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  5. Incentives and Contracts
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Incentives and Contracts

Paper Session

Sunday, Jan. 8, 2023 1:00 PM - 3:00 PM (CST)

Sheraton New Orleans, Rhythms II
Hosted By: American Finance Association
  • Chair: Carola Frydman, Northwestern University

Put Credit Rating Agency’s Money Where Its Mouth Is

Ping Liu
,
Purdue University
Alexei Tchistyi
,
Cornell University

Abstract

We derive an optimal compensation contract that incentivizes a credit rating agency
(CRA) to exert effort and issue unbiased ratings. The contract rewards CRA when its
credit rating is matched by the subsequent bond performance and penalizes it otherwise.
The optimal contract can be implemented by giving CRA options to buy bonds
or credit default swaps. In a competitive environment, the contract is part of a procurement
auction. Our empirical findings show that the credit rating industry remains
problematic. Compared to incumbent CRAs, new entrants are consistently issuing
more favorable ratings and are willing to rate more CMBS tranches.

Debt and Water: Effects of Bondholder Protections on Public Goods

Kelly Posenau
,
University of Chicago

Abstract

How do creditors influence the quality of local public goods through municipal debt contracts? I examine this question in the context of municipal water utility debt covenants. As utilities approach their covenant violation thresholds, they increase prices. But, utilities also reduce hiring growth and reduce manager pay. I also find that officials sequence their budget decisions according to a pecking order hierarchy: they raise revenues as much as possible, then cut spending. The incidence of cuts is first on water system expenses and then on administrative expenses. System problems and pipe breaks are most sensitive to distance to covenant thresholds for the most constrained utilities. These utilities respond on a per capita basis to a $1 move toward covenant thresholds by raising revenues $0.26, cutting water system expenses $0.19, and reducing administrative expenses $0.13. I confirm the pecking order using a drought shock to water demand: covenant-constrained utilities raise prices 9% relative to unconstrained utilities following the shock. Local hostility to taxes imposes an additional friction on the revenue-raising process. After accounting for tax hostility following the drought shock, the overall effect of the rate covenant for an average covenant-constrained utility is a 9.5% reduction in water system expenses.

Providing Incentives with Private Contracts

Andrea Buffa
,
University of Colorado Boulder
Qing Liu
,
City University of Hong Kong
Lucy White
,
Boston University

Abstract

Agents working together to produce a joint output care about each other’s incentives. Because real world contracts are typically private information, observed only by their direct signatories, agents are vulnerable to the principal opportunistically reducing the power of other agents’ incentives. When agents are sufficiently skilled, the principal can mitigate this commitment problem by making the most skilled one “team-leader,” with authority to write other agents’ contracts. This endogenous hierarchy, never optimal with public contracts, raises effort, output, and compensation, but distorts effort allocation due to rent extraction. Our model applies to bank syndicates, venture capital, organizational design, and outsourcing.

Discussant(s)
Asaf Bernstein
,
University of Colorado Boulder
Daniel Green
,
Harvard Business School
George Georgiadis
,
Northwestern University
JEL Classifications
  • G3 - Corporate Finance and Governance