Showing papers on "Debt published in 1986"

Oligopoly and Financial Structure: The Limited Liability Effect

Abstract: We argue that product markets and financial markets have important linkages. Assuming an oligopoly in which financial and output decisions follow in sequence, we show that limited liability may commit a leveraged firm to a more aggressive output stance. Because firms will have incentives to use financial structure to influence the output market, this demonstrates a new determinant of the debt

On the Limitations of Government Borrowing: A Framework for EmpiricalTesting

Abstract: This paper seeks to distinguish empirically between two views on the limitations of government borrowing. According to one view, nothing precludes the government from running a permanent budget deficit, paying interest due on the growing debt load simply by issuing new debt, An alternative perspective holds that creditors would be unwilling to purchase government debt unless the government made a credible commitment to balance its budget in present value terms. We show that distinguishing between these possibilities is mathematically equivalent to testing whether a continuing currency inflation might be fueled by speculation alone or is instead driven solely by economic fundamentals. Empirical tests which have been developed for this economic question lead us to conclude that postwar U.S. deficits are largely consistent with the proposition that the government budget must be balanced in present-value terms.

The Pure Theory of Country Risk

Abstract: This paper attempts to survey, and to put into perspective, recent lterature that has analyzed the nature of credit relations between developed and developing countries.This analysis has made use of recent advances in the economics of information and strategic interaction. Traditional concepts of solvency and liquidity are of little help in understanding problems of soverign debt. Creditors do not have the means to seize the assets of a borrower in default. Hence the borrower who is expected eventually to repay his debts should be able to borrow to meet any current debt-service obligations. A problem that is essential to a theory of international lending is that of enforcement. The difficulty is one of ensuring that the two sides of a loan contract adhere to it, in particular that the borrower repays the lender and the lenders can commit themselves to penalize the borrower if he does not.

Moral Hazard and Adverse Selection: The Question of Financial Structure

Abstract: This paper looks at the moral hazard and adverse selection problems confronting an entrepreneur offering securities to an uninformed, but competitive financial market The adverse selection aspect of the problem is generated by the unobservable entrepreneur's ability to transform effort into value Moral hazard arises because the investment decision is made subsequent to financing We consider the joint use of both debt and equity, and characterize the equilibrium relation between capital structure and unobservable attributes It is shown that: (1) investment and financing are not separable; (2) there is an underinvestment problem for "better" firms; and (3) simultaneous use of both debt and equity can resolve this difficulty We also establish a connection between expected terminal firm value and debt-promised payment level and between share retention and standard deviation AGENCY PROBLEMS IN CORPORATE finance originated with the influential papers of Jensen and Meckling [11], Myers [17], Ross [21], and Leland-Pyle [14] They show that the market imperfections induced by unobservable actions, lack of contracting ability, and information asymmetry generally lead to second-best outcomes in which the distribution of corporate ownership is achieved only at significant cost These costs take the form of excessive perquisite consumption, overinvestment, underinvestment, and incomplete diversification of personal investment portfolios Moral hazard and adverse selection comprise two forms in which agency problems may take shape Arrow [1] equates these two terms with hidden action and hidden information, respectively Moral hazard arises when the action undertaken by the agent is unobservable and has a differential value to the agent as compared to the principal Adverse selection problems arise when the agent has more information than the principal The resolution of such difficulties has been explored in a number of contexts with both signals and contingent contracting mechanisms These definitions exclude certain agency problems in the delegation literature for which the preference incongruity results from a lack of precommitment rather than some exogenous feature of the model In corporate finance, one would thus identify the Jensen-Meckling paper with moral hazard because perquisites enter the insider's objective differently from outsiders, while * Darrough is from Columbia University and Stoughton is from the University of California, Irvine The second author's research was partially supported by Grant Number 410-83-0786 R-1 from the Social Sciences and Humanities Research Council of Canada This paper was presented at the 1984 meetings of the Western Finance Association in Vancouver and at the 1985 European Finance Association meetings in Bern We thank Kose John and Frans Tempelaar for their comments at the meetings

Some evidence on the uniqueness of bank loans

Abstract: This paper presents evidence that banks provide some special service with their lending activity that is not available from other lenders. I find evidence that bank borrowers, not CD holders, bear the cost of reserve requirements on CDs. In addition, I find a positive stock price response to the announcement of new bank credit agreements that is larger than the stock price response associated with announcements of private placements or public straight debt offerings. Finally, I find significantly negative returns for announcements of private placements and straight debt issues used to repay bank loans.

Debt and crisis in Latin America : the supply side of the story (external finance, transnational banks, development)

Abstract: Examining the causes of the acute Latin American debt crisis that began in mid-1982, North American analysts have typically focused on deficiencies in the debtor countries' economic policies and on shocks from the world economy. Much less emphasis has been placed on the role of the region's principal creditors--private banks--in the development of the crisis. Robert Devlin rounds out the story of Latin America's debt problem by demonstrating that the banks were an endogenous source of instability in the region's debt cycle, as they overexpanded on the upside and overcontracted on the downside.Examining the causes of the acute Latin American debt crisis that began in mid-1982, North American analysts have typically focused on deficiencies in the debtor countries' economic policies and on shocks from the world economy. Much less emphasis has been placed on the role of the region's principal creditors--private banks--in the development of the crisis. Robert Devlin rounds out the story of Latin America's debt problem by demonstrating that the banks were an endogenous source of instability in the region's debt cycle, as they overexpanded on the upside and overcontracted on the downside.

Callable Bonds: A Risk-Reducing Signalling Mechanism

Abstract: The theory of financial economics has failed to distinguish advantages of callable bonds from those of short-term debt. This paper shows that either type of borrowing can signal a firm's better prospects but that short-term debt does so at the cost of weakened risk-sharing with capital markets. By issuing either equity or long-term, non-callable debt, a firm with poor investment opportunities will not pool its prospects with those of a better firm. But equity produces superior risk-sharing. Perhaps this explains the almr,ost complete absence of long-term, non-callable bonds from observed corporate capital structures. FINANCIAL THEORY HAS FOUND only moderate success in explaining the routine inclusion of call provisions among the covenants of corporate bonds. In the absence of market imperfections or incompleteness, the incremental compensation promised to bondholders should exactly offset the value of the call provision retained by equityholders. Indifference should obtain.1 Nevertheless, it is hard to accept indifference as an explanation, given the near universality of call provisions in corporate bond contracts. In this paper, we argue that, in the presence of asymmetric information about investment quality, corporate managers can signal their firm's better prospects by issuing bonds that include call provisions. Our major result shows that this signalling mechanism can be more attractive to risk-averse managers than would be the choice of short-term debt (which could also serve to signal). Furthermore, we demonstrate that non-callable corporate debt is a dominated security. That is, both it and equity signal "Bad News," but equity provides risk-sharing. This finding helps to explain the relative absence of long-term, non-callable debt from corporate financial markets. Previous attempts to explain the prevalence of call provisions in corporate bond contracts fall into four categories. Two categories involve pure wealth transfers from bondholders to stockholders. In these constant sum environments, a gain to one group constitutes a loss to the other. In the first category, managers possess private information with regard to future interest rate movements. Issuing callable bonds will capture gains for stockholders when anticipated drops

The political process and the use of debt financing by state governments

Abstract: Empirical evidence offered in this study suggests that decisions by state government officials to effect debt-financed spending depend in part on the state's gubernatorial election cycle. More specifically, the results reveal relative increases in state debt issues in anticipation of elections, and furthermore, they reveal that such increases are more significant for states characterized by high interparty political competition. While theoretical limitations preclude a definitive explanation for these results, the evidence is consistent with a view of state political markets where incumbent parties manipulate public policy so as to enhance the probability of success in pending elections. This insight is significant in that it suggests a relationship between public policy decisions and election cycles in a context heretofore unexplored.

A Constant Recontracting Model of Sovereign Debt

Abstract: Few sovereign debtors have repudiated their obligations entirely. But despite the significant sanctions at the disposal of lenders, many borrowers have been able to consistently negotiate for reduced repayments. This paper presents a model of the on-going bargaining process that determines repayment levels. We derive a bargaining equilibrium in which countries with large debts achieve negotiated partial default. The ability to credibly threaten more draconian penalties in the event of repudiation may be of no benefit to lenders. Furthermore, unanticipated increases in world interest rates may actually help the borrowers by making lenders more inpatient for a negotiated settlement. Finally, Western governments may be induced to make payments to facilitate reschedulings even though efficient agreements will be reached without their intervention.

Some Effects of the Bankruptcy Reform Act of 1978

Abstract: THE use of formal bankruptcy by private and corporate debtors increased markedly-well over 100 percent-in the last decade.1 Several writers in the financial media claimed this dramatic increase to be the result of radically incorrect expectations and the subsequent accumulation of short-term, high-interest debt in the late 1970s combined with the high real interest rates of the 1980s.2 Others have argued that an emerging acceptability of bankruptcy-both as an area of practice for lawyers and as a solution to financial problems for consumers-has strongly contributed to the observed increase in filings.3 Another potential explanation of the bankruptcy explosion lies with institutional change. In October 1978 Congress changed the legal rules governing personal bankruptcy; specifically, it increased the dollar amounts of certain physical assets and cash that debtors can withhold from creditors on filing for bankruptcy. Our aim in this paper is twofold: first, to shed some light on the causes of the dramatic increase in bankruptcy filings and, second, to examine the relation between the institutional change and the ratio of secured to unsecured debt. Particular emphasis is placed on the Bankruptcy Reform Act of October 1978 (BRA).4 The Reform Act was intended to modernize

Finance for the developing countries

Abstract: The Basic Principles of Development Finance Capital Market Theory and the Developing Countries The Impact of the Domestic Financial System on Economic Development Mobilising Domestic Finance: Government Mobilising Domestic Finance: Formal and Informal Financial Institutions Mobilising Domestic Finance: Securities Markets Foreign Capital for Developing Countries: Background and Public Sector Flows Foreign Capital for Developing Countries: Export Credits and Private Sector Flows Debt, Adjustment and the IMF The Financing of Capital Investment Recent Proposals to Improve the Quantity and Quality of Development Finance.

The nature, extent, causes, and consequences of problematic debt situations

Abstract: The paper reports on the most important and salient results of an investigation which was carried out in the Netherlands in 1980/1981. The object of the research was to establish the actual number of borrowers with a problematic debt situation and to provide an answer to the question of how the problems have arisen and what their consequences are for the borrowers and their families. The research was divided into two parts: In the explanation of how a problematic debt situation comes about, institutional, socioeconomic, personality, and decision-behaviour factors were taken into account. The results of both investigations provide an impetus for policy-makers to modify their policies aimed at preventing problematic debt situations from arising. Some starting points for such a re-orientation are discussed in this paper. The first point relates to the predictability of problematic debt situations and the implementation of an early warning system; the second point relates to the acceptance policy of financial institutions, in particular the use and functioning of credit score systems; the third point suggests restraint in the granting of additional credit to borrowers who have already taken out one or more credit; the fourth point relates to advice which could be provided to improve borrowers' (information-seeking) behaviour and level of knowledge.

Dollars, debts, and deficits

Abstract: This interesting and provocative collection of essays addresses most if not all of the key current policy issues in open economy macroeconomics: the strong dollar, LDC debt problems, and deficit financing. Although these three areas involve widely different policy problems, Dornbusch brings a common political economy perspective to bear on the issues, giving the essays a coherent perspective and revealing that more than ever, modern macroeconomics is useful as a framework for active policy. Professionals interested in the world economy and students of international finance will appreciate the author's strong analytical approach and the clear, cogent defense of his viewpoints.Three chapters in the book's first part, Exchange Rate Theory and the Overvalued Dollar, cover the rise in the dollar, equilibrium and disequilibrium exchange rates, and flexible exchange rates and interdependence. Those in the second part, The Debt Problems of Less Developed Countries, present three case studies in overborrowing, and discuss the world debt problem from 1980 to 1984 and beyond, and what we have learned from stabilization policy in developing countries. A concluding part, Europe's Problems of Growth and Budget Deficits, takes up public debt and fiscal responsibility, and sound currency and full employment.Rudiger Dornbusch is Ford International Professor of Economics at MIT. "Dollars, Debts, and Deficits" is based on three related lectures he gave in 1984 at the University of Leuven in the Gaston Eyskens Lecture Series. Dornbusch is the editor with Mario Henrique Simonsen of "Inflation, Debt, and Indexation," available in paperback from The MIT Press.

Debt and Development Crises in Latin America: The End of an Illusion

Abstract: Latin America's worst socioeconomic crisis since the Great Depression the increasing limitations of the import substitution model towards 1970 the Bretton Woods international financial system - its contribution and its contradictions financial flows to Latin America in the 1950s and 1960s the privatization of the international financial system in the 1970s and its implications the slow-down of growth in the industrial countries causes and management of debt crises in the early 1980s will the industrial countries' recovery solve the crises of debt and national development in Latin America? the search for a new international financial system towards reactivation and new development strategies.

The Politics and Economics of the New City Debt

Abstract: his paper contrasts nonguaranteed city debt with taxation and general obligation debt. Drawing upon Bureau of the Census, Advisory Commission on Intergovernmental Relations (ACIR) and Municipal Year Book data, the analysis shows that both per capita tax revenue and outstanding general obligation debt are best explained by background factors such as total population, functional scope, and region, while fiscal strain plays a secondary role. Political structures, in the shape of legal constraints on taxation and debt and of form of government, do not account for patterns of these traditional revenue sources. By contrast, nonguaranteed debt is best explained by a model in which fiscal strain has a paramount role, but with both legal constraints on taxing and regional differentiation contributing significantly to the explanation, at least for data collected prior to 1978. The findings suggest a two-tiered model of the revenue side of fiscal decision making, with historical accommodations to powerful economic and demographic factors dominating taxing and general obligation debt, while nonguaranteed debt serves as a flexible instrument of shorter-term strategy.

Federal deficits, macro-stabilization goals, and federal reserve behavior

Abstract: The effects of federal deficits on Federal Reserve behavior as proxied by changes in the growth rate of the monetary base are analyzed in this study. Multivariate Granger-causality tests are employed in the analysis. The deficit measure that is the focus of the analysis is the change in the real market value of privately held federal debt. The tests indicate that the deficit Granger-causes the monetary base. Additionally, concerns for financial market stability, real output, and exchange rate movements in the period of floating rates also affect Federal Reserve behavior.

A New Look at Debt Rescheduling Indicators and Models

Abstract: This paper presents logit and discriminant models of debt rescheduling. The models incorporated new short-term debt data and variables representing economic shocks. The 30-country database covered the period from 1975 to 1982 and contained the largest number of debt rescheduling observations of any previous database. Because of the new indicators and more recent data, the models captured the effects of the changes that have occurred in the world economy since the oil price shocks and the period of rapid debt accumulation by the developing countries. Compared to the earlier research models, the models have proven to be efficient in forecasting debt reschedulings.

Interest Rates, the Markets, and the New Financial World.

Abstract: Part 1 Introduction: from Wenings to Wall Street. Part 2 Financial markets: financial markets yesterday and today - interest-rate differences, the institutional credit structure, volatility and monetarism, the budget deficit dangers in the rapid growth of debt - rapid debt growth, danger signals, forces that encourage credit expansion, policy proposals the integrity of credit - credit without a guardian, the proper role of financial institutions, the role of government a disregard for capital - manifestations of the desregard for capital, social claims, defenders of capital ferment in financial institutions - regulation deregulation, financial innovation, financial institutions are unique, managing risk international financial problems - laissez faire, official intervention, international cooperation, fixed versus floating exchange rates banking in changing world credit markets - banking growth, growth of euromarkets, banking linkages and innovations, the freeing of markets the equity market over the long term - growth of the equity market, the emerging global equity market, the growth of proxy instruments, the expanding role of the institutional investor, a more demanding role for securities dealers, new challenges for investment decision makers fallen financial dogmas and beliefs - high real interest rates encourage substantial increases in savings, high real interest rates discourage economic recovery, financial deregulation lowers the general level of interest rates, credit quality is constant in our financial system, the growth of debt is closely linked to growth in nominal gross national product, a nation's large trade deficit weakens its currency in foreign exchange markets, fiscal policy can be a flexible anticyclical tool and, combined with monetary, can prolong economic expansion and limit economic and financial excesses. Part 3 Interest rates: secular and cyclical trends in interest rates - secular trends, cyclical trends, extremes in quality yields, interest rates and economic activity, conventional wisdoms the many faces of the yield curve - theories, four major yield curves, the optimum long opportunity, prospects changing techniques in forecasting interest rates - anticipation and realization, the effects of deregulation, international credit flows, other benefits from credit flow analysis new interest-rate precepts - the perception of high and low interest rates does not remain constant, substantial interest-rate volatility is here to stay and should be incorporated into portfolio and financing decision making, bonds are bought more for their price appreciation potential than for their income protection, (part contents).

Notes on the Tax Treatment of Structures

Abstract: More than three quarters of the United States tangible capital stock represents structures. Tax policies potentially have a major impact on both the level and composition of investment in structures and equipment. This point is explicitly recognized in most discussions of the effects of capital income taxation. Two aspects of the taxation of structures --the relative burden placed on structures as opposed to equipment investment and the non-taxation of owner occupied housing under the income tax -- have attracted substantial attention in recent years. This paper explores these two aspects of the taxation of structures investments. While the tax system may well have a potent impact on the level and composition of structures investment, this paper argues that conventional analyses of these effects are very misleading. We reach two main conclusions. First,under current tax law, certain types of structures investment are very highly tax favored. Structures can be transferred and therefore depreciated more than once, and structures may be readily financed with tax-favored debt. Overall, itis unlikely that a significant bias towards equipment and against structures exists under current law. Second, the conventional view that the tax system is biased in favor of homeownership is wrong. Because of the possibility of "tax arbitrage" between high bracket landlords and low bracket tenants, the tax system has long favored rental over ownership for most households. The 1981 reforms by reducing the top marginal tax rate reduced this bias somewhat.

Debt: the threat to economic and financial stability

Abstract: I was pleased to have received an invitation to be the leadoff speaker at this conference to present an overview of the current debt situation in the United States and of financial stability. It was in the late 1960s when I first detected that developments in debt creation might be taking an ominous turn. Since then, I have spoken about the subject a number of times. While many debt problems have surfaced in recent years, the issue of debt and financial stability does not yet have the national attention it so crucially deserves. Now, the problems associated with debt are well past their infancy and, indeed, are dangerously full grown. Even so, there is still only some awareness today that debt has both a sunny and a dark side to it. Historically, the act of creating debt contributed to economic and financial exhilaration. But in the past several years we have realized that the obligations inherent in debt may impose hardships on lenders and borrowers and, indeed, on the economy and the financial markets as a whole. The reality is that our debt problem is not going to go away. It is complex; there are no easy solutions. To cope successfully with this problem and stave off an economic disruption of major proportions, the role of our financial system will need to be redefined and structural changes and disciplines that are lacking today will have to be imposed. Unfortunately, there is as yet no evidence that adequate measures will be undertaken soon to ameliorate this situation.