...Archive for May 2009

Plastic fantastic

So I’ve belabored the distinction between transactional and revolving credit quite enough, I think. And I’m pleased, reading around the intertubes, that people seem comfortable with that distinction, and with the idea that it might be good public policy to treat these two forms of credit differently, despite attempts by credit card issuers to blur the lines. Yay!

But my previous piece seems to have left readers with two pretty big WTFs:

  1. Don’t we already have a ubiquitous and perfectly good transactional credit product called debit cards?
  2. What would be the point of having the government provide a charge card?

Let’s take those in turn.

1. Are debit cards good enough?

Debit cards are indeed a transactional credit product. Specifically, they offer overnight transactional credit which is automatically repaid from a designated bank account. Problem solved, right? Everyone should just use debit cards.

Debit card use is on the rise in the United States (and in other countries use of debit cards is often the norm). But very many of us — possibly even you, dear reader — have both debit and credit cards, but prefer the credit card, even though we pay our balances monthly. Why might that be?

Here’s a minibarrage of reasons. Using a credit card…

  1. is more convenient, since you needn’t keep track of an account balance unless you are very near your credit limit;
  2. is cheaper because it doesn’t require keeping a substantial buffer of funds in a zero or low interest checking account;
  3. is cheaper because you can get some of the interchange fee refunded via rewards programs;
  4. is safer, because it offers the opportunity to review and occasionally repudiate transactions prior to transferring funds;
  5. is safer, because stronger consumer protections are offered in the event of theft or fraud;
  6. is safer, because if the cardholder faces an unexpected liquidity crisis, she can shift from transactional to revolving credit. Cardholders have the option of making partial payments with little penalty.

If we want a purely transactional product, we’ll have to do without that last, the option to revolve. A competitive market for transactional credit might or might not offer kickbacks on transaction fees (American Express does). But to be conservative, let’s suppose not. That still leaves four pretty good reasons why an American-Express-style, pay-at-the-end-of-the-month “charge cards” are superior to debit cards. Banks have tried to address the consumer safety and dispute resolution issues that disadvantage debit cards, but there is still a big gap in perceived and I think actual safety. But the first two issues are the zingers. To get the same payment flexibility with a debit card that you would get with a charge card, you need to maintain a large checking account balance, which costs you in interest foregone. If you keep your buffer savings in an investment account, then you have to track your account balance carefully and transfer funds between accounts frequently. Even with a $95 annual fee (the going rate for a basic American Express card), most families would be better off earning interest on their savings and paying the fee than keeping substantial savings in a no interest account. (Right now this may not be true, because interest rates are so low that you don’t lose much by holding funds in a checking account. But it has usually been true when we’ve not been in ZIRP mode.)

There are arguably behavioral disadvantages to the buffered debit card strategy. If you spend unusually much in a month, there is nothing that forces you to replenish your buffer. But if your savings are held in a separate investment portfolio, transferring funds to cover a shortfall may feel like raiding the piggy bank. Avoiding that might encourage people to not spend more than current income. If you keep substantial savings in a debitable checking account, the mechanics of dissaving are indistinguishable from the mechanics of ordinary spending, and there is no third party demanding that you make yourself whole at the end of the month. With a charge card and a separate investment account, spending beyond income compels painful, explicit transfers from what you thought was savings, which might motivate you to replenish the overdraft quickly. (This entire paragraph is bullshit if you don’t believe in things like “mental accounting” — money in an investment account is viewed differently than ordinary spending money — or “anchoring” — once you reach a level of “savings”, it comes to define where you “ought to be”, and you will strive to maintain or recoup that level. Do you believe?)

A lot of debit card enthusiasts will find all this comparing of “buffered” debit cards and charge cards artificial: Debit cards, they will claim, are good because you can’t ever spend more than the cash you have. It’s as simple as that, right? But we keep wealth we may wish to spend in a variety of different forms, and many of us even have multiple bank accounts. Debit cards without a cash buffer don’t really do the job of transactional credit, that is letting you spend what you can near-term afford without having to much worry about how your (liquid) wealth is held. One might argue that extra friction is good. Perhaps people are so undisciplined that we should have to track balances and arrange transfers prior to even routine spending. That’s an argument for an electronic “cash only” economy, and I think it’s farther than we need to go. It’s a judgment call, but my sense is that people handle short-term transactional credit pretty well, and benefit from the convenience of it, while indefinite-term, low monthly minimum revolving credit frequently becomes a trap.

2. What would be the point of government provided transactional credit?

In the previous post, I suggested that the government could offer a “Treasury Express” card, supplying access to transactional credit as a public good. To my surprise, some people seemed to actually like the idea (e.g. Ezra Klein, Matt Yglesias, Doug Singsen). Others understandably dislike the idea of more state involvement in a sphere that has been traditionally left to the private sector. Kevin Drum just doesn’t see the point:

We already have “Treasury Express” cards: this is basically what debit cards are, and they provide the same benefits of transactional credit that regular Visas or Mastercards do. Why do we need the government for that?

That leaves us with the problem of limiting revolving credit, which is the same problem we have now. Do we need firmer rules on interest rates, fees, and penalties? Better bankruptcy protection? Bans on things like universal default? An end to tricks and gimmicks and fine-print-laden marketing come-ons? More sensible ways of setting credit limits? Maybe. Probably. But unless Steve is suggesting that we essentially ban credit cards entirely — and then create some kind of federal mega-authority to limit every other kind of consumer credit too — those are all the same issues we have now. I’m not really sure what his proposal would accomplish.

If it’s true that the differences between a pay-at-the-end-of-month charge card and a debit card aren’t very important, then Kevin’s right, and there wouldn’t be much point. But suppose that I am right, and people really value the efficiency, convenience, and safety of a charge card, even if they do not intend to run a balance. As things stand now, they have two choices: they can pay $95 per year for an American Express card, or they can get the same product for free with a credit card, as long as they accept a dangerous option not to pay in full at the end of the month. (If having to pay more for fewer options strikes you as odd, you are not alone. In two posts, the amazing Rortybomb tries to make sense of credit-card-pricing mysteries, including this one, using ideas we learned in finance class. Only his training in critical theory prevents a Scanners-style head explosion.)

A free basic transactional credit product would let people avoid signing on to temptation when all they want is a charge card.

A public option would also create political space for better regulating revolving credit. The obvious way to limit revolving credit to those most likely to use it well is to force rationing via price controls. In English, that means we should bring back usury laws. Credit card companies won’t offer cards to financially insecure customers if interest rates, penalties, and transaction fees are capped. Under the present terms of debate, that would be a bad thing, “limiting access to credit”. But the meaning of that phrase is very slippery. “Access to credit” is let to stand for participation in the modern economy, i.e. the ability to rent a car or hotel room, to make purchases or pay bills on-line, etc. If we unbundle those good things from credit cards, what usury laws would limit is “access to high-interest, high-fee unsecured revolving credit”. Put that way, it doesn’t sound so bad.

The existence of universal charge card accounts would offer some side benefits. Such accounts would provide uniform and convenient means for the government to make payments to citizens, rather than mailing out stimulus or social security checks. It would make it easier to implement flat transfers, which I consider a better form of fiscal policy than tax cuts or aggressive government spending.

Finally, it’s worth thinking generally about when public sector competition helps to keep the private sector honest. Critical industries that are prone to concentration due to network effects or economies of scale, that are informationally opaque, or that have high barriers to entry may benefit from the implicit threat presented by even inferior public sector competition. I am a huge fan of UPS and Fedex, and generally prefer their services to those offered by the post office. But I wouldn’t be at all comfortable disbanding the postal service, even though as a taxpayer I am forced to fund its losses. Perhaps I underestimate the magic of the marketplace, but if USPS weren’t there to put under a floor under the quality and price of service offered by the private couriers, the degree of concentration and barriers to entry in that industry would make me nervous. There are other examples: State schools offer useful competition to private colleges and universities. A “universal Medicare” option in health care would serve as a low bar that private sector providers would have to overleap. Consumer banking services may be an industry where public sector competition would be useful. We don’t want the government making fine-grained decisions about the allocation of business capital. There are good reasons to think that capital markets and profit-motivated relationship lenders do a better job of that than the state. But there’s little reason why the public sector shouldn’t provide basic transactional credit and checking account services. (Other countries have state-affiliated banks that compete with fully private institutions. A public/private banking ecosystem is not a radical idea.)

All that said, there are good reasons to oppose a “Treasury Express” card. I share the cynicism of libertarian critics. The only thing I trust less or want less involved in my life than the government are cartelized private corporations. To the degree that people choose to make payments with publicly provided cards rather than with cash or private credit products, the government would obtain detailed individual payment histories. This may (or may not be) worse than Chase or Citigroup having access to the intimate details of our lives. Universal access to transactional credit might do harm by altering the incentives of people on the margins of the economy. For example, someone who currently lives in the cash economy might max out, and not repay, their “Treasury Express” card. Even though the penalties they’d face for nonpayment would be mild, they would have created a new hurdle they’d have to overcome if they wish to reintegrate themselves into the mainstream. Dispute resolution might be a nightmare for a public program. Disputed credit card transactions leave either a customer or a merchant feeling screwed. What is now private cause to switch banks would suddenly become a contentious matter of public policy. The government might meddle in what people can buy and sell with the card, creating a nanny-state non-neutral form of money. Government entry into the banking sector with a limited, basic product could lead by increments of mission creep to a state-subsidized monopoly taking over financial services and credit allocation. These are all real concerns that would have to be addressed, if we were to give public sector transactional credit a try.

Neither this post nor the previous one has been intended as full-throated advocacy. A state-provided universal charge card is a speculative idea that merits further consideration. It might be worth doing. It might not be. But as we negotiate with the banking sector going forward, we will no doubt hear dire warnings about how this or that regulation will force thousands of widows and orphans into bartering chickens for shelter. We should keep in mind that if banks won’t provide the simple, consumer-friendly financial products we require, we can create other options.

By the way, if you haven’t read Felix Salmon’s candid correspondence with former industry insiders about credit card business models, do that now. It is remarkable. For more of the weekend’s credit card links, try Conor Clark on credit cards for college kids (and Richard Serlin’s response), Michelle Singletary, and all the other brilliant writers I’m sure I’ve missed.

Distinguish between transactional and revolving credit

Megan McArdle

[M]aybe it’s worth remembering that the tyranny that credit scores exercise over our imagination have everything to do with the fact that we’ve built a society so utterly dependent on credit.

Kevin Drum responds

[T]here’s nothing per se wrong with the fact that modern economies are so dependent on credit. Widespread use of credit really does make life more convenient, really does make banking more efficient, really does enable useful advances like online shopping, and really does allow easier access to goods and services that would otherwise be difficult to get hold of. Used in moderation, it’s good stuff. I sure don’t want to return to the days of hauling around travelers checks whenever I fly off to Europe.

Speaking for myself, my jeremiads against the credit-industrial complex have never been meant as an attack on widespread access to credit itself. Used reasonably, credit cards are a boon and credit reporting is a necessary part of providing credit responsibly in a big, complex world. That said, credit is critically important to everyday living now, and that means that it needs to handled fairly and transparently.

We won’t get very far in the debate about credit in the US economy if we fail to distinguish between transactional and revolving credit. These are two are fundamentally different products, and much ill has come from conflation of the two. All of the good things Kevin attributes to widespread credit access are benefits of transactional credit. Because credit cards have often bundled transactional and revolving credit together, it is easy to attribute these good things to revolving credit. That’s a mistake. Transactional credit is essential, and might even be publicly provided. Revolving credit is a double-edged sword.

Transactional credit is a means of decoupling the process of making payments from the form in which ones liquid wealth is held. More simply, if you have the money to pay for what you are buying, but just don’t want to carry cash or keep track of your checking account balance every day, you are making use of transactional credit. Many people only use credit cards for transactional credit. They pay off their entire balance each month.

Revolving credit is a different product. It provides a means by which people can spread the cost of purchases over an indefinite period of time. If you wish to go on a vacation, and can afford to pay for it from your next six months’ salary, but could not easily come up with the money now, you are making use of revolving credit.

Both transactional and revolving credit are useful, and conventional credit cards give consumers access to both. But revolving credit is much more prone to abuse than transactional credit. Though economists hate to admit it, it is a fact of life that human beings do not, in general, seem to have time-consistent preferences. If preferences aren’t time-consistent then people are prone to making short-term deals that they will seriously regret in the distant future. Revolving credit is like morphine: When used properly, it can be very useful. But experience has shown that it can cause great harm if used incautiously.

Revolving credit needn’t be bundled with transactional credit. The traditional American Express card, for which you are charged a flat annual fee and pay your balance in full each month, is a transactional pure play. Transactional credit has different characteristics than revolving credit. In particular, consumers can get most of the benefits of transactional credit with low credit limits, perhaps twice a typical month’s expenses. (If restricted to transactional credit, consumers may have to find other means of paying for occasional large purchases. They might need to put funds into a bank account in advance, and pay via debit. As long as such purchases are infrequent, this is not a terrible burden.)

If we set aside “tricks and traps“, transactional and revolving credit products should inspire very different business models. Transactional credit resembles an insurance product, while revolving credit is like a traditional loan. The primary benefit a consumer receives from transactional credit is not the financing debt, but the option to purchase at any time without having to track specific account balances or coordinate transfers. This service is provided regardless of the size of any given month’s balance. Consumers should be (and historically have been) willing to pay a flat fee for it. Even very modest interchange fees more than cover the cost of capital on the loans, so fees can be quite low and might go to zero for some customers. (A 1% interchange fee amounts to a 12% annualized rate for a low-balance, 1 month loan. Conventional interchange fees of 2-3% offers exorbitant returns on 1-month loans, part of which may be rebated via rewards programs.) There is no reason why transactional credit can’t be a fine business, and it has been, both for American Express and every other credit card provider sending unsolicited offers to people whom they know pay their balances off monthly.

Revolving credit, when it is not about tricks and traps, is all about the interest rate. Revolving credit is prone to abuse, and should be made available cautiously, not automatically or indiscriminately. Credit card interest rates should simply be capped, which would prevent less creditworthy borrowers from gaining access to revolving credit lines. That is a feature, not a bug. In a world where agents have inconsistent time preferences, paying high interest rates for present consumption is prima facie evidence of selling out future selves for present goods. Rational high interest rate borrowers are either those who intend to default (thereby extracting a wealth transfer from the more responsible subset of the population), those who are financing goods that will yield benefits over time, and those who face an unusual emergency which requires the future be held hostage to the present. We want to deny credit to the first group, the rational defaulters. People who are financing goods that will yield benefits over time can usually get credit on much better terms by taking out securable, asset-specific loans. We should encourage the resurgence of secured vendor financing, because that form of credit can offer huge savings to less creditworthy borrowers, compared with ubiquitous unsecured plastic. Finally, the usefulness of high limit credit cards as kind of insurance is undeniable, but dangerous. Every day has its crises; that is the human condition. It is easy to err by taking on “absolutely necessary” debt today that leaves one absolutely destitute tomorrow. We should develop better forms of emergency insurance than unsecured debt. To the degree that we do rely upon access to credit as a reserve cushion, it shouldn’t be attached to our instrument of casual commerce. It should be special, and have a “break-glass-in-case-of-emergency” feel to it.

Access to revolving credit should be rationed, but transactional credit should indeed be ubiquitous. Not having to carry and count cash, deal with paper checks, or even worry about some particular account’s balance at the time of purchase are important benefits. Indeed, an efficient payments system is a public good. That’s why states are in the business of establishing currencies, right?

In fact, while transactional credit provision is a perfectly good business, it might be reasonable for the state to offer basic transactional credit as a public good. This would be very simple to do. Every adult would be offered a Treasury Express card, which would have, say, a $1000 limit. Balances would be payable in full monthly. The only penalty for nonpayment would be denial of access of further credit, both by the government and by private creditors. (Private creditors would be expected to inquire whether a person is in arrears on their public card when making credit decisions, but would not be permitted to obtain or retain historical information. Nonpayment of public advances would not constitute default, but the exercise of an explicit forbearance option in exchange for denial of further credit.) Unpaid balances would be forgiven automatically after a period of five years. No interest would ever be charged.

Let’s think about how this would work. For most people, access to various forms credit — transactional credit, auto and home loans, unsecured revolving credit, whatever — is worth more than $200 per year. Although people might occasionally fall behind, for the most part borrowers would pay off their government cards, simply because convenient participation in the economy is worth more than a once-in-five-years $1K windfall. However, people with no savings and irregular income (for whom transactional credit is a misnomer, since they haven’t the capacity to pay) might well take the money and run. The terms of the deal amount to a very small transfer program to the marginal and disorganized, and a ubiquitous form of currency for everyone else. People with higher incomes would want more transactional credit, or revolving credit, which they would acquire from the private sector.

I’ve posited that people often have time-inconsistent preferences. Am I, them, inconsistent to suggest that most people wouldn’t people take a free $1K today and be stuck without credit thereafter? No. The degree to which people underweight future costs varies between individuals, and is changeable. Most people do work to avoid present choices that will create future hardship. (Many people arguably overweight the future.) However, high-limit revolving credit is a particularly nasty trap for those who even slightly underweight future costs. One nice aspect of a low-limit, indiscriminate, mechanical public credit system would be educational. Many younger people would spend some period of time modestly in debt and shut out of the credit economy. This would provide a more gentle lesson than the current practice of running up revolving balances in college and working desperately for years to pay them down.

The notion of transactional credit as a state-provided public good is speculative. Maybe it’s a terrible idea. Regardless, the distinction between transactional and revolving credit is crucial. A modern economy probably does require widespread access to transactional credit. But revolving credit is a different story entirely, and we would be better off controlling it more carefully. We shouldn’t be shy about adopting policies that would curtail the provision of unsecured revolving credit, as long as transactional credit is protected.

Some of this was inspired by a conversation with the excellent keyholez over Twitter. (I have been playing on Twitter recently, and am still trying to decide what I think of it. If you’re into that here’s me and here’s keyholez.)

Update History:
  • 22-May-2009, 1:15 p.m. EDT: Minor fixes, took out overly wordy “role of” stuff from first para, fixed spelling of forbearance, clarified an apparent redundancy, “is variable…and is not fixed”.

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.

Continuous bankruptcy

I’d like to propose a financial innovation that I think would actually be good (besides the ATM). It would be a new security that firms could market to investors, just like CDOs and all of that good stuff. But rather than being a means of expanding the supply of credit (the questionable purpose of most “financial innovation”), this investment product would change the character of credit provided by investors to firms. It would provide an alternative to the customary form of corporate debt.

True believers might argue that if what I suggest were a good idea, a free capital market already would have discovered it. I’m not a true believer, but I’ll make common cause in part, and point out that securities like those I propose are presently tax disadvantaged, so capital markets have not been free to discover them. In particular, if dividends on preferred equity were tax-deductible to firms like interest, perhaps these securities would already be commonplace. But I’ll reveal my cruel, statist heart by hinting that since firm managers may be myopic in their preference for cheap financing, and since distress costs are in part external to firms, an active policy tilt in favor of more robust capital structures might be worth considering. [1]

I’m suggesting a new financial instrument. Here’s its catchy name: “In-arrears convertible cumulative preferred equity”, or “IACCPE”. (“Yak-pee” for short?) Let’s chop that aromatic mouthful into tasty, digestible chunks:

Preferred equity is a form of investment that is like debt, in that the issuing firm promises to pay an agreed dividend level (like an interest rate), rather than a share of a firm’s variable profits. However, preferred equity is unlike debt, and like stock, because if a firm for whatever reason does not pay the promised dividend, aggrieved investors cannot sue for bankruptcy. Preferred shareholders’ only means of enforcing payment is priority: common equityholders cannot receive dividends if preferred shareholders’ dividends have not been paid.

Cumulative means that if the issuing firm has skipped some dividend payments, the firm is said to be “in arrears”, and must pay preferred investors all past skipped dividends before it can make any payout to common shareholders. “Cumulativity” ensures that, unless a firm goes bust before ever paying another dividend, preferred investors will eventually get all the payments they were promised, although they may suffer from delay. Cumulative preferred equity is more “debt-like” than noncumulative preferred equity, in that noncumulative investors permanently lose claim to some dividends if a company falls on hard times and suspends payments, while debtors always have claim to interest owed.

In-arrears convertible means that while payments on the preferred shares are “in arrears”, when the firm had failed to pay some of the dividends that it had promised and not yet cured the failure, investors would have the option of converting the shares to common stock on favorable terms.

It’s the in-arrears contingency that makes this security novel and interesting (I hope). But the feature requires some explanation. Usually, a convertible security has a par value and a conversion price that fix the number of shares of common stock an investor would get for converting a share of the security. This means that investors normally convert only when a firm is doing well. Suppose you have a share of preferred stock that (without the conversion feature) would be worth $100, but that can be converted to 10 shares of common stock. You would never exercise that right when the common stock price is less than $10, since the preferred share is more valuable than the stock you’d get. You would only convert when the common stock is doing well enough so that the value of the stock you would get on conversion exceeds the value of your preferred share. [2]

An “in-arrears convertible” would be pretty useless unless the conversion price were very low, since firms stop paying their preferred stock dividends in difficult times, when their stock price is depressed. So rather than fixing the conversion price in advance, these securities would be convertible at a discount to the market price of the stock at the time the preferred dividend was not paid. [3] That is, by going into arrears on the preferred shares, firms would open themselves up to dilutative preferred-to-common-equity conversions, at the option of the preferred shareholders. If a firm does have long-term, going-concern value, but is simply unable to meet the cash flow requirements of its capital structure, preferred shareholders could convert at a bargain rate during the limited in-arrears period. If a firm is not likely to be viable as a going concern, preferred shareholders could choose to hold tight. They’d be paid out in preference to common stock holders at the eventual liqudation.

Firms could issue multiple classes of “IACCPE”, like they now offer multiple debt issues, each with a distinct priority in the capital structure of the firm. Ordinarily, these securities would be indistinguishable from debt, both to the firm and to investors. Investors would fork over a set amount of cash, and then expect to be repaid with interest (formally dividends) on a predetermined schedule. But in bad times, firms that fail to meet their obligations would be forced to offer equity, including control rights, to creditors on very favorable terms. (Non-payment of a dividend could also provoke a special shareholders meeting, and holders of the unpaid preferred could be given the right to propose replacement directors, thereby maximizing the value of converters’ control rights.)

Substituting this kind of security for debt in firms’ capital structure would enable a kind of bankruptcy in increments, an automatic and self-enforcing reorganization. I think this would improve value for all stakeholders compared to our present system. Chapter 11 bankruptcy was itself a great innovation, but it exposes even viable firms to large, indirect distress costs when capital structure and cash flows become misaligned. To the degree that a firm has widespread or important stakeholders outside its capital structure (customers, employees, financial counterparties, local governments, etc), Chapter 11 even at its best produces costly externalities, as stakeholders must provision for abrupt and unpredictable changes even when a firm is likely to survive and even thrive once arguments over who gets what are resolved. Because Chapter 11 bankruptcies (and receiverships for financial firms) are disruptive, governments sometimes intervene to prevent them or to the process with subsidies. The expectation of intervention causes investors in “systemically important” firms to over-lend and under-monitor. For large firms, the threat that contractually prescribed, preferred-to-common conversions might be triggered would be more credible than the threat of an uncontrolled bankruptcy without government subsidy. Investors would be forced to actually price the “lower tail”, rather than hoping it will be truncated by the state. Common stockholders would face a steep penalty for missing “debt” payments, but the extent of their dilution would be predictably related to the scale of the obligations they fail to meet.

IACCPEs wouldn’t replace or eliminate traditional bankruptcy, of course. Regardless of capital structure, firms that are not viable businesses will need to be liquidated. Sometimes firms have contractual arrangements other than straight debt that need to be modified if a firm is to become viable. Moreover, even if all “financial” debt were eliminated from firm capital structures (I think that would be a good thing), firms would still have transactional business creditors, for whom traditional “hard” debt makes sense. [4] This proposal does not directly address off-balance-sheet contingent liabilities or pension and health obligations, which are increasingly sources of firm distress. I think pension and health issues will have to be addressed on a national basis, that our employer-centric system of managing health and retirement issues will ultimately have to be, um, retired. But some contingent liabilities (uncollateralized derivative exposures) could and probably should be replaced by contracts that can be paid off in some form of equity (at punitive valuations) when they cannot be paid in cash.

Highly leveraged capital structures make individual firms, and networks of interdependent firms and communities, brittle. Replacing debt in firm capital structures with some form of preferred equity would serve as a shock absorber, allowing viable firms to survive transient cash flow shocks without affecting outside parties. It might be enough to simply level the playing field between debt and preferred equity by making preferred stock dividends tax-deductible for firms. But debt investors take some comfort in the fact that they have power, via the bankruptcy process, to enforce payment. That threat may reduce the cost to firms of debt finance. The sense of the present proposal is to define an instrument that gives fixed-income investors as much of the power they would have in a bankruptcy as is possible while reducing the likelihood of a “singularity” that creates far-reaching costs and uncertainties.

[1] The proposed “IACCPEs” would not necessarily be a more expensive form of financing than traditional debt: On the one hand, they take a weapon away from creditors, so creditors would want to be compensated for the additional vulnerability. On the other hand, by reducing the likelihood that a transient shock provokes an unnecessary bankruptcy, replacing debt with IACCPEs might reduce expected distress costs, and thereby increase overall firm value relative to a firm financed with traditional debt, which would be reflected in a lower cost of financing across the capital structure. Which of the two offsetting factors dominates would have to be an empirical question.

[2] Usually you would wait quite a bit longer than that, because the option of converting at any time makes the convertible security as valuable as the shares, but the agreed-in-advance payments of the unconverted security provides protection should the stock price tank. Exactly when it’s worthwhile to exercise the conversion option on convertible shares is complicated, and in real life depends on the level of dividends paid by common shares and the relative liquidity of the market for common and preferred shares. In frictionless markets for a firm that issues no common dividend, it would only be worthwhile to convert an instant prior to maturity of the convertible security (if it is not perpetual). For our purposes, however, all that matters is that investors usually convert preferred stock only when the common shares are doing well.

[3] Getting the conversion option trigger right would be an important technical issue in defining these securities. Managers might try to manipulate their stock price around the time of the triggering nonpayment, in order to minimize the cost of dilution to existing shareholders (and themselves). The conversion price might be based on an average stock price over 30 days prior. Managers would not have very much scope to time the nonpayments, because they would be required to skip dividends on the most junior class of preferred shares, whose dividend schedule would have been set in advance.

[4] Broadly, “financial” investors should be expected to research and take some responsibility for the firms in which they invest, while customers and suppliers should be able to do business with a firm without worrying very much about its balance sheet. There is no bright line between transactional credit and financial debt, but it is nevertheless a distinction worth making, and even policing, in firms’ capital structure. The “cash efficiency” movement, which encourages firms to maximize their use of transactional credit as a source of cheap financing, is in my view pernicious. But that’s a rant for another day.

Update History:
  • 2-May-2009, 3:50 p.m. EDT: Reorganized a bit, changing the name “In-arrears contingent convertible cumulative preferred equity” to the more svelte “In-arrears convertible cumulative preferred equity”.