Wednesday, November 11, 2009

Is Modigliani-Miller theorem the next casualty?

The dramatic events in the aftermath of the bursting of the sub-prime mortgage bubble has destroyed many reputations and repudiated much of the theoretical edifice of modern finance including the famous Efficient Market Hypothesis (EMH). The latest casualty may be the Modigliani-Miller theorem, the cornerstone of corporate finance, which states that under cetain conditions (absent taxes and in an efficient market) a firm’s value is unaffected by its capital structure (deb-equity ratio).

The Economist points to the evidence that MM theory may not hold - in the form of the reluctance of leverage-hungry bankers to increase their equity base on the grounds that "equity is too expensive and will have a knock-on effect on the price of credit". This arguement that flies in the face of MM theory, comes in the face of the tumultuous events of the past twelve months that have highlighted the need for banks to have deep enough equity buffers to cover for losses and the cost of any potential bailout.

As The Economist explains, "This theory says that although equity owners demand a higher return than creditors, their required rate of return on each unit falls as the amount of equity rises, since profits after interest become less volatile. The cost of debt falls too, since creditors have a bigger buffer beneath them. The firm’s blended cost of capital is unchanged, and is driven largely by the risk of the firm’s assets, not how they are paid for."

The article points to "quirks in the real world", which comes in the way of MM by making debt very attractive and equity costly and therefore uncompetitive, atleast in case of banks

1. The tax-deductibility of interest costs give debt an advantage and incentivize financial institutions to gorge on debt. In the lead up to the sub-prime crisis, leverage had accordingly become the pivot that amplified the gains of many banks, leave alone hedge funds and private equity firms.

2. Banks enjoy the advantage of using their deposits (which are liabilities), in addition to their equity, to fund their assets, and having these deposits covered with government backed guarantees. Other creditors too now enjoy a near-explicit government guarantee.

3. Further the deposits are priced at the Central Banks' short term interest rates, whereas the returns they make (or interests they charge) on their long term debt (or loans) are much higher. This coupled with access to unlimited short-term liquidity, thanks to the generous liquidity auction windows, means that banks do not have to worry about financing their short-term liabilities even if mismatches arise.

4. Further, the prevailing low interest rates means that the cost of raising debt is minimal compared to the returns available from the numerous investment alternatives. America’s mega-banks typically paid a blended annual interest rate on borrowings and deposits of 1-2% in the second quarter.

5. Finally, armed with the confidence (and resulting moral hazard) and societal/systemic underwirting that they are "too-big-to-fail", banks prefer smaller equity buffers and periodic bailouts over big equity buffers that push up the price of credit but make things safer.

The solution to keeping banks honest and covering the cost of potential bailouts from a systemic crisis include raising the ratio of equity to risk-adjusted-assets (or capital adequacy ratio) or even simple asset based reserve ratios, knockout ratio (ratio of gross NPAs to equity), force creditors to take the hit, have a layer of convertible debt (that gets used up after the equity is covered) etc.

In defence of MM theorem, it can be argued that the aforementioned "quirks in the real world" means that the pre-conditions required for it to hold - absence of taxes, bankruptcy costs, and asymmetric information, and efficient market - are not available.

Update 1 (20/3/2010)

The MM Theorem states that a firm’s value as a business enterprise is independent of how it is financed, i.e, its debt (leverage) to equity ratio. The debt-equity ratio determines how the risky cash flow from operations is divided among creditors and owners, but it does not affect whether the firm is fundamentally viable as an on-going concern.

As Greg Mankiw points out, the rate of return on equity should be endogenous (dependent) to the degree of leverage - if a bank is less levered, its equity will be safer, and the required rate of return (for both equity and debt) should fall. However, a bank with little or almost no leverage (and making loans with its own capital) will not play any "maturity transformation" role that conventional banks and other intermediaries play by borrowing short and lending long. And it has for long come to be accepted that this maturity transformation is a crucial feature of a successful financial system.

In other words, as Mankiw puts it, the debate is between whether as the Modigliani-Miller theorem says leverage and capital structure are irrelevant, or as many bankers claim they are central to the process of financial intermediation. However, given the central role played by maturity mismatch in all banking panics and financial crises, it is a moot point as to what value maturity transformation has. Do the benefits of our current highly leveraged financial system exceed the all-too-obvious costs?

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