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Know thy CEO

Posted on | October 7, 2009 | 802 views |

CEO’s home mortgage explains firm’s use of debt

By Jeff Grabmeier

If you want to know how much debt a corporation is willing to take on, take a look at the CEO’s personal finances.

A new study finds that corporations with higher levels of debt tend to have CEOs who also owe more on their own homes.

Firms whose CEOs have home mortgages have about 4 percentage points more debt than do firms whose CEOs do not take out a mortgage to finance their primary personal residences.

The results suggest that the personal attitudes of CEOs toward debt have a strong effect on their firms’ financial decisions.

“It’s not just the characteristics of the firm or the industry that determine a company’s debt choices. Our findings suggest that you have to also look at the personal characteristics of the CEO to fully explain these financial decisions,” said Anil Makhija, co-author of the study and Rismiller Professor of Finance at Ohio State University’s Fisher College of Business.

While other studies have shown how a CEO’s personal characteristics shape management styles and some financial policies at a firm, Makhija said this is the first research to show how CEOs’ personal preferences can impact debt use — one of the most important financial decisions made by a firm. Past studies have ignored the personal debt preferences of CEOs in explaining the use of debt by firms.

Makhija conducted the study with Henrik Cronqvist, professor of economics and finance at Claremont McKenna College, and Scott Yonker, a graduate student at the Fisher College.

The study is available as a working paper at the Social Science Research Network, the Dice Center for Research in Financial Economics Web site, and other places.

The researchers started by looking at the CEOs of the largest U.S. firms — those leading the S&P 1,500. They then used several public data sources to collect information on the CEOs’ primary residences and mortgages.

They ended up with a sample of 1,351 CEOs. This data provided an interesting snapshot of the lifestyles of the country’s top CEOs. Results showed that the average CEO bought his or her home for $1.65 million in 2005 home price dollars. The average house was 5,180 square feet, had four bedrooms, and about 11 rooms in total.

Results showed that 67 percent of the corporate leaders used a mortgage when they purchased their home, and that they borrowed an average of 66 percent of the purchase price — only somewhat lower than the US average of 75 percent. How the CEOs financed their homes is an indicator of their tolerance for debt, a trait that is difficult to measure otherwise, Makhija said.

The researchers then compared how much debt the CEOs had on their homes with how much debt the firms they led had compiled.

They found a strong positive relationship between personal and corporate debt, even after they took into account a wide variety of factors that could affect either kind of leverage, personal or corporate.

Of course, that fact isn’t necessarily bad if corporate boards of directors are choosing CEOs because of their personal views on debt, and with the expectation that they will follow those preferences at the company.

To test that theory, the researchers also looked at what happened when firms changed CEOs. They found that firms generally hired new CEOs that were similar to their previous leaders in terms of personal preferences for debt on their homes.

But when boards did select new CEOs that had different personal views on debt than did their predecessors, the firm tended to change its own debt structure in ways consistent with the new CEO.

However, the researchers also found evidence of another explanation: CEOs were more likely to imprint their own personal views on debt of the corporations they led when the firms had weak governance, meaning that the boards did not adequately control the actions of their leader.

“When boards provide strong leadership, CEOs don’t have as much opportunity to let their personal views on debt — instead of only business reasons — impact their management of the firm,” he said. “But when the boards are weak, CEOs can push the firm in the direction of their own traits and preferences.”

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