Job Market Paper

The Externalities of Fire Sales: Evidence from Collateralized Loan Obligations

BlackRock Applied Research Award Winner, Stigler Center PhD Dissertation Award, QCGBF Young Economist Prize Runner-Up

I investigate how covenants, intrinsic to Collateralized Loan Obligation (CLO) indentures, provide a mechanism through which idiosyncratic shocks may amplify, imposing negative externalities on other unrelated firms in CLO portfolios. I exploit cross-sectional variation in firm exposure to the Oil & Gas (O&G) industry through CLOs, as well as the timing of the O&G bust in 2014, to study how non-O&G firms in CLO portfolios are affected. When CLOs are subject to idiosyncratic shocks that push them closer to their covenant constraints, they fire-sell unrelated loans in the secondary loan market to alleviate these constraints. The ex-post, secondary market price becomes the effective cost of capital for these innocent bystanders as the expected rate of return across debt instruments is equalized in market equilibrium. Hence, the real costs of fire sales can exacerbate credit crunches through the contraction of credit. In response, the firms make financial and real adjustments. Contrary to traditional fire sale settings, I find CLOs fire-sell loans issued by riskier firms for contractual arbitrage purposes – exploiting loopholes in the design of covenants. The sample period for this study is 2013-2015, a relatively benign macroeconomic period. However, the results suggest the effects may be significantly larger during times of stress, including the outset of the COVID-19 pandemic.

Working Papers

Financial Covenants and Fire Sales: Fractures in the Leveraged Loan Market

I study the externalities of Collateralized Loan Obligation (CLO) contracts on asset prices. I introduce several new stylized facts about the role of CLOs in the provision of credit to risky firms. Managers preemptively sell loans issued by distressed firms before firms’ bankruptcy filings. CLO managerial sales generate price pressure for distressed loans around bankruptcy defaults, introducing fire sale risk. This behavior is driven mainly by covenants. Constrained CLOs experience significantly lower cumulative returns relative to unconstrained CLOs. Furthermore, covenants can explain CLO size as well as equity distributions – two salient features of capital structure.

The Anatomy of Collateralized Loan Obligations: On the Origins of Covenants and Contract Design

This paper provides a dissection of the Collateralized Loan Obligation (CLO) market and examines the significance of covenants in facilitating the provision of credit. Since the Great Financial Crisis, the leveraged loan market has witnessed unprecedented growth. CLOs play an increasingly central role in the provision of credit to corporations, holding as much as 75% of all new institutional leveraged loans, as reported in 2019. The rise of the leveraged loan and CLO markets have attracted the attention of central banks which have been concerned with both the growth of the market and the opaque nature of interconnections between intermediaries, leveraged borrowers, and investors. Despite their increasing importance, little is understood about CLO intermediaries. In this paper, I describe the agency frictions inherent in the CLO market, and discuss how optimal contracts are derived with covenants that curtail against such frictions. In addition, I describe the general macroeconomic milieu that has facilitated the rapid growth of the CLO market as well as recent changes that have developed. Understanding the structural aspects and dynamics of CLOs intermediaries, situated between a gamut of investors and a loan syndicate, is paramount for analysis of the innards of the market, the role of covenants, and developing insights into the shadow banking sector as well as other securitizations.

Banking Networks and Economic Growth: From Idiosyncratic Shocks to Aggregate Fluctuations (with Nishant Vats)

The objective of this paper is to explore the transmission of non-bank capital shocks through banking networks. We develop a methodology to construct non-bank capital shocks, idiosyncratic shocks, using labor productivity shocks to large firms. We document a change in the relationship between (foreign) idiosyncratic shocks in state j and (domestic) economic growth in state i between 1978 and 2000 wherein the relation changes from positive to negative over this period. We show that the contemporaneous changes in banking integration across states is a key driver of this phenomenon. This is driven by geographically diversified banks diverting funds away from economies experiencing negative shocks towards other unaffected economies. Hence, the relation between foreign idiosyncratic shocks and domestic aggregate fluctuations is negative. This result operates through changes in bank loan supply. Our instrumental variable estimates suggest that a 1% increase in the bank loan supply is associated with a 0.05-0.26 pp increase in economic growth. Lastly, we argue that this mechanism can explain the decrease in covariance of state-level fluctuations, potentially explaining the Great Moderation, the period of relatively low aggregate volatility.

What Explains Geographic Variation in Investment? (with Nishant Vats)

We show that institutions can explain geographic concentration over and above agglomerative forces. This paper uses within country variation in institutional quality, combined with a local identification approach and instrumental variable strategy to explain spatial differences in investment. We use direct (indirect) British rule as proxies for areas with low (high) institutional quality. Institutions can explain 13% of total geographic variation in investment. Moreover, investment is 8-10% lower in areas with low institutional quality. Differences in institutional quality manifest as greater court delays, impeding individual and stakeholders’ contractual claims, property rights, and dispute resolution, thereby decreasing ex-ante investment and increasing ex-post project abandonment.

Work in Progress

Bank Participation and Window Dressing in the Repo Market: Evidence from German Banks

The objective of this paper is to investigate how the heterogeneity in key measures of capital and liquidity across German reporting banks affects window dressing in the repo market. Using the ECB’s Money Market Statistical Reporting dataset for German reporting banks at the Deutsche Bundesbank and SNL Financial data for balance sheet information, I find evidence of “run-like” behavior at quarter-ends primarily resulting from liquidity and capital concerns. On average, banks reduce the overall amount repo-ed at quarter-ends to improve the leverage ratio. Banks substitute the type of collateral used to secure repos at quarter-ends, thereby improving the liquidity coverage ratio. These results suggest that banks engage in regulatory arbitrage to nominally meet regulatory requirements at quarter-ends, while bearing significant capital and liquidity risk during the quarter. Moreover, I find that window dressing is most prevalent among repo agreements backed by high-quality spot-next and overnight collateral traded with non-CCPs. The effect is (cash) demand driven.