Sep

21

The Modigliani and Miller theorem states that in the absence of taxes, bankruptcy costs, and asymmetric information, the capital structure of the firm does not matter.

We know, of course that these assumptions do not hold true. The tax treatment of debt financing vs. equity financing provides an incentive to carry debt. At the same time, bankruptcy costs reduce the incentive for carrying debt.

Hence, firms carry debt to the point that the marginal benefit of the tax treatment of debt meets the marginal predicted bankruptcy cost of that debt.

Bankruptcy costs can be represented by the cost of a bankruptcy times the likelihood of a bankruptcy. The likelihood depends on the volatility of the assets of the firm.

Hence, firms with low asset volatility, such as utilities, tend to carry more debt than firms with higher asset volatility, such as software companies.

Bankruptcy costs are the reduction in the value of assets of the firm that result from bankruptcy. This is not just the money eaten up by lawyers and investment bankers, but also the ease with which assets are transferred to another owner.

So, for example, if an E&P company hits bankruptcy, it is very easy to transfer ownership of wells to a new company, meaning the bankruptcy costs for energy companies are low. The same goes for railroads. If the primary asset is track and rolling stock, it is very easy to transfer the assets to a new owner.

For firms where the asset is primarily intellectual or relationship based, bankruptcy costs are very high because the knowledge and individuals with relationships cannot easily be "re-painted" like a box car and sold to another company.

With Amaranth, the asset is roughly $4 billion in financial markets positions (perhaps levered to a much greater amount than that), as well as intellectual capital. The finance industry is notoriously poor at being able to hold on to intellectual capital, so Amaranth's intellectual capital will leave. This is because, 50% in the hole, Amaranth will not be able to earn performance fees until its high water mark. This means that other funds can poach Amaranth talent by offering higher pay than Amaranth can possibly offer.

Hence, Amaranth will have to ultimately either close up shop or become a much smaller organization based on the strategies that the founder can run himself, assuming he is willing to stick it out without performance fees for a while.

Therefore, there is a huge bundle of financial assets coming on to the market. The question is, how easily are those assets repainted and sold?

Theoretically, it is very easy to repaint the assets. All it requires is exchanging the title of ownership at the brokers/clearing houses.

The problem, however, is that others are able to short these assets, in essence front-running Amaranth.

One cannot really do something like this in the corporate world. If BNSF goes bankrupt, one cannot borrow and sell box cars and engines, hoping to cover at the BNSF box car auction.

One can, however, do that with financial assets.

How this plays out at Amaranth will have repercussions for years to come. Presently, banks are willing to lend vast sums to hedge funds. So long as margin calls are met, there is not a great deal for the banks to lose. But what happens if the bankruptcy costs are higher than pre-supposed, i.e. the value of assets used in calculating margin calls is not as great as believed due to the bankruptcy costs being higher than the Street assumed?

If things do not go well, credit on Wall Street could become much tighter.


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