Haircut - Reuters - 19.4.12
Bondholders have to set their own limits in order to avoid future haircuts. Photo by Reuters
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There's a fine and simple way to solve the problem bondholders have been subjected to by "haircuts" that force them to accept a fraction of the debt they are owed. Just repeal the concept of a limited liability company and set up debtors' prisons of the kind that existed in Britain and the United States less than 200 years ago. If that happened, maybe bondholders wouldn't suffer from haircuts. Then again, our modern economy would disappear.

There is of course another way to impose control over borrowers, but it's not being used. Money managers can, and must, demand better financial conditions in their contracts for the purchase of the bonds, and they should refuse to acquire bonds at an interest rate that doesn't compensate for opportunistic conduct on the part of the issuer. If bondholders stick to their demands, the issuers will be forced to agree to better financial provisions for the bondholders.

Purchasers of bonds can require a provision that limits the bond issuer from making dividend distributions or other corporate payments to a controlling shareholder, for example, or from major cash acquisitions. This will reduce the controlling shareholder's ability to draw funds in return for inferior assets that the company might otherwise accept in exchange. Bondholders can also demand that the corporation's capital equity, which constitutes a first line of defense, not dip below a specified level. Or they can require that liquid assets be maintained at a specific value. If these conditions are violated, the bonds would come due immediately.

The terms can also provide for immediate redemption of bonds if there are organizational changes in the company or if there is a change in ownership, which could be an indication of worsening prospects for repayment, even if the firm is capable of meeting its obligation. If such provisions are not required, problems in the company will only be apparent when the bond issuer is on the verge of collapse. At that point, it won't have the resources to make payment.

When investors don't require terms like these, or when the conditions that are demanded are insufficient, some borrowers exploit loopholes available to them. Such conduct doesn't violate the law, and there is nothing regulatory agencies can do about it. It's simply ridiculous to demand that regulators intervene and require borrowers to dip into their own personal assets under such circumstances.

The principle behind the limited liability of corporations is one of the most revolutionary and important business innovations in the annals of human commerce. Absent such limitations, the modern major corporation as we know it would simply never have come into existence. Some borrowers' businesses fail, and that is not a crime. Investors, however, need to use the means at their disposal to protect themselves from opportunistic borrowers. If they don't, they have only themselves to blame.

The Hodek committee, which examined regulation of institutional investors, recommended expanding the use of financial provisions, but it seems investors and money managers are overlooking the option. The small investor would claim that he is not an expert in all these things, which is why he is entrusting his money to an investment fund. But that prompts a question. Let's assume there are two funds; one invests in secure bonds that are subject to appropriate financial terms and pay a low interest rate. A second fund invests in risky bonds from companies that offer a higher yield, but those firms may run into trouble and give their bondholders a haircut.

When everything is fine and risky bonds are paying high yields, wouldn't many people invest in the riskier funds? And if that's the case, what incentive does a more cautious money fund have to insist on investing in more secure bonds? The problem lies with money managers who don't work as they should. It also lies with investors looking to make a fortune, who are willing to take risks as long as they prosper. But when they suffer losses, they run to the regulatory agencies for help. Investors have to understand that risky investments sometimes involve losses.

The writer is a professor of entrepreneurial finance at the Stern School of Business at New York University.