Reflexivity in Credit Markets
Reflexivity is the idea that investors' biased beliefs affect market outcomes, and that market outcomes in turn affect investors' beliefs. We develop a behavioral model of the credit cycle featuring such a two-way feedback loop. In our model, investors form beliefs about firms' creditworthiness, in part, by extrapolating past default rates. Investor beliefs influence firms' actual creditworthiness because firms that can refinance maturing debt on favorable terms are less likely to default in the short-run—even if fundamentals do not justify investors' generosity. Our model is able to match many features of credit booms and busts, including the imperfect synchronization of credit cycles with the real economy, the negative relationship between past credit growth and the future return on risky bonds, and "calm before the storm" periods in which firm fundamentals have deteriorated but the credit market has not yet turned.
A previous version of this paper circulated under the title "A Model of Credit Market Sentiment." We are grateful to Nicholas Barberis, Jonathan Ingersoll, Gordon Liao, Yueran Ma, Andrei Shleifer, Jeremy Stein, Lawrence Summers, Adi Sunderam, Yao Zeng, and seminar participants at Brandeis University, Columbia University, the Federal Reserve Bank of San Francisco, the London School of Economics, London Business School, Oxford University, the University of Massachusetts Amherst, the University of Michigan, the University of North Carolina at Chapel Hill, the University of Washington, the American Economic Association Annual Meetings, the FIRN Annual Asset Pricing Workshop, and the LA Finance Day Conference for their helpful comments. Greenwood and Hanson gratefully acknowledge funding from the Division of Research at Harvard Business School. Outside activities and other relevant disclosures are provided on the authors' websites at their host institutions. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
This document contains a list of professional activities beyond my main employment at Harvard University. Please feel free to contact me with any questions about this disclosure statement.
Outside activities since 2008, paid and unpaid:
Academic Advisory Board, Martingale Asset Management (chairman) Consultant, Martingale Asset Management
AllianceBernstein, research presentation and consultation Capital structure consultation to two non-financial companies Associate Editor, Review of Financial Studies (unpaid) Editor, Review of Financial Studies (2014-present, unpaid)
In 2014, the Brookings Institute paid me an honorarium for the working paper “Government Debt Management at the
Zero Lower Bound”
The Banco Central de Chile paid me an honorarium for the paper “Forward Guidance in the Yield Curve: Short Rates versus Bond Supply.”
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HBS Investment Management Workshop (various years, since 2008) HBS Finance for Senior Executives (various years, unpaid before 2016) SanfordBernstein Research Conference
Robeco Q-Group Arrowstreet Capital Pyramis
Windham Capital Management
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