Chicago Booth Review Podcast Do All Loans Have a ‘Pound of Flesh’ Clause?

Raghuram Rajan: So asset values matter. It's just that they're in the background. So if you have a boom and bust, even in a developed country, you will have fluctuations in your ability to borrow and you'll have really bad consequences if you've over-borrowed and asset values plummet.

Hal Weitzman: Almost all companies borrow money. Some of it's secured by assets they own, other debts, unsecured. But is that distinction meaningful in the real world? Welcome to the Chicago Booth Review Podcast, where we bring you groundbreaking academic research in a clear and straightforward way. I'm Hal Weitzman, and today I'm talking with Chicago Booth's Raghuram Rajan about his research into corporate debt. In the past century, the amount of unsecured debt has soared. What's the significance of that and is it really unsecured? Welcome to the Chicago Booth Review Podcast.

Raghuram Rajan: Thanks for having me.

Hal Weitzman: We're here to talk about your research on debt and all companies have debt, and broadly there are two kinds of debt, right? There's secured debt and there's unsecured debt. What's the difference? Remind us between the two.

Raghuram Rajan: Secured debt is when I attach an asset to the debt and say, "If I default on my debt, you can take the asset." So for example, when you lease a car, basically the debt is secured by the car and if you stop car payments, somebody comes and takes your car away. Similarly, for firms, a lot of secured debt against property plant and equipment, you have debt against receivables. So that's secured debt. Unsecured debt is when you have an obligation to pay, but there's no asset that the lender can seize. Of course, essentially all debt is against all assets. So while there's no specific asset they can seize if you don't pay, they basically can put you in bankruptcy, in which case the assets are really moved over to the creditor.

Hal Weitzman: Okay. And so that's kind of the conceit of this research, is that even unsecured debt is somehow secured. It's implicitly asset-backed.

Raghuram Rajan: Exactly.

Hal Weitzman: So if as you say, the reality is even if you have unsecured debt, at some point I'll be able to claim something back, does that mean there's not much of a difference practically between secured debt and unsecured debt?

Raghuram Rajan: Well, there is in the sense that if I secure my debt today, it gives me less flexibility. Obviously, I can't use the same asset to get more borrowing from somebody else down the line because I've already pledged it to somebody. So it gives me less financial flexibility. It may also give me less real flexibility in the sense that sometimes in the course of business, I want to sell this asset, I don't need it as much, but if it's pledged to a lender, I have to get their permission. Can I substitute this other asset? So it complicates matters.

It complicates the running of your business. It gives you less flexibility. It may also subject you to hold up if your lender basically said, "No, I want no other asset." Then you're stuck with this asset because you've already pledged it and you can't substitute it with something else. So if firms had a choice, they would prefer unsecured debt rather than secured debt as a form of issuance.

Hal Weitzman: Right. And so for those who are not in this world, that begs the question, why can't they get it? Is it just because people don't want to lend against not implicit assets rather than explicit ones?

Raghuram Rajan: Exactly. I mean, go back to Merchant of Venice.

Hal Weitzman: Sure.

Raghuram Rajan: What was the collateral there? It was basically a pound of flesh, right? And if you didn't deliver on it, if you didn't pay your debt-

Hal Weitzman: It was the ships.

Raghuram Rajan: Yeah.

Hal Weitzman: I think that the pound of flesh was consequence.

Raghuram Rajan: The ships were the sort of ephemeral cash flow, which the lender couldn't get his hands on, which Shylock couldn't get his hands on. And so the collateral that was pledged was a pound of flesh if you couldn't repay the debt. So similarly, I think, yeah, I would love to borrow unsecured, but you don't trust me. You don't trust that I will generate the cash flow. You don't trust that I won't steal the cash flow if I generate it. So what you want is a hard asset. Think of a car loan. I mean, I don't know what salary you're making, but I am happy to lend to you if I know that there's an underlying car. So asset as security makes me more willing to lend.

Hal Weitzman: You're reminding me of the pre-financial crisis when people used to say, "Well, if the bank will lend to me, I must be good for it." Right? So you're saying, "Actually, it was the house that was good for it, not you."

Raghuram Rajan: Exactly.

Hal Weitzman: By the way, I love the fact that we're talking about Shakespeare, so let's try and get more Shakespeare in. So it's currently, I think, standard industry practice, isn't it, to classify debt as purely asset-based or cash flow-based? But you're kind of challenging that a little bit as a false dichotomy. So why is that traditional distinction problematic when we think about how companies actually borrow money?

Raghuram Rajan: Well, people have looked at how companies borrow and said, "If you're not backed by assets, it must be that you're relying on cash flows." And what we want to say is, "Wait a minute, wait a minute." If I recognize what we've just been talking about that firms are generally reluctant to offer security if they can get away by offering unsecured debt, they prefer that because it allows them to retain flexibility. However, that doesn't necessarily mean that that debt is unsecured because it's backed by the underlying assets of the firm in the first place. And second, that when times get difficult, because I haven't pledged any of my existing assets, I can go to my lender and say, "Hey, don't withdraw your loan from me. Renew it and I will back it now with assets." So a lot of debt becomes secured as you get closer to distress.

So what's that debt? It is based on assets, but it's based on assets in a contingent way that when you get into difficulty, I will demand security. And so then you have this phenomenon of firms that can borrow unsecured in good times will do so retaining the flexibility for bad times. And when bad times comes, they will actually secure their debt. And we have a very good example in the paper of that, which is Carnival Cruise Lines. Carnival Cruise Lines runs cruise ships. These have value, but they never secured their debt with these ships when they had an investment grade rating and they had that in normal times. Come the pandemic, well, ships are breeding infection. Nobody wants to go on ships anymore, and their business plummets. How did they renew their debt? How'd they borrow to keep their business going? they pledge their ships.

So suddenly Carnival Cruise Lines starts issuing secured debt. They survived the pandemic. Obviously they're now back to minting money on cruises. So what the availability of collateral did for them was give them the ability to borrow in difficult times. Was their debt asset-based or cash flow-based? Well, it was cash flow-based in normal times, but became asset-based in bad times. So this dichotomy, it's one versus the other? Well, it really depends. To some extent, all debt is both cash flow-based and asset-based. It becomes more asset-based when you fear for the company, when the company's riskier. And it becomes more cash flow-based when cash flows stabilize and you're confident about the company. So I think this one or the other categorization is probably a little too dramatic.

Hal Weitzman: So this idea that all, I mean, all debt is asset-based then in some sense, as you said. Where there's always a pound of flesh whether we put it in the contract or not.

Raghuram Rajan: But I always want to be paid in cash if I can. So it's also cash flow-based. I rely on you to generate the cash flows and I'll rely on your assets when you can't generate them. I mean, that's obvious, but does suggest that this distinction is a little more sort of time-bound, situation-bound. And so when I issue, I can't say this is permanently cash flow-based or this is permanently asset-based. Its nature will change over time.

Hal Weitzman: Okay. And so for those of us who are not in the financial or academic world, is that an innovation, what you've just described, that you're breaking down this hard distinction?

Raghuram Rajan: Well, academia goes in cycles, right? So people try and make a distinction first of these are really two different forms of debt. And then you have the synthesis saying, "Well, not quite. They're more similar than you think for these reasons." Now why does this matter? And that's the key question, right? People started saying, "Well, in developed countries, there's a lot more cash flow-based debt, which is not related to the value of the assets and that might actually reduce economic fluctuations. We talked about the global financial crisis, one of the big issues there was house prices went up and then house prices plummeted. And so that created a whole lot of distress for the household sector.

When you say debt is all going to be cash flow-based, not asset-based, then the rise in the value of the assets and the plummeting of the value of the assets matters less, right? So you don't get these dramatic booms and busts based on asset values. Cash flows are smoother in that kind of telling. But what we're saying is, "No, no, you haven't got away from assets. It's just that you get back to asset-based borrowing in bad times." But then the value of the asset matters then. And in good times when you get away from the asset, it's partly because the assets have gone up in value and you feel confident you don't need a specific part of it to secure your debt. There's enough of it out there to secure all the debt implicitly, you don't need the explicit security.

So asset values matter. It's just that they're in the background. So if you have a boom and bust, even in a developed country, you will have fluctuations in your ability to borrow and you'll have really bad consequences if you've over-borrowed and asset values plummet. So what we're saying is old-style macro still prevails. We haven't gotten away from it even in developed countries, don't take your eye off asset values.

Hal Weitzman: If you're enjoying this podcast, there's another University of Chicago Podcast Network show that you should check out. It's called The Pie. Economists are always talking about the pie, how it grows and shrinks, how it's sliced, and who gets the biggest share. Join host Tess Vigeland as she talks with leading economists about their cutting edge research and key events of the day. Hear how the economic pie is at the heart of issues like the aftermath of a global pandemic, jobs, energy policy and much more. Raghu, in the first half we talked about your research on debt and how you're breaking down this hard distinction people have drawn between debt that's backed by assets and debt that's unsecured. You also talk in this research about the difference between a company's going concern value, that's its value as an ongoing business and its liquidation value. How does that affect everything we've talked about about this implicit asset backing?

Raghuram Rajan: To some extent, you want to know what a firm looks like when it's distressed. Does it have value because it has brand names, it has people, human capital, which is valuable because you've got people who are used to working with each other and as an organization that has value. Or is it, are the assets worth more by selling them off piecemeal, as with a restaurant which fails and you're basically selling the oven separately from the plates and the utensils? That matters because in the latter case where you're liquidating it, the only thing that matters is the liquidation value of the assets. But if it's going to be a going concern, then in bankruptcy, lenders are going to try to keep that going concern alive and put the firm back on its feet. But then things like security matter primarily in the sense of can you keep that going concern as high as possible and not erode that value? Can you preserve that going concern?

And sometimes security can help even there. It is true that with security, lenders can become impatient and say, "Look, hang it, I don't want to keep the firm as a going concern. I just want my pound of flesh and get out." But it can also keep bankers, for example, patient because if they're fully secured on their debt, essentially they can interest on their claims. And so they can wait out. So long as the bankruptcy goes on, they will be compensated for waiting and all the negotiation takes place. And finally the firm comes out as a going concern. And the lenders who had security and were fully secured and were patient, get interest on their claims. So these things, the details matter in how this is structured.

Hal Weitzman: But that has to do with bankruptcy, has to do with-

Raghuram Rajan: Yeah, it has to do with bankruptcy in the form of bankruptcy, whether it's liquidation or reorganization.

Hal Weitzman: So that distinction tells us whether a company is going to emerge from bankruptcy or not.

Raghuram Rajan: Exactly. And typically large companies, there's enough value that they are reorganized, but in that reorganization, which at the end of it spits out a going concern, security still matters, and how it matters, the details are important.

Hal Weitzman: Okay. Now I know we'll have some accounting type CFOs listening to the podcast and they'll be wondering what should they do with this new research? What are the practical implications?

Raghuram Rajan: Well, this is a sequence of papers and what those papers established is, first, if you look at the history of U.S. debt, corporate debt, it used to be nearly 100% percent secured in the early part of the 20th century. Every debt you issued, the lenders wanted collateral. Today it's about 10, 15% of the debt is secured for large firms. So it's come down a lot. And so part of our exercise was trying to explain why this has come down. And the narrative we have is really one, companies have found ways of making creditors trust them in the normal course. They don't need that pound of flesh up front. Companies value the flexibility of not giving up all their collateral, as with Carnival Cruise Lines that we talked about earlier.

So CFOs tend to hold on to collateral and not give it away. They tend to be unsecured as long as they can and then use that collateral for additional borrowing when they are in a tight situation. So the only companies that borrow using collateral up front are small, risky companies that have a lot of debt. Large companies tend to preserve that collateral for the bad time. So that's the second aspect. And the third aspect is this preservation can be really, really very valuable for the company because it allows it to survive as a going concern even through tough times like the pandemic. So in a sense, try and maintain corporate flexibility. That's really the message that comes from it.

Hal Weitzman: So you're really describing what CFOs are already doing, which is, as you say, they're not taking out any kind of... They're trying to avoid secured debt as much as possible.

Raghuram Rajan: They're trying to avoid, even though in the short term you might say, "I get a lower rate when I secure this debt, but I'm giving up flexibility." So in normal times when I can issue unsecured, it actually turns out that because there's so much in terms of asset backing for that, adding more security to that particular debt doesn't give you much of a break in terms of lower interest rates. So it's sort of almost ironic when you have a lot of assets, the lender doesn't benefit from taking security. When you have few assets left, that's when they really benefit from taking security. And you can see a huge difference between debt that is secured issued by that company and debt that is unsecured. The debt that is secured has a much lower interest rate. So it's a little bit like-

Hal Weitzman: And that applies to the earlier companies, startup companies or whatever.

Raghuram Rajan: It applies to-

Hal Weitzman: Smaller companies, yeah.

Raghuram Rajan: To smaller companies also. But of course, smaller companies, nobody trusts them and therefore the lenders want security. But for large companies, essentially in normal times, there's not much point in offering security because you don't get much of a break in interest rates. But as times get worse, the ability to offer collateral gets you a large break in your interest rates. And so the market also encourages this kind of behavior. Preserve your collateral in good times, give it up in bad times.

Hal Weitzman: We talked in the first half a little bit about the impacts, the implications of your research for policy. You've been a financial regulator and central banker. I mean, what should they make of... The trend that you've talked about where 90% of debt is now unsecured, is that a concern?

Raghuram Rajan: No, it's not. It's basically saying that corporations are trying to preserve flexibility, which is a good thing. But that doesn't mean that you as a regulator can take your eye off asset prices. Fluctuations in asset prices, for example, the price of land, for example, other kinds of assets like cars and so on, they will have an effect on the macro economy. And so letting land prices boom and saying this doesn't really matter, there's not a whole lot of secured debt in the economy, or at least in the corporate sector is not an appropriate view for the policymakers because that boom in asset prices is implicitly fueling a whole lot of borrowing, which is implicitly backed by those assets. And you see the consequences when the asset prices crash and everybody's running for their collateral and nobody finds it. And these firms have a hard time at that point borrowing.

Hal Weitzman: Okay. Just so I understand, is the trend away from secured debt, you're saying that's positive or negative?

Raghuram Rajan: It's positive, but it doesn't give policymakers license to let the underlying asset values boom and bust because they have to recognize that this trend is implicitly related to assets also. And so the fact that it's not secured doesn't mean it's only cash flow-based. It doesn't ever become asset-based. It will become asset-based in bad times. Bad times is when asset values have collapsed, and at that point, if there's not enough collateral, these firms can't borrow and they're in deep trouble.

Hal Weitzman: So I was going to finish up with another Shakespeare. All's well that ends well, but maybe it doesn't necessarily end well, but it's ending better.

Raghuram Rajan: We are in a better place than we used to be. Firms have more flexibility and that's a good thing, but that doesn't mean they should be complacent.

Hal Weitzman: Excellent. Well, Raghu Rajan, thank you so much for coming on the Chicago Booth Review Podcast to talk about your research on debt and assets.

Raghuram Rajan: Thank you.

Hal Weitzman: That's it for this episode of the Chicago Booth Review Podcast, part of the University of Chicago Podcast Network. For more research, analysis, and insights, visit our website at chicagobooth.edu/review. When you're there, sign up for our weekly newsletter so you never miss the latest in business-focused academic research.

This episode was produced by Josh Stunkel. If you enjoyed it, please subscribe, and please do leave us a five-star review. Until next time, I'm Hal Weitzman. Thanks for listening.