Modigliani-Miller, RIP

Even a casual observer knows that the current financial crisis was partially caused by high leverage ratios. But did you know that a Nobel Prize in Economics [sic] was awarded for a theorem that "proved" that leverage ratios don't matter? Yes, it is called the Modigliani-Miller theorem:

Leverage doesn't matter!

Consider two firms which are identical except for their financial structures. The first (Firm U) is unlevered: that is, it is financed by equity only. The other (Firm L) is levered: it is financed partly by equity, and partly by debt. The Modigliani-Miller theorem states that the value of the two firms is the same.

See if you can spot the completely unrealistic efficient market "no-arbitrage" assumption used to prove the theorem:

Proposition: VU = VL, where VU is the value of an unlevered firm = price of buying a firm composed only of equity, and VL is the value of a levered firm = price of buying a firm that is composed of some mix of debt and equity.

To see why this should be true, suppose an investor is considering buying one of the two firms U or L. Instead of purchasing the shares of the levered firm L, he could purchase the shares of firm U and borrow the same amount of money B that firm L does. The eventual returns to either of these investments would be the same. [Ha ha ha ha!] Therefore the price of L must be the same as the price of U minus the money borrowed B, which is the value of L's debt.

If U and L are banks investing in risky mortgage assets, which do you think is going to collapse due to a run when those assets are marked down? (See here for more problems.)

Believe it or not, Nobelist Myron Scholes invokes Modigliani-Miller in this debate over stronger financial regulation at the Economist web site. ***

Here is what I wrote in a post back in March 2008 (Privatizing gains, socializing losses).

I'd like to hear a believer in efficient markets try to tell the story of Bear Stearns' demise. One week it was OK for them to be levered 30 to 1, the next week it wasn't? When the stock was at 65 people were comfortable with their exposure to mortgages, but then suddenly they weren't? Come on.

My corollary to the Modigliani-Miller theorem: A Nobel in Economics ain't no Nobel in Physics. (Sorry, Krugman.)


*** Footnote: I do agree with Scholes' point that any argument for regulation needs to take into account the benefits from innovation that we might be giving up.