A fundamental feature of the financial reporting landscape is that investors want a firm’s management to diligently and faithfully report on its firm’s affairs. In the event of fraudulent material misstatement or omission of information, the federal securities laws provide investors with the right to take legal action. The conventional view is that heightened legal damages discourage managerial misreporting (e.g., Caskey 2010; Evans and Sridhar 2002; Francis, et al. 1994; Grundfest and Perino 1997; Johnson, et al. 2001; Kasznik and Lev 1995; Skinner 1994; Trueman 1997; Spindler 2008).
For most of the postwar period the unsecured market for credit has been small. Ellis (1998) shows that truly unsecured credit (credit card and related plans issued by insured banks) did not appear in any significant amount until the late 1960s. Furthermore, as Figure (1) shows the filing rate for Chapter 7 bankruptcy over the past 70 years was flat and very low until the late 1970s, reflecting the absence of significant unsecured indebtedness.
However, over the past three decades there have been dramatic changes in this market. First, the availability of unsecured credit has increased both along the extensive and intensive margin; Narajabad (2007) documents that the fraction of US households with positive credit card limits increased by 17 percentage points between 1989 and 2004, while the average credit limit more than doubled over the same time period. In addition to the increase in availability of credit, Krueger and Perri (2006) measure that unsecured debt (utilized credit) as a fraction of disposable income has risen from 2 percent to 9 percent from 1980 to 2005. Given the presence of exemptions, the best measure of unsecured credit is negative net worth; Sanchez (2008) documents that the mean debt to mean income ratio has risen from 0.63 percent in 1983 to 1.41 percent in 2004 and the percentage of households with negative net worth has risen from 5.04 percent to 6.93 percent.
Economic theory suggests that all else equal, higher levels of short interest imply a built in demand for an asset. This is due to the mechanics of short selling. In order to sell short, one should first borrow the security (usually from a broker-dealer or an institutional investor) and then sell it. Eventually, the short seller must buy back the shares and return them to the lender.
