Shedding Debt: What Could Possibly Go Wrong?
- Corporate borrowers and mortgage holders alike need a more nuanced understanding of the downside of leverage in order to manage risks properly and avoid being exposed to unsustainable levels of debt.
- Corporate managers are less rational than expected in assessing debt risk when credit is easy, responding too strongly to short-term incentives.
- For many firms, going public via IPO is a form of “permanent deleveraging.”
- When creditors tighten margin requirements, hedge fund managers behave in similar ways, despite their promise of portfolio diversification.
- Misplaced confidence in continued high home prices prompted excessive borrowing by corporations and home buyers.
Taking on debt is a routine financial activity, whether you are a corporation seeking to expand or an individual buying a home. As long as the prospects for repayment are good, the risks of borrowing are minimal and borrowers enjoy access to the kind of capital they would otherwise find difficult or impossible to raise on their own.
Rational actors, acting rationally. When times are not so good, however, leverage quickly becomes a burdensome liability. Then, the rational thing to do is to deleverage. But when everyone tries to deleverage at the same time, things quickly spiral out of control. Enter the global financial crisis of 2007-08.
Deleveraging has been a juicy research topic for Evan Dudley, assistant professor of finance at Smith School of Business, since 2009. He has combed through industry-level accounting information, data on futures margins, and mortgage foreclosures, and has produced counterintuitive findings about how the process of deleveraging is handled by corporations, hedge funds, and individuals.
His big takeaway is that we — corporate borrowers and mortgage holders alike — need a more nuanced understanding of the downside of leverage in order to manage risks properly and avoid being exposed to unsustainable levels of debt.
“I don’t think the concept of leverage is bad,” Dudley says. “It’s the application of the concept that’s difficult, because sometimes these liabilities are hidden."
Corporate Exuberance to Short-Term Incentives
In the case of corporations, many analysts realized following the 2007-08 crisis that corporations borrow excessively when equity markets are overheated and credit is cheap, responding to short-term incentives.
But this vision of how firms operate differs dramatically from what is normally taught, says Dudley. “In textbooks, we have this view of managers as efficient, where they're continuously balancing the pros and cons of leverage on their balance sheet,” he says. “In reality, it’s much messier. When credit is cheap, they’re going to borrow for a host of reasons. They behave opportunistically, borrow excessively, and get themselves into trouble. And then they’re forced to deleverage."
It generally does not become apparent to management that they are holding too much debt until economic conditions deteriorate, which is precisely when deleveraging is most difficult. “It’s harder than just paying back debt,” Dudley says, “since they’re typically losing money at the same time that they’re trying to deleverage.”
One way corporations deleverage is through an initial public offering (IPO), where shares in the firm are first offered on the open market. IPO is, in fact, one of the best ways to shed debt, Dudley says. Prior to going public, firms pile on debt to stoke product development or build market share. When they go public, they raise a lot of equity and reduce their leverage.
In downturns, “it’s harder than just paying back debt, since they’re typically losing money at the same time that they’re trying to deleverage”
Dudley’s research, however, uncovered another contradiction to financial orthodoxy. “One of the conventional wisdoms was that firms all have target leverage ratios that they want to revert to after they go public,” he says. “What we show is that’s not at all the case. It’s a permanent reduction. Going public is a form of permanent deleveraging for many private firms.”
More broadly, Dudley’s research undermines the idea that firms constantly weigh the tax-related benefits of debt with expected distress costs. “My findings suggest that managers in many firms would actually prefer zero or very little debt, but they sometimes use debt excessively when credit market conditions are easy,” he says. “The reason is that individuals respond very strongly to short-term incentives.”
Hedge Fund Leverage: What Good is Diversity in Bad Times?
Hedge funds probably took the biggest PR hit in last financial meltdown. Fund managers were perceived as having lured investors into dubious investments that ultimately left them holding the bag. And, as with corporations, it was a concerted move by hedge fund managers to deleverage that played a large role in exacerbating the crisis.
“The process of deleveraging here was really interesting,” Dudley says. “It overturned a lot of preconceived notions many investors had about these vehicles before the crisis.”
As alternative investment vehicles whose managers could invest in anything that promised a good return, hedge funds had effectively positioned themselves as offering a high degree of diversity in their holdings – a crucial measure of investment security.
“The idea was that they wouldn’t get by just by holding the Standard & Poor’s 500 index,” Dudley says, referring to one of the most commonly followed equity indices. “These hedge funds had very different investment strategies. Some invested in stocks, some in bonds, some took opposite directions on the same axis. Some were betting on an increase in home values, some were betting on a decrease in asset values. And they all lost money at the same time. This was totally counter to how they had advertised themselves as being very diverse.”
“For many investors in these types of products, diversification disappears during bad times, which is precisely when you need it the most”
Hedge fund managers were simultaneously trying to sell off assets and pay off debts – exactly what was going on in the housing market and at the corporate level at the same time. And their banks – their "prime brokers" – were all exposed to the housing market. When the prime brokers lost money on that market, they asked their hedge fund borrowers for higher margin requirements – to increase the amount of collateral or equity they would have to post with the lender if they wanted to borrow.
“If you have to post more margin and you’re already leveraged up to your neck, you have to sell some of your assets,” Dudley says. “The hedge funds were being asked to reduce their leverage, but this caused the prime broker to ask them to reduce their leverage even more, because assets were being sold at fire sale prices.” Hedge funds across the board reacted identically, regardless of how diverse their holdings were.
For Dudley, the widely held notion that hedge funds provide portfolio diversification is problematic at best. “They do offer diversification, but only when times are good,” he says. Unfortunately, this is when diversification is the least valuable. “For many investors in these types of products, diversification disappears during bad times, which is precisely when you need it the most.”
Misplaced Confidence in Home Values
In the run-up to the 2007-2008 financial crisis, one of the main factors that fueled overconfidence and helped relax restrictions on borrowing was the widely shared assumption that house prices would remain high over the long term. This assumption led to a compound of behaviours that in retrospect were highly risky.
Not surprisingly, individual mortgage holders were at centre stage. Households simply borrowed too much with too little down to pay for their homes, Dudley says. Banks financed these loans by borrowing on the credit markets. And they repackaged the mortgages and sold them to other investors, who purchased them with funds borrowed from the same banks.
Here is where a surprising asymmetry crept into the equation. While the credit market borrowing that the banks did to finance the mortgages was over the short term, Dudley says, the opposite was true of the loans they offered mortgage holders.
“They were lending out at 10- to 15-year terms to homeowners, while the loans they themselves took matured very short-term – as little as a month, sometimes even a day. Everything was predicated on home prices staying high. When that turned out not to be the case, it all unravelled like giant house of cards."
— Andrew Brooks