IDEAS home Printed from https://ideas.repec.org/p/nbr/nberwo/14581.html
   My bibliography  Save this paper

Equity Depletion from Government-Guaranteed Debt

Author

Listed:
  • Robert E. Hall

Abstract

Government guarantees of private debt deplete equity. The depletion is greatest during periods when the probability of a guarantee payoff is highest. In a setting otherwise subject to Modigliani-Miller neutrality, firms issue guaranteed debt up to the limit the government permits. Declines in asset values raise debt in relation to asset values and thus deplete equity directly, under the realistic assumption that the government is unable to enforce rules calling for marking asset values to market. Less widely recognized is that guaranteed debt creates an incentive to pay equity out to owners -- such a payout lowers the value of the firm's call option on its assets by less than the amount of the payout. I build a simple dynamic equilibrium model of an economy that would have a constant consumption/capital ratio but for debt guarantees. Exogenous changes in asset values cause major swings in allocations as participants respond to changing incentives. Periods when default is unusually likely because asset values have fallen are times of abnormally high consumption/capital ratios. The withdrawal of equity from firms to pay for the consumption will turn out to be free on the margin if the firm defaults. Consumers concentrate their consumption during the periods when consumption is cheap. Because these periods are transitory, they generate expectations of negative consumption growth, which implies that interest rates are low. Thus guarantees generate substantial volatility throughout the economy.

Suggested Citation

  • Robert E. Hall, 2008. "Equity Depletion from Government-Guaranteed Debt," NBER Working Papers 14581, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:14581
    Note: EFG
    as

    Download full text from publisher

    File URL: http://www.nber.org/papers/w14581.pdf
    Download Restriction: no

    References listed on IDEAS

    as
    1. George A. Akerlof & Paul M. Romer, 1993. "Looting: The Economic Underworld of Bankruptcy for Profit," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 24(2), pages 1-74.
    2. Narayana R. Kocherlakota & Ilhyock Shim, 2007. "Forbearance and Prompt Corrective Action," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(5), pages 1107-1129, August.
    3. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    Full references (including those not matched with items on IDEAS)

    More about this item

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:14581. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (). General contact details of provider: http://edirc.repec.org/data/nberrus.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.