Discussion of “The Role of
Managerial Overconfidence in the
Design of Debt Covenants”
Sudipta Basu
Is the paper interesting?
No accounting content
Behavioral finance – but old theory…
Managerial hubris... Roll (1986)
Still interesting to understand whether
bondholders “pierce the corporate veil”
(i.e. look through firm characteristics to
managers actually making decisions)
What’s the paper about?
Are overconfident managers more
restricted in their business activities?
Do managers who do not rush stock
option exercises have their judgment
questioned by bondholders?
Merger restrictions correlated with
overconfidence, “abnormal” accruals,
M/B, ROA, financing restrictions…
Libby Boxes
Independent
Conceptual
Overconfidence
Dependent
1
X (X )
Distrust
Y (Y)
2
Operational
Option delay
X
3
5
Debt covenants
Y
4
Control
Agency costs, Transparency, Profitability
Vs (prior), Zs (current causes)
Validity threats related to
Libby Boxes
From easiest to hardest to think about:
• Statistical Conclusion Validity (5)
• Internal Validity (4)
• Construct Validity (2 and 3)
• External Validity (1 generalizes to ??)
Are the results persuasive?
Basic question is how well are potential
validity threats addressed?
Is a definitive/sharp test presented?
Are multiple test results consistent?
What is the totality of the evidence?
Thin (regression) versus thick (case
study, institutional detail) association
Theory/External Validity
Independent
Conceptual
Overconfidence
X (X )
Dependent
1
Distrust
Y (Y)
Do we usually distrust overconfident people?
How much is “optimal” confidence?
How do we identify overconfidence?
Can you be both depending on domain?
Is overconfidence the same as optimism?
Review PSYCHOLOGY research
Construct Validity (1)
Independent
Conceptual
Overconfidence
X (X )
2
Operational
Option delay
X
NegativeDependent
Proxy
1
Founder
CEO?
Distrust
Y (Y)
Family CEO?
Very wealthy CEO?
3
Power-hungry
CEO
Debt covenants
Y
Try Positive Proxies like N successive
optimistic forecasts, MD&A or conference call
tone, press or analyst descriptions…
Construct Validity (2)
Independent
1
What are distrustful
actions?
Overconfidence
Conceptual
Avoidance X (X )
Recommend others
2
Limited trial (credit line?)
Boundaries
(covenants)
Option
delay
Operational
X (interest)
Compensation
Model other distrustful actions
—selection bias issues
Dependent
Distrust
Y (Y)
3
Debt covenants
Y
Internal Validity
Easier to observe proxy for overconfidence?
repeated optimistic management forecasts
conference call 2behavior or MD& A tone
3
Operational
Option delay
5
X
Debt covenants
Y
4
Control
Agency costs, Transparency, Profitability
Vs (prior), Zs (current causes)
WHO observes and decides?
Other minor issues
Why don’t shareholders fire these CEOs?
Abnormal accruals = accounting ignorance
Conservatism reduces control denominators
Time-series clustering? (mid-1980s?)
Benchmark model with only control variables
Medians not means (very skewed variables)
Include predicted signs in tables