1. The Paradox of Liquidity Stewart C. Myers Raghuram G. Rajan Presented by: Michael Keefe February 13, 2007 FIN 7340 Corporate Theory IIDr. Nina Baranchuk

2. 2 External Financing and Liquidity Tension Illiquidity => creditors get less if seize and sell assets Illiquidity => higher probability assets will be there Greater Liquidity increases conflict over property rights of asset

3. 3 Model Set-Up The Players Investor - Principal Manager/Owner – Agent Assumptions Manager has positive $1 NPV project 2 period model with renegotiation Cash Flows C 1 and C 2 are generated at dates 1 and 2 respectively Project requires purchase and use of asset with replacement cost of d 1 and d 2 at dates 1 and 2 respectively $1 NPV => Investment-(C 1 + C 2 + d 2) > 1 Assume C 2 + d 2 >= d 1 Index of Liquidity α (i.e. can liquidate for αd) Information and Contracts C1 and C2 not observable by Investor Contractual Variables Ownership of Asset => right to choose who operates or sell asset Cash Paid by Manager to Investor can be verified and contracted on Manager can not operate asset efficiently

4. 4 Liquidity and Transformation Risk Investor Worries Manager Steals Asset (e.g. commodities) Sell asset and take cash (payoff proportional to liquidity) Transform to assets specific to manager expertise Substitute with risky assets (shift value from debt to equity) Nature of Liquidity Initial Assumption α m =α Efficient legal system => α m <α Trader => high transformation risk due to opaque environment (complex positions not easily monitored)

5. 5 The Order of Play

6. 6 Date 2 Negotiation Mngr Inv Mngr Pay Not Pay Offer X Accept Reject (Manager, Investor) (C 2 +d 2 -X, X) (C 2 +d 2 -P 2,P 2 ) (C 2, αd 2 ) Result – Manager offers min[P 2,αd 2 ] Note – Manager and Investor both KNOW α, d 2, and P 2

7. 7 Date 1&1/2 Incentives Mngr Transform Continue (αd 2,0) (C 2 +d 2 -min[αd 2, P 2 ], min[αd 2,P 2 ]) (Manager, Investor) It is in the incentive of investor to insure the Manager continues.

8. 8 Date 1 Negotiation Mngr Inv Offer X RejectNature a (1-a) Inv Mngr Take Leave Take Leave Mngr Inv Nature acts w.p. a investor makes offer & w.p. (1-a) manager makes offer 1. Given bargaining power investor or manager will each make take it or leave it offer (Demand C 2 ) 1. Yes No Yes No Since investor can force liquidation at Date 1, the value to Lender is:

9. 9 Date ½ Incentives Manager can transform asset and receive αd 1  The Manager can commit to not transform assets only if: The Investor will only offer financing at date 0 if:

10. 10 Maximum Debt the Manager can commit to repay

11. 11 Scenario I – Large C 2 and P 1 (9) & (10) do not bind  (8) reduces to: Note that d 1 is greater than d 2

12. 12 Date ½ Transformation Risk Constraint (7)

13. 13 Financing Capacity Example

14. 14 Financing Capacity Assumption – Assets of a firm can not be transformed or liquidated seperately Constraints bind over three possible ranges of liquidity (a) Illiquid – Debt determined by cash flows and final liquidation (b) Liquid – Debt determined by liquidation value of assets (c) Overly Liquid – Debt capacity reduced by excessive liquidity Ranges

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16. 16 Robustness Equity – Manager can beat investor to transformation Investor has unconditional ownership and not conditional on default Investor pays salary (assume large enough to cause default and start negotiation process) If (7) binds manager will tranform Transformation incentive of manager reduced when illiquid projects added (way to check transformation risk) Endogeneity – Manager gives up transformation ability to get more internal financing

17. 17 Manager Flexibility – Set Up

18. 18 Endogeneity Findings If f is concave in b, the b* is increases with cash flow decreases with θ decreases with the date 1 value of assets (less opportunity for transformation with small d 1 ) Relationship between optimal flexibility and liquidity depends on f b,α f b,α small then db*/dα negative (buy and hold assets) f b,α large then db*/dα decreases (e.g. trader requires more flexibility)

19. 19 Transformation Risk Entrenching Investment – Manager can substitute general purpose assets into specific assets - Shleifer and Vishny (1989) Results also hold when specific assets can be transformed

20. 20 Banking Banks originated in middle ages as money changers due to quality issues with coins. (DeRoover 1948) Kept 30% of deposits as reserves Laws focussed on preventing fraud Riu(1979) Governments formed banks Transformation risk endured (war, fiscal distress) 100% reserves and still defaults Why did the government banks not put the private banks out of business? Municipal kept 100% in liquid asset reserves => temptation for municipality to raid Illiliquid loans and investments of money changer served to bind the liquid assets of the money changer

21. 21 Banks Today Assets – Mix of illiquid loans and liquid securities Liabilities – Short Term Deposits Model to Banking For banks to serve demand depositors => need liquidity; however scale will not solve transformation issue Banks make illiquid loans to increase debt capacity

22. 22 Bank Model Set-Up Approach & Findings Evaluates recourse of individual investors if bank misses payment  Individual investor gets reduced payoff Implication is that intermediation may not dominate direct lending

23. 23 Contrasting Theories Diamond and Dybvig (1993) – Banks exist to so consumer can fund uneven consumption and fund projects Calamiris and Kahn (1991) – First come first serve nature of banks incent depositors to monitor Transformation risk of banks is increasing due to technology=>hard for banks to make loans to most credit worthy accounts M&M world – A credit rated bank could make loan to AAA company and get correct return Model – Transformation risk does not allow loan to fall to cost of capital of that loan.

24. 24 Conclusions Transformation Risk => Debt Capacity is not monotonic in the intrinsic liquidity of assets Assets in an overly-liquid firm can not be used as collateral for debt => debt capacity is increased by taking on less liquid projects