"Optimal Securitization with Moral Hazard" (DOI) with Tomazs Piskorski and Alexei Tchistyi, Journal of Financial Economics, 104(1) (2012) 186-202
abstract: We consider the optimal design of mortgage-backed securities (MBS) in a dynamic setting in which a mortgage underwriter with limited liability can engage in costly hidden effort to screen borrowers and can sell loans to investors. We show that (i) the timing of payments to the underwriter is the key incentive mechanism, (ii) the maturity of the optimal contract can be short, and that (iii) bundling mortgages is efficient as it allows investors to learn about underwriter effort more quickly, an information enhancement effect. Finally, we demonstrate that the optimal contract can be closely approximated by the “first loss piece.”
 "Reputation and Signaling in Asset Sales" (DOI) (sole authored), Journal of Financial Economics 125(2) (2017) 245-265. Internet Appendix.
abstract: Static adverse selection models of security issuance show that informed issuers can perfectly reveal their private information by maintaing a costly stake in the securities they issue. This paper shows that allowing an issuer to both signal current security quality via retention and build a reputation for honesty leads that issuer to misreport quality even when owning a positive stake—the equilibrium is neither separating nor pooling. An issuer retains less as reputation improves and prices are more sensitive to retention when the issuer has a worse reputation.
 "Are Lemons Sold First? Dynamic Signaling in the Mortgage Market" (DOI) with Manuel Adelino and Kris Gerardi (2018), Forthcoming at Journal of Financial Economics.
abstract: A central result in the theory of adverse selection in asset markets is that informed sellers can signal quality by delaying trade. This paper uses the residential mortgage market as a laboratory to test this mechanism. Using detailed, loan-level data on privately securitized mortgages, we find a strong relation between mortgage performance and time-to-sale. Importantly, this finding is conditional on all observable information about the loans. This effect is strongest in the "Alt-A" segment of the market, where loans are often originated with incomplete documentation. The results provide some of the first evidence of a signaling mechanism through delay of trade.
 "Capital Share Dynamics when Firms Insure Workers" with Hanno Lustig and Mindy Zhang Xiaolan (2017), Forthcoming, Journal of Finance.
abstract: Although the aggregate capital share for U.S. firms has increased, the firm-level capital share has decreased on average. The divergence is due to the largest firms. While these mega-firms now produce a larger output share, their labor compensation has not increased proportionately. We develop a model in which firms insure workers against firm-specific shocks. More productive firms allocate more rents to shareholders, while less productive firms endogenously exit. Increasing firm-level risk delays the exit of less productive firms and increases the measure of mega-firms, raising the aggregate capital share and lowering it on average. We present evidence supporting this mechanism.
 Growth Options, Incentives, and Pay-for-Performance: Theory and Evidence" with Sebastian Gryglewicz and Geoffery Zheng (2017), Forthcoming, Management Science.
Winner, Jacob Gold & Associates Best Paper Prize, ASU Sonoran Winter Finance Conference 2017
abstract: Pay-performance sensitivity is a common proxy for the strength of incentives. We show that growth options create a wedge between pay-effort sensitivity, which determines actual incentives, and pay-performance sensitivity, which is the ratio of pay-effort to performance-effort sensitivity. An increase in growth option intensity can increase performance-effort sensitivity more than pay-effort sensitivity, so that as incentives increase, pay-performance sensitivity decreases. We document empirical evidence consistent with this finding. Pay-performance sensitivity, measured by dollar changes in manager wealth over dollar changes in firm value, decreases with proxies for growth option intensity and increases with proxies for growth option exercise.
 "Investment Timing and Incentive Costs" with Sebastian Gryglewicz (2018), Revise and Resubmit, Review of Financial Studies. Previously titled Dynamic Agency and Real Options.
abstract: We analyze how the costs of smoothly adjusting capital, such as incentive costs, affect in- vestment timing. In our model, the owner of a firm holds a real option to increase a lumpy form capital and can also smoothly adjust an incremental form of capital. Increasing the cost of incre- mental capital can delay or accelerate investment in lumpy capital. Incentive costs due to moral hazard are a natural source of costs for the accumulation of incremental capital. When moral hazard is severe, delaying investment in lumpy capital is costly and it is optimal to overinvest relative to the first-best case.
 "The Insurance is the Lemon: Failing to Index Contracts" with Benjamin Hebert (2016), Revise and Resubmit, Journal of Finance.
abstract: We introduce a model to explain the widespread failure to index contracts to aggregate indices, despite the apparent risk-sharing benefits of indexation. Our model features these benefits, but demonstrates that asymmetric information about the ability of indices to measure underlying aggregate states can lead to risk-sharing failures and non-indexation. Suppose that a borrower receives an offer from a lender that features higher repayments in “good” states, in exchange for lower repayments in “bad” states. To make such an offer, a lender must ask for higher average repayments, because the lender is exposed to these aggregate risks. The borrower, however, is concerned that she is paying something for nothing; if the index is a poor measure of the true aggregate state, the cost of this contract might exceed its benefits. We provide conditions under which this effect is strong enough to cause the borrower to reject this contract, and choose a conventional, non-contingent contract instead. Under these conditions, many equilibria are possible, and they can be Pareto-ranked; the use of non-contingent contracts can be viewed as a coordination failure.
 "Collateral constraints, wealth effects, and volatility: evidence from real estate markets" with William Mann (2016). Revise and Resubmit, Review of Finance.
abstract: We document that, within-region, lower-income zip codes have more volatile returns to housing than do higher-income zip codes, without any corresponding higher returns. We rationalize this finding with a simple model that features a collateral constraint on borrowing and non-homothetic preferences over housing. Shocks to the representative household's marginal rate of substitution lead to volatility in the return to housing via the collateral constraint. We argue that lower-income households have a more volatile marginal rate of substitution, and thus more volatile returns to housing, consistent with our empirical findings. We provide further evidence for our mechanism using (1) variation in wealth induced by lagged housing returns; (2) cross-sectional data on the housing expenditure share; and (3) state-level non-recourse status, which instruments for the tightness of collateral constraints. Finally, we observe that endogenous volatility in housing returns may limit the available supply of housing, via producers' option to delay. Consistent with this hypothesis, the age of the housing stock is monotonically decreasing in local income levels.
 “Corporate Liquidity Management under Moral Hazard” with Simon Mayer and Konstantin Milbradt (2018).
abstract: We present a model of liquidity management and financing decisions under moral hazard in which a firm accumulates cash to forestall liquidity default. When the cash balance is high, a tension arises between accumulating more cash to reduce the probability of default and providing incentives for the manager. When the cash balance is low, the firm hedges against liquidity default by transferring cash flow risk to the manager via high powered incentives. This risk transfer occurs even though the manager is risk averse and the firm’s owner’s are risk neutral because default is inefficient. Firms with more volatile cash flows transfer less risk to the manager and hold more cash. Agency conflicts lead to endogenous flotation costs related to the severity of the moral hazard problem. These flotation costs always reduce the funds raised during a refinancing round to below the no-moral-hazard benchmark.
 "Mortgage Underwriting Standards in the Wake of Quantitative Easing" with Richard Stanton and Nancy Wallace (2014), Very old version, new version coming soon).
abstract: While the large-scale asset purchases (LSAPs) have funneled vast amounts of capital into the secondary market for mortgages, the direct effect of these programs on the primary mortgage market is not yet clear. We present evidence that while the LSAPs may have improved conditions for the least risky borrowers, they have not improved conditions for all borrowers. For example, the average FICO score of agency securitized mortgages increased from below 720 (low risk) in 2008 to above 760 (extremely low risk) in 2012. What explains this dramatic shift in the average quality of agency securitized mortgages, and why did it persist even with the flood of capital into the secondary mortgage market from the LSAPs? We argue that the change in the probability of buy back requests on Fannie and Freddie mortgage backed securities can explain the tightening of mortgage credit standards.
Work in Progress:
"A Theory of Optimal Capital Structure and Endogenous Bankruptcy" with Hengji Ai (2016).
“Bad Culture" with Mark Egan, Gregor Matvos, Amit Seru (2018).