The Debt Overhang 411

Thu, 20 Nov 2008 17:56:41 +0000

Yesterday, I participated in a panel at the Cato Institute as part of its 26th Annual Monetary Conference, "Lessons from the Subprime Crisis." A dozen people spoke before I did, and none of them mentioned the words, "debt overhang," which was the main point of my remarks. That no one stole my thunder suggests to me that this is an underappreciated reason why the bailout of financial and non-financial companies in financial distress is such a thorny issue.

Debt overhang is a situation in which a firm’s debt is so large that in many possible future scenarios, earnings generated by new investment projects are entirely appropriated by existing debt holders. The implication is that even worthwhile projects (relatively safe ones with positive value added) will be hard to finance. New investors put in the money, but old investors get a big share of the proceeds.

The two main methods of bailing companies out in the TARP do help overcome the problem of debt overhang. Purchasing troubled assets for cash reduces the relative number of those future scenarios in which debt holders rather than equity holders are the residual claimants on the firm. This would allow the firm to raise new capital more easily. This is true even if the purchases are made at a slight discount. The trouble with these purchases is that it is hard to determine the appropriate price. What we've observed is that Treasury didn't have any confidence in its ability to do that, so they ultimately didn't try after fumbling around for a bit.

Injecting equity into banks or other companies via preferred stock lessens the debt overhang problem by having the government do what no one else would be willing to do -- contribute new money but get in line behind all of the existing debtholders in the event that the company still goes bankrupt. That sort of charity is hard to justify in my book.

It wouldn't be charity if the government offered financing in the form of debt that was senior to the existing debtholders. The contract would have to be that no other financial stakeholders were paid anything until the government was repaid. (In the first bailout of AIG, the government's loan did have this characteristic in theory -- the loan was secured by "all of the firm's assets. But in practice, the government did not control the disposition of the assets very carefully, and AIG just started retiring its old debt and coming back for more bailout money. As I said, charity.)

In general, it is very difficult to make the non-charitable offer to a distressed company outside of bankruptcy. A company filing for protection from its creditors is actually essential here. In bankruptcy, the claims of the existing debtholders are reduced. While that reduction is in process, there may be an opportunity for the government to put capital in with adequate protections against the funds being used as a simple transfer to existing debtholders.

The government's role here should not be to make an offer, have it rejected, and then feel like it is incumbent upon the government to continue to sweeten the offer until the distressed company accepts it. The government's role here should be to insist on large concessions from the existing debtholders as a precondition for any government involvement. For insured financial institutions, the FDIC moves this process along. For other companies, filing for bankruptcy may be the move that triggers the large concessions.

Of course, if all of those concessions were made, it is not clear why the government, as opposed to some private entity, would have to then get involved.