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Ó The Eli Broad Graduate School of Management, Michigan State University, 2008
Lessons from the Financial Crisis
Lessons from the Financial Crisis
Charles J. Hadlock
Department of Finance, MSU
2Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Academic PerspectiveAcademic Perspective
• Financial economists trying to sort out what happened in 2008 and thereafter
• Was policy response optimal? How likely is another crisis? General outlook for financial markets looking forward
• Some of this work being done at MSU
• Not always easy to answer these questions, real world is many shades of gray
3Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
SecuritizationSecuritization
Bright Side
Lowered costs of borrowingIncreased rate of home ownershipAllowed better consumption smoothingMay have permanently increased housing prices
Dark sideLenders did not screen securitized loans as
carefully as other loans
Conditional on delinquency, securitized loans more likely to be foreclosed
4Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Role of Banks in the CrisisRole of Banks in the Crisis
Observations
Negative shock to real estate valuesNegative to shock to securities backed by real estateNegative shock to asset values of banksBanks are highly levered institutions
Result Financial distress [Bear Stearns, Lehman Bros.]Debt overhang problem
Other complications Counterparty risk, linkages across firmsDifficulty in assessing information, opaqueness
5Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Regulatory ResponseRegulatory Response
• Preferred equity investments in 10 largest banks plus guarantees on new debt/deposits
• Estimated increase in enterprise value because of these investments = $130 billion
• Estimated cost to taxpayers because of these investments ≤$ 44 billion
• Looks like a wise investment
• Future costs – bigger moral hazard problem
6Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Response by Financial InstitutionsResponse by Financial Institutions
• Limited new lending
• Banks with more deposit financing cut back less than banks using alternative funding sources
• Banks that syndicated loans with troubled institutions cut back lending more
• Firms drew down credit lines, exacerbated problem
7Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Response by FirmsResponse by Firms
• Firms cut investment spending sharply
• Firms without cash/credit lines/long-term debt cut back investment much more than others
• Financing crisis exacerbated recession and may inhibit recovery
8Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Challenges/LessonsChallenges/Lessons
• Good and bad features of interconnected financial markets
• Understand and regulate incentive problems brought about by financial innovation
• Regulation is a tricky business, hindsight is 20/20
• How do we avoid asset bubbles?
9Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Panelists/TopicsPanelists/Topics
• Naveen Khanna – Macroeconomic outlook
• Andrei Simonov – International perspectives
• Michael Mazzeo – Strategies for growth and value creation in challenging times
Ó The Eli Broad Graduate School of Management, Michigan State University, 2008
The current state of the economy
The current state of the economy
By Professor Naveen Khanna
Broadlink presentation
24th September, 2010
11Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
StimuliStimuli
•May ’08 Bush stimulus $ 178 b (tax rebate checks)•July ’08 Bush stimulus $ 200 b (for Fannie-Freddie)•Oct ’08 Bush stimulus $ 700 b (AIG, FF, (TARP))•Feb ’09 Obama stimulus $ 787 b (tax cuts, states,
public investments)•Total $ 1,865 billion
•Fed intervention to ease credit (guarantees, commercial paper, toxic asset purchases) amounted to as much as $2 trillion at its height.
•Unprecedented amount of intervention, possible only because of borrowing capacity and ability to print money since moved away from gold standard during Nixon’s presidency.
•Will it work? At what cost?
12Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
DeficitsDeficits
13Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Tax cuts or tax deference?Tax cuts or tax deference?
14Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
National debt as percent of GDPNational debt as percent of GDP
15Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
National debt in dollarsNational debt in dollars
16Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Money supply over timeMoney supply over time
17Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
GDP growth estimatesGDP growth estimates
18Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Unemployment estimatesUnemployment estimates
19Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Inflation estimatesInflation estimates
20Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Erosion of manufacturing baseErosion of manufacturing base
21Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Home valuesHome values
22Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Construction and vacancy ratesConstruction and vacancy rates
23Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Comparison of bear marketsComparison of bear markets
24Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
History of stock pricesHistory of stock prices
25Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Breakdown of GDPBreakdown of GDP
26Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Some wise sayingsSome wise sayings
• “No generation has the right to contract debt greater than can be paid off during the course of its own existence.” George Washington to James Madison 1789.
• “We hear sad complaints sometimes of merciless creditors; whilst the acts of merciless debtors are passed over in silence.” William Frend 1887.
• “I place economy among the first and most important virtues, and debt as the greatest of dangers to be feared.” Thomas Jefferson.
• “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crises should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” Ludwig von Mises.
27Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Non-structural versus structural illiquidityNon-structural versus structural illiquidity
• Was the recent economic crises due to non-structural illiquidity?
• Illiquidity in credit markets can destroy value.
• Businesses unable to function, consumers unable to create demand, increased unemployment reducing demand further, so on and on.
• Short sellers can initiate bear raids, making a bad situation critical?
• OR is the illiquidity structural; i.e., due to of lack of good projects?
• Banks are being sensible about withholding credit.
• Waiting for the excessive investment to work through the system
• Then Government induced liquidity may be only prolonging the recession and delaying recovery!!!
Ó The Eli Broad Graduate School of Management, Michigan State University, 2008
Lessons from the Financial Crisis:
Some International Aspects
Lessons from the Financial Crisis:
Some International Aspects
Andrei Simonov
Department of Finance
29Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
What really happens 2 years ago?What really happens 2 years ago?
•One view is that greedy US banks created subpime mess and impose suffering to the rest of the world.•Yet another view is that what happens was rational response of both households and financial institutions
–The problem of bad incentives built in extremely low interest rates and securitization process multiplied by extremely short horizon of most players
•This process was fundamentally international
30Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
31Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
32Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
EU: the same pattern as in the US, but in TreasuriesEU: the same pattern as in the US, but in Treasuries
33Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Fundamental instability of EuroFundamental instability of Euro
34Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Euro complications: New gold standard?Euro complications: New gold standard?
• Euro lacks a self-equilibrating mechanism. • Instead, countries with chronic trade deficits, such as Greece and
Portugal, have relied on the recycling of trade surpluses from Germany. Their economies buckled when lending dried up.
• No FX tools available to national government. • Among others, Italy and Ireland, have seen their labor costs rise
relative to Germany. Under a floating exchange rate regime, they would simply devalue. Within the Eurozone, however, they are forced into deflation and high unemployment to regain competitiveness.
• Spain’s unemployment rate at 20%. Ireland is experiencing its severest deflation since the 1930s.
• Euro might be worse than the gold standard. • The costs of going off gold turned out to be negligible. Leaving the
Eurozone is going to be much harder.
• Euro as political vs Euro as economic project.
35Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
36Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Fundamental problems with EU stress tests – and each one would have invalidated them.Fundamental problems with EU stress tests – and each one would have invalidated them.
• Tests left out some important institutions, whose financial health is not entirely clear.
• One of those is KfW, the German state-owned institution that is legally not a bank but carries out bank-like functions – such as accumulating lots of toxic assets.
• The second problem is the definition of the pass rate – a tier-one ratio of 6 per cent of a bank’s total assets.
• “The current definition of tier one capital is the reason why all the German Landesbanken have passed the tests. If one had used a narrower definition – equity and retained earnings only – the results would almost surely have been different” (FT).
• Sovereign default is off the picture
37Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
And EU banks are heavily exposed…And EU banks are heavily exposed…
38Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Stress tests: unrealistic assumptionsStress tests: unrealistic assumptions
Assumptions were created by national regulators, not ECB!
–Austria: in the worst case scenario unemployment is up 0.1% and (Sic!) real estate is up.–Italy: Real Estate declines 1.5%-2%–Spain: Unemployment is up 0.3%–Poland: real estate flat…
39Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
But despite 650B package, the default is comingBut despite 650B package, the default is coming
40Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
41Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
ConclusionConclusion
–Greek crisis is just an example. Real problems are in Italy, Spain, Portugal, Ireland.–Eurozone can survive Greek default, but it is unlikely to survive Spanish or Italian default.
•Finally, US did survive Lehman default (but Citi default could be more serious blow)
–Real problems now are not in the US financial system, but in Europe.
•Early signs are not that encouraging
–It is important to clean the system early on (done in the US, not done in Europe).–Lesson to the US: Refinancing is risky
42Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Ó The Eli Broad Graduate School of Management, Michigan State University, 2008
The Financial Crisis:Some Corporate
Observations and Consequences
The Financial Crisis:Some Corporate
Observations and Consequences
Michael A. Mazzeo
Department of Finance
44Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Fall 2008Fall 2008
• World financial markets were in the midst of a credit crisis
• We want to analysis how firms reacted to this crisis or maybe better termed a sharp aggregate credit supply shift.
• Constrained and unconstrained firm– Self Reported– Firm size correlates where small firms tend
to be more constrained
45Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Financially Constrained Firms in the U.S.Financially Constrained Firms in the U.S.
• Planned to Reduce for 2009 :– Employment by 11%– Technology spending by 22%– Capital investment by 9%– Dividend payment by 14%
• These are the results of surveying CFO’s based on Q4 of 2008*
• What causes this reaction?– Credit limitations? Real or Perceived?
• 81% of firms indicating that they were constrained indicated:– 59% believed they faced capital constraints– 55% cited difficulties in initiating or renewing a credit line
* Campello, Graham & Harvey (2010) Journal of Financial Economics
46Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Cash HoldingCash Holding
• The typical firm in the U.S. had cash and marketable securities of 15% of total assets in 2007
– Unconstrained firms were able to maintain these values into 2008
– Constrained firms burned through 1/5 of these cash assets in the last three months of 2008 leaving cash and marketable securities to about 12% of 2007 total assets.
47Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Credit Lines and Cash are Viewed as Connected
Credit Lines and Cash are Viewed as Connected
• When CFOs of constrained firms were asked about the use of lines of credit:
– 13% indicated they draw on their lines of credit in order to have cash for future needs.
– Another 17% indicated that they would draw down their lines of credit just in case their banks deny them credit in the future
48Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Corporate InvestmentCorporate Investment
• 86% of constrained firms indicated that they bypassed attractive investments due to difficulties in raising external funding
• 44% of unconstrained firms indicated that they bypassed attractive investments due to difficulties in raising external funding
• If a firm was unable to find external financing:– 56% of constrained firms canceled project,– A vast majority actually dis-invested by selling
assets for cash– Is this suboptimal or did firm's overinvest?
49Ó The Eli Broad Graduate School of Management,
Michigan State University, 2008
Corporate CashCorporate Cash
• The Federal Reserve recently indicated that corporate cash has reached $1.2 Trillion
• What we observe:
– Acquisitions have increased
– Share repurchases