Statements to Congress.
Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Ways and Means, U.S. House of Representatives, February 2, 1989.
I am pleased to be here today to discuss corporate restructuring and the need for reducing the federal budget deficit, issues raised in your letter of invitation.
CORPORATE RESTRUCTURING AND
The spate of mergers, acquisitions, leveraged buyouts (LBOs), share repurchases, and divestitures in recent years has major implications for the American economy. While the evidence suggests that the restructurings of the 1980s probably are improving, on balance, the efficiency of our economy, the worrisome and possibly excessive degree of leveraging associated with this process could create a set of new problems for the financial system.
Corporate restructuring is not new to American business. It has long been a feature of our enterprise system, a means by which firms adjust to everchanging product and resource markets and to perceived opportunities for gains from changes in management and management strategies.
However, the 1980s have been characterized by features not present in previous episodes. The recent period has been marked not only by acquisitions and mergers but also by significant increases in leveraged buyouts, divestitures, asset sales, and share repurchase programs. In many cases, recent activity reflects the breakup of the big conglomerate deals packaged in the 1960s and 1970s. Also, the recent period has been characterized by the retirement of substantial amounts of equity (more than $500 billion since 1983) mostly financed by borrowing in the credit markets.
The accompanying increase in debt has resulted in an appreciable rise in leverage ratios for many of our large corporations. Aggregate book value debt-equity ratios, based on balance sheet data for nonfinancial firms, have increased sharply in the 1980s, moving outside their range in recent decades, although measures based on market values have risen more modestly.
Along with this debt expansion, the ability of firms in the aggregate to cover interest payments has deteriorated. The ratio of gross interest payments to corporate cash flow before interest provision is currently about 35 percent, close to the 1982 peak when interest rates were much higher and profits were weak owing to the recession. Lately, profits have been fairly buoyant; the current deterioration has been due to heavier debt burdens.
A measure of credit quality erosion is suggested by an unusually large number of downgradings of corporate bonds in recent years. The average bond rating of a large sample of firms has declined fairly significantly since the late 1970s, from A+ to A-.
To fashion an appropriate policy response, if any, to this extraordinary restructuring-LBO phenomenon, there are some key questions that must be answered: What is behind the corporate restructuring movement? Why is it occurring now, in the middle and late 1980s, rather than in some earlier time? Why has it involved such a broad leveraging of corporate balance sheets? And finally, has it been good or bad for the American economy?
The 1980s has been a period of dramatic economic changes: large swings in the exchange value of the dollar, with substantial consequences for trade-dependent industries; rapid technological progress, especially in automation and telecommunications; rapid growth in the service sector; and large movements in real interest rates and relative prices. Clearly, such changes in the economic environment imply major, perhaps unprecedented, shifts in the optimal mix of assets at firms--owing to corresponding shifts in synergies--and new opportunities for improving efficiency. Some activities need to be shed or curtailed, and others added or beefed up. Moreover, the long period of slow productivity growth in the 1970s may have partly exacerbated the buildup of a backlog of inefficient corporate practices.
When assets become misaligned or less than optimally managed, there is clearly an increasing opportunity to create economic value by restructuring companies, restoring what markets perceive as a more optimal mix of assets. But restructuring requires corporate control. And managers, unfortunately, often have been slow in reacting to changes in their external environment, some more so than others. Hence, it shouldn't be a surprise that, in recent years unaffliated corporate restructurers, some call them corporate raiders, have significantly bid up the control premiums over the passive investment value of companies that are perceived to have suboptimal asset allocations. If a company has an optimal mix and is appropriately managed, there is no economic value to be gained from restructuring and, hence, no advantage in obtaining control of a company for such purposes. In that case, there is no incentive to bid up the stock price above the passive investment value based on its existing, presumed optimal, mix of assets. But in an economy knocked partially off kilter by real interest rate increases and gyrations in foreign exchange and commodity prices, there emerge significant opportunities for value-creating restructuring at many companies.
This presumably explains why common stock tender offer prices of potential candidates for restructuring have risen significantly during the past decade. Observed stock prices generally (though not always) reflect values of shares as passive investments. But there can be, for any individual company, two or more prices for its shares, reflecting the degree of control over a company's mix of assets.
Tender-offer premiums--which represent the price that active investors are willing to pay for corporate control--ranged from 13 percent to 25 percent in the 1960s, but have moved to 45 percent and higher during the past decade, underscoring the evident increase in the perceived profit to be gained from corporate control and restructuring.
Interest in restructuring also has been spurred by the apparent increased willingness and ability of corporate managers and owners to leverage balance sheets. The gradual replacement of managers who grew up in the Depression and developed a strong aversion to bankruptcy risk probably accounts for some of the increased proclivity to issue debt now.
Moreover, innovations in capital markets have made the increased propensity to leverage feasible. It is now much easier than it used to be to mobilize tremendous sums of debt capital for leveraged purchases of firms. Improvements in the loan-sale market among banks and the greater presence of foreign banks in U.S. markets have greatly increased the ability of the banking sector to participate in merger and acquisition transactions. The phenomenal development of the market for low-grade corporate debt, so-called junk bonds, also has enhanced the availability of credit for a wide variety of corporate transactions. The increased liquidity of this market has made it possible for investors to diversify away firm-specific risks by building portfolios of such debt.
The tax benefits of restructuring activities are, of course, undeniable, but this is not a particularly new phenomenon. Our tax system has long favored debt finance by taxing the earnings of corporate debt capital only at the investor level, while earnings on equity capital are taxed at both the investor and corporate levels. There have been other sources of tax savings in mergers that do not depend on debt finance, involving such items as the tax basis for depreciation and foreign tax credits. And taxable owners benefit when firms repurchase their own shares, using what is, in effect, a tax-favored method of paying cash dividends. In any event, the recent rise in restructuring activity is not easily tied to any change in tax law.
Evidence about the economic consequences of restructuring is beginning to take shape, but much remains conjectural. It is clear that the markets believe that the recent restructurings are potentially advantageous. Estimates range from $200 billion to $500 billion or more in paper gains to shareholders since 1982. Apparently, only a small portion of that has come at the expense of bondholders. These gains are reflections of the expectations of market participants that the restructuring will, in fact, lead to a better mix of assets within companies and greater efficiencies in their use. This, in turn, is expected to produce marked increases in future productivity and, hence, in the value of American corporate business. Many of the internal adjustments brought about by changes in management or managerial policies are still being implemented, and it will take time before they show up for good or ill in measures of performance.
So far, various pieces of evidence indicate that the trend toward more ownership by managers and tighter control by other owners and creditors has generally enhanced operational efficiency. In the process, both jobs and capital spending in many firms have contracted as unprofitable projects are scrapped. But no clear trends in these variables are yet evident in restructured firms as a group. For the business sector, generally, growth of both employment and investment has been strong.
If what I have outlined earlier is a generally accurate description of the causes of the surge in restructurings of the past decade, one would assume that a stabilization of interest rates, exchange rates, and product prices would slow the emergence of newly misaligned companies and opportunities for further restructuring. Such a development would presumably lower control premiums and reduce the pace of merger, acquisition, and LBO activity.
This suggests that the most potent policies for defusing the restructuring-LBO boom over the long haul are essentially the same macroeconomic policies toward budget deficit reduction and price stability that have been the principal policy concerns of recent years.
Whatever the trends in restructuring, we cannot ignore the implications of the associated heavy leveraging for broad-based risk in the economy. Other things equal, greater use of debt makes the corporate sector more vulnerable to an economic downturn or a rise in interest rates. The financial stability of lenders, in turn, also may be affected. How much is another question. The answer depends greatly on which firms are leveraging, which financial institutions are lending, and how the financings are structured.
Most of the restructured firms appear to be in mature, stable, noncyclical industries. Restructuring activity has been especially prevalent in the trade, services, and, more recently, the food and tobacco industries. For such businesses, a substantial increase in debt may raise the probability of insolvency by only a relatively small amount. However, roughly two-fifths of merger and aquisition activity, as well as LBOs, have involved companies in cyclically sensitive industries that are more likely to run into trouble in the event of a severe economic downturn.
Lenders to leveraged enterprises have been, in large part, those that can most easily absorb losses without major systemic consequences. They include mutual funds, pension funds, and insurance companies, which generally have diversified portfolios and have traditionally invested in securities involving some risk, such as equities. To the extent that such debt is held by individual institutions that are not well diversified, there is some concern. At the Federal Reserve, we are particularly concerned about the increasing share of restructuring loans made by banks. Massive failures of these loans could have broad ramifications.
Generally, we must recognize that the line between equity and debt has become increasingly fuzzy in recent years. Convertible debt has always had an intermediate character, but now there is almost a continuum of securities varying in their relative proportions of debt and equity flavoring. Once there was a fairly sharp distinction between being unable to make interest payments on a bond, which frequently led to liquidation proceedings, and merely missing a dividend. Now the distinction is smaller. Outright defaults on original issue high-yield bonds have been infrequent to date, but payment difficulties have led to more frequent exchanges of debt that reduce the immediate cash needs of troubled firms. Investors know when they purchase such issues that the stream of payments received may well differ from the stream promised, and prices tend to move in response to changes in both debt and equity markets. In effect, the yields on debt capital rise toward that of equity capital when scheduled repayments are less secure.
In view of these considerations, and the very limited evidence on the effects of restructuring at the present time, it would be unwise to resrtict arbitrarily corporate restructuring. We must resist the temptation to seek to allocate credit to specific uses through the tax system or through the regulation of financial institutions. Restrictions on the deductibility of interest unavoidably involve an important element of arbitrariness, one that will affect not only those types of lending intended but other types as well. Moreover, foreign acquirers could be given an artificial edge to the extent that they could avoid these restrictions. Also, the historical experience with various types of selective credit controls clearly indicates that, in time, borrowers and lenders find ways around them.
All that does not mean that we should do nothing. The contribution of our tax structure to corporate leveraging warrants attention. The double taxation of earnings from corporate equity capital has added to leveraging, and thus debt levels are higher than they need, or should, be. Our options for dealing with this distortion are, unfortunately, constrained severely by the federal government's still serious budget deficit problems, a matter that I will turn to in a moment. One straightforward approach to this distortion, of course, would be to substantially reduce the corporate income tax. Alternatively, partial integration of corporate and individual income taxes could be achieved by allowing corporations a deduction for dividends paid or by giving individuals credit for taxes paid at the corporate level. But these changes taken alone would result in substantial revenue losses; a rough estimate of IRS collections from taxing dividends is in the range of $20 billion to $25 billion annually.
Dangers of risk to the banking system associated with high debt levels also warrant attention. As I have noted, the Federal Reserve, in its role as a supervisor of banks, has particular concerns in this regard. In 1984, the Board issued supervisory guidelines for assessing LBO-related loans, which are set forth in an attachment to my text.1 These guidelines emphasized that the circumstances associated with highly leveraged deals require that creditors exercise credit judgment with special care, assessing those risks that are firm-specific as well as those common to all highly leveraged firms. The Federal Reserve is currently in the process of reviewing guidelines regarding the evaluation of bank participation in highly leveraged financing transactions; we anticipate that this review will be completed shortly.
THE BUDGET DEFICIT AND THE ECONOMY
The remainder of my prepared remarks will concentrate on the budget deficit and the corrosive impact it is having on the economy.
It is beguiling to contemplate the strong economy of recent years in the context of very large deficits and to conclude that the concerns about the adverse effects of the deficit on the economy have been misplaced. But this argument is fanciful. The deficit already has begun to eat away at the foundations of our economic strength. And the need to deal with it is becoming ever more urgent. To the extent that some of the negative effects of deficits have not as yet been felt, they have been merely postponed, not avoided. Moreover, the scope for further such avoidance is shrinking.
To some degree, the effects of the federal budget deficits over the past several years have been muted by two circumstances, both of which are currently changing rapidly. One was the rather large degree of slack in the economy in the early years of the current expansion. This slack meant that the economy could accommodate growing demands from both the private and public sectors. In addition, to the extent that these demands could not be accommodated from U.S. resources, we went abroad and imported them. This can be seen in our large trade and current account deficits. By now, however, the slack in the U.S. economy has diminished substantially. And as inflows of foreign saving are reduced along with our trade deficit, other sources of saving must be found, or demands for saving curtailed. The choices are limited; as will become clear, the best option for the American people is a further reduction in the federal budget deficit, and the need for such reduction is becoming more pressing. 1. The attachments to this statement are available on request from publications Services, Board of Governors of the Federal Reserve System, Washington, D.C. 20551.
Owing to significant efforts by the executive branch and the Congress, coupled with strong economic growth, the deficit has shrunk from 5 percent to 6 percent of gross national product a few years earlier to about 3 percent of GNP today. Such a deficit, nevertheless, is still very large by historical standards. Since World War II, the actual budget deficit has exceeded 3 percent of GNP only in the 1975 recession period and in the recent deficit experience beginning in 1982. On a cyclically adjusted or structural basis, the deficit has exceeded 3 percent of potential GNP only in the period since 1983.
Government deficits, however, place pressure on resources and credit markets, only if they are not offset by saving elsewhere in the economy. If the pool of private saving is small, federal deficits and private investment will be in keen competition for funds, and private investment will lose.
The U.S. deficits of recent years are threatening precisely because they have been occurring in the context of private saving that is low by both historical and international standards. In the 1980s, net personal plus business saving in the United States has been about 3 percentage points lower relative to GNP than its average in the preceding three decades. Internationally, government deficits have been quite common among the major industrial countries in the 1980s, but private saving rates in most of these countries have exceeded the deficits by very comfortable margins. In Japan, for example, less than 20 percent of its private saving has been absorbed by government deficits, even though the Japanese general government has been borrowing almost 3 percent of its gross domestic product in the 1980s. In contrast, more than half of private U.S. saving in the 1980s has been absorbed by the combined deficits of the federal and state and local sectors.
Under these circumstances, such large and persistent deficits are slowly but inexorably damaging the economy. The damage occurs because deficits tend to pull resources away from net private investment, which damps the growth of the nation's capital stock. This, in turn, has meant less capital per worker than would otherwise have been the case, and this will surely engender a shortfall in labor productivity growth and, with it, a shortfall in growth of the standard of living.
All else equal, the higher real interest rates associated with increased borrowing by the Treasury in the 1980s have reduced private investment in the aggregate. Moreover, the higher real interest rates have shifted the composition of investment away from long-lived assets, such as factories, toward computers and other shorter-lived equipment. The data also underscore a recent decline in the average service life of consumption as well as investment goods and a systematic tendency for this average to move inversely with real rates of interest. That is, the higher are real interest rates, the heavier is the concentration on short-lived assets.
Not surprisingly, we have already experienced a disturbing decline in the level of net investment as a share of GNP. Net investment has fallen to 4.7 percent of GNP in the 1980s from an average level of 6.7 percent in the 1970s and even higher in the 1960s. Moreover, it is low, not only by our own historical standards, but by international standards as well.
International comparisons of net investment should be viewed with some caution because of differences in the measurement of depreciation and in other technical details. Nevertheless, the existing data do indicate that total net private and public investment as a share of gross domestic product over the period between 1980 and 1986 was lower in the United States than in any of the other major industrial countries except the United Kingdom.
It is important to recognize, as I indicated earlier, that the negative effects of federal deficits on growth in the capital stock may be attenuated for a while by several forces in the private sector. One is a significant period of output growth in excess of potential GNP growth--such as occured over much of the past six years--which undoubtedly boosts sales and profit expectations and, hence, business investment. Such rates of output growth, of course, cannot persist, making this factor inherently temporary in nature.
Another factor tending to limit the decline in investment spending would be any tendency for saving to respond positively to the higher interest rates that deficits would bring. The supply of domestic private saving has some interest elasticity, as people put off spending when borrowing costs are high and returns from their financial assets are favorable. But most analysts find that this elasticity is not sufficiently large to matter much.
Finally, net inflows of foreign saving can be, as recent years have demonstrated, an important addition to saving. In the 1980s, our ability to tap foreign saving has kept the decline in the gross investmenT--GNP ratio, on average, to only moderate dimensions (slightly more than 1/2 percentage point) compared with the 1970s, while the federal deficit rose about 2 1/2 percentage points relative to GNP. Net inflows of foreign saving have amounted, on average, to almost 2 percent of GNP, an unprecedented level.
Looking ahead, the continuation of inflows of foreign saving at current levels is questionable. Evidence for the United States and for most other major industrial nations over the past 100 years indicates that such sizable foreign net capital inflows have not persisted and, hence, may not be a reliable substitute for domestic saving on a long-term basis. In other words, domestic investment tends to be supported by domestic saving alone in the long run.
Let me conclude by reiterating that the budget deficit must be brought down. I do not underestimate the difficult decisions that you must make if we are to achieve the necessary reduction in the deficit. But allowing deficits to persist courts a dangerous corrosion of our economy and risks potentially significant reductions over time in our standard of living.
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|Title Annotation:||Policy Statements by Members of Federal Reserve System|
|Publication:||Federal Reserve Bulletin|
|Date:||Apr 1, 1989|
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