Anand M. Goel

Green with Envy: Implications for Corporate Investment Distortions

We model agents whose preferences exhibit envy. An envious agents utility increases with what he has and decreases with what others have. With this setup, we are able to provide a new perspective on the nature of investment distortions with centralized and decentralized capital budgeting systems. Centralized capital budgeting leads to corporate socialism in investments in multidivisional firms, whereas decentralized capital budgeting leads to overinvestment. Numerous additional testable predictions are also generated.

Rationality, Overconfidence and Leadership

This paper examines the process by which individuals get selected to be leaders and the attributes of leaders. It develops a model in which managers of a priori unknown ability are being judged relative to each other to determine who should be appointed the leader of the group. Managers are making unobservable choices about the payoff distributions of the projects they manage, and their abilities are being (noisily) inferred ex post from observed project outcomes. We have three main results. First, all managers choose higher levels of project risks when they are competing for leadership. Second, an overconfident manager - one who underestimates his project risk - has a higher probability of being chosen as the leader than an otherwise identical rational manager. Third, an overconfident leader may be better for the firms shareholders than a rational leader. Numerous implications of the analysis for real-world leadership behavior, new product development, relation of risk-taking to firm size and organization culture are discussed.

Optimal Contracts When Agents Envy Each Other

We examine the characteristics of endogenously-determined optimal incentive contracts for agents who envy each other and work for a risk-neutral (non-envious) principal. Envy makes each agent care not only about absolute consumption but also about relative consumption. Incentive contracts in this setting display properties strikingly different from those associated with optimal contracts in standard principal-agent theory. We derive results that help explain some of the discrepancies between the predictions of principal-agent theory and the stylized facts about real-world contracts.

Why Are Credit Ratings Coarse

An enduring puzzle is why credit ratings are coarse indicators of issuer credit quality, with a relatively small number of ratings categories being used to describe credit qualities that lie in a continuum. We develop a theoretical model to explain why ratings are coarse even though coarseness reduces welfare. We model the ratings-determination process as a cheap-talk game in which there is a divergence between the goals of issuing firms and those of investors, and the rating agencys objective gives positive weight to both goals. We show that the rating agency is willing to inflate ratings, but wishes to keep the rating inflation below a threshold bias. Consequently, it prefers an unbiased rating to a rating inflated by an amount exceeding the threshold bias. Coarse ratings arise as an equilibrium phenomenon due to the effects of these forces. The coarseness of ratings means that rating inflation, if it were to exist, would have to exceed the threshold bias, so ratings exhibit no bias/inflation in equilibrium, and legal liability to eliminate bias is unnecessary. Moreover, competition among rating agencies does not necessarily reduce ratings coarseness. We also examine welfare implications of regulatory initiatives involving ratings.

Resource Allocation in Conglomerates under Moral Hazard

This paper investigates the resource allocation decision in conglomerates under moral hazard. We consider a firm where the input factors are unknown managerial ability that is common to all divisions, capital allocated to each division, and intangible resources that the manager allocates to each division. While capital allocation across divisions is fully observable, the allocation of intangible resources is only partially observable. The divisions differ in how informative of their cash flows are about managerial ability. The manager maximizes perceived ability. In this set up, we show that divisions with more informative cash flows about the managers ability receive more than the first-best allocation of both capital and intangible resources. This allocation inefficiency results in conglomerates being valued less than a portfolio of single-segment firms. The paper shows that the diversification discount increases with the variance of informativeness, and the correlation, between the divisions. The discount decreases as the observability of the intangible resource allocation improves. The model also highlights a cost of segment reporting, namely, that it creates avenues for managers to distort their perceived ability at the expense of shareholders.

The Problem of Hindsight Bias in Fraudulent Conveyance Cases: A Review of Possible “Market-Based” Solutions

Abstract Purpose In fraudulent conveyance cases, plaintiffs allege that by entering into a complex leverage transaction, such as an LBO, a firm’s former owners ensured its subsequent collapse. Proving that the transaction rendered the firm insolvent may allow debtors (or their proxies) to claw back transfers made to former shareholders and others as part of the transaction. Courts have recently questioned the robustness of the solvency evidence traditionally provided in such cases, claiming that traditional expert analyses (e.g., a discounted flow analysis) may suffer from hindsight (and other forms of) bias, and thus not reflect an accurate view of the firm’s insolvency prospects at the time of the challenged transfers. To address the issue, courts have recently suggested that experts should consider market evidence, such as the firm’s stock, bond, or credit default swap prices at the time of the challenged transaction. We review market-evidence-based approaches for determination of solvency in fraudulent conveyance cases. Methodology/approach We compare different methods of solvency determination that rely on market data. We discuss the pros and cons of these methods and illustrate the use of credit default swap spreads with a numerical example. Finally, we highlight the limitations of these methods. Findings If securities trade in efficient markets in which security prices quickly impound all available information, then such security prices provide an objective assessment of investors’ views of the firm’s future insolvency prospects at the time of challenged transfer, given contemporaneously available information. As we explain, using market data to analyze fraudulent conveyance claims or assess a firm’s solvency prospects is not as straightforward as some courts argue. To do so, an expert must first pick a particular credit risk model from a host of choices which links the market evidence (or security price) to the likelihood of future default. Then, to implement his chosen model, the expert must estimate various parameter input values at the time of the alleged fraudulent transfer. In this connection, it is important to note that each credit risk model rests on particular assumptions, and there are typically several ways in which a model’s key parameters may be empirically estimated. Such choices critically affect any conclusion about a firm’s future default prospects as of the date of an alleged fraudulent conveyance. Practical implications Simply using market evidence does not necessarily eliminate the question of bias in any analysis. The reliability of a plaintiff’s claims regarding fraudulent conveyance will depend on the reasonableness of the analysis used to tie the observed market evidence at the time of the alleged fraudulent transfer to default prospects of the firm. Originality/value There is a large body of literature in financial economics that examines the relationship between market data and the prospects of a firm’s future default. However, there is surprisingly little research tying that literature to the analysis of fraudulent conveyance claims. Our paper, in part, attempts to do so. We show that while market-based methods use the information contained in market prices, this information must be supplemented with assumptions and the conclusions of these methods critically depend on the assumption made.

Small-Dollar Installment Loans: An Empirical Analysis

Small-dollar credit is a form of unsecured consumer credit primarily characterized by the low dollar amounts of loans. There has been increasing debate about the benefit and harm to consumers from small-dollar loans, along with recent discussion of greater regulation. Determining the need for and appropriate form of regulation requires an understanding of the current state of the small-dollar credit industry based on actual industry data. One significant change is the shift from single-payment payday loans to multiple-payment loans or installment loans. This paper is the first systematic study of small-dollar installment loans.Our main findings are as follows. A typical installment loan is for

Irrationality, Asset Pricing, and Financial Intermediaries

900 and is scheduled to be repaid in 12 biweekly installments over six months. Less than a quarter of borrowers take another loan within 14 days of ending a previous loan. Most borrowers do not keep their loan until maturity. Even repeat borrowers generally either pay off the loan or have it charged off before the maturity date of their original loan. Those who borrow repeatedly are more likely to repay their loans on average and are offered lower interest rates, indicating that at least some of these repeat borrowers are utilizing the opportunity to borrow again based on their past track record of payments. Payment-to-income ratio alone is a poor metric for predicting whether the loan will be paid off or not. Regulation imposing an upper limit on payment-to-income ratio is likely to result in reduced access to credit for a large majority of current borrowers, without a large improvement in loan payoff rates. A payment-to-income limit of 5% would reduce the volume of credit between 55.1% and 92.6%. It would only increase the loan payoff rate by 0.7% (from 72.9% to 73.6%). A payment-to-income limit of 10% will result in reduction of credit between 26.5% and 67.8% without any increase in loan payoff rate.A regulation that prohibits lending based on simple affordability criteria risks substantial reductions in credit availability to a population that often has few available alternatives. A cost-benefit analysis of the proposed regulation requires weighing the cost of reduced access to a financially underserved segment of the population against the benefit of a higher loan payoff rate and lower incidence of indebtedness. Limiting the payment-to-income ratio to 5% would benefit fewer than 1% of borrowers by reducing the incidence of loans that are not paid off, but it would impose costs on 86% of current borrowers, who could not be offered the same credit on the same terms that they now obtain. Raising the permitted ratio can reduce these costs, but it also reduces the benefits, because payment-to-income ratio alone is poor predictor of the likelihood of repayment.

Overconfidence, CEO Selection, and Corporate Governance

We model irrational investors who can impact prices to cause predictability in returns and rational investors who are wealth-constrained in their attempts to arbitrage mispricing. We show that rational investors relax wealth constraints by forming financial intermediaries which leverage the wealth of the irrational investors. Surprisingly, financial intermediation is facilitated by the learning ability of irrational investors. Irrational investors attribute the superior trading profits of rational investors to superior information. They delegate the intermediary to invest on their behalf because they think it has better information, even though the source of its trading profits is its rationality. This helps the intermediary mitigate the predictability in prices the irrational investors create in the first place, despite the fact that it possesses no informational advantage over anybody. The intermediary does not eliminate equilibrium mispricing because it strategically limits the size of its funds to maximize its profit. A large financial intermediary is shown to be more profitable than multiple small intermediaries. Empirical implications are drawn about the profitability of intermediaries, predictability in prices, and wealth transfers between rational and irrational investors.