Pledgeability, Industry Liquidity, and Financing Cycles

• Author: YUNZHI HU,DOUGLAS W. DIAMOND,RAGHURAM G. RAJAN
• Published date: 01 February 2020
• DOI: http://doi.org/10.1111/jofi.12831
• Date: 01 February 2020

THE JOURNAL OF FINANCE •VOL. LXXV, NO. 1 •FEBRUARY 2020

Pledgeability, Industry Liquidity,

and Financing Cycles

DOUGLAS W. DIAMOND, YUNZHI HU, and RAGHURAM G. RAJAN∗

ABSTRACT

Why do firms choose high debt when they anticipate high valuations, and underper-

form subsequently? We propose a theory of financing cycles where the importance of

creditors’ control rights over cash flows (“pledgeability”) varies with industry liquidity.

The market allows firms take on more debt when they anticipate higher future liquid-

ity. However, both high anticipated liquidity and the resulting high debt limit their

incentives to enhance pledgeability.This has prolonged adverse effects in a downturn.

Because these effects are hard to contract upon, higher anticipated liquidity can also

reduce a firm’s current access to finance.

WHY DO DOWNTURNS FOLLOWING EPISODES OF HIGH firm valuations result in

more protracted recessions (see Krishnamurthy and Muir (2017), L´

opez-Salido,

Stein, and Zakrajˇ

sek (2017))?1One traditional rationale is based on the idea

of “debt overhang”—debt built up during the boom restricts investment and

borrowing during the bust. However, if everyone knows that debt reduces in-

vestment, debt holders have an incentive to write down the debt in return for a

stake in the firm’s growth. For debt overhang to be a serious concern, the firm

and debt holders must be unable to negotiate value-enhancing contracts. An-

other view is that borrowers cannot be trusted to pursue only value-enhancing

investments, even in a downturn, in which case debt overhang is needed to

constrain the borrower’s investment—overhang is a second-best solution to a

∗Diamond and Rajan are with Chicago Booth and NBER. Hu is with the University of North

Carolina. Diamond and Rajan thank the Center for Research in Security Prices at Chicago Booth

and the National Science Foundation for research support. Rajan also thanks the Stigler Center.

We are grateful for helpful comments from three referees; the Editor; Florian Heider; Alan Morri-

son; Martin Oehmke; Adriano A. Rampini; workshop participants at the OXFIT 2014 conference,

Chicago Booth, and the Federal Reserve Bank of Chicago, the Federal Reserve Bank of Richmond,

the NBER 2015 Corporate Finance Summer Institute, Sciences Po, American Finance Association

meetings in 2016, and Princeton, MIT Sloan, the European Central Bank, Boston University,Har-

vard University, Stanford University, Washington University in St. Louis, and the University of

Maryland. The authors have read the Journal of Finance’s disclosure policy and have no conflicts

of interest to disclose.

1Krishnamurthy and Muir (2017) document a negative correlation between precrisis spreads

and credit growth, as well as a positive correlation between the change in spread as the crisis

hits and the severity of the subsequent crisis. L´

opez-Salido, Stein, and Zakrajˇ

sek (2017) show that

narrow credit spreads predict a slowdown in real activity in subsequent years, including in GDP

growth, investment, consumption, and employment.

DOI: 10.1111/jofi.12831

C2019 the American Finance Association

419

420 The Journal of Finance R

fundamental moral hazard problem (see Hart and Moore (1995) or Shleifer and

Vishny (1992)). The immediate questions raised by the latter view is why would

we want to constrain borrowers more in bad times following high valuations,

when the constraints imposed by debt are already high, and why would the

moral hazard problem be so much more serious in such episodes.

In this paper, we provide an explanation for high debt and show why its

consequences are more acute following periods of high valuations and rational

optimism about future values. In doing so, we differentiate between financier

control rights that are due solely to high resale prices for assets and control

rights that derive from pledging cash flows. The former are especially useful

in enforcing claims during an asset price boom, whereas the latter facilitate

enforcement of external claims at other times, including downturns. The tran-

sition between regimes in which the importance of control rights associated

with cash flows differ significantly causes the debt built up during a boom to

have prolonged adverse effects during a downturn.

To be more specific, consider an industry that requires special industry

knowledge to produce. Within the industry, there are firms run by incumbents,

there are experts (those who know the industry well enough to be able to run

firms as efficiently as the incumbents), and there are industry outsiders (such

as financiers who do not know how to run industry firms but have general

managerial/financial skills).

Financiers have two sorts of control rights: control through the right to re-

possess and sell the underlying asset being financed if payments are missed,

and control over the cash flows generated by the asset. The first right only

requires the frictionless enforcement of property rights in the economy, which

we assume. This right is particularly valuable when a large number of capable

potential buyers are willing to pay a high price for the firm’s assets. Greater

wealth among experts (which we term industry liquidity) increases the avail-

ability of this asset-sale-based financing. Because we analyze a single industry,

high levels of this industry liquidity can be interpreted as an economy-wide

boom.

The second type of control right is conferred on creditors by the firm’s in-

cumbent manager as she makes the firm’s cash flows more appropriable by, or

pledgeable to, creditors over the medium term. For example, she could improve

accounting quality or set up escrow accounts so that cash flows are hard to

divert. In general, an increase in experts’ higher prospective wealth (that is,

liquidity) as well as in their ability to borrow against the future cash flows of

the firm they buy (that is, pledgeability) will increase their bids for the firm.

In turn, higher prospective bids will increase debt recovery, and thus the will-

ingness of creditors to lend up front. It therefore follows that higher liquidity

and pledgeability increase the firm’s debt capacity.

However, pledgeability is endogenously determined. Consider the incentives

of an incumbent firm manager while choosing cash flow pledgeability for the

next period. We assume that she may sell some or all of the firm next period

with some probability, either because she is no longer capable of running it

or because she needs to raise capital for new investment. If she owned the

Pledgeability, Industry Liquidity, and Financing Cycles 421

firm and had no debt claims outstanding, she would undoubtedly want to in-

crease pledgeability, especially if the direct costs of doing so are small—this

would simply increase the amount that she would obtain by selling the firm to

experts if she lost ability to run the firm. If she has taken on debt, however,

enhancing cash flow pledgeability is a double-edged sword. Higher bids from

experts also allow existing creditors to collect more if the incumbent stays in

control because creditors have the right to seize assets and sell them when not

paid in full. In such situations, the incumbent has to “buy” the firm from cred-

itors by outbidding experts (or paying debt fully). The higher the probability

that she retains ability and stays in control, and the higher the outstanding

debt, the lower her incentives to raise pledgeability. Higher outstanding debt

thus reduces the incumbent manager’s incentives to raise pledgeability.

Now consider the effect of industry liquidity on pledgeability choice. If experts

are rational, they will never pay more for the firm than its fundamental value.

When future industry liquidity is very high, experts will have enough wealth

to buy the firm at full value without needing to borrow more against the firm’s

future cash flows. If so, higher pledgeability has no effect on how much experts

will bid to pay for the firm. In other words, high future liquidity crowds out the

need for pledgeability in enhancing debt repayments. We therefore have two

influences on pledgeability—the level of outstanding debt and the anticipated

liquidity of experts. The key results of the paper stem from the interaction

between the two.

To see this, consider a prospective boom, which is anticipated with high

probability, during which experts will have plenty of wealth. Repayment of any

corporate borrowing today is enforced by the potential high resale value of the

firm—at the future date, wealthy experts will bid full value for the firm as in

Shleifer and Vishny (1992), without needing high pledgeability to make their

bid. The high anticipated resale value increases the promised payment that a

firm can credibly repay and thus the amount it can borrow today (see Acharya

and Viswanathan (2011)).

Because pledgeability is not needed to enforce repayment in a future highly

liquid state, a high probability of such a state encourages creditors to lend

large amounts to the incumbent up front, even though they know that doing

so crowds out the incumbent’s incentives to enhance pledgeability, and even

if there is a possible low liquidity state in which pledgeability is needed to

enhance creditor rights. Prospective liquidity thus encourages borrowing, which

can crowd out pledgeability. Consequently, if the low-liquidity state is realized,

the enforceability of the firm’s debt, as well as its borrowing capacity, will fall

significantly because pledgeability has been set low. Experts, also hit by the

downturn, no longer have much personal wealth, nor does the low-cash-flow

pledgeability of the firm allow them to borrow against future cash flows to pay

for the firm. The adverse effect of anticipated liquidity on pledgeability via

higher leverage is a key new focus of this paper.

Because external claims are high in these low-liquidity episodes, the firm may

be sold to outsiders. Although industry outsiders have little ability to operate

the firm themselves, this may be a virtue—outsiders have strong incentives