20th May 2010
Conventional wisdom attributes the positive association to tangibility of assets and leverage; it is because of the belief that the resale value of the tangible assets is considerable in the case of financial distress. From the general equilibrium analysis, asset tangibility doesn’t seem to be a sufficient condition for the high leverage. The sufficient condition would be their redeployability or liquidity. If assets are redeployable for alternative uses, the resale value will be (very close to) their fundamental value, hence the liquid assets are best candidates for the collateral. Here redeployability of assets means, the inherent opportunity of assets to be used for alternative purposes which attribute close to their fundamental value. Thus, the asset liquidity is positively associated with the leverage.
There are three potential buyers for the assets of the distressed firm: a) the other firms in the same industry, b) outsiders who may venture into the industry c) prospective investors who may convert the assets and put them for alternative uses. Here question comes, whether assets are liquid/redeployable? If assets are liquid/redeployable easily at the value close to their fundamental value, the resulting competition for them will drive their liquidation value close to their fundamental value. But most of the assets are not efficiently  redeployable and have to be put in for the same use e.g. oil rigs, aircrafts etc. The value of such non-redeployable assets to the internal firms (from the same industry) will be close to their fundamental value and will be relatively higher than the same to the outsiders who incur some agency costs . If the shock is idiosyncratic, the other firms in the industry will out-compete the outsiders and the price for the assets of the distressed firm will be equal to their fundamental value. Hence, creditors will need not to consider the idiosyncratic shocks (mismanagement etc) specific to the particular firm in the industry. If the shock is industry wide, almost all the firms in the industry do face debt-overhang problem and can’t be able to secure finance to buy the assets of the distressed firm. This results in the fire sale of assets to the outsiders who has far lesser value to the assets, causing the private costs to the seller as well as social costs (assets will not be deployed efficiently for their best use).
Implications: While appraising the (secured) loans, the creditors need to consider the following:
- The potential redeployability of pledging assets rather than their tangibility.
- Assigning the more weight to industry wide shocks rather than idiosyncratic shocks.
 Efficient redeployment means putting the assets for the alternative uses whose value will be close to their fundamental value.
 Agency costs for the outsiders are due to asymmetric information about the nature of assets, industry and so on
(Constructive comments are welcome)