The Debt Addiction

A series of congressional hearings is now looking into various aspects of the nation’s financial markets. These hearings occur at a time when confidence in the integrity of the nation’s financial system and in the ability of the economy to sustain itself in an increasingly competitive world seems steadily to be declining. Especially since the stock market crash of October 19, 1987, confidence has been eroding in some of our most important financial institutions, which many in American society now view more as parasites on the economy than as forces contributing to its growth.

In particular, questions have been raised about corporate takeovers in the US: it is asked whether they help companies to become more efficient or whether they mainly add more debt to an economy already heavily burdened with it. These worries have been revived by the recent series of large leveraged buyouts (LBOs)—takeovers of companies using substantial amounts of borrowed funds, with the assets of the target company often being used as security for the loans. Such takeovers have occurred, moreover, at the very time when there have been losses of over $100 billion in the savings and loan industry, which must now be bailed out in good part by the taxpayers; charges of insider trading against Wall Street executives; and renewed questions about the soundness of the US banking system, not only because of LBOs but also because of renewed third-world debt problems and other sizable domestic credit risks.

All these issues have been argued over for the past several years. What is new is the scale of recent transactions (at whose peak is the takeover of RJR Nabisco for $25 billion) and the size of the profits generated as a result. New questions are being raised about the rights of bondholders in such transactions; about whether management in these takeovers is fulfilling its fiduciary obligations to stockholders, bondholders, employees, and communities; and what the relationship should be between institutions such as pension funds, which often provide cash for takeovers and LBOs, the target companies themselves, and the investors who actually acquire the companies.

These issues are at best very complicated and not easy to subject to quantitative analysis. In addition, they involve very large economic interests. But what is really involved here is the condition of American business as we approach the twenty-first century, and the level of our confidence in the quality, skills, and judgment among the business and financial institutions that are the backbone of our economy.

What happens when the managers of a firm take over a large share of its ownership by piling up debt—whether in the form of junk bonds, bank loans, or other forms of borrowing? Some have argued that special benefits result. The entrepreneurial spirit of the company’s management, it is said, becomes sharper and the firm is pressed to become more efficient so that it can pay back debt. This argument is questionable. Ownership by management is desirable; so is employee ownership, profit sharing, etc. But…

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