Good Theory,Bad Practice

In the 1950s, two brilliant young economists, Franco Modigliani and Merton Miller, were asked to create a corporate finance curriculum at Carnegie Institute of Technology (now Carnegie Mellon University). Having no experience in the field, the two quickly reviewed the existing literature on the subject and found it to be both inconsistent and counterintuitive. As they sat down to figure things out, a remarkable theory emerged that led to a Nobel Memorial Prize in Economics for Modigliani in 1985 (Miller won the Nobel for economics in 1990) and ushered in the era of modern finance.

Modigliani and Miller's theory showed that, for any given company, its valuation was totally independent of its capital structure. In other words, a firm that is totally financed with equity (i.e., an unleveraged firm) is worth exactly the same as an identical company financed through debt.

Their work came out at a serendipitous time. In 1984, Continental Illinois National Bank and Trust Company ran into trouble because of massive loans to the U.S. oil and gas industry. With investors and creditors spooked by rumors that the bank might fail, Continental was shut
out of its usual wholesale funding markets. Rumors
quickly spread about the vulnerability of other banks, which created a credit crunch.

At the same time, investment banks were opening their tills. Michael Milken had recently introduced high-yield bonds, giving corporate borrowers a plethora of new
options. Banks no longer held all the cards when it came to acquiring capital. Over time, rates moved lower and companies borrowed freely from the public debt markets.

Since that time, there have been a number of disruptions: Stocks were torpedoed in 1987. The high-yield market fell apart in 1989; the Russian bond default caused problems in 1998. Technology stocks crashed in the early 2000s. The attacks on the World Trade Center followed in 2001.

In all of these cases, the markets were able to adjust and continue moving forward. Even in this period of huge write-offs and frozen credit, capitalism--like a living organism--will adapt and survive.

A century ago, family offices profited by factoring receivables. I expect that this type of activity will become increasingly popular. We're also likely to see an increase in peer-to-peer lending, helped along by Web sites such as prosper.com. Non-bank banks such as hedge funds will also make capital available. Private equity funds, with billions in commitments, will take the lead in "reflating" bank balance sheets.

After all, as the "M&M" twins of modern finance said, the origin of the capital doesn't matter.

Ben Warwick (ben@qesinvest.com) is chief investment officer of Quantitative Equity Strategies LLC, in Denver, and Memphis-based Sovereign Wealth Management, Inc.