U.S. financial regulators found themselves on the receiving end of an outpouring of concern from law makers last Wednesday about the risks to the banking sector and debt markets from the treatment of collateralized loan obligations (“CLOs”) in the Volcker Rule final regulations. Regulators and others have come to realize that treating CLOs as if they were hedge funds is a problem and we now understand from Governor Tarullo’s testimony that the treatment of CLOs is at the top of the list for the new interagency Volcker task force. But what, if any, solutions regulators will offer—and whether they will be enough to allow the banking sector to continue to hold CLOs and reduce the risks facing debt markets—remains to be seen.
Posts Tagged ‘Corporate debt’
Following a robust 2012, the financing markets in 2013 continued their hot streak. Syndicated loan issuances topped $2.1 trillion, a new record in the United States. However, as in 2012, financing transactions in the early part of 2013 were devoted mostly to refinancings and debt maturity extensions rather than acquisitions. In fact, new money debt issuances were at record lows during the first half of 2013. The second half of 2013, though, saw an increase in M&A activity generally, and acquisition financing in the fourth quarter and early 2014 increased as a result.
In our paper, Corporate Funding: Who Finances Externally?, which was recently made publicly available on SSRN, we provide new information on security issues and external financing ratios derived from annual cash flow statements of publicly traded industrial companies over the past quarter-century. Our use of cash flow statements permits us to differentiate between competing forms of internal financing, including operating profits, cash draw-downs, reductions in net working capital, and sale of physical assets. Unlike leverage ratios which dominate the focus of the extant capital structure literature, our cash-flow-based financing ratios are measured using market values (cash) and are unaffected by the firm’s underlying asset growth rate.
The empirical analysis centers around three main issues, the first of which is to establish the importance of external finance in the overall funding equation. In our pool of nearly 11,000 (Compustat) non-financial firms, the net contribution of external cash raised (security issues net of repurchases and dividends) was negative over the sample period. Moreover, the average (median) firm raised merely 12% of all sources of funds externally. Also, annual funds from total asset sales contributed more to the overall funding equation than net proceeds from issuing debt.
Scholars have traditionally assumed that lenders that protect themselves using credit derivatives like credit default swaps (CDS) have limited interest in debt governance. The rationale behind this proposition seems straight-forward. Lenders that have bought credit protection should have little incentive to invest in monitoring and disciplining a borrower where they know they will be repaid under the CDS. Indeed, scholars argue, lenders that have purchased CDS protection have considerable interest in seeing a borrower fail. When this happens, they can easily and cheaply exit their investment by triggering repayment on the CDS.
This paper, the New Market in Debt Governance, recently made available on SSRN, challenges this consensus and proposes a new theory of governance in the context of credit derivatives trading. While scholars have traditionally focused on lenders that protect themselves using CDS, they overlook the role of financial firms that sell this credit protection and thereby assume economic risk on the underlying borrower. These protection sellers take on the risk of a borrower defaulting, but possess no legal tools with which they can discipline the borrower to stave off default. As a result, unlike ordinary lenders, protection sellers have no direct means to control a borrower’s risk-taking. They possess no legal powers to influence how much leverage a borrower takes on, its use of collateral, cash reserves or its acquisitions and enterprise strategy. Given this precarious position, it follows that protection sellers possess powerful incentives to seek out ways to influence how a borrower company is run to better control how risky it is allowed to become.
Amid the current debate over tax policy in Washington, there is a bipartisan consensus on one issue: the corporate tax rate, which is currently 35 percent, should be reduced to roughly 25 percent. At the same time, budgetary pressures preclude any significant increase in the deficit to accomplish corporate tax reform.
In light of these competing demands, most corporate tax reformers advocate broadening the corporate tax base to pay for any rate reduction. Unfortunately, few politicians have put forth base-broadening measures that would generate revenue sufficient to significantly lower the corporate tax rate on a revenue-neutral basis.
In fact, revenue-neutral corporate income tax reform is likely to be very difficult, because corporate tax expenditures represent a relatively small portion of total corporate tax revenues. A preliminary analysis by the Joint Committee on Taxation suggested that the elimination of all corporate tax expenditures—except for the deferral of tax on foreign source profits, a provision whose repeal would be politically and economically infeasible—would allow for the corporate tax rate to be reduced to only 28 percent.
Therefore, if policymakers want to reduce the corporate tax rate on a revenue-neutral basis, they will likely have to adopt other types of reforms to broaden the corporate tax base. Ideally, those reforms should offer the potential for significant revenue gains and reduce economic distortions.
In the paper, Classified Boards, the Cost of Debt, and Firm Performance, which was recently made publicly available on SSRN, I analyze the effects of classified boards on bondholders’ wealth and the cost of debt, as well as the implications on firm performance. The empirical results suggest that classified boards are strongly associated with a lower cost of debt, and the effect is robust to the inclusion of other governance variables the literature has shown to be relevant to the cost of debt, especially the G-index.
In the paper, Ownership Structure and the Cost of Corporate Borrowing, forthcoming in the Journal of Financial Economics, we study the financial consequences of the divergence between control rights and cash-flow rights in a large sample of companies across 22 East Asian and Western European countries during the period from 1996 to 2008. Specifically, we analyze the effects of control rights-cash-flow rights divergence on firms’ cost of borrowing and provide new insights into the link between the separation of ownership and control and corporate value.
In the paper, Inside Debt, which is forthcoming in the Review of Finance, we show that CEOs should be paid with debt in their own firm, to deter them from taking risky actions (e.g. sub-prime lending) that hurt bondholders, as was common in the recent financial crisis. Our theory justifies the substantial use of debt compensation documented by recent evidence, and underpins recent proposals to tie CEOs to the value of their debt to prevent future crises (as recently implemented at AIG).
Three decades of theoretical research on CEO pay have focused almost exclusively on justifying compensating CEOs with equity-like instruments alone, such as stock and options. This has likely been driven by the long-standing belief that, empirically, executives don’t hold debt. However, this belief arose not because CEOs actually don’t hold debt, but because disclosure of debt compensation was extremely limited and so researchers missed this component of compensation. New disclosures mandated by the SEC from March 2007 show that CEOs hold substantial debt in their own firms (known as “inside debt”) in the form of deferred compensation and defined benefit pensions. Indeed, in some cases, CEOs hold even more debt than they do equity. Since the use of debt sharply contrasts with existing theories which advocate only equity, some commentators have argued that it must be inefficient. By contrast, we show that inside debt can be optimal, and that it should be used in the types of firms in which they are indeed used in reality.
In the paper, The Cost of Debt, which is forthcoming in the Journal of Finance, we use panel data from 1980 to 2007 to estimate the marginal cost function for corporate debt. This is the first explicit estimate of the cost of debt function in the literature. We use variation in debt tax benefit curves to help us map out the marginal cost function. We employ two identification strategies: (i) a full panel approach using all time-series and cross-sectional information from 1980 to 2007, (ii) a time series approach focused on the 1986 Tax Reform Act.
The estimated marginal cost of debt functions are positively sloped. The location of the function depends on firm characteristics such as asset collateral, size, book-to-market, asset tangibility, cash flows, and whether the firm pays dividends. Our findings are robust to firm fixed effects, year fixed effects, across time periods, and when accounting for fixed adjustment costs of debt. We provide an easy-to-use formula that allows others to create firm-specific marginal cost of debt functions. We also provide firm-specific recommendations of optimal debt policy against which firms’ actual debt choices can be benchmarked, and we quantify the welfare costs to the firm from deviating from the model-recommended optimum.
In our paper, Collateral, Risk Management, and the Distribution of Debt Capacity, which is forthcoming in the Journal of Finance, we provide a dynamic model of collateralized financing in which collateral constraints are endogenously derived based on limited enforcement. In the model, firms have access to complete markets, subject to collateral constraints, and thus are able to engage in risk management. We show that there is an important connection between firm financing and risk management since both involve promises to pay by the firm, which are limited by collateral.
Our model predicts that firms with low net worth exhaust their debt capacity and hedge less, since financing needs override hedging concerns, consistent with the empirical evidence. In contrast, this evidence is considered a puzzle from the vantage point of the standard theory of risk management, which takes investment as given. Rampini and Viswanathan (2009) study an infinite horizon model and show that the same trade-off between financing and risk management obtains generally.