Two Essays on Liquidity Endogeneity and Effects of Political Connections

Abstract

The two essays in my dissertation explore separately the issues related to stock market liquidity and corporate financial distress. My first essay examines the effects of widespread liquidity demand on the stock liquidity. My second essay explores the effect of political connections on the corporate financial distress. In the first essay, I explore several questions related to the effect of liquidity demand on the individual stock liquidity level. I find that domestic actively managed equity funds in general hold less liquidity than their corresponding benchmarks. This leads them to rely more on the small fraction of liquid assets for immediacy when faced with financial distress and significant outflows. I further find that mutual funds sell more of liquid stocks when they are faced with negative fund flows. Consistent with prior literature that funds have to meet redemptions and reduce price impact, their engagement in liquid stock sale is more severe when the market volatility is high and when the aggregate market flow is low. Consequently, a widespread liquidity shock would be more likely to exert pressure on the liquidity of the stocks they sell. Using the mutual fund involuntary sale to proxy for the exogenous widespread liquidity demand, I find that a stock with a greater level of mutual fund forced sale tends to be less liquid in the next period. This liquidity erosion exists mostly among liquid stocks. I further find that the liquidity demand deteriorates liquid stocks' liquidity even more during volatile periods, when more funds face outflows and are forced to sell. The liquidity deterioration is also followed by return reversals in the subsequent quarter as the compensation for investors to provide liquidity, especially for liquid stocks and during bad market times. My overall evidence provides empirical evidence of the endogenous effect of liquidity demand on the stock liquidity and helps to at least partially explain the market liquidity spiral during turmoil periods by showing that liquid assets worsen in liquidity due to the market wide liquidity demand. One lesson to learn is that the market is far from resilient to absorb the liquidity demand. In the second essay, I propose and test several hypotheses to examine the impact of politically connected debtors on the resolution of distress. The results suggest that firms with politically connected debtors are more likely to exit the Chapter 11 process as a going-concern rather than through acquisition or liquidation. Additionally, I find that firms with politically connected debtors are less likely to undergo a subsequent distressed restructuring following emergence from Chapter 11. The findings suggest that the effects of debtors' political connections on bankruptcy outcomes are most likely due to the economic benefits associated with political connections rather than the potential for debtors to use political capital to coerce creditors into approving suboptimal continuations of unprofitable firms. Further, my findings indicate that firms with politically connected debtors are able to effectively reduce their financial leverage to the industry level after getting out of bankruptcy, while leverage ratios in firms without politically connected debtors remain above industry levels. Further evidence shows that creditors of firms with politically connected debtors are more willing to take equity in exchange for their debt claims. This result is indicative of investors' greater confidence in the firm's viability due to implicit guarantees linked to debtors' political connections. Overall, the study provides evidence that politically connected debtors may improve the debtors' bargaining power, thereby resulting in a higher incidence of out-of-court restructurings.