In economic downturns, loans issued in better times can weigh on struggling businesses and their lenders. The abundance of loans can create a debt overhang that causes lenders to pull back—and the ensuing credit crunch can make it harder for businesses to grow, or even to repay their debts.

Why don’t lenders renegotiate these loans? Research by a group of Chicago Booth economists—Douglas W. Diamond, PhD candidate Yunzhi Hu, and Reserve Bank of India Governor Raghuram G. Rajan—suggests that the problem lies in part with controlling corporate management.

During boom times, lenders rely on high asset values to secure their investments. They can recoup their money if, for example, borrowers are stressed, by selling the underlying assets. A lender’s loan is well securitized as long as there are willing and able buyers in the market for its borrower’s assets. If the assets need to be repossessed or resold in a boom time, when there are many potential buyers, company management is unlikely to be critical to the process.

During downturns, however, when asset sales are few, the cash flows generated by those assets become more important in determining recovery. That’s where firm managers come in, as they have more immediate control over the cash flows that are made available to creditors. “It is the change in the nature of the control rights that makes it so hard to renegotiate debt efficiently, and causes the debt buildup to have long-drawn adverse effects in the downturn,” the researchers write.

Managers have opposing incentives during this process. As the researchers note, managers can make their companies’ cash flows more pledgeable to investors (and potential buyers), for example, by improving accounting standards and transparency; setting up escrow accounts and monitoring arrangements; including debt covenants and conditions on dividend payments; eliminating waste; or even standardizing managerial procedures to make managers easier to replace—so as to prevent excessive management pay.

But such actions can also hurt managers if there is no need to raise money through asset sales. Managerial jobs may be more secure as well as cushier without buyers for their companies. Also, the changes they make to appeal to new buyers or investors can also make it easier for existing creditors to collect more money.

The researchers describe how these opposing incentives can drive cycles of strong lending followed by credit crunches. Generally, pledgeability is neglected in good times as the ease of asset sales supports borrowing. Financial capacity falls during bad times as asset sales dry up. Nevertheless, creditors may not write down their debt because they bank on greater debt recovery if cash flows are made more pledgeable. This may require financiers, even those who know little about the industry, such as private equity, buyout firms, and vulture funds, to take control of the firm for a while and enhance the pledgeability of cash flows. Eventually, when the industry recovers health, industry insiders can buy the firm from the financiers, taking advantage of the enhanced pledgeability to raise the necessary funds and resume control. And so it goes.

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