There are three prevailing theories of mortgage default: strategic default (driven by negative equity), cash flow default (driven by negative life events), and double-trigger default (where both negative triggers are necessary). It has been difficult to compare these theories in part because negative life events are measured with error. We address this measurement error using a comparison group of borrowers with no strategic-default motive. Our central finding is that only 6% of underwater defaults are caused exclusively by negative equity, an order of magnitude lower than previously thought. We then analyze the remaining defaults. We find that 70% are driven solely by negative life events (i.e., cash flow defaults), while 24% are driven by the interaction between negative life events and negative equity (i.e., double-trigger defaults). Together, the results provide a full decomposition of the theories underlying borrower default and suggest that negative life events play a central role. JEL Codes: G21, G51, G41.

For many years, scholars and investment professionals have argued that value strategies outperform the market. These value strategies call for buying stocks that have low prices relative to earnings, dividends, book assets, or other measures of fundamental value. While there is some agreement that value strategies produce higher returns, the interpretation of why they do so is more controversial. This article provides evidence that value strategies yield higher returns because these strategies exploit the suboptimal behavior of the typical investor and not because these strategies are fundamentally riskier. FOR MANY YEARS, SCHOLARS and investment professionals have argued that value strategies outperform the market (Graham and Dodd (1934) and Dreman (1977)). These value strategies call for buying stocks that have low prices relative to earnings, dividends, historical prices, book assets, or other measures of value. In recent years, value strategies have attracted academic attention as well. Basu (1977), Jaffe, Keim, and Westerfield (1989), Chan, Hamao, and Lakonishok (1991), and Fama and French (1992) show that stocks with high earnings/price ratios earn higher returns. De Bondt and Thaler (1985, 1987) argue that extreme losers outperform the market over the subsequent several years. Despite considerable criticism (Chan (1988) and Ball and Kothari (1989)), their analysis has generally stood up to the tests (Chopra, Lakonishok, and Ritter (1992)). Rosenberg, Reid, and Lanstein (1984) show that stocks with high book relative to market values of equity outperform the market. Further work (Chan, Hamao, and Lakonishok (1991) * Lakonishok is from the University of Illinois, Shleifer is from Harvard University, and Vishny is from the University of Chicago. We are indebted to Gil Beebower, Fischer Black, Stephen Brown, K. C. Chan, Louis Chan, Eugene Fama, Kenneth French, Bob Haugen, Jay Ritter, Ren6 Stulz, and two anonymous referees for helpful comments and to Han Qu for outstanding research assistance. This article has been presented at the Berkeley Program in Finance, University of California (Berkeley), the Center for Research in Securities Prices Conference, the University of Chicago, the University of Illinois, the Massachusetts Institute of Technology, the National Bureau of Economic Research (Asset Pricing and Behavioral Finance Groups), New York University, Pensions and Investments Conference, the Institute for Quantitative Research in Finance (United States and Europe), Society of Quantitative Analysts, Stanford University, the University of Toronto, and Tel Aviv University. The research was supported by the National Science Foundation, Bradley Foundation, Russell Sage Foundation, the National Bureau of Economic Research Asset Management Research Advisory Group, and the National Center for Supercomputing Applications, University of Illinois.

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Previous articleNext article No AccessThe Past, Present, and Future of Economics: A Celebration of the 125-Year Anniversary of the JPE and of Chicago EconomicsCorporate FinanceRobert Vishny and Luigi ZingalesRobert VishnyUniversity of Chicago Search for more articles by this author and Luigi ZingalesUniversity of Chicago Search for more articles by this author PDFPDF PLUSFull Text Add to favoritesDownload CitationTrack CitationsPermissionsReprints Share onFacebookTwitterLinkedInRedditEmail SectionsMoreDetailsFiguresReferencesCited by Journal of Political Economy Volume 125, Number 6December 2017 Article DOIhttps://doi.org/10.1086/694643 Views: 3943Total views on this site Citations: 3Citations are reported from Crossref © 2017 by The University of Chicago. All rights reserved.PDF download Crossref reports the following articles citing this article:Chih‐Chun Chen, Chun‐Da Chen, Donald Lien Financial distress prediction model: The effects of corporate governance indicators, Journal of Forecasting 39, no.88 (Apr 2020): 1238–1252.https://doi.org/10.1002/for.2684Andreas Charitou, Irene Karamanou, George Loizides Intention to Acquire and M&As: Evidence from European IPOs, The International Journal of Accounting 46 (Jul 2020): 2050007.https://doi.org/10.1142/S1094406020500079Andreas Charitou, Irene Karamanou, George Loizides Intention to Acquire and M&As: Evidence from European IPOs, SSRN Electronic Journal (Jan 2018).https://doi.org/10.2139/ssrn.3302684

We examine the business model of traditional commercial banks in the context of their co-existence with shadow banks. While both types of intermediaries create safe 'money-like' claims, they go about this in very different ways. Traditional banks create safe claims with a combination of costly equity capital and fixed income assets that allows their depositors to remain 'sleepy': they do not have to pay attention to transient fluctuations in the mark-to-market value of bank assets. In contrast, shadow banks create safe claims by giving their investors an early exit option that allows them to seize collateral and liquidate it at the first sign of trouble. Thus traditional banks have a stable source of cheap funding, while shadow banks are subject to runs and fire-sale losses. These different funding models in turn influence the kinds of assets that traditional banks and shadow banks hold in equilibrium: traditional banks have a comparative advantage at holding fixed-income assets that have only modest fundamental risk, but are relatively illiquid and have substantial transitory price volatility.

We present a new model of money management, in which investors delegate portfolio management to professionals based not only on performance, but also on trust. Trust in the manager reduces an investor’s perception of the riskiness of a given investment, and allows managers to charge higher fees to investors who trust them more. Money managers compete for investor funds by setting their fees, but because of trust the fees do not fall to costs. In the model, 1) managers consistently underperform the market net of fees but investors still prefer to delegate money management to taking risk on their own, 2) fees involve sharing of expected returns between managers and investors, with higher fees in riskier products, 3) managers pander to investors when investors exhibit biases in their beliefs, and do not correct misperceptions, and 4) despite long run benefits from better performance, the profits from pandering to trusting investors discourage managers from pursuing contrarian strategies relative to the case with no trust. We show how trust-mediated money management renders arbitrage less effective, and may help destabilize financial markets.

We model a financial market in which investor beliefs are shaped by representativeness. Investors overreact to a series of good news, because such a series is representative of a good state. A few bad news do not change investor minds because the good state is still representative, but enough bad news leads to a radical change in beliefs and a financial crisis. The model generates debt over-issuance, “this time is different” beliefs, neglect of tail risks, under- and over-reaction to information, boom-bust cycles, and excess volatility of prices in a unified psychological model of expectations.

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ABSTRACTWe present a model of shadow banking in which banks originate and trade loans, assemble them into diversified portfolios, and finance these portfolios externally with riskless debt. In this model: outside investor wealth drives the demand for riskless debt and indirectly for securitization, bank assets and leverage move together, banks become interconnected through markets, and banks increase their exposure to systematic risk as they reduce idiosyncratic risk through diversification. The shadow banking system is stable and welfare improving under rational expectations, but vulnerable to crises and liquidity dry‐ups when investors neglect tail risks.

We introduce the model of asset management developed in Gennaioli, Shleifer, and Vishny (2012) into a Solow-style neoclassical growth model with diminishing returns to capital.Savers rely on trusted intermediaries to manage their wealth (claims on capital stock), who can charge fees above costs to trusting investors.In this model, the size of the financial sector rises with aggregate wealth, and wealth grows relative to GDP.As a consequence, the ratio of financial income to GDP rises over time, even though fees for given financial services decline.Because the size of the financial sector fluctuates with changes in investor trust, the model can account for the sharp decline of finance in the Great Depression, as well as its slow recovery afterwards.Entry by financial intermediaries as wealth increased in recent years may have further deepened investor trust and encouraged growth of financial income.

We present a standard model of financial innovation, in which intermediaries engineer securities with cash flows that investors seek, but modify two assumptions. First, investors (and possibly intermediaries) neglect certain unlikely risks. Second, investors demand securities with safe cash flows. Financial intermediaries cater to these preferences and beliefs by engineering securities perceived to be safe but exposed to neglected risks. Because the risks are neglected, security issuance is excessive. As investors eventually recognize these risks, they fly back to the safety of traditional securities and markets become fragile, even without leverage, precisely because the volume of new claims is excessive.

US state chartered commercial banks are supervised alternately by state and federal regulators. Each regulator supervises a given bank for a fixed time period according to a predetermined rotation schedule. We examine differences between federal and state regulators for these banks. Federal regulators are significantly less lenient, downgrading supervisory ratings about twice as frequently as state supervisors. Under federal regulators, banks report higher nonperforming loans, more delinquent loans, higher regulatory capital ratios, and lower ROA. There is a higher frequency of bank failures and problem-bank rates in states with more lenient supervision relative to the federal benchmark. Some states are more lenient than others. Regulatory capture by industry constituents and supervisory staff characteristics can explain some of these differences. These findings suggest that inconsistent oversight can hamper the effectiveness of regulation by delaying corrective actions and by inducing costly variability in operations of regulated entities. Sumit Agarwal Federal Reserve Bank of Chicago 230 South LaSalle Street Chicago, IL 60604 ushakri@yahoo.com David Lucca Federal Reserve Bank of New York 33 Liberty Street New York, NY 10045 david.lucca@ny.frb.org Amit Seru Booth School of Business University of Chicago 5807 South Woodlawn Avenue Chicago, IL 60637 and NBER amit.seru@chicagobooth.edu Francesco Trebbi University of British Columbia 1873 East Mall Vancouver, BC, V6T1Z1 Canada and NBER ftrebbi@mail.ubc.ca

We present a new model of money management, in which investors delegate portfolio management to professionals based not only on performance, but also on trust. Trust in the manager reduces an investor‟s perception of the riskiness of a given investment, and allows managers to charge higher fees to investors who trust them more. Money managers compete for investor funds by setting their fees, but because of trust the fees do not fall to costs. In the model, 1) managers consistently underperform the market net of fees but investors still prefer to delegate money management to taking risk on their own, 2) fees involve sharing of expected returns between managers and investors, with higher fees in riskier products, 3) managers pander to investors when investors exhibit biases in their beliefs, and do not correct misperceptions, and 4) despite long run benefits from better performance, the profits from pandering to trusting investors discourage managers from pursuing contrarian strategies relative to the case with no trust. We show how trust-mediated money management renders arbitrage less effective, and may help destabilize financial markets. 1 The authors are from CREI and UPF, Harvard University, and University of Chicago, respectively. We are grateful to Charles Angelucci, Nick Barberis, John Campbell, Roman Inderst, Sendhil Mullainathan, Lubos Pastor, Raghuram Rajan, Jonathan Reuter, Josh Schwartzstein, Charles-Henri Weymuller, Luigi Zingales and Yanos Zylberberg for extremely helpful comments. Disclosure: Shleifer was a co-founder of LSV Asset Management, a money management firm, but is no longer a shareholder in the firm. Shleifer‟s wife is a partner in a hedge fund, Bracebridge Capital. Vishny was a co-founder of LSV Asset Management. He retains an ownership interest.

We present a model of shadow banking in which financial intermediaries originate and trade loans, assemble these loans into diversified portfolios, and then finance these portfolios externally with riskless debt. In this model: i) outside investor wealth drives the demand for riskless debt and indirectly for securitization, ii) intermediary assets and leverage move together as in Adrian and Shin (2010), and iii) intermediaries increase their exposure to systematic risk as they reduce their idiosyncratic risk through diversification, as in Acharya, Schnabl, and Suarez (2010). Under rational expectations, the shadow banking system is stable and improves welfare. When investors and intermediaries neglect tail risks, however, the expansion of risky lending and the concentration of risks in the intermediaries create financial fragility and fluctuations in liquidity over time. Nicola Gennaioli CREI Universitat Pompeu Fabra Ramon Trias Fargas 25-27 08005 Barcelona (Spain) ngennaioli@crei.cat Andrei Shleifer Department of Economics Harvard University Littauer Center M-9 Cambridge, MA 02138 and NBER ashleifer@harvard.edu Robert W. Vishny Booth School of Business The University of Chicago 5807 South Woodlawn Avenue Chicago, IL 60637 and NBER Rvishny@gmail.com