Financial Innovations and Macroeconomic Volatility

1. Financial Innovations and Macroeconomic Volatility Urban Jermann & Vincenzo Quadrini Discussion by Wouter J. Denhaan

2. Excellent new framework • Both debt and equity as external finance (typically only one form of external finance) • Aggregate shock is a change in the probability of “market loss”, which is like a change in ownership. • No aggregate or idiosyncratic TFP shocks

3. Excellent topic • Study cyclical properties of debt and equity • Study impact of financial innovation on volatility of debt, equity, & output

4. Nice set of results • Financial innovation can explain changes in volatility • Innovations in equity markets seem more important for reduction in volatility than innovations in debt markets • Output much more volatile than measured TFP

5. Link between theory and empirical result • Paper tries to do too much, i.e., tries to match too many empirical results • For some results, neither the empirical estimates nor the theoretical predictions are very robust to modifications • Better to focus on key predictions of the paper

6. Outline • Simplified version of model • Cyclical behavior of debt and equity • Modifications of the model • Empirical findings

7. A simplified version

8. A simplified version

9. First-Order Conditions pdoes not show up directly but comes in through 

10. Frictionless solution if  = 0 &  = R-1 Equity can “undo” the friction on debt financing

11. First-Order Conditions

12. Theory on cyclical behavior of debt and equity Substitutes • Jermann and Quadrini (2006) • Debt pro-cyclical and equity countercyclical • Levy and Hennessy (2006) • opposite Complements • Covas and Denhaan (2006) • Debt and equity pro-cyclical

13. Theory on cyclical behavior of equity Jerman and Quadrini (counter-cyclical): • No increase in need of funds during boom, but obtaining debt financing becomes easier • Debt procyclical and equity countercyclical Levy and Hennessy (pro-cyclical): • Obtaining equity becomes easier during boom

14. Theory on cyclical behavior of equity Choe, Masulis, and Nanda (pro-cyclical) • Adverse selection problem is relatively less important during a boom • Equity issuance implies a transfer to debt holdings (reduction in default probability and the value of this transfer is smaller during a boom) • Covas and Denhaan (pro-cylical) • Standard debt contract with default  Desire to expand leads to tightening of bank break-even condition  pro-cyclical equity issuance • Counter-cyclical risk premium and equity issuance costs

15. How would alternatives affect cyclical behavior of equity What if lending rate increases with debt? • First-order condition for equity and capital not affected • With standard debt contract & default & bankruptcy costs, however, equity issuance would be procylcical Cyclical exogeonous TFP Cyclical equity issuance costs Cyclical required rate of return on risky assets Alternative bargaining

16. First-Order Conditions

17. Would modifications matterfor main prediction of model? • Some might but several will not affect the result that easing of financial constraints reduces output volatility and increases debt and equity volatility

18. Some of the Empirical Results Jerman and Quadrini Empirical Fact #2 “The debt exposure [debt/gdp] has increased during the last 50 years” Frank and Goyal Stylized Fact #1 “Over long periods of time, leverage [debt/assets] is stationary” Frank and Goyal Stylized Fact #2 “Over the past half century, the aggregate market-based leverage ratio has been about 0.32. There have been surprisingly small fluctuations in this ratio from decade to decade.

19. Some of the Empirical Results Jerman and Quadrini Empirical Fact #3 “Equity payouts [dividends minus equity issuance scaled by GDP] are counter-cyclical” Covas and Denhaan • Dividends are pro-cyclical across firms • Aggregate results affected by largest top 1 to 5% and by leveraged buyouts • If you take out mergers • (Net) Equity issuance is pro-cyclical for most firms • (Net) Equity issuance counter-cyclical for top 1% • No clear pattern with aggregate data

20. Minor Comments • Is it costly to issue dividends/repurchase shares? As costly as issuing new equity • Model is a bit of a black box • Does the representative firm ever issue equity? • How important are changes in asset prices?

21. Concluding comments • Optimal contracts: • One type of contract • No unique way of implementing it with cash reserves, debt, & equity • Often odd properties like no defaults • Fixed types of contracts: • Frictions too segmented. For example, couldn’t you avoid friction on debt finance by also buying some equity? • More helpful in understanding data