Subprime Mortgage Loans and Financial Crisis - Essay Example

?Finance and Accounting Introduction The United s suffered a severe financial crisis in the first decade of the twenty-first century. Originating in the United States in 2007, the crisis had spread rapidly to the other parts of the world (Aubuchon and Wheelock, 2009). The European countries were hit hard by the subprime crisis of 2007. The origin of the financial crisis was rooted to the situation in which the mortgage loans were defaulted and the debt instruments backed by such loans failed (Mizen, 2008). As an ultimate effect of the crisis financial markets in the US were disrupted along with which the financial markets of Europe and other countries were also adversely affected. The capital structures of the companies were affected strongly since the availability of debt capital financing as well as equity capital financing declined considerably. Under influence of the financial crunch firms reduced security issuance and financial institutions reduced issuance of loans by a large extent (Fosberg, 2012). Among many consequences, the major consequence faced by the firms was in their capital structure. The defaults of mortgage loans led to significant increase in debt amount of the firm’s capital structure. Results of recent research show that between the years 2006 and 2008 the market debt ratio (MDR) of the firms increased on average by 5.5 percent (Fosberg, 2012). The financial crisis was supplemented by severe recession in the US economy which boosted the soaring market debt ratios of the firms. If the effect of recession is removed then debt accumulation of the firms solely due to the financial crisis has been found to be approximately 5.1 percent (Fosberg, 2012). This affirms the severity of the effect of the financial crisis on debt accumulation by the corporations and their capital structure. The purpose of this study is investigate the impacts of the subprime mortgage crisis of 2007 on corporate capital structures and to present a detailed analysis of how the firms’ choice of capital structure changed under influence of the financial crisis. By evaluating the knowledge gathered from the studies made for this research it has been found that the recession was created by the financial crisis. In order to identify the effects on capital structure made by the financial crisis, different factors were adjusted, such as, reduced profitability of the firm that resulted from recession. Although the effects cast by the financial crisis were major, the effects of recession were also huge and put significant effects on the debt capital financing by the firms. This paper evaluates the effects of the crisis critically from the points of view of three most recognized theories of capital structure and provides explanation with the help of real examples of companies that have suffered the impacts of the crisis. Literature Review Brigham and Ehrhardt (2002) explain in their book, Financial Management, that capital structure is one of the important instruments that allow firms to maintain control of its administration. Improper capital structure might be fatal for any organization. Capital structure relates to the various components of the financial policies made by the firms regarding investment activities (Jones, 2011). It is related to bankruptcy risk that high leverage firms might face during financially instable times. While the use of more leverage magnifies returns for equity holders, the downside threat of holding a large amount debt is very high. Therefore, firms should carefully consider their capital structure in their financial policies (Gunay, 2002). Debt financing The proportion of debt financing in the capital structure of a firm differ between firms and also depend on the existing capital structure. The type of debt incurred and the extent up to which the debt is extended are decided by the factors such as the cost of the debt and its availability to the firm. Without taking bonds into consideration, debt financing can be categorized in to two types, namely, financial credits and trade credits (Balsari and Kirkulak, 2010). It is important to have a developed financial and capital market for sustenance of firms having high leverage. Since they are very close to the situation of financial risk, cost burden for the firms for their debts is very high. This debt would be even higher in the post crisis period than in the pre crisis period (Gunay, 2002). Theories of capital structure The theory of Modigliani and Miller (1958) is one of the modern theories of capital structure. Following these authors, many other researchers put forth several theories of capital structure. This paper examines the financial of 2007 in light of the three most recognized models; static trade-off model, pecking order theory and the MM theory. These three theories have been discussed elaborately for an in-depth understanding of the theories and to relate these theories with the occurrence of the financial crisis. The static trade-off theory In the static trade-off theory, the organization is believed to aim at a target debt-equity ratio and move towards achieving the ratio gradually. This theory foretells an optimal debt level by drawing a balance between tax advantages enjoyed on borrowed amounts of money and the costs incurred on account of the financial stress suffered by the firm when it has made huge amounts of loans (Shyam-Sunder and Myers, 1999). Borrowing leads to increased financial risk that amounts to agency cost and risks of bankruptcy if the firms go uncontrollably on debt financing. However, if a firm makes debt financing, the interests paid by the firm are tax-deductible. Given that companies have to pay corporate tax on the equity income, debt financing is viewed as a more advantageous way of financing than equity financing. But, taking into account the financial risk involved with making a big proportion of debt, debt financing does not seem less expensive than equity. Therefore within the framework of static trade-off between debt and equity financing, organizational leaders consider the company’s debt-equity decision by making a trade-off between the extent of benefits earned from the “interest tax shields of debt and the costs of financial distress” (Niu, 2008, p. 134). The composition of the capital structure is made in such a way that it might move towards the target debt-equity ratio and mirror tax rates, profitability, type of assets involved, bankruptcy costs and overall business risk. In effect any firm that focuses on value-maximizing aims to strike a balance between the benefit that can be earned and the cost that has to be incurred on account of the resource borrowed by the company while making its investment plans (Myers, 1984). The marginal present value of interest tax is balanced against the costs arising from financial stress. However, according to Jonathan Baskin (1989) there are various published studies that have been established, through statistical investigation that a prominent inverse relationship exists between debt ratio maintained by the firm and its profitability. Baskin (1989) claims that these studies are the testimony of the fact that the static trade-off theory is highly irrelevant for determination of capital structure. Weill (2002) and Campello (2003) have also supported this point of view. Pecking order theory Presence of asymmetric information allows the managers in an organization and other insiders to possess confidential information regarding the distinctive characteristics of the returns yielded by the firm and various investment opportunities that are visible to them but are not known to outside investors. Asymmetric information might lead to inefficiencies in the investment decision of the firm. Due to the presence of asymmetry in the information possessed by the insiders of the firm and the outside investors, equities issued by the firms for financing new investments might be under-priced in the market if compared with the real state of capital structure of the organization. In the theory of asymmetric information, managers are believed to act in a way to safeguard the interest of the existing shareholders rather than optimizing the benefit of existing as well as new shareholders. Pecking order theory of capital structure refers to hierarchical financing of firms. This theory advocates that firms make financing decisions in accordance to the prevalence of information asymmetry between the organization and the potential financiers. According to Myer (1984), firms favour internal financing over external financing. In cases when external financing has to be adopted then firms choose to incur debts than to raise capital by issuing equity. Myer (1984) emphasises that it is because internal funds (or retained earnings) do not incur flotation costs and necessitate no additional revelation of financial information related to the company’s investment opportunities or potential profits for which managers give more preference to retained earnings than to debt. MM Theory The Modigliani-Miller Theorem is regarded as the cornerstone of the modern theory of capital structure (Villamil, 2012). According to Modigliani and Miller (1958) under certain conditions the financial decisions of the firm are not affected by its capital structure. It is assumed in the MM framework that the capital market is perfect. This implies that all agents in this market, whether outsiders or insiders, possess symmetric information, transaction costs are not present and there is no existence of distortion effects of taxation. In this framework the internal funds can be perfectly substituted with the external funds and vice versa and choice between equity and debt is irrelevant to the firm’s profitability. The MM theory says that if these suppositions are relaxed, the capital structure of the firm would no more hold enough relevance to firm value. This is an ideal situation and in the real world scenario the above mentioned assumptions do not hold. Causes of the financial crisis Modigliani and Miller theory The system of assessing the central financial parameters of companies at preset rests on the series of Nobel Prize winning works by Modigliani and Miller (1958, 1963, and 1967). It should be noted in this context that the MM theory has been explained under an array of assumptions that act as limitations for the model. It imparts a rough character to the model and establishes a weak link with the economy of the real world. Despite these limitations and dissimilarities with the real world, the MM theory has been widely used. While some of the restrictions had been removed by the authors themselves, many of the restrictions still exist that lead to inaccurate quantitative estimates. The absolutization of the MM theory leads to neglect of several aspects of the market. This significantly lowers the estimates of the weighted average cost of capital and of value of equity for the company. It is inaccurate when compared with the actual estimates. Due to this underestimation the values of market capitalization of the firm are overestimated (Brusov et al, 2012). Myers (2001) suggested that the theory propounded by Modigliani–Miller provides the lowest bound estimate of the average cost of capital. Incorrect estimations of the basic financial parameters of the companies make way for underestimation of financial risks faced by the company and its feasibility of the company, thereby creating difficulties for the managers to make suitable management decisions. This has been one of the implicit reasons behind the financial crisis (Brusov et al, 2012). Such failures of the enterprises on making good financial management led by huge proportion of debt and small proportion of equity had a deep economic significance in the capital structure of the companies and played a prominent role in the crisis. This frankly contradicts the proposition made by the neo-classical MM theory. According to the theorem, leverage plays no important role in the process of the company’s market evaluation. However, in the absence of symmetric information and the presence of transaction costs, the omnipresence of the importance of leverage has been felt by the economy during the period of financial crisis. High level of debt or leverage has entailed the hazard of bankruptcy and insolvency. According to some observers that possessed enough relevant information, companies consciously neglected the importance of equity financing since they were driven by the objective of maximizing the rate of return. External effects, such as risks, have been overlooked by the firms, since the immediate effects of these costs would be felt by the tax payers, creditors and the outsider stakeholders of the organization (Tilly, 2012). Adrian and Shin (2008) shows that at the time of subprime boom firms’ leverage increases. However, during the financial crisis in the United States in the year of 2007 the exact opposite of subprime boom prevailed. This provoked the enterprises to make alterations in capital structure of the firms (Leeuwen, 2011). There are four fundamental factors that determine capital structure of a firm; size of firm, growth possibility of the firm, its profitability and finally the firm’s tangibility. Empirical results from different studies suggest that the factors like growth possibility of the firm and its tangibility possess significant relevance with the firm’s leverage and are particularly important at the time of financial crisis. Size of the firm holds more importance with regard to book leverage during crisis and rather less importance with market leverage. Although size of the firm has been found to have a positive relationship with the capital structure of the firm, the exact relationship has not been deciphered (Rajan and Zingales, 1995; Titman and Wessels, 1988). The relationship of leverage with profitability is the opposite. Size of the firm is expected to act as a proxy against the possibility of bankruptcy of the firm. The bigger the firms, the less susceptible it is to financial crisis and bankruptcy. Profitability, on the other hand, holds less importance with book leverage but more importance with market leverage at the time of crisis. Thus it vividly shows that the 2007 financial crisis has put considerable influence on the structure of capital and pattern of investment decision of enterprises in the US (Leeuwen, 2011). Pecking order theory The pecking order theory advocates that firms put more preference on internal funds rather than on external funds. In their decision to use of external funds, managers like to follow debt financing more than equity. Existence of information asymmetry in almost all facets of corporate financing complicates the facility enjoyed by the managers to maximize value of firms significantly. For firms of good market standard it might pose a challenge for the firm’s insiders to convince their creditors and investors about the actual quality of the organization. This is of sheer importance particularly when such activity holds concern for future performance. If the firms fail to convince the investors directly, the investors would seek indirect evidences to make use of them in building their perception of performance by the firm. Evaluation of the firm’s performance by investors is a highly sensitive act, and any kind of asymmetry in information might lead to the development of wrong perception. Capital structure of a firm is considered important from this point of view (Miglo, 2010). The financial crisis of 2007 had been fuelled by the presence of asymmetric information. Asymmetric information approach to explain financial crisis provides those insights that are hard to account for otherwise. Asymmetry in information leads to economic activity that focuses on the disparity in information held by the parties engaged in a given financial contract. It is known that borrowers are in an advantageous position over lenders in terms of information possession since borrowers have exact and accurate knowledge about the projects to be undertaken by them (Mishkin, 1991). On the other hand, lenders always suffer from informational lack. Such informational disadvantage leads to adverse selection which is similar to the "lemons" problem as was first explained by Akerlof (1970). The situation of US subprime mortgage crisis can be related intimately with this theory. While the capital structure of many of the organizations in the country had been burdened with debt financing, the increase of defaulting borrowers aggravated the situation of crisis. Lenders held lesser information than the borrowers about the borrowers’ credibility which was among the sharp reasons for the fall of these companies. The pecking order theory relates to adverse selection analysis that shows that a disruption had occurred in the financial market of the US and affected economic activity adversely in the aggregate level. Due to the problem of adverse selection significant fall in lending further dampened investment activities in the economy thereby lowering the overall level of economic activity. This has been the cause of the severe recession that engulfed the US and subsequently the global economy in the 2007-2008. The static trade-off theory The basis of financial decisions by big US firms is founded on this theory although the theory has been marked as irrelevant by researchers. Going by this theory the firms have tried to draw a balance between the benefits of tax advantage and costs of high leverage. But in reality, given that companies have to pay corporate tax on the equity income, debt financing has been adopted almost unwisely by the US firms. The interest-tax shield has failed to protect the firms on the advent of the crisis augmenting the overall business risk. Conclusion The subprime mortgage loans have been one of the major causes of the crisis. The financial crisis laid significant impact on the corporate firms and banking institutions in the US. On spreading to other countries it took the shape of global crisis (Kalse, 2008). Firms reduced security issuance and lending was reduced by the financial institutions. The consequence of this market disruption was found in the changes in the capital structure of the companies, which dangerously depended on debt financing. Between the years 2006 and 2008 a recession occurred that increased market debt ratios by almost 5.5%. The debt accumulation has been found to be an outcome of the severe crisis in the financial market. This result is further grounded on the result found later that by the end of 2010 the firms’ capital structure was altered with the recovery of the crisis. The result of this study indicates the system of assessing the major financial parameters of organizations have to be transformed or modified wherever necessary, namely, their market capitalization, value of equity and weighted average cost of capital. This would lower financial risks in future and also prevent future occurrences of financial crises that might endanger the global financial market (Brusov et al, 2012). References Akerlof, G., 1970. The Market for Lemons: Quality Uncertainty and the Market Mechanism. Quarterly Journal of Economics, 84 (August), pp. 488-500. Aubuchon, C. and Wheelock, D., 2009. The Global Recession. Economic Synopses, 22, pp. 1-2. Balsari, C. K. and Kirkulak, B., 2010. Effect of Financial Crises on the Capital Structure Choice: Evidence from Istanbul Stock Exchange (ISE). 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