Question

Which of the following are not examples of a vicious cycle of deleveraging? Explain. a. Your university decides to sell several commercial buildings in the middle of town in order to upgrade buildings on campus. b. A company decides to sell its large and valuable art collection because other asset prices on its balance sheet have fallen below a critical level, forcing creditors to call in their loans to the company because of provisions written into the original loan contract. c. A company decides to issue more stock in order to voluntarily pay off some of its debt. d. A shadow bank must sell its holdings of corporate bonds because falling asset prices have led to a default on the terms of its loans with some creditors.

Short answer

a. Selling commercial buildings to upgrade campus buildings b. Selling an art collection to meet loan contract provisions c. Issuing more stock to voluntarily pay off debt d. Shadow bank selling corporate bonds due to falling asset prices Answer: a, c

Step-by-step solution

a. Selling commercial buildings to upgrade campus buildings

In this case, the university is selling assets (commercial buildings) to upgrade its campus buildings. There is no indication that the university is selling these buildings to pay off any debt, or that the sale is causing asset prices to drop. Therefore, this is not an example of a vicious cycle of deleveraging.

b. Selling an art collection to meet loan contract provisions

Here, the company is selling its art collection because asset prices on its balance sheet have fallen below a critical level, forcing creditors to call in their loans. This indicates that the company is selling the art collection to pay off the debt, and this selling could potentially lead to further decline in asset prices. Thus, this is an example of a vicious cycle of deleveraging.

c. Issuing more stock to voluntarily pay off debt

In this scenario, the company is issuing more stock to pay off its debt voluntarily. This approach does not involve selling any assets, and so it cannot lead to a decline in asset prices. As a result, this is not an example of a vicious cycle of deleveraging.

d. Shadow bank selling corporate bonds due to falling asset prices

The shadow bank has to sell its corporate bond holdings because falling asset prices have led to a default on the terms of its loans with some creditors. This indicates that it is selling assets to pay off its debt, and this selling can cause prices to drop further, leading to more selling and more debt. Therefore, this is an example of a vicious cycle of deleveraging. In conclusion, options a and c are not examples of a vicious cycle of deleveraging.

Key concepts

Asset Selling

Asset selling plays a pivotal role in financial cycles, often acting as a measure that organizations resort to when faced with financial distress. When a company or entity decides to sell off its assets, it usually does this to free up cash.
This can solve short-term liquidity issues, or repay outstanding debts.
In a normal scenario, selling assets might simply be part of strategic financial management or planning for growth and investment.

• For example, if a university sells buildings to upgrade its campus, it's a strategic decision rather than an obligation to meet deleveraging demands.
• However, when the need to sell assets is driven by external financial pressures, it could lead to a vicious cycle of deleveraging, as in the case of a company forced to sell its art collection to meet creditor demands.

During deleveraging, the forced selling of assets can lead to a decrease in their market value. This can trigger further sales as the pressure to satisfy creditors mounts. This cycle can perpetuate, continuously lowering asset prices and causing financial strain.

Debt Management

Effective debt management is crucial for maintaining the financial health of an organization. It involves juggling current assets and liabilities to ensure that there's enough liquidity to handle day-to-day operations and long-term commitments.

Companies might employ a variety of strategies to manage their debt:

• Issuing new stock, as seen in the exercise, can be a solution to manage debts. By increasing equity rather than selling off assets, a company can maintain its asset base and possibly prevent further financial strain.
• Voluntarily paying off debt, when circumstances allow, is a proactive approach to reduce financial liabilities without triggering a harmful cycle of asset devaluation.

In contrast, ineffective debt management or being forced to take hasty actions like asset selling under creditor duress can lead to a vicious cycle. This cycle consists of falling asset values leading to more sales and declining financial stability.

Creditor Relations

Managing relationships with creditors is an essential aspect of financial management.
Relationships are based on trust that the borrower will meet its obligations.
This becomes especially pivotal during financial downturns.

• In a smooth scenario, the company maintains open communication with creditors, ensuring that all loan terms are honored.
• However, if asset prices fall significantly, creditors might lose confidence and demand loan repayments urgently, as stated in the loan contracts of the exercise.

This can result in asset sales to quickly generate cash. This action can damage the company’s financial standing due to hurried and likely undervalued asset sales. Maintaining solid creditor relations and negotiating terms can help avoid spiraling into the vicious cycle of deleveraging.

Financial Cycles

Financial cycles refer to the natural ebb and flow of economies and markets over time. They encompass expansions and contractions, where periods of growth can eventually lead to downturns.

During a financial downturn, companies might find themselves in a deleveraging cycle, where falling asset values necessitate more sales, further depressing the market.

• This vicious cycle can become detrimental if not managed quickly, leading to decreased asset valuations across the board.
• Understanding financial cycles helps businesses prepare for market downturns, potentially reducing the risks of falling into a deleveraging loop.

Proactive strategies, such as maintaining diversified asset portfolios and prudent debt management practices, could safeguard against the adverse impacts of financial cycles. Avoiding excessive reliance on short-term financing can also be a wise preventative action against falling into these cycles.