Corporate Finance

This essay in celebration of Grossman and Hart (1986) (GH) discusses how the introduction of incomplete contracts has fundamentally changed economists' perspectives on corporate finance and control. Before GH, the dominant theory in corporate finance was the tradeoff theory pitting the tax advantages of debt (relative to equity) against bankruptcy costs. After GH, this theory has been enriched by the introduction of control considerations and investor protection issues.

This paper finds statistically and economically significant out-of-sample portfolio benefits for an investor who uses models of return predictability when forming optimal portfolios. The key is that investors must incorporate an ensemble of important features into their optimal portfolio problem, including time-varying volatility, and time-varying expected returns driven by improved predictors such as measures of yield that include share repurchase and issuance in addition to cash payouts. Moreover, investors need to account for estimation risk when forming optimal portfolios.

This paper presents a comprehensive analysis of mortgage delinquency between 2004 and 2008 using a unique loan-level dataset from a major national mortgage bank. Our analysis highlights two major problems underlying the mortgage crisis: a heavy reliance on mortgage brokers who tend to originate lower quality loans, and a high prevalence of low-documentation loans—known in the industry as "liars' loans"—which results in information falsification by borrowers.

The regulation of bank capital as a means of smoothing the credit cycle is a central element of forthcoming macro-prudential regimes internationally. For such regulation to be effective in controlling the aggregate supply of credit it must be the case that: (i) changes in capital requirements affect loan supply by regulated banks, and (ii) unregulated substitute sources of credit are unable to offset changes in credit supply by affected banks. This paper examines micro evidence—lacking to date—on both questions, using a unique data set.

Why are banking systems unstable in so many countries—but not in others? The United States has had twelve systemic banking crises since 1840, while Canada has had none. The banking systems of Mexico and Brazil have not only been crisis prone but have provided minuscule amounts of credit to business enterprises and households.

What kinds of credit substitution, if any, occur when changes to banks' minimum capital requirements induce them to change their willingness to supply credit? The question is of first-order importance given the emergence of "macro-prudential" policy regimes in the wake of the global financial crisis, under which regulatory tools — in particular, minimum capital ratio requirements for banks — will be employed to control the supply of bank credit as part of the effort to improve the resilience of the financial system.

Using country index returns from 8 developed countries and 8 emerging market countries, we re-explore the benefits to international diversification over the past 30 years. To examine various theories in a comparable way, we intentionally limited ourselves to an examination of country index returns and a limited number of types of investments.