asymmetry of debt
"Debt and leverage cause fragility; they leave less room for errors as the economic system loses its ability to withstand extreme variations in the prices of securities and goods. Equity, by contrast, is robust: the collapse of the technology bubble in 2000 did not have significant consequences because internet companies, while able to raise large amounts of equity, had no access to credit markets. ... A loan hides volatility as it does not vary outside of default, while an equity investment has volatility but its risks are visible. Yet both have similar risks. Thus debt is the province of both the overconfident borrower who underestimates large deviations, and of the investor who wants to be deluded by hiding risks. ...Instead of sending hate mail to near-insolvent homeowners, banks should reach out to borrowers and offer lower interest payments in exchange for equity. Instead of debt becoming “binary” – in default or not – it could take smoothly-varying prices and banks would not need to wait for foreclosures to take action. Banks would turn from “hopers”, hiding risks from themselves, into agents more engaged in economic activity. Hidden risks become visible; hopers become doers."
"The zero-sum redistribution characteristic of derivatives contracts in a frictionless world becomes a negative-sum redistribution when default and insolvency is involved. There is a fundamental asymmetry in the market game between winners and losers: there is no such thing as super-solvency for winners. But there is such a thing as insolvency for losers, if the losses are large enough."
Debt is more senior than equity. In other words cash first flows to creditors before it trickles down to shareholders.
Another important difference between the two instruments is highlighted by Taleb and Buiter: While equity absorbs both positive and negative income shocks in a continuous way, debt responds in a more discrete and asymmetric fashion.
A shock greater than a certain magnitude will trigger default. The indebted company may be saved from an outright liquidation via a successful restructuring, but the wounds inflicted by the direct and indirect costs of going through a bankruptcy process will stay with it. And what started out as a temporary problem, which could have been easily corrected by a contraction of the equity pillow, will acquire a long-lasting dimension.
