reputation for honesty leads that issuer to misreport quality even when owning a positive stake—the equilibrium is neither separating nor pooling. An issuer retains less as reputation improves and prices are more sensitive to retention when the issuer has a worse reputation.
"Growth Options, Incentives, and Pay-for-Performance: Theory and Evidence" with Sebastian Gryglewicz and Geoffery Zheng (2017).
Abstract: When firm value is non-linear in manager effort, pay-for-performance, measured as the sensitivity of manager compensation to firm value, is not a sufficient statistic for the strength of managerial incentives. To demonstrate this effect, we characterize the optimal contract between an investor and a risk-averse manager in the presence of a lumpy investment option. In our model, increasing the size of the growth option can decrease pay-performance sensitivity despite always increasing managerial effort and incentives. Low pay-performance sensitivity is consistent with higher effort and incentives because increasing the size of the growth opportunity increases the sensitivity of firm value to managerial effort. We document new empirical evidence consistent with our model. In a within firm analysis, a one standard deviation increase in Market-to-Book, a proxy for the presence of growth options, is associated with a roughly 6.5\% decrease in Jensen and Murphy's (1990) pay-performance sensitivity, as measured by dollar changes in manager wealth to dollar changes in firm value.
"Dynamic Agency and Real Options" with Sebastian Gryglewicz (2016).
Abstract: We analyze how dynamic moral hazard affects corporate investment. In our model, the owners of a firm hold a real option to increase capital. They also employ a manager who controls the firm's productivity, but is subject to moral hazard. Although this conflict reduces capital productivity, both over- and under-investment can occur. When moral hazard is severe, the firm invests at a lower threshold in productivity than in the first-best because investment is a substitute for effort. When the growth option is large, the investment threshold is higher than in the first-best.
"Are Lemons Sold First? Dynamic Signaling in the Mortgage Market" with Manuel Adelino and Kris Gerardi (2016).
Abstract: A central result in the theory of adverse selection in asset markets is that informed sellers can signal quality by delaying trade. This paper uses the residential mortgage market as a laboratory to test this mechanism. Using detailed, loan-level data on privately securitized mortgages, we ﬁnd a strong relation between mortgage performance and time-to-sale. Importantly, this ﬁnding is conditional on all observable information about the loans. This effect is strongest in the "Alt-A" segment of the market, where loans are often originated with incomplete documentation. The results provide some of the ﬁrst evidence of a signaling mechanism through delay of trade.
"National Income Accounting when Firms Insure Managers: Understanding Firm Size and Compensation Inequality" with Hanno Lustig and Mindy Zhang (2016).
Abstract: We develop a model in which firm-specific shocks have a first-order effect on the distribution of rents between shareholders and managers. In our model, firms optimally provide managers with contracts that do not expose them to risk. Consequently, larger and more productive firms return a larger share of rents to shareholders while less productive firms endogenously exit. An increase in firm-level risk lowers the threshold at which firms exit and increases the measure of firms in the right tail of the size distribution. As a result, such an increase always increases the aggregate capital share in the economy, but may lower the average firm's capital share. Moreover, the aggregate capital share reported in national income accounts produces a biased estimate of the ex-ante distribution of rents because the data only contain surviving firms. We confirm that the average firm's capital share has declined amongst publicly traded U.S. firms, even though the aggregate capital share has increased. We attribute the secular increase in the aggregate capital share amongst these firms to an increase in firm size inequality that results from an increase in firm-level risk. This effect is only partially mitigated by an increase in inter-firm labor compensation inequality.
"The Insurance is the Lemon: Failing to Index Contracts" with Benjamin Hebert (2016).
Abstract: We introduce a model to explain the widespread failure to index contracts to aggregate indices, despite the apparent risk-sharing benefits of indexation. Our model features these benefits, but demonstrates that asymmetric information about the ability of indices to measure underlying aggregate states can lead to risk-sharing failures and non-indexation. Suppose that a borrower receives an offer from a lender that features higher repayments in “good” states, in exchange for lower repayments in “bad” states. To make such an offer, a lender must ask for higher average repayments, because the lender is exposed to these aggregate risks. The borrower, however, is concerned that she is paying something for nothing; if the index is a poor measure of the true aggregate state, the cost of this contract might exceed its benefits. We provide conditions under which this effect is strong enough to cause the borrower to reject this contract, and choose a conventional, non-contingent contract instead. Under these conditions, many equilibria are possible, and they can be Pareto-ranked; the use of non-contingent contracts can be viewed as a coordination failure.
"Collateral constraints, wealth effects, and volatility: evidence from real estate markets" with William Mann (2016).
Abstract: We document that, within-region, lower-income zip codes have more volatile returns to housing than do higher-income zip codes, without any corresponding higher returns. We rationalize this finding with a simple model that features a collateral constraint on borrowing and non-homothetic preferences over housing. Shocks to the representative household's marginal rate of substitution lead to volatility in the return to housing via the collateral constraint. We argue that lower-income households have a more volatile marginal rate of substitution, and thus more volatile returns to housing, consistent with our empirical findings. We provide further evidence for our mechanism using (1) variation in wealth induced by lagged housing returns; (2) cross-sectional data on the housing expenditure share; and (3) state-level non-recourse status, which instruments for the tightness of collateral constraints. Finally, we observe that endogenous volatility in housing returns may limit the available supply of housing, via producers' option to delay. Consistent with this hypothesis, the age of the housing stock is monotonically decreasing in local income levels.
"Mortgage Underwriting Standards in the Wake of Quantitative Easing" with Richard Stanton and Nancy Wallace (2014).
Abstract: While the large-scale asset purchases (LSAPs) have funneled vast amounts of capital into the secondary market for mortgages, the direct effect of these programs on the primary mortgage market is not yet clear. We present evidence that while the LSAPs may have improved conditions for the least risky borrowers, they have not improved conditions for all borrowers. For example, the average FICO score of agency securitized mortgages increased from below 720 (low risk) in 2008 to above 760 (extremely low risk) in 2012. What explains this dramatic shift in the average quality of agency securitized mortgages, and why did it persist even with the flood of capital into the secondary mortgage market from the LSAPs? We argue that the change in the probability of buy back requests on Fannie and Freddie mortgage backed securities can explain the tightening of mortgage credit standards.
Work in Progress:
"A Theory of Optimal Capital Structure and Endogenous Bankruptcy" with Hengji Ai (2016).
"Cash and Dynamic Agency" with Konstantin Milbradt (2014).