Joshua Mitts

How Quickly Do Markets Learn? Private Information Dissemination in a Natural Experiment

Using data from a unique episode in which the SEC disseminated securities filings to a small group of private investors before releasing them to the public, we provide a direct test of the process through which private information is impounded into stock prices. Because the delay between the time when the filings were privately distributed and when the filings were made public was randomly distributed, our setting provides a rare natural experiment for examining how markets process new private information. We find that it takes minutes — not seconds — for informed traders to incorporate fundamental information into stock prices. We also show that the private investors who had early access to fundamental information profited more, and convey more information into stock prices, when the delay before the filings are released to the public is longer. More importantly, the rate at which information is impounded into stock prices is more correlated with the length of the predicted delay before public release than the actual delay, suggesting that informed investors trade strategically. Our study serves as the modern counterpart to Koudijs’s (2014a) study on insider trading on eighteenth-century stock exchanges — except, in our case, week-long sailing voyages have been replaced by modern electronic transmission as the conduit for information flows.This study takes advantage of a unique episode in which the SEC distributed securities filings to a small group of investors ahead of their public releases. The random delay time provides a rare natural experiment for examining how markets process new private information. It takes minutes – not seconds – for informed traders to incorporate fundamental information into stock prices. The early-informed convey more information into stock prices when the delay before public release is longer. More importantly, the rate at which information is impounded into prices is more correlated with the length of the predicted delay than with the actual delay.

Three Proposals for Regulating the Distribution of Home Equity

The CFPB’s recently released “qualified mortgage” rules effectively discourage predatory lending but miss an equally important source of systemic risk: low-equity clustering. Specific “volatility inducing” mortgage terms when present in a substantial cluster of mortgage contracts exacerbate macroeconomic risk by increasing the chance that the housing and lending markets will have to absorb a wave of simultaneous defaults after a downturn in housing prices. We show that these terms became prevalent in a substantial proportion of residential mortgages in the years leading up to the home mortgage crisis. In contrast, during the earlier “amortization era” (when mortgagors were more likely to borrow at different times, with more substantial down payments, and more continual rates of amortization, without a need to refinance), an equally sized negative shock to housing prices would likely produce less negative equity, to a smaller set of borrowers. Instead of prohibiting the volatility-inducing terms, we propose three policies to better assure a greater diversification in the distribution of equity: (a) a modified home-mortgage interest deduction; (b) a modified “qualified residential mortgages” standard; and most importantly, (c) direct macroprudential regulation through a “cap-and-trade” system of leverage licenses and instituting varying degrees of “conforming mortgages” for Fannie Mae and Freddie Mac. Limiting the simultaneous clustering of negative equity mortgages can reproduce the structural advantages that were a natural byproduct of the amortization era where inevitable downturns, which disparately impacted homeowners with different levels of equity, could more easily be absorbed by the market.

Law and Mechanism Design: Procedures to Induce Honest Bargaining

A classic challenge in contract and property law is unstructured negotiation between two parties with asymmetric information (i.e., each party has different private information) under bilateral monopoly (each party must negotiate with the other to try to reach an agreement), which often leads to prohibitively high transaction costs and, if the parties fail to agree, social costs as well. In these situations, the law should incorporate principles of mechanism design, a methodology that employs structured procedures to give the parties incentives to reach agreement. In terms of contract theory, mechanisms constitute algorithmic altering rules that reduce if not eliminate inefficient transaction costs. We review two bargaining mechanisms that inherently elicit honesty by making it a dominant strategy and discuss two extensions for legal applications. In particular, we show that algorithmic procedures would reduce transaction costs and lead to more efficient bargaining in pretrial settlement negotiations and blockholder disclosure under section 13(d) of the Securities Exchange Act of 1934. The former is a straightforward application of mechanism design to a negotiation situation where the social externalities of non-agreement justify inducing the honest disclosure of reservation prices, or “bottom lines.” The latter is an example of using mechanism design to facilitate negotiated settlements in situations presently subject to a suboptimal mandatory rule.

Activist Directors and Agency Costs: What Happens When an Activist Director Goes on the Board?

We develop and apply a new and more rigorous methodology by which to measure and understand both insider trading and the agency costs of hedge fund activism. We use quantitative data to show a systematic relationship between the appointment of a hedge fund nominated director to a corporate board and an increase in informed trading in that corporation’s stock (with the relationship being most pronounced when the fund’s slate of directors includes a hedge fund employee). This finding is important from two different perspectives. First, from a governance perspective, activist hedge funds represent a new and potent force in corporate governance. A robust debate continues as to whether activist funds reduce the agency costs of corporate governance, but this is the first attempt to investigate whether the activist hedge fund also imposes new agency costs through widened bid/ask spreads and informed trading. Second, although insider trading is almost universally condemned, it has only been studied in individual cases. Using instead a quantitative approach, we develop a tool that enables regulators (civil and criminal) to identify suspicious trading patterns: Both to demonstrate such a pattern and to map these new agency costs, we assembled a data set of 475 settlement agreements, between target companies and activists funds relating to the appointment of fund nominated directors, from 2000 and 2015, in order to focus on what happens once such a fund-nominated director goes on the board. Among our principal findings are: 1. Prevalence of Hedge Fund Employees on Slate. Approximately 70% of fund-nominated director slates include a hedge fund employee. 2. Increase in Information Leakage. Once a fund-nominated director goes on the board, an abrupt increase in “information leakage” follows, with the result that the target corporation’s stock price begins to anticipate future public disclosures. Specifically, we examine some 635,450 Form 8-K’s filed by 7,799 public traded companies over the period of January 1, 2000 to September 30, 2016, and we construct a control group for each of the corporations subject to an activist intervention. We find that firms appointing an activist nominee or nominees experience a difference-in-differences increase in leakage of 25-27 percentage points. 3. Hedge Funds versus Other Activists. We next consider whether post-appointment increases in leakage depend on the identity of the activist investors (i.e., hedge fund versus other activist investors). We find that the leakage effect is clearly driven by hedge fund activists (and no other type of activist). 4. Leakage and Hedge Fund Employees. We investigate whether leakage increases depend on the identity of the director appointed to target firm’s board, distinguishing between hedge fund employees and non-hedge fund employees. We find that the increase in leakage is driven by the appointment of activist fund employees to the corporate board (and not by the appointment of other persons, such as industry professionals). 5. Leakage and Confidentiality Provisions. We consider whether post-settlement increases in leakage are associated with confidentiality provisions restricting information sharing in the settlement agreements. The majority of settlement agreements have no confidentiality provisions, and information leakage is concentrated in these cases. 6. Market Response to Settlement Agreements. We next examine whether the stock market’s response to settlement agreements depends on (a) whether a hedge fund employee is on the director slate, and (b) whether the settlement agreement contains or refers to a confidentiality provision. We find that the 5-day CAR is more than twice as high (4.2% vs. 1.97%) for settlements with only non-employee directors and also significantly higher (2.02% vs. 0.42%) for settlements with an explicit restriction on information sharing. 7. Effect on Bid-Ask Spread. Bid-ask spreads increase by statistically meaningful amounts in our treatment group after an activist director gains access to the boardroom. Bid-ask spreads do not widen for the control groups. Further, we find that the increase in bid-ask spreads is concentrated in those cases in which (i) a hedge fund employee is appointed to the board, or (ii) no confidentiality provision is referenced in the settlement agreement. 8. Options Trading. We find that options trading increases significantly after the appointment of an activist director and in a manner consistent with informed trading. Consistent with earlier research on informed trading, we find that options traders exploit unscheduled Form 8-K filings. 9. Implications. The foregoing pattern is most plausibly explained as the product of informed trading. Material, non-public information appears to travel on a conduit from the hedge fund’s employee-director to others, whose trades move the market price prior to public disclosure. We reach no conclusions about who is trading or its legality in any individual case. Yet, the widened bid-ask spread strongly suggests that the market expects such trading, and the much more positive market response to director slates without a hedge fund employee (or with a confidentiality provision) suggests that the market suspects that informed trading is closely associated with the appointment of a hedge fund employee to the board. 10. Hypothesis. Our data suggests that the ability to engage in informed trading is a significant subsidy that may inflate the rate of hedge fund activism (producing more engagements than if stronger controls on information sharing were imposed) and may encourage activists to pursue inefficient engagements. Further, information sharing may be the cement that holds together a “wolf-pack” of activists that would otherwise logically be unstable. 11. Reforms. We consider and evaluate a variety of possible reforms that are consistent with an energetic role for hedge fund activism, but that remove (to various degrees) the subsidy of informed trading.

Informed Trading and Cybersecurity Breaches

Cybersecurity has become a significant concern in corporate and commercial settings, and for good reason: a threatened or realized cybersecurity breach can materially affect firm value for capital investors. This paper explores whether market arbitrageurs appear systematically to exploit advance knowledge of such vulnerabilities. We make use of a novel data set tracking cybersecurity breach announcements among public companies to study trading patterns in the derivatives market preceding the announcement of a breach. Using a matched sample of unaffected control firms, we find significant trading abnormalities for hacked targets, measured in terms of both open interest and volume. Our results are robust to several alternative matching techniques, as well as to both cross-sectional and longitudinal identification strategies. All told, our findings appear strongly consistent with the proposition that arbitrageurs can and do obtain early notice of impending breach disclosures, and that they are able to profit from such information. Normatively, we argue that the efficiency implications of cybersecurity trading are distinct — and generally more concerning — than those posed by garden-variety information trading within securities markets. Notwithstanding these idiosyncratic concerns, however, both securities fraud and computer fraud in their current form appear poorly adapted to address such concerns, and both would require nontrivial re-imagining to meet the challenge (even approximately).

I Promise To Pay

AbstractConsumers are more likely to keep a repayment promise they make themselves. When a scheduling conflict prevents a borrower from attending a mortgage closing, a power of attorney (POA) empowers a third party to promise that the borrower will repay the loan. On a matched sample of POA and non-POA loans, and comparing within borrower and within property, I link POAs to greater delinquency and foreclosure. Although POAs are uncorrelated with cash flow shocks, they reflect reduced promise keeping when borrowers undergo financial distress. This association vanishes for originator-servicers’ loans, which suggests that financial intermediation plays a role in consumer lending.

Did the JOBS Act Benefit Community Banks? A Regression Discontinuity Study

This study examines the effect of section 601(a)(2) of the Jumpstart Our Small Business (JOBS) Act of 2012, which modified the threshold for unlisted banks and bank holding companies (BHCs) to deregister under the Securities Exchange Act of 1934 from 300 to 1,200 shareholders of record. This change in the cutoff permits utilizing the quasi-experimental technique of regression discontinuity to identify the causal effect of Exchange Act deregistration on the performance of banks and BHCs that took advantage of the statutory change. Using an original dataset consisting of 187 community banks and a novel application of comparative interrupted time series analysis to regression discontinuity, I estimate the local average treatment effect of deregistration on compliers. Consistent with theory and qualitative evidence that the JOBS Act was beneficial for smaller banks, deregistration caused

How Much Mandatory Disclosure is Effective

1.27 higher net income and

Finding Order in the Morass: The Three Real Justifications for Piercing the Corporate Veil

3.38 lower pretax expenses per

The 8-K Trading Gap

1 of average assets, and