Low Credit Quality Research Articles

Financial Distress and the Cross‐section of Equity Returns

ABSTRACTWe explicitly consider financial leverage in a simple equity valuation model and study the cross‐sectional implications of potential shareholder recovery upon resolution of financial distress. Our model is capable of simultaneously explaining lower returns for financially distressed stocks, stronger book‐to‐market effects for firms with high default likelihood, and the concentration of momentum profits among low credit quality firms. The model further predicts (i) a hump‐shaped relationship between value premium and default probability, and (ii) stronger momentum profits for nearly distressed firms with significant prospects for shareholder recovery. Our empirical analysis strongly confirms these novel predictions.

Detrimental Effects of Retention Regulation – Incentives of Loan Screening in Securitization Under Asymmetric Information

We consider an economy where a lender finances his loans to borrowers by issuing a securitized product to investors and where the credit quality of the product may depend on whether the lender screens the borrowers. In the presence of asymmetric information between the lender and the investors about the credit quality of potential borrowers that the lender faces, overvaluation (from the lender’s viewpoint) of the low quality securitized product may occur, which reduces the lender’s incentive to conduct costly screening of the borrowers and hence leads to issuance of the securitized product of low credit quality. This is likely to occur when the probability is low that the average credit-quality of potential borrowers is low. Hence, in the OTD business model, the low quality product tends to be issued just after the economic boom hits the peak, or when some of the lending opportunities start deteriorating, but not in the recession where majority of the lending opportunities are already bad. In this situation, we investigate the efficacy of retention regulation that requires the lender to hold a minimum ratio of his own securitized products, and find that such regulation is not necessarily effective to solve this incentive problem. Even worse, in a certain situation, the retention regulation discourages the lender's screening effort and reduces welfare.

Emerging from Chapter 11 Bankruptcy: Is It Good News or Bad News for Industry Competitors?

A firm under Chapter 11 bankruptcy protection may emerge from bankruptcy in a more advantageous competitive position within its industry to the detriment of their industry rivals. Using a sample of 264 firms that emerged from Chapter 11 bankruptcy during the period 1999‐2006, I find that its industry competitors demonstrate negative postemergence long‐term equity returns and deteriorating financial performance. Additional tests indicate that this outcome is less likely due to overall industry distress. Competitors tend to be more adversely affected if they are in more concentrated industries, if they have lower credit quality, when a more efficient firm emerges, and when the duration of bankruptcy is longer. This study suggests a need to reconsider Chapter 11's role in promoting competition and allocation of resources given its negative externalities on industry competitors.

The Financial Sector and the Real Economy During the Financial Crisis: Evidence from the Commercial Paper Market

Shocks to the financial sector led credit spreads to widen to unprecedented levels in many markets during the 2007-2008 financial crisis. The rise in spreads attracted attention because it could signal a disruption in financial markets, which has been widely linked to an increased burden on non-financial firms. This paper disentangles the relative contributions of credit and liquidity risk in explaining the widening of commercial paper spreads. In doing so, we find that liquidity risk was isolated to the financial sector throughout the first two major shocks to the system (August 2007 and March 2008). Indeed, controlling for credit risk, non-financial corporations saw little or no change in the cost of funding during this time period. After the bankruptcy of Lehman Brothers, for the first time, liquidity problems in the commercial paper market spilled out of the financial sector into the spreads of low credit quality non-financial firms. This effect had a disproportionately larger impact on those low credit-quality non-financial firms that placed paper exclusively through financial sector dealers. High credit quality firms remained unaffected throughout. Our interpretation of the results is that markets were able to differentiate not only between safe and imperiled firms in the midst of the crisis, but also to isolate where liquidity effects were most likely to be salient.

Bond Market Access, Credit Quality, and Capital Structure: Canadian Evidence

We examine the impact of bond market access (measured by having a credit rating) on leverage for Canadian high credit quality (HQ) and low credit quality (LQ) firms, and find that the leverage impact is more pronounced for LQ firms. The results are similar for U.S. firms. Our results are confirmed when we control for the firm's credit quality, examine the change in leverage around rating initiation, and account for the issue size effect. A similar leverage impact for Canadian and U.S. LQ firms suggests that the Canada-U.S. bond market integration has mitigated the financial constraints for Canadian LQ firms.

Capital Structure and Debt Structure

Using a novel data set that records individual debt issues on the balance sheets of public firms, we demonstrate that traditional capital structure studies that ignore debt heterogeneity miss substantial capital structure variation. Relative to high credit quality firms, low credit quality firms are more likely to have a multi-tiered capital structure consisting of both secured bank debt with tight covenants and subordinated non-bank debt with loose covenants. We discuss the extent to which these findings are consistent with existing theoretical models of debt structure in which firms simultaneously use multiple debt types to reduce incentive conflicts.

Debt Maturity Structure and Credit Quality

We examine whether a firm's debt maturity structure affects its credit quality. Consistent with theory, we find that firms with greater exposure to rollover risk (measured by the amount of long-term debt payable within a year relative to assets) have lower credit quality; long-term bonds issued by those firms trade at higher yield spreads, indicating that bond market investors are cognizant of rollover risk arising from a firm's debt maturity structure. These effects are stronger among firms with a speculative grade rating, declining profi tability, and during recessions.

The Informational Role of Bond Analysts

ABSTRACTThis study uses a large sample of sell‐side bond analysts' reports to examine the properties of recommendations provided by bond analysts and the impact of these recommendations on bond securities. First, we document that the distribution of bond analysts' buy, hold, and sell recommendations is skewed positively, but less so than the distribution of equity analysts' recommendations. The positive skewness in bond analysts' recommendations is greater for low than for high credit quality bonds. Second, we find that bond analysts' reports generate bond trading and return reactions that are both economically significant and greater for low credit quality bonds. The bond market reaction is greater for bond analysts' reports than for equity analysts' reports. Finally, while both bond and equity analysts lead rating agency announcements, we find no evidence of a difference in timeliness between bond and equity analysts' reports. Overall, our results are consistent with bond analysts issuing more negative reports than equity analysts and providing more information about low credit quality bonds as a result of the asymmetric demand for negative information by bond investors.

Government Guarantees: Pricing the Risk of Future Premium Losses

In this paper, we study the problem of potential premium losses when the premiums of guarantees of long maturities are collected periodically throughout the duration of the guarantee. Using a ratings based approach, we show how to price the risk of future premium losses and we assess the size of the extra premium required to cover these expected losses. We find that the required extra premium is conditional on the guaranteed firm's present credit worthiness. It is negligible when the present credit worthiness of the guaranteed firm is high, i.e. when the firm is classified as investment grade, even for guarantees of very long maturity, and increases when credit quality deteriorates. The extra premium is still low for firms with low credit quality and it converges quickly for longer maturities

Tax Arbitrage Feedback Theory

A new angle for understanding the global credit crisis of 2008-2009 is presented. Based on control theory principles and the axiom that investors seek the highest, expected after-tax return, I develop the Tax Arbitrage Feedback Theory. TAFT explains how the subtle effects of differential tax rates for various market participants produce incentives that strongly contribute to instability and boom/bust economic activity. Moreover, TAFT explains how observed bond credit spreads should be impacted by differential tax rates, in addition to the conventional bankruptcy and recovery factors. The purpose of debt securitization products, when viewed through a TAFT lens, is not only diversification and partitioning of risk, but also tax minimization. Credit default swaps are revealed to be a massive tax arbitrage that shifted government tax receipts to Wall Street bonus pools and necessitated the creation of massive quantities of low credit quality debt.

Relationship Banking, Monetary Policy, and Consumer Credit Reform

The increasing dependence of American households on debt financing and the rising rates of personal bankruptcy raise several welfare considerations that we analyze in this paper. We pose a theoretical model of relationship banking to first evaluate how strategic actions between banks and borrowers yield interest rates for various credit types and drive credit rationing in the market. Based on these results, we evaluate several policies that the government may implement to influence lending policies in consumer credit markets. We derive conditions under which the government optimally wishes to induce credit rationing and show that under some conditions, it is welfare enhancing to encourage banks to have a liberal lending policy, even if it means that interest rates are exceedingly high for low credit quality borrowers. Finally, we analyze the effects that a credit rating agency has on the dynamics of this market. Our theoretical analysis is consistent with empirical observations from these markets, and has significant importance especially given the recent subprime mortgage financial crisis.

New Empirical Evidence on the Debt Maturity Choice and the Role of Credit Risk

Using cross-sectional time series data on 710 US firms over the period from 1995 to 1998 this paper firstly employs a new approach to estimate the maturity of a firm's total debt based on debt level and flow data. We secondly provide new insights into the role of credit risk in the debt maturity choice. Consistent with theory our results confirm the nonmonotonic relation between credit rating and debt maturity. However, in contrast to previous studies we observe a considerable deviation in the debt maturity structure for unrated firms and for firms with medium credit ratings. Introducing alternative measures for credit risk our results show that the predicted screen-out of firms with low credit quality from the long-term maturity market is less pronounced based on these alternative measures.

Financial Distress and the Cross Section of Equity Returns

We explicitly consider financial leverage in a simple equity valuation model and study the cross-sectional implications of potential shareholder recovery upon resolution of financial distress. We show that our model is capable of simultaneously explaining lower returns for financially distressed stocks, stronger book-to-market effects for firms with high default likelihood, and the concentration of momentum profits among low credit quality firms. The model further predicts (i) a hump-shaped relationship between value premium and default probability, and (ii) stronger momentum profits for nearly distressed firms with significant prospects for shareholder recovery. Our empirical analysis strongly confirms these novel predictions.

Enhancing Mortgage Credit Availability Among Underserved and Higher Credit-Risk Populations: An Assessment of Default and Prepayment Option Exercise Among FHA-Insured Borrowers

This paper estimates an option-based hazard model of the competing risks of FHA mortgage termination. Results indicate that the elevated default risks of loans originated among lower credit quality and minority borrowers are more than offset by the damped prepayment speeds of those loans, so as to result in markedly lower loan termination probabilities among underserved borrower groups. Those damped termination risks translate into sizable reductions in risk premia to investors in simulated lower credit-quality mortgage pools. Empirical findings suggest that such pooling and risk-based pricing of FHA-insured mortgages could serve to substantially reduce housing finance costs among underserved borrowers, so as to advance both their homeownership opportunities and related federal housing policy objectives.

The Joint Size and Ownership Specialization in Banks' Lending

In this paper we study the specialization of Spanish banks along two intertwined dimensions: size and ownership form. We find some interesting results at odds with the existing empirical literature. As commercial banks increase their size, they lend more to large borrowers but that is not the case for the largest banks. For savings banks, the larger the size the more likely is the lending to small borrowers. Moreover, we find evidence that larger commercial banks are more willing to lend to low credit quality borrowers than medium size banks, while the opposite is true among savings banks. Banks' specialization in lending to business firms seems to go across the reputation considerations, risk shifting behavior and lending technologies most often considered in the literature.

Revisiting cumulative preferred stock valuation

This paper revisits the valuation of cumulative preferred stock, whose fair price is shown to critically depend on dividend arrears and the firm's earnings. Such fair price is an almost everywhere concave function of the firm's assets value and it tends to increase in the rate at which the firm generates earnings. When dividends are in arrears, the preferred stock call price should increase accordingly. If not, cumulative preferred stock becomes similar to the non-cumulative one. The value of a low credit quality preferred stock may well increase with interest rates. A finite difference algorithm is presented to value preferred stock as a function of the firm's asset, stochastic interest rates and dividend arrears.

Piercing and then Papering over the Vail of Ignorance: GSE Monopoly and Informational Advantage in the Market for Residential Mortgages

A model of a monopolistic (GSE-dominated) market for mortgages is constructed in which the GSE employs a proprietary credit evaluation technology to produce a precise estimate of mortgage loan credit quality. When the private value of the information underlying the screening technology is sufficiently high, the GSE introduces noise in order to block inferences of potential competitors. The GSE does this by: i) rationing lower credit quality consumers from the prime mortgage market, and ii) charging a locally uniform rate to qualified applicants. The GSE thus trades off monopoly rents for information rents, in which credit rationing and pool pricing rationally occur in a market where agents do not have a unilateral informational advantage. Comparative statics are derived that simultaneously account for the equilibrium mortgage loan rate and relative market size. Policy implications in the context of consumer welfare and the sub-prime mortgage market are analyzed and discussed. Optimal GSE capital structure, empirical tests of racial discrimination, and dynamic learning through sub-prime market lending are also considered as extensions to our basic model.

The choice among bank debt, non-bank private debt, and public debt: evidence from new corporate borrowings

Using a sample of 1,560 new debt financings, we examine the choice among bank debt, non-bank private debt, and public debt. The primary determinant of the debt source is the credit quality of the issuer. Firms with the highest credit quality borrow from public sources, firms with medium credit quality borrow from banks, and firms with the lowest credit quality borrow from non-bank private lenders. Non-bank private debt thus plays a unique role in accommodating the financing needs of firms with low credit quality. In addition, the choice of debt source is (weakly) influenced by managerial discretion.

The Choice Between Bank Debt, Non-Bank Private Debt and Public Debt: Evidence from New Corporate Borrowings

Using a sample of 1,560 new debt financings, we examine the choice among bank debt, non-bank private debt, and public debt. The primary determinant of the debt source is the credit qualit y of the issuer. Firms with the highest credit quality borrow from public sources, firms with medium credit quality borrow from banks, and firms with the lowest credit quality borrow from non-bank private lenders. Non-bank private debt thus plays a unique role in accommodating the financing needs of firms with low credit quality. In addition, the choice of debt source is (weakly) influenced by managerial discretion.

The estimation of transition matrices for sovereign credit ratings

Rating transition matrices for sovereigns are an important input to risk management of portfolios of emerging market credit exposures. They are widely used both in credit portfolio management and to calculate future loss distributions for pricing purposes. However, few sovereigns and almost no low credit quality sovereigns have ratings histories longer than a decade, so estimating such matrices is difficult. This paper shows how one may combine information from sovereign defaults observed over a longer period and a broader set of countries to derive estimates of sovereign transition matrices.