# Richard Stanton's Papers

## Published and Forthcoming Articles

1. "Pricing Continuously Resettled Contingent Claims", Journal of Economic Dynamics and Control 16, 561-573, 1992 (with D. Duffie).
2. "Rational Prepayment and the Valuation of Mortgage-Backed Securities", Review of Financial Studies 8, 677-708, 1995.
3. "ARM Wrestling: Valuing Adjustable Rate Mortgages Indexed to the Eleventh District Cost of Funds", Real Estate Economics 23, 311-345, 1995 (with N. Wallace).
4. "A New Strategy for Dynamically Hedging Mortgage-Backed Securities", Journal of Derivatives 2, 60-77, 1995 (with J. Boudoukh, M. Richardson and R. Whitelaw).
5. "Unobservable Heterogeneity and Rational Learning: Pool Specific vs. Generic Mortgage-Backed Security Prices", Journal of Real Estate Finance and Economics 12, 243-263, 1996.
6. "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).
7. "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).
8. "Mortgage Choice: What's the Point?", Real Estate Economics 26: 173-205, 1998 (with N. Wallace).
9. "Anatomy of an ARM: The Interest Rate Risk of Adjustable Rate Mortgages", Journal of Real Estate Finance and Economics 19, 49 - 67, 1999 (with N. Wallace).
10. "Nonparametric Mortgage-Backed Security Pricing", in Advanced Fixed Income Valuation Tools, John Wiley, 2000 (with J. Boudoukh, M. Richardson and R. Whitelaw).
11. "From Cradle to Grave: How to Loot a 401(k) Plan", Journal of Financial Economics 56, 485-516, 2000.
12. "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).
13. "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).
14. "Managerial Ability, Compensation, and the Closed-End Fund Discount", Journal of Finance 62, 529-556, 2007 (with J. Berk) (nominated for Smith-Breeden award).
15. "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).
16. "An Empirical Test of a Contingent Claims Lease Valuation Model," Journal of Real Estate Research 31, 1-26, 2008 (with N. Wallace).
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. "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).
19. "Human Capital, Bankruptcy and Capital Structure", Journal of Finance 65, 891-926, 2010 (with J. Berk and J. Zechner) (nominated for the Brattle prize).
20. "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).
21. "Revisiting Asset Pricing Puzzles in an Exchange Economy", Review of Financial Studies 24, 629-674, 2011 (with C. Parlour and J. Walden).
22. "The Bear's Lair: Indexed Credit Default Swaps and the Subprime Mortgage Crisis", forthcoming, Review of Financial Studies (with N. Wallace).
23. "Estimation of Dynamic Term Structure Models", forthcoming, Quarterly Journal of Finance (with G. Duffee).
24. "Financial Flexibility, Bank Capital Flows, and Asset Prices", forthcoming, Journal of Finance (with C. Parlour and J. Walden).

## Abstracts of Published/Forthcoming Articles

### 1. 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.

### 2. 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.

### 3. 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.

### 4. 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.

### 5. 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.

### 6. 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.

### 7. 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.

### 8. 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.

### 9. 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.

### 10. 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.

### 11. 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.

### 12. 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.

### 13. 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.

### 14. 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.

### 15. 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.

### 16. 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.

### 17. 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.

### 18. 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.

### 19. 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.

### 20. 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.

### 21. 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.

### 22. The Bear's Lair: Indexed Credit Default Swaps and the Subprime Mortgage Crisis

(with N. Wallace)
forthcoming, Review of Financial Studies

#### 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.

### 23. Estimation of Dynamic Term Structure Models

(with Greg Duffee)
forthcoming, Quarterly Journal of Finance

#### 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.

### 24. Financial Flexibility, Bank Capital Flows, and Asset Prices

(with C. Parlour and J. Walden).
forthcoming, Journal of Finance

#### 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.

## Abstracts of Working Papers

### The End of Mortgage Securitization? Electronic Registration as a Threat to Bankruptcy Remoteness

(with J. P. Hunt and N. Wallace), 2011.

#### Abstract

A central tenet of asset securitization in the United States - that assets are bankruptcy remote from their sponsors - may be threatened by innovations in the transfer of mortgage loans from the loan-originators (sponsors) to the legal entities that own the mortgage pools (the Special Purpose Vehicles (SPVs)). The major legal argument advanced in the paper is that because the mortgage is an interest in \emph{real property}, the bankruptcy-remoteness rules applicable to real property, including S 544(a)(3) of the Bankruptcy Code, create a risk to the bankruptcy remoteness of mortgage transactions unless proper recording occurs. We review the traditional mortgage transfer process and discuss why the real-property characteristics of mortgages makes them special. We next discuss how the chain of title transfer using traditional recorded assignment at the local jurisdiction helps to assure that the promissory note and the mortgage that are transferred into the SPVs are, indeed, bankruptcy remote from the loan originators and sponsors. We then discuss why the more recently introduced Mortgage Electronic Registration System (MERS) method of transfer introduces significant vulnerability into the mortgage transfer process and leads to a significant risk that bankruptcy remoteness will fail. Our arguments address scholarly and case-law theories of the legal foundations of achieving bankruptcy remoteness for mortgage transfers, the eligibility requirements for true-sale'' accounting treatment of transferred mortgages under Financial Accounting Standards (FAS 140), and the finance literature that addresses the economics of securitization through bankruptcy remoteness. We conclude with a first step toward policy prescriptions concerning possible promissory note and mortgage transfer processes that could achieve bankruptcy remoteness and the associated economic efficiency objectives of mortgage securitization.

### CMBS Subordination, Ratings Inflation, and Regulatory-Capital Arbitrage

(with N. Wallace), 2011.

#### 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 AAA CMBS yields and AAA corporate bond yields fell significantly following a loosening of capital requirements for highly rated CMBS in 2002, while no comparable drop occurred for lower-rated bonds (which experienced no similar regulatory change). We also find that AA-rated CMBS upgraded to AAA significantly faster than comparable AA-rated residential RMBS (for which there was also 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' subordination levels.

### Accounting for Employee Stock Options

(with M. Rubinstein).

#### Abstract

The problem of accounting for employee stock options (ESOs) has proven surprisingly intractable. Rubinstein, in his 1995 article, argues that the one barrier complicating a clear solution to this problem is the difficulty of measuring the value of these options. Approaches to valuing standard listed options do not seem easily transferable due to the difficulty of measuring volatility and dividends over the long times-to-expiration, the seeming necessity of forecasting employee option forfeiture and departure rates, and the effects of non-transferability on the optimal timing of exercise. However, using something similar to the service period accounting method discussed briefly in FASB 123 and advocated recently anew by Bulow and Shoven, this problem can be overcome. In this paper, we show that the accounting problem can be reduced to valuing over time a sequence of short-term options for which these measurement problems become relatively unimportant. Our solution offers a more general justification for the service period method than heretofore advanced and harmonizes accounting in both the post- and pre-vesting periods. For both periods, only short-term options need be valued. In particular, for almost all large firms, the market prices of similar exchange-traded options can be used as objective valuation estimates. Theoretical considerations and desirable practice can now be combined in a happy marriage.

### 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.

Richard Stanton <stanton@haas.berkeley.edu>