Debt, Equity and Leverage

Question 1

Features of debt?

Answer 1

Promised return, no control over firm unless in default, held by creditors or lenders (bondholders)

Question 2

Features of equity?

Answer 2

Subordinated to debt (no return until creditors receive promised return), controls firm unless in default, held by owners (shareholders)

Question 3

How does bankruptcy work?

Answer 3

Creditors get first claim on assets

May control or liquidate the firm if debts not satisfied.

Question 4

Which corporate entities have limited liability?

Answer 4

Limited liability: creditors can have no claim on assets of owners.
Corporations that have LL: Limited liability corporates and partnerships.

Question 5

Describe the US Bankruptcy law

Answer 5

Chapter 7: Liquidation
Assets sold, creditors get first claim, equity gets residual, valueless if no residual.
Chapter 11: Reorganisation
Firm stays in business, debt marked down by court if better for creditors than liquidation, controlled by creditors.

Question 6

Define Leverage

Answer 6

Assets/Equity

If no debt, leverage = 1 since A = L + NW

Question 7

Why leverage?

Answer 7

Increases expected return
Allows owners to control more assets than they own
But also increases riskiness of return
Allows investors to specialise
But magnifies returns as well as losses

Question 8

How does limited liability act as a put option?

Answer 8

Losses can exceed value of assets.

Question 9

What is an option?

Answer 9

Right but not obligation between the holder and write to transact an asset at a particular exercise price.
Value of call decreases with higher exercise price.
Value of put increases with exercise price.
Both increase with riskiness of underlying asset.
Holders must pay for the option.

Question 10

How is the value of a call option calculated?

Answer 10

C = max (A0 - E, 0)
If E = 0, the value = A0
Usually, At, or random value of asset at option maturity T, is known.

Question 11

Why is C>max(A0-E,0) if At is unknown?

Answer 11

Increased riskiness, which also increases expected payoff. Therefore, option becomes more valuable.

Question 12

How is the value of a put option calculated?

Answer 12

C= max(E-A0,0), if E ever exceeds A0, then put option valuable since the asset can now be sold at a higher than market price (therefore protecting from loss)

Question 13

Graph of the value of a put option?

Answer 13

zero until A0, then upward sloping

Question 14

Graph of the value of a call option?

Answer 14

downward sloping, then 0

Question 15

How does default in the presence of LL act as a put option?

Answer 15

Put option written by creditors.

LL gives equity owners option to sell assets A to creditors for face value of debt L (meaning A is forced to equal to L even if A

Question 16

How does risky debt function as risk free debt in the presence of a LL put option?

Answer 16

Debtors can sell collateral to lender for amount due. Risk reduces value of debt by put value of default option.

Question 17

How does moral hazard work in this case? and how can lenders circumvent this risk?

Answer 17

Moral hazard: borrowers have incentive to increase value of default option by increasing risk of assets, which magnifies returns but limits losses due to LL put option.

Lenders can eliminate moral hazard to some extent through a demand default premium, or restrict borrower’s ability to increase risk, leverage through i.e
bond convenants
liens on assets (claims)
mortgages etc.

Question 18

How does debt seniority work?

Answer 18

Senior, older secured debt generally has prior claim over more junior, newer debt.
First mortgage = senior debt
But new debt used to buy new asset may have first claim on that asset (if purchaser defaults, creditor gains possession of asset)

Question 19

Why has debt securitization gained popularity in recent years?

Answer 19

Borrowers can sell a large chunk of debt to a buyer or syndicate of buyers, and avoid the issue of debt seniority since no one bond subordinates another (since they are all sold at once)

Investment banks specialize in underwriting such offerings
Very risky but very profitable.

Question 20

What is the difference between preferred stock and common stock?

Answer 20

Intermediate between debt, equity
Has promised return like debt, but no voting rights unless promised return not met.
Failure to provide such a return, however, does not result in bankruptcy.
Exact terms vary with issue (customized, in contrast to common)

Question 21

State some examples of preferred stock issuances

Answer 21

Buffet received preferred stock + options from GS in exchange for a 5 billion dollar injection.
2008 TARP program invested 245 billion in BHC. Made a small profit, but could have lost all. Return small relative to capital commitment.

Question 22

Recall the key features of the TARP program

Answer 22

Troubled Asset Relief Program
Invested 245 billion in BHCs through preferred stock.
Gave BHC underpriced option.
Rescued BHC creditors, shareholders,
Did not help FDIC or commercial depositors.

Question 23

Name some top bank holding companies

Answer 23

Citigroup, BoA, JP Morgan Chase, in 2011, JP was the biggest, 2006 Citi.

Question 24

Explain the principal agent problem

Answer 24

Principal: shareholders, agents: managers.
Shareholders may lose control of managers, incentive conflicts. Agents may not act in the best interest of shareholders.

2008 example: rogue traders, AIG rogue Credit Default swap department almost brought down the company.

Question 25

Define Ponzi Fund

Answer 25

Fund that provides a high return with low risk by paying out newly invested funds to existing investors.
Best example: Bernie Madoff
NW goes negative, since L>A.

Ponzi: postal rate arbitrage
Madoff: trading strategy to generate high returns with little risk.
Enron: Declared profits, paid dividends, hit losses in black box subsidiaries. Found guilty in 2001, 10 charges, died before sentencing. Was in cahoots with Arthur Anderson, an accountant who helped cover the losses.

Fed now doing the same? Hiding the losses of AIG, Bear Stearns black box subsidiaries such as Maiden Lane I, II, III LLCs?