Summary Advanced Corporate
Finance
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Summary Advanced Corporate
Finance
Part 1 Back to the Basics
Week 1 – Lecture 1&2&3
Finance sources: Internal and External capital.
1. Internal capital: Retained earnings – profts not payed back to shareholders but used to fnance
investment, current expenses etc.
2. External capital:
a. Debt: Debtholders have a contract specifying that their claim must be paid in full before
the frm can make payments to the eqouity holders, they dontt have votng rights. Debt is
a senior claim to eqouity. So if a company goes bankruptcy: frst pay your debtholders
and the lefover money is for the eqouity holders.
b. Eqouity : eqouity holders receive a dividend only afer the debtholders claims are satsfed
and they have the right to vote at the general meetng of shareholders.
Two forms of leverage:
1. Academic leverage:
Debt
Debt
or
Equity
Total Assets
Leverage can change because of: debt is
issued (more leverage) or paid back (leverage goes down). Or eqouity is issued or paid back.
2. Industry leverage:
Debt
this is the most common measure of leverage. It is usually
EBIT
indicated with 3x, 4x … (3x means for example that it will take (on average) 3 years to pay back
your debt).
Taking an easy framework, Finance wontt mater (so the rato between debt & eqouity doesntt mater –
so: your frm will not become more valuable by using more debt or eqouity).
Assumptions of M&M (Modigliani – Millerl
1. Perfect fnancial markets:
• Compettve: Individuals and frms are price-takers
• Frictonless: No transacton costs, etc.
• All agents are ratonal
2. All agents have the same informaton
3. A frmts cash-flows do not depend on its fnancial policy (e.g. no bankruptcy costs – because
otherwise the lawyer can manipulate their pay-of to maximize her own earnings)
4. No taxes
These assumptons are not the case in real-life (you always have to pay taxes etc.)  SO: Finance does
mater! If you life in a perfect world (the assumptons hold), Finance doesntt mater, but the investment
maters. So, the way you fnance your proeectiinvestment will maters if you life in a real world!
The original propositions:
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•
MM-Proposition I (MM 1958): A frmts total market value is independent of its capital structure
(so: capital structure doesntt mater) SO: Vl = Vu
The value of a frm is the Present Discounted value of Future Cash Flows (CF). When a frm issues debt &
eqouity securites, it splits its CF into a safe stream (to bondholders) and a risky stream (to stockholders)
What maters is how much money (Cash flows) the company is able to generate and to pay. So the size
of the cash flows maters, not the rato between eqouity and debt – the way we fnance it wontt make the
CF bigger (or smaller) (CF = debt + eqouity). So frms cannot change the total value of their securites by
splitting CFts into two diferent streams. But: Firm value is determined by the real assets.
VU = VE = (EBIT) i rU
VL = D + E = [INT + (EBIT – Int)] i rU
These two eqouatons will gave the same answer
VU = Value unlevered. Vl = Value levered. VE = Value Eqouity.
•
MM-Proposition II (MM 1958): A frmts cost of eqouity increases with its debt-eqouity rato
The Firm Weighted Average Cost of Capital is:
If WACC >r d  r E is increasing with
D
E
D
E
rd +
r
(D+ E)
( D+ E) E
D
r E=( WACC−r d ) +WACC
E
WACC =
Intuition: increasing Debt makes eqouity riskier, increasing the expected returns investors demand
Debts generates risk (so: higher reqouired return), there are two types of risk:
1. Business risk: Typical enterprise risk - this depends on the type of investment you undertake (if
you want to become the new Steve Jobs (Apple), your business risk is high.
Business risk = Financial risk in an all eqouity fnanced frm.
Business risk < fnancial risk, when a frm is partly debt fnanced
2. Financial risk: Risk of the eqouity investment. It is the additonal risk placed on the common
stockholders as a result of the decision to fnance with debt. Leverage increase shareholder risk
and the return on eqouity (to compensate for the higher risk)
(
β L =β U 1+
The beta changed because it is a measure of risk (higher beta  more risk)
Βl > βU = Always!
D
E
)
Common mistake propositon II: when you have more debt, you have higher returns  wrong: dontt
forget the risk!
•
Dividend Irrelevance (MM 1961): A frmts total market value is independent of its dividend
policy (= pay out your dividend or have retained earnings)
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Investor Indiference (Stglitz 1969): Individual investors (the ones who are supposed to buy shares from
a company) are indiferent to all frmst fnancial policies (so they invest in companies which make
profts) – we dontt care about the rato debt & eqouity.
The morale of this propositon: managers should not care about the risk preferences of the investor. We
eust need that investors have the ability to borrow and lend for their own account (= homemade
leverage: borrowing at the same rate as frms – because we assume all informaton is available) so that
they can “undo” any changes in frmts capital structure. So as a manager: care about your investments,
not how to finance them!
Clientèless Theory (or Financial Marketng Theory): diferent investors prefer diferent consumptons
streams, they may prefer diferent fnancial assets and fnancial policy serves these diferent clienteles.
Example: All-eqouity frms might fail to exploit investorst demands for safe and risky assets. It may be
beter to issue both debt and eqouity to allow investors to focus on their preferred asset mix
Intuiton from MM: Investorts preferences are over consumpton, not fnancial assets. They can
sliceidiceicombineire-trade the frmts securites. If investors can undertake the same transactons as
frms, they will not pay a premium for frms to undertake them on their behalf  no value in fnancial
marketng.
Because we dontt care about the rato debt & eqouity (any combinaton of securites is as good as any
other), two frms with the same operatng income and who difer only in capital structure:
- Unlevered frm: VU = EU
- Levered frm: EL = VL – DL
EL = Value of eqouity
VL = (Total) value of the company
If you borrow money on your own account = homemade leverage (so go to a bank and borrow money,
you can do this for example to invest it aferwards in a company without leverage).
M&M is not a literal statement about the world but it helps you to avoid frst-order mistakes, their most
basic message is:
- Value is created only (i.e. in practce mostly) by operatng assets, i.e. on Lef and Side of the
Balance Sheet
- A frmts fnancial policy should be (mostly) a means to support the operatng policy, not
(generally) an end in itself
Debt and taxes:
Corporatons pay (usually) less taxes on debt than eqouity (because debt is subsidized), this is important
because:
- Efficiency: introducton of taxes and subsidies may distort otherwise socially optmal decisions
- Financial stability: companies may issue “too much” debt, putting pressure on the banking
system
Because interest is tax-free, corporatons are more likely to issue more debt (too much) – this can lead
to a fnancial crisis.
Finance stll does not have a clear idea of the impact of taxes on debt.
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M&M propositions with taxes: By using debt – you have higher CFts because of the debt (you pay more
tax on eqouity and no tax on interest, so interest is tax-free)  CF = debt + eqouity (net income)
PV of Tax Shield=
Debt∗r d∗Tax rate
= Debt∗Tax rate
rd
The frm value of a levered frm = Value of all eqouity frm + PV tax shield.
The all eqouity value = cash flow debt + eqouity (unlevered frm) i r u.
Paper “Capital Structure and Taxes: What happens when you (alsol subsidize equity?”
The paper is about Belgium, where the government decided to subsidize eqouity. The NID (Notonal
Interest Deducton) is an explicit eqouity deducton (introduced in Belgium in 2006). The obeectve was to
reduce the tax-driven distortons that favour the use of debt fnancing. The NID allows frms to deduct
from their taxable income a notonal charge eqoual to the product of the book value of eqouity * a
benchmark interest rate based on historical long-term government bonds (so it means that a X amount
of your eqouity is tax-free). Your CF at the end = net income + NID). So NID is for ex. 5% of your eqouity.
When you have a levered frm, debt is stll subsidized as well! (so not only NID is available). Net income
will be the same for the levered frm as unlevered frm,
because NID is calculated over you eqouity (eqouity is
lower when you have debt). See example:
NID was only introduced in Belgium (in 2006) = threated
country, and The Netherlands, Germany, Luxembourg
and France are the “control countries” – they are
unchanged. This empirical strategy is called diference
in diference analysis.
Data: (eqouaton)
y ikt =α +θ NID kt +d t + d k +Ψ X ikt + ε ikt
The dummy variable: θ NID kt will take value 1 if your
company is located in Belgium afer 2006 and take value 0 if itts about the control countries. (only
important variable for us)
Data: they observed the countries before and afer the treatment of the NID (2002-2009). They had on
average 6 observatons per type frm (diferent frms) (sample more than 1 million, 235,000 uniqoue
frms).
This fgure is only related to Belgium frms. The vertcal axes:
Eqouity over total assets in %. orizontal axes: years (2005 is the
last year before the reform). As you can see they already started
to use more eqouity before the NID was introduced (but the
biggest increase was afer 2005).
The fgure below (frm level analysis  eqouity rato = Belgium –
control countries):
doted line is the
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interval (correcton lines). There is a positve relatonship between eqouity and NID (debt could be bad
because of a new fnancial crisis…)
Results (small vs large companiesl: Small companies in 2006 in Belgium increase their eqouity very litle,
because small companies dontt really like eqouity because they tend to be private  itts very important
for them to have control on their company, if they use more eqouity, they have to involve other people
(and lose control). Thatts why they didntt increase the eqouity that much afer the NID with respect to
bigger companies. For bigger companies, if they make use of the NID – it is cheaper to use eqouity.
The most interestng result is that the numbers (eqouity to assets) are increasing from 2006 on and the
net leverage is going down (not for small companies) they also tend to pay less taxes afer 2006.
Assumption three M&Ml: a firmm’s CF do not depend on its financial policy (e.g. no bankruptcy costsl
Financial distress = When a frm has problems with paying billsicreditors.
Cost of fnancial distress: costs arising from bankruptcy or distorted business decisions before
bankruptcy. If you have lots of debt – costs of fnancial distress increase.
- Direct costs: Legal and administratve costs (for ex. hiring a lawyer)
- Indirect costs: Impaired ability to conduct business (e.g., lost sales). Selfsh strategy 1: Incentve
to take large risks (for ex. gambling). Selfsh strategy 2: Incentve toward underinvestment.
Selfsh Strategy 3: “Milking the property”
• Example indirect costs: your company produced computers, if the customer now youtre
going bankrupt, they wouldntt buy a new computer, because you dontt know if you can
stll deliver the computer (and when itts broken you dontt have guarantee). So even the
rumour of going probably bankrupt, you lose sales!
Market value = Value if all eqouity fnanced + PV tax shield – PV costs of fnancial distress
Market value = Actual value and book value = historical value.
NPV of a proeect: if itts positve undertake the investment.
In terms of taxes: leverage is good. In terms of fnancial
distress: leverage is bad. So fnd the optmal amount of
debt (afer the optmal point – the bankruptcy costs are
rising too much) = trade-of theory.  see fgure
There is a trade-of between the tax advantage of debt and
the costs of fnancial distress.
M&M assumption 2: All agents have the same information
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The problem of asymmetric information arises when a seller know something, that the buyers do not
(or vice versa). Adverse selection means that because of asymmetric informaton, the buyers want a
lower price – good ones are leaving the market (they dontt want to sell their stuf at a lower price) and
the bad ones are stll selling their stuf. So the likelihood of buying bad stuf is increasing.
So example: A company has eqouity worth $5 per share and another company has eqouity worth $10 per
share. Investors are not able to distnguish the two companies… they price eqouity $7.5 per share. Bad
companies will enter the market, good companies will stay out.
Pecking order theory
Companies will deal with this problem by preferably use retained earnings, than borrow from debt
market (debt is less sensitve to asymmetric informaton issues – you always have to pay the same face
value, for good and bad companies) and as a last resort – issue eqouity. So asymmetric informaton
between a frm and the market makes external fnance more costly than internal funds and makes debt
less costly than eqouity (because less informaton sensitve).
So pecking order theory gives the order to maximize the value of your company: (this only applies when
there is asymmetric informaton)
1. Own resources (retained earnings)
2. Debt
3. Eqouity
The mother of all the equations:
Tangible assets: for ex. property, plants and eqouipment, so fxed assets(divided by) i total assets.
Universites are very tangible – a lot of chairs i pcts etc.
There is a positve relatonship between tangible assets & debt  curators can take all the stuf and sell
it, so itts easier to satsfy the claims. So tangible assets should be associated with higher leverage.
Tangibility is more related to bankruptcy costs (they will be lower): itts easier to sell the stuf.
- SO: more tangible companies have higher leverage ratos!
Firmm’s size (log salesl: bigger frms should be more leveraged. They are more diversifed (than small
frms) – so less risky (borrowers like diversifcaton).
Return on Assets (higher proftability): (two ways to look at this) higher profts should be associated
with lower leverage (pecking order) because proftable frms prefer internal funds to debt.
igh Profts should be associated with higher leverage. (Jensen, 1986): Market of Corporate Control is
efectve and forces managers to pay out cash by levering up
Market to book ratio: negatve relatonship because of the indicaton of mispricing. If frms issue
eqouites when share prices are above their “true” value, leverage should be negatvely correlated with
market to book rato. If the share price is high: manager would issue eqouity. If the share price is $50 but
sold for $60, you want more eqouity (market to book rato could be a sign of mispricing).
- SO: leverage rato goes down when the market-to-book rato is high!
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Results:
• Tangibility and Size are positvely associated with leverage
• Return over Assets are negatvely associated with leverage (consistent with Pecking Order)
• Market to book negatvely associated
Part 2 Debt covenants
Week 2 – Lecture 4
50 years ago frms were very tangible (they produced stuf). But: economy is changing and there are
now more intangible frms than before (apps, sofware, data companies etc.). Itts harder to get your
money back as a creditor (in case of default) because you cantt sell that much stuf from an intangible
frm.
Debt can have diferent types of seniority:
1. Senior debt (usually from a bank). The interest rate tend to be lower (variable) and it is usually
secured by (a part of) the assets. Because in case of default, they can sell their assets  this is
why interest rate is lower (risk premium is low, they can sell it in case of default and get their
money). And: Yearly amortsaton of principal.
2. Subordinated debt: usually high yield bonds. The costs are higher (compensates for lack of
protectons that senior lenders have  more risk). There is a fxed interest rate and it is
unsecured. (it is paid before eqouity)
Parts of a typical loan agreement:
• The Note: Specifes the principal and the interest and the tming of repayment
• Collateral: Specifes assets assigned and terms under which lender takes possession of assets
• Borrower Guarantees: a promise by one party to assume the debt obligaton of a borrower if
that borrower defaults
• Events of Default: Exact conditons under which a loan is considered in default. For ex. if you
miss 3 interest payments in a row (can be considered as default – you have to specify it).
• Debt covenants: agreements between a company and its creditors that the company should
operate within “certain limits” (it protect the borrower from doing ‘badt things while the loan is
stll actve and for that, it reduces the risk of the lender, so lower interest rates for the
borrower). For ex.: The ABN AMRO and you agree to not pay dividend for 5 years, but to have
retained earnings, so that you (the frm) can generate enough money to pay the loan. Covenants
may be changed if debt is restructured (it is a conditon of borrowing)
• Very tangible companies, dontt need agreements like that, because they can always sell
their assets (if they default)
• If they breach the contract, it allows creditors (usually) to demand immediate
repayment (but in practce it usually leads to renegotaton of terms of debt because the
debtor can usually not make an immediate repayment).
Companies would accept covenants because:
- without a covenant, the interest rate will be 8%, but with a covenant 4%.
- the bank would not lend you money without a covenant
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Negatve debt covenants: state what the borrower cannot do (for ex. pay cash dividends exceeding
certain threshold, sell certain assets, combine in any way with another frm (M&A) or compensate or
increase salaries of certain employees).
Positve debt covenants state what the borrower must do (for ex. maintain certain minimum fnancial
ratos, perform regular maintenance of real assets used as collateral, maintain all facilites in good
working conditon, maintain life insurance policies on certain key employees).
Example of covenants (Alibaba & Yahool
Alibaba.com had emerged as the worldts largest online business to business trading platorm for small
businesses with three market places. In 2005: Yahoo had a 40% stake in Alibaba (bought for $1 mln), this
helped Alibaba becoming a premier internet player in China, but they (Yahoo & Alibaba) didntt get along
so Alibaba bought back their shares in 2012 from Yahoo (for $7.1 billion - $6.3 bln in cash and $800 mln
in preference shares). They fnanced it by:
- leverage buyout (this occurred when the buyer (Alibaba) uses debt to acqouire eqouity in the frm
of another owner (Yahoots stake)
- A syndicated loan provided by a group of lenders (is structured and arranged by a bank: known
as the arranger - it was a $3 billion loan, and there were 5 arrangers and 11 partcipatng banks).
- Loans used for highly leveraged transactons contain strict covenants, while corporate loans with
deeper eqouity based typically exhibit fewer covenants.
Covenants were used because Alibaba has almost no tangible assets, so they had to assure that the
lenders would have access to its net profts ($500 mln in 2011).
Paper (Roberts and Sufi – 2009l
This papers is about examining the response of corporate fnancial policies to covenant violatons (US
based). 25.6% of the publicity listed companies in the US violated the covenants at least once.
- smaller companies violated more than bigger companies
- based on industry: not really clear which industry is more likely to violate a covenant
- frms who dontt have a credit ratng, do probably have a bad ratng (otherwise they will rate
them) and they are a bit more likely to default than frms who have a credit ratng.
If you violate the covenant, you buy back your debt (because you was a ‘badt guy)
At the horizontal axes, the zero means: you violated the
covenant (1 means: 1 qouarter afer violatng the
covenant and -1 means 1 qouarter before violatng).
The line goes downwards afer zero and means that the
company is paying back their debt. Around qouarter 4:
debt level stabilised  no more extra debt. Below 0
means: they are repaying debt (paying back more debt
than initally was given).
Violatons of debt covenants (most important fndings paper):
ave a strong efect on net debt issuance
- Do not have a very strong efect on eqouity issuance
- Leverage rato becomes signifcantly lower
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Column 1 shows that, on average, net debt
issuance falls from eight basis points
(0.08%) above the frm mean (Covenant
violatont) to 62 basis points below in the
qouarter immediately afer the covenant
violaton (covenant violatont-1) = a decline
of 70 basis points.
In column 2,3,4, there is added a new factor
(so itts not about tme).
This table shows the long-run evoluton of net
debt issuance and leverage ratos afer a
covenant violaton. ere, t-8 means 8
qouarters afer the covenant violaton. So as
you can see, the net debt issuance drops
sharply.
Column 3 and 4 demonstrate the long-run
efect of the decline in net debt issuance on
leverage ratos  they also decline.
The speed of adjustment and firmm’s
characteristics:
∆
Net Debt Issuance (t)
is the change in net
Total Assets(t−1)
debt issuance of a frm (normalized by its size)
and indicates how fast a company adjusts
the net debt issuance afer a covenant
violaton. ow smaller it is, how faster the
frm adeusts. A negatve outcome means that
the net debt issuance this qouarter is smaller
than the previous qouarter.
Outcomes table:
igh leverage rato: higher declines in net debt issuance – they adeust faster so it takes less
longer to pay back debt.
igh market-to-book rato: smaller declines in net debt issuance (so slower paying back their
debt, because they have more money). So negatve relaton between high market-to-book and
speed of paying back your debt.
- Firms with a credit ratng have smaller reductons of their net debt issuance (they already have a
good ratng, and they want to keep it high, but there is no need to pay back it really fast,
because they know you will pay back).
So: frms with less alternatve sources of capital experienced the highest drop.
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Table IX: Is about creditors (the bank) who will intervene in case the company violates the covenant
A negatve number in the table means that the creditor is less likely to take actons. Actons a creditor
can take, is increasing the interest rate or downsize credit facilites.
- high leverage rato: creditor is more likely to take some acton (more leverage – more risk)
- If the borrower has a lot of cash: credit is less likely to take some acton because they can easily
get their money back.
- If the borrower is proftable: less likely to take actons by creditors
igher credit ratng: less likely to take some acton
If a company violates a covenant: what happens to the fnancial strategy:
1. leverage goes down
2. high leverage rato  pay back faster
3. 68% of the creditors is going to take no acton afer a violaton.
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Private & Public firms (lecture 5&6l
Important to know:
1. What characterizes the capital structures and funding behavior of private frmss
2. Do existng theories of capital structure provide an appropriate descripton of the fnancing
behavior of private frmss
Private firms:
- Equity: not a big choice for raising eqouity capital (eqouity is not publicity traded)  normally
owned by family.
• Raise equity by: Family & Venture capital (=type of private eqouity, venture capital frms
invest in frms that are deemed to have high growth potental in exchange for
eqouityiownership stake).
- Debt: Normally: not rated because they generally do not access public debt markets. Most debt
on the books is bank debt. Trade Credit is another important form of debt
If a public company wants to issue eqouity:
- Common stock
• IPOs (inital public oferings) = raising eqouity publicly for the first tme
• SEOs (seasoned eqouity oferings) = subseqouent issues of common stock
- Preferred stock: eqouity-like instrument: there is no expiraton day (goes on forever irredeemable). If the company dontt pay dividend, it doesntt mean default.
• it becomes more a debt-instrument when: it last for (for ex.) more than 20 years or afer
2 years (2 tmes) not paying the dividend (= default)
- Tracking stock: itts a stock issued against specifc assets or a segment (so not the total frm) of
the frm, they typically do not provide investors with votng rights  for ex. if you trade motor
bikes & cars, it is only based on the car segment.
- Warrants: provides investors with the opton to buy eqouity at a fxed price in the future in return
for paying for the warrants today
Because public frms are rated (normally) they have access to large bond markets and the possibility of
bank debt.
Level efect (important!l: Refers to conseqouences that arise from the fact that private frmst relatve
cost of eqouity to debt capital is higher than that of public frms.
1. Private frms are more likely to choose debt versus eqouity fnancing than public frms
2. The level of private frmst debt ratos is higher than the level of their public counterpartst debt
ratos
Private frms prefer debt over eqouity (pecking order) because:
1. Asymmetric information: investors know more about public frms (for ex. through the
(published) fnancial statement), and the value of eqouity is more sensitve to informaton
asymmetry than the value of debt, the cost of eqouity relatve to debt will be higher for private
frms.
2. Private firms tend to be owned by family  if you issue debt, you dontt lose the control. So,
family prefers to get money from a bank, they are not allowed to get votng rights or to get
involved in the frms strategy.
According to the level efect, public frms are more likely to choose eqouity relatve to debt.
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Sensitivity efect (important!l: refers to conseqouences that arise from the fact that private frmst
absolute cost of accessing the external capital markets is higher than that of public frms.
1. Private frmst fnancial policies are more passive than those of public frms, i.e., private firms are
less likely to visit the external capital markets – they prefer internal funds
2. Since it is more costly for private frms to rebalance their debt ratos, their leverage will exhibit
larger sensitiity to operatng performance
Consistent with the sensitvity efect public frms are more likely to visit the external capital markets,
either to raise or to retre capital. (So private firms prefer debt over equityl
Paper: Acces to Capital, Capital Structure, and the Funding of the Firm (Brav, O.l
M&M says that the capital market structure is irrelevant for frm value, but there are some market
frictons that violate this theorem, because private eqouity tend to be more costly than public eqouity.
- the main diferences is the degree to which control is valued by their shareholders (private,
family) and the level of informaton asymmetry.
- Firms where ownership is more dispersed (verspreid) and frms that are more transparent rely
more on eqouity than debt.
Pecking order theory is about the ranking of getting more money
1. Internal capital
2. Debt
3. Eqouity
The data of the paper: US frms. We look at balance sheet, income & cashflow statement and ownership
informaton from the FAME database. We take only frms that satsfy the auditng reqouirements.
In this paper, a private frm can also be a public non-qouoted frm, itts a frm that has unrestricted rights
to issue eqouity and debt to the market, not qouoted in an ofcial market.
An exam qoueston can be: what do you see in these graphs with respect to public and private frmss
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-
public frms are issuing more eqouity and are also actve in buying back eqouity (so they are more
actve on eqouity markets than private frms) – they are 3 tmes more likely to issue eqouity than
private frms (consistence with level efect)
- public frms are a litle bit more actve in debt issuance
This means that the level efect is true (private frms are less likely to enter fnancial markets, but this
applies more for eqouity than for debt).
Table II: Afer an IPO, eqouity goes up, leverage goes down (due to more eqouity). If a frm goes private (so
public to private): less eqouity, more debt. So leverage ratiom’s are higher (on averagel for public firms.
Table III: If you get a negatve coefcient on proftability (ROA = return on assets): pecking order applies.
For private is this more negatve than for public ant this means that pecking ore is more important for
private frms. So they rely frst on internal funds. So, leverage of private frms is more sensitve to profts.
The tangibility is almost the same for private & public frms.
The market-to-book rato: you cantt calculate it for private frms, so you cannot test leverage & marketto-book rato ofcially, but you can use:
- growth of sales: if you grew a lot in the past, you expect to grow further in the future  good
predictor for market-to-book rato. The leverage of public frms is negatvely correlated with
growth opportunites and for private frms, they are positvely correlated with growth
opportunites.
Diference in behaviour between private and public frms, because:
 ownership concentraton in private frms is higher, it makes the cost of eqouity higher than the
cost of debt (they dontt want to lose control)
 and they are less transparent than public frms (leads to higher cost of eqouity – because eqouity is
a more eunior claim – more risk for eqouity)
Now we add two new variables: ownership concentraton (number of shareholders) and distncton
between private non qouoted frms and public non-qouoted frms as a proxy for transparency (public non
qouoted have to adhere to more legal reqouirements).
- the public non qouoted tend to issue more eqouity than private not qouoted.
- leverage is higher for the non qouoted private frms because they issue more debt than the public
non qouoted
So, conclusions:
 Private frms: less external fnance in respect to public frms
 If they go for external fnancing: prefer debt over eqouity because:
o transparency: public frms are more transparent
o Ownershipiagency consideraton: eqouity for private is more costly than for public.
Part 3 Dividend Policy
Week 3 – Lecture 7 & 8
Dividend: A payment made by a corporaton to its shareholders, usually as a distributon of profts. It is
allocated as a fxed amount per share, with shareholders receiving a dividend in proporton to their
shareholding.
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-
Cash dividend: if they pay qouarterly. You can get an extra cash dividend and sometmes
(extreme cases): liqouidatng dividend.
- Stock dividends: no cash leaves the frm, but increasing in the number of shares outstanding
- Dividend in kind: For ex. a chewing gum company sends around a box of chewing gums.
Declaration Date: The Board of Directors declares a
payment of dividends
Cum-Dividend Date: The last day that the buyer of a
stock is enttled to the dividend
Ex-Dividend Date: The frst day that the seller of a
stock is enttled to the dividend
Record Date: The corporaton prepares a list of all individuals believed to be stockholders as of 6
November
In a perfect world, the stock price will fall by the amount of the dividend on the ex-dividend date.
Homemade dividend: See the example below
Bianchi Inc. is a $42 stock about to pay a $2 cash dividend.
Bob Investor owns 80 shares and prefers $3 cash dividend
and Bobts homemade dividend strategy: Sell 2 shares exdividend
Since investors do not need dividends to convert shares into cash, dividend policy will have no impact on
the value of the frm
In the above example, Bob Investor began with total wealth of $3,360:
Afer a $3 dividend, his total wealth is stll $3,360:
$ 3,360=80 s h ares ×
$ 3,360=80 s h ares ×
$ 42
s h are
$ 39
+$ 240
s h are
Afer a $2 dividend, and sale of 2 ex-dividend shares, his total wealth is stll $3,360:
3,360=78 s h ares ×
$ 40
+$ 160+$ 80.
s h are
Since investors do not need dividends to convert shares to cash they will not pay higher prices for frms
with higher dividend payouts
- In other words, dividend policy will have no impact on the value of the frm because investors
can create whatever income stream they prefer by using homemade dividends
Firms should never forgo positve NPV proeects to increase a dividend (or to pay a dividend for the frst
tme): Investments come frst and
“The investment policy of the frm is set ahead of tme and is not altered by changes in dividend policy”
Taxes: If there are personal taxes, dividends are taxed twice (corporate tax over profts, personal tax
over dividend). This makes it a costly way to move money to your shareholders. Therefore, managers
have an incentve to seek alternatve uses for funds to reduce dividends.
- In most countries (legislatons), tax authorites treat share repurchases as capital gain and you
dontt pay personal income tax on that. So though personal taxes mitgate against the payment
of dividends, these taxes are not sufcient to lead frms to eliminate all dividends
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Example: share repurchase vs dividend
A frm wants to distribute $100,000 to its
shareholders. The original balance sheet looks like
this:
If they distribute this money as cash dividend, the
balance sheet will look like this: 
So the price per share goes down with the amount of
the dividend.
But if they distribute the money through a stock repurchase,
the balance sheet will look like this: (below)
The price per share stays the same (number of shares is lower)
As you can see, there is $180 more lefover for the
shareholders.
Three ways to do a share repurchase:
1. Open market (most common): company
announced that it will repurchase some shares
in the market as the market conditon allows it
(based on the market price and acceptng all reqouirements and regulatons). The shareholders
can decide if they want to take the deal.
2. Fixed price tender: The company makes an ofer, which specifes in advance a single purchase
price, the number of share sought and the duraton of the ofer. The company decide the price
and the shareholder can decide to accept it or not.
3. Dutch Auction: The frm sets a price range within the share will ultmately be purchased.
Shareholders are invited to tender their shares, at any price within the stated range. But, the
purchase price will be the lowest price that allows the frm to buy the number of shares sought
in the ofer and the frm pays that price to all shareholders who tendered at or above that price
(so if the price range is between $10 and $20, and all
shareholders who wants to give up their shares want
$20, but 1 shareholder want $11,- the ultmate price
will be $11 for all shareholders)  once you set a
price as a shareholder, you have to go on with the
deal even if it is below the price you set.
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a. Not all shareholders will pick the highest price ($20) because they dontt want the stock
to be overvalued if they have more stocks.
The blue line in this fgure is the stock market index (the price index) and the bars are the qouarterly
amounts of repurchases. If the market index goes up – company is more proftable and they tend to pay
back less shares (less repurchases).
Repurchases and Executive compensation
CEOts and executves are paid with respect to their performance (they can get bonuses based on the
previous year level of earnings per share (EPS), it is a way to measure the performance of a company. If
it is high  manager gets a bonus (for ex.).
- share repurchase decrease the number of share – so increase EPS (so more bonus for CEO).
Nowadays: low interest rates (bad for lenders, good for borrowers). Companies are (most of the tme)
the borrowers and have to make use of it, so they exploit it by issuing more debt.
Debt can be used to buy back shares:
1. Cash is paid out to shareholders
2. Leverage Rato increases – Increasing returns on eqouity
3. Earnings per share increase
4. … But also fnancial risk increases!
Dividend is taxed twice with personal income taxes, so why do frms stll pay dividendss
1. Clientele efect: Diferent group of stockholders prefer diferent dividend payout policies.
a.
igh (personal income) tax: prefer low payouts (they have no need for current cash
income) – young people (they earn more on average)
b. Low tax: high payouts (retrees, but pension funds as well, because they are in low tax
brackets and have a need for current cash income)
c. For some investors, the tax on dividend is only paid once, so they prefer high payouts.
2. Asymmetric information: (What is the “informaton content” or “signaling” hypothesiss
a. Dividend cuts are followed by negatve stock returns (so shareholders hate dividend cuts
more than they hate dividend raises)
b. Managers dontt want to cut dividends, so they only raise dividends when they are really
sure about it (and the raise is sustainable).
c. Raising dividends is a way for a mangers to signal themselves as good (and separate
them from companies that are not so good.
d. So: share price goes up at the tme of the dividend increase because it could reflect
higher expectatons for future earnings.
3. Agency consideration is about how much money a company should retain.
a. Not many investment opportunites  frms should disburse cash to shareholders
b. So: low market-to-book rato (litle R&D), should pay higher dividends
c. Ex. I own Apple & Coca-Cola shares, both pay no dividends. Apple has more investment
opportunites and can aford it to have more cash on their balance sheets, because they
can say: Next year something amazing will happen (=high-tech companies)  so they
eustfy to their shareholders where they use their cash for. But low-tech companies, such
as Coca-Cola, if they have a lot of cash on their balance sheet, it is hard to eustfy, why
they pay no dividend to shareholders.
i. So, not paying dividend as a low-tech company: shareholders think you use the
cash for your own good, so dividends force the manager to behave good.
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Dividends are disappearing, because:
1. share repurchases are increasing
2. afer the 1980ts: new technology (computers)  larger amount of high-tech companies
3. There are new ways for managers to show they behave good (beter Corporate Governance
techniqoues)
4. increasing number of small, publicly traded frms with low reported earnings and high growth
5. Managers are more likely to paid with stock optons (they prefer capital gains to dividends)
Paper: Dividends and share repurchases in the European Union (Von Eije, H. and W.L. Megginsonl
Is about cash dividends and share repurchases between 1989 and 2005 in the 15 natons that were
members of the EU before May 2004.
As in the US, the fracton of European frms paying dividends declines but total real dividends paid
increase and share repurchases surge. Financial reportng freqouency is associated with higher payout,
and privatzed companies account for almost one-qouarter of total cash dividends and share repurchases.
Increasing fractons of retained earnings to eqouity do not increase the likelihood of cash payouts,
whereas company age does.
Results paper
- EU companies and American companies have kind of the same dividend & share repurchase
policies. But the diferences are:
• In Europe, the trend of share repurchasing started later than in US, but have grown
more rapidly over the past decade.
• Privatzed companies account for almost one-qouarter of the total value of EU cash
dividends and share repurchases.
• Fracton of retained earnings in EU frmts total eqouity is not signifcantly correlated with
the likelihood to pay cash dividends, but that company age (in years) is.
- higher leverage reduces the likelihood of paying cash dividends
- larger cash holdings reduce the probability of paying cash dividends, but increase the probability
of repurchasing and increase the amount of cash dividends paid if the company is a cash
dividend payer.
- More liqouid stocks  repurchase more if they do repurchase. Companies with maeority
shareholders repurchase less.
Conclusion:
- Larger frms are more likely to pay dividends
- Firms with higher market-to-book are less likely to pay dividends
- Older frms are more likely to pay dividends (less growth)
- Firms with lots of cash are less likely to pay dividends, pay larger amounts when they do
- Privatzed frms arentt more likely to pay dividends
Part 4: Corporate Governance and Financial Development
Lecture 8 and 9 – week 3 & 4
This topic is about the basics of Moral azard, Asymmetric informaton and Pecking order (important
topics for the exam!)
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Moral hazard may occur where the actons of one party may change to the detriment of another afer a
fnancial transacton has taken place. For instance, fnancially distressed frms may gable for resurrecton
or turn down positve NPV proeects.
Agency problems is between the principal, the one who is going to be harmed, (the investor i
shareholder i outsider) and the agent (insiderientrepreneurimanager) is the one who harms somebody.
The basics of credit rationing: fxed investment model.
Example: The proeect costs I (investment) and the entrepreneur has cash A < I (so the cash the agent has
in his pocket is less than he reqouires for the investment).
• If undertaken the proeect either succeeds and yields R (verifable), or fails and yields 0
• Probability of success is denoted by p
• Proeect is subeect to Moral azard. The entrepreneur can behave or misbehave (he would
misbehave, because he can get some private benefts = denoted as B). Behaving yields
probability p=ph. Misbehaving yields probability p=pl (pl<ph)
• Both Borrower and Lender are risk neutral  Discount rate eqoual to 0
• Borrower is protected by limited liability (LL) (not personal default)
• Lenders behave compettvely. In eqouilibrium, expected profts are eqoual to zero
• Zero Proft Conditon for the lender: phRl=I-A, where Rl is the compensaton for the lender.
The risk neutral entrepreneur has
one proeect and needs outside
fnancing.
You want your entrepreneur to
work hard (in terms of society).
This leads to this formula:
will be:
and if the entrepreneur doesntt work hard, the NPV
Contract: Succes: Rb + Rl = R. And Failure: 0 each.
Incentve compatbility (IC) (you want to force to let the entrepreneur work hard):
ph Rb ≥ pl R b +B
( ph − pl ) R b =Δ pRb ≥B ( IC )
. This frst formula: you give the entrepreneur more when he works hard,
then when he does nothing. You have to choose a Rb, so that he will have a higher return than when he
does nothing – solve with second formula.
p ( R )≥I −A
ph ( R−Rb )≥I− A ( IR ) . These
h
l
Lenderts partcipaton constraint
formulas says that the returns for lenders has to be higher than he pays to the borrower.
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The last formula
summarize the conditon on which the entrepreneur works
hard & the
lender is happy to lend money. The lef-side of eqouaton has to
be big and it will be more likely that lenders lend money and entrepreneur works hard (so right side is
smaller). If A is very high (right-side is smaller), it means that we want to have a borrower who loses
money when he doesntt work hard (so he is forced to work hard).
The minimum eqouaton (see previous page) is important because borrowing (in the US) tend to be easier
than to lend in Uruguay (for ex.) Á will be lower in good countries, the reqouired amount for Á is
diferent in diferent countries, because access to fnancial markets is diferent as well. A debtor needs
to have enough assets (A) to be granted a loan.
 If A< Ā the proeect has positve NPV and yet is not funded
• With insufcient assets, the entrepreneur must borrow a large amount and therefore
pledge a large fracton of the return in case of success
• If A ≥ Ā the entrepreneur is able to secure fnancing
• Good banks are more concentrated in countries with a good wealth.
• B can be diferent in poorer countries (diferent legalisaton)  when you steal for ex.  no
conseqouences.
Do investors hold debt or eqouitys  The Lenderst claim can be both debt and eqouity
• Debt interpretaton: the borrower either pays R l or goes bankrupt.
• Eqouity interpretaton. The borrower and the lender hold fractons Rb iR and RliR
respectvely. Call them Inside and Outside eqouity.
Central question: Related to B in the formula. igh B: corrupt and low B not corrupt. B can be country
specifc: do countries with beter developed banks and fnancial markets eneoy substantally greater
economic successs Eqouity and bond markets should be able to detect B.
Paper: Finance and Growth: Schumpeter might be right (King, R. G. and Levinel.
Their paper examines the relatonship between fnance and growth by adoptng a cross country growth
regression approach. They regress growth rates on several measures of fnancial development.
The measures of economic growth are:
 GDP per capita growth
 Growth of total capital stock (net investment)
 Gross investment
 Productvity (of the country)  more use of technology – more productvity
These measures are regressed on various Financial Development measures and other controls (as: Log
of inital income and log of initals secondary school enrolment).
Four measures of Financial development which are constructed by fnancial intermediaries:
1. Financial Depth: overall size of the formal fnancial intermediary system, i.e. the rato of liqouid
liabilites to GDP  “Classical” Measure of Financial Depth
2. Importance of Deposits Banks relatve to Central Banks in allocatng credit  Breaking down
which fnancial insttutons are providing the most important contributon. Commercial Banks
should do a beter eob that Central Bank in managing risk and allocatng credit
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3. Credit Issued to nonfnancial private frms to total credit  To what extent fnancial resources
are channelled to the private sectors
4. Credit Issued to nonfnancial private frms to GDP (=how big is the economy)  To what extent
fnancial resources are channelled to the private sectors SO: in principal it would be beter to
lend money to entrepreneurs (instead to private people (you buying a house)
All measures of fnancial development are positvely associated to diferent proxies of economic growth
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Data:
igh fnancial development  you are more willing to bring your money into a bank. In less developed
countries, Central banks are also actng as ‘normalt banks. Central banks are less efectve in lending
money (making loans) than private banks.
The research qoueston: Do countries with beter developed banks and fnancial markets eneoy
substantally greater economic successs There are 5 views according to this (Finance):
1. Finance promote growth  during a crisis: fnancial banks should lend money to a good bank,
but not to bad banks (who are illiqouid but solvent).
2. Finance hurts growth (so itts bad for economic growth)
3. Finance follows growth  where enterprise leads, fnance follows.
4. Finance doesntt mater (you can keep growing as long as you have technological progress)
5. Finance maters because fnancial crises hurt growth (fnance protect you from bad things)
According to the paper, view 1&3 are correct and 2&4 not. About view number 5 we cantt say.
Causality is solved by look at how ex-ante fnancial development afects ex-post economic growth
Table VIII: LLY in 1960 (means: Finance in 1960). To examine the data, they set Finance frst and then
check if you grow less or more later on (according to the table, you see there was a growth).
igher level of fnancial development are positvely associated with faster rates of economic
growth and economic efciency improvements both before and afer controlling for numerous
country and policy characteristcs. Corrupt countries  low fnancial development & economic
growth
- Predetermined component of fnancial development is a good predictor of long-run growth over
next 10 to 30 years. igher level of fnancial development  strongly associated with future
rates of capital accumulaton and future improvement in efciency with which economies
employ capital. Thus, Finance does not only follow economic actvity, relatonship between level
of fnancial development and rate of economic growth does not simply reflect positve
associaton between contemporaneous shocks to bots fnancial and economic development.
Remarks on the paper:
• King and Levine are mainly focused on the importance of banks for economic growth
• Levine & Zervos look at the interacton between banks and fnancial markets (bonds, eqouity)
• Measures of Stock Market Liqouidity are positvely and signifcantly correlated with current and
future measures of economic growth
• … other (more recent) works deal beter with the issue of causality
• Remember that having an overly large fnancial sector may also create problem… In Iceland the
size of the banking sector in 2007 was above 100% of GDP
• Paper only gives positve associaton between fnance and economic growth (correlatons).
Results might be influenced by reverse causality or omited variable.
Sheets: Law & Finance (still topic 4)
Normally, Finance is important for economic growth. Beter fnancial development implies that:
1. Firms have larger amount of credit available at a lower rate
2. Suppliers of funds have beter informaton about borrowers
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3. Corporate governance works beter. Less amount of “stealing” by management and controlling
shareholders
4. Overall a larger amount of savings can be transformed into physical capital
5. R&D can be more easily fnanced
B: the private benefts of control (how much the entrepreneur likes to do nothing).
There are several causes of fnancial development:
- Proximate causes:
• Legal system (each country has their own legalisatons – they threat the shareholders
diferent). So this may explain why Finance is diferent in each country.
• Social norms: for ex. you like the streets to be clean -as an individual, you want no crime
• Trust: You trust your friends if you lend money to your friend – how to measure trust 
fnancial transactons are based on trust (if you trust the transacton, youtre more likely
to lend the money).
• Quality of informaton intermediaries: in countries where more news is published, it
prevents you from doing bad things
• Tax systems: the government is forcing to companies to have a good balance sheet. And
corporate fnance works beter in countries where the government is good in collectng
money (tax).
- Deep causes:
•
istorical Legacy: Traditon
• Politcal: bad fnance because of politcs (corrupton)
• Cultural: is about trust  religion  catholic countries: less fnancial development
(because once you commit a crime, you go to the church and you admit it  they
forgive you). But the protestants – they dontt forgive people who commit a crime.
The legal approach: is about the maeority shareholders
- if eqouity market development is an important factor for growth  corporate governance
becomes crucial.
Corporate governance is the set of arrangements by which a frm is directed and controlled. It involves
balancing the interests of a companyts many stakeholders (shareholders, managements, customers). A
good governance selects the most able managers and makes them accountable to investors.
• The principal goal of Corporate Governance is to restrict expropriaton of outside investors
(shareholders and creditors) by insiders (controlling shareholders and managers)
Because of the law, there is beter fnancial development (so, strong investor protecton leads to beter
fnancing terms for frms.
The legal approach: Legislaton comes frst, than fnance came.
The origins: legal scholars divide legal systems in several families, there are three diferent traditons:
French, German, Scandinavia. Because these are old – they must precede economic and fnancial
development.
The diference between common law and civil (codedl law:
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1. Common law: Our eudge decide – if you have a car accident and somebody saws it, you go to the
lawyer. Because there were a lot of cases like this before, you get a eudgement based on
previous cases (same treatment).
2. Civil law: The eudge decide – based on the lawicode  it tells you how to handle based on a X
number of cases (so based on the interpretaton of the law).
Paper: Law and Finance (La Porta, R.F, Shleifer and Vishnyl
They make a distncton between coded law (French, German, Scandinavia) and common law (Britain).
ow do legal origins afect minority shareholders protectons There are several things (in some
countries, which minority shareholders do not like:
1. If proxy by mail is allowed: you can vote by email if you are not able to go to the general
shareholders meetng  lawyers dontt like this. Shareholders need to deposit the shares before
the meetng, to have the votng rights – this is bad for minority shareholders.
2. The reqouirement that you need more than 10% of the shares to call a shareholder meetng is
bad for the minority shareholders, because you need more than 10% to be able to discuss
something you dontt like the managers does.
Table 2: it discuss that for ex. 17% (frst row) of the English countries force companies to imply the 1
share-1 vote rule (this is good for minority shareholders). A 1 in the table means: good for creditor.
If a company goes bankrupt
- money goes frst to tax (government), second: employees (wages) and then to the secured
creditors (even if itts collateral). If creditors would be ranged frst  in their favour.
- and management will be fred: good for creditors  management will work harder to not go
bankrupt, otherwise they lose their eobs.
If there are restrictons according to reorganisatons  good for creditors.
Table 5: igh score  good guyts. Low score  bad guy.
How efficient your judicial system will be:
This is about how long it takes to get back your money afer going bankrupt. In Scandinavian-origin
countries for ex. you get your money really fast back. Corrupton is the lowest in Scandinavian-origin
countries.
y it =α +θ Legal Origins i+Ψ GNP per Capitait−1 + ε it
OLS analysis:
The higher your dependent variable, the beter is your country.
Table 6: negatve number: not signifcant
Dummy: common-low English country: 0 and Scandinavian, French, German country = 1.
With Civil law countries: more corrupton, more risk of expropriaton, less efcient eudiciary system, less
rule of law (all not signifcant), worse accountng standards.
Summarize:
• Judicial system is less efcient in French and German origins countries
• There is more corrupton in French and German origins countries
• Risk of expropriaton is higher in French origin countries
• Contracts are more likely to be repudiated by the government in French and German origin
countries
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•
Concentraton of ownership of shares in largest public companies is negatvely related to
investor protectons.
SO: why is finance diferent in each country?
Creditor legislaton is worse in for ex. French countries. If the borrower doesntt repay their loan, it
depend in each country how long it will take before the eudge decide something (if you get back your
money or not)  in most places they tend to give investors a limited bundle of rights. Common law tend
to protect investors beter than civil law countries.
The ownership concentration defnes how much control of the company few shareholders have.
Measurement can be: take 10 largest countries, look at the % of the ownership of 3 largest shareholders
Max. concentraton: One shareholder owns all the shares
Min. Concentraton: each shareholder owns one share.
- you expect more ownership concentraton where investment protecton is worse, because:
• Large shareholders who monitor the managers may need more capital to exercise more
control power.
• Poor protecton reduces the willingness to be minority shareholders
- companies would get very low prices from share issues, so they dontt sell
- it is very bad to be minority shareholders, so the maeority shareholders want to
be sure to remain such
For ex. an IPO in French (bad country): nobody wants them  leads to a low price. You dontt do the IPO
as a company, so the one who does the IPO will end up owning everything. Another ex. if person A owns
40% of a company and person B 60%, than will person A get control of the company and the right of
getting dividend.
If the maeority shareholder & CEO the same person = maximum control (so in bad countries, even big
companies can be controlled by families  bad investment protecton).
Conclusions paper:
- small, diversifed shareholders are not important in countries that fail to protect their rights.
- Being a shareholdericreditor in diferent legal eurisdictons enttles an investor to very diferent
bundles of rights.
- Most widely spread legal families, originatng in French civil law  worst efciency propertes
from the perspectve of corporate governance, because:
• when countries adopt legal system, their leaders are more focused on the revolutonary
spirit and more basic rights than those of investors
• legal system does not mater very much, and investors can generally contract around
limitatons of legal system
- In French and German origin countries: Judicial system: less efcient, more corrupton and a
contract is more likely to be repudiated by government.
From here on, for this topic. (not in the Exam!l
NEW PAPER: Private benefits of control: an International Comparison (Dyck and Zingalesl
There are some problems with law and fnance, to measure them we use private benefts (=Bl and relate
them to the law (but these are hard to measure). Private benefts are personal satsfacton and perks
(difcult to verify). Higher B: less developed capital markets, more concentrated ownership and more
privately negotiated privatizations.
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Two methods:
1. Using premia for controlling block:
• Price paid per share for controlling block includes discounted expected future dividends
and private benefts
• Price on exchange afer announcement of control transfer reflects expected future
dividends
• Diference provides an estmaton of private benefts
2. Price diference between votng and non-votng stock
• If make the assumpton about strategic value of votes in corporate control from
diference in price of votnginon-votng shares
In this paper, they used method 1.
An example: stocks traded at 80. A 40% block is exchanged at 140 per share
• Afer the announcement of the deal, stock price goes to 100
• 140-100=40 per share control premium, this premium is paid only on 40% of stock
• Thus 0.4*40=16 total premium paid
• Normalized by the market value afer the announcement, 16i100=16%
• This is the number reported
In Brazil, being the boss is the most valuable.
The efect of personal benefts on fnancial development. If a country has high PB of control,
entrepreneurs:
1. are reluctant to take companies public  fewer companies will be listed and eqouity market will
be underdeveloped.
2. if you fnd a company that goes public, they will retain a control stake (because entrepreneurs
and market factors possibility that someone else will acqouire controlling stake and loot the
company. That is, wontt be able to get much for share).  % of widely held companies will be
smaller and ownership concentraton will be larger.
3. Will fnd it optmal to sell control in a private negotaton. (You fnd a buyer of the market – you
prefer to sell it to him, rather than on the market).  Since more revenues in selling in private
negotatons, governments will be more likely to sell companies through asset sale than through
share oferings
Table VII: The relatonship between the control premia and ownership concentraton is positve. This
makes sense, because Finance should be more worse where the ownership concentraton is higher.
Other measures of bad Finance:
- Countries with high control premia: less IPOts – you dontt like to make your company private.
They dontt want to pay a good price because nobody wants to become a minority shareholder
of this country.
- Number of listed countries: low if Finance is bad (so control premia is high).
Besides the law, there are several mechanisms to constrain the authority of controlling shareholders:
- External: product market competton, public opinion pressure
• Product Market Competton (β<0): In compettve markets, diversion will lead to loss of
market shares and bankruptcy. Extent of competton has a natonal dimension
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-
(enforcement of competton laws, market failures in fnancial sectors). More
competton  less likely to steal  more efcient work and honest. And if youtre
profts are close to zero: it push the frm to be more efcient and honest.
• Argument against the link: Product market penaltes can take long tme to work
Internal: moral norms, labor as monitor, state as monitor.
• Labor as monitor (β<0): labor has capability to monitor and ability to impose penaltes
without going to court (i.e. strikes). Argument against: labor could align with
entrepreneur against outside investors.
• State as monitor (through tax enforcement): in monitoring and outlawing taxes: it
indirectly beneft investors. Argument against: state may only disallow for tax purposes,
not stop behaviour, informaton from tax audits may not be made available.
The media plays a role as well (β<0): (more likely to act good if they publish a lot of news) penaltes for
abuse not only through courts but also through public opinion and implicit threat of government acton.
So more newspaper  more potental los of reputaton afer penaltes. But itts hard to measure these
kind of social norms.
Part 5 Political connections
Lecture 10 – week 4
Firms with difcultes obtaining Finance may beneft from social connectons (increase frm value)  it is
easier to get money)
- reduce agency costs
- they alleviate contract enforceability problems
BUT: social networks may come with favouritsm, nepotsm (drawbacks). For ex. if the bank can give
money to a good entrepreneur and a bad one, but he knows the bad one personally, you give him the
money because he is your friend (but itts bad for the bank).
Paper: Estimating the value of political connections (Fisman, R.l & Do Lenders Favor Politically
Connected Firms (Khwaja, Al
We want to know the value of politcal connectons. We can do this by looking at the asset prices of
companies in partcular circumstances. For ex. in Indonesia, the politcal system is centralized and many
companies have established relatonship with the (former) president and his family. To study this we
need: asset prices, index of politcal connectveness and events that may endanger the connecton.
The fgure is about the degree of dependence on politcal connectons for their proftability.
The lef side (1) means: least dependent and right side (5):
most dependent. So companies which were afliated with
the presidents his children received a score of 5.
So, as you can see in the fgure, if you are very connected,
the share returns went down (negatve).
Analysis
Rie =α + ρPO Li+ ε ie 
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Rie Return on the price on the price of security i during episode e
POLi is the frmts Suharto Dependency Number
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Results:
If you are a politcally connected frm (this means that there is a politcian on board – politcian is an
individual who stood on a natonal or provincial electon), you receive a beter treatment from banks
(they receive 45% larger loans, beter terms and conditons) – so they bring value to your company. BUT:
the loans granted to politcally connected frms have lower recovery rates (i.e. afer a default – they are
less likely to be paid in full). So being connected = good for company (more valuel but bad for society
(more likely to defaultl. And positive relation between corruption and politically connected.
Preferental treatment mainly granted by government owned banks.
Part 6 – Banks and banks’ merger
Lecture 11 - Week 4
Mergers & Acqouisitons (M&A):
- Merger: Two (or more) corporatons come together to combine their resources and achieve a
common goals. A merger always need approval from the EU Directorate-General for
Competton (in the EU).
- Acqouisiton: one company acqouires shares and control of another company.
The purpose is to generate synergies and efciency gains. The value of the newly generated frm should
be higher than the sum of bidder and the target. They may also generate anti-competitive efects for
other rivals: the newly generated frm will have more market power.
3 types of M&As:
1.
orizontal: companies in the same industry (Coca Cola & Pepsi)
2. Vertcal: companies in diferent industries but along the same value chain (Cars & Trucks)
3. Conglomerate: companies in diferent industries (Coca Cola & Volkswagen)
The economic efects of bank mergers from academic literature on both sides of bankst balance sheet:
 Deposit side: Trade-of between higher market power (short term) and greater efciency (long
term). (Market power means: you can adeust by interest rates)
 Loan side: Greater ability of merged banks to screen borrowers because they have more
informaton (if you have the whole market, you know ‘everythingt, but if there are 2 banks, you
know only the half of the people).
Paper: Are Mergers Beneficial to Consumers? (Focarelli, D and Paneta, F.l
It investgate the efect of bank mergers on deposit interest rates (in comparison with non-merged
banks), fnding the following results:
 Mergers cause an increase in market power in the short run (First 2 years afer merger). 
Decrease in deposit interest rates by about 13.5 basis points of merged vs non-merged banks.
 Mergers cause an increase in efciency in the long run (afer 3 years)  increase in deposit
interest rates by about 12.6 basis points of merged vs non-merged banks. This is eqouivalent to
$252 gain for consumer with $10,000 deposit.
How an M&A increase a firmm’s market power:
 Local competton: competton for deposits is local, because households dontt go to far. So
banks that are closer to households have more market power
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
Entry barriers: banks face high costs to open a branch, making it more likely to have few large
local banks  which means more market power for each of them.
These sources of market power imply that a merged bank, that becomes more efciency, will not
necessarily pass these efciency gains on to consumers.
The distance between the borrower and the bank afect the loan interest rates in the following way:
 greater distance means greater transportaton costs for the borrower, so bank needs to ofer
cheaper credit to atract them. So: If distance goes up, loan rates goes down.
The distance between the borrower and rival bank B afect loan interest rates ofer by bank A by:
 if the distance to the rival is greater – more transportaton costs for the borrower to reach rival
bank  bank A can ofer more expensive credit. So distance to rival goes up – loan rate goes up.
The same, as above, but now according to the deposit rates:
 Greater distance between the bank and the borrower: Distance goes up – Deposit rate goes up
 Greater distance from rival  deposit rate goes down (bad for borrower).
Less compettons means more expensive credit as well (more market power). Less banking
compettons means fewer frms and larger size (so less frms on the market). More concentraton 
more difcult to start up a company and survive (too costly).
Efficiency gains that M&A can produce:
 Cost saving: you can have economies of scale & scope if your company is bigger. Because either
the target or bidder might have more cost-saving technology than the other. And fxed costs can
be spread over a larger basis, reducing average costs (economies of scale). Economies of scope:
M&A may allow frms to enter new markets and cross-sell product to wider customer base.
o Managerial efficiency: M&A may allow frms to improve their managerial performance.
Market power vs Efficiency
The conseqouences of a merger are ambiguous, they depend on whether the efciency gains outweigh
the market power or vice versa. Post-merger efciency and market power changes might however
reqouire diferent tmes to take place  Market power will change in the short run (so manager can
immediately modify its pricing strategies). But efciency gains: it change in the long run, because:
- cost-cutting takes tme, restructuring (closing branches) will happen gradually, laying of
employees is a slow process, etc..
- Merging diferent workforces can be a slow process (diferent communicaton styles)
- Setting and achieving new targets is not immediate (new lending and deposit policies, training
new personnel, etc.)
Stilll the paper: are mergers beneficial to consumers:
The efects of M&A on interest rates in the Italian deposit market (good example to analyse, because it
is a local market with entry barriers and likely to be subeect to market power). In this market: deposits
are unafected by asymmetric informaton, the efect of M&As on interest rates not caused by change in
borrowerst risk. The tme period is the 90ts because there were a lot of M&As
The tree main sources of data:
1. Central credit register (data on interest rates and outstanding deposits)
2. Banking supervision register (bankst balance sheet & income statement informaton)
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3. Census of banks (Data on M&As)
They concentrate on householdst current accounts, and on provinces with in-market mergers, that is
markets where both merger partcipants are present, as opposed to out-of-market mergers, where one
of the partcipants is not in the market.
In-market mergers can have some market power efect & efciency
Out-of market mergers can only have efciency efect
(IMPORTANT TO KNOW)
If the bank of Tilburg & Roterdam merged: no efect on the number
of banks in Tilburg (so no market power efect  only efciency (for
ex. because the bank in Roterdam may be more efcient & will pass
on this to the bank in Tilburg).
Do in-market mergers produce an increase (efciency) or decrease (market power) in deposit interest
rates of the merging banks relatve to non-merging bankss
- In the short run: merged banks decrease their interest rates compared to non-merged. And in
the long run merged banks increase the interest rate compared to non-merged.
- Transitory period = short run (market power)
- Completon period = long run (efciency)
Market power: the increase in market power is stronger for small deposits compared to larger ones,
because they have higher cost of shopping around (looking for other banks). Because for smaller
deposits, the change of interest rates dontt change your proft that much.
Summary of the above, bank mergers can lead to:
 Increase in market power in the short run  decrease in deposit interest rates and increase in
loan interest rates.
 An increase in efciency in the long run  increase in deposit rates, decrease in loan rates.
Paper: Do mergers improve information? Evidence from the loan market (F. Paneta, F. Schivardil
They investgate whether bank mergers lead to greater ability of merger banks to screen borrowers. The
default risk for borrowers, is an important source of asymmetric informaton between borrower (agent –
informed) and lender (principal – uninformed).
Afer a merger, beter screening ability: the merged bank can charge an interest rate more closely
related to borrowerst risk, compared to non-merged banks.
Data:
During 1988 – 1998 there were large waves of bankst mergers (in the Italian market) and there were
large numbers of small and opaqoue (hard to get informaton from) frms  asymmetric informaton is
more relevant. In this paper, we look at their credit lines. The data they use is mainly from their fnancial
statement. They also used a measure of default risk for each frm each year. The score is based on frmts
balance sheet, taking values form 1 (safe) to 9 (risky), so how well the bank is pricing risk.
The relatonship between the loan interest rate and borrowerts risk, depend on bankts ability to screen.
If you are bad at screening borrowers (so as a bank, you dontt have informaton about your borrower):
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loan doesntt change (no more risk). But, higher risk means, higher interest rate, for merged banks (more
informaton). So if merged banks can beter screen  charge an interest rate more related to
borrowerst risk (compared to non-merged). So afer a merger, good frms get lower interest rates and
bad frms get higher interest rates.
There can be some other efects between the score (how risky the borrower is) and merger, such as:
 Beter screening of borrowers over tme (because of technology etc.)
 Beter qouality of borrowers selected by merged banks (controlled interactng score with firms
characteristics (leverage, return on sales, size)

eterogeneity across banks in screening qouality (controlled interactng score with bank
dummies)
But afer testng, with including these omited variables (as shown above), β3 is stll statstcally
signifcant (β3 is the Score * merger). But this can mean that there is a sample selection problem (we
cannot compare the same borrowers between merged and non-merged banks) because merged banks
maybe reeect risky borrowers. If we stll want to know if a merger leads to beter informatonal
efciency: compare subsamples with diferent informatonal gains:
1. Short vs long frm-bank relatonship.
a. Afer a long relatonship, bank learnt more about a borrowers creditworthiness
So: less informatonal gain from mergers compared to a short relatonship
b. Short relatonship (< 5 years): merger increase diference in interest rates between less
risky frms (score 1) and most risky frms (score 9) by 53.6 basis points.
c. Long relatonship: diference in interest rates increase between less risky (score 1) and
worst (score 9) by 16 basis point.  So most efficiency gains in short relationship!
2. Main vs Fringe lenders
a. Bank that supply a large share of a frmts credit (main) have beter informaton about
that frmts creditworthiness.  Less informatonal gain from mergers compared to
Fringe banks (because if merger didntt happen, you also had that informaton gain).
b. Main lenders (proporton of lending above median of 15%): Merger increase diference
in interest rate between best (Score 1) and worst (score 9) frms by 63 basis points
c. Fringe lenders (<15%): increase diference between best and worst frms by 86 BP.
β2 is the score, and β3 is the score*merger. Mergers increase the slope from (β2 to β2+β3) of the interst
rate-score relatonship because:
1. Merged banks rely more on hard informaton (obeectve) than sof informaton (uncodifable).
Small banks are more likely to use sof informaton before merger. So there is a larger increase
in slope for small banks afer merged compared to large banks. (Small banks are bad at
screening borrowers (they are less sensitve to SCORE before they merge) and therefore they
get more advantage from a merger).
2.
igher market power of merged banks can explain steeper interest rate profle, but not lower
rates for safe borrowers. So maybe market power dominates for risky frms and efciency gains
for safe frmss  Compare in-market vs out-of-market mergers.
a. Out-of-market mergers increase interest-rates even more increase in the slope is
larger, because they only have efciency gains (is the opposite result to what market
power efect would suggest).
Mergers can lead to beter informaton efciency because: beter use of existng informaton about
borrowers and increased acqouisiton of new informaton of borrowers.
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Part 7 Corporate Finance under Asymmetric Information
Asymmetric informaton: Actors on one side of the market have much beter informaton than those on
the other side. For ex. Borrowers know more than lenders about their repayment prospects. And
managers and boards know more than shareholders about the frmts proftability. This makes it for ex.
difcult for elderly to fnd private medical insurance. But it can also lead to very high borrowing rates in
third world countries because they have less technology etc. to screen borrowers.
Agency problems
Asymmetric informaton can cause agency problems: conflict of interest between two parts involved in
a relatonship or contract, the principal is for ex. the bank (the one who doesntt have the informaton)
and the agent is the clientiborrower (he knows whether he can repay or not). The relatonship implies
that the principal gives some form of transfer to the agent to perform a task. For ex. a bank (principal)
will give a loan at some interest rate (transfer) to a borrower (agent) in exchange for a repayment
(perform a task).
Agency problems might arise under two conditons:
1. The agent has private informaton about her own type andior the efort she decides to put in
the task:
Type: When the bank lends money, it cannot distnguish a safe and risky borrower
Efort: The bank cannot change the decisions of the borrower (for. Ex. their investments
it makes)  but this afect the likelihood of repayment.
2. The principal and agent have diferent obeectves. For ex. the bank wants to maximize its return
from repayment and the borrower wants to minimize its own returns (in some case not repaying
is more proftable for the borrower).
Under these conditons, there can be two agency problems:
 Adverse selection: bad types of agents are more likely to take the transfer (ex-ante: beginning
of relatonship). For ex. it is more proftable for risky borrowers to take the loan compared to
the safe ones. The ones who take loans represent an adversely (negatvely) selected group, as
risky borrowers are less likely to repay.
o Example: the bank doesntt know who the bad or good borrower is and for that reason it
charge an average interest rate – the good borrowers dontt want to lent at that rate
(too expensive) and the bad borrowers can make a good deal, so as a bank you are
lefover with the bad ones.
o But: the bank is beter of when not acceptng the deal – so no transacton afer all. This
is bad because the good guys dontt get a loan and there is no lending at all.
o Soluton: try to screen the borrowers beter to address these problems.
 Moral hazard: a lower transfer induces the agent to put less efort in the task (ex-post): end of
relatonship). igher interest rate induces the borrower to take more risk and be less likely to
repay (because if you have profts of $50,000 and they charge you higher rates, you have less
profts at the end, less triggered to do your best).
o So: higher interest rates, makes borrowers less likely to repay. The more the bankst
profts from their eforts – the less incentve has the borrower to repay.
o They can make use of collateral loans to make sure that you pay back the loan.
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The main reason for banks to exist is to address 3 problems of credit markets: Adverse selecton, moral
hazard and liqouidity.
In 2007i2008 (crisis) the Northern Rock (Britsh bank) focused on mortgages that when into trouble
during these years, it was the frst Britsh bank that failed due to bank run (because when informaton
came out that the bank didntt do well, all people came to get their money bank). It became a natonal
bank. Afer this: mortgage redemption program was implemented  allowed borrowers to pay of
outstanding balance earlier  adverse selecton because the bank ofers this deal but not everyone was
able to do that (the bad guys are lef over with the bank, because only good ones where able to pay of).
The good guys would now mortgage elsewhere.
Moral hazard example: Bear Stearns was a US investment bank that invested heavily in CDOs backed by
MBS before the crisis – in 2007: frst loss in 80 years to rescue 2 of its hedge funds, due to their
subprime mortgages investment  clients and investors rapidly pulled out their ash. NY Fed lent $30b
to JP Morgan to purchase Bear, allowing it to default if Bear did not have enough assets to repay. NY Fed
save Bear Stearns because its failure could spread to other over-leveraged investment banks (they were
too big to fail).
The following model:
says something about interest rates and defaults.
β>0 is consistent with: igh risk borrowers who are more likely to accept higher rates (adverse selecton)
and higher rates causes more default for eqoually risky borrowers (moral hazard).
Problem is: they cannot distnguish between those two  soluton: assign diferent rates before vs afer
the loan contract is signed.
- μ include unobserved borrowerts risk and unobserved borrowerts efort put into repayment.
- Problem: these are likely to be correlated with interest rate, and β is likely to be upward biased.
 soluton: assign interest rates randomly across borrowers.
Paper: “Observing Unobservables: Identifying Information Asymmetries with a Consumer Credit Field
Experiment (D. Karlan, J. Zinmanl.
This paper qouantfes the importance of hidden informaton (adverse selecton) and hidden acton (moral
hazard) problems in a consumer credit market (using a feld experiment). Informaton asymmetries
cause inefciencies in credit markets (under- or overinvestment for ex.), many policies aimed at
addressing these issues (credit scoring).
 It is difcult to qouantfy informaton asymmetries empirically (it depend on an agentts private
informaton, unobserved by a researcher using observatonal data). And it is difcult because it
is hard to disentangle adverse selecton & moral hazard (they generate similar outcomes,
typically defaults).  But it is important to distnguish them, they reqouire diferent policies
o Adverse selecton: informaton coordinaton, beter screening strategies, subsidies
o Moral hazard: Legal reforms for liability, dynamic contracts
 The feld research allows to both: identfy informaton asymmetries empirically and disentangle
adverse selecton & moral hazard.
Data (used for empirical analysis, advantage: researcher can identfy the causal efect of interestl
1. Observatonal data (sample from a populaton – variables are not under the control of
researcher)
2. Data from Field experiment: A natural setting where subeect are randomly allocated into
treatment and control groups, and an outcome is compared between the two groups
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3. Data from lab experiment: a laboratory setting where a hypothesis is tested enforcing high
control over subeects.
Disadvantage empirical analysis: External validity: the results may be specifc to the partcular setting.
(So itts about: how much can we learn about 1 bank – itts not so representatve).
They used former clients of the lender, with good repayment histories for their analysis. The drawbacks
from picking former clients: it may not be random and the bank already know the repayment history of
them (so, maybe less asymmetric informaton – may be not as relevant).
They did the experiment in 3 waves (July, September and October) and the borrowers were randomly
assigned 3 interest rates, conditonal on their risk, at diferent stages of the loan applicaton process.
Three rates:
ro: ofer rate  clients receive at home an ofer (direct mail) and can apply for a loan. It determines
borrowerst choice to self-select into the loan (afects clientst qouality before contract is signed (ex-ante)
rc: contract rate  revealed by sofware to client and loan ofcer only at the end of the applicaton
process
rF: future rate  revealed to client and loan ofcer afer the loan ofcer completed her inital
underwritng.
 rF and rc: change borrowers incentive to repay, conditonal on having already taken the loan
(afects clients “qouality” afer contract is singed (ex-post)
rc < ro in 41% of the cases, but only 3% adeusted loan size.
This fgure shows how we can use the data if there is moral
hazardiadverse selecton.
ŕ means: high rate and r means low rate. So these two are
diferent people. If there is adverse selecton, the high rate
group (lef) is more risky, because only risky people wants to
accept the average (higher) rato.
The r c < ŕ o means: lower rate = giving a discount.
r c < ŕ o and r c = r o  these people are paying exactly the same
(but r c < ŕ o is less likely to repay (due to adverse selecton)
More likely to default if there is moral hazard (=the high rate) = repay - ŕ c = ŕ o. So the diference at the
lef side (bot at accept: ŕ c = ŕ o and r c < ŕ o is caused by moral hazard)
The main outcome variable is borrowerst repayment behavior and default. Default measures the true
economic cost of lending, but is hard to measure, focus on 3 default measures (monthly average
proporton past due, proporton of months in arrears, account in collecton status).
Some outcomes:
- female have lower risk
The model they used:
There is no relatonship with the error term (high ofer rates  selected ‘badt people).
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If β0 > 0 it implies adverse selection: compare repayments of those who took up at r o and received r c = r
o
, to those who took up at ŕ o and received r c < ŕ o.  clients selected in at diferent rates but then were
randomly assigned the same rate (any repayment diference due to selecton).
βc > 0 implies moral hazard: compare repayments of those who took up at ŕ o and received ŕ c = ŕ o, to
those who took up at ŕ o and received r c < ŕ o. Clients selected in at identcal rates, but then were
randomly assigned a diferent rate (any repayment diference due to moral hazard).
βf< 0 implies moral hazard: Compare repayment of those who received the dynamic incentve r F, to
those who didntt, separately for the 2 subgroups of r c = r o and r c < ŕ o. Clients selected in at, and were
randomly assigned identcal rates, but then were randomly assigned diferent dynamic repayment
incentves (any repayment diference due to moral hazard).
- If they get dynamic repayment, theytre more likely to repay (for females)
Results: Informaton asymmetries by freqouency of borrowing history:
- Ofer rate of prior loans: the more loans you had in the past, the more adverse selecton, it tells
you something about the informaton the bank has (for ex. rate of default).
END OF PAPER
Moral Hazard within the bank:
Agents normally self-report on the performance of their tasks – but there is potental space for moral
hazard by hiding bad performance. In various contexts: agents hide informaton that reflects poorly on
their performance: for ex. pension fund managers sell losing stocks from their portolio before their
annual evaluaton and police ofcers downgrade ofence classifcatons to reduce criminal incidence.
An example is the Enron Scandal: it was the 7th largest US company in 2001 and it was heavily involved
in energy brokering and trading. But in turned out that between 1993-2001 it had used complex,
dubious and fraudulent trading and accountng schemes  to reduce their tax and inflate profts, stock
price etc. It was under supervision of the accountng frm Arthur Andersen (one of the top 5 worldwide).
This scandal led to the largest bankruptcy ever at the tme. Enron was bankrupt in Dec. 2001 and Arthur
Andersen was indicted for obstructon of eustce for destroying documentaton related to its audit of
Enron  moral hazard due to conflict of interest between frm and auditor, incentve to misreport on
bad performance (problem of long relatonship and lack of independence).
Because of this scandal  mandated rotation can solve problems (it includes routne change of auditteams  it avoids personal relatonships). (The EU audit reform had introduced a 10-year audit frm
rotaton for all public interest enttes (included all EU listed frms, all banks and insurances). This would
be a good soluton for moral hazard because
Paper: Information and Incentives Inside the Firm: Evidence from Loan Officer Rotation (Hertzberg, Al
This paper gives empirical evidence of the efectveness of mandated rotatons. It shows that an agent
has reduced incentves to suppress bad news when the principal can compare her report with that
issued by her successor. It provide evidence for the underlying mechanism that suppressing bad news
has a negatve efect on an agentts career if these bad news are exposed by as successor.
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Data: From large US banks operatng in Argentna, looking at the reportng behavior of its loan ofcers
(LOs). LOs are assigned multiple corporate borrowers to monitor, for each borrower they:
1. Recommend an amount of lending
2. Assess and communicate to bank the frmts repayments prospects, assigning internal risk ratng
(IRR) (ranging for 1 (best) to 5 (worst) (used for, for ex. loan approval and loan covenants)
LOs perform a dual role:
1. Active monitoring: manage the relatonship with the frm to maintain high repayment prospects
2. Passive monitoring obtain and report informaton about the frmts repayment prospects.
The IRR is assigned by the LO making use of verifiable (hardl information (cash flow, leverage) and nonverifiable (sofl information (reliability of fnancial statements, frmts managerst competence).
The private (non-verifable) informaton determining the IRR gives rise to potental agency problems in
communicaton. LO may hide bad news about a frm because it would reflect poorly on how she
performed as actve monitor.
The bank adopted a rotaton policy to limit agency problems, recommending 3 years max length of LOfrm relatonship, the rotaton implies that a borrower is taken from a LO and assigned to another one.
The mandate rotaton is not compulsory for everyone because it can be costly.
How can rotation afects a LOm’s incentive to report bad news?
1. Without rotaton: LO observing non-verifable bad news about the borrower faces trade-of
from reportng
a. Will damage her reputaton as actve monitor
b. Will demonstrate her ability as passive monitor
2. With rotaton: Increases LOts incentve to report bad news due to threat of the successor
reportng them
a. Successor has an incentve to immediately report bad news
i. Wouldntt afect her reputaton as actve monitor
ii. Would demonstrate her ability as passive monitor
We should test two hypotheses with the data:
1. Ability of IRR to predict default should vary over the course of the LO-frm relatonship (3 years)
2. Career impact for a LO of revealing bad news should vary over the course of the LO-frm
relatonship  no efect if newly assigned LO downgrades a borrower, negatve if LO
downgrades frm she had for many years and negatve and large for old LO if new LO
downgrades the frm the old LO had for many years.
See fgure: the right tme to hide bad news is in the 2th period
(close to the rotaton)  if rotaton happen, you cantt hide bad
news.
Identifying efect of rotation of reporting:
 Use the 3-year rotaton policy to identfy the causal
efect of antcipated threat of rotaton on likelihood of
LO reportng bad news about own borrower.
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

This reqouires variaton in rotaton  uncorrelated with frm creditworthiness and with tming
predictable by both LOs and econometrician.
Find that rotaton policy induce an increase in the unconditonal probability of rotaton between
month 34-36 (3 years)  entrely driven by the relatonshipts startng date.
Focus on changes in reportng behavior around the high-rotaton qouarter ( RQ) = months 34-36. It
turned out that 2 qouarters before and afer the RQ the numbers are statstcally signifcant. So a
potental rotaton might work. So, closer to rotaton there is:
 Positve and signifcant correlaton between IRR and default in the next 12 months
 Signifcantly higher IRR compared to the other qouarters.
Equation: βs is the efect of IRR on default varies with qouarter to rotaton (compared to baseline β of
relatonships not reaching RQ). The IRR (risk) increase when the probability of default increase. For the
eqouaton with the rotaton qouarter it is a bigger slope than for the eqouaton without no rotaton or long
beforeiafer rotaton (because if there is rotaton – they report well and their risk is reported fairly).
The fgure represents that once the rotaton qouarter is past,
the green line goes up. The predicted power goes down
again afer 3 qouarters afer rotaton. But there is no linear
relatonship – doesntt make much sense.
But remember the frst testable implicatons of the model:
ability of IRR to predict default should vary over the course
of the LO-frm relatonship (3 years).
 End year 1: Low & optmistc, LOts actve
monitoring (you dontt predict much of that default)
 End year 2: igh & not optmistc, higher threat of rotaton
 End year 3: igh & not optmistc, new LO is in charge
Results
As rotaton gets closer, LOs produce more informatve reports about a frmts creditworthiness. Other
explanatons may be:
 ERR by qoR controls for frm level shocks
 The non-monotonic patern is unlikely to be driven by learning, that would imply a gradual
informatveness increase
 LO-month dummies rule out any shocks to LOs
 Patern explained by non-verifable component of IRR, as
computer risk ratng show no patern around RQ
 LO know in advance if theytll be replaced or not: ruled out
by coefcients for relatonships that are not turned over,
itts threat of rotaton inducing more informatve reports.
 this fgure implies that LOts maybe not will be
replaced.
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The second model we
change with qouarter-to-
use, estmate if the average IRR will
rotaton (qoR).
The
represent the average IRR for every qouarter-to-rotaton. This is compared to baseline of
relatonships not reaching RQ. Controlled for frm, Lo and industry-month fxed efects.
If IRR goes down (as it does between qouarter 4 and 6) it is beter.
But remember the frst testable implicatons of the
model: ability of IRR to predict default should vary over
the course of the LO-frm relatonship (3 years).
 End year 1: Low & optmistc, LOts actve
monitoring (you dontt predict much of that
default)
 End year 2: igh & not optmistc, higher threat
of rotaton
 End year 3: igh & not optmistc, new LO is in
charge
Another important qoueston: does the bank change its
lending decision as the IRR becomes more informatves
(So, if the bank trust its loan ofcers or not – so if you
trust the informaton the LO give you) We use a new model to investgate this.
- As a bank, you trust your LO more close to the rotaton period.
- Immediately afer RQ: good reportng.
The line will be upward sloping if youtre close beforeiafer
the RQ are (then you can trust the LO). But no RQ:
downward sloping  see image.
IRR and credit amount is signifcantly correlated at RQ.
When IRR becomes more informatve the same
downgrade leads to a larger decline in amount lent.
The threat of rotaton afects LOts reportng behavior
(through the IRR). This is caused by the career concerns: discourage LO reportng bad news, but rotaton
mitgates this problem. Think about the second testable implicaton of the model:
 Career impact for a LO of revealing bad news should vary over the course of the LO-frm
relatonship
o No efect if newly assigned LO downgrades a borrower
o Negatve if LO downgrades frm she had for many years
o Negatve and large for old LO if new LO downgrades the frm the old LO had for many
years (so negatve if the LO downgrades a frm in the 6 months before RQ)
Career Concerns – Summary:
1. Number of tmes LO e downgrades a frm in the 6 months before the RQ has a negatve efect
on that LOts career
a. Confrms predicton of negatve career impact if LO downgrades a frm she had for many
years
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2. Number of tmes LO e downgrades a frm in the 6 months afer the RQ has no efect on that
LOts career
a. Confrms predicton of no career impact if newly assigned LO downgrades a borrower
3. Number of tmes a frm managed by LO e is downgraded by a successor in the 6 months afer the
RQ has a strong negatve efect on that LOts career
a. Confrms predicton of negatve and large career impact for old LO if new LO
downgrades frm old LO had for many years
Topic 8 Mortgage crisis
Week 6: Lecture 14&15
The crisis of 2007i08 crisis was important because it costed the average American $70k in lifetme
income (FED). It was caused by banks who give too much credit to people who didntt deserve it. It leads
to unemployment, lost in health insurance and expensive mortgages.
Lef image: EBP = measurement of risk.
(Excess bond premium)
The right image: the red line is the
scenario when the crisis did not
happen, so the GDP would have been
much higher.
3 key facts of U.S. Mortgage crisis (that makes this time diferent from ‘normalm’ timesl: Important!
1. Growth in mortgage credit, mostly to
subprime borrowers (borrowers who have
high credit risk) (see fgure )
The line in this image shows the share of mortgages
that was given to subprime borrowers.
2. Increase in securitzaton of subprime
mortgages (see fgure below)
The image shows the diferent types of mortgages.
The grey line (the upper line) shows the mortgages
which are insured by the government (not much risk).
3. Growth in mortgage defaults for subprime
borrowers  loans that are riskier end up
defaultng more.
Paper: The Consequences of Mortgage Credit
Expansion: Evidence from the U.S. Mortgage Default
Crisis (Mian, A. and A. Sufil
This paper makes use of three diferent hypotheses for testng the subprime mortgage expansion.
1. Income-based hypothesis: expansion was driven by beter income prospects for subprime
borrowers. (borrowers are getting richer)
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2. Supply-based hypothesis: Expansion was driven by an outward shif in the supply of credit by
lenders. (Means: banks have access to more and cheaper credit)
3.
ouse price expectaton-based hypothesis: expansion was driven by lenderst increased
expectatons of future house prices. (they expect house prices to increase – so they can give
higher credit).
These hypotheses can happen at the same tme, or apart. They investgated which one was the main
driver for the crisis  it turned out that the supply-based hypothesis was the one (stronger evidence)
A ZIP-code is a code for a specifc area where you can collect data for. For areas where a lot of people
live (New York), the ZIP-codes are very small, so for ex. Manhatan had +i- 60 ZIP-codes. In areas with
less people: bigger ZIP-codes.
Data:
No-mortgage debt did not change that much (no more default) but on the mortgage loans: default rates
increased a lot (during 2005-2007).
A subprime borrower is defned in the US as consumers with a FICO credit score below 660. A measure
of consumer credit risk computed by a data analytcs company (FICO) is based on: payment history, debt
burden, length of credit history etc. In 1996 on average 29% of consumers in a ZIP code have credit
score below 660.
If we compare ZIP codes in the lowest (prime) vs highest (subprime) qouartle of credit score, we see that
the subprime mortgages are denied more than the prime ones. The fracton of subprime borrowers
within a ZIP code is:
- Negatvely correlated with ZIP codets income growth (so there were less subprime borrowers if
the income growth  income growth is higher if you get a beter credit score).
- Positvely correlated with ZIP codets credit growth (so there were more subprime borrowers
when the credit growth)
• Comparing growth rates of subprime – prime ZIP codes within the same country leads to
higher growth in number of mortgages for subprime vs prime and higher growth in
amount of mortgages for subprime vs prime
- Combined with evidence of sharp drop in subprime vs prime interest rate
spreads during 2001-2004. 
owever, the growth diference in lending is followed by a relatve increase in defaults for subprime
versus prime ZIP codes.
These mechanisms could be explained (comparing subprime vs prime borrowers) for the hypotheses:
1. Income-based hypothesis: if borrowers income goes up  borrowerst default risk decrease 
mortgage rates decrease  acceptance rate increase.
2. Supply-based hypothesis: if the bankst funding costs decrease  mortgage rates decrease 
acceptance rate increase
3. House price expectation hypothesis: if the future house price increase  bankts loss from
borrowerst default decrease  mortgage rates decrease  acceptance rate increase.
Income-based hypothesis (evidencel:
There is a positve relatonship between mortgage originaton growth in 2002-2005 and fracton of
subprime borrowers in 1996. This result is maybe driven by a nonlinear relatonship between income
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growth and mortgage growth (worst ZIP codes have 12% higher mortgage growth than best ZIP codes in
the same country). This result implies a negatve correlaton between credit growth and income growth
in 2002-2005, which can explain the sharp increase in mortgage default rates in 2005-2007.
More evidence for this hypothesis: if increase in debt is driven by income increase, you would expect all
debt (credit card etc.) to increase as well, but only mortgage increase (non-mortgage debt decrease). In
1990-1994 there was a constant & negatve mortgage growth for subprime – prime ZIP codes. This can
imply that mortgage growth for subprime is lower than prime (so only good people get loans). But later
on (2001-2005) itts the other way around and the growth in credit is stronger for subprime.
Supply-based hypothesis (we investgate if hypothesis 2 can be true).
Can the growth in mortgage credit to subprime borrowers be explained by a shif in credit supplys 
Subprime borrowers would experience a higher growth as they are ex-ante more likely to be credit
ratoned. During 2002-2005 the denial rate was higher for the prime ZIP codes comparing to the
subprime ZIP codes (so you accept more subprime).
So: if banks get more credit available for loans  subprime get more loans because the primes already
have all the money they need (from the bank) and the extra money that is available for the bank now,
goes to the subprime.
Is there more credit supply driven by growth in securitzatons This would lead to higher fracton of
mortgages sold by originators (lenders) to non-GSE investors. There was a greater increase in
securitzaton in subprime ZIP codes (those were not risk adeusted and more proftable).
Subprime ZIP-codes had lower denial rate and securitzed more. So they sold less to afliate and
commercial banks, but more to securitzed pools & noncommercial banks (so more securitzaton for
them). But you dontt want to give it to afliates and commercial banks because: for afliates: you hurt
yourself. Commercial banks: may have some screening possibilites that non-commercial banks dontt
have (could explain the negatve relaton).
Data for the mortgage defaults in 2005-2007: Afliates and commercial banks had less default (so the
decline in mortgage loans was good) and securitzed pools and noncommercial banks had more defaults.
These results are consistent with lenderst moral hazard:
- Lenderts incentves aligned with afliated investors. There is a negatve correlaton between
mortgage sales and default rate.
- Commercial banks have screening abilites that prevented them to buy bad loans. So: Negatve
correlaton between mortgage ales and default rate
- Lenders incentves not aligned with securitzed pools and unafliated investors, who have no
screening abilites. So: positve correlaton between mortgage sales and default rate.
It is difcult to claim causality, but results are consistent with the supply-based hypothesis.
House-based expectation based hypothesis:
ouse price drops when default increased (2005-2007). And there was a higher growth in housing prices
for subprime vs prime mortgages.
To check if this hypothesis is true, we have to separate two explanatons comparing areas where both
hypotheses (supply-based or price expectaton) can hold from areas where only supply holds. 
Inelastc vs elastc housing supply areas.
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-
-
Inelastc area in terms of housing supply: New York (so very populated). The prices will increase
if there is more demand, because: no space for building new houses.  you can lend more
money (if house prices increase)  so both hypotheses can hold
• In the subprime areas, the housing prices went up a lot before the crisis.
Elastc: In areas with few people. If there is more demand for houses  they build more, so
price dontt increase (stays constant, also during a crisis  so only supply hypothesis hold,
because there was no increase in price, the house-based hypothesis cantt be hold).
Data: we test the same as before (so why the subprime mortgage expanded) but now for the housebased expectaton.
So: if house price expectaton hypothesis drives the credit expansion: elastc areas should have no
changes in subprime mortgage credit growth. But if income growth, we see that the fracton for
subprime borrowers decrease (so negatve correlaton between credit growth and income growth in
2002-2005). This is evidence against this house price expectaton-based hypothesis.
The relatve house price growth in subprime (inelastc) ZIP codes in 2002-2005 can be explained by the
correlaton between house price growth and household income growth since 1991. In 2002-2005:
Subprime ZIP codes with negatve income growth have 1.1% higher relatve annualized house price
growth than prime ZIP codes with positve income growth in the same country (so for subprime – house
prices increases more).
Results suggest that the mortgages expansion for subprime borrowers, driven by securitzaton, is likely
to be responsible for the relatve house price growth in subprime areas. Important:
- If house prices increase  the collateral value increase  the credit availability increase and
the house prices increase (=feedback mechanism between credit growth and house price
growth).
The supply-based hypothesis explains the 2002-2005 variaton in:
 Mortgage credit growth by 21.4%

ouse price growth (39.9%)
 Default rate growth (40.9%)
Securitization and lendersm’ Moral Hazard:
Growth in mortgage credit for subprime borrowers can be explained by:
 A shif in credit supply caused by growth in securitzaton of subprime borrowers
 Consistent with lenderst moral hazard, as lenderst incentve are not aligned with investors with
no screening abilites.  lenders have no incentve to carefully screen loans they sell to these
investors
So, does securitzaton generate lenderst moral hazards  Is securitzaton benefcial for the mortgage
markets
Securitization: another type of agency problem. You expand your loans in a secondary market (and get
more money back). The more subprime borrowers, the less securitzaton you have.
Securitzaton converts illiqouid assets (mortgages) into liqouid securites (MBS). In 2006 was 60% of U.S.
mortgage debt traded in MBS. You can trade MBS in 2 diferent ways:
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1. Agency market (for prime): mortgage pools which are securitzed by Government-Sponsored
Enterprises (GSEs).
a. Agency eligibility is determined by hard informaton (loan size, credit score and
underwritng standard).
2. Nonagency markets (subprime): mortgage pools securitzed by investment banks and hedge
funds.
The subprime lending (nonagency market) grew from $65 billion in 1995 to $500 billion in 2005  prime
lending grew much less. So, securitzaton rates grew from 30% to 80%.
Characteristics of subprime loans are:
- More costly for borrowers: interest rates depend on credit score, loan length etc.
- More risky for investors who buy MBS: credit risk is not mitgated by government guarantees
like in the agency market, but instead sofened with tranches.
The benefts of securitzaton:
1. Improving risk sharing: makes product safer on average (loanst default risk not on (small)
lenders, but on (large) investors, and diversifed through pool of loans).
2. Reducing bankst cost of capital: loans fnanced by selling MBS to investor.
Costs of securitzaton in subprime market:
1. Delinqouencies increased by 50% from 2005-2007. (you end up selectng worse borrowers)
a. Many mortgage lenders out of business
b. Generated worldwide fnancial crisis.
The increase in delinqouencies can possibly explained by moral hazard:
 Screening & monitoring borrowers is costly for lenders.
o Actve & passive role based on sof and hard informaton, you need to pay loan ofcers,
costs of moral hazard
 Allows lenders to collect sof informaton about borrowers
 Lenders need an incentve to screen and monitor given by having the illiqouid loan on their
balance sheet.
 Selling the loan through MBS means that it is not on the balance sheet anymore. This reduce the
lenderst incentve to screen and monitor and as long as MBS is rated based on hard informaton.
o MBS is based on hard informaton because if you use sof info – youtre not able to
screen them right.
Paper: Did Securitization Lead to Lax Screening? Evidence from Subprime Loans (B.J. Keys, Mukherjeel
This paper investgate lenderst moral hazard in subprime loans and allows for adverse selecton and
moral hazard in borrower-lender relatonship. We fnd that a portolio with greater ease of securitzaton
default more than a similar risk profle group (by about 10% to 25%). (Moral hazard: depending on the
conditon you (bank) give them, theytre (frm) moreiless likely to default)
Data:
The borrowerts credit qouality is measured with FICO score: produced with sofware and based on credit
history and outstanding debt, but not on income or assets. The score is from 400 – 900 where 400 is
very risky and 900 very safe.
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So: GSEst underwritng guidelines to standardize securitzaton cautoned against lending to risky
borrowers:
 FICO < 620: Subprime borrowers (riskier) securitzed only by nonagency sector  more difcult
to securitze  higher incentve for lender to collect sof info.
 FICO ≥ 620: Prime borrowers securitzed mostly by agency sector  easier to securitze  lower
incentve for lender to collect sof info.
Close values to 620 (619 and 621 for ex.) are not so diference but the default rate for people with score
621 is higher, because the banks screen less and securitzing is easier!
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Borrowerm’s documentation:
 Borrowerts credit qouality also measured with borrowerts documentaton collected by lender,
categorized as:
 Full: borrowers provide verifcaton on income and assets
 Limited: borrowers provide some informaton on their assets
 No: Borrowers provide no informaton on income and assets.
Information on property financed and loan purpose:
 Typo of mortgage loan: fxed rate, adeustable rate, hybrid, …
 LTV rato: amount of loan as percentage of home value.
There was a great growth in credit to low documentaton (comparing with the full documentaton). So
they gave out more loans (and higher) to low documentaton people (that are people who have given
less informaton to the banks about their creditworthiness etc.).
The main steps of a mortgage application
1. Lender collects informaton on borrower
a.
ard info: FICO score & Sof info: Documentaton on income and assets
2. Lender makes ofer and borrower accepts or declines
a. Main contract terms are interest rate and LTV rato
3. If borrower accepts the mortgage can be sold as part of securitzed pool of loans (MBS)
a. Only FICO score and contract terms used by investors and ratng agencies to rate
tranches of securitzed pool
Even if the loans are securitzed, lenders should make efort to process sof informaton because
- Securitzaton leads to lax screening  bad loans are less likely to be reeected  more defaults.
- Lenders have incentve to securitze worse loans, therefore securitzaton need to be randomly
assigned.
Implies easier securitzaton more securitzed loanss (due to less careful screening of the borrowers with
a score > 620). What we see is that there is a eump in the number of low documentaton securitzed
loans around FICO score 620.
There is a positve relaton between FICO score and number
of loans granted (more safe borrowers leads to more loans).
See fgure 
owever, the true data relatonship is:
 There are two problems with previous approach
o FICO = 620 is not the intercept
⇒ Soluton: Create new variable g FICO = FICO – 620
o Relatonship between Y and FICO is very nonlinear
⇒ Soluton: Allow for flexible slope on both sides of 620
The Beta is important: what happens to the number of loans if it is easy
to securitzes  see slope of regression line (last fgure). Closer to the
crisis: Securitzaton becomes more important. As you can see there is a gap in the 2 lines at the 620
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threshold. This discontnuity (gap) is captured by beta. The discontnuity increases from 2001 – 2006.
We have to compare the contract terms and borrower characteristcs around the 620 cutof, to see if
this increase is driven by any diferences in hard informaton around this 620 border. So we look at the
interest rates and household income for example.
owever, the results imply that hard informaton is not diferent around the 620 border. So if we fnd
any diference in loan performance it must be due to diferences in sof informaton (= less careful in
screening). Our fndings suggest that around the 620 cutof, loans with higher credit scores (> 620)
default more ofen than lower credit scores (< 620). SO: securitization leads to less screening.
 The lack of hard informaton for low documentaton loans implies that lenders need to acqouire
sof informaton. And if lenderst moral hazard was driving these results, than:
o Lenders are acqouiring more sof information for loans more difcult to securitze (<620)
o Lenders acqouiring less sof info for loans easier to securitze (>620)
o But in the case of hard informaton: incentve for moral hazard is smaller (because you
already have informaton about them (for ex. Income)).
If we look at full documentaton loans, we can check if the lack of hard informaton maters:
- They give out more loans around threshold.
- Securitzaton creates an issue even for <620 (full-documentaton loans).
- The number of full-documentaton loans becomes bigger & bigger. For these loans: the aspects
of securitzaton maters.
For people who are close above >620, the incentve to screen them good is bigger.
So conclusion topic:
Securitization leads to worse screening:
- Depending on their FICO score (>620: easier to securitze – less screening)
- There is a eump in default around the threshold
- Good thing about securitzing: risk sharing (giving out more loans).
Topic 9 Rating Agencies
Credit ratng agencies (CRAs) are companies specialized in assigning credit ratngs over the
creditworthiness of:
 Issuers of debt obligatons (companies, sovereign countries, …)
 Debt instruments (government bonds, corporate bonds, MBS, …)
The CRA market is really concentrated (three CRAs control 95% of the ratng market):
1. Standard & Poorts (S&P): 40%
2. Moodyts: 40%
3. Fitch: 15%
This market is so concentrated because of historical regulatons (due to the great depression  banks
werentt allowed to invest in speculatve investments (<BBB), so banks were forced by law to use the
eudgment of one of these 3 agencies (the only one who were recognized as good CRA). Insurance
regulators and Securites and Exchange Commission did the same (so they accepted only ratngs from
one of these 3 agencies).
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We give credit ratngs because of asymmetric informaton between borrowers and lenders. By having a
credit score, we provide investors with fnancial informaton about an industry  it is too costly for an
individual investor to get this informaton alone.
Credit ratings are opinions about the credit risk of a security (based on statstcal models and subeectve
eudgements). It ranks from AAA (best) to D (worst).
For MBS it can be expressed in terms of level of subordination below a ratng (ranging from 0 to 1). We
use the following formula for this: Si=1−
Total Face Value securities with rating i∨above
. ow
Total Face Value of all mortgages underlying deal
higher this number, how riskier the set of the underlying deal is. So a security with score BBB with an
outcome of: 0.05 (5%) means that 95% of bonds in MBS deal have ratng BBB- or higher (understand
this!l. So if the outcome was 50% (for the same credit ratng) it means the deal is riskier.
First (1970) the investor pays the CRA, but now the issuer (frm) pays the CRA, because:
 Avoid free riding among investors
 Issuers needed ratngs, given the regulatory changes
But this change, can generate agency problems  CRA might inflate ratng to keep the issuer happy. But
the conseqouence of this can be a worse reputaton (if they dontt rate them well, the others dontt trust
the CRA). owever, the CRA had become too powerful, but there where entry barriers for new players
to enter the ratng market (scale of economies, experience advantage, brand reputaton).
People invested in these credit agencies, because the business was a natural duopoly, which gave it
incredible pricing power.
In the 2000s there came controversies (doubts) about the reliability of CRAs. The CRAs have incentves
(to some extend) to give companies a good ratng because frms provide their loans. So the unreliable
ratngs might be driven by investorst and issuerst needs, such as:
 Ratngst stability, avoid freqouent & costly adeustments.
 Inflated ratngs to get higher yields
 No downgrades as issuers pay high fees.
Issuerst needs are relevant if they have bargaining (=negotatng) power, and this was the case for
securitzaton (is the process of taking an illiqouid assets and transform it to a security).
Ratng was the key to success of securitzaton. Because securitzaton of subprime mortgages succeeded
only because of favorable ratngs of senior tranches.
Corporate bonds are products which are easy to understand and so to rate them correct. owever:
Due to the complexity of the MBS: the credit agencies give them a higher ratng (they thought it was a
safe product, and ratng errors where difcult to spot). Because it was a complex product: more room to
cheat. If the CRA give the MBS favorable ratngs: Securitzes would get higher profts from higher ratngs
on larger percentages of tranches. So issuers would pressure CRAs to obtain favorable ratngs.
- Furthermore, issuers had bargaining power with CRAs. Since the MBS involved only a small
number of investment banks (with high volumes and large proft margins)  they threatened
the CRAs to leave them and go to their rivals if they were unpleased with their ratng.
CRAs in MBS ratng market were:
 Without prior experience on these complex products
 Deeply involved in the design of these securites
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 Under fnancial pressure to give answer that issuers wanted (otherwise they lef).
Paper: The Credit Rating Crisis (E. Benmelechl  not so important paper.
They look for evidence of rate shopping for structured products. Rate shopping (important!l is getting
more rates and take the best one.
Rate shopping (important!l: we investgate if the threat of the issuers was real to leave their CRA.
Unless investors demand multple ratngs, issuers of structured products have incentve to do rate
shipping.
The main fndings were that when you had eust 1 rater, the threat to leave the CRA is higher  so CRA is
more likely to keep the ratng high (you dontt want the customer iissuer to leave). So if they had already
2 ratngs – the last rater is more likely to rate correct.
There were more downgrades than upgrades (2005-2008) if the number of raters increase. (So if you
have 3 raters, more downgrades, than when you have 1 rater). If there are less downgrades, it means
that there was a bigger threat to leave the CRAs (so theytre more likely to have given a wrong ratng). - - But during the crisis (2008l the change in ratngs was the biggest for the issuers who had 1 rater
(because they now knew that the MBS (for ex.) were eunk and had to change their rate).
If beta is for ex. 0.061 it means that 6.1% of the securites which are rated by one agency are more likely
to be downgraded. So results suggest that rate shopping might explain collapse (decrease) in ratngs in
2008, and that S&P inflated ratngs most.
 S&Pts ratng model for CDOs backed by corporate debt based on assumpton of 0% interindustry
correlaton.
This was especially the case for structured products (like MBS), but corporate bonds experienced no
much diference in number of downgrades before & during crisis.
Paper: MBS Ratings and the Mortgage Credit Boom: A. Ashcraf, P. Goldsmith
This paper is about the fast downgrade of the ratng of MBS. Because before the fnancial crisis, a large
fracton of subprime MBS were rated against the AAA rate. This kept the level of the investment on
these securites high  but: large downgrades during the crisis. This paper investgate if this downgrade
suggest that CRAs werentt providing accurate ratings.
- Because of the agency problems (incentve for CRAs to misreport)
- Or eust insufcient diligences
- Or were there unexpected shocks which were difcult to predicts (For ex. Sharp decline in house
pricess)
The data they used was about security characteristcs (face value, coupon rate, inital credit ratngs from
main CRAs) but also mortgage characteristcs (loan performance at diferent horizons afer deal issued,
amount, originaton date, FICO score, ZIP code).  They covered almost the whole populaton with their
sample (very representatve).
Non-agency mortgage securitization: Non-agency MBS deals have no credit guarantee from GSEs, but
are structured with credit enhancement features (to protect investors from credit losses):
1. Subordination structure: Mortgage principal payments frst paid to senior tranches, they have
highest ratngs and pay lowest yield. But also (realized) mortgage losses frst applied to eunior
tranches  have lowest ratngs and pay highest yields.
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2. Excess spread: diference between payments from loans and sum of servicer fees, net and
coupon payments  used to absorb credit losses, with remainder kept in reserve or distributed
to eqouity tranche owners.
3. Insurance: Some tranches insured by external bond insurer.
Over tme the AAA ratngs declined. The interestng part of the fndings: the number of deals increased
& credit qouality goes down. This means that the market was growing (but they already serve money to
the good ones) to for facilitatng the growth 
they fnanced the ‘badt people. In the beginning
they dontt default because theytre able to pay
the interest, but once they have to pay the
principal  default.
The subordinaton level is how risky a mortgage
is. So how higher (it is increasing untl qouarter 1
in 2005), it means that the mortgages became
riskier. So we can see that the mortgages were
getting riskier, but CRA didntt notce that.
Rating accuracy:
We use three hypotheses to test how accurate
inital ratngs (subordinatons) are at predictng
future performance of MBS deals. The three
hypotheses are:
1. Rating stability: Subordinaton remains
stable over tme afer controlling for credit risk and credit enhancement
2. Risk ranking: mortgage performance or ratng downgrades should be explained by inital
subordinaton (and conditonal on subordinaton other data available to CRAs should have no
predictve power).
3. Opacity: controller for subordinaton, deals with more low documentaton loans dontt
underperform other deals.
Credit enhancement is the improvement of the credit profle of a structured fnancial transacton or the
methods used to improve the credit profles of such products or transactons. Itts a key part of the
securitzaton transacton and is important for the CRA when ratng a securitzaton.
 Subordination (also called: Credit tranching) is a techniqoue to create internal credit
enhancement by establishing a seniorisubordinated structure (so frst pay seniors – than
euniors). Cash flows generated by assets are allocated with diferent priorites to classes of
varying seniorites. The seniorisubordinated structure thus consists of several tranches, from
the most senior to the most subordinated (or eunior). The subordinated tranches functon as
protectve layers of the more senior tranches. The tranche with the highest seniority has the
frst right on cash flow. If an asset in the pool defaults  losses (incurred by the botom) do not
afect the senior tranche (ofen rated as AAA), unless the amount of the loss exceed the amount
in the subordinated tranches.
Hypothesis 1:
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igher risk leads to higher default and higher subordinaton (CRA did a good eob).
- In 2005 tll 2007 the risk-adeusted subordinaton declines despite the sharp increase in defaults.
This might be evidence against this hypothesis:
• Rating stability: subordinaton remains stable over tme afer controlling for credit risk
and credit enhancement.
- We can decompose the change in risk-adeusted subordinaton afer 2004 into four components
1. Changes in unconditonal subordinaton 2. Changes in house price appreciaton 3. Changes in
other components of mortgage credit risk 4. Changes in credit enhancement.
Furthermore, it seems that CRAs in 2005-2007 ignored (or underweighted) the home price trends and
borrowerst risk  this can be consistent with CRAst agency problem, trade of from misreportng:
current revenues vs future reputatonal costs.
Hypothesis 2:
It seems that higher subordinaton, implies higher default rates (this is consistent with CRAts ratngs
being accurate). Further, MBS deals backed by risky mortgages have higher default rates, conditonal on
subordinaton (this last point is evidence against hypothesis 2).
Evidence against 2 and 3 hypothesis is that subordinaton is too low for deals with low documentaton
(several deal characteristcs have a statstcally signifcant efect on default rates, conditonal on
subordinaton). The % of subordinaton below AAA class for a partcular deal is increased during the
market peak of 2005-07: this is evidence against the second and third hypotheses.
Conclusions:
- Evidence didntt suggest that ratngs are informatve. It reeects the story that credit ratng
standards decline uniformly over pre-crisis period.
• MBS deals backed by risky mortgages, summarized by model-proeected default rate,
consistently experience worse performance than would be predicted based on dealts
subordinaton levels alone.
- MBS ratngs didntt fully reflect publicly available data.
- Results arentt conclusive about role of explicit agency frictons in ratng process. owever, two
of the results appear to be consistent with recent literature:
• Poor performance of deals backed by low-documentaton loans (larger default).
• Observed decline in risk-adeusted subordinaton around peak of MBS issuance, when
incentve problems are likely most severe.
We now investgated two issues with credit ratngs
 Accuracy for structured products before the fnancial crisis
 Rate shopping by large issuers of structured products
Now we focus on the ‘bright side of ratngst. Can ratng agencies contribute to improve allocaton of
credit in the economys
 Mitgate asymmetric informaton on borrowerst qouality
 Reduce cost of certfcaton
 Allow borrowers to access capital from uninformed investors
Paper: The Real Efects of Debt Certification: Evidence from the Introduction of Bank Loan Ratings”
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We focus on the introducton (in 1995) by S&P and Moodyts of loan ratngs in the syndicated loan
market. So we look at frms that had no access to public debt (before 1995) and get loan ratng afer.
So before 1995, the fracton of the frms who had a loan ratng was 0%.
Syndicated Loan is a loan made to a frm eointly by more than one lender, following these steps
1. Lead bank (arranger) signs mandate (preliminary agreement) with borrower, specifying:
Covenants, fees, collateral, amount, interest rate range
2. Lead bank provides informaton about the borrower to potental partcipant lenders
3. If partcipants agree, loan agreement signed by all partes  Lead bank acts as agent (monitor,
admin, manage, etc..)
The rating of the syndicated loan: S&P and Moodyts began ratng these syndicated loans in 1995 to help
expand inital base of investors during syndicaton process and to encourage secondary market liqouidity.
- Introducton of loan ratngs driven by desire of nonbank insttutonal investors to partcipate in
the market.
This was Supply driven: Insttutonal investors wanted to partcipate, but need ratngs to mitgate
asymmetric informaton:
 Agency problems between lead bank and other partcipants.
 Agency problems between partcipant banks and investors.
Ratng process works in two steps:
1. Borrower is assigned an issuer credit ratng  overall creditworthiness of borrower
2. Loan is assigned a loan ratng:
a. Focus on loan default risk and probability of recovery
b. Borrower decides to get ratng and pays fee
c. Moodyts rated some loans without borrowerst reqouest
Following the data, 50% of frms got a loan ratng of BB+ or worse. And 30% of the frms that get a loan
ratng, were previously unrated and get BB+ or worse.
Use theory from olmstrom, Tirole (1997) to understand how loan ratngs afect frmts fnancial &
investment policies, based on debt market with 3 partcipants:
 Firms (borrowers), privately informed about proeect qouality  Lenderts actve monitoring can
prevent them from taking bad proeects, avoid moral hazard
 Informed Lenders, can lend and exert efort to monitor frm  Efort is costly and unobservable
(private informaton) ⇒ Will exert efort only with right incentve, commit own capital
 Uninformed Lenders (investors), can only lend to frm  Will not lend to borrower without
lenderts monitoring ⇒ Will only lend if informed lender commits own capital
Introduce loan ratngs into this framework:
 Informed Lenders can lend and perform  Monitoring, exertng costly and unobservable efort
and certfcaton (costly evaluaton of borrowerts qouality), might imply extra costs passed on to
the borrower
 Ratng Agencies can perform cheaper certfcaton
o
ave beter ratng technology, scaleiscope economies, etc.. •
o Regulaton reqouires ratngs from recognized CRAs •
o Avoid agency problems of informed lender (lead bank) •
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Cheaper certfcaton allows for: If expensive informed lenderts capital decrease and cheap uninformed
lenderts capital increase  credit availability increase and the frmts investments increase as well.
Loan ratngs will be more benefcial to frms which obtain loan ratngs and has public debt (they have the
highest EBITDAitotal assets. The size and age of a frm are the key to acces public debt markets.
Firms with no loan ratng and no public debt would benefit more from certfcaton (so they had no
issuer ratng before loan ratng and had a low qouality  measured by inital loan ratng).
Results
The main fndings consistent with theory predictons:
1. Firm without issuer ratng experiences increase in debt issuance 4 tmes larger than frm with
loan ratng  Similar result for increase in leverage
2. Firm without issuer ratng and low qouality experiences even higher increase in debt issuance 
Similar result for increase in leverage
The main channels of debt expansions
- From informed lenderss (Domestc banks)
- From uniformed lenderss (Foreign banks, insttutonal investors)
We found that loan ratngs increase access to debt  they experience larger increases in investment,
consistent with certfcaton efect (allows to raise more capital and therefore invest more). So frmts
frst rated loan compares to its previous unrated loans:
 Large increase in loan a mount
 Syndicate compositon shifs towards less-informed lenders
 In partcular, shif from domestc lenders to foreign lenders and non-bank insttutons.
Results:
 Rated frms experience increase in asset growth (of 0.078) when obtaining loan ratng (in
comparing to when they didntt have a loan ratng).
 Unrated frms experience statstcally signifcantly larger increase in asset growth (0.274).
 Similar results for ash acqouisitons: unrated frms obtain loan ratng experience increase in cash
acqouisitons of 0.081.
 Similar coefcient estmates afer controlling for many frm level tme varying investment
opportunites variables.
 Increase in asset growth, cash acqouisitons and working capital investment is larger for frms that
are both unrated and subseqouently obtain loan ratng of BB+ or worse
 Firms that initally obtained loan ratng beneft more than frms that initally obtained issuer
ratng (without loan ratng). The efect of loan ratng for unrated frms is that they experienced a
bigger increase in debt fnancing than unrated frms that didntt obtain a loan ratng.
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Part 10 Bankruptcy Law
Bankruptcy is the legal status of a frm, person, or other entty that is unable to repay its creditors
- Diferent laws worldwide regulate the bankruptcy process
• For ex. The U.S. has a bankruptcy code (law) – bankruptcy can fle for under diferent
chapters of this code.
- Chapter 7 is for ex. the frmts assets are liqouidated to creditors
- Chapter 11: designs a reorganizaton plan to temporarily avoid liqouidaton of
assets (the frm cannot pay debt, but has positve value for investors)
These bankruptcy codes can difer substantally worldwide.
 Debtor friendly: eqouityholders retain all control rights in bankruptcy (US)
 Creditor friendly: all control rights are transferred to frmts creditors (Germany)
These diferences in creditor rights, mater for frmst fnancing. Because lenderst decision to give loans,
and their contract terms, will depend on their legal rights during bankruptcy.
- Can lenders control the insolvency processs
- Do they have rights over the property of bankrupt frms
Example of Debtor Friendly Bankruptcy
Marvel was a leading publisher of comics books, bankrupt in 1996 (despite their restructuring plan).
According to chapter 11 – the court allowed Marvel to:
- get $100m in Debtor-In-Possession fnancing to pay current & expected oblatons, meet
operatng & investment needs  depends on current manager remaining in charge
• They have 120 days to propose re-organizaton plan and the decision challenged by
bondholders due to their ownership of collateral shares, court ruled against them
- No need for unanimous support of debtholders for re-organizaton plan, 51% support within
each creditor class
• Marvel presented almost same plan as before fling (going bankrupt)
Example of Creditor Friendly Bankruptcy
Kirch Media was 2th largest German media conglomerate and invested a lot in Pay-TV – lead to
bankruptcy in 2002. Their insolvency proceeding implies that either Kirch or the creditors have to fle a
petton due to companyts illiqouidity or overindebtness within 3 weeks
- Group declared insolvency, court appointed new managers
- Court mostly takes control away from current managers
• Kirch Group was notable excepton, strong politcal links
- Creditors can choose among 3 optons
• Liqouidate business & give funds from asset sale to creditors
• Selling as going concern to an investor
• Restructuring with insolvency plan (if approved by creditors)
Lead to long dispute between Kirch and Deutsche Bank with setlement in 2012
So Debtor friendly bankruptcy: managers stays in organizaton and the eqouityholders have the control
rights. Creditor bankruptcy: new managers – creditors get the control rights.
Bankruptcy and property rights
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Important for bankruptcy law is enforceability of contracts. It means to which extend the legal system
protects the property rights (difers worldwide).
- Lenderst decisions to give loans and its contract terms will depend on contractst enforceability:
• If the credit qouality of the borrower declines  lenders want to recontract  increase
in interest rates i more collateral i shorten maturity (so pay-of your loan earlier). But it
is difcult to recontract if property rights are
- But: Difcult to recontract if property rights are not well enforced (explained i see through)
•
Lower recovery rates, higher cost of repossessing collateral
Paper: “Creditor Rights, Enforcement, and Bank Loans” (Bae K.H., Goyal V.K. -2009l.
This paper examines the efect of creditor and property rights protecton on loan contracts. In countries
with weaker rights, the lenders are more likely to:
 charge higher interest rates, raton borrowers (= lend less with higher legal risk) and set shorter
maturites (allows to review lending decisions more freqouently)
So, in countries with beter contract enforceability:
 increase in loan sizes
 Lengthen loan maturity
 Reduce loan spreads (also for lenders in countries with beter creditor rights)
During crisis: lenders increase spreads more in countries with weak property and creditor rights.
Data
They focused on loan data from 48 countries and on data with borrower risk characteristcs. They
focused on property rights protecton (how well legal system and insttutons enforce contracts) and on
creditor rights (in reorganizatonsiliqouidaton procedures)
Property rights can be measured with 3 variables:
1. corrupton within the politcal system
a.
ow likely are governments to demand payments
b. it change economic and fnancial environment
c. it reduce government and business efciency
2. Repudiaton risk: contract change for foreign business
3. Risk of expropriaton (=dispossession) of private investment (Risk of outright confscaton and
forced natonalizaton)
All these variables are combined into one index of property rights protecton. Where ~20 is poor
protecton to ~30 = strong protecton
Creditor rights: based on bankruptcy lawst defniton of insolvency process, these are 4 measures
powers of secured lenders in bankruptcy:
1. Ability of creditors to seize collateral (to take the collateral)
2. Creditor consent must be observed when borrower fles for reorganizaton, as opposed to
debtorts unilateral protecton
3. Secured creditors paid frst out of frmts liqouidaton
4. Creditor or administrator running business during reorganizaton, as opposed to debtor ⇒
Combined into creditor rights index  From 0 (poor rights) to 4 (strong rights)
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Lenders may respond to legal risks in various ways:
 Syndicate structure: Small and concentrated syndicates have beter monitoring incentves and
greater recontractng abilites
 Foreign lenders in syndicate: Property & creditor rights more important to foreign lenders
 Agency partcipaton: Lenders can mitgate legal risk by co-lending with multlateral agencies
(development banks, central banks,..)
 Borrower risk characteristcs: Large and proftable borrowers have lower default risk and fewer
contractng problems
o Firms with more tangible assets will imply lower contractng costs, tangible assets easier
to collateralize
To estmate the efect of property and creditor rights on the
loan size, loan maturity and loan spread. We use this
formula: 
There was poor enforcement of contract, this implies that
lenders choose:
 loan size restrictons in response to uncertainty
 Shorter maturity to be able to review lending
decisions more freqouently and reduce expropriaton risk
 Greater spread to compensate for enforceability risk
aving both strong property and creditor rights implies
additonal reducton in spreads.
Alternative measures – if we use alternatve
measures, do the results hold of property rightss
- Rule of law: Countryts historical traditon of
respect of law and order, from 0 (weak) to 10
(strong)
- Efciency eudicial system: Integrity of legal
system towards businesses, especially foreign,
from 0 (low) to 10 (high)
- Enforcement: Efectveness of legal system at
enforcing contracts, average of previous two
and expropriaton risk
- Enforcement tme & cost: Efciency of courts,
measures
• Number of days court takes to enforce
contract
• Costs (share of income) incurred in the
process
- Property rights indexes: Alternatve
combinaton of other measures
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If we test the alternatve measures of property rights, the efect on loan spread is signifcant for each
measure, except for the property rights (economic freedom).
Asian Financial Crisis (1997-98l
They didntt change the property and creditor rights and reduced expected returns on investments 
higher defaults (higher probability of contractng problems and legal rights of lenders become more
important).
- Loans in East Asia during crisis periods have higher spreads  bankst response to increase in
credit risk
- During crisis period loans in countries with strong property and creditor rights have lower
spreads
Summary
Loans in countries with strong property
rights have greater size, longer maturity and
lower spreads.
Loans in countries with strong creditor
rights have lower spreads.
During Financial crisis property and creditor
rights become more relevant for loan
outcomes  higher borrowerst riskiness, contractng problems more likely.
Creditor vs Debtor rights:
Creditor rights regulate a potental conflict of interest between debtor and creditor during bankruptcy
- Regulator decides strength of creditor rights
• Creditor-friendly: All control rights transferred to creditors •
• Debtor-friendly: Eqouityholders retain control
- Trade-of from creditor-friendly rights
• Lower spreads, cheaper credit for borrowers
• Debtors have weaker rights in bankruptcy
igher risk of liqouidaton, assets seized
- Might discourage borrowerst risk-taking behaviors
Paper: Bankruptcy Codes and Innovation (V.V. Acharya, E. Subramanian (2009l.
The paper investgates the efect of creditor rights on frmts innovaton. And investgate if creditorfriendly bankruptcy codes can discourage frmts risk taking behavior
 Innovaton: Decision to invest in risky (innovatve) versus safe (conservatve) technology
 Firm facing creditor-friendly code prevent liqouidaton risk
o Finance innovatve technology with less debt, more costly
Innovation: the measure for innovaton is:: patent issued by U.S. Patent Ofce.
 Intellectual property: Set of temporary exclusive rights granted by authority to inventor for an
inventon that is
o Novel, useful, non-obvious
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

In exchange for detailed public disclosure of inventon
Temporary monopoly rents to recover innovaton costs •
o 20 years from date of applicaton fling in US and EU
Does creditor-friendly bankruptcy code lower innovatons See image!
 Biotech sector: more innovatve sector, more patents
 Textle: less innovatve sector, less patents
We have to compare these two industries with debtor friendly states (US) and creditor friendly
(Germany).
Diference-in-diference tests find that:
Countries that became more creditor-friendly generated:
 9.7% less patents
 13.3% less citatons of those patents
 8.4% less patentng frms
Countries that became more debtor-friendly generated
 10.7% more patents
 15.4% more citatons of those patents
 9.2% more patentng frms
 Stronger results for more innovatve industries
Creditor rights: Based on bankruptcy lawst defniton of insolvency process, measures 4 powers of
secured lenders in bankruptcy
1. Ability of creditors to seize collateral
2. Creditor consent must be observed when borrower fles for reorganizaton, as opposed to
debtorts unilateral protecton
3. Secured creditors paid frst out of frmts liqouidaton
4. Creditor or administrator running business during reorganizaton, as opposed to debtor
This is combined into creditor rights index: from 0 (poor rights) to 4 (strong rights)
Empirical models investgate the efect of creditor rights on frmts innovaton:
1. Compare changes in innovaton between
a. Countries that changed creditor rights
b. Countries that didntt change creditor rights
2. Compare changes in innovaton as creditor rights changed between
a. More innovaton intensive industries (biotechnology)
b. Less innovaton intensive industries (textle)
According to the data, the increase in creditor rights implies less patents, less citatons, less frms
patentng.
Diference-in-diference interpretaton, implies that becoming more creditor friendly reduces
innovaton.
Creditor rights & Innovation across diferent industries
Signifcant economic magnitude, take two patent classes
difering by 1 patent in their median number of patents
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-
In debtor-friendly country (CRct =0)
• More innovatve class generates 14.9% more patents
- In debtor-friendly country (CRct =1)
• More innovatve class generates 10.4% more patents
- In creditor-friendly country (CRct =4)
• Less innovatve class generates 2.1% more patents
Creditor-friendly countries (Germany) focus innovaton on less-innovatve industries (textle)
Financial implications
Mechanism for less innovaton with strong creditor rights
- Leverage is more costly for more innovatve frms ⇒ Need to use more own cash to innovate
- More lending overall ⇒ But in less innovatve industries
Welfare and efciency trade-of from stronger creditor rights
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