Wacky WACC and the cost of capital

WAAC is an acronym widely used in corporate finance which stands for Weighted Average Cost of Capital. It is often identified (confused) as the marginal cost of capital or the rate of return required by a firm. In discounted cash flow models, WACC is used as a discount rate to evaluate investment projects or to value companies.

There are several controversies regarding the way it should be computed (e.g. see Fernandez, 2011) but I do not address them here. I shall focus on its abusive identification with a true definition of the cost of capital. Indeed, the WACC is neither a cost nor a required return, but an weighted average of both.

Initially, finance theory discussed the concept of the cost of capital in the context of how to fix the rates of public utilities, in order to recover the costs of investment, their replacement costs, their financing costs and any other costs. In corporate finance, it originates from the valuation of investments, and can be regarded either as a discount rate or a multiple used to obtain the present value of expected future net cash flows.

So, what is the appropriate discount rate? Since different investors may use different valuations for different objectives, there is no single rate derived independently of specific markets and circumstances (e.g. Somers, 1971, even argues that “appropriate discount rates are not only project-specific, they are project-unique”).

Nevertheless, modern corporate finance, has been dominated by a specific choice that is consistent with the model of the irrelevance of capital structure and dividend policy. At the theoretical level, the modern school of finance (Modigliani and Miller 1958) postulated that the cost of capital, measured as the market rate of return, is a perfectly definite quantity not subject to manipulation through capitalization or dividend policies.

On the contrary the old school of finance (Durand 1952 and 1966), regards the cost of capital as too nebulous and elusive to play a key role in financial policy. I shall argue that the “old school” argument is more reasonable and does not introduce an unnecessary bias in favor of managerial capitalism.

From an empirical point of view the approach followed by the modern theory of finance may be dismissed on the grounds that a valuation based merely on a small share of total financing – traded debt and common stock – is necessarily unreliable. In fact, that was the argument for its dismissal by its first proponent (William, 1938).

Nonetheless, from a theoretical point of view, it could still be useful. However, it happens that its theoretical value is also limited, even at the mathematical level, despite its straightforward mathematical definition.

Weighted averages must be meaningful. For instance, one may calculate the weighted average cost of a piece of fruit in two baskets by summing the average price of each basket multiplied by the percentage of fruits it contains, regardless of whether both baskets contain apples or one has apples and the other has pears.

However, for most purposes one is only interested in averaging close substitutes, e. g. apples with apples or apples with pears, not baskets with a mix of completely different fruits. Likewise, with various sources of funding one must ascertain if they are really close substitutes beyond a narrow range within the capital structure.

So, for a start, one may consider weird a metric like WACC that averages two distinct terms - the cost of debt, which is indeed clearly perceived as a cost and easily measureable, and the required return on equity, which is not unquestionably defined or easily perceived as a cost in an accounting sense but as a potential gain that needs to be estimated. This mix up is reasonable if presented as an expedient or academic exercise but not as a scientific foundation for investment decisions made by different agents.

It is true that seen from an investor perspective exchange-traded debt and equity issued by a firm look like two substitute financing instruments suitable for arbitrage. However, debt and equity financing are not identical or sufficiently similar instruments to be considered perfect substitutes for controlling shareholders or for pure arbitrage. They may be sufficiently correlated for statistical arbitrage but that is not enough to combine them in the same basket. Let me show why by explaining first why the return on equity cannot be considered truly a cost like debt.

Imagine a business run by Mr. Management and funded by Mr. Supplier, Mr. Creditor and Mr. Stockholder. From time to time Mr. Management organizes a tender to finance the firm´s funding needs and asks suppliers, debt providers and stockholders to bid. Mr. Supplier would have to compete with other suppliers to offer better payment terms for the amounts procured. Similarly, Mr. Creditor needs to outbid other debt providers and Mr. Stockholder would need to beat other equity investors.

It is obvious that the tender would have to offer investors different terms for different types of funding. For suppliers, other than business preference, the firm may not offer any explicit consideration for deferred payment. To creditors it offers to pay interest in cash or kind. To stockholders it offers a payment in kind by giving them part ownership in the company.

Suppliers, creditors and shareholders bid for the three types of funding would depend on the respective consideration and the seniority of their claims on the firm’s assets. Stockholders are the last in terms of seniority and the cost of funding (the return demanded) declines as the seniority of the claims increases.

Now, imagine that Mr. Management has a fiduciary duty to minimize net working capital, the cash conversion cycle and funding costs. So, he must bargain hard payment terms and fund as much as possible from the cheapest source of funding. The first two suppliers of finance are easy to bargain independently, but not so with stockholders.

Stockholders pose a special challenge since they should be able to bid for how much they wish to plowback into the business and the possibility of providing additional financing. Indeed, Mr. Management would need to make sure that the value of the stock owned by their existing shareholders would not be reduced by the ownership dilution of their holdings. That is the new capital would need to earn enough to meet the current owners required rate of return plus any dilution costs.

When Mr. Management is also the majority owner of the company this paradox is easily solved by treating the other shareholders as junior partners. However, this is not the case for firms operating under managerial capitalism. In such firms, the directors’ ownership is small or inexistent making them simply agents of other stockholders. These, in general, have only small stakes. Indeed, their capital dispersion may be so high that managers are able to select shareholders rather the other way around, creating serious agency problems when choosing different sources of funding and defining objectives.

So, the key issue is whether firms should leave the amount of equity (including retained earnings) as a residual source of financing after exhausting all other funding sources or instead should the shareholders decide how much they wish to fund the business and let the others with the residual to be funded through other sources?

Traditionally, textbooks avoid this question by assuming that shareholders can attain their objectives in terms of capital structure through homemade leverage, leaving the firm to invest up to the point where its marginal return equals the marginal cost of capital.

But then, the capital structure and the marginal cost of capital cannot be determined separately when both depend on the same determinants (lenders mark-ups and risk aversion) and leverage has simultaneously contractionary and expansionary effects on investment (Marques-Mendes and Mheica, 2006).

For a simple illustration of the kind of confusions caused by the cost of capital theory consider the valuation of two unlevered companies with the same cash flow. Imagine that they are quoted in the same market and one of them is seen as outperforming and the other as lagging the market, so that the first appreciates more than the market while it rises and falls less when it declines and the opposite happens with the second company. For instance, assuming that when the market declines at a rate of 2% the first company declines at 1% and the second at 3%, and the opposite happens during rising markets, the average betas would be 1.09 and 0.93, respectively. Assuming further that the risk free rate and equity risk premium are 4 and 6%, respectively, the second company would be worth more 10% than the first company. So, using the popular CAPM model to estimate the required rate of return, the first company would have a higher beta and therefore a higher rate of return. However, assuming that it is the true cost of capital, this would mean that investors would value more the second company which is the opposite of what they are doing.

The reasons why such an obscuring theory achieved such popularity among academics and professionals were already given in another post. So, I will conclude by recalling how a reasonable minor departure from profiting maximization was seized by special interest groups on the basis of a somewhat wacky theory.

Asymmetries in access to leverage

There is a justified apprehension that in credit-based economies, of the type associated with capitalism, the excessive reliance of credit on collateralization perpetuates an unfair advantage for those endowed with more capital. The popular sentiment that money-attracts-money and misery-attracts-misery. However, the rise of capital markets and the spreading of banking philosophies based on the ongoing concern principles, means that market capitalism dilutes such concerns about the misallocation of savings.

Before addressing the potential misallocation of leverage under financial capitalism, let me make a qualification about the differences between savings and investment and credit and borrowing. The two concepts are often confused because ex-post, in an accounting sense, their value is identical and also because in a popular sense saving is seen as a form of abstinence. Likewise, lending is popularly identified with renting an existing asset, e.g. a lawnmower or cash.

To be more exact we should define investment as the carrying of any asset (whether the butter in the fridge or the computer in the office) from one accounting period (whatever period unit one uses, year, month, etc.) into the next period, either because it cannot be entirely used up within a single period or for precautionary or speculative reasons.

Under this definition one would consider consumption as the use of a portion of newly produced or existing assets during the current accounting period. Thus, as Keynes put it, “when investment changes, income must necessarily change in just that degree which is necessary to make the change in saving equal to the change in investment” . Hence, savings and investment are jointly determined by the propensity to consume, the schedule of the marginal efficiency of capital and the rate of interest.

Therefore, one needs a theory of how financial leverage influences these determinants. In the absence of such theory, one can nevertheless intuition (see Mendes 2000) that the rise of finance capitalism has two offsetting effects on investment – contractionary and expansionary – whose net effect has to be ascertained under specific circumstances.

In particular, large scale investments need to be collateralized through a mix of financial assets and guarantees involving a complex engineering between banks and governments. This necessarily degenerates into collusion between these two sectors which occasionally may crowd-out the funding of enterprise in favor of speculation and government spending. In this sense it is a threat to market capitalism.

However, some speculative occurrences in financial assets have as an underlying a non-financial asset like real estate or similar which causes a misallocation of resources into non-financial assets (e.g. the sub-prime real estate bubble and crash in US). On other occasions it is not clear if the speculative frenzy began with non-financial assets and after transmitted to the financial sector or vice versa. However, such cycles are neither the result nor a threat to capitalism.

In conclusion, finance capitalism may cause some misallocation of resources and favor the leveraging of some sectors (e.g. managerial capitalism) but it is not a fatal threat to market capitalism.

We’re all capitalists now

The six pillars of capitalism – private property, profit motive, free markets, rule of law, joint ownership and limited liability – allowed this economic system to be the most productive as well as the most equalitarian system ever tried by humanity. Nevertheless, this result was neither procured nor foreseeable from the outset.

For example, one of the widest off the mark forecasts in history was Marx’s prediction that under capitalism the greater part of the middle-class would constantly sink into the proletariat leaving the population divided into a small bourgeoisie and a large proletariat. Indeed, exactly the opposite has happened. Although the wealthiest one percent has increased its share of total income the number of proletarians (those without any assets other than their labor) dwindled to a small number. So, instead of all becoming proletarians now we are all capitalists.

The explanation for Marx’s failure resides in his erroneous theory of wages and employment and from unforeseen developments in terms of labor organization (unionization), welfare state and compulsory savings through retirement, unemployment and health insurance.

Furthermore, apart from the number of capitalists in society, there were other developments that also changed the perception and the role of capitalists.

In fact, under capitalism the social structure no longer is based on breeding but on work and merit. Social mobility is now achieved mostly through education while the social standing of business people as well as that of wealthy and poor capitalists is now at par with the traditional higher classes of nobility and clergy.

Popular capitalism, a term used to describe the rise in shareholding by individual investors, may occasionally hit the headlines but it should not be confused with the process through which people are now simultaneously workers and capitalists. Whether people choose to own shares in a company directly or indirectly through institutional investors depends simply on their perception about which is the best way to manage their capital.

The role of the capitalists investing in equity has also changed in the sense that most of them do not participate in the life of the company into which they invested or simply monitor its development. Indeed, some do not even want to know much about the company where they invested except its price so that they do not become sentimentally attached to the stock.

Nevertheless, although day trading based in technical analysis is a popular approach among some investors, the majority of investors still follow an investment approach based on event or portfolio investing which require a good knowledge about the company. Thus the signs they transmit through their buy and sell orders cannot be ignored by company managers, even when they are not part of the small group of investors that have or might exercise the control of the company.

So, although trading plays an increasing role in today’s capitalism, we cannot identify the kids gesticulating in a modern trading room with a Rothschild standing at the door of the London Exchange in the XIX century. Mostly because they are just agents, while Rothschild was simultaneously agent and principal. So, traders cannot be used to symbolize modern capitalism. Nor should the wealthy be confused with capitalists whenever they invest only in government debt.

As I said elsewhere, 100% leveraged companies cannot exist in the capitalist sector. In this sector, shareholders are indispensable to preserve the profit motive and profit maximization indispensable to a capitalist system. So, although consumers are the main beneficiaries of capitalism with an unequivocal interest in free markets (another pillar of capitalism) they cannot play the role of capitalists and force managers to pursue profit maximization because they would have an interest in securing lower prices at the expense of profits.

Then, since most people are simultaneously consumers, workers and capitalists, how can they achieve at the same time lower prices, higher wages and more profits? This is a false conundrum easily solved in a capitalist system through competition and profit maximization. To pursue profit maximization firms have to optimize their labor/capital mix while investing more in physical and human capital to increase productivity and wages. Through free and competitive markets corporations are at the same time forced to take good care of their customers and try to offer the best service at a lowest price.

In conclusion, as more people becomes capitalist they improve their wealth and income, and, most importantly, they play a role in keeping the system alive and efficient.

In general, most of us, including those with more than a million invested in securities, cannot live on capital earnings alone. Therefore we do not recognize ourselves in the old stereotype of an idle capitalist with a top hat living on investment income and spending only a few hours a month monitoring or trading his securities. But, generally, now we are all capitalists (whether directly or indirectly) despite not fitting into a stereotype. This is clearly an important civilizational advancement of capitalism.

The Reinhart-Rogoff controversy: some microeconomic evidence

The duel between pro-austerity and pro-stimulus advocates is now being fought on the relationship between economic growth and debt/GDP ratios, following the Reinhart and Rogoff finding that there was a "tipping point" around 90 per cent of debt-to-GDP ratio when the correlation between debt and economic growth would become negative.

Their finding was questioned by Herndon-Ash-Pollin who estimated that the strength of the negative relationship was actually much stronger at low ratios of debt-to-GDP. Recently Dube, using the same set of data, estimated that current period debt-to-GDP is a pretty poor predictor of future GDP growth at debt-to-GDP ratios of 30 or greater but it does a great job predicting past growth which he claims is a tell-tale sign of reverse causality. That is, recession leads to increased spending and greater government borrowing not the other way around. Krugman joined the debate on Dube´s side but cautioned about claiming any causal relationship, or, if it existed, it would be pretty slim.

The debate is not over and, most likely, macroeconomists will continue sabre-rattling with lags and correlation studies to discuss the direction of causality and the location of the “tipping point”. In my view, it is unlikely that they will arrive at any unequivocal conclusion at the macroeconomic level for three main reasons. First, if we assumed a closed economy with a single firm we would end up with an accounting identity between total assets and their financing that would prevent any causality conclusions. Second, since leverage amplifies both gains and losses, any relationship must be very sensitive to the business cycles. Finally, the microeconomics of debt financing is too complex to build a one-way macroeconomic theory.

Yet at the firm level it must be easier to find if there is such a tipping point. There are basically three ways in which we can use debt-financing – to finance consumption, failed investments (including gambling) and profitable investments. In the long run only the third use is sustainable, but in the short run the three types of spending have a positive multiplier effect on economic growth. Elsewhere, I have shown why at the corporate level debt financing has simultaneously contracting and expansionary effects on investment, with the positive generally offsetting the negative effect depending on lender’s mark-ups and borrowing limits.

The corporate level is the right place to find out if and where there is any tipping point in the spectrum of leverage, because if there is one it should be close to the maximum debt-capacity financiers impose on the basis of several debt coverage ratios. Moreover, we may extrapolate those results to the macro level under the following, not very extravagant, assumptions: a) the shares of labour and capital in total income are relatively stable; b) an ever increasing number of companies do not pay dividends so that the growth of equity is a good proxy for economic growth; and c) listed companies give a good representation of the entire business sector.

Since profitable companies should use leverage to increase the return to their shareholders, the correct way to verify if they benefit from increased leverage is to check if the elasticity of equity in relation to debt is greater than one or at least positive. Since at SADIF Investment Analytics we cover more than 20,000 stocks worldwide we quickly pulled the quarterly growth rates of equity and debt for the last four years which allow us to gauge the relationship between equity growth and debt-financing.

We used data from countries that in the popular imagination epitomise the three types of use for debt financing. Americans are often seen as reckless shopaholics pursuing consumption-led growth policies, Euromeds (Portuguese, Spaniards, Italians, Slovenes and Greeks) are generally perceived as castle-in-the-air investors in loss-making projects in transportation and alternative energies generously financed by the EU/EIB and Germans are traditionally depicted as successful thrifty mercantilists. The distribution of firms and the median equity elasticity in each quadrant of the equity and debt growth space is given below.

The median equity elasticities highlighted in the table seem to validate the popular view on the use of debt financing since the Germans have the highest value and the Euromeds the lowest. The only discordant note is that the percentage of firms with a positive elasticity is much higher in spendthrift America than in thrifty Germany which weakens any macroeconomic extrapolation.

To test the location of a possible tipping point I plotted the equity elasticity against the extra debt capacity measured as the spare level of debt capacity as a percentage of total outstanding debt, so that we can measure the leverage spectrum from left to right in the chart below for the USA.
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The expectation is that elasticities rise as firms deleverage or leverage towards their maximum debt capacity (0% extra-capacity). The maximum of the quadratic functions fitted are indeed close to zero (i. e. -1.7% in the US and 7.3% in Germany). However the function is meaningless for the Euromeds and the coefficient of determination is too low for the other two countries.

So, in conclusion, this microeconomic evidence suggests that it is not possible to settle the debate on the correlation between growth and debt without allowing for the business cycle and the microeconomic complexities of debt financing.

We can’t all deleverage at the same time

We can’t all deleverage at the same time. That would be equivalent to everyone moving to the same spot in a sinking ship. It would capsize immediately. To see why, imagine this nightmare scenario: everywhere and everybody – banks, firms, governments and families – think that they are overleveraged (i.e. is excessively in debt) and decide to reduce debt (deleverage) simultaneously. Regardless of whether they are right or wrong about their excessive level of debt (in a previous post we explain why this is difficult to define); the simultaneous deleveraging could start the following fatal spiral.

Banks reduced excessive leverage by not renewing their lending facilities to firms; these add misery to injury and reduce further their leverage by firing workers and trying to sell assets. Braced with lower tax revenues and higher calls for unemployment insurance, governments answer by reducing public debt through higher taxes and massive cuts in spending; which reduce the revenue streams of banks, firms and families. Families, affected by higher unemployment, loss of revenues and fearing the future, decide also to deleverage by saving more or defaulting on their loans and by massive cuts in spending. This would reduce further the revenues of banks, firms and governments. Thus, to pursue their debt reducing objectives all would initiate a new round of cuts. This would cause a downward spiral of spending cuts that would stop only after the economy was brought to a complete halt and widespread defaults.

Wait, there must exist some break point on this spiral. After all, debts are owed to someone and those receiving the debt repayments must use their surplus money. Yes, but what if, fearing that same spiral, they decide to hoard it by holding cash, exchanging it for some remote currency (e.g. the Swiss Franc) or buying some relic from the past (e.g. gold). The first, if not offset by the Central Bank, would cause a major liquidity crisis accelerating the depression. The other two may lead to absurd bubbles whose anticipated bust would hang on the heads of enterprising people. So, not much hope here.

What if there is somewhere an unleveraged entity willing to finance an orderly sequence of deleveraging through saving and inflation? To a large extent that was the situation at the end of World War II, when the US played that role. Can’t China and other emerging nations play that role now? Probably not, because they do not have the economic size needed to face a much bigger problem. Moreover, by accepting a rescue from a dictatorship, the Western democratic nations would risk losing their freedom.

Indeed, despite some double counting, the following table shows that the net international investment position of the Western countries is less than 3% of their GDP, largely because of the high level of savings in Japan. Yet, Japan has the largest government debt as a percentage of GDP (226%).

Unfortunately, a deleveraging spiral may start without all countries being overleveraged. A debt crisis in one sector (e.g. the Government) may easily infect the remaining or be started off by a generalized downgrade by the rating agencies. In fact, some fear that the leading Western nations (US, European Union and Japan) may be in the brink of getting into such a depression spiral started by deleveraging in the sovereign debt sector. So they desperately need to find an alternative solution.

First, they must plug once and for all the holes emerging in the weaker economies of the Euro Area. Second, they must mobilize the spending power of the few remaining sectors with borrowing capacity. Finally, and most importantly, they must acknowledge that at least one entity must be allowed to continue to increase its leverage while the others deleverage.

Here the obvious choice must be the Government (except in Japan), due to its policy powers, but mostly because it is the only one that can borrow with very long maturities.

Thus, although we live in a peacetime period, sovereign debt limits in the US and Europe can be increased to levels close to those observed at the end of wars. That is, countries with national debts around 60% of GDP could borrow close to a 100%, while those already above the 100% should be allowed to borrow up to 180% of GDP.

The process, relying on multilateral facilities, should be sequential with an agreed calendar and coordinated at the level of the G3 group of countries (not the G20, which should only have a consultative role).

Leverage as Friend and Foe

As far as I am aware there are only four legal ways to become seriously rich in a short period of time: to inherit or marry into money, to hit a lottery or sales jackpot, to become the CEO of a large public company or investment fund in the USA or to leverage one’s way into wealth. Out of the four, only leverage is not fundamentally determined by destiny or luck.

Not surprisingly, this explains why, throughout history, leverage never ceased to fascinate people as a kind of “Aladdin's lamp” for immense wealth. In fact, the history of financial innovation is little more than a continual re-invention of some form of leverage. Leverage or gearing is the percentage of external financing and it is often measured as the ratio of capital to debt or as the ratio of total debt to total assets.

Indeed, credit is an essential element of market capitalism. It allows those with entrepreneurial spirit to invest beyond their own capital and gives those without such spirit the chance to share in the success of entrepreneurship. This means that passive investors must accept a lower return to make it worthwhile for entrepreneurs to take the added risk.

The case to make debt-financed investments applies equally to families and governments. So, in a closed economy this might create an impossible situation where everyone wants to be a net borrower, leaving the central bank as the only net lender by creating the money necessary to fulfill the demand for debt. In such a system those in charge of dispensing credit have an extraordinary power over the fate of the borrowers.

In practice market economies rarely reach this extreme situation for three main reasons. First, many people cannot or do not bother to search for investment opportunities with returns well above the risk free rate of return. In particular, families and governments are often in this situation. Second, many do not have the collateral required by lenders or do not fulfill the requirements to access non-recourse finance. Finally, leverage is a double-edged sword and not all can or know how to cope with the risks of debt-financing.

To understand that there is a thin line between fortune and misery in the use of leverage, imagine that one can invest up to four times the value of his capital to achieve an expected return of 25%. If he succeeds his return will be 100%. But what if instead of an appreciation of 25% there is a loss of 25%? He would be completely wiped out.

The fact that the likelihood of a 25% loss is very small is not enough comfort because it will happen one day. And, if one keeps reinvesting all his proceeds, he will lose all his previous gains. Any roulette player knows this, but people often tend to forget it. Especially when prices have been going always in the same direction, as happened recently in the real estate market (many people had never observed a fall in housing prices).

So is it true that leverage, like death, in the end will always finish by catching us on the wrong side of the bet? Not necessarily, provided that we do not re-leverage all our gains, do not exceed a prudent level of leverage and manage it correctly (for instance by not carrying leveraged positions over-night).

To be prudent one needs to answer the important question of whether there is an optimal level of leverage and what are its determinants. Unfortunately, neither in theory nor in practice can we find an answer to this question.

First, different assets have different levels of volatility (for instance in the last 10 years, intra-day, the Dollar never fell by more than 4.8% in the Euro/Dollar market while in the stock market the shares of Microsoft never fell by more than 12%). Second, in itself, leverage changes the optimal composition of investment portfolios. Thirdly, because the optimal level of leverage may be above what lenders consider safe and lenders are often prone to stampede behavior creating wild fluctuations in what they judge as safe or not.

But, most importantly, at the theoretical level we find ourselves in a difficult position. This is true, even after ignoring the wild fluctuations in banker’s lending limits while considering only the spreads (or mark-ups) they charge to compensate for risk. Theoretically the optimal level can be defined as the level of leverage that maximizes the difference between the returns achieved with debt finance and those obtained without any leverage. The problem lies in the fact that the two curves depicting the marginal efficiency of capital cannot be derived separately.

In the absence of estimates for the optimal level of leverage, prudence dictates that one should err on the down side by keeping a reasonable margin below the level of debt capacity acceptable to lenders. This can be easily defined in relation to margin requirements or the present value of future free cash-flows. With this proviso and knowledge of the nature of debt-financing, investors may be able to turn a potential foe into a friend.

Mandatory debt ceilings: yes or no?

Today, at 6:30PM, the US Congress is due to vote on vote on a bill that would raise the nation's $14.3 trillion debt limit to $16.3 trillion without any accompanying spending cuts. The idea that mandatory debt ceilings inscribed in special legislation or even in the Constitution is again the focus of strong controversy in both the USA and Europe. However, many people oppose or support the ceilings on the basis of two apparently reasonable ideas.

For the opposing camp they are useless because they will be broken whenever politically expedient horse-trading takes place. The supporters defend them on the grounds that they force the politicians to compromise and thus reduce their impetus toward spending. However, both are misguided because they fail recognize what is the rationale behind mandatory limits.

When mandatory limits are imposed by creditors, its rationale is clear - to reduce the risk for existing creditors. However, when the limits are self-imposed the logic must be based on some idea of what is the optimal level of leverage. Here comes the problem – what is the optimal level?

To find the optimum leverage is extremely difficult in the case of private companies, and almost impossible in the case of governments. Fifteen years ago I worked on a corporate model for such purpose based on the common practice of using the debt coverage ratios demanded by bankers. However, because such optimum is constrained by the availability of collateral and the supply of leverage it means that in practice it is defined in relation to two volatile factors – the availability of investment opportunities with sufficiently good returns and loanable funds.

The recent credit crisis has shown again that when markets deviate from generally accepted trends the uncertainty caused by fear or euphoria will inevitably shift substantially any leverage levels previously defined as optimal.

For this reason in corporate finance we now prefer to use the concept of maximum debt capacity, calculated on the basis of the present value of projected free cash flows. Unfortunately, this is not easily applied to public finances because its accounting standards does not allow the calculation of the free cash flow and for the reason that the return on public spending is difficult to measure let alone forecast.

In the absence of a scientifically defined debt ceiling for normal circumstances (excluding war and massive natural disasters) it is wiser to rely on common sense and some prudence. So, if a ceiling is to be defined it should not be inscribed in the Constitution but on a special law approved by a qualified majority. The ceiling itself must be defined well below a conservatively defined level of leverage supply under normal circumstances using as a benchmark the corporate sector.

Otherwise, do not waste time fighting over arbitrarily defined ceiling limits, instead of the underlying policies.

Mankiw's proposal for contingent convertible debt

In the ongoing debate on financial regulation, most reform proponents seem to be under the illusion that it is possible to prevent future financial crisis. Therefore, Mankiw’s article on Trying to Tame the Unknowable is a welcome alert.

Proposals to prevent future taxpayer bailouts for financial institutions revolve around three key ideas:
1) Limiting the type of activities that banks can do (e.g. the Volcker rule on proprietary trading);
2) Capping the size of banks considered too big to fail; and
3) Requiring banks to have more capital to cope with the higher levels of leverage used today (e.g. Greenspan’s proposal to go beyond the current Basle II).

Mankiw’s favorite proposal is to require banks, and perhaps a broad class of financial institutions, to sell contingent debt that can be converted to equity when a regulator deems that these institutions have insufficient capital. This debt would be a form of preplanned recapitalization in the event of a financial crisis, and the infusion of capital would be with private, rather than taxpayer, funds. Think of it as crisis insurance.

This is an interesting idea on how to increase bank capitalization while privatizing the risk of reckless lending. However, its fundamental weakness is that rating agencies and regulators can hardly be trusted to decree such debt conversion before losses are too big to be absorbed by this share of capital alone.

The one thing that the history of speculation teaches us is that nobody is willing to remove the bowl of punch while the party is still going on. For instance, this last year alone, with inflation below 3%, the stock market has risen more than 40%. Would anyone be willing to classify this as a bubble and to force banks to stop lending to finance stock purchases? I doubt.

The only way the regulation could work would be to set up pre-defined conversion rules based on asset inflation targets. But, which assets classes? Shall we use rules based on price indexes for stocks, real estate, fixed-income, or commodities? And what should be considered a speculative price run over, say three months? 20%, 40% or 60%? These questions as well as the size of this quasi-capital buffer would raise many interesting debates.

However, the rules would only work if we could agree on a simple set of pre-defined conversion rules. If we are sufficiently naïve or optimistic to believe that such agreement is possible, let us advocate the Mankiw’s rule as a good policy.