Capital Gains Taxes and Asset Prices: Capitalization or Lock-In?

This paper examines the impact on asset prices from a reduction in the long-term capital gains tax rate using an equilibrium approach that considers both demand and supply responses. We demonstrate that the equilibrium impact of capital gains taxes reflects both the capitalization effect (i.e., capital gains taxes decrease demand) and the lock-in effect (i.e., capital gains taxes decrease supply). Depending on time periods and stock characteristics, either effect may dominate. Using the Taxpayer Relief Act of 1997 as our event, we find evidence supporting a dominant capitalization effect in the week following news that sharply increased the probability of a reduction in the capital gains tax rate and a dominant lock-in effect in the week after the rate reduction became effective. Nondividend paying stocks (whose shareholders only face capital gains taxes) experience higher average returns during the week the capitalization effect dominates and stocks with large embedded capital gains and high tax sensitive investor ownership exhibit lower average returns during the week the lock-in effect dominates. We also find that the tax cut increases the trading volume during the week immediately before and after the tax cut becomes effective and in stocks with large embedded capital gains and high tax sensitive ownership during the dominant lock-in week.

Does Financial Constraint Affect Shareholder Taxes and the Cost of Equity Capital?

We show that firms with the least elastic demand for equity capital should benefit the most from reductions in shareholder taxes. Consistent with this prediction, we find that, following 1997 and 2003 cuts in U.S. individual shareholder taxes, financially constrained firms, and particularly those with disproportionate ownership by U.S. individuals, enjoyed larger reductions in their cost of equity capital than did other firms. The results are consistent with the incidence of the tax reductions falling mostly on firms with the most pressing needs for capital. Furthermore, the findings provide an explanation for the heretofore puzzling finding that, following the unprecedented 2003 reduction in dividend tax rates, non-dividend-paying firms outperformed dividend-paying firms. Not surprisingly, we find that non-dividend-paying firms are more financial constrained than dividend-paying firms are. When a firm’s financial constraint and dividend choice are jointly considered, we find that the extent of financial constraint affects the change in the cost of equity capital, but whether a firm issues a dividend does not. In other words, it appears that the extant studies suffered from the omission of a correlated variation, the extent to which a firm is financially constrained.

Risk and CEO turnover

This paper investigates the role played by performance risk in impacting a board’s ability to learn about a CEO’s unknown talent and influencing their decision to fire or retain a CEO. We posit that idiosyncratic stock return volatility reflects information arrival about the impact of CEO talent on firm performance, enhancing the informativeness of performance with respect to CEO talent, while systematic volatility captures aspects of return variability beyond the CEO’s control. We predict that these distinct aspects of volatility will have opposite effects on CEO turnover given their differential implications for the process of learning about CEO talent. We provide robust empirical evidence that the likelihood of CEO turnover is increasing in idiosyncratic risk and decreasing in systematic risk, after controlling for firm performance. We also predict and document that turnover-performance-sensitivity increases in idiosyncratic risk and decreases in systematic risk, consistent with the information content of performance with respect to learning about CEO’s talent increasing in idiosyncratic risk and decreasing in systematic risk. This result stands in stark contrast to the extant executive compensation literature where higher performance risk from any source is generally expected to decrease pay-performance-sensitivity due to risk aversion considerations. In our turnover setting, risk impacts the learning process, and can either increase or decrease turnover-performance-sensitivity depending on the underlying source of the volatility! Finally, we investigate relations between the threat of termination and CEO compensation, documenting that for retained CEOs, both subsequent pay-performance-sensitivity and pay levels decrease in the probability of turnover

Hiding behind Writing: Communication in Offering Process and MBS Performance

Abstract Securities Offering Reform (SOR) in 2005 formalized free writing prospectus (FWP) as permittable written communication in the offering process by securities issuers. Using non-agency mortgage deals securitized following SOR, we find the surprising result that MBS deals with more usage of FWPs sufferred up to 20% higher cumulative net loss. Using textual analysis as an identification strategy, we attribute our finding to the more aggressive sales tactic associated with more FWP usage being employed for deals with more adverse information withholding. Consequently, the cumulative net loss on these deals are worse than their reported characteristics. Lending support to this explanation, we find that the FWP effect persists even after controlling for deal initial yield spreads and credit enhancements, and higher usage of FWPs are associated with increased content ambiguity in the final prospectus. The latter is a tactic often used to hedge litigation risk on undisclosed information. Keywords: Written Communication, Free Writing Prospectus, Information withholding, Uncertain Text, MBS Performance * We thank Zhonglan Dai, Jun Li, Tim Loughran, and Han Xia for helpful comments. All three authors are from Naveen Jindal School of Management, University of Texas at Dallas, 800 West Campbell Road, Richardson, Texas, 75080, email: [email protected], [email protected], [email protected] "In many ways, mortgage products such as RMBS were ground zero in the financial crisis. Misrepresentations in connection with the creation and sale of mortgage securities contributed greatly to the tremendous losses suffered by investors once the U.S. housing market collapsed.&quot

Hiding behind Writing: Communication in the Offering Process of Mortgage-Backed Securities

Abstract Securities Offering Reform (SOR) in 2005 formalized free writing prospectus (FWP) as permittable written communication in the offering process by securities issuers. Using non-agency mortgage deals securitized following SOR, we find the surprising result that MBS deals with more FWP usage suffered up to 2% higher cumulative net loss, accounting for almost 18% of the deal average loss. Examining the contents of FWPs, we uncover that textual FWPs rather than loan data tape played a more significant role for the larger deal losses. More FWPs are associated with increased uncertain text usage in the final prospectus supplements, a tactic often used to hedge litigation risk on undisclosed information. Our findings provide evidence that MBS issuers may have hidden information behind writing for their financial benefits. Keywords: Written Communication, Free Writing Prospectus, Information Withholding, Uncertain Text * We thank Dion Bongaerts, Zhonglan Dai, Kathleen Weiss Hanley, Jun Li, Tim Loughran, Han Xia, and the seminar participants at Erasmus University for helpful comments. All three authors are from Naveen Jindal School of Management, University of Texas at Dallas, 800 West Campbell Road, Richardson, Texas, 75080, email: [email protected], [email protected], [email protected] "In many ways, mortgage products such as RMBS were ground zero in the financial crisis. Misrepresentations in connection with the creation and sale of mortgage securities contributed greatly to the tremendous losses suffered by investors once the U.S. housing market collapsed.&quot

Taxation of Risky Investment and Paradoxical Investor Behavior

Under uncertainty and irreversibility, real option-based models are widely accepted for assessing investment projects. So far the existing post-tax analyses do not provide a general analytical description of investor reactions towards profit tax rate changes. This paper sets out to fill part of the void. We implement a simple tax system and focus on risky capital market investment and an option to wait. Taxes affect risk-free and risky capital market investment asymmetrically and hence cause distortions. We analytically identify a set of neutral tax rates (tax regimes) that preserve the critical post-tax investment threshold in case of tax rate changes as well as general normal and paradoxical settings. Unlike for other tax paradoxa neither depreciation rules nor loss offset restrictions are responsible for the observed paradoxical reaction. Identifying normal and paradoxical tax regimes can be regarded as a first step to a generalized description of tax effects under uncertainty, both for individual project evaluation as well as for understanding tax effects on an aggregate level

Risk and CEO turnover

a b s t r a c t This paper investigates how performance risk impacts a board's ability to learn about the unknown talent of a chief executive officer (CEO). We theorize that the information content of performance is increasing in idiosyncratic risk and decreasing in systematic risk. We provide robust empirical evidence that the likelihood of CEO turnover is increasing in idiosyncratic risk and decreasing in systematic risk and that turnoverperformance-sensitivity is also increasing in idiosyncratic risk and decreasing in systematic risk. We further investigate relations between the threat of termination and CEO compensation, showing that for retained CEOs, both subsequent pay-performancesensitivity and pay levels decrease in the probability of turnover

Risk and CEO turnover

This paper investigates how performance risk impacts a board's ability to learn about the unknown talent of a chief executive officer (CEO). We theorize that the information content of performance is increasing in idiosyncratic risk and decreasing in systematic risk. We provide robust empirical evidence that the likelihood of CEO turnover is increasing in idiosyncratic risk and decreasing in systematic risk and that turnover-performance-sensitivity is also increasing in idiosyncratic risk and decreasing in systematic risk. We further investigate relations between the threat of termination and CEO compensation, showing that for retained CEOs, both subsequent pay-performance-sensitivity and pay levels decrease in the probability of turnover.CEO turnover Idiosyncratic risk Systematic risk CEO compensation