Essays on Financial Contracting and Asymmetric Information.

Abstract

This dissertation comprises three essays on financial contracting and intermediation under information asymmetry. They examine both some of the asymmetric information problems that contracts can mitigate as well as some of the distortions they can cause. The first essay examines real investment distortions that occur as a result of information intermediation through credit ratings. Credit Rating Agencies emphasize the importance of Debt/EBITDA ratio thresholds in their rating process. I show that firms near these salient thresholds respond to the incentive to improve their appearance on this dimension by distorting R&D and SG&A investment activities during periods leading up to bond issuance. Subsequently, these firms are more likely to experience declines in innovation output, profitability, and Tobin’s Q than observationally similar firms not near a threshold. These distortions highlight at important cost of transparency in corporate credit rating criteria.

The second essay examines how high-quality borrowers use the design of performance-sensitive bank debt contracts to alleviate financial constraints. I show that borrowers use a convex pricing grid (i.e., a contract where the increase in the loan spread following a decline in performance exceeds the decrease in the spread following a performance improvement) to signal their unobservable creditworthiness. I find that these borrowers receive loans that are 21-28% larger with a spread that is 31-37 basis points lower than observationally similar borrowers who use fixed-spread loans. Consistent with the notion that a costly signal should positively correlate with future financial health, signaling borrowers are one third less likely to experience financial distress during the term of their loans.

The third essay examines the role of security design in mitigating informational frictions in securitization markets. We show that residential mortgage-backed security deals with a higher level of equity tranche have a significantly lower foreclosure rate that cannot be explained away by the underlying loan pool's observable credit risk factors. The effect is concentrated within pools with a higher likelihood of asymmetric information between deal sponsors and potential buyers of the securities. Further, securities that are sold from high-equity-tranche deals command higher prices conditional on their credit ratings.