Money Matters
Wall Street vs. Main Street QE
Eric Sims & Jing Cynthia Wu
NBER Working Paper, June 2020
Abstract:
The Federal Reserve has reacted swiftly to the COVID-19 pandemic. It has resuscitated many of its programs from the last crisis by lending to the financial sector, which we refer to as "Wall Street QE." The Fed is now proposing to also lend directly to, and purchase debt directly from, non-financial firms, which we label "Main Street QE." Our paper develops a new framework to compare and contrast these different policies. In a situation in which financial intermediary balance sheets are impaired, such as the Great Recession, Main Street and Wall Street QE are perfect substitutes and both stimulate aggregate demand. In contrast, for situations like the one we are now facing due to COVID-19, where the production sector is facing significant cash flow shortages, Wall Street QE becomes almost completely ineffective, whereas Main Street QE can be highly stimulative.
Did Banks Pay 'Fair' Return to Taxpayers on TARP?
Thomas Flanagan & Amiyatosh Purnanandam
University of Michigan Working Paper, May 2020
Abstract:
Financial institutions received billions of dollars from the U.S. Treasury in the form of preferred equity under the Troubled Asset Relief Program (TARP) in 2008. Investments were made during a bad state, but the repayments came in a relatively good time. Comparing TARP's realized returns to private market securities with similar or lower risk over the same time period, we show that the recipients paid considerably lower returns to the taxpayers than the benchmarks. The subsidy, defined as the difference in return between the benchmark and TARP investment, was especially high for riskier and larger banks. The ex-post renegotiation of TARP contract terms contributed to the subsidy. Banks that aggressively renegotiated their contracts paid much higher levels of dividends and CEO compensation soon after the repayment. Our study does not evaluate the net social benefit of TARP, rather it highlights an important cost which should be a key input in that evaluation.
Searching for Approval
Sumit Agarwal et al.
NBER Working Paper, June 2020
Abstract:
We study the interaction of search and application approval in credit markets. We combine a unique dataset, which details search behavior for a large sample of mortgage borrowers, with loan application and rejection decisions. Our data reveal substantial dispersion in mortgage rates and search intensity, conditional on observables. However, in contrast to predictions of standard search models, we find a novel non-monotonic relationship between search and realized prices: borrowers, who search a lot, obtain more expensive mortgages than borrowers' with less frequent search. The evidence suggests that this occurs because lenders screen borrowers' creditworthiness, rejecting unworthy borrowers, which differentiates consumer credit markets from other search markets. Based on these insights, we build a model that combines search and screening in presence of asymmetric information. Risky borrowers internalize the probability that their application is rejected, and behave as if they had higher search costs. The model rationalizes the relationship between search, interest rates, defaults, and application rejections, and highlights the tight link between credit standards and pricing. We estimate the parameters of the model and study several counterfactuals. The model suggests that "overpayment" may be a poor proxy for consumer unsophistication since it partly represents rational search in presence of rejections. Moreover, the development of improved screening technologies from AI and big data (i.e., fintech lending) could endogenously lead to more severe adverse selection in credit markets. Finally, place based policies, such as the Community Reinvestment Act, may affect equilibrium prices through endogenous search responses rather than increased credit risk.
The Fed's Response to Economic News Explains the "Fed Information Effect"
Michael Bauer & Eric Swanson
NBER Working Paper, April 2020
Abstract:
High-frequency changes in interest rates around FOMC announcements are a standard method of measuring monetary policy shocks. However, some recent studies have documented puzzling effects of these shocks on private-sector forecasts of GDP, unemployment, or inflation that are opposite in sign to what standard macroeconomic models would predict. This evidence has been viewed as supportive of a "Fed information effect" channel of monetary policy, whereby an FOMC tightening (easing) communicates that the economy is stronger (weaker) than the public had expected. We show that these empirical results are also consistent with a "Fed response to news" channel, in which incoming, publicly available economic news causes both the Fed to change monetary policy and the private sector to revise its forecasts. We provide substantial new evidence that distinguishes between these two channels and strongly favors the latter; for example, (i) high-frequency stock market responses to Fed announcements, (ii) a new survey that we conduct of individual Blue Chip forecasters, and (iii) regressions that include the previously omitted public macroeconomic data releases all indicate that the Fed and Blue Chip forecasters are simply responding to the same public news, and that there is little if any role for a "Fed information effect".
Bank Market Power and Monetary Policy Transmission: Evidence from a Structural Estimation
Yifei Wang et al.
NBER Working Paper, May 2020
Abstract:
We quantify the impact of bank market power on monetary policy transmission through banks to borrowers. We estimate a dynamic banking model in which monetary policy affects imperfectly competitive banks' funding costs. Banks optimize the pass-through of these costs to borrowers and depositors, while facing capital and reserve regulation. We find that bank market power explains much of the transmission of monetary policy to borrowers, with an effect comparable to that of bank capital regulation. When the federal funds rate falls below 0.9%, market power interacts with bank capital regulation to produce a reversal of the effect of monetary policy.
Can Strong Creditors Inhibit Entrepreneurial Activity?
Nuri Ersahin, Rustom Irani & Katherine Waldock
Review of Financial Studies, forthcoming
Abstract:
We examine entrepreneurial activity following the staggered adoption of modern-day fraudulent transfer laws in the United States. These laws strengthen unsecured creditors' rights and are particularly important for entrepreneurs whose personal assets commingle with the firm's. Using administrative data from the U.S. Census Bureau, we document declines in startup entry - particularly among riskier entrants - and closures of existing firms after these laws pass. Firm financial data shows that entrepreneurs lower leverage by reducing demand for unsecured credit. Our results suggest that strong creditor protections can limit entrepreneurs' appetite for risk, which may reduce churning along the extensive margin among the smallest firms in the economy.
Product Market Peers in Lending
Gus De Franco, Alexander Edwards & Scott Liao
Management Science, forthcoming
Abstract:
This study examines how product market peers affect lending relationships. We contend that firms are more likely to borrow from a bank that has previously lent to a peer to mitigate information asymmetry with the bank when potential information processing efficiencies are greater (i.e., information efficiency hypothesis), but there will be a decreased propensity to borrow from a shared lender when the costs of leaking proprietary information are greater (i.e., proprietary information leakage hypothesis). We find that, after bank mergers that involve peers' lenders, firms are more likely to switch banks to avoid sharing the same lenders as a product market peer. In cross-sectional analyses, we find that after bank mergers that involve a peer's bank, firms are less likely to switch when the firm's financial reporting is more opaque and has greater monitoring needs, consistent with the information efficiency hypothesis. In contrast, firms are more likely to switch after bank mergers that involve a peer's bank when the firm belongs to an industry with greater proprietary costs and when the bank has greater incentives to leak information, consistent with the proprietary cost hypothesis.
Observing Enforcement: Evidence from Banking
Anya Kleymenova & Rimmy Tomy
University of Chicago Working Paper, April 2020
Abstract:
We find that the public disclosure of regulators' supervisory actions changes their enforcement behavior. Using the setting of the 1989 Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA), which required public disclosure of enforcement actions and orders (EDOs), and a novel sample of EDOs, we find that after the disclosure-regime change, U.S. banking regulators issue more EDOs, intervene sooner, and rely more on publicly observable signals. The content of EDOs also changes, with documents becoming more complex and boilerplate. Taken together, our results suggest regulators respond to the increased public scrutiny of their actions. We demonstrate the disclosure of EDOs affects regulators' behavior over and above other changes that occurred around FIRREA. Finally, we assess the impact of the regime change on bank outcomes and find a decline in deposits and acceleration of bank failure, despite improvements in banks' capital ratios.
Does Temporary Mortgage Assistance for Unemployed Homeowners Reduce Longer Term Mortgage Default? An Analysis of the Hardest Hit Fund Program
Stephanie Moulton et al.
Ohio State University Working Paper, March 2020
Abstract:
The substantial costs of foreclosures to individuals and society motivated nearly $40 billion in government subsidies to homeowners during the Great Recession. Most of these subsidies were in the form of permanent loan modifications with mixed evidence of effectiveness. This paper estimates the loan outcomes of an alternative form of mortgage subsidy that provided unemployed homeowners with temporary mortgage payment assistance, through the U.S. Department of Treasury's Hardest Hit Fund (HHF). Our primary empirical strategy exploits the fact that some states were not eligible to offer an HHF program and that certain Metropolitan Statistical Areas (MSAs) encompass jurisdictions in both HHF and non-HHF states. We match HHF-assisted homeowners to otherwise similar non-assisted homeowners who lived in the same MSA but were not eligible for HHF assistance because they lived in a non-HHF state. By 48 months after the start of assistance, receipt of HHF is associated with a 28 percentage point reduction in the probability of default, which is a 49 percent reduction in the average default rate of 57 percent. In support of the liquidity hypothesis, we find that the HHF effect is not driven by a reduction in mortgage balance, which only occurs for about 10 percent of HHF borrowers. Further, the effect is larger for borrowers who were underwater on their mortgages at the time of assistance.
Speculators and Middlemen: The Strategy and Performance of Investors in the Housing Market
Patrick Bayer et al.
Review of Financial Studies, forthcoming
Abstract:
Using data from the Los Angeles area from 1988 to 2012, we study the behavior and sources of returns of individual investors in the housing market. We document the existence of two distinct investor types. The first act as middlemen, purchasing substantially below and reselling above market prices throughout the cycle, improving liquidity and the existing capital stock in the process. The second act as speculators, who primarily enter during the boom, buying and selling at essentially market prices. Neither type anticipated the housing bust. We document similar behavior by speculators and middlemen in 96 other U.S. metro areas.
Dream Chasers: The Draw and the Downside of Following House Price Signals
Taylor Begley, Peter Haslag & Daniel Weagley
Vanderbilt University Working Paper, April 2020
Abstract:
We study individual labor market decisions during the house price run-up of the early 2000s using the career paths of nearly 7 million workers. We find that individuals switch careers to become real estate agents (REAs) at higher rates in areas with stronger house price growth, despite little or no growth in average REA wages. We find that those drawn into real estate come from virtually all parts of the skill, wage, and education spectrums, and respond to both fundamental and non-fundamental house price growth. Examining wages, we find that those drawn into REA near the peak of the run-up experienced substantially lower wage paths than similar non-entrants through the end of our sample in 2017. These effects are particularly severe for entrants in areas with higher non-fundamental growth. Overall, we shed light on some important consequences of house price fluctuations, both fundamental and non-fundamental, on labor market outcomes.