Richard Stanton’s papers

Table of Contents

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Select paper title to read abstract and (optionally) download PDF file.

Published and Forthcoming Articles

  1. Employee Stock Option Exercise and Firm Cost forthcoming, Journal of Finance (with J. Carpenter and N. Wallace).
  2. Mortgage Loan-Flow Networks and Financial Norms, Review of Financial Studies 13, 3595-3642, 2018 (with J. Walden and N. Wallace).
  3. Liquidity Crises in the Mortgage Market, Brookings Papers on Economic Activity (Spring), 347-406, 2018 (with Y. Kim, S. Laufer, K. Pence and N. Wallace).
  4. CMBS Subordination, Ratings Inflation, and Regulatory-Capital Arbitrage, Financial Management 47, 175-201, 2018 (with N. Wallace) (best paper in Financial Management, 2017-2018).
  5. Energy Factors, Leasing Structure and the Market Price Of Office Buildings in the U.S., Journal of Real Estate Finance and Economics (forthcoming) (with D. Jaffee and N. Wallace).
  6. The Industrial Organization of the U.S. Residential Mortgage Market, Annual Review of Financial Economics 6, 2014 (with J. Walden and N. Wallace).
  7. U.S. Residential-Mortgage Transfer Systems: A Data-Management Crisis, in Margarita S. Brose, Mark D. Flood, Dilip Krishna, and Bill Nichols, eds., Handbook of Financial Data and Risk Information II: Software and Data, chapter 18 (Cambridge University Press, Cambridge, England), 2014 (with J. P. Hunt and N. Wallace).
  8. Rebalancing Public and Private in the Law of Mortgage Transfer, American University Law Review 62, 1529–1586, 2013 (with J. P. Hunt and N. Wallace).
  9. Estimation of Dynamic Term Structure Models, Quarterly Journal of Finance 2, 2012 (with G. Duffee).
  10. All in One Basket: The Bankruptcy Risk of a National Agent-Based Mortgage Recording System, U. C. Davis Law Review 46, 1–63, 2012 (with J. P. Hunt and N. Wallace).
  11. Financial Flexibility, Bank Capital Flows, and Asset Prices, Journal of Finance 67, 1685–1722, 2012 (with C. Parlour and J. Walden).
  12. Revisiting Asset Pricing Puzzles in an Exchange Economy, Review of Financial Studies 24, 629-674, 2011 (with C. Parlour and J. Walden).
  13. The Bear’s Lair: Indexed Credit Default Swaps and the Subprime Mortgage Crisis, Review of Financial Studies 24, 3250-3280, 2011 (with N. Wallace).
  14. Human Capital, Bankruptcy and Capital Structure, Journal of Finance 65, 891-926, 2010 (with J. Berk and J. Zechner) (nominated for the Brattle prize).
  15. Optimal Exercise of Executive Stock Options and Implications for Firm Cost, Journal of Financial Economics 98, 315-337, 2010 (with J. Carpenter and N. Wallace).
  16. A Multifactor, Nonlinear, Continuous-Time Model of Interest Rate Volatility, Chapter 14 in Volatility and Time Series Econometrics: Essays in Honor of Robert F. Engle, Oxford University Press, 2010 (with J. Boudoukh, M. Richardson and R. Whitelaw).
  17. A Liquidity-Based Theory of Closed-End Funds, Review of Financial Studies 22, 257-297, 2009 (with M. Cherkes and J. Sagi) (winner, Best Paper award, Utah Winter Finance Conference, 2006).
  18. Evidence on Simulation Inference for Near Unit-Root Processes with Implications for Term Structure Estimation, Journal of Financial Econometrics 6, 108-142, 2008 (with G. Duffee).
  19. An Empirical Test of a Contingent Claims Lease Valuation Model, Journal of Real Estate Research 31, 1-26, 2008 (with N. Wallace).
  20. Managerial Ability, Compensation, and the Closed-End Fund Discount, Journal of Finance 62, 529-556, 2007 (with J. Berk) (nominated for Smith-Breeden award).
  21. An Empirical Test of a Two-Factor Mortgage Valuation Model: How Much Do House Prices Matter?, Real Estate Economics 33, 681-710, 2005 (with C. Downing and N. Wallace).
  22. MaxVaR: Long-Horizon Value at Risk in a Mark-to-Market Environment, Journal of Investment Management 2, 1-6, 2004 (with J. Boudoukh, M. Richardson and R. Whitelaw).
  23. From Cradle to Grave: How to Loot a 401(k) Plan, Journal of Financial Economics 56, 485-516, 2000.
  24. Nonparametric Mortgage-Backed Security Pricing, in Advanced Fixed Income Valuation Tools, John Wiley, 2000 (with J. Boudoukh, M. Richardson and R. Whitelaw).
  25. Anatomy of an ARM: The Interest Rate Risk of Adjustable Rate Mortgages, Journal of Real Estate Finance and Economics 19, 49 1. 67, 1999 (with N. Wallace).
  26. Mortgage Choice: What’s the Point?, Real Estate Economics 26: 173-205, 1998 (with N. Wallace).
  27. Pricing Mortgage-Backed Securities in a Multifactor Interest Rate Environment: A Multivariate Density Estimation Approach, Review of Financial Studies 10: 405-446, 1997 (with J. Boudoukh, M. Richardson and R. Whitelaw).
  28. A Nonparametric Model of Term Structure Dynamics and the Market Price of Interest Rate Risk, Journal of Finance 52: 1973-2002, 1997 (nominated for Smith-Breeden award).
  29. Unobservable Heterogeneity and Rational Learning: Pool Specific vs. Generic Mortgage-Backed Security Prices, Journal of Real Estate Finance and Economics 12, 243-263, 1996.
  30. A New Strategy for Dynamically Hedging Mortgage-Backed Securities, Journal of Derivatives 2, 60-77, 1995 (with J. Boudoukh, M. Richardson and R. Whitelaw).
  31. Rational Prepayment and the Valuation of Mortgage-Backed Securities, Review of Financial Studies 8, 677-708, 1995.
  32. ARM Wrestling: Valuing Adjustable Rate Mortgages Indexed to the Eleventh District Cost of Funds, Real Estate Economics 23, 311-345, 1995 (with N. Wallace).
  33. Pricing Continuously Resettled Contingent Claims, Journal of Economic Dynamics and Control 16, 561-573, 1992 (with D. Duffie).

Working Papers and Research in Progress

  1. Consumer-Lending Discrimination in the FinTech Era (with R. Bartlett, A. Morse and N. Wallace), 2018.
  2. Energy Efficiency and Commercial-Mortgage Valuation (with D. Jaffee and N. Wallace), 2012.
  3. Valuing Mutual Fund Companies (with J. Boudoukh, M. Richardson and R. Whitelaw), 2003.

Abstracts of Published/Forthcoming Articles

The Importance of Behavioral Factors in the Exercise and Valuation of Employee Stock Options

(with J. Carpenter and N. Wallace)
forthcoming, Journal of Finance.

Abstract

We develop an empirical model of employee-stock-option exercise that is suitable for valuation and allows for behavioral channels in the determination of employee option cost. We estimate exercise rates as functions of option, stock and employee characteristics in a sample of all employee exercises at 88 publicly traded firms, of which 27 are in the S&P 500. Increasing vesting date frequency from annual to monthly reduces option value by 11-16%. Men exercise faster than women, reducing option value by 2-4\%. Top employees exercise more slowly than lower-ranked, increasing value by 2-7\%. Finally, we develop an analytic valuation approximation that is much more accurate than methods used in practice.

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Mortgage Loan-Flow Networks and Financial Norms

(with J. Walden and N. Wallace)
Review of Financial Studies 31, pp. 3595-3642.

Abstract

We develop a theoretical model of a network of intermediaries, which gives rise to heterogeneous financial norms and systemic vulnerabilities. The optimal behavior of each intermediary regarding its attitude toward risk, the quality of the projects that it undertakes, and the intermediaries it chooses to interact with, is affected by the behavior of its counterparties. These strategic network effects influence the financial strength and systemic vulnerability of individual intermediaries, as well as in aggregate. We apply the model to the mortgage-origination and securitization network of financial intermediaries in the U.S., using a data set containing all of the more than three million private-label, fixed-rate mortgages originated and securitized between 2005 and 2007, for which we track the ex-post default performance using loan flows to define linkages. We find that default risk was closely related to network position and evolved in a predictable manner among linked nodes, and document a positive relationship between a firm’s estimated quality and its labor intensity. This suggests that network effects are of vital importance in the U.S. mortgage market.

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Liquidity Crises in the Mortgage Market

(with Y. Kim, S. Laufer, K. Pence and N. Wallace)
Brookings Papers on Economic Activity (Spring), 347–406, 2018.

Abstract

Non-banks originated about half of all mortgages in 2016, and 75% of mortgages insured by the FHA or VA. Both shares are much higher than those observed at any point in the 2000s. We describe in this paper how non-bank mortgage companies are vulnerable to liquidity pressures in both their loan origination and servicing activities, and we document that this sector in aggregate appears to have minimal resources to bring to bear in a stress scenario. We show how the same liquidity issues unfolded during the financial crisis, leading to the failure of many non-bank companies, requests for government assistance, and harm to consumers. The high share of non-bank lenders in FHA and VA lending suggests that the government has significant exposure to the vulnerabilities of non-bank lenders, but this issue has received very little attention in the housing-reform debate.

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CMBS Subordination, Ratings Inflation, and Regulatory-Capital Arbitrage

(with N. Wallace)
Financial Management 47, pp. 175-201, 2018.

Abstract

Using detailed origination and performance data on a comprehensive sample of CMBS deals, along with their underlying loans and a set of similarly rated residential MBS, we apply reduced-form and structural modeling strategies to test for regulatory-capital arbitrage and ratings inflation in the CMBS market. We find that the spread between CMBS and corporate-bond yields fell significantly for ratings AA and AAA after a loosening of capital requirements for highly rated CMBS in 2002, while no comparable drop occurred for lower-rated bonds (which experienced no similar regu- latory change). We also find that CMBS rated below AA upgraded to AA or AAA significantly faster than comparable residential RMBS (for which there was no change in risk-based capital requirements). We use a structural model to investigate these results in more detail, and find that little else changed in the CMBS market over this period except for the rating agencies’ persistent reductions in subordination levels between 1997 and late 2007. Indeed, had the 2005 vintage CMBS used the subordination levels from 2000, there would have been no losses to the senior bonds in most CMBS structures.

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Energy Factors, Leasing Structure and the Market Price Of Office Buildings in the U.S.

(with D. Jaffee and N. Wallace)
forthcoming, Journal of Real Estate Finance and Economics.

Abstract

This paper presents an empirical analysis of the relationship between energy factor markets, leasing structures and the transaction prices of office buildings in the U.S. We employ a large sample of 15,133 office building transactions that occurred between 2001 and 2010. In addition to building characteristics, we also include information on the operating expenses, the net operating income, and the market capitalization rates at sale to estimate an asset pricing model for commercial office real estate assets. A further set of important controls in our analysis is the one-to-twelve month forward contract prices and the shape of the forward contract price curve, using auction data for the regional electricity trading hubs in which the building is located and auction data from the Henry Hub for natural gas. We also include weather metrics in the form of the variance in the last twelve months of minimum and maximum temperature and precipitation for each building’s location and sale date. Our final set of controls in- cludes information on the dominant contractual leasing structure of the buildings. Our empirical results suggest that Energy Star labels do not explain additional variance in property prices once the key asset pricing factors of expenses, income and market capitalization rates are included. Energy factor market prices, the shape of the energy forward price curves, and weather metrics are consistently shown to be statistically sig- nificant determinants of office building transaction prices, suggesting that commercial office building prices are likely to be exposed to shocks in these markets.

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The Industrial Organization of the U.S. Residential Mortgage Market

(with J. Walden and N. Wallace).
Annual Review of Financial Economics 6, 2014

Abstract

We show that the U.S. residential single-family mortgage-origination market is highly concentrated once account is taken of the contractual coordination that arises from the correspondent- and warehouse-funding channels. We represent these channels as a network, using the flow of loans through three strata of the loan origination market: origination, aggregation, and securitization. We develop a network representation of the origination market and demonstrate that it is a “small world,” in that most nodes are close in the network. We then rank-order the interlinked aggregators and securitizers using ex post mortgage foreclosure rates as a proxy for performance. Our findings suggest that these significant interlinkages in the mortgage origination network represent a previously under-appreciated source of systemic risk. Many apparently atomistic mortgage underwriters are, in fact, coordinated to act in parallel because of their funding relationships with the large, “too-big-to-fail” bank holding companies.

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U.S. Residential-Mortgage Transfer Systems: A Data-Management Crisis

(with J. P. Hunt and N. Wallace).
in Margarita S. Brose, Mark D. Flood, Dilip Krishna, and Bill Nichols, eds., Handbook of Financial Data and Risk Information II: Software and Data, chapter 18 (Cambridge University Press, Cambridge, England), 2014

Abstract

This paper reviews the current state of residential-mortgage data structures from origination through the securitization supply chain. We discuss the various uses of these data, their limitations in mortgage-risk management, and the current lack of transparency in important segments of the mortgage market. We conclude that despite the size and importance of the mortgage market in the overall U.S.\ economy, current data-management practices make it difficult or impossible for borrowers, lenders, investors and government regulators to perform the oversight and analysis functions necessary to maintain an orderly market and to ensure fair pricing of securities backed by those mortgages.

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Rebalancing Public and Private in the Law of Mortgage Transfer

(with J. P. Hunt and N. Wallace).
American University Law Review 62, 1529–1586, 2013

Abstract

The law governing the United States’ $13 trillion mortgage market is broken. Courts and legislatures around the country continue to struggle with the fallout from the effort to build a 21st century global market in mortgages on a fragmented, arguably archaic legal foundation. These authorities’ struggles stem in large part from the lack of clarity about the legal requirements for mortgage transfer, the key process for contemporary mortgage finance.

We demonstrate two respects in which American mortgage transfer law is unclear and offer suggestions for fixing it. Revisions to the Uniform Commercial Code adopted around the turn of the century may be interpreted as doing away with preexisting laws arguably requiring parties to record their ownership interests to protect them. But the interaction of these revisions and preexisting state recording laws is most unclear.

Moreover, it is not clear just what parties have to do to invoke the provisions in question: the rules require that the mortgages be transferred “in return for any consideration sufficient to support a simple contract,” but that concept is notoriously malleable. In fact, our study indicates that in many transactions the requirement may not have been met because the parties used only nominal or other questionable consideration. At least in some states, the use of questionable consideration in existing transactions makes foreclosure more difficult and makes mortgage investments less secure. Consequently, the use of nominal consideration seems to strengthen mortgage investors’ claims that transactions were not executed properly.

We suggest an approach to law reform that would provide needed clarity and bring about an appropriate balance between private and public. The Article 9 revisions reflect a preoccupation, prevalent in the 1990s, with reducing the cost of mortgage transfers to the transacting parties. Obviating public recording, as the Article 9 revisions purport to do, does reduce cost, but it also tends to eliminate public records of mortgage ownership. As we show, these public records have value not just for parties that may transact in mortgages, but for the public more generally. A more balanced approach would clearly require transacting parties to record their interests in order to protect them, but would adopt this change in tandem with an expansion of low-cost digital recording. This approach provides the public benefits of high-quality mortgage records while reducing the cost and inconvenience of recording to transacting parties.

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Estimation of Dynamic Term Structure Models

(with Greg Duffee)
Quarterly Journal of Finance 2, 2012.

Abstract

We study the finite-sample properties of some of the standard techniques used to estimate modern term structure models. For sample sizes similar to those used in most empirical work, we reach three surprising conclusions. First, while maximum likelihood works well for simple models, it produces strongly biased parameter estimates when the model includes a flexible specification of the dynamics of interest rate risk. Second, despite having the same asymptotic efficiency as maximum likelihood, the small-sample performance of Efficient Method of Moments (a commonly used method for estimating complicated models) is unacceptable even in the simplest term structure settings. Third, the linearized Kalman filter is a tractable and reasonably accurate estimation technique, which we recommend in settings where maximum likelihood is impractical.

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All in One Basket: The Bankruptcy Risk of a National Agent-Based Mortgage Recording System

(with J. P. Hunt and N. Wallace).
U. C. Davis Law Review 46, 1–63, 2012

Abstract

Mortgage Electronic Registration Systems, Inc. (“MERS, Inc.”) owns legal title to some thirty million mortgages in the United States via its role in the Mortgage Electronic Registration System (“MERS”). The company, which was a key part of the mortgage securitization apparatus in the late 1990s and 2000s, is now under intense pressure from public and private lawsuits and investigations and faces a very real threat of insolvency. Policymakers are looking ahead to potential replacements for MERS, as a recent Fed staff proposal for a substitute system indicates. This Article examines what might happen to the mortgages that MERS, Inc. at least nominally owns in the event that the company enters bankruptcy, a question that apparently has never been explored in a publicly available analysis.

Although the legal analysis underlying the design of MERS does not appear to be publicly available, a key assumption seems to have been that if the company ever entered bankruptcy, the mortgages in its hands would not enter the company’s bankruptcy estate and would not be available to creditors. This Article challenges that assumption, pointing to the broad authority the Bankruptcy Code confers on the bankruptcy trustee with respect to interests in real property, such as mortgages. Most courts that have considered the issue have found that the bankruptcy trustee can bring into the estate any real property interest that the debtor could have conveyed to a good-faith purchaser. There is a risk that MERS, Inc. can convey MERS mortgages to a purchaser acting in good faith.

The risk arises in large part from the company’s conduct in making and acquiescing in claims in court that the company can sell the mortgages, has constitutionally protected property interests in the mortgages, is a creditor of mortgage borrowers, and owns a beneficial interest in the mortgages. But under current law, part of the risk is inherent in any mortgage recording system that operates nationally, is subject to the Bankruptcy Code, and holds mortgages as an agent. Policymakers should give serious consideration to creating a transparent, authoritative national mortgage registry with a solid legal foundation, and should consider the bankruptcy risk we identify as they do so.

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Financial Flexibility, Bank Capital Flows, and Asset Prices

(with C. Parlour and J. Walden).
Journal of Finance 67, 1685–1722, 2012

Abstract

We develop a parsimonious general-equilibrium model of banking and asset pricing, in which intermediaries have the expertise to monitor and reallocate capital. The model allows us to study the connection between financial development, intra-economy capital flows, the size of the banking sector, the value of intermediation, expected returns in the market, and the risk of bank crashes. We show that realized capital flows are informative about financial development, whereas other common empirical proxies, such as the size of the banking sector, may be only weakly related. Our model also has strong asset-pricing implications; for example, a market’s dividend yield is related to its financial flexibility, and capital flows should be important in explaining expected returns and the risk of bank crashes. The model’s predictions are broadly consistent with the aggregate behavior of the U.S. economy since 1950.

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Revisiting Asset Pricing Puzzles in an Exchange Economy

(with C. Parlour and J. Walden)
Review of Financial Studies, 24, 629-674, 2011

Abstract

We show that several well-known asset pricing puzzles are largely mitigated if we endow the representative agent with an arbitrarily small minimum consumption level. This allows us to solve the model for parameter values where the standard “Lucas tree” model is not defined. For these parameters, disasters become more important, and the market risk premium therefore higher, even though consumption is less risky. Our model yields reasonable risk premia, Sharpe ratios and discount rates; excess price volatility; and a high market price-dividend ratio. We derive closed-form solutions for all variables of interest.

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The Bear’s Lair: Indexed Credit Default Swaps and the Subprime Mortgage Crisis

(with N. Wallace)
Review of Financial Studies 24, 3250-3280, 2011

Abstract

ABX.HE indexed credit default swaps on baskets of mortgage-backed securities are now the main benchmark used by financial institutions to mark their subprime mortgage portfolios to market. However, we find that current prices for the ABX.HE indices are inconsistent with any reasonable assumption for mortgage default rates, and that ABX.HE price changes are only very weakly correlated with observed changes in the credit performance of the underlying loans in the index. These results cast serious doubt on the suitability of the ABX.HE indices as valuation benchmarks. We also find that ABX.HE price changes are related to short-sale activity for publicly traded builders, the commercial banks, the investment banks and the government sponsored enterprises (GSEs). This suggests that capital constraints, limiting the supply of ABS insurance, may be playing a role here similar to that identified by Froot (2001) in the market for catastrophe insurance.

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Human Capital, Bankruptcy and Capital Structure

(with J. Berk and J. Zechner)
Journal of Finance, 65, 891-926, 2010

Abstract

In an economy with perfectly competitive capital and labor markets, we derive the optimal labor contract for firms with both equity and debt, and show that it implies employees will become entrenched and therefore face large human costs of bankruptcy. The firm’s optimal capital structure emerges from a trade-off between these human costs and the tax benefits of debt. Our model delivers optimal debt levels consistent with those observed in practice without relying on frictions such as moral hazard or asymmetric information. In line with existing empirical evidence, our model implies persistent idiosyncratic differences in leverage across firms, and shows that wages should have explanatory power for firm leverage.

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Optimal Exercise of Executive Stock Options and Implications for Firm Cost

(with J. Carpenter and N. Wallace)
Journal of Financial Economics, 98, 315-337, 2010

Abstract

This paper conducts a comprehensive study of the optimal exercise policy for an executive stock option and its implications for option cost, average life, and alternative valuation concepts. The paper is the first to provide analytical results for an executive with general concave utility. Wealthier or less risk-averse executives exercise later and create greater option cost. However, option cost can decline with volatility. We show when there exists a single exercise boundary, yet demonstrate the possibility of a split continuation region. We also show that, for CRRA utility, the option cost does not converge to the Black-Scholes value as the correlation between the stock and the market portfolio converges to one. We compare our model’s option cost with the modified Black-Scholes approximation typically used in practice, and show that the approximation error can be large or small, positive or negative, depending on firm characteristics.

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A Multifactor, Nonlinear, Continuous-Time Model of Interest Rate Volatility

(with J. Boudoukh, M. Richardson and R. Whitelaw)
Chapter 14 in Volatility and Time Series Econometrics: Essays in Honor of Robert F. Engle, Oxford University Press, 2010

Abstract

This paper presents a general, nonlinear version of existing multifactor models, such as Longstaff and Schwartz (1992). The novel aspect of our approach is that rather than choosing the model parameterization out of “thin air”, our processes are generated from the data using approximation methods for multifactor continuous-time Markov processes. In applying this technique to the short- and long-end of the term structure for a general two-factor diffusion process for interest rates, a major finding is that the volatility of interest rates is increasing in the level of interest rates only for sharply, upward sloping term structures. In fact, the slope of the term structure plays a larger role in determining the magnitude of the diffusion coefficient. As an application, we analyze the model’s implications for term structure pricing, focusing on the conditional distribution of interest rates and the term structure of term premiums and volatilities.

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A Liquidity-Based Theory of Closed-End Funds

(with M. Cherkes and J. Sagi)
Review of Financial Studies 22, 257-297, 2009

Abstract

This paper develops a rational, liquidity-based model of closed-end funds (CEFs) that provides an economic motivation for the existence of this organizational form: They offer a means for investors to buy illiquid securities, without facing the potential costs associated with direct trading and without the externalities imposed by an open-end fund structure. Our theory predicts the patterns observed in CEF IPO behavior and the observed behavior of the CEF discount, which results from a tradeoff between the liquidity benefits of investing in the CEF and the fees charged by the fund’s managers. In particular, the model explains why IPOs occur in waves in certain sectors at a time, why funds are issued at a premium to net asset value (NAV), and why they later usually trade at a discount. We also conduct an empirical investigation, which, overall, provides more support for a liquidity-based model than for an alternative sentiment-based explanation.

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Evidence on Simulation Inference for Near Unit-Root Processes with Implications for Term Structure Estimation

(with G. Duffee)
Journal of Financial Econometrics, 6, 108-142, 2008.

Abstract

The high persistence of interest rates has important implications for the preferred method used to estimate term structure models. We study the finite-sample properties of two standard dynamic simulation methods—efficient method of moments and indirect inference—when they are applied to an AR(1) process. For data that are as persistent as interest rates, the finite-sample properties of EMM differ dramatically both from their asymptotic properties and from those of indirect inference and maximum likelihood. EMM produces larger confidence bounds than indirect inference and maximum likelihood, yet they are much less likely to contain the true parameter value. This is primarily because the population variance of the data (which is extremely sensitive to the autocorrelation coefficient for persistent data) plays a much larger role in the moment conditions for EMM than in the moment conditions for either indirect inference of maximum likelihood. These results suggest that indirect inference is preferable to EMM when working with persistent data such as interest rates.

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An Empirical Test of a Contingent Claims Lease Valuation Model

(with N. Wallace)
Journal of Real Estate Research 31, 1-26, 2008.

Abstract

Despite the importance of leases in the US economy, and the existence of several theoretical lease pricing models, there has been little systematic attempt to estimate these models. This paper proposes a simple no-arbitrage based lease pricing model, and estimates it using a large proprietary datset of leases on several property types. We find sizeable pricing errors that cannot be explained using interest rates, lease maturity, or information on the options embedded in the contracts, suggesting the presence of significant mispricings in the market for real estate leases. We also propose a new measure, the Option-Adjusted Lease Spread, or OALS (analogous to an option’s implied volatility, or a mortgage-backed security’s Option-Adjusted Spread), that allows leases with different maturities and contract terms to be compared on a consistent basis.

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Managerial Ability, Compensation, and the Closed-End Fund Discount

(with J. Berk).
Journal of Finance 62, 529-556, 2007.

Abstract

This paper shows that the existence of managerial ability, combined with the labor contract prevalent in the industry, implies that the closed-end fund discount will exhibit many of the primary features documented in the literature. We evaluate the model’s ability to match the quantitative features of the data, and find that it does well, although there is some observed behavior that remains to be explained.

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An Empirical Test of a Two-Factor Mortgage Valuation Model: How Much Do House Prices Matter?

(with C. Downing and N. Wallace).
Real Estate Economics 33, 681-710, 2005.

Abstract

This paper develops a two-factor structural mortgage pricing model in which rational mortgage-holders choose when to prepay and default in response to changes in both interest rates and house prices. We estimate the model using comprehensive data on the pool-level termination rates for Freddie Mac Participation Certificates issued between 1991 and 2002. The model exhibits a statistically and economically significant improvement over the nested one-factor (interest-rate only) model in its ability to match historical prepayment data. Moreover, the two-factor model produces origination prices that are significantly closer to those quoted in the TBA market than the one-factor model. Our results have important implications for hedging MBS.

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MaxVaR: Long-Horizon Value at Risk in a Mark-to-Market Environment

(with J. Boudoukh, M. Richardson and R. Whitelaw)
Journal of Investment Management 2, 1-6, 2004.

Abstract

The standard VaR approach considers only terminal risk, completely ignoring the sample path of portfolio values. In reality interim risk may be critical in a mark-to-market environment. Sharp declines in value may generate margin calls and affect trading strategies. In this paper we introduce the notion of MaxVaR, analogous to VaR in every way except it quantifies the probability of seeing a given loss on or before the terminal date rather than at the terminal date. Under standard set of assumptions we provide a simple formula for MaxVaR and examine the ratio of MaxVaR to VaR. For reasonable parameterizations MaxVaR may exceed VaR by over 40%. MaxVaR exceeds VaR by as much as 80% or more for high Sharpe Ratio hedge-fund-like sets of portfolio return distribution.

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From Cradle to Grave: How to Loot a 401(k) Plan

Journal of Financial Economics 56, 485-516, 2000.

Abstract

The regulations governing asset distributions from many retirement plans give plan participants the option to time retirement or rollovers from the plan strategically. They possess a long-lived put option, whose exercise price resets periodically to the current value of the assets in the plan. We derive a recursive closed-form valuation formula for the option, and develop a numerical algorithm for implementing the result. We find that, for reasonable assumptions about volatility and life expectancy, the option’s value may approach 40% of the value of the assets in the plan, financed entirely by those still contributing. This wealth transfer can, however, be easily avoided by making a simple change to the current regulations governing valuation and payout of these retirement plans.

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Nonparametric Mortgage-Backed Security Pricing

(with J. Boudoukh, M. Richardson and R. Whitelaw)
in Advanced Fixed Income Valuation Tools, John Wiley, 2000.

Abstract

This chapter presents a non-parametric technique for pricing and hedging mortgage-backed securities (MBS). The particular technique used here is called multivariate density estimation (MDE). We find that MBS prices can be well described as a function of two interest rate factors; the level and slope of the term structure. The interest rate level proxies for the moneyness of the prepayment option, the expected level of prepayments, and the average life of the MBS cash flows, while the term structure slope controls for the average rate at which these cash flows should be discounted. We also illustrate how to hedge the interest rate risk of MBS using our model. The hedge based on our model compares favorably with existing methods.

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Anatomy of an ARM: The Interest Rate Risk of Adjustable Rate Mortgages

(with Nancy Wallace)
Journal of Real Estate Finance and Economics 19, 49 - 67, 1999.

Abstract

This paper analyzes the dynamics of the commonly used indices for Adjustable Rate Mortgages, and systematically compares the effects of their time series properties on the interest rate sensitivity of adjustable rate mortgages. Our ARM valuation methodology allows us simultaneously to capture the effects of the dynamics of the index, discrete coupon adjustment, and caps and floors, and can either calculate an optimal prepayment strategy for mortgage holders, or use an empirical prepayment function. We find that the different dynamics of the major ARM indices induce significant variation in the interest rate sensitivities of loans based on different indices. We also find that changing assumptions about contract features, such as loan caps and coupon reset frequency, has a significant, and in some cases unexpected, impact on our results.

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Mortgage Choice: What’s the Point?

(with Nancy Wallace)
Real Estate Economics 26, pp. 173-205, 1998.

Abstract

This paper shows that, in the presence of transaction costs payable by borrowers on refinancing, it is possible to construct a separating equilibrium in which borrowers with differing mobility select loans with different coupon rate/points combinations. We also show that, in the absence of such costs, no such equilibrium is possible. This provides a possible explanation for the large menus of mortgages typically encountered by potential borrowers, and suggests that the menu of contracts available at the time of origination should be an important predictor of future prepayment. We numerically implement such an equilibrium, developing the first contingent claims mortgage valuation algorithm that can quantify the effect of self-selection on real contracts in a realistic interest rate setting. Our algorithm allows investors to account for self-selection when valuing mortgages and mortgage-backed securities. It also, for the first time, allows lenders to determine the optimal points/coupon rate schedule to offer to a specified set of potential borrowers, given the current level of interest rates.

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Pricing Mortgage-Backed Securities in a Multifactor Interest Rate Environment: A Multivariate Density Estimation Approach

(with Jacob Boudoukh, Matt Richardson and Robert Whitelaw)
Review of Financial Studies 10, pp. 405-446, 1997.

Abstract

This paper uses multivariate density estimation (MDE) procedures to investigate the pricing of mortgage-backed securities (MBS) in a multifactor interest rate environment. The MDE estimation suggests that weekly MBS prices from January 1987 to May 1994 can be well described as a function of the level and slope of the term structure. We analyze how this function varies across MBSs with different coupons and investigate the sensitivity of prices to the two factors. An important finding is that the interest rate level proxies for the moneyness of the option, the expected level of prepayments, and the average life of the cash flows, while the term structure slope controls for the average rate at which these cash flows should be discounted. Though the origination and prepayment behavior of mortgages differ substantially across coupons, there remains an unexplained common factor which explains 80-90% of the remaining variation of MBS prices. This factor does not seem to be related to the usual suspects, and therefore presents a puzzle to financial economists.

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A Nonparametric Model of Term Structure Dynamics and the Market Price of Interest Rate Risk

Journal of Finance 52, pp. 1973-2002, 1997.

Abstract

This paper presents a technique for nonparametrically estimating continuous-time diffusion processes which are observed at discrete intervals. We illustrate the methodology by using daily three and six month Treasury Bill data, from January 1965 to July 1995, to estimate the drift and diffusion of the short rate, and the market price of interest rate risk. While the estimated diffusion is similar to that estimated by Chan, Karolyi, Longstaff and Sanders (1992), there is evidence of substantial nonlinearity in the drift. This is close to zero for low and medium interest rates, but mean reversion increases sharply at higher interest rates.

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Unobservable Heterogeneity and Rational Learning: Pool-Specific versus Generic Mortgage-Backed Security Prices

Journal of Real Estate Finance and Economics 12, pp. 243-263, 1996.

Abstract

Previous mortgage prepayment and valuation models assume that two mortgage pools with the same observable characteristics should behave indistinguishably. However, even pools with apparently identical characteristics often exhibit markedly different prepayment behavior. The sources of this heterogeneity may be unobservable, but we can infer information about a pool from its prepayment behavior over time. This paper develops a methodology for using this information to calculate pool-specific mortgage-backed security prices. Knowledge of these prices is important both for portfolio valuation and for determining the cheapest pool to deliver when selling mortgage-backed securities. We find that unobservable heterogeneity between mortgage pools is statistically significant, and that pool-specific prices, calculated for a sample of outwardly identical mortgage pools between 1983 and 1989, may differ greatly from any single representative price.

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A New Strategy for Dynamically Hedging Mortgage-Backed Securities

(with Jacob Boudoukh, Matt Richardson and Robert Whitelaw)
Journal of Derivatives 2, pp. 60-77, 1995.

Abstract

This paper develops a new strategy for dynamically hedging mortgage-backed securities (MBSs). The approach involves estimating the joint distribution of returns on MBSs and T-note futures, conditional on current economic conditions. We show that our approach has a simple intuitive interpretation of forming a hedge ratio by differentially weighting past pairs of MBS and T-note futures returns. An out-of-sample hedging exercise is performed for 8%, 9% and 10% GNMAs over the 1990-1994 period for weekly and monthly return horizons. The dynamic approach is very successful at hedging out the interest rate risk inherent in all of the GNMAs. For example, in hedging weekly returns on 10% GNMAs, our dynamic method reduces the volatility of the GNMA return from 41 to 24 basis points, whereas a static method manages only 29 basis points of residual volatility. Moreover, only 1 basis point of the volatility of the dynamically hedged return can be attributed to risk associated with U.S. Treasuries, which is in contrast to 14 basis points of interest rate risk in the statically hedged return.

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Rational Prepayment and the Valuation of Mortgage-Backed Securities

Review of Financial Studies 8, pp. 677-708, 1995.

Abstract

This article presents a new model of mortgage prepayments, based on rational decisions by mortgage holders. These mortgage holders face heterogeneous transaction costs, which are explicitly modeled. The model is estimated using a version of Hansen’s (1982) generalized method of moments, and shown to capture many of the empirical features of mortgage prepayment. Estimation results indicate that mortgage holders act as though they face transaction costs that far exceed the explicit costs usually incurred on refinancing. They also wait an average of more than a year before refinancing, even when it is optimal to do so. The model fits observed prepayment behavior as well as the recent empirical model of Schwartz and Torous (1989). Implications for pricing mortgage-backed securities are discussed.

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ARM Wrestling: Valuing Adjustable Rate Mortgages Indexed to the Eleventh District Cost of Funds

(with Nancy Wallace)
Real Estate Economics 23, pp. 311-345, 1995.

Abstract

This paper analyzes adjustable rate mortgages (ARMs) based on the Eleventh District Cost of Funds Index (EDCOFI). We study the behavior of EDCOFI over the period 1981-1993, and find that adjustments in this index lag substantially behind term structure fluctuations. We also find that the seasonality and days-in-the-month effects noted by previous authors are really symptoms of a “January effect”.

Due to the lag in EDCOFI, if interest rates fall, mortgage holders may want to refinance their mortgage loans to avoid paying a coupon rate that exceeds the market rate. We develop a finite difference valuation algorithm which accounts for all usual ARM contractual features, in addition to the dynamics of EDCOFI. The advantage of our pricing algorithm over commonly used simulation strategies is that it allows us to determine endogenously the optimal prepayment strategy for mortgage holders, and hence the value of their prepayment options. We find that the dynamics of EDCOFI give significant value to this option, typically around 0.5% of the remaining principal on the loan. Our algorithm permits issuers and investors in ARMs based on EDCOFI to quantify the effects of the many interacting contract features, such as reset margin, coupon rate caps and reset frequency, that determine mortgage value.

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Pricing Continuously Resettled Contingent Claims

(with Darrell Duffie)
Journal of Economic Dynamics and Control 16, pp. 561-573, 1992.

Abstract

This paper is a study of continuously resettled contingent claims prices in a stochastic economy. As special cases, the relationship between futures and forward prices is analyzed, and a preference-free expression is derived for these prices, as well as the price of a continuously resettled futures option, whose formula differs from Black’s futures option pricing formula due to the effects of marking-to-market the changes in the futures option premium.

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Abstracts of Working Papers

Consumer-Lending Discrimination in the FinTech Era

(with R. Bartlett, A. Morse and N. Wallace), 2018.

Abstract

Ethnic discrimination in lending can occur in face-to-face decisions or in algorithmic scoring. The GSEs’ model for pricing credit risk provides us with an identified setting to estimate discrimination for FinTech and face-to-face lenders, as well as to offer a workable enforcement interpretation of U.S. fair-lending laws using the court’s justification of legitimate business necessity. We find that face-to-face and FinTech lenders charge Latinx/African-American borrowers 6-9 basis points higher interest rates, consistent with the extraction of monopoly rents in weaker competitive environments and from profiling borrowers on shopping behavior. In aggregate, Latinx/African-American pay $250-$500M per year in extra mortgage interest. FinTech algorithms have not removed discrimination, but two silver linings emerge. Algorithmic lending seems to have increased competition or encouraged more shopping with the ease of applications. Also, while face-to-face lenders discriminate against minorities in application rejection, FinTechs do not.

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Energy Efficiency and Commercial-Mortgage Valuation

(with D. Jaffee and N. Wallace), 2012.

Abstract

Energy efficiency is a key factor to the future of the U.S. economy, and commercial buildings are among the largest users of energy. However, existing commercial mortgage underwriting practices provide little incentive for building owners to make their buildings more energy efficient. In this paper, we extend standard mortgage valuation methods, which account for the expected dynamics of interest rates and building prices, by including the expected dynamics of the electricity and gas forward prices as well as average building-level energy consumption. This allows us explicitly to incorporate energy risk and efficiency measures, which depend on both the energy efficiency of the building and the characteristics of its location, into commercial mortgage valuation and underwriting. We apply our valuation methodology to price a sample of 1,390 mortgages, originated between 2005 and 2007 on office buildings located in 28 cities across the U.S. We find that, relative to the traditional mortgage valuation methodology, our proposed strategy leads to an 5% reduction in the mispricing of the default risk of commercial mortgages.

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Valuing Mutual Fund Companies

(with J. Boudoukh, M. Richardson and R. Whitelaw).

Abstract

Combining insights from the contingent claims and the asset-backed securities literatures, we study the economics of value creation in the asset management business. In particular, we provide a theoretical model and a closed form formula for the value of fund fees in the presence of the well known flow-performance relation, giving rise to interesting nonlinearities and volatility-related effects. The theoretical model sheds light on the role of fees, asset growth, asset and benchmark volatility, and the intensity of the flow-performance relation. To better understand the role of changing fund characteristics such as age and size on the fund value and fund risk, we estimate the empirical relation between returns and flows conditional on these characteristics for various asset classes. We study these effects using Monte Carlo simulations for various economically meaningful parameter values for specific asset classes. Measuring value as a fraction of assets under management, we find that both value and risk, systematic and idiosyncratic, decline in size and age. In addition, value is a complex, non-monotonic function of the fee charged on the fund.

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(C) 2017 Richard Stanton