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 managers do not need mountains of debt to make them more efficient. We should also remember that the companies with the best records for profit and growth, as well as the best records in employee relations, innovation, and community relations, are those with moderate amounts of debt, high levels of investment, and high levels of research and development—companies such as IBM, the Digital Equipment Corporation, Pfizer, Merck, Coca-Cola, and General Electric. Their borrowing has increased in the last decade because economic factors, such as preferential tax treatment for interest expense over dividend expenses, require it; but they have kept their levels of debt down to reasonable amounts, and have not had recourse to the more exotic forms of loans created by the junk-bond markets.
During the last five years, more than $400 billion in equities—mainly stocks—of US companies have been retired and replaced with debts. There are many reasons for this, but, mainly, these are the result of takeovers, LBOs, or restructurings carried out to avoid takeovers. This is a distinctly American phenomenon. In most other Western countries, companies are not permitted to buy up their own stock, or the power to do so is severely constrained. To take shares out of circulation and replace them with debt is elsewhere not permitted on so large a scale. In the US, this use of credit more often than not results in less rather than more investment. It forces companies to liquidate assets in order to meet the high interest costs of the debt they acquired to buy the shares when instead they should have concentrated on forward-looking, aggressive new investment.
Although the current congressional hearings are mostly concerned with LBOs and excessive use of debt, the central issues concerning the financial system are more diverse and are all related to one another. They include leverage—borrowing in general—takeovers, taxes, junk bonds, regulation, and financial institutions. I will briefly discuss each.
1) Leverage. The judicious, even aggressive, use of credit is a perfectly normal and acceptable business strategy, but several trends have now become troublesome and distinguish recent use of leverage from previous practice.
In many companies the proportions of debt to equity—the ownership interest of the shareholders—that have been built up in takeovers, restructurings, and LBOs have become dramatically high, and potentially dangerous. It is not uncommon to find a ratio of 90:10, or even higher, of debt to equity. In addition, much of what counts as equity often consists not of common stock but of subordinated debt or preferred stock. These are paper obligations with interest or dividends payable in additional paper. They only further reduce the amount of real capital invested as a percentage of the capital of the enterprise.
Many companies have issued large amounts of junk bonds and must now meet abnormally high interest payments for the life of these bonds. Junk bonds appeared in the early 1980s as a way for companies without a long history of earnings or sales, or those with a low credit rating, to obtain financing. They have now become widely used as a way to raise money for takeovers and LBOs. These bonds carry interest rates ranging from 13 to 18 percent, often more than the average return on investment of the underlying business. When businesses combine issuance of these bonds with high debt-to-equity ratio, many are burdened with interest costs that are so heavy that they probably could not be sustained during a recession.
Much of the debt is taken on to reacquire a company’s own stock, or to acquire another company’s stock, at a significant premium over the market price, instead of being invested in the company’s own business for internal growth. This limits the company’s potential for future investment and growth.
2) Takeovers. It is unwise to attribute either economically beneficial or harmful qualities to takeovers. Study after study has failed to show any clear-cut conclusion. This is also true when it comes to moral judgments; takeovers are neither good nor bad, whether they are friendly or hostile. The same can be said of leveraged buyouts. But takeovers and LBOs can have implications for the national economy, depending on the validity of their business strategies, on the soundness of their financial structures—particularly the amount of debt that is acquired—and on the fairness of the transaction to the shareholder of both the acquiring and the acquired company.
It should be clear that financial structures that are not overburdened by debt are necessary if there are to be adequate levels of new investment and economic activity. The government could encourage corporate arrangements in which there is more equity and less debt either indirectly through tax incentives or directly by regulation. Shareholders must also be assured of the fairness of the takeover process if the US is to have healthy capital markets in which individual investors can participate without feeling institutional or other professional investors have too many advantages. Fairness to shareholders, for example, may require special legislation concerning leveraged buyouts by a company’s own management. In these transactions there can be a clear conflict of interest between the management, as a potential acquirer, and the existing shareholders. Regulatory or possibly legal changes could be used to protect shareholders’ rights in these cases.
Finally, companies should be discouraged from repurchasing their own equities. We do not need to go as far as the European countries that prohibit a company from acquiring its stock as a matter of law. In the US acquiring shares to be used for stock options or for stock purchase plans is a normal transaction; the shares will be reissued when the options are exercised. Acquiring stock by making use of the proceeds of the sale of some of a company’s assets similarly does not change the amount of capital in the firm. But payments for extensive repurchases of stock with borrowed capital in restructurings—i.e., attempts to shrink the company’s outstanding shares dramatically in order to frustrate a takeover—are not essentially different from LBOs. Instead of the investment house financing the LBO, the public does so by retaining an interest in a significantly shrunken equity. The economics, and the related problems, are the same.
3) Taxes. The tax code could be changed to discourage the current tendency toward excessive corporate borrowing, and to encourage long-term investment instead of short-term speculation. Of course, whenever taxes are involved, questions of fairness and of practicality must be taken into account. One proposal for limiting borrowing, for example, is to reduce the amount of interest payments that can be deducted from corporate taxable income. Opponents of this proposal have argued that eliminating some of the deductibility of interest would favor foreign companies competing to take over US companies, since the foreign firms would not be affected by such tax penalties. This is not necessarily the case. Foreign companies rarely have 90:10 ratios of debt to equity; nor do they pay interest rates of between 14 and 16 percent for their financing. Thus they don’t benefit as significantly from tax write-offs of interest costs as highly leveraged US companies. In many cases, moreover, foreign companies finance their acquisitions in the US and are subject to the same tax treatment.
Taxes can be used to discourage excessive borrowing in two ways. First, we could revive the old “thin incorporation doctrine,” which held that debt in excess of a certain percentage of total capital was in reality equity, and that the interest on this portion was a dividend and therefore not deductible from income for tax purposes. Second, junk bonds, because of their excessively high interest rates, could also be considered as having two interest rates: a “normal” interest rate plus a “liquidating return” on capital, i.e., the return one expects when a company is going out of business. The notion of “liquidating return” can be justified by the economic requirement to sell assets created by the use of junk bonds. The amount of deductible interest could be related, perhaps, to the yield of an investment-related bond of equivalent maturity. Either of these limitations should apply only to companies that have made substantial acquisitions (or reacquired substantial amounts of their own stock) within a specified period. Such regulations would probably be cumbersome, but not impossible to apply.
For a regulatory authority to determine desirable ratios of debt to equity quickly raises, among many others, complicated accounting questions such as how to treat tangible and intangible assets. Dealing with interest rates alone would be far simpler, and this is one reason I would, between the two options, favor a limit on deductible interest. However, whether the beneficial effects of either of these approaches would outweigh the considerable administrative problems that would be involved in applying them is open to question. Economists would need to test the proposals by constructing sophisticated economic models before one could reach any conclusion with confidence.
Such limitations should not, in any case, be put into effect without two additional changes in the tax code. First, the double tax on dividends—whereby the government taxes dividends first as corporate earnings, then again as the personal income of stockholders—should be eliminated. Corporations should be allowed to deduct their payment of dividends on common stock. This would increase the incentives for issuing stock and would make equity financing as attractive to a corporation as debt financing. Second, the tax on capital gains—the difference between an asset’s purchase price and selling price—should be changed so that long-term holdings will be taxed at a lower rate than short-term profits, which often depend on brief swings in market prices. Such a change would encourage shareholders to keep their stock for longer periods of time and give management confidence that they can make investments that may temporarily reduce company profits without risking investors’ interest in owning the company’s stock. The President’s recent proposal to lower the tax on capital gains does not accomplish this objective. It simply reduces capital gains rates, whereas, in my judgment, rates on short-term profits should be increased and rates on long-term profits should be decreased in proportion to the length of the holding period.
I assume that such a policy would result in a net loss of revenue, even though tax collections would increase in some transactions because of the reduced deductibility of interest and the higher tax on short-term profits. Such new tax arrangements would therefore have to be phased in gradually to avoid reducing government receipts too sharply in this period of high budget deficits.
4) Junk bonds were and still are a perfectly acceptable way to finance growing businesses that can’t otherwise obtain financing in the marketplace. In moderate amounts, they have their place among the various financial instruments created during the last decade by computer technology and inventive bankers. Used in huge amounts, however, as parts of takeovers, LBOs, or restructurings, they can have dangerous consequences.
In times of economic growth, such as during the last seven years, junk bonds provide returns so much greater than competing investments that they have become irresistible to financial institutions that are under pressure to show high short-term returns on their investments—for example, mutual funds trying to attract investors and savings and loan or insurance company managers who feel they need high returns in order to compete for customers.
The extremely high yields on these bonds produce, essentially, an enormous transfer of wealth from production to investment capital, since funds are drawn away from new investment to service a growing amount of debt. The scale of this transfer can be measured by the institutional market for junk bonds, which now amounts to $200 billion or more. As a result, junk bonds became the favorite way to finance takeovers, LBOs, and highly leveraged restructurings. The very factors that make junk bonds attractive for such purposes, however, also make them potentially dangerous for the economy. First, the high cost of capital requires relatively rapid sales of the assets in the newly acquired company so that the rest of the business can be carried on. Hence many of these takeovers have a “bust-up” effect, as parts of the company are sold, sometimes at a disadvantage, just to finance the acquisition. Second, in the event of an economic downturn the interest charges might not be tolerable. We have yet to experience such a downturn in the current business cycle, but we have already seen evidence of the kinds of difficulties that can occur with takeovers or LBOs that have been too aggressively financed, for example, the financial problems of Revco, a large drug chain that filed in bankruptcy some time ago.
Recently junk bonds have been marketed with more abandon than ever before. Some provide for interest (or dividends, in the case of preferred stocks) to be paid not in cash but in additional bonds or stock. This relieves the near-term cash requirements of the borrower, but in the process creates an even greater burden of debt on the company. Wherever one turns, the financial pyramids get higher and higher.
Junk bonds and similar financial instruments are a product of a unique convergence of circumstances during the decade of the 1980s: deregulation of financial markets, computer technology, very aggressive financial institutions (many of them government-insured), huge amounts of liquidity, falling interest rates, and booming markets for assets. But the most important reasons for the success of highly leveraged takeovers and LBOs are the willingness of financial institutions to invest hundreds of billions of dollars in junk bonds and of the banks to provide more and more credit. Without the aggressive policies of financial institutions, the leveraging of American business could not have happened on nearly this scale.
In addition to the institutional market for junk bonds, a new vehicle for lending has been developed by the investment banking community: the bridge loan. These loans, as the name implies, are supposed short-term credits provided by an investment banking house to a client company engaged in a takeover or an LBO. The client company then refinances the bridge loan with junk bonds that are sold to the public several months later. This is risky because in some cases the bridge loans have exceeded the total net capital of the investment firms extending the loans. To raise the money for these loans, the investment houses sell very short-term commercial paper, which must be repaid in ninety days or less. If, someday, a serious problem of payment develops in the junk-bond market, and the refinancing of some of the outstanding bridge loans comes into doubt, securities firms may suddenly face serious financial difficulties.
5) Regulation should be used more aggressively to protect the US economy from excessive borrowing. The Federal Reserve Board chairman, Alan Green-span, has expressed concern about commercial banks participating too heavily in takeovers and LBOs. The same concern should apply to the investment banks and securities houses as well. During the October 1987 stock-market crash, for example, the Federal Reserve in effect guaranteed that the securities industry would be able to meet its obligations. Quite correctly, the Federal Reserve advised banks to provide whatever cash the securities houses required; but in so doing it made clear that its legitimate authority extends to maintaining an adequate supply of capital not only in commercial banks but also in the securities industry.
The Federal Reserve, if it wanted, could certainly raise reserve requirements for banks that, in its judgment, provide the riskier kinds of credits. The Securities and Exchange Commission and the stock exchanges can, and should, require that bridge loans and similar instruments provided by securities houses be financed to a much greater extent by permanent capital instead of by short-term loans. Coordinating these actions with the agencies of foreign governments that regulate banking and securities would make them more effective.
The depth of the scandal in the savings and loan industry is still not fully appreciated. Dozens of S&Ls have already failed and 350 others are insolvent. The final cost to taxpayers of rescuing the failed institutions is now estimated to be some $120 billion. What has happened is a clear example of the failure of deregulation. Before the deregulation legislation of 1980 and 1982, the savings and loans were allowed to make only fairly safe home-mortgage loans; the government also set the maximum interest rates—ranging during the 1970s from 4.25 to 5.50 percent—they could pay depositors on savings accounts. The difference between this rate and the somewhat higher rates on the mortgage loans assured the financial health of all but a few S&Ls. But deregulation ended restrictions on both the interest rates S&Ls could pay depositors and the types of loans they could make. Overzealous, and in some cases unscrupulous, managements soon were competing for savers’ money by offering higher and higher interest rates. With this money they made profitable but risky loans in speculative deals in real estate or energy projects, as well as huge investments in junk bonds.
When many of these high-risk investments collapsed, especially in the oil-producing states after the crash in oil prices in 1985–1986, the more aggressive S&Ls, many of which had only very small amounts of capital, were soon insolvent. These problems, though they first became evident in states like Texas and Oklahoma, have since affected S&Ls in every region of the country. What is required now is a thorough review of the workings of Federal Deposit Insurance, not only among savings and loans, but throughout the banking system. While such a review takes place, any institutions carrying Federal Deposit Insurance (bank or savings and loan) should be prohibited for the next five years from acquiring below-investment-grade securities of any type.
The Employee Retirement Income Security Act of 1974 (ERISA), which governs the operation of private pension and benefit plans, should also come under review. With billions of dollars to invest annually, pension funds are among the largest sources of capital in the US; yet they must be managed with exceptional care because millions of workers depend on them for income after retirement. Strict limits should be set on pension-fund participation in the junk-bond market, and higher standards of care and diligence should apply to fund managers making such investments.
Leveraged buyouts in which managers purchase their own companies should also be regulated because of the very real conflict between, on the one hand, management’s interest as a potential buyer and, on the other, its obligation to the board of directors and the shareholders to maximize the value of the company. To give competitors the time and information to organize bids, full disclosure of management’s plans could be required; so could a longer waiting period, say between sixty and ninety days after the announcement of an offer, than is the case in other tender offers.
Finally, we should consider the possibility of regulating the amount of firmly committed financing that is required to launch a tender offer to take control of a corporation. At the present time tender offers are made with actual commitments as low as 15 to 20 percent of the total amount of cash required. The balance is in the form of “highly confident” letters—written assurances from a variety of financial institutions that no difficulty is expected in providing financing, although all arrangements have not yet been made. The primary obstacle to bidders raising even more money is the high cost of getting firm commitments of financing, without assurance of success. Thus raising the minimum firm commitment required for a tender offer would discourage financially riskier takeovers. Such a requirement would clearly favor the large bidder over the small one; on the other hand, the large bidder is usually more strongly financed, and the resulting capital structures are likely to be sounder.
6) Financial Institutions. The term “financial institution” now includes mutual funds, public and private pension funds, savings and loan associations, banks, domestic and foreign, hedge funds, and many others. When it comes to the takeovers and LBOs that depend on these institutions, most of them tend to favor near-term profits over the long-term development of the companies in question. The result is constant pressure on management to maximize immediate stock-market returns by restructuring their firms, for example by selling off company holdings that are not producing high short-term profits. This can result in greater efficiency, but it can also reduce long-term competitiveness. Along with arbitrageurs, the financial institutions have become more and more a destabilizing influence in corporate America, unlike Japanese and European banks and other institutional shareholders, which provide greater stability to their economies.
The fault, however, does not lie solely with money managers. True, their compensation is too often geared to short-term performance. But pressure by corporations on the managers of their pension funds to maximize earnings is also a factor, as are the competitive standards set by the trustees of public pension funds. We are talking here of an entire culture that emphasizes short-term performance, not of a few culprits.
What should be clear by now is that LBOs, takeovers, restructurings, junk bonds, and other unique developments in the US economy are not causes but effects. They are the products of a highly speculative environment fostered in the 1980s as well as of excessive or ineffectual deregulation of financial markets. Something is structurally wrong not only in the US system of economic rewards and incentives but also in the relation between corporations and their shareholders and bankers, and the relation of financial institutions to those responsible for regulating them. State and federal courts, for example, now often have a more important part in corporate governance than boards of directors, their managements, or their advisers. They do so through their powers to interpret state takeover statutes and to override the actions of corporate directors in contests for corporate control.
The Congress and the administration, if they so choose, can deal with these issues in a piecemeal manner, by amending some tax laws here and changing some regulations there. However, the issue goes to the basic functioning of the financial markets and to the ability of the US to make adequate new investments in the economy. It may be time for an equivalent of the Cohen Commission of the 1960s to undertake an objective review of these matters for the Congress and the administration, and make recommendations, both legislative and regulatory, that could change the direction in which we are heading. Such a commission should include leaders from the business and the financial community as well as from the administration and Congress. It should agree to a two-year deadline to make constructive proposals, with the understanding that failure to do so would likely result in much more drastic legislative action by the Congress.
In the last analysis, this country needs to shift from consumption to investment. Major world powers have, historically, been characterized by a strong currency and low interest rates, not the other way around; they have been exporters of capital and technology, not borrowers. This should be our national objective and it will require basic changes in our national policies, starting with real reductions in our budget and trade deficits. The shift I have suggested here from debt to equity investment is just one aspect of such a national investment strategy.
April 13, 1989