In modern economies, the government guarantees the debt of many borrowers. In a few cases, the promise is explicit; in others it is implicit but known to be likely; and in others, the guarantee occurs because the alternative is immediate collapse, with substantial harm to the rest of the economy. The modern government cannot stop itself from making good on the obligations of many borrowers, large and small. I demonstrate that debt guarantees deplete equity from fi rms at times of declines in asset values. Not only do fi rms fail to replace equity lost when leveraged portfolios lose value, but they have an incentive to deplete equity further, by paying unusually high dividends.
The government adopts a safeguard to protect the taxpayers against the worst abuses of guarantees|it imposes a capital requirement to limit the ratio of guaranteed debt to the value of the underlying collateral. In the United States, organizations with explicit guarantees on some debt (deposits) are mainly banks. The non-deposit obligations of banks and other intermediaries, notably the two huge mortgage-holders, Fannie Mae and Freddie Mac, enjoy market values that only make sense on the expectation of a government guarantee.
The recent interventions to avert the collapse of Bear Stearns and AIG con rmed that the government will pay o on private debt obligations in times of stress even in sectors distant from any formal debt guarantees. The Federal Housing Administration guarantees the debt of individual mortgage borrowers; the government is extending this guarantee to a larger set of individual borrowers under pressure from declining housing prices. Almost any borrower faces some probability that adverse future events will result in the government repaying the borrower's debt.
A key issue is the withdrawal of equity capital from rms with guaranteed debt the phenomenon I call equity depletion. A counterpart is the unwillingness of investors to supply equity to rms that face positive probabilities of insolvency and payo s on government guarantees. Equity depletion rises along with the probability of default. Withdrawing equity from a rm in one period has zero marginal cost in states next period where default occurs and the government pays o on guaranteed debt|the value of equity claims is zero in those states. If a larger fraction of future states have zero equity value, the expected payo to equity investments this period declines. In a partial equilibrium setting, this factor would result in knife-edge behavior|the owners of a rm would pay out all of the equity value of a rm as a dividend so as to maximize the value of the government bailout. Akerlof and Romer (1993) describe actions of this type leading up to the savings and loan crisis in the U.S. in the 1980s. In the model of this paper, however, a countervailing force limits the depletion of capital. Any injection of equity to rms in general comes from reduced consumption and any removal of capital takes the form of a consumption binge. With a non-zero value of the elasticity of marginal utility with respect to consumption, the desire to smooth consumption keeps equity flows into and out of rms at nite rates. But consumption does rise substantially in periods when expected defaults and accompanying bailouts become more likely.
The paper reaches these conclusions in a simple general-equilibrium model. Capital is the only factor of production; output is proportional to capital. The real return to capital is a random variable. Each period, consumers decide between consuming and saving. The government guarantees debt secured by capital. If the borrower's capital falls far enough, because of negative returns, the rm may default because its quantity of capital falls below the amount of its debt.
I characterize the limitations on the government's debt guarantee in what I believe is a realistic way. The government enforces a capital requirement: At the time a company issues debt, the amount borrowed may not exceed a speci ed fraction of the rm's capital. The remaining value is the borrower's equity, sufficient to meet the capital requirement. If the return is negative enough so that the new quantity of capital falls short of the value of the debt, the government makes up the di erence. The lender receives a payment of the difference. Equity shareholders in the rm receive nothing back when default occurs and the government pays o ff.
My characterization of the government's capital requirement has an important dynamic element: If the quantity of capital falls, but not enough to push the borrower into insolvency, the borrower may keep debt at its earlier level. The government fails to follow the principle of prompt corrective action. Under that principle, the borrower would mark its collateral to market and could borrow only the speci ed fraction of the new, lower value of the collateral. Instead, the government acts as if the collateral had its historical value and permits the borrower to keep the historical level of debt, which the government guarantees.
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