Tag: Credit supply

Acquisition Financing: the Year Behind and the Year Ahead

Eric M. Rosof is a partner focusing on financing for corporate transactions at Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell Lipton memorandum by Mr. Rosof, Joshua A. FeltmanGregory E. Pessin, and Michael S. Benn.

Last year’s robust acquisition financing market helped drive the headline-grabbing deals and record volume of M&A in 2015. At the same time, credit markets were volatile in 2015 and appeared to have shifted fundamentally as the year went on—and with them, the types of deals that can get done and the available methods of financing them. U.S. and European regulation of financial institutions, monetary policy, corporate debt levels and economic growth prospects have coalesced to create a more challenging acquisition financing market than we’ve seen in many years. As a result, 2016 is likely to be a year that demands creativity from corporate deal-makers, and where financing costs, availability and timing have significant influence over the type, shape and success of corporate deal-making.


A Reassessment of the Clearing Mandate

Ilya Beylin is a Postdoctoral Research Scholar at Columbia Law School and the Editor-at-Large of the CLS Blue Sky Blog. This post is based on an article authored by Mr. Beylin.

Following the financial crisis, the G-20 nations committed to a raft of reforms for swap markets. These reforms are intended to mitigate systemic risk, and with it, the damage that failing financial institutions inflict on the financial sector and the broader economy. A core component of the reforms is the introduction of the “clearing mandate” for standardized swaps.

Clearing refers to the interposition of a clearinghouse, or central counterparty, between the two parties to a financial transaction. When a swap is cleared, the initial swap is extinguished and two new swaps are created in its place. The first is an identical swap between the first counterparty and the clearinghouse, and the second is another identical swap between the clearinghouse and the second counterparty. In this manner, absent default, parties make payments as they would if they had transacted bilaterally and the clearinghouse simply passes the payments between counterparties. However, when one of the counterparties to a transaction defaults, the presence of the clearinghouse as an intermediate counterparty shields the non-defaulting party from losses; that is because although the defaulting party may not pay the clearinghouse, the clearinghouse is still liable for, and makes, the payment to the remaining counterparty.


Acquisition Financing 2015: the Year Behind and the Year Ahead

The following post comes to us from Eric M. Rosof, partner focusing on financing for corporate transactions at Wachtell, Lipton, Rosen & Katz, and is based on a Wachtell Lipton memorandum.

Acquisition financing activity was robust in 2014, as the credit markets accommodated increased demand from rising M&A activity. At over $749 billion, global 2014 M&A loan issuance was up approximately 40 percent year over year, the highest total since before the Great Recession. While the aggregate figures suggest a borrower-friendly market, the actual picture is more nuanced. Investment grade acquirors benefited from a consistently strong financing environment throughout 2014 and finished the year with a flourish (including a $36 billion commitment backing Actavis’ acquisition of Allergan), while leveraged acquirors encountered more volatility, as lenders responded quickly to regulatory changes and market conditions, and both high-yield commitments and debt became more costly.


Equity Overvaluation and Short Selling

The following post comes to us from Messod Daniel Beneish, Professor of Accounting at Indiana University, Bloomington; Charles M. Lee, Professor of Accounting at Stanford University; and Craig Nichols, Assistant Professor of Accounting at Syracuse University.

In our paper, In Short Supply: Equity Overvaluation and Short Selling, which was recently made publicly available on SSRN, we use detailed equity lending data to examine the role of constraints on equity prices. We find that constrained stocks underperform, the short interest ratio (SIR) has a nonlinear association with constraints, constrained stocks have negative returns regardless of short interest ratio, high short interest yet unconstrained stocks do not underperform, yet low short interest unconstrained stocks outperform. Moreover, we show that limited supply is a key feature distinguishing constrained and unconstrained stocks, and that among constrained stocks, those with the lowest supply have the strongest negative returns. Our findings confirm that supply varies across firms (in contrast to SIR, which assumes supply is 100 percent of outstanding shares for all stocks) and short supply in the equity lending market has implications for the informational efficiency of equity prices.


The Capital Structure Decisions of New Firms

The following post comes to us from Alicia Robb, Senior Fellow with the Ewing Marion Kauffman Foundation, and David Robinson, Professor of Finance at Duke University.

Understanding how capital markets affect the growth and survival of newly created firms is perhaps the central question of entrepreneurial finance. Yet, much of what we know about entrepreneurial finance comes from firms that are already established, have already received venture capital funding, or are on the verge of going public—the dearth of data on very-early-stage firms makes it difficult for researchers to look further back in firms’ life histories. Even data sets that are oriented toward small businesses do not allow us to measure systematically the decisions that firms make at their founding. This article uses a novel data set, the Kauffman Firm Survey (KFS), to study the behavior and decision-making of newly founded firms. As such, it provides a first-time glimpse into the capital structure decisions of nascent firms.

In our paper, The Capital Structure Decisions of New Firms, forthcoming in the Review of Financial Studies, we use the confidential, restricted-access version of the KFS, which tracks nearly 5,000 firms from their birth in 2004 through their early years of operation. Because the survey identifies firms at their founding and follows the cohort over time, recording growth, death, and any later funding events, it provides a rich picture of firms’ early fund-raising decisions.


The Procyclical Effects of Bank Capital Regulation

The following post comes to us from Rafael Repullo, Professor of Economics at CEMFI, Madrid, Spain; and Javier Suarez, Professor of Finance at CEMFI, Madrid, Spain.

The basic argument about the procyclical effects of bank capital requirements is well-known. In recessions, losses erode banks’ capital, while risk-based capital requirements, such as those in Basel II, become higher. If banks cannot quickly raise sufficient new capital, their lending capacity falls and a credit crunch may follow. Yet, correcting the potential contractionary effect on credit supply by relaxing capital requirements in bad times may increase bank failure probabilities precisely when, because of high loan defaults, they are largest. Given the conflicting goals at stake, some observers think that procyclicality is a necessary evil, whereas others think that procyclicality should be explicitly corrected. Basel III is a compromise between these two views. It reinforces the quality and quantity of the minimum capital required to banks, but also establishes that part of the increased requirements be in terms of mandatory buffers—a capital preservation buffer and a countercyclical buffer—that are intended to be built up in good times and released in bad times.

In our paper, The Procyclical Effects of Bank Capital Regulation, forthcoming in the Review of Financial Studies, we develop a model that captures the key trade-offs in the debate. The model is constructed to highlight the primary microprudential role of capital requirements (containing banks’ risk of failure and, thus, deposit insurance payouts and other social costs due to bank failures) as well as their potential procyclical effect on the supply of bank credit.


Does Macropru Leak? Evidence from a UK Policy Experiment

The following post comes to us from Shekhar Aiyar, Senior Economist at the International Monetary Fund; Charles Calomiris, Henry Kaufman Professor of Financial Institutions at the Columbia University Graduate School of Business; and Tomasz Wieladek, MPC Adviser, External MPC Unit, Bank of England.

How can governments limit excessive and unstable credit growth? Should they raise capital requirements for banks? In our recent NBER working paper, Does Macropru Leak? Evidence from a UK Policy Experiment, we address these questions using evidence from a policy experiment in the UK. The minimum capital ratio requirements that national regulatory authorities impose on banks have two sets of objectives: (i) so-called ‘micro-prudential’ motives, to ensure the safety and soundness of individual banks; and (ii) ‘macro-prudential’ goals, especially to influence the aggregate supply of credit. Micro-prudential regulation has a long pedigree, but the focus on macro-prudential regulation has increased sharply in the wake of the global financial crisis. This sharpened focus underlies recent changes in the international regulatory regime for banks. Basel III, as the new regime is called, establishes a “countercyclical capital buffer”, under which national regulators would vary banks’ required capital-to-risk-weighted assets ratio over time, thereby helping smooth the credit cycle. For variation in minimum capital requirements to be effective in regulating the aggregate supply of credit, three conditions must be satisfied:


The Anatomy of a Credit Crisis

Raghuram Rajan is Professor of Finance at the University of Chicago.

How important is the role of credit availability in inflating asset prices? And what are the consequences of past greater credit availability when perceived fundamentals turn? In our recent NBER paper, The Anatomy of a Credit Crisis: The Boom and Bust in Farm Land Prices in the United States in the 1920s, my co-author, Rodney Ramcharan, and I broach answers to these questions by examining the rise (and fall) of farm land prices in the United States in the early twentieth century, attempting to identify the separate effects of changes in fundamentals and changes in the availability of credit on land prices. This period allows us to use the exogenous boom and bust in world commodity prices, inflated by World War I and the Russian Revolution and then unexpectedly deflated by the rapid recovery of European agricultural production, to identify an exogenous shock to local agricultural fundamentals. The ban on interstate banking and the cross-state variation in deposit insurance and ceilings on interest rates are important regulatory features of the time that allow us to identify the effects of credit availability that we incorporate in the empirical strategy.


Derivatives and the Legal Origin of the 2008 Credit Crisis

Lynn A. Stout is the Paul Hastings Distinguished Professor of Corporate and Securities Law at the University of California, Los Angeles School of Law. This post is part of a series discussing articles appearing in the inaugural issue of the Harvard Business Law Review, which is published in partnership with the Harvard Law School Program on Corporate Governance.

In the paper Derivatives and the Legal Origin of the 2008 Credit Crisis (published in the inaugural issue of the Harvard Business Law Review), I argue that the credit crisis of 2008 can be traced first and foremost to a little-known statute Congress passed in 2000 called the Commodities Futures Modernization Act (CFMA). In particular, the crisis was the direct and foreseeable (and in fact foreseen, by myself and others) consequence of the CFMA’s sudden and wholesale removal of centuries-old legal constraints on speculative trading in over-the-counter (OTC) derivatives.

Derivatives contracts are probabilistic bets on future events that can be used to hedge (which reduces risk) but also provide attractive vehicles for speculation on disagreement (which can increase risk). The common law recognized the differing welfare consequences of hedging and speculative trading in derivatives by applying a doctrine called “the rule against difference contracts” to discourage derivatives that did not serve a hedging purpose by treating them as unenforceable wagers. Speculators responded by shifting their trading onto organized exchanges that provided private enforcement mechanisms, in particular clearinghouses through which exchange members guaranteed contract performance. The clearinghouses effectively cabined and limited the social cost of derivatives speculation risk. In the twentieth century, the common law rule was replaced by the federal Commodity Exchange Act (CEA). Like the common law, the CEA confined speculative derivatives trading to the organized (and now-regulated) exchanges. This regulatory system also for many decades also kept derivatives speculation from posing significant problems for the larger economy.


Did Structured Credit Fuel the LBO Boom?

The following post comes to us from Anil Shivdasani, Professor of Finance at the University of North Carolina, and Yi Hui Wang of the Department of Finance at the Chinese University of Hong Kong.

In our forthcoming Journal of Finance paper, Did Structured Credit Fuel the LBO Boom? we study how large shifts in the availability of credit affected the corporate use of leverage by examining LBO transactions that rely heavily on debt financing. We argue that developments that led to the growth of structured credit contributed to increased credit supply that at least partially fueled the recent LBO boom. Our evidence highlights important linkages between structured credit, the dual role of banks in the structured credit markets as loan originators and underwriters, and the corporate use of leverage.