"Synthetic or Real? The Equilibrium Effects of Credit Default Swaps on Bond Markets" (with Adam Zawadowski), Review of Financial Studies, (forthcoming)
Abstract: We provide a model of non-redundant credit default swaps (CDSs), building on the observation that CDSs have lower trading costs than bonds. CDS introduction involves a trade-off: It crowds out existing demand for the bond, but improves the bond allocation by allowing long-term investors to become levered basis traders and absorb more of the bond supply. We characterize conditions under which CDS introduction raises bond prices. The model predicts a negative CDS-bond basis, as well as turnover and price impact patterns that are consistent with empirical evidence. We also show that a ban on naked CDSs can raise borrowing costs.
"Maturity Rationing and Collective Short-Termism" (with Konstantin Milbradt), Journal of Financial Economics (forthcoming)
Abstract: Financing terms and investment decisions are jointly determined. This interdependence, which links firms’ asset and liability sides, can lead to short-termism in investment. In our model, financing frictions increase with the investment horizon, such that financing for long-term projects is relatively expensive and potentially rationed. In response, firms whose first-best investments are long-term may adopt second-best projects of shorter maturities. This worsens financing terms for firms with shorter maturity projects, inducing them to change their investments as well. In equilibrium, investment is inefficiently short-term. Equilibrium asset-side adjustments by firms can amplify shocks and, while privately optimal, can be socially undesirable.
"Should Derivatives be Privileged in Brankruptcy?" (with Patrick Bolton), Journal of Finance (forthcoming)
Abstract: Derivatives enjoy special status in bankruptcy: They are exempt from the automatic stay and effectively senior to virtually all other claims. We propose a corporate nance model to
assess the effect of these exemptions on a firm's cost of borrowing and its incentives to engage in efficient derivative transactions. While derivatives are value-enhancing risk management tools, seniority for derivatives can lead to inefficiencies: It transfers credit risk to debtholders, even though this risk is borne more efficiently in the derivative market. Seniority for derivatives is efficient only if it provides sufficient cross-netting benefits to derivative counterparties that provide hedging services.
"Predatory Short Selling" (with Markus K. Brunnermeier), Review of Finance (forthcoming)
Abstract: Financial institutions may be vulnerable to predatory short selling. When the stock of a financial institution is shorted aggressively, leverage constraints imposed by short-term creditors can force the institution to liquidate long-term investments at fire sale prices. For financial institutions that are sufficiently close to their leverage constraints, predatory short selling equilibria co-exist with no-liquidation equilibria (the vulnerability region), or may even be the unique equilibrium outcome (the doomed region). Increased coordination among short sellers expands the doomed region, where liquidation is the unique equilibrium. Our model provides a potential justification for temporary restrictions of short selling for vulnerable institutions and can be used to assess recent empirical evidence on short-sale bans.
"Liquidating Illiquid Collateral" Journal of Economic Theory 149(1), 183-210
Abstract: Defaults of financial institutions can cause large, disorderly liquidations of repo collateral. This paper analyzes the dynamics of such liquidations. The model shows that (i) the equilibrium price of the collateral asset can overshoot; (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; (iii) repo lenders should take into account creditor structure, strategic interaction, and their own balance constraints when setting margins; and (iv) the model provides a framework to analyze transfers of repo collateral to 'deep pocket' buyers or a repo resolution authority.
"The Maturity Rat Race" (with Markus K. Brunnermeier), Journal of Finance, 68(2), 483-521.
- "Winner of the 2013 Brattle Group Distinguished Paper Adward"
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 debtors 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.
BOOK CHAPTERS AND CONFERENCE PROCEEDINGS
"Strategic Conduct in Credit Derivative Markets" (with Patrick Bolton), International Journal of Industrial Organization 31(5), 652-658
Abstract: This paper reviews recent research at the intersection of industrial organization and corporate finance on credit default swap (CDS) markets. These markets have been at the center of the financial crisis of 2007-2009 and many aspects of their operation are not well understood. The paper covers topics such as counterparty risk in CDS markets, the 'empty creditor problem', 'naked' CDS positions, the super-senior status of credit (and other) derivatives in Chapter 11 bankruptcy, and strategic behavior in CDS settlement auctions.
"Bubbles, Financial Crises, and Systemic Risk" (with Markus K. Brunnermeier), Handbook of the Economics of Finance, Vol. 2
This chapter surveys the literature on bubbles, financial crises, and systemic risk. The first part of the chapter provides a brief historical account of bubbles and financial crisis. The second part of the chapter gives a structured overview of the literature on financial bubbles. The third part of the chapter discusses the literatures on financial crises and systemic risk, with particular emphasis on amplification and propagation mechanisms during financial crises, and the measurement of systemic risk. Finally, we point toward some questions for future research.
"The Anatomy of the CDS Market" (with Adam Zawadowski)
Abstract: What is the economic role of the market for credit default swaps (CDSs)? Using novel position and trading data for single-name corporate CDSs, we provide evidence that CDS markets emerge as "alternative trading venues" for hedging and speculation: CDS markets are larger and more likely to exist for firms with bonds that are fragmented into many separate issues - suggesting a standardization and liquidity role of CDS markets. Whereas hedging motives are associated with comparable trading volume in the bond and CDS markets, speculative trading volume concentrates in the CDS. Crossmarket arbitrage links the CDS and the bond market via the basis trade.
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