Follow-up to “Continuous Bankruptcy”
I am continually amazed at the quality of comments that Interfluidity attracts. But commenters to the previous post truly outdid themselves. I proposed a “novel” security intended to make debt-to-equity conversions gradual and automatic, in hopes of avoiding disruptive “discrete” bankruptcies. Commenters quickly pointed out earlier work along the same lines, and some serious problems that I hadn’t considered. All in all, I remain convinced that “continuous bankruptcy” is a goal worth pursuing. But I’m equally convinced that the specific security I suggested would probably not quite do it.
First, it turns out that better minds than mine have considered debt-like securities that would convert to equity as firms became undercapitalized. The excellent Economics of Contempt pointed out two antecedents, Mark Flannery’s “Reverse Convertible Debentures“, and a recent proposal by the “Squam Lake Working Group on Financial Regulation”. The Squam Lake piece is a diamond in the rough, but Flannery’s ideas are carefully developed. Flannery considers and tries to address most of the problems I would have missed without help from the comments. He also includes a detailed review of related work.
Flannery’s Reverse Convertible Debentures and my proposed “IACCPEs” are both fixed income securities convertible to common stock at a price not set in advanced, but determined by the market price of the stock at the time of conversion. Commenters Alex R and Independent Accountant were reminded of the infamous death-spiral convertibles from the late 1990s. bondinvestor pointed out that a form of catastrophe bond, “catastrophic equity puts” are similar, in that they allow the issuer to convert a fixed income obligation to equity in the event of a prespecified bad event. (Here the bad event that would trigger conversion is running short of capital.) Thomas Barker and jck of Alea pointed out that these securities resemble Islamic “sukuk convertibles”. jck suggests that these, like the death-spiral convertibles, have mostly not worked out so well. (I’d like to know more about Islamic convertibles, both the theory behind them and their history in practice — if you know of a good reference, please do drop a note in the comments.)
The trouble with my proposal is that it failed to adequately consider how both investors and firms would try to game them. Alex R pointed out that investors shorted the hell out of “death-spiral convertibles”. Those who owned them gained if prices could be pushed downward, as lower stock prices meant ownership of a larger fraction of the firm upon conversion. Other traders had incentives to short as well, since dilution caused share prices to drop post-conversion. If the conversion trigger is predictable to investors, and the same dynamic might hold for IACCPEs. (beezer thought this likely as well.)
Also, Alex R and Awake noticed that conversions are effectively at the option of the firm, since “IACCPEs” are only convertible “in arrears” — that is, when a firm hasn’t paid a dividend owed on the preferred shares. Since conversions (under my proposal) are made on terms favorable to IACCPE holders and disadvantageous to incumbent equity, managers might insist on paying dividends to the bitter end, even if overall firm value would be enhanced by preserving cash. Shareholders might prefer to “gamble for redemption” rather than transfer wealth up the capital structure and adopt a more conservative strategy. (In other words, the option value of an undercapitalized firm might be worth more to the original shareholders than the expected value of their fraction of a better capitalized firm.) Further, the fact that convertibility is at the option of firm management creates an incentive towards opacity and surprise non-payment of dividends. Firms would want to skip dividends when shares are overvalued (so that conversion would be on terms favorable to existing shareholders), and would want to hide any possibility of skipping dividends in distress (so that short-sellers don’t front-run à la death-spiral convertibles. Modifying capital structure in a way that creates incentives for managers to reduce transparency and promote mispricing doesn’t seem like a good thing.
Mark Flannery’s “Reverse Convertible Debentures” try to avoid gaming by managers and short sellers in three ways: First, RCDs convert automatically, at the option of neither issuers nor investors, based on a debt-to-market-equity trigger. Secondly, the securities are designed to avoid any transfer of net wealth from equityholders to creditors (or vice versa) upon conversion. Conversions would be based on the market value, not the par value, of the RCDs at the time of conversion, and the market price of the stock. In theory, this would make for a perfectly even exchange, so that no party would have strong incentives to game the trigger. Finally (as foreseen by commenter Bill) “triggered” RCDs wouldn’t all convert all at once. Only the minimal fraction required to bring a firm to a set level of capitalization would be affected, which again might make the threshold event less of an event worth manipulating.
I don’t think that Flannery has solved all problems of strategic behavior — both the “automatic” trigger and the effective conversion ratio are susceptible to gaming, and I don’t think it would be either possible or desirable to define terms under which investors would be indifferent to conversion. Nevertheless, Flannery’s paper makes a serious attempt to address the problem of gaming the trigger, which really is the achilles heel of this genre of proposal.
But let’s pull back. There might not even be a need for an explicit conversion scheme. Plain vanilla cumulative preferred equity has a built-in duality. As long as an issuer is paying out dividends, cumulative preferred equity is very debt-like. Investors expect a fixed coupon, and firms have strong incentive to pay it (so that common shareholders can take dividends, and because nonpayment of preferred dividends is taken as a bad signal by the market). When preferred goes “in arrears”, it suddenly becomes very equity-like: Its value becomes dependent on the promise of dividend payments at some unspecified future date, and the probability that dividends will actually get paid is sensitive to the operating performance of the firm. Cumulative preferred equity has already been invented. So why do we still have a problem?
The first, easiest, and most important thing we could do to reduce the systemic risk and deadweight bankruptcy costs caused by brittle capital structure is change the %*$%&! tax code to eliminate the tax preference for debt over preferred equity. Long-term debt and cumulative preferred equity are basically identical, except for two things: 1) Taxpayers subsidize the issuance of debt while 2) debt contracts are enforceable via socially costly bankruptcy. Taxing preferred equity dividends but not interest on debt is like taxing people for the privilege wearing seatbelts, then wondering in gape astonishment at highway mortality rates. It is bass ackwards. We can either make dividends (at the very least cumulative preferred dividends) tax deductible, or we can make interest payments non-deductable (as Richard Serlin prefers). But we have got to stop tilting the capital structure scales towards bankruptcy-enforceable debt finance. The status quo is absurd, ridiculous, untenable.
(I have yet to encounter even an attempt to justify why interest payments should be deductible but CPE dividends not. There are arguments by definition — expenses are deductible, obligatory payments are expenses, obligatory means enforceable by bankruptcy, q.e.d. But the tax code needn’t be slave to an arguable and legally alterable set of definitions.)
If cumulative preferred equity were not tax disadvantaged, firms might find that it is not much more expensive than debt. But there are two other problems with vanilla CPE as “natural convertibles”. First, there is the question of control. When a firm runs into trouble and then deep goes into arrears on cumulative preferred equity, economically speaking, the preferred becomes equity-like, while the common stock becomes option like. Unfortunately, control usually in the hands of common equity, whose incentives may be to maximize the volatility rather than expected value of firm assets. Secondly, as a matter of convention, financial regulators and analysts often treat preferred equity like debt. When a financial firm is in jeopardy of skipping preferred dividends, regulators become inclined to intervene their “prompt corrective action” mandate. Markets may view skipping preferred dividends as tantamount to a default, and question firm viablity, potentially leading to self-fulfilling distress.
The second issue may or may not be easy to address. Economists pay too little attention to the role of convention in shaping corporate finance, and even less attention to the dynamics of convention. If preferred equity is going to serve as a means of strengthening firm capital structures, we need to move to an equilibrium where occasional periods of missed dividend payments are normalized, and not taken as a death knell for a firm. Sure, skipping preferred dividends is usually bad news, just as it is not a good sign when firms cut common stock dividends. But a skipped dividend needn’t signal a death spiral for a well-capitalized firm. Perceptions might change naturally if preferred equity managed to shed its tax disadvantage. Firms might then lever themselves to the hilt with preferred stock, and over a period of time, investors would observe viable companies go into brief arrears and then emerge. Regulators could help quite a lot by treating preferred equity as equity full stop rather than as a kind of pseudo debt. For financial firms, regulators should commit not to intervene if preferred payments are skipped or threatened, so long as the value (primarily the market value) of a firm’s total equity base remains high. Regulators should treat preferred equity as high risk capital. Regulated insurers, pension funds, etc. should be required to invest as if preferred shares are no less risky than common stock. Regulators should make it clear that during resolutions, preferred shares would go to zero as easily as common if any payout is made on guaranteed liabilities.
Control issues may be more difficult to address, but not impossible. In one of several very helpful e-mails, Economics of Contempt pointed out that
[D]ebenture indentures have included a wide range of covenants over the years that were designed to serve as early warning systems (e.g., the negative pledge clause). No need to reinvent the wheel.
Debt covenants are the means by which divergence of interests within firm capital structures are usually addressed. Lenders do not explicitly exercise control over firms, but they can attach very stringent conditions to loans that limit the ability managers and stockholders to gamble with creditors’ money. Lenders hold a very big stick — if covenants are violated, they can demand immediate repayment of funds that will usually have already been spent. Debt covenants are violated quite frequently, but firms are not often forced to liquidate assets and cough up the cash. Instead, occasional violations allow lenders to renegotiate the terms of loans from a position of strength. So, even though lenders are not represented on a company’s board of directors, their interests are protected both passively (firm managers strive not to violate covenants) and actively (when a covenant is breached — and they are designed to be breached easily — lenders can intervene to actively shape firm decisions).
Preferred stock can include covenants as well, but how to enforce them is a tricky question. It would defeat the purpose of replacing debt with preferred equity if preferred shareholders could force repayment upon a covenant violation. I know very little nothing at all about how preferred stock covenants are written and work in practice. (Hint, hint, amazing commenters!) However, via Google books, I came upon the notion of “contingent proxy” in Raising Entrepreneurial Capital by John Vinturella and Susan Erickson. Apparently there is precedent for clauses that transfer voting rights as “a penalty for breach of covenant”. This idea could be very helpful. As preferred shares become more equity-like and common shares take on properties of options, control might be transferred quite directly to preferred shareholders without a formal debt-to-equity conversion. Transfers of voting rights could be architected so as to be gradual. They might be a function of the degree to which a firm is in-arrears, rather than the mere fact of in-arrear-edness, so that common shareholders would not much surrender control during occasional, brief lapses. Preferred shareholder control rights could depend upon the full mix of the solvency and health metrics typically included in debt covenants, so that there is little incentive by firm managers to game any one potential trigger. Formal options to convert to common equity could gradually be extended as well. Obviously, devils are in the details, and I don’t yet know enough to attempt an exorcism. But, as EoC reminds us, we don’t have to reinvent the wheel. Investors up and down firm capital structures have been eying one another warily for centuries. We have millions of paranoid legal documents to draw ideas from.
It seems to me that the right species of “trigger convertible”, in David Murphy’s coinage might well evolve from negotiation and experimentation, if fairly minimal changes in policy were made. First, we desperately need to level the tax playing field between debt and equity. At the very least, the differential treatment of debt and near-debt-but-safer cumulative preferred equity needs to be eliminated. Secondly, for financial firms, regulators should radically increase capital requirements for financial firms. Bankers will do what they do best, which is to seek the cheapest means possible of pretending to hold capital by inventing the most debt-like equity that they possibly can. Regulators should scrutinize these instruments carefully, but only to enforce two very simple requirements — that under no circumstances are dividend or principal repayments obligatory, and that no agreements made between the different classes of equity encumber firm assets or compel behavior that would compromise the interests of claimants higher in the capital structure. (Regulators, and creditors, would have to guard against “poison pill” arrangements, in which some form of “equity” is cheap because purchases have some means of sabotaging the firm if they are not paid. But this is not a new problem, see the negative pledge clause in EoC’s comment.)
Finally, regulators would have to severely curtail the ability of regulated entities from holding preferred equity. All equity securities should be treated like common stock for risk-weighting purposes. No matter how the contract is writtem, when a security acquires a sufficiently high weighting in the portfolios of insurance companies, pension funds, and banks, it acquires an implicit state guarantee that issuers will aggressively exploit. One lesson of the current crisis is that the distinction between debt and equity has less to do with the legal characteristics of securities than with the political connectedness, financial interconnectedness, and risk-bearing capacity of the entities who hold them. Equity securities, preferred or common, must be restricted to parties whose losses the state would tolerate.
With regard to the tax treatment of debt versus equity, you might be interested to know that in Australia dividends on Australian earnings are effectively paid from pre-tax income. (In fact it’s more complicated than that: dividends come out of post-tax income but include a tax credit, known as the franking credit, which is equivalent to the tax paid in Australia on the income that was used to pay that dividend. Australian taxpayers can claim the credit back when they submit their tax return.)
So does this lead to preferred equity of the kind discussed? Nope. Prefs are pretty rare here, actually. I believe that there are slightly higher levels of equity and higher dividend payout ratios than in other parts of the world, and companies do change their legal structure to maximise the number of credits they receive. But most investment managers are assessed on pre-tax performance, so franking credits are ignored by them. Which is a shame, as they add about 1% to the index return, or 2% in a sensible value portfolio targeting them (about 5% tracking error).
May 19th, 2009 at 6:23 am PDT
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For Islamic finance, be sure to check out the work of Mahmoud El-Gamal at Rice University.
May 19th, 2009 at 8:46 am PDT
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Yay! This was exactly the way I was thinking around my comment to “Contracts are not billateral” (except that it wasn’t relevant at the time and I haven’t looked at your blog for a while).
Remove debt, issue equity. In reality the debt is equity anyways (tiered) – if the company has no value debt holders aren’t going to be paid either, so why to try to claim differently?
May 19th, 2009 at 9:30 am PDT
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Canada also has a dividend tax credit, which roughly equalizes the effective tax rates on interest and dividend income. Tax rates on dividend income are reduced to allow for the fact dividends are paid from after-tax income.
May 19th, 2009 at 9:58 am PDT
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Great discussion!
I like the idea of debt securities that get turned into equity (and have never really understood the “taxed twice” argument, so I’m not getting into that). The key to making it work is to create a trigger that won’t be affected by either the firm’s or the investor’s behavior. So how about going back to your original idea, but making the debt to equity conversion trigger a single call by the regulators for all financial firms at the same time.
Yes, some financial firms will be upset that regulators make a call that leaves them “over capitalized”, but in an environment with systemic instabilities that’s a plus. In fact, there can be tiered convertible equities, where the first tier gets called by regulators first; the second tier (which has to be a fraction of the first) gets called second, etc.
Or how about dropping the “smaller fraction” requirement and why not make all financial institution debt legally convertible at the regulators’ discretion? The most debt-like debt will be that which is called only after 20 other tiers of debt are called.
May 19th, 2009 at 1:05 pm PDT
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A scatter of comments:
1) the good place to look for ideas about these structures is private equity, in the UK at least. There would have been a lot of preferred equity because it was usefully not treated as debt for some accounting measures but was debt for others. There are also many precedents for share classes having rights that “flower” in the event of trigger events, e.g. to hand preferred shareholders control or at least a veto right on certain transactions
2) The new accounting standards (FRS 25?) have forced firms to account for such hybrid capital as its component parts. This may reduce the effectiveness of your scheme, in that the firm may appear bankrupt from the start. I’m not sure, I”m not an accountant and don’t intend to puzzle it out from first principles!
3) I have a bigger concern. Why bother? An honest doctor would tell you that some patients should not be saved. Do we want to give bad enterprises – and more pertinently, bad management, because they won’t go quietly just because they wiped their shareholders out! – a get-out-of-gaol-free card? These structures would prevent or postpone desirable restructuring (e.g. failure followed by acquisition out of bankruptcy and the creation of a larger, lower-cost producer).
4) A final point is that debt fund managers would risk owning equity. This is not healthy for the debt fund LP’s (different management skills), not healthy for the businesses under creditor ownership, and not healthy for the structured products which assume debt components, e.g. life insurance portfolios with annuity rates, duration etc.
May 19th, 2009 at 1:21 pm PDT
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rtah100 – the point is that the only entity that can issue real debt is the state (assuming fiat money). Otherwise it’s really just super-senior equity, as if the company has no value the debt of the company has no value either. Calling it debt or equity is really small discussion as both are claims on the company, and the only real difference is seniority of the claim (preferred equity has the cashflow predictability of the debt, including the lack of dividends treated as a credit event, perpetual bonds have the no-redemption-date of common stock, lenders in days of yore could impose more controls on the company and management that shareholders could, and the pension funds nowadays were touting that they didn’t vote their shares to leave the management the freedom to do the best – or worst, as the case might be)
May 19th, 2009 at 5:09 pm PDT
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to continue a bit – in personal debt the equity is “you”, and the bankruptcy laws are effectively to prevent slavery (i.e. making a complete claim on your equity), although in more “civilized” times it was called indentured servitude for debtors.
May 19th, 2009 at 5:12 pm PDT
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SW:
I suggested making dividends tax deductible over 30 years ago. It’s called “partial tax integration” in CPA terminology. Preferred stocks with “contingent” voting rights have been around for at least 15 years. It was 15 years ago that I encountered a preferred stock with voting rights as if it was common. The voting rights “trigger” was passing two dividends. As soon as two dividends were passed the preferred had voting rights until all dividends were paid. Other permutations on this theme are possible.
May 19th, 2009 at 5:26 pm PDT
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I’m new here, but what I like is your willingness to go straight to fundamentals and challenge everything. This is an awesome site. One thing I’ve always wondered is: what hedge does a mortgage borrower have against down market risk? Basically his only hedge is zero debt, which means that he winds up paying off the debt and thereby assuming full market risk. The lender has risk of not getting back full repayment, but also has secure collateral. It would seem that a new breed of mortgage is needed wherein the debt adjusts proportionate to the FMV of the home asset. Perhaps the lender retains a small percentage of ownership in the asset when the parcel is sold. If the debt is no longer fixed but is tied to FMV, then the lender has no incentive to artificially manipulate the appraised home value, just to sell the loan. What are your thoughts?
May 20th, 2009 at 12:38 am PDT
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RowanS — Do the tax credits go to firms, or to the investors receiving dividends? In some verions of economic theory it should amount to the same thing, but in the real world it pretty clearly does not…
TB — Thanks. Looks very interesting.
vlade — reading through your series of comments, we are on a very similar wavelength. firms have claimants, both “debt” and “equity” are exposed to firm risk. laws overdistinguish “debt” from “equity” in a manner that sometimes leads economically productive firms into a disruptive reorganization due to conflicts between classes of financial investors. changes in the law and custom of investment that would make it unlikely that a well-operated firm should enter bankruptcy would be positive. creating means by which lenders could exercise more control as their claim on the firm grows (as equity value falls) might reduce the need for disruptive transfers of control via bankruptcy.
May 20th, 2009 at 4:44 am PDT
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anon — same question as for RowanS: is the tax credit to the firm, or to dividend-receiving investors? again, it turns out this makes a big difference, even if in theory it should not…
ccm — Your suggestion of a regulatory trigger that would affect all banks mirrors the “Squam Lake” proposal referenced above. They suggest a dual trigger, so that only during a regulator-declared systemic crisis and when a firm is individually troubled would shares convert. I don’t like the systemic trigger, because I think that regulators would be under enormous pressure not to pull it. I do think that regulatory involvement in firm-specific triggers might be useful, not in a way that would give regulators veto power, but in a manner such that regulatory action could increase the likelihood of conversions.
Broadly, I think it’s too much to ask that triggers be entirely independent of firm or investor behavior, but they can be designed continuously and diffusely enough so that the marginal cost of gaming exceeds the marginal benefit in terms of a change in the likelihood or quantity of shares that will be triggered. (I think it might be useful to embed synthetic randomness in these securities &mdash a score would be computed from a wide variety of factors that would represent the probability that any share converts. Proverbial dice would be rolled, and shares would randomly convert in a quantity mostly determined by the score.)
Re tiers — I think that convertible securities absolutely could and should be tiered. (I’m including securities with explicit triggers or implicit conversion a la cumulative-preferred-with-contingent-rights in the category “convertible securities”.)
For individual firms, I like the idea making debt convertible at a regulators’ discretion. See this previous post for something similar. Broadly, I think there should be four layers of response to a firm crisis: 1) equity takes a valuation hit, as firm asset values ae compromised; 2) “programmed” conversions of the sort described here begin to take place; 3) some junior debt claims are converted to equity and a judge or regulator’s discretion; 4) formal bankruptcy.
rtah100 —
1) I think that you’re right, private equity and VC arrangements are really where I need to look for antecedents, and not in the academic finance literature but in professional references (and maybe the academic law literature).
2) This sort of standard is incompatible with my proposal. That is, I don’t want to try to tease out what “is” debt and what “is” equity in some security. I want to define a class of claims to be formally equity, regardless of how debt-like its cashflows might or might not be, then ensure that those claims will be treated and behave like equity in a crisis, even though in good times they might look very much like debt. If a thing is “equity” under this scheme it is 100% equity.
3) Good point. This proposal is based on the theory that sometimes firms that are high quality from an operating standpoint fail because they are encumbered with brittle capital structures. “Continuous bankruptcy” only makes sense for this kind of firm. Firms that are operating poorly absolutely should go through a cathartic, disruptive reorganization or liquidation. These proposals don’t eliminate bankruptcy. If a firm can’t meet its obligations to commercial counterparties, off to the courthouse they go. But when firms can’t meet their obligations to purely financial counterparties, to investors with no stake in a particular firm product or asset, my contention is that it would often be better to let a transfer of control occur amongst financial investors without upsetting the operations of the firm. That could be wrong — it could be that overleveraged cap structures correlate with firms so poorly run that management should be perfunctorily sacked. In this case the tendency of overleveraged firms to show up in Chap 11 is a feature, not a bug. But I’m not persuaded of this. I think the finance guys (especially around acquisitions) often make a hash of decently operated firms.
4) I think we collectively have a lot to come to terms with re what “debt investors”, like maturity matching pension funds etc, can and ought reasonably invest in. I agree with vlade above that corporate debt fundamentally is equity, unless the state guarantees it. Debt investors are exposed to downside operating risk of firms. Proposals like mine make that more explicit, and arguably enhance overall firm value, but they don’t alter the fundamental economics of holding debt. We face the issue you describe right now, as one of the arguments often mooted against debt2equity conversions in the financial sector is that many fiduciaries would have to fire-sale dump them, while they can hold debt. But that is idiotic: distressed debt behaves like equity whatever you call it. So I think the right way to phrase your objection is that debt fund managers would come to be more aware that the securities they hold are really equity in some states of the world. Put that way, it certainly doesn’t sound like a bad thing.
BTW, I’m delighted to read, “There are also many precedents for share classes having rights that ‘flower’ in the event of trigger events.” The less new ground that has to be trod to craft securities that economically convert to equity equitably and without bankruptcy the better.
May 20th, 2009 at 5:33 am PDT
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IA — I’m not surprised that we agree on this one. Do you know what the arguments against “partial tax integration” are? How did the preferred with “in-arrears contingent” voting rights work out? That sounds like a remarkably apropos example!
Gregman2 — I’ve dropped you an e-mail…
May 20th, 2009 at 5:37 am PDT
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The Canadian dividend tax credit goes to the investor.
I don’t get your question or your point. This only makes sense as it is intended – the tax credit goes to the investor. That’s the purpose of the tax credit – to equalize asymmetric tax treatment at the firm level by offsetting it with inverse asymmetric treatment at the investor level. There is no comparison with a tax credit for the firm – that would be nonsense. So there is no issue of theory versus practice here.
The equity investor gets credit for corporate taxes paid on the pre-tax income required to pay dividends on a corporate after tax basis.
The result is that the investor receives (roughly) the same after-tax income stream, whether the capital structure is 100 per cent debt or 100 per cent equity.
This could assume 100 per cent payout of earnings as dividends for comparative purposes. But in fact capital gains incur similar effective tax rates as dividends in Canada.
The point is – the tax code attempts to reverse the corporate tax asymmetry by inverting it at the investor level, which is all that matters. Investors capitalize the value of debt and equity on an after-tax basis.
This makes tax treatment at the firm level much less relevant. Do you disagree?
May 20th, 2009 at 7:25 am PDT
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“I don’t like the systemic trigger, because I think that regulators would be under enormous pressure not to pull it.”
I think the point is that regulators would not be able to tap the taxpayer for a bailout until after all systemic triggers had been pulled. Yes, the banks would hate it, but there’s no way you’d get Congress to authorize funds for a bailout if the built in systemic triggers haven’t been pulled yet. It has the advantage of taking power from the lobbyists and putting it in the hands of taxpayers. Furthermore, because the banks will know that they can’t win a bailout under these circumstances, it will probably create the incentives for them to clean up their act.
May 20th, 2009 at 12:19 pm PDT
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anon — I disagree very strongly. Looking through the firm to investors as though organizations are transparent to cash flows is a terrible mistake made only by smart people. Firm behavior, including capital structure is set by agents in the context of imperfect markets. Investors are heterogenous, and include nontaxable investors as well as taxable investors with widely varying marginal tax rates at all times. Empirically, studies of the effect of changes in dividend taxes in the US tend to show that to the degree firms increase dividends on sharp drops, that is heavily correlated with holdings of straight equity by firm managers. (cf the 2003 tax cut in the US) At some level it doesn’t matter how “investors capitalize cashflows”, since expected discounted cash flow methods are very weak predictors of stock performance.
Managers do not, and should not, think in terms of a some idealized taxable stockholder in making cap structure decisions. They think at firm level, devote themselves to firm objectives (and problematically to their own personal objectives). Increasing share prices is a crappy proxy for firm objectives, and to the degree that is what managers try to do, they are more likely to zetz reported earnings by reducing the accounting cost of capital than to rely on the perfection of a hypothetical taxable investor community to captalize dividend flows at higher rates.
The Canadian tax code may attempt to reverse corporate tax asymmetry via investor tax credits, but the attempt is doomed to failure. Tax treatment at the firm level is always relevent.
May 20th, 2009 at 1:25 pm PDT
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ccm — haven’t you noticed? going to Congress is passe. TARP was approved over dramatic public outcry after bullying and an astonishingly crass do-over. PPIP puts taxpayers on the hook for bank bailouts with no funds appropriated. even if pulling a systemic trigger were required prior to bailouts, i’m afraid that regulators would argue that pulling it would be “massively destabilizing”, and financially engineer whatever transfers they deem desirable. at this point, i’d be willing only to give regulators the ability to accelerate equitization of debt that would occur automatically without them. anything that gives inevitably captured regulators veto power over equitization strikes me as awful.
Note that the 1991 FDICIA was explicitly designed to remove regulator discretion to forbear during banking crises (after the awful 1980s experience). That hasn’t worked out so well.
May 20th, 2009 at 1:30 pm PDT
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Perhaps, you are right, but my reading of the events is different. TARP was approved because the too big to fail problem had not been addressed by regulators (they knew this was a problem underlying FDICIA, but put off resolution as not an immediate concern).
Giving regulators the right to turn debt into equity addresses too big to fail. I think the regulators have been forced into a corner by their lack of authority to resolve too big to fail institutions and that that is the reason for the extraordinary growth of their powers. I guess I just see them as less captured than you do.
May 20th, 2009 at 2:43 pm PDT
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ccm — fair enough. i don’t think regulators were forced into a corner — i think they’ve had plenty of leverage throughout this crisis to engineer anything they want, and they’ve always gotten what they want when they’ve played hardball.
but degree of capture is a judgment call, and i could be overly cynical. if so, resolution authority and explicit authority to equitize (or trigger contractually foreseen equitizations) might be sufficient.
but i mistrust regulatory discretion, very very much. FDICIA is good law in that it tried very hard to limit discretion. it fudged TBTF a bit with the systemic risk exception, but since a formal invocation of that for a specific institution (as anticipated when the law was written) would be deeply stigmatizing event. one way or another, FDICIA mandates rough treatment of banks receiving any form of bailout (and much more prompt intervention than we’ve seen). i really don’t think there’s a good explanation for why we haven’t seen resolutions other than that banks and regulators don’t want ’em. it was more than a year after Bear, with Paulson, Geithner, &Bernanke in the saddle the whole time, before Lehman. if lack of resolution options was the problem, these very sharp people could have made that case. they did the opposite, and invented whole new means of forbearing while quietly laying groundwork for TARP style bailouts (see Swagel’s piece, which portrays this plan as wise foresight kept in secret because of sniping politicians).
May 20th, 2009 at 3:54 pm PDT
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Consider a company where on winding up, the senior creditors would be made good and the junior creditors would get pence in the pound; the equity holders would be wiped out.
As far as I understand it, the continous bankruptcy would convert the junior creditors into equity holders to the value of their shortfall and creditors for the balance, for a b/s of zero.
The junior creditors would need to take an even deeper haircut on their loans for the company to have nett assets after the conversion. So, the continuous bankruptcy leaves the junior creditors with a larger write-off on their loans than traditional bankruptcy.
Worse, the business is not wound up so they are not paid out in cash. But the junior creditors might have been able to make better use of the (larger) cash pay out on winding up, to make a new loan to a different business or just to pay back their own creditors.
But it doesn’t matter! Fatally, the junior creditors can, post-conversion, just force the winding up, because they are now the shareholders. Only by stripping shareholders of their power to dissolve the business can this be avoided. But, of course, this power is fundamental. Never get into what you cannot get out of – good advice for investors and escapologists, both. Without the right to dissolve a partnership or wind up a company, there is no freedom of capital.
On a separate note, in my view quoted equity is a terrible way to finance a business. The agency problem is insurmountable. Large business should be funded with quoted debt (dispassionate, ineluctable judgment of arithmetic) and concentrated control (family stakes / private equity). This provides the correct mix of control and discipline (more BDSM than CAPM!). But even if this happy state of governance could be reached, conversion of the quoted debt would create just another dispersed equity business.
May 20th, 2009 at 6:28 pm PDT
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rtah100 — as you say, so long as control transfers with equitization, nothing prevents junior-creditors-turned-shareholders from winding down the business if they value the (risk adjusted) potential going concern value less than immediate liquidation value. that’s a feature, as far as I’m concerned, not something to be blocked or eliminated. the point of continuous bankruptcy is to minimize the disruption of viable firms whose controlling claimants would prefer to reorganize than to liquidate, not to prevent liquidation of nonviable firms or firms less to most-at-risk investors than liquidation value. i’ not quite as philosphical about investor rights as you are, but i’d say that eliminating the right of investors to wind up firms they deem nonperforming is in practical terms a sure route to squandering real capital. and wise use of real, scarce (as opposed to socially constructed financial) capital has to be the ultimate goal of any financial arrangement.
your view on equity is interesting to me. i am precisely half way with you. i agree that widely dispersed “ownership” is not ownership at all, and that what we refer to benignly as “agency problems” are entirely and irrevocably the core of how firms are managed. trying to “align” shareholders and managers’ interest, while noble in theory, is mostly a sucker’s game, since even among shareholders there are widely divergent interests that can’t be papered over unless markets are perfectly evaluaters of some hypothetical true infinite horizon value. so, i think we should consider insiders owners and widely dispersed claimants as financiers and nothing more. i think we are on the same page with that.
but i would rather we adopt an “equity” rather than “debt” model for our widely dispersed financiers, while overtly dispensing with the fiction of active control rights. debtors have a nasty habit of expecting payment in all states of the world, no matter how badly a firm performs, and of holding long-term valuable firms hostage to this expectation.
letting widely dispersed financiers hold cumulative preferred equity is my, um, preferred model. as you say, in decent states of the world, CPE is easy to value, same as debt. but it fails more gracefully (and making it fail yet more gracefully is the point of this post and the previous). it does mean that in failure states, dispersed claimants are left with control rights they are not well suited to exercise. but this is true of debt in bankruptcy as well. in bad states, all claims not guaranteed by the state become equity. there is a trade-off: if discontinuous bankruptcies are very easily triggered, the bankruptcy process can serve to organize dispersed de-facto equity holders to exercise control more effectively. however, that same process extracts real costs from firms that do merit reorganization (and also create external costs). in a world where most claimants want fixed-coupon obligations (or hybrids with an embedded lottery ticket), which I think is the world both you and i are imagining, it is quite likely that ordinary volatility would trigger banktuptcies “too early”, and thus create real and unnecessary costs inside and outside the firm as an artifact of capital structure. so, on balance, i’m in favor of delaying “discontinuous bankruptcies” for firms that are heavily funded with fixed income (debt or preferred eq) instruments.
note, regardless of the debt or preferred eq model, when claimants become equitized by a bad outcome, we run headlong into the agency nightmare. we need to develop fair processes whereby widely dispersed “owners” can rapidly escape from freedom by exalting new, more effective bands of insiders and then resuming their comfortable role of collecting coupons mindlessly. perhaps most debt should convert to preferred equity in a bankruptcy, once the acute stage has passed, rather than to common.
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“This provides the correct mix of control and discipline (more BDSM than CAPM!).” — beautiful.
May 20th, 2009 at 8:52 pm PDT
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Poole’s (admittedly non-original) idea of rolling unsecured subordinated debt prevents TBTF and shrink troubled ones
A market solution to secure banks’ future
May 21st, 2009 at 11:22 pm PDT
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SW:
The argument against “partial tax integration” is: Uncle Sam wants the money. It would be bad for tax lawyers and CPAs if we would no longer be able to fight the IRS over whether a piece of paper is debt or equity.
The preferred stock in question got it voting rights. After about two years the preferred stock holder converted his position to common on, in my opinion, advantageous terms. No bankruptcy or lawsuit was filed.
May 22nd, 2009 at 9:10 am PDT
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Brewster — I think Poole’s sub debt idea is intriguing, although the question remains whether regulators would let anything called “debt” get wiped out. If regulators’ commitment is not rock solid, the “market prices” at each roll will go postmodern.
The same idea might be more credible if sub debt were nonperpetual cumulative preferred equity. Economically, the two should be very close, but as IA reminds us, there’s that magic debt/equity distinction that accountants are paid to fight about.
IA — The arguments against “partial tax integration” are deeply inspirational… At least it sounds like the preferred stock with contingent voting rights performed as advertised, smoothly transferring ownership to PE holders on advantageous terms. So this kind of arrangement can work, at least sometimes.
May 22nd, 2009 at 1:24 pm PDT
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First, one point of fact; Deutsche Bank has issued securities that are convertable at their option into common. You may want to research these.
Second, the securities do not need to be mandatorily convertable with a trigger, but rather just need to be convertable at the option of the firm. The firm needs to buy the option, then the firm can choose to execute the option (or their regulators could apply some suasion)
Third, beware of hard-wired triggers; they often have perverse unanticipated consequences
May 26th, 2009 at 12:39 pm PDT
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