Presidential Address: Collateral and Commitment

• Author: PETER M. DEMARZO
• Date: 01 August 2019
• Published date: 01 August 2019
• DOI: http://doi.org/10.1111/jofi.12782

The Journal of Finance R

Peter M. DeMarzo

THE JOURNAL OF FINANCE •VOL. LXXIV, NO. 4 •AUGUST 2019

Presidential Address:

Collateral and Commitment

PETER M. DEMARZO∗

ABSTRACT

Optimal dynamic capital structure choice is fundamentally a problem of commitment.

In a standard trade-off setting with shareholder-debtholder agency conflicts, full com-

mitment counterfactually predicts the firm would rely almost exclusively on debt fi-

nancing. Conversely, absent commitment a Modigliani-Miller-like value irrelevance

and policy indeterminacy result holds. Thus, the content of dynamic trade-off theory

must depend on the commitment technology. In this context, collateral is valuable as

a low-cost commitment device. Because ex ante optimal commitments are likely to be

suboptimal ex post, observed capital structure dynamics will exhibit hysteresis and

depart significantly from standard predictions.

DESPITE DECADES OF RESEARCH, the determinants of capital structure dy-

namics remain elusive. The traditional trade-off and pecking-order theoreti-

cal frameworks provide primarily static predictions that are unable to explain

much of the observed cross-sectional and time-series variation in leverage.

Capital structure is not static, but rather evolves over time as an aggregation

of sequential decisions in which shareholders have an incentive to act strategi-

cally,maximizing the share price at the potential expense of creditors. I analyze

a setting in which investors anticipate this behavior and set prices accordingly.

Building on related work, I demonstrate that when trade is frequent, this price

feedback is sufficient to destroy all benefits from leverage. Optimal dynamic

capital structure thus becomes, fundamentally, a commitment problem. View-

ing it through this lens provides new insights into the dynamics of leverage, its

impact on firm valuation, and especially the importance and value of collateral

and alternative commitment technologies.

My goal in this address is to demonstrate why commitment must be a pri-

mary determinant of capital structure. Specifically, in a standard trade-off

model I show that when the firm cannot commit to its future capital structure

∗Peter DeMarzo is at the Stanford University Graduate School of Business and NBER. This

Presidential Address was delivered to the American Finance Association at the annual meeting in

Atlanta, January 5, 2019. I am grateful to Anat Admati, Jonathan Berk, David Bizer, Philip Bond,

Doug Diamond, Darrell Duffie, Mike Fishman, Zhiguo He, Martin Hellwig, Stefan Nagel, Paul

Pfleiderer, Adriano Rampini, Andy Skrzypacz, Fabrice Tourre, Branko Uroˇ

sevi´

c, and Jeff Zwiebel

for their comments, suggestions, and collaborations. I thank Dan Luo for research assistance, and

Kau’ilani DeMarzo for helpful discussions and endless patience. I hereby declare that, under the

Journal of Finance’s disclosure guidelines, I have nothing to disclose.

DOI: 10.1111/jofi.12782

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1588 The Journal of Finance R

choices, the optimal leverage policy is indeterminate and does not benefit cur-

rent shareholders, providing a Modigliani-Miller-like irrelevance result even

in the presence of tax benefits and other standard frictions. Thus, to capture

the potential benefits of leverage, firms must commit ex ante to constrain their

future choices. These constraints imply that observed capital structures will

be both path dependent and ex post inefficient. As a result, similar firms may

have very dissimilar leverage levels and dynamics, even when both are be-

having optimally. In this context, collateral endogenously emerges as a critical

determinant of capital structure because of its commitment value.

To demonstrate these results, I develop a simple stylized model in which tax

benefits and/or pricing differentials (due to liquidity or market segmentation)

provide potential valuation gains from the use of leverage. These gains must be

balanced against the investment distortions and default costs associated with

excessive leverage. In other words, the model represents a standard trade-off

setting.

In standard static trade-off theory, capital structure is a one-time decision

made at the birth of the firm. In that context, there exists a unique optimal debt

level that the firm should choose. Much of the empirical literature on capital

structure seeks to explain the variation in actual firm leverage based on com-

parative statics from such a model. In a dynamic context, however, the static

predictions of trade-off theory do not apply. Moreover, equilibrium outcomes

depend almost entirely on the commitment technology available to firms. At

one extreme, suppose that the firm can commit ex ante to its future lever-

age decisions. Then, by committing to reduce leverage whenever profitability

declines, the firm can avoid the expected costs of financial distress. In other

words, the “trade-off” of the trade-off theory disappears, and full commitment

implies the following counterfactual prediction: firms should be almost exclu-

sively debt financed and avoid default via a commitment to issue equity and

quickly deleverage in the event of a downturn.1

At the other extreme, suppose that the firm cannot commit ex ante, and in-

stead actively manages its capital structure at each point in time to maximize

the firm’s share price. In this case the leverage ratchet effect, highlighted in

Admati et al. (2018), implies that firms will never choose to actively reduce

leverage.2Instead, they would prefer to issue new debt even when doing so

would be detrimental to total firm value. In anticipation, creditors raise their

required yield even when leverage is low, making debt issuance less attractive.

Drawing on the methodology in DeMarzo and He (2019) and DeMarzo, He,

and Tourre (2019) (hereafter, DH19 and DHT19), I show that when the firm

borrows using unsecured debt, this behavior fully dissipates any funding cost

advantages of debt. In particular, although the firm actively manages lever-

age toward a target level, the expected rate of debt issuance raises the credit

1In theory, with full commitment default should never occur unless the firm’s value drops

instantaneously to the point of insolvency. In practice, firm value declines gradually, with firms

often increasing their total indebtedness during the period leading up to bankruptcy.

2See also Bulow and Rogoff (1991) and Bizer and DeMarzo (1992) for related results in the

context of sovereign or individual borrowing.