Conflict between shareholders and lenders: the perfect example

For years, I have been explaining to my students that there is a potential conflict of interest between the owners of a company and the people that lend money to it.  Indeed, shareholders have the chance to get an upside on their investment, while the lenders “only” get the interest but nevertheless suffer the risk of losing (part of) their money if  the company can’t reimburse them in the end.  Therefore, shareholders have a definite interest in taking risk while the lenders have absolutely none!  As long as everything goes well, all those considerations are not at the forefront and there is no actual conflict.

When the situation gets tougher and the risk of not being repaid becomes a possibility that can’t be ignored, the conflict appears.  At a certain point, the shareholders have lost so much that they could be prepared to gamble the company, i.e. to take very large risk and even to make investments with negative NPV.  Why is that?  Because they have a limited liability (unless they commit a fraud obviously), they are only committed to the funds they have provided to the company, not to further capital increases.  The NPV of a project is always an estimate of its average value, meaning averaged over the various possible future outcomes.  So a risky project with negative NPV has some chances of turning positive, even largely positive, but, on average, will be negative.  The point is that shareholders, who are left with a very small financial stake in the company, are not interested in the average: if the gamble turns out to be profitable, they will be the beneficiaries but if the investment is loss-making, they will lose the small amount their stake was still worth but the lenders will bear the bulk of the loss. The typical: heads I win, tails you lose.

And, for all those years, I had trouble coming up with actual examples of these extreme situations, that are nevertheless important to understand the debt-equity ratio. Now, thanks to the financial crisis, we have a surfeit of cases.

The best one is probably the Swiss bank UBS. UBS, one of the world largest and most respected banks, had lost not less than $ 50 bn during the crisis, largely thanks to its underestimated and unreported exposure to the infamous US mortgage market. And between the top of the market in the spring 2007, just before the crisis exploded, and two years later, the stock price had dropped by 85%.  The scene was set for my conflict of interest : the bank regulator, representing and defending the depositors, wanted UBS to be managed as conservatively as possible, but with a really conservative investment policy shareholders had no chance of recovering part of their losses for ages.

That this conflict actually took place was reported in 2009 in a fantastic article of The Economist appropriately entitled “Rebuilding UBS: Ossie’s casino” (Ossie being the CEO’s nickname): “I’d like to see us put more risk on the table and actually trade a bit harder.” In these times, such words from any banker might be enough to cause a little concern. Coming from the chief financial officer of a bank that is still clawing its way out of a $50 billion hole of accumulated losses and write-downs, they ought to set the fire alarms ringing. In fact, the gambling-for-redemption strategy outlined by UBS, Switzerland’s biggest bank, is winning the support of shareholders. … Taking a big bet may make perfect sense for shareholders. Yet the thought of UBS doing so again terrifies its regulators

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