Bruce Tuckman

Do Bondholders Lose from Junk Bond Covenant Changes

This paper documents that firms can and do change the convenants of their public debt indentures through consent solicitations. A game theoretic model of these solicitations shows that they can coercive, i.e. bondholders who cannot coordinate their actions may consent to convenant changes even when it is not in their collective interest to do so. Despite this theoretical finding, abnomral bondholder returns around the announcements of consent solicitations are significantly positive. Further analysis of the data indicates that bondholders can, in fact, coordinate their actions to modify or defeat disadvantageous proposals. As a result, bondholders obtain a portion of the gains resulting from convenant modifications. The public policy implication of these findings is that bondholders do not need additional regulatory or judicial protection in the solicitation process.

Calling Nonconvertible Debt and the Problem of Related Wealth Transfer Effect

An often-cited rule in corporate finance is that a firm should call a bond as soon as the bonds market price equals its call price. But, in fact, many callable bonds sell for more than their call prices. One explanation is that the implicit assumption that calls are executed so as to leave capital structure unchanged fails to hold in practice. This paper examines the impact of capital structure changes on optimal call policy and presents empirical evidence consistent with the results of that explanation.

Special levies on punitive damages: Decoupling, agency problems, and litigation expenditures

Abstract This article extends the economic model of “decoupling” the damage award payable by a defendant and the award received by a plaintiff in the context of recently enacted “special levy” statutes. These statutes require plaintiffs to hand over portions of their punitive damage awards to the state. The basic model of decoupling is expanded by incorporating the effect of levies on litigation expenditures and settlement and by examining the effect of agency problems between plaintiff and his attorney. Consistent with the basic model, we find that, in the absence of agency problems, if a case goes to trial, levies reduce the expected award payable by the defendant and the plaintiffs litigation expenses. However, the effect of levies on settlement is indeterminate. In the presence of agency problems, certain forms of levies will have no effect on the defendants expected payments, on litigation expenses, or on settlement; and other forms will either be equally ineffective as the former forms or less effective than they are in the absence of agency problems.

Federal Liquidity Options: Containing Runs on Deposit-Like Assets Without Bailouts and Moral Hazard

In response to the 2008 runs on deposit-like assets, namely repo and money market funds, the Fed created new liquidity facilities for nonbanking institutions and the Treasury guaranteed certain money market fund balances. These extraordinary actions, while justified by officials as necessary to preserve the financial system, did rescue nonbanks by exposing the public to unprecedented risks. Since 2008, despite legislation and regulation, deposit-like assets are still vulnerable to runs. The fallback policy to contain such runs is still ad hoc lending by the Fed. Bailouts, though officially outlawed, may very well be justified and used again. Finally, because the implicit safety net of government action is still in place, moral hazard remains a feature of the financial landscape. This paper proposes that the Fed auction Federal Liquidity Options (FLOs) as the exclusive means of providing liquidity to nonbanks in a crisis. Having issued FLOs that encompass a sufficient quantity and breadth of collateral, authorities will be able to claim, with credibility, that no additional emergency lending programs or bailouts will be required to safeguard the viability of solvent nonbanks. In the resulting policy regime, the Fed does not rescue individual firms or industries but fulfills its contractual obligations under options previously sold at market-determined prices. Furthermore, with the cost of contingent liquidity internalized by the purchasers of FLOs, and with other extraordinary provisions of liquidity credibly renounced, moral hazard will drop significantly.

Prime and Score Premia: Evidence Against the Tax-Clientele Hypothesis

Primes and scores split the cash flows of a share of stock into dividend and capital gain components, respectively. An analysis of the transaction prices reveals that the sum of prime and score prices exceeds the price of the underlying stock. This paper develops a tax-clientele explanation of this premium over the stock price. It test jointly the clientele effect and an after-tax version of the Black-Scholes option pricing formula. The data reject this joint hypothesis in a manner that suggest the tax-clientele model is not supported.

Sinking Fund Prepurchases and the Designation Option

The corporate borrower may, from time to time, choose to purchase its outstanding bonds in the open market. Under SEC regulations, the borrower may not resell these bonds, but must retire them in a manner governed by the relevant indenture.

Derivatives: Understanding Their Usefulness and Their Role in the Financial Crisis

This article makes two main arguments that are intended to guide policymakers and regulators of financial markets: (1) when used properly, derivatives are enormously useful to companies in managing business risks; and (2) neither derivatives nor derivatives-related products played significant roles in causing or exacerbating the financial crisis of 2007–2009. The author begins by illustrating the corporate use of derivatives with a detailed example of how a large brewer uses both exchange-traded wheat futures and over-the-counter aluminum swaps to hedge the risks of higher wheat and aluminum prices. In the process, the value of much-maligned OTC derivatives, and the role of financial intermediaries in facilitating their use, are clearly demonstrated. The second part of the article refutes the popular claims, widely expressed in the media and on Capitol Hill, that derivatives were at the heart of the financial crisis. Losses and failures during the crisis are shown to have resulted primarily from excessive non-derivative leverage and from investments in non-derivative mortgage products that fell dramatically in value. The only significant exception involved the insurance company AIG, whose failure and bailout are attributable not only to large losses on credit default swaps, but to comparable losses on non-derivative mortgage products. Moreover, by the time AIG failed, many other large financial institutions had already either failed or experienced large losses. Whats more, and all but forgotten during the controversy, some large banks were able to reduce risk by hedging with those derivatives.

Embedded Financing: The Unsung Virtue of Derivatives

In theoretical derivatives pricing models, such as those for equity options, the interest rate is often simply specified as r, a fixed constant rate on a “bond” with no default risk. Rates must be treated as stochastically time varying for interest rate derivatives, but still, little attention is paid to the “financing rate.” Tuckman points out that this oversimplifies what happens in the real world. The proper financing rate to use in pricing a given derivative, and especially in setting up an arbitrage trade against the underlying, depends on the specific market practices the trader will face regarding collateral requirements, securities lending terms, and the availability of long-term financing markets (or lack of them). In theory, buying a bond in the cash market and “putting it out on repo” should yield the same payoff as a forward contract on the bond. But this requires financing the bond over the lifetime of the trade, which is rarely possible at a rate that is fixed ex ante for the whole period. The cash market transaction, financed by rolling over short-term repo loans, entails financing risk that the equivalent forward contract does not have. Embedded financing is an important, and frequently overlooked, benefit of derivatives.