Monday, February 16, 2009

Why Debt

Why does debt exist?  Why don't we throw the money lenders out of the temple once and for all and finance all business ventures with equity? 

An economy modeled on this idea would look appealingly simple -- a few people who have, over some period of time, managed to produce more than they consumed could get together and use the savings to fund a new business.  The legal wonders of private property and modern joint-stock company accounting being in place, they could all take a pro-rata share of the profits of the company based on the amount of savings they invested.  This to me is the very heart of classic liberalism (a la Adam Smith, Milton Friedman, and Noam Chomsky); create the conditions of possibility for non-zero sum games to arise where people can enter into voluntary arrangements of mutual benefit.  Some of us just call it Anarchy for the sake of simplicity.

In this toy economic world, if we both put up equity for a business, we both want to see it do as well as possible.  As equity holders, the only way we can see a return on the investment of our hard-earned capital is for the business to make money and grow, thus paying us out some form of dividend, or for us to sell our ownership interest in it in the secondary market.  Since this secondary market will be inherently forward looking when it establishes the value of the business, again, the original funders and the new owners all will be aligned in wanting to see the business maximally growing and succeeding. 

Why should debt ever enter this picture?  Debt mars the symmetry of mutually beneficial games.   If I merely loan you the money to start a business, I am now no longer especially interested in seeing the business thrive.  Clearly the business must be viable enough to accommodate the repayment of that loan when its ticking time bomb time limit expires, but that minimal definition of success is all I, Creditor care about.  As long as the business generates sufficient cash over the life of the loan to just pay back the interest and principal I will be happy.  In fact, we occasionally see an even more extreme version of this pessimism, where a lender turns an entrepreneur into a sort of sharecropper.  The lender may be happy charging an interest rate high enough that it prevents the business ever paying back the principle.  Then the lender can just roll over the loan when it matures, and keep the company working for him forever (normally we trust in the benefits of competition between lenders to eliminate any such magnificent money making scheme well before the need arises for Jesús to show up in his purple polyester suit and bust up the party).

So when debt enters the thought experiment, we still have a non-zero sum game -- the entrepreneur gets his additional capital, now, and the holder of capital gets to hold some more of it, eventually -- but the incentives of all the providers of capital are no longer identical, and in particular, one owner is strongly incented to make the company do well and one owner doesn't care if the thing stays on eternal life-support, just so long as it doesn't croak.

Given the inelegance of the system, we can ask why the publicly traded bond markets are larger than the equity markets (worldwide) and why they are completely dwarfed by the overall debt markets if you take into account bank's direct lending.  There would appear to be two basic risk reward calculations, one for each side of the transaction:
  1. An entrepreneur accepts the risk that he may have to repay his creditors on a fixed date, and may thus have to liquidate his business, in exchange for not being forced to share its potential success with anyone else. 
  2. A debt holder accepts an extremely limited potential return in exchange for the guarantee that he can get his capital back at a pre-specified date without having to worry about whether the business is a rousing success.
Number 2 here relates to an interesting debate that is at the heart of William Poundstone's book Fortune's Formula.  The book is a fun read for a whole host of reasons from its exposition of how to count cards in blackjack, to its discussion of the applications of information theory to the stock market and its history of the slimy early career of Rudy Guliani.  But the intellectual meat of it centers around a somewhat esoteric debate on how you define the utility of money -- basically, some people just want to have as much of it as possible, and others see it as merely a means to an end, and so prefer to trade some amount they consider superfluous for a greater guarantee that they will satisfy these ends.  In more technical terms, the difference is between people who invest so as to maximize the geometric mean of their returns, and those who pay more attention to the arithmetic mean.  For someone who just wants to have the largest pile of shekels at the end of the day (He Who Dies With The Most Toys Wins) the only important criteria in investing is the compounding annual growth rate over the long term.  This type of investor is willing to stomach any amount of volatility so long as it is associated with a higher return.  On the contrary, for those who just want to have enough money never to have to think about money again, the temptation is to seek investments that pay out the exact amount necessary for each of life's future expenses. 

The book details the nearly theological level to which this debate has been elevated over the years, but to me it seems pretty clear that from a practical perspective there will always be some actors in the market that prefer the higher and more volatile returns of equity to the relatively certain timing of payout that a bond allows.  Investors have different time horizons not because some are smart and some are dumb or because some are greedy and others slothful, but because they really do have differing needs for cash at different times. 

You can see this more clearly if you imagine again our toy world that consists uniquely of equities.  Let's further assume that in this toy world the frictional costs have been dramatically reduced, and one of the behavioral reasons an investor might be tempted to opt or the safety of a bond -- namely, that he doesn't know anything about the company in which he is investing -- has been overcome.  An ideal world of micro-equity, if you will, where every entrepreneurial undertaking is publicly traded with full disclosure of its structure, financial results and prospects.  If I have some capital to invest for the next 50 years, this world is pretty appealing.  I am almost certainly better off partnering with all of these businesses and taking a share of the upside, than I am letting them keep it for themselves after paying me back.  Over time these businesses will presumably grow and become more productive, and hence become more valuable.  And if for some reason I need to get my capital back, or prefer to hold one set of businesses rather than another, the secondary market will generally accommodate this without problems.

But if I plan to take my capital back next month or next year to buy a house or a car or whatever, I might not want to put all of my money in this micro-equity market.  Over a long time, certainly, these businesses will grow, but over shorter horizons they may shrink.  To some extent, I can mitigate this problem by investing in a great many of them, hoping that this diversified portfolio will always contain a preponderance of growing rather than shrinking businesses, and so will always grow steadily as a whole.  But we all know that certain large cycles do sweep over whole national and even global economies, and unless you believe that the very act of eliminating debt from the world (ex hypothesi in this case) will eliminate these cycles, then you may wish to hold some of your funds back from the market to assure that you have the cash ready to purchase you new mobile home. 

Where would you put this money?  Well, a sock works okay, but pays little interest, so you might make a deal with one of these equity-only entrepreneurs such that you give him the money (as equity of course)  to use until you need it, but he agrees to buy your equity back from you (plus maybe a little for your trouble) at a fixed price on some fixed future date.  Witness the birth of the modern repo transaction (I'm oversimplifying, but the idea is close enough).  If the entrepreneur lines up enough of these transactions, he can run a profitable business where he never has to share the profits of whatever he uses the money for, while at the same time fulfilling the public service of roundly outperforming the liquidity management characteristics my sock.

So, in short, debt makes sense from the perspective of the investor, and once we see that there is value to be had by debt existing, its introduction into our economic Eden of equities is as inevitable as Eve eating the ur-etamame. 

Anyhow, back to number 1.  It's easy to understand at first why an entrepreneur would want to fund his business entirely with debt; if it works he's gonna be rich, and it's all for him.  This is why, at first, it seems as if debt is almost progressive.  If there were no debt, new businesses that required capital would have no choice but to share the open ended economic benefits of their innovations.  Of course, there is always the question of the price of the equity, that is, what valuation the company is given before it even has any capital, but it seems reasonable to imagine that outlawing debt would generally tip the competitive dynamic of the capital markets in favor of capital and away from the entrepreneurs. 

But what crazy entrepreneur wants someone to be able to tell him when he has to liquidate his business!?  Funding a business with debt is only superficially rational, at least for most businesses, and certainly for those early on in their life or facing uncertain prospects.  This is common knowledge of course, and more debt is available to fund stable time tested business models backed by assets that do not tend to loose (too much) value upon liquidation -- ie. real estate -- than is available for brilliant, forward-looking, but inherently 'asset-lite' businesses such as

In addition, what may appear progressive from an individual perspective (because it serves to distribute greater gains to founders than to capital) may in practice not be so progressive when seen from a systemic perspective.  In other words, what if all the creditors want to buy mobile homes at the same time?  If one debtholder wants to cash in he can always be replaced with another, so long as the business is even marginally healthy.  But if creditors en masse refuse to roll over their obligations they can force a huge chunk of the economy into immediate liquidation, and in fact, can end up owning the lion's share of what is left over after the mayhem.  Just ask J.P. Morgan how it felt in 1907.  When the option is underwater for the entrepreneur, debt may not look so progressive at all.

Where are we at the end of all this rambling?  It seems to me that the simplistic pure equity world suffers from no endogenous instabilities.  Equity capital is permanent capital a company never has to repay, so that even if some systemic event should come along and cause everyone to simultaneously want a winnebago, a shotgun and a bunker full of canned tuna, no functioning businesses need be liquidated as a result.  Prices in the secondary market for equities may collapse, and so it may be difficult to start a new business for a time, but the secondary market has a buyer for every seller, so that while everyone selling stocks may come up short of what they wish they had, the buyers will be setting the stage for a future fortune.  This again is oversimplifying as the secondary equity markets are also important in price signaling and do not simply serve as side-bet and redistribution mechanisms, so that a collapse in share prices can indirectly cause the uncertainty that reduces the future cash flows from a business.  But that's a definite bank shot, theoretically speaking, and I ain't no Keynes.

Then death intervenes in this relatively stable world.  People don't actually have an infinitely long horizon; they buy the farm.  And what's more, they know that they're going to.  And the plan for it.  And lo, and behold, debt comes to be.  This great force of instability in the markets and asymmetry in incentives ironically stems from the primordial desire to secure future expenditures with greater certainty. 

Which is to say that if we all lived forever, it would be in a capitalist paradise.

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