How Businesses Raise Financial Capital

Bank of Canada Banque du Canada Working Paper 2004-20 / Document de travail 2004-20 Commodity-Linked Bonds: A Potential Means for Less-Developed Countries to Raise Foreign Capital by Joseph Atta-Mensah ISSN 1192-5434 Printed in Canada on recycled paper Bank of Canada Working Paper 2004-20 June 2004 Commodity-Linked Bonds: A Potential Means for Less-Developed Countries to Raise Foreign Capital by Joseph Atta-Mensah Monetary and Financial Analysis Department Bank of Canada Ottawa, Ontario, Canada K1A 0G9 jattamensah@bankofcanada.ca The views expressed in this paper are those of the author. No responsibility for them should be attributed to the Bank of Canada. [...]... by arguing that a country with a large debt overhang suffers in two ways from a fall in economic efficiency First, the high debt-service payments made by debt-laden countries require high tax rates that discourage capital formation and the repatriation of capital Second, since governments of heavily indebted LDCs are responsible for making the debt-service payments and, therefore, those payments appear... their debts and the potential challenges they face Caballero (2003) calls on the IMF to set up a Contingent-Markets Department and a Crisis Department Caballero’s proposal, which is close to that of Williamson (2000), calls for the Contingent-Markets Department to be responsible for identifying a country’s sources of capital- inflow volatility that are potentially contractible The Crises Department would... notes Each note had a lifetime of five years and paid an annual coupon rate of 9 per cent As Fall (1986) explains, each note was expected to pay the face value (principal), the accrued interest, and a contingent interest on the maturity date The contingent interest, which had a feature of a cap, was defined as the increase over US$668.96 of (i) the average crude oil price of 18.5 barrels of crude oil for. .. accepted in the financial markets as the “Giscard.” The “Giscard” carried a 7 per cent nominal coupon rate and a redemption value indexed to the price of a 1 kilogram bar of gold The bearers of the “Giscard” were protected by a safeguard clause, which stated that interest and the face-value payments would be indexed to a 1 kilogram bar of gold should the French franc lose its parity with gold and other currencies... from Price Volatility For years, LDCs have been faced with colossal foreign debt The retirement and/or servicing of this debt has been a major problem for LDCs and their creditors due to the volatility of the prices of export commodities and hence their export revenues The crisis created by these debt “overhangs” has drawn academics and practitioners to research ways and means for creditors to receive,... itself to export to that country a specific amount of commodities at an agreed date Under this arrangement, LDCs are protected against export-commodity price risk Furthermore, the transactions made under this arrangement are similar to the importing LDC entering into a mixture of spot and forward contracts with the developed economies Hence, LDCs enjoy similar advantages offered by forward contracts 3.4... instantaneous average return of holding one unit of the export commodity, σp is the instantaneous standard deviation of the rate of change of the commodity price, and dzp has a standard normal distribution with a mean of zero and a variance of dt Note that αp and σp may be functions of P and t For the purpose of this exercise, however, they are How Businesses Raise Financial Capital How Businesses Raise Financial Capital By: OpenStaxCollege Firms often make decisions that involve spending money in the present and expecting to earn profits in the future Examples include when a firm buys a machine that will last 10 years, or builds a new plant that will last for 30 years, or starts a research and development project Firms can raise the financial capital they need to pay for such projects in four main ways: (1) from early-stage investors; (2) by reinvesting profits; (3) by borrowing through banks or bonds; and (4) by selling stock When owners of a business choose sources of financial capital, they also choose how to pay for them Early Stage Financial Capital Firms that are just beginning often have an idea or a prototype for a product or service to sell, but few customers, or even no customers at all, and thus are not earning profits Such firms face a difficult problem when it comes to raising financial capital: How can a firm that has not yet demonstrated any ability to earn profits pay a rate of return to financial investors? For many small businesses, the original source of money is the owner of the business Someone who decides to start a restaurant or a gas station, for instance, might cover the startup costs by dipping into his or her own bank account, or by borrowing money (perhaps using a home as collateral) Alternatively, many cities have a network of wellto-do individuals, known as “angel investors,” who will put their own money into small new companies at an early stage of development, in exchange for owning some portion of the firm Venture capital firms make financial investments in new companies that are still relatively small in size, but that have potential to grow substantially These firms gather money from a variety of individual or institutional investors, including banks, institutions like college endowments, insurance companies that hold financial reserves, and corporate pension funds Venture capital firms more than just supply money to small startups They also provide advice on potential products, customers, and key 1/9 How Businesses Raise Financial Capital employees Typically, a venture capital fund invests in a number of firms, and then investors in that fund receive returns according to how the fund as a whole performs The amount of money invested in venture capital fluctuates substantially from year to year: as one example, venture capital firms invested more than $27 billion in 2012, according to the National Venture Capital Association All early-stage investors realize that the majority of small startup businesses will never hit it big; indeed, many of them will go out of business within a few months or years They also know that getting in on the ground floor of a few huge successes like a Netflix or an Amazon.com can make up for a lot of failures Early-stage investors are therefore willing to take large risks in order to be in a position to gain substantial returns on their investment Profits as a Source of Financial Capital If firms are earning profits (their revenues are greater than costs), they can choose to reinvest some of these profits in equipment, structures, and research and development For many established companies, reinvesting their own profits is one primary source of financial capital Companies and firms just getting started may have numerous attractive investment opportunities, but few current profits to invest Even large firms can experience a year or two of earning low profits or even suffering losses, but unless the firm can find a steady and reliable source of financial capital so that it can continue making real investments in tough times, the firm may not survive until better times arrive Firms often need to find sources of financial capital other than profits Borrowing: Banks and Bonds When a firm has a record of at least earning significant revenues, and better still of earning profits, the firm can make a credible promise to pay interest, and so it becomes possible for the firm to borrow money Firms have two main methods of borrowing: banks and bonds A bank loan for a firm works in much the same way as a loan for an individual who is buying a car or a house The firm borrows an amount of money and then promises to repay it, including some rate of interest, over a predetermined period of time If the firm fails to make its loan payments, the bank (or banks) can often take the firm to court and require it to sell its buildings or equipment to make the loan payments Another source of financial capital is a bond A bond is a financial contract: a borrower agrees to repay the amount that was borrowed and also a rate of interest over a period of time in the future A corporate bond is issued by firms, but bonds are also issued by various levels of government For example, a municipal bond is issued by cities, a state bond by U.S states, and a Treasury bond by the federal government through the 2/9 How ...[...]... learned the lessons of the 1930s • 1 • 2 • THE COST OF CAPITALISM When faced with a collapse of the financial system, any and all steps are taken to stabilize the situation But policies leading up to the crisis of 2008, enacted over the past 25 years, make it abundantly clear that economists, elected of cials, and central bankers did not learn the lessons of the 1920s The record of the U.S economy over the. .. on Main Street and the Boom and Bust Cycle of the Past 25 Years In years to come a casual reader of economic history may find it hard to piece together how things so quickly went from serenity to panic as the first decade of the new millennium came to a close Paradoxically, the seeds of the 2008 crisis can be found in the widespread acceptance of the notion that the U.S economy, over the previous decades,... legal access to the safety nets put in place for commercial banks in the aftermath of the Great Depression It is not hyperbole, therefore, to lay the multi-trillion-dollar bill for the 2008 financial system bailout, and the deep recession of 2008-2009, at the doorstep of misguided confidence in the infallibility of free markets Is this book, therefore, simply an indictment of Alan Greenspan and Ben Bernanke?... winter of 1990, on the eve of the first U.S war with Iraq, I lunched with a close friend and colleague, Paul DeRosa, a fellow economist Over the course of the meal I explained that I intended to publish a radical forecast for the U.S economy The centerpiece of my outlook was the S&L crisis and the high debt levels of U.S households Oil prices and the Mideast, I was convinced, were sideshows The headline for... in the pages that follow, mainstream policy makers, economists, and central bankers spent the past 25 years willfully denying these two self-evident truths The global financial crisis of 2008 and the 2008-2009 worldwide recession, this book will make clear, can be laid at the doorstep of these painful omissions of economic fact Amidst the wreckage of the recent crisis, calls for expansive retooling of. .. recession was baked in the cake, and that the snowballing problems in the financial system would require both dramatic additional Fed ease and some form of direct federal intervention Just as in 1990, it turned out, my understanding of Hy Minsky’s work put me lightyears ahead of the consensus thinkers in the months leading up to the 2008 crisis But by the summer of 2008, as the world flirted with an economic... Crisis, and End 6 • T HE C OST OF C APITALISM Figure 1.2 010099989796959493929190898887868584 40000 30000 20000 10000 9000 100 90 80 70 Index, 6-Month Moving Average, Log ScaleIndex, 1-Month Moving Average, Log Scale Japan’s Stock Market Collapse and the Lost Decade for Its Economy Japan: Nikkei Stock Market Index vs. Industrial Production Nikkei Stock Price Index (L) Industrial Production (R) economy did not reduce wild Wall Street swings. In succession, we wit- nessed the 1987 stock market crash, the S&L crisis of the early 1990s, the Long-Term Capital Management meltdown, and the spectacular technology boom and bust dynamic of the late nineties. In Asia we had two bouts of financial market mayhem: Japan’s early 1990 collapse (see Figure 1.2) which was followed a few years later by the panic that swept through much of the newly emerging Asian economies. As it turned out, this daunting list of financial market upheavals were simply dress rehearsals for what was to later occur. The unprece- dented rise and then swoon in U.S. residential real estate catalyzed a global financial market meltdown of unprecedented proportions. And the cost around the world includes a deep global recession. Any notion that the Great Moderation was a permanent fixture died in 2008. How did things go from so good to so bad in such short order? May- hem on Wall Street following serenity on Main Street, I contend, is no coincidence. Instead, quiescence on Main Street invites big risk taking on Wall Street. And big wagers create the potential for big prob- lems from small disappointments—despite the reality of a moderate economic backdrop. And therein lies the paradox. Goldilocks growth on Main Street spawned risky finance on Wall Street and, ultimately, the crisis of 2008. Mainstream economists missed this dynamic because they were so excited about low wage and price inflation. Thus, a legion of con- ventional analysts simply failed to recognize that the inflationary boom and bust cycle of the 1970s had been replaced by an equally violent Wall Street driven cycle. Hyman Minsky, a renegade financial economist of the postwar period, would be amused if he were alive today. Minsky, throughout his professional life, insisted that finance was always the key force for mayhem in capitalist economies. He put it this way: Whenever full employment is achieved and sustained, busi- nessmen and bankers, heartened by success, tend to accept larger doses of debt financing. During periods of tranquil expansion, profit-seeking financial institutions invent and reinvent “new” forms of money, substitutes for money in portfolios, and financ- ing techniques for various types of activity: financial innovation is a characteristic of our economy in good times. 1 Minsky argued that this phenomenon guaranteed financial insta- bility. He developed a thesis that linked the boom and bust cycle to the way in which investment is bankrolled. He made two simple The Postcrisis Case for a New Paradigm • 7 observations. First, the persistence of benign real economy circum- stance invites belief in its permanence. Second, growing confidence invites riskier finance. Minsky combined these two insights and asserted that boom and bust business cycles were inescapable in a free market economy—even if central bankers were able to tame big swings for inflation. Much of this book critically reexamines the last several decades with an eye toward the interplay of Goldilocks growth expectations versus increasingly risky finance. I make the case that U.S. recessions in Recall that when Hanna boarded the bus for Phoenix, she had handed her house to her bank. The bank, at that moment, had a house that it could sell for $538,000. But it loaned Hanna $588,000. Thus, the bank lost $50,000 on the deal. Banks are in the business of borrowing money from some and lending to others. The value of what they owe—their liabilities—is always supposed to be lower than the value of what is owed to them—their assets. When they subtract their liabilities from their assets, the remainder is their equity. The problem for banks arises if the banks have lots of Hannalike loans in their portfolio. As the pie charts in Figure 3.2 make clear, that is exactly what happened. In 2001 nearly 60 percent of mort- gage borrowers looked like Hal, and less than 10 percent were involved in risky finance. By 2006 fully one-third of home buyers opted for risky mortgage products. Moreover, a large number of homeowners with no moving plans decided that Hanna had the right strategy. If we combine refinancing with risky home buying finance, we discover that by 2006, nearly half of the housing-related financ- ing was done with risky loans. When the bank forecloses, it replaces one asset with another. The loan to Hanna is replaced by the house, since the loan has gone bust and the bank now owns the home. But the loan was for $588,000, and the house is worth $538,000. If lots of home loans go the way of Hanna’s loan, then the total value of the bank’s assets falls below the total value of its loans to other people—its liabilities. When a bank’s liabilities are larger than its assets, it is bankrupt. When banks, and investors in those banks, simultaneously discover that bank assets are worth much less than previously thought, we have hit the Minsky moment. At that juncture, if we force banks to 34 • T HE C OST OF C APITALISM The ABCs of Risky Finance • 35 Figure 3.2 Risky Finance in Mortgages 2001 Jumbo Prime 20% Subprime 5% Alt-A 3% FHA & VA 8% Home Equity Loans 6% Conventional, Conforming Prime 58% 2006 Conventional, Conforming Prime 33% Home Equity Loans 14% FHA & VA 3% Alt-A 13% Subprime 20% Jumbo Prime 16% 2007 Jumbo Prime 10% Subprime 3% Alt-A 6% FHA & VA 7% Home Equity Loans 13% Conventional, Conforming Prime 61% revalue their assets to current market prices, it becomes apparent that they are insolvent. At such moments, Minsky liked to talk about the “parade of walking bankrupts” that dotted the banking commu- nity landscape. But we don’t drive all banks into bankruptcy. We collapse inter- est rates. We engineer forced mergers. We come to the banks’ res- cue with expensive bailouts. Policy makers, thankfully, learned their Source: Inside Mortgage Finance (by dollar amount); 2007 data is as of December 31, 2007 lessons from the 1930s. There is a paper trail of furious governmen- tal efforts, cycle to cycle, each aimed at protecting the banking system. The most important two lessons to take away from the saga of Hanna and Hal? When good times persist, risky finance is the logi- cal outcome. Risky finance, in turn, sets both the borrower and the lender up for mayhem somewhere down the road. 36 • T HE C OST OF C APITALISM • 37 • Chapter 4 FINANCIAL MARKETS AS A SOURCE OF INSTABILITY Those of us who looked to the self-interest of lending institutions to protect shareholder’s equity (myself especially) are in a state of shocked disbelief. —Alan Greenspan testimony, October 23, 2008 I’m shocked, shocked to find that gambling is ... nominating alternative members of the board How Firms Choose between Sources of Financial Capital There are clear patterns in how businesses raise financial capital These patterns can be explained... federal Securities and Exchange Commission 6/9 How Businesses Raise Financial Capital Key Concepts and Summary Companies can raise early-stage financial capital in several ways: from their owners’... Clear It Up feature on Lehman Brothers shows How did lack of corporate governance lead to the Lehman Brothers failure? 5/9 How Businesses Raise Financial Capital In 2008, Lehman Brothers was the