Essays in financial intermediation
Ganduri, Rohan Rao Srinivas
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This thesis uncovers the behavior of market participants in reponse to regulatory changes in the financial intermediation sector. The first essay, "Repo Regret?", I find that Independent Mortgage Companies (IMCs), which accounted for a third of all mortgage originations in the U.S., experienced an exogenous increase in their funding after the passage of the 2005 bankruptcy reform act. The act increased creditor protection by including mortgage related collateral to bankruptcy safe harbored repos, thereby expanding IMCs’ funding opportunities. Using multiple identification strategies based on funding constraints, discontinuity in securitization propensity, and geographic discontinuity in anti-predatory lending laws, I find that IMCs responded to this funding shock by increasing the issuance of risky home loans which culminated in higher ex-post defaults. Areas exposed to significant IMC lending also experienced a greater house price growth. My results highlight the unintended role of regulation in aiding the U.S. housing market boom and bust by safe harboring mortgage related repo collateral. In the second essay, "Are credit ratings still relevant?", we show that firms' stock prices react significantly less to credit rating downgrade announcements when they have Credit Default Swap (CDS) contracts trading on their debts. We find that CDS spreads predict firms' future rating downgrades and defaults, and document a significant information flow from the CDS to equity and bond markets before firms are downgraded. Further, the CDS term structure can be used to construct a more reliable measure of default risk premium for firms undergoing rating revisions. While the CDS market is not a perfect substitute for credit ratings, our results suggest that credit rating revisions have become less informative to equity investors in the presence of the CDS market. In the third essay, "Credit Default Swaps and Moral Hazard in Bank Lending", we analyze whether introducing Credit Default Swaps (CDSs) on a borrower's debt leads to lender moral hazard around covenant violations, wherein lending banks can terminate or accelerate the loan. Using a regression discontinuity design, we show that CDS firms, including those with agency problems, do not decrease their investment after covenant violations, pay a higher loan spread, and perform poorly, but do not go bankrupt at a higher rate when compared with non-CDS firms that violate covenants. These results are magnified when lenders have weaker incentives to monitor and suggest that introducing CDSs misaligns incentives between lenders and borrowers. In the fourth essay, "Do Bond Investors Price Tail Risk Exposures of Financial Institutions?", we analyze whether bond investors price tail risk exposures of financial institutions using a comprehensive sample of bond issuances by U.S. financial institutions. Although primary bond yield spreads increase with an institutions' own tail risk (expected shortfall), systematic tail risk (marginal expected shortfall) of the institution doesn't affect its yields. The relationship between yield spreads and tail risk is significantly weaker for depository institutions, large institutions, government-sponsored entities, politically-connected institutions, and in periods following large-scale bailouts of financial institutions. Overall, our results suggest that implicit bailout guarantees of financial institutions can exacerbate moral hazard in bond markets and weaken market discipline.