Tuesday, 26 August 2008

Recapitalisation and the Debt/Equity Spectrum

Myron Scholes gave a good talk at the Lindau Nobel Prize winners meeting. The video is here.
Scholes has a number of points but one that is of immediate interest is his observation on debt holder pressure. Scholes notes that as banks get riskier and require more capital debt holders want the new capital to be more equity like than the instruments they hold - making their debt safer - while equity holders do not want to be diluted. Therefore recapitalisations tend to involve hybrid, subordinated instruments. Which indeed they have.

His other point in this area is that leveraged capital structure are naturally negatively convex in the sense that as asset prices fall, the issued debt gets riskier, and so to reduce this, institutions must delever in falling markets. This certainly happens -- it is just not clear to me that Scholes has established the need for institutions to hedge movements in the CDS spreads. After all, this (from FT alphaville) is a pretty good sign that any such hedging has not been entirely successful:

This does however throw an interesting theoretical light on Goldman and Morgan Stanley's decision to link the amount of leverage it will provide to their own debt spread.

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