PUBLICATIONS

"The Maturity Rat Race" (with Markus K. Brunnermeier), Journal of Finance (forthcoming)

Abstract: Why do some firms, especially financial institutions, finance themselves so short-term? We develop an equilibrium model of maturity structure and show that extreme reliance on short-term financing may be the outcome of a maturity rat race: an individual creditor can have an incentive to shorten the maturity of his loan, allowing him to adjust his financing terms or pull out before other creditors can. This, in turn, causes all other creditors to shorten their maturity as well. This dynamic toward short maturities is present whenever interim information is mostly about the probability of default rather than the recovery in default. For borrowers that cannot commit to a maturity structure, most importantly financial institutions, financing is inefficiently short-term.

"Credit Default Swaps and the Empty Creditor Problem" (with Patrick Bolton), Review of Financial Studies, 24(8), 2617-2655

Abstract: The empty creditor problem arises when a debtholder has obtained insurance against default but otherwise retains control rights in and outside bankruptcy. We analyze this problem from an ex-ante and ex-post perspective in a formal model of debt with limited commitment, by comparing contracting outcomes with and without insurance through credit default swaps (CDS). We show that CDS, and the empty creditors they give rise to, have important ex-ante commitment benefits: by strengthening creditors’ bargaining power they raise the debtor’s pledgeable income and help reduce the incidence of strategic default. However, we also show that lenders will over-insure in equilibrium, giving rise to an inefficiently high incidence of costly bankruptcy. We discuss a number of remedies that have been proposed to overcome the inefficiency resulting from excess insurance.

WORKING PAPERS

"Should Derivatives be Privileged in Brankruptcy?"

Abstract: Derivative contracts, swaps, and repos enjoy “super-senior” status in bankruptcy: they are exempt from the automatic stay and, if collateralized, they are effectively senior to virtually all other claims. We propose a simple corporate finance model to assess the effect of this exemption on a firm’s cost of borrowing and incentives to engage in derivative transactions. Our model suggests that, while derivatives are value-enhancing risk management tools, effective seniority for derivatives can lead to inefficiencies because it shifts credit risk to the firm’s creditors, even though this risk could be borne more efficiently by derivative counterparties. In addition, because senior derivatives dilute existing creditors, firms may take on derivative positions that are too large from a social perspective.

"Liquidating Illiquid Collateral"

Abstract: Defaults of financial institutions often cause large, disorderly liquidations of repo collateral. This paper analyzes the dynamics of such liquidations as a continuous-time trading game, in which following a default balance-sheet constrained lenders unwind illiquid collateral positions. The model shows that (i) the equilibrium price of the collateral asset can overshoot during such liquidations, potentially causing spillovers to other market participants; (ii) the creditor structure in repo lending involves a fundamental tradeoff between risk sharing and inefficient `rushing for the exits' by competing sellers of collateral after a default; (iii) rather than relying on purely statistical models, repo lenders should take into account creditor structure, strategic interaction, and their own balance constraints when setting margins to manage counterparty risk; and (iv) the model provides a framework to analyze transfers of repo collateral to `deep pocket' buyers or a repo resolution authority.

"Gradual Arbitrage"

Abstract: Capital often flows slowly from one market to another in response to buying opportunities. I provide an explanation for this phenomenon by considering arbitrage across two segmented markets when arbitrageurs face illiquidity frictions in the form of price impact costs. I show that illiquidity results in gradual arbitrage: mispricings are generally corrected slowly over time rather than instantaneously. The speed of arbitrage is decreasing in price impact costs and increasing in the level of competition among arbitrageurs. This means arbitrage is slower in more illiquid markets for two reasons: First, there is a direct effect, as illiquidity affects the equilibrium trading strategies for a given level
of competition among arbitrageurs (strategic effect). Second, in equilibrium fewer arbitrageurs stand ready to trade between illiquid markets, further slowing down the speed of arbitrage (competition effect). Jointly, these two effects may help explain the observed cross-sectional variation of arbitrage speeds across different asset classes.

"Complexity in Financial Markets" with Markus K. Brunnermeier

Abstract: Should we regulate complex securities, subject them to an FDA-style approval process, or limit who can invest in them? To answer these questions, one first needs to establish why complexity matters, and what defines a complex security. Complexity is an important concept in financial markets with boundedly rational agents, but that finding a workable definition of complexity is difficult. For example, while CDOs are viewed by most as highly complex, equity shares of financial institutions, whose payoff structures are even more complicated, are often seen as less complex. We point out three different ways in which boundedly rational investors can deal with complexity: (i) by dividing up difficult problems into smaller sub-problems or by using separation results, (ii) by using models – simplified pictures of reality, (iii) through standardization and commoditization of securities. Importantly, simply increasing the quantity of information disclosed to investors does not resolve complexity, since in the presence of bounded rationality it leads to information
overload.