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Lessons from the Financial Crisis

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					                                                 Lessons from the
                                                  Financial Crisis
                                                       Charles J. Hadlock
                                                   Department of Finance, MSU




 The Eli Broad Graduate School of Management,
  Michigan State University, 2008
                 Academic 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


     The Eli Broad Graduate School of Management,
2     Michigan State University, 2008
                 Securitization

        Bright Side

                          Lowered costs of borrowing
                          Increased rate of home ownership
                          Allowed better consumption smoothing
                          May have permanently increased housing prices

        Dark side
               Lenders did not screen securitized loans as
               carefully as other loans

                          Conditional on delinquency, securitized loans more
                          likely to be foreclosed
     The Eli Broad Graduate School of Management,
3     Michigan State University, 2008
                 Role of Banks in the Crisis

        Observations

                          Negative shock to real estate values
                          Negative to shock to securities backed by real estate
                          Negative shock to asset values of banks
                          Banks are highly levered institutions

        Result
                          Financial distress [Bear Stearns, Lehman Bros.]
                          Debt overhang problem

        Other complications
              Counterparty risk, linkages across firms
              Difficulty in assessing information, opaqueness
     The Eli Broad Graduate School of Management,
4     Michigan State University, 2008
                 Regulatory 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


     The Eli Broad Graduate School of Management,
5     Michigan State University, 2008
                 Response 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




     The Eli Broad Graduate School of Management,
6     Michigan State University, 2008
                 Response 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




     The Eli Broad Graduate School of Management,
7     Michigan State University, 2008
                 Challenges/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?




     The Eli Broad Graduate School of Management,
8     Michigan State University, 2008
                 Panelists/Topics


        • Naveen Khanna – Macroeconomic outlook

        • Andrei Simonov – International perspectives

        • Michael Mazzeo – Strategies for growth and value
          creation in challenging times




     The Eli Broad Graduate School of Management,
9     Michigan State University, 2008
                                         The current state of the
                                               economy




                                                    By Professor Naveen Khanna

                                                      Broadlink presentation
                                                       24th September, 2010




 The Eli Broad Graduate School of Management,
  Michigan State University, 2008
                    Stimuli

           •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?


      The Eli Broad Graduate School of Management,
11     Michigan State University, 2008
                  Deficits




      The Eli Broad Graduate School of Management,
12     Michigan State University, 2008
                  Tax cuts or tax deference?




      The Eli Broad Graduate School of Management,
13     Michigan State University, 2008
                  National debt as percent of GDP




      The Eli Broad Graduate School of Management,
14     Michigan State University, 2008
                  National debt in dollars




      The Eli Broad Graduate School of Management,
15     Michigan State University, 2008
                  Money supply over time




      The Eli Broad Graduate School of Management,
16     Michigan State University, 2008
                  GDP growth estimates




      The Eli Broad Graduate School of Management,
17     Michigan State University, 2008
                  Unemployment estimates




      The Eli Broad Graduate School of Management,
18     Michigan State University, 2008
                  Inflation estimates




      The Eli Broad Graduate School of Management,
19     Michigan State University, 2008
                  Erosion of manufacturing base




      The Eli Broad Graduate School of Management,
20     Michigan State University, 2008
                  Home values




      The Eli Broad Graduate School of Management,
21     Michigan State University, 2008
                  Construction and vacancy rates




      The Eli Broad Graduate School of Management,
22     Michigan State University, 2008
                  Comparison of bear markets




      The Eli Broad Graduate School of Management,
23     Michigan State University, 2008
                  History of stock prices




      The Eli Broad Graduate School of Management,
24     Michigan State University, 2008
                  Breakdown of GDP




      The Eli Broad Graduate School of Management,
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                  Some 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.

      The Eli Broad Graduate School of Management,
26     Michigan State University, 2008
                  Non-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!!!

      The Eli Broad Graduate School of Management,
27     Michigan State University, 2008
                                                 Lessons from the
                                                  Financial Crisis:
                                                 Some International
                                                      Aspects

                                                        Andrei Simonov
                                                     Department of Finance




 The Eli Broad Graduate School of Management,
  Michigan State University, 2008
                   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
       The Eli Broad Graduate School of Management,
29      Michigan State University, 2008
      The Eli Broad Graduate School of Management,
30     Michigan State University, 2008
      The Eli Broad Graduate School of Management,
31     Michigan State University, 2008
                  EU: the same pattern as in the US, but in
                  Treasuries




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32     Michigan State University, 2008
                  Fundamental instability of Euro




      The Eli Broad Graduate School of Management,
33     Michigan State University, 2008
                  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.
      The Eli Broad Graduate School of Management,
34     Michigan State University, 2008
      The Eli Broad Graduate School of Management,
35     Michigan State University, 2008
                  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



      The Eli Broad Graduate School of Management,
36     Michigan State University, 2008
                  And EU banks are heavily exposed…




      The Eli Broad Graduate School of Management,
37     Michigan State University, 2008
                   Stress 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…




       The Eli Broad Graduate School of Management,
38      Michigan State University, 2008
                  But despite 650B package, the default is
                  coming




      The Eli Broad Graduate School of Management,
39     Michigan State University, 2008
      The Eli Broad Graduate School of Management,
40     Michigan State University, 2008
                  Conclusion

           –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

      The Eli Broad Graduate School of Management,
41     Michigan State University, 2008
      The Eli Broad Graduate School of Management,
42     Michigan State University, 2008
                                                 The Financial Crisis:
                                                   Some Corporate
                                                  Observations and
                                                   Consequences

                                                       Michael A. Mazzeo
                                                      Department of Finance




 The Eli Broad Graduate School of Management,
  Michigan State University, 2008
                  Fall 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
      The Eli Broad Graduate School of Management,
44     Michigan State University, 2008
                  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
      The Eli Broad Graduate School of Management,   * Campello, Graham & Harvey (2010) Journal of Financial Economics
45     Michigan State University, 2008
                    Cash 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.




      The Eli Broad Graduate School of Management,
46     Michigan State University, 2008
                               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




      The Eli Broad Graduate School of Management,
47     Michigan State University, 2008
                  Corporate 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?
      The Eli Broad Graduate School of Management,
48     Michigan State University, 2008
                  Corporate Cash

         • The Federal Reserve recently indicated that corporate
           cash has reached $1.2 Trillion

         • What we observe:

                  – Acquisitions have increased

                  – Share repurchases




      The Eli Broad Graduate School of Management,
49     Michigan State University, 2008

				
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