Behavioral Finance Strikes Again: Anchoring in Loan Markets

Anchoring on Credit Spreads

• Dougal, Engelberg, Parsons, and Wesep
• A version of the paper can be found here.
• Want a summary of academic papers with alpha? Check out our Academic Research Recap Category.

Abstract:

This paper documents that the path of credit spreads since a firm’s last loan influences the level at which it can currently borrow. If spreads have moved in the firm’s favor (i.e., declined), it is charged a higher interest rate than justified by current fundamentals, and if spreads have moved to its detriment, it is charged a lower rate. We evaluate several possible explanations for this finding, and conclude that anchoring (Tversky and Kahneman [1974]) to past deal terms is most plausible.

Alpha Highlight:

I know, I know…markets are efficient, everyone is rational, and we should all buy passive value-weight portfolios of all assets in the macro-economy.

Great story, but that isn’t how the real-world operates.

Let’s review the evidence from this paper, which examines how anchoring bias can effect lending markets.
Consider an example from the paper:

Suppose that two neighbors living across the street from one another both want to re finance their home loans, and that prevailing rates on 30-year mortgages are currently 6% on average.

• Neighbor 1 originated his mortgage 5 years ago, when average rates were 8%.
• Neighbor 2 originated her mortgage 10 years ago, when average rates were 4%.

The neighbors should both pay 6%, since that is the market price. However, neighbor 1 views 6% as “cheap” and neighbor 2 views 6% as “expensive.” As the authors show, this anchoring affect implies that Neighbor 1 will end up paying a higher rate than Neighbor 1.

Remarkably, this behavioral bias among borrowers is not confined to the one-off crazy person in the neighborhood. Turns out that sophisticated corporate borrowers and bank lenders are influenced by anchoring bias. That is, the level of credit spreads of a borrower’s most recent loan correlates with the spread it receives on a new loan.

2008 Financial Crisis Example:

Before the 2008 financial crisis, average credit spreads were relatively low. After the crisis, risk appetite dropped and credit spreads widened. Credit spreads shot up roughly 35% (see Panel A).

Given the dramatic changes in credit spreads following the Financial Crisis we should expect that macro credit spread changes should be reflected in bank loans. In Panel B the authors show something completely different: a large number of loans are issued at the exactly the same credit spread! 
The evidence supports the hypothesis that borrowers/lenders anchor on past credit spreads, without fully considering current market conditions.

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Other Fun Findings

Anchoring bias can affect both lenders and borrowers. A quote from the paper:

If the borrower’s predicted spread is higher than the spread on its most recent loan, then anchoring would yield a spread below market rates, harming the lender… On the other hand, if the borrower’s predicted spread is lower than the spread on its most recent loan, then anchoring would yield a spread above market rates, harming the borrower.

The paper also highlights that while both lenders and borrowers can be subject to anchoring, the anchoring is much stronger when it benefits the lender (See Table IX). Casey Dougal, one of the authors, shared his comments below:

I think this is interesting because it suggests that the bankers to some degree recognize what is going on, and that they take advantage of this bias at the borrowers expense.