What is capital?

TED recently discussed “the pool of capital available to the economy” as if this were a concept with a clear meaning.  Capital is sometimes used to refer to the equity in a business, to the working capital used to operate a business or simply to the investable funds that investors have and fund-managers or IPO-issuers want to get.

Equity capital is something that we think we understand – until we think about it a little longer.    It often incorporates the value of many intangible assets that may be alienable only as part and parcel of the whole business and/or fragile in the sense that they may be easily destroyed by bad managerial decisions (e.g. goodwill).  Furthermore it is axiomatic that equity capital is inflated when asset prices are too high and it evaporates when they fall.  (Steve Waldman has expounded on these issues much more thoroughly and penetratingly than I do here.)  In order to have a meaningful “pool of [equity] capital,” it’s necessary to have some kind of stability in asset prices – but this is precisely what we don’t have in our current system.

Thus, it’s a mistake in my view to think of equity capital as part of the “pool of capital available to the economy,” as if there were a simple fixed quantity of “capital” in the world and it’s only the price that varies.  What precisely the aggregate value of the stock market represents is far from clear – and that’s why it is in some sense not particularly surprising when this value drops by 40% over the course of a year.  What comes to my mind when I hear “pool of capital” is the “K” of economist’s models working to constrain our ability to think about what capital is.

In addition, the focus on equity capital obfuscates the important role played by the finance of working capital in the economy.  Many real goods come into existence only because of the availability of working capital.  While only a fraction of the output financed by working capital is converted via retained earnings into equity capital, the ubiquitous finance of working capital may mean that it plays a more important role in the economy and production process than equity capital itself.  I get the impression that most people don’t consider working capital to be an important component of the “pool of capital available to the economy,” but it’s far from clear to me why this is the case and whether it could possibility be justified.

As I have argued elsewhere, the finance of working capital plays an important role in the transformation of human capital from an inalienable asset into tangible, alienable assets.  The realization of human capital is, possibly, the most important role played by financial institutions in the economy — and this requires unsecured lending and well developed underwriting processes that distinguish borrowers who are likely to repay from those who will not.  Capital is created along with “good” debt and destroyed when the enforcement mechanisms for debt weaken.

In short, capital should be understood as a social construct, not in fixed supply or growing due to investment, but a product of institutional infrastructure.

Related posts:
What banks do
The problem with collateral
Comparing bankers past and present

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The End of Equity?

Barry Ritholtz is blaming the falling value of bank stocks on the decision not to require mark-to-market accounting.  I’m wondering whether the fall isn’t a delayed reaction to the implementation of broad safe harbors for derivatives in the bankruptcy code (which was completed in 2005).

After all, Lehman Bros. made clear that anyone who holds equity in a financial institution can expect to get nothing when the company is wound up — in fact, it looks like the unsecured creditors will get 20 cents on the dollar.  What happened to the $640 billion in assets and $26 billion in shareholders’ equity that was reported for May 2008?  You can be sure that a large chunk of it ended up being posted as collateral on derivative obligations and thus removed from the control of the bankruptcy estate.

Why after this experience would anyone own the shares of a financial institution that could possibly go bankrupt or be resolved?

Another concern is what will happen when some large real economy firm ends up with such big derivatives exposures that its shareholders get treated the same way as Lehman’s.  Will one-time equity investors decide that, after the recent changes to the bankruptcy code, being a shareholder of a listed stock is just an option on nothing at all?

Unintended consequences, indeed.

Update 10-8-11:  In case it wasn’t clear, the issue that is created by the new bankruptcy code is that is that in the months leading up to a bankruptcy (or resolution) the claims on the firm’s assets are likely to change dramatically with the result that the accounting statements don’t reflect the relevant information.  So the underlying problem is that equity investors are asked to invest blindly.  While this problem is worse for financial firms, it’s far from clear that the problem is limited to them.

Should default be a business decision?

John Quiggin asks:

Bankruptcy is once again as common as divorce. … And, as with divorce, we must soon be reaching the point where most people who take out loans will do so in the knowledge that default is an option. The question is – can the consumer credit system survive this?

But I think his more interesting point is:

Lowenstein’s key point is that businesses (including those owned or controlled by the banks themselves) treat default as a straightforward business decision, to be adopted whenever it is profitable to do so. … To be fair, it’s only in the last thirty years or so that such ethics have become dominant in the corporate sector, to the point where a board that rejected profitable opportunities to stiff their creditors would now be regarded as having violated its fiduciary obligations to shareholders

This recalled to mind Brad de Long’s work on the early years of the stock market.  Or actually a comment on that work, published with the paper in Temin’s book to which I don’t have a link.  In this comment Charles Sabel argued that in fact the first duty of any firm whose stock issue was underwritten by Morgan was to make sure that creditors were repaid.  That is, the author argued that in order to maintain their reputation, the first duty of Morgan’s Men was to protect the bond-holders.

So I think there’s another question here is:  How long can the bond market survive in a world where default has just become a business decision?

Update:  In fact as I read Mark Thoma (“you have to ask (and understand) why securitizers were so willing to take this paper from the loan originators”) I think that maybe there’s a sense in which this question explains the whole of the crisis.

Does Caballero support a convertible bank debt policy?

Ricardo Caballero is once again proposing that the government insure private financial institutions against risk.  His theory is that there are no solvency crises, only liquidity crises, and therefore public insurance is needed to support asset prices.  (“Once the crisis sets in, insurance acquires great value and leads to more risk-taking and speculative capital injections into the financial system, but by then this is mostly desirable since the main economy-wide problem during a financial panic is too little, not too much, risk-taking.”)

Caballero is opposed to the resolution of failed financial firms, because decisions made during the resolution would be based on panic prices and therefore error-prone.  Thus resolution, he believes, would only fuel the panic.

I would like to know what Caballero thinks of the idea that whole debt structure (excluding deposits) of financial firms should be convertible in tiers.  By insuring that banks have ample access to capital when they need it, a convertible debt structure guarantees that resolution will occur only when bank assets fall so low that they can’t even support the bank’s deposits.  As long as Caballero’s theory that all crises are liquidity crises is correct, conversion into equity will be in the interests of bank creditors because they will earn spectacular gains as the economy recovers from the crisis that triggered the conversion.  And if Caballero is wrong and there are solvency crises, then the policy insures that it is the creditors of the firm — instead of the government — that bear the cost of the crisis.

An alternative to a resolution regime

This post of Steve Waldman’s prompted a discussion that I still think provides the best alternative to a resolution regime.  Regulators are currently encouraging the issue of contingent convertible bonds (or CoCos).  Because these haven’t been issued before some are concerned that the conversion itself could cause a crisis.  And there is much discussion regarding the value of this form of convertible debt.

Broader application of this contingent convertibility would do a lot to fix the problem of “too big to fail” financial institutions.  All financial institution debt should be convertible, with a few carefully chosen exceptions — such as deposits and perhaps some select categories of secured loans.  The convertibility of debt should be tiered, so that some investors are buying CoCos comparable to those that Lloyds is issuing and other investors — whose purchases convert only after 20 other issues convert — are very unlikely to convert and therefore are more like traditional forms of debt.

Requiring banks to have a convertible liability structure would solve for regulators the problem of not being able to put such banks through bankruptcy court.  It would obviously also raise the cost of funds for financial institutions — but only because lenders would have to be compensated for the costs that taxpayers are currently bearing.  Allowing the market to price the risks that banks are carrying is surely better than asking regulators to devise some model that will allow them to guesstimate an insurance premium for “too big to fail” firms.

Thoughts on measuring liquidity

Liquidity is a notoriously ill-defined concept.  On the stock market I think liquidity should be defined as the ease with which you are able to sell your holding at (that is without causing a decline in) current prices.  The most important measure of liquidity is then likely to be the demand for your position at current prices.  An important contrary indicator would be supply of your position at current prices.

Thus I propose that the SEC use as one measure of daily stock market liquidity for each stock:  the dollar value of purchases that resulted in an end of day increase in the buyers’ holdings of the stock.  An important related measure would be reverse liquidity or the dollar value of sales that resulted in an end of day decrease in the sellers’ holdings of the stock.  To keep the definition of the entities trading in the market from being gamed, the SEC would probably have to track these trades using something like the entity’s tax ID number.

These measures of liquidity would have the benefit of ignoring day traders and other trend followers that do little or nothing to ensure that the market is robust at current prices.

It is true that the end of day measure is chosen at random and thus that it would make sense separate hourly, daily, weekly, monthly and annual measures of liquidity.

Another advantage for the SEC of collecting comprehensive data on the trades of investors with a longer-term horizon is that the SEC would have the information necessary to assess whether current market practices impose a tax on long horizon investors by causing them to buy at higher prices and sell at lower prices than the noise traders.

The double taxation canard

I’ve never understood the argument that corporate equity is taxed twice.  It seems to be based on simplistic economic models where the owners of the firm are identified with the firm itself, but bankruptcies never take place.

Of course, corporations exist mostly because they grant the owners limited liability in the event of bankruptcy — so it’s pretty clear that any economic model that does not have corporate bankruptcies in equilibrium does not actually have anything to say about corporations.  Limited liability is possible because corporations are persons under the law.  For the same reason corporations have to pay their own taxes and economic models that confound the corporation with its owners fail to capture what a corporation is.  Equity owners who want to avoid “double taxation” have always had the option of forming a partnership.

Double taxation is a canard that exists mainly because economic models don’t capture the costs and benefits of corporations.