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Banking on Failure: Point of Failure

WORLDWORKS by Joe Pimbleyby Joe Pimbley, Columnist & Featured Contributor[message type=”custom” width=”100%” start_color=”#F0F0F0 ” end_color=”#F0F0F0 ” border=”#BBBBBB” color=”#333333″]Editor’s Note: This is the next in a new Series of Articles by Joe, as excerpted from his Book; “Banking on Failure” co-authored by Laurel McDevitt. [/message]

Lessons for Running the Business

It requires little business acumen to state that a business should minimize its debt and all related expenses if it wishes to keep its risk of failure as low as possible. Low debt level and the attendant low debt interest cost will make leverage measures low and coverage levels Banking on Failurehigh. One form of debt – working capital loans – improves a company’s ability to pay employees and suppliers in timely fashion. Hence, the “optimal level” of debt to avoid business failure need not be zero.

Few companies of significant size choose to operate with near-zero debt. The exceptions that come to mind are Microsoft (Microsoft Corporation) and Apple (Apple Inc.) at various points in their histories. These businesses produced abundant cash flow and were therefore able to fund all financial needs and strategic initiatives without debt. The dominant reason that businesses carry debt (rather than equity) is to improve return on equity (ROE) – the annual net income divided by balance sheet equity.

When a company replaces equity with debt, its ROE will increase as long as the (after-tax) interest it pays on the debt is less than the ROE. Thus, if debt-to-equity leverage is currently 1.0 and ROE is 10% per annum, then ROE will rise above 13% per annum if the company borrows at 5% per annum to buy stock from the market to increase its leverage to 2.0. (This statement makes the simplifying assumption that the stock is available for purchase at book value and incorporates the tax deductibility of the debt interest payment.) See figures 2-2(a) and 2-2(b) for the comparison.

Screen Shot 1It’s not immediately clear that equity investors are in a better position with the capital structure of figure 2-2(b) relative to figure 2-2(a). ROE is higher when the leverage is higher, but the risk of failure is also higher. This tradeoff between risk and return is ubiquitous in the investing world. As a reasonable yet rough perspective, we’d say the increased return (ROE) is simply the fair compensation for the increased risk. The improved ROE is certainly not “free.”

A positive observation is that the degree of leverage – which is the balance between high ROE and low likelihood of failure – is a choice that management makes. As long as the company is open, honest, and transparent with equity investors, creditors, and employees, management should have this latitude. The Board of Directors oversees management. The equity shareholders elect the Board. The lenders to the company make their own self-interested lending determination. That is, lenders may choose not to lend or they may lend if they receive an interest rate they consider high enough to compensate for the risk of failure.

The key point is that the business chooses its own failure risk level with its mix of debt and equity. Beyond the amount of debt, the next choice of management is the debt maturity schedule. As per the earlier discussion, it is unwise for a company to have a large fraction of its debt maturing within a short timeframe. Since most companies plan to refinance (i.e., roll) the debt as it matures and the alternative is to sell assets if new banks will not lend, then it is common sense to plan the debt maturity schedule to avoid high concentration of debt maturities.

Yet even this debt maturity schedule can be a “choice” to trade risk against return. Generally, the interest a borrower must pay on its debt increases as the maturity of the debt increases. Thus, a borrower has an incentive to issue short-term debt if one considers only the interest cost. But a borrower cannot favor short-term debt if it wishes to minimize its refinancing risk by maintaining a “flat” debt maturity schedule. (We call this debt maturity schedule “flat” if it has equal amounts of debt maturing each year far into the future.)

Presumably, there exists an optimal trade-off here between favoring short-term debt to give higher ROE and maintaining a flat debt maturity schedule to reduce refinancing risk. But the picture for this tradeoff – which we sketch in figure 2-3 – is not as intuitive or analytically tractable as the capital structure tradeoff of figures 2-2(a) and 2-2(b).

Screen Shot 2The maturity of short-term debt can range from one day (“overnight repo”) to nine months (maximum maturity in the U.S. for commercial paper). The word “repo” is jargon for “repurchase transaction” and is essentially a secured loan. Commercial paper (“CP”) most often has maturity of one week to one month and is unsecured. Clearly, the risk of short-term debt is that when it matures, no lender is obligated to refinance this debt. Yet refinancing is required every day (for overnight lending) or every week (for one-week CP), et cetera.

Conducting a more in-depth and quantitative analysis of high-leverage “capital structure” risk and of short-term debt refinancing risk is both challenging and far beyond the goal of this chapter. Rather, we’ll reiterate that businesses with such risks choose these risks. We’ll also state that high leverage and/or high concentration of short-term debt may be prudent management choices under certain conditions. For example, if the firm’s assets are readily understandable and clearly of high quality, lenders will likely not have anxiety due to high leverage. Or, if the assets themselves have short maturities and, therefore, convert to cash over short time periods, then choosing to fund the assets with short-term debt can be quite reasonable.

Foreshadowing One Message of this Book

This chapter has established our qualitative framework for discussing the risk of failure of any business whether it be a financial institution, such as a bank, or a non-financial entity. While there are significant differences between, say, an early-stage biotechnology company and a long-established electric utility, the concepts of leverage, coverage, and debt maturity schedule apply universally. The utility will have far more predictable assets and revenue stream than the biotech firm. The utility, then, will likely possess the higher leverage and lower coverage simply because debt investors are comfortable that the predictability of assets and revenues permit high leverage and low coverage.

By the same reasoning, banks will naturally operate with financial metrics that differ from those of businesses in other industries. In later chapters we will argue, though, that the high leverage and deliberately short-term-concentrated debt maturity schedule of typical banks are not at all consistent with “safety and soundness” in the absence of government guarantees and other forms of support. These leveraged banks with unstable funding survive from one year to the next due only to the explicit, implicit, and assumed support of their governments. To end the losses that banks impose on taxpayers, banks must properly manage their default risk like ordinary, un-guaranteed entities.

In other words, why should banks be different from other businesses? Are banks really different?

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Joe Pimbley
Joe Pimbleyhttp://www.maxwell-consulting.com/
Joe is Principal of Maxwell Consulting, a firm he founded in 2010. Joe is expert in complex financial instruments, financial risk management (certified as FRM by the Global Association of Risk Professionals), valuation, structured products, derivatives, and quantitative algorithms. His recent and current engagements include financial risk management advisory, valuation and credit underwriting for structured and other financial instruments, and litigation testimony and consultation. In a prominent engagement from 2009 to 2010, Joe served as a lead investigator for the Examiner appointed by the Lehman bankruptcy court to resolve numerous issues pertaining to history’s largest bankruptcy. Joe and his colleagues discovered Repo 105 and also reported the critical importance of pledged collateral mishaps and mischaracterizations to the Lehman failure. Joe holds a Ph.D. in Theoretical Physics and is a co-author of Banking on Failure (2014), Simple Money (2013), and Advanced CMOS Process Technology (1989). He serves on several corporate and academic Boards, has written more than thirty finance articles, presented more than sixty finance seminars, and holds numerous patents for engineering inventions.

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