Collateral and the limits of debt capacity: theory and evidence

This paper considers how collateral is used to finance a going concern, and demonstrates with theory and evidence that there are effective limits to debt capacity and the kinds of claims that are issued to deploy that debt capacity. The theory shows that firms with (unobservably) better quality collateral optimally pledge an unused portion of that collateral to finance new investment opportunities with unsecured debt, while firms endowed with lower quality collateral use project-specific secured debt. Better quality firms must also commit to maintaining an equity cushion to separate themselves from lesser quality firms, implying lower relative leverage and greater uncommitted cash flow from operations with which to meet debt service requirements. The fundamental empirical prediction derived from our model is that a firm’s financing choice, as it relates to asset quality, reveals information about firm value. To establish this link empirically, we rely on a natural experiment from the listed-property firm industry. Housing property-firms had access to Fannie Mae-Freddie Mac secured debt financing during the peak of the 1998 Russian crisis (but not other financing options), whereas Non-Housing firms were shut out of all financing channels. Empirical evidence indicates that, consistent with our theory, better quality Housing firms migrated from the unsecured debt market into the secured debt market during a time of high equity issuance costs, thus raising the average revealed asset quality of firms in the pool of secured debt issuers. We rely on a series of falsification tests to rule out alternative explanations for our empirical findings.