Loans and homes

In the period 1972-73 there was a fateful coincidence. Three developments happened in a short span of time, and together they spawned a revolution in corporate finance. The pressures on corporate financial managers until that time were intensifying, but the events of 1972-73 ratcheted up the intensity.

The events began when Black and Scholes published a formula for valuing the price of an option. This formula used more advanced mathematics than the three breakthroughs that preceded it. Time might have elapsed before the formula would have come into widespread use, but the other two events put the formula to work almost immediately.

Hewlett Packard began marketing a high-end hand-held calculator that could find solutions to the formula quickly. The calculator was expensive, and many scientists did not buy it because they could solve formulas on their mainframe computers. But the third event was that the Chicago Board of Trade launched a new category of product, options on common stocks. These were different from futures contracts, which were what the Board of Trade had offered before. These options on common stocks were difficult to value, and the young traders who acted as market makers knew that. Some of them found the Black-Scholes formula and the new Hewlett Packard calculators, and as soon as they had those two tools, they were able to buy options that were underpriced and sell options that were overpriced.

Other market makers who did not use those two tools were trying to do the same thing, and their methods were less accurate. Option trading is a fast-moving game, and a market maker can make hundreds or thousands of trades a week. The people who used the formula and the calculator had an advantage, making fewer errors and higher average profits on each trade. In a very short time the formula and the calculator were absolute requirements for survival.

Trading volume in options grew rapidly. Portfolio managers and individual investors found ways of using the Chicago Board of Trade options. The options allowed them to alter the risk characteristics of their portfolios and to stabilize the rates of return their portfolios delivered. By using the options correctly, a sophisticated investor could buy risky securities with high expected yields but high volatility and convert them into a portfolio that was quite stable. The options added stability to portfolios that had already been made as stable as Markowitz’s and Sharpe’s techniques could make them.

Corporate treasurers saw what was happening, and some of them began to investigate ways of applying the new options to improve the financial stability of their companies. For them, the new options were another kind of hedging product. There had been hedging products before the new options came along. For example, foreign exchange hedging products had existed for centuries, and corporate treasurers had used them extensively. There had also been a wide range of insurance policies, and corporate treasurers had bought those to protect their companies.

Corporate treasurers as a group were slow to take advantage of the new options. They faced restrictions and had to wait until new hedging products appeared. The success of the Chicago Board of Trade options showed that there is demand for new hedging products, and financial institutions began to offer innovative products. The result has been called the Derivatives Revolution.

The term derivative is a catch-all that includes options, futures contracts, and swaps. All these products have some common elements, despite having evolved separately. They all protect against one risk or another. In that sense they are all like specialized insurance policies that pay off when some specific event occurs. A company can buy them individually or in combinations, or it can sell one and use the proceeds to buy another. As these products began to appear in large numbers and variations, corporate treasurers had a complicated but potentially rewarding task. They had to choose which ones to use, and they had to keep reviewing the ones they were using, and replacing some of the ones that expired. The name of the task is risk management.

Companies that are good at risk management show steady growth despite the volatility of the industry sectors they operate in. They use risk management products to smooth the ups and downs of the underlying commodity cycles. In that fashion they deliver stable, growing returns to shareholders. Among investors there is always a strong demand for shares that do not fluctuate violently, but instead rise steadily, with few bumps along the way. The companies that are able to deliver that performance succeed, and their shares rise in the market. The companies quickly gain leadership status and often are able to raise enough capital to buy their competitors. Stock market performance gives them the advantage they need to acquire dominance in their industry sector.

The Markowitz technique gave a method of figuring out how risky each security is, relative to another individual security, but it did not give a calibration for the risk of each security vis-à-vis a standard benchmark of risk. Beginning in 1966, Sharpe and three other writers put forward methods that calibrate how risky an individual security is. They distinguished two types of risk: a type that can be eliminated by diversification, like the vulnerability to fluctuations in the price of oil in our earlier example, and risk that cannot be eliminated by diversification. They called these two types of risk unsystematic and systematic, or diversifiable and undiversifiable. The model they put forward is called the Capital Asset Pricing Model. Its key parameter is the measure of risk of an individual security, and they used the Greek letter beta to represent that.

The Capital Asset Pricing Model was a breakthrough because it simplified Markowitz’s method. After it came out, more portfolio managers could apply scientific portfolio selection criteria. It helped in two other ways that were equally important. It allowed independent observers to calibrate whether one portfolio manager was taking more risk than another. In the past, there had been star managers who took big risks and sometimes made big returns for their clients. The Capital Asset Pricing Model allowed observers to tell whether these star managers had achieved their superior performance by selecting mostly risky stocks or by selecting safer stocks. Managers who take bigger risks sometimes do well, but are more likely to have periods of very bad performance. The other way it helped was to give analysts a formula that could predict the effect on a company’s stock price if it acquired another company, sold off a division, issued bonds and then bought back its common stock, or took any other major step.

This breakthrough accelerated several trends in portfolio management and corporate financial management. It gave the scientific portfolio managers another advantage over the old portfolio managers who relied on rules of thumb. It broke the remaining ties of loyalty that were still remaining between stockholders and corporate treasurers. Professional portfolio managers attracted more money, and individual investors handed over more and more of their assets to professionals and paid them to manage the assets. Corporate treasurers learned quickly that they had to offer securities with attractive features, or they would have difficulty placing the securities. Buyers were experts, and they eyeballed each new issue critically before deciding whether to buy any of it. There were no longer as many gullible buyers, no captive buyers, and no buyers who would subscribe to a new issue for reasons of loyalty. The new formula made it too easy to compute the correct price of the security, and if the company tried to get a price higher than that, the buyers would shun the issue.

The next breakthrough happened in 1958. The typical corporation gets money by borrowing it and by selling shares. Different corporations use these two sources of financing, debt and equity, in different proportions. The old rule of thumb was that companies with stable cash flow could rely more on debt financing, and companies that were more cyclical had to use less debt financing and rely more on funds from shareholders. There was no satisfactory proof of this rule of thumb, besides the experience of the marketplace. Two writers, Modigliani and Miller, sought to understand why companies choose to obtain capital from these two sources in specific proportions. They observed that companies appear to have an ideal mix of debt and equity financing in mind. The mix of debt and equity financing is called capital structure, and when a company sets a target for its mix of debt and equity financing, finance experts say it is making a capital structure decision.

To probe the underlying rationale for choosing debt or equity financing, Modigliani and Miller used a method of analysis that in mathematics is called proof by contradiction. They started by asking whether it makes any difference whether the company uses debt financing or equity financing. They asserted, as a way of challenging the old rule of thumb, that companies would not be worth any more or any less if they were financed 100 percent with debt or 100 percent with stockholders’ equity. Then they began testing this bold assertion to see whether it is true or false.

Their initial assertion triggered a healthy debate among finance experts, and by 1962 a much deeper understanding of the capital structure decision had emerged. The debate revealed that capital structure does matter – a company can be worth more if it uses debt and equity financing in the appropriate proportions. The debate also revealed that if a company is using too much equity financing, it can raise its stock price by borrowing money and then using the money to buy back some of its shares in the open market. This maneuver changes its capital structure and raises its ratio of debt to equity financing. Many companies have done this, and the maneuver is now called a common stock buyback.

Many seasoned executives were skeptical of this maneuver. They did not see why the company should be worth more after it alters its mix of debt and equity financing. They thought the company’s stock price went up only because the company was buying its own shares. Some of them believed the maneuver was a manipulation and denied that it creates real value. As the debate among experts continued, however, these executives finally had to admit that capital structure does make a difference. There are many ways of understanding why optimizing a company’s capital structure creates value. All of these ways rest on a premise that needs to be stated clearly at the beginning. The premise is that investors are not buying the whole company; they are buying only small amounts of its stock or bonds. If an investor is buying the whole company, its value depends on how the company will fit with the investor’s other businesses and operations. An investor who is buying only a small amount of the company’s stock or bonds thinks of different issues. If the investor is buying the company’s bonds, he or she judges how risky the bonds are and tries to assess whether the projected yield is high enough to compensate for the risk. If the investor is thinking of buying the company’s common stock, he or she judges how risky the stock is by itself and how risky it will be in his or her portfolio. Once this premise is stated, the assertion that a company’s capital structure affects its value sounds more reasonable. Once everyone agrees that the entire company is not for sale, and that it is a going concern, then everyone agrees the company will raise new funds from time to time. The buyers will be passive portfolio investors, who will not try to exercise control over the company, and who will only put the securities in their portfolios.

Then it makes sense to talk about how many bonds the company should try to sell during a given time interval, relative to the amount of stock it has outstanding. The company finances itself by offering two classes of securities: bonds targeted to risk- averse investors and common stock targeted to risk-tolerant investors. It puts out amounts of each type according to the demand. If it tries to put out too many bonds, investors will refuse to buy or will demand a higher coupon rate. If it puts out too much stock, the market price of the stock will decline.