Corporate Finance.

• Author: Rajan, Raghuram G.
• Position: Program Report - Company overview

The NBER's Program on Corporate Finance was founded in 1991, and has initiated some very promising avenues of research since then. Narrowly interpreted, corporate finance is the study of the investment and financing policies of corporations. Because firms are at the center of economic activity, and almost any topic of concern to economists--from microeconomic issues like incentives and risk sharing to macroeconomic issues such as currency crises--affects corporate financing and investment, it is however increasingly difficult to draw precise boundaries around the field.

The range of subjects that Corporate Finance Program members have addressed in their research reflects this broad scope. Rather than offering a broad brush survey of all the work currently being done, however, I thought it would be most useful to focus on what our researchers have contributed to the analysis of the ongoing financial crisis. Even here, I have had to be selective, given the large number of papers on this subject in the last two years. I should also note that even prior to the crisis, Corporate Finance Program members had done important work on such topics as credit booms, illiquidity, bank runs, and credit crunches. This work laid much of the foundation for the more recent analyses. In the interests of space, though, I will not survey that earlier work.

A number of papers offer an overview of the crisis (Brunnermeier, 14612; Diamond and Rajan, 14739; Gorton, 14398). There is some consensus on its proximate causes: 1) the U.S. financial sector financed low-income borrowers who wanted to buy houses, and it raised money for such lending through the issuance of exotic new financial instruments; 2) banks seemed very willing to take risks during this time, and a significant portion of these instruments found their way, directly or indirectly, into commercial and investment bank balance sheets; 3) these investments were largely financed with short-term debt. But what were the more fundamental reasons for these proximate causes?

Why Low Income Borrowers?

Atif Mian and Amir Sufi (13936) offer persuasive evidence that it was an increase in the supply of finance to low-income borrowers--not an improvement in the credit quality of those borrowers--that drove lending, appreciation of house prices, and subsequent mortgage defaults. They argue that zip codes with high unmet demand for credit in the mid-1990s (typically dominated by low-income potential borrowers) experienced large increases in lending from 2001 to 2005. These increases occurred even though these zip codes experienced significantly negative relative income and employment growth over this time period, suggesting that improvements in demand did not drive lending. The increase in the supply of credit seemed to be associated with a sharp relative increase in the fraction of loans from these zip codes sold by originators for securitization. The increase in the supply of credit from 2001 to 2005 led to subsequent large increases in mortgage defaults from 2005 to 2007. Mian and Sufi conclude that originators selling mortgages were a main cause of the U.S. mortgage default crisis.

Why did supply increase? One possibility is that financial innovation--the process of securitization which spread risk--enabled the financial sector to lend to risky borrowers who previously were rationed. The reality, though, is that deep flaws in the process of securitization seem to have compromised quality. Efraim Benmelech and Jennifer Dlugosz (14878, 15045) offer some evidence on the extent to which low quality mortgage packages were transformed into highly rated securities. They suggest that "ratings shopping" by some issuers of mortgage backed securities (which refers to the process by which an issuer finds the rating agency that will offer the most favorable rating), as well as a fall in standards at some rating agencies, must have played a role in the deterioration in quality. Vasiliki Skreta and Laura Veldkamp (14761) argue that for complex products, where rating agencies could have produced a greater dispersion in ratings even if totally unbiased, the incentive for the issuer to shop for the highest rating may have been higher, and therefore the inherent bias in published ratings larger. It would be interesting to see whether ratings shopping by issuers could come close to accounting for the size of the errors that were made.

Another possibility is raised by Charles Calomiris (15403) and Mian and Sufi (13936), all of whom argue that government pressure to expand housing to low-income segments, and government involvement through the Federal Housing Authority and mandates to Fannie Mae and Freddie Mac, may have caused the explosion in supply.

The effects of both flawed financial innovation and undue government pressure to lend may have been aggravated by household behavior. For instance, Mian and Sufi (15283) document the...