loans or by issuing shares? Well, many entrepreneurs find themselves unable to get bank loans because the banks distrust their ideas. And that is not just a problem for newly started companies, it is often a problem for companies that have existed for a while and want to start new projects. By issuing bonds, they can turn directly to investors, and they might be able to find someone willing to buy their bonds, which therefore enable new business expansion while providing investors with superior return. Usually companies and particularly companies have to pay significant risk premiums compared to governments to compensate investors for the higher level of risk. Because of the higher risk, these bonds are often referred to as “junk bonds”, but studies have shown that companies issuing junk bonds are more successful than other companies27.
The alternative of issuing stocks might be a good alternative in many cases, but for others less so. One reason could be that by issuing stocks, the current owners would lose their control of the company. Also, if the project is deemed to be profitable enough, it will be cheaper to raise capital by issuing junk bonds than by issuing shares that would give the new investors part of the abnormal profits.
Another form of bonds that have become increasingly controversial are asset backed securities, and various financial instruments that were based upon them, including Structured Investment Vehicles (SIV). Nouriel Roubini, president of RGE Monitor and economic professor at NYU famously called for a ban on SIVs28, and SIVs and the asset backed securities they were based upon were similarly indicted in the famous humorous “interview” between comedians John Bird and John Fortune about the financial crisis29. The reason why they have become so controversial is that they have been blamed for reckless lending standards by banks and other mortgage lenders. The idea is that if mortgage lenders can sell the mortgage to investors as the collateral in mortgage backed securities; this means that they can issue loans to people who can’t afford them and then sell the loan to others who will then take the loan losses. Yet this begs the question as to why investors would want to buy such dodgy debt. Or to put it another way: how could
27 The Fortune Encyclopedia of Economics (1993) pages 589-590 ”Junk Bonds” http://skepticaltexascpa.blogspot.com/2007/12/mlec-rip.html http://www.youtube.com/watch?v=mzJmTCYmo9g 28 29