The Eli Broad Graduate School of Management, Michigan State University, 2008 Lessons from the Financial Crisis Charles J. Hadlock Department of Finance,

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



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



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



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



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



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



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?



Panelists/TopicsPanelists/Topics

• Naveen Khanna – Macroeconomic outlook

• Andrei Simonov – International perspectives

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


The current state of the economy

The current state of the economy

By Professor Naveen Khanna

Broadlink presentation

24th September, 2010



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?



DeficitsDeficits



Tax cuts or tax deference?Tax cuts or tax deference?



National debt as percent of GDPNational debt as percent of GDP



National debt in dollarsNational debt in dollars



Money supply over timeMoney supply over time



GDP growth estimatesGDP growth estimates



Unemployment estimatesUnemployment estimates



Inflation estimatesInflation estimates



Erosion of manufacturing baseErosion of manufacturing base



Home valuesHome values



Construction and vacancy ratesConstruction and vacancy rates



Comparison of bear marketsComparison of bear markets



History of stock pricesHistory of stock prices



Breakdown of GDPBreakdown of GDP



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.



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!!!


Lessons from the Financial Crisis:

Some International Aspects

Lessons from the Financial Crisis:

Some International Aspects

Andrei Simonov

Department of Finance



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







EU: the same pattern as in the US, but in TreasuriesEU: the same pattern as in the US, but in Treasuries



Fundamental instability of EuroFundamental instability of Euro



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.





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



And EU banks are heavily exposed…And EU banks are heavily exposed…



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…



But despite 650B package, the default is comingBut despite 650B package, the default is coming





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




The Financial Crisis:Some Corporate

Observations and Consequences

The Financial Crisis:Some Corporate

Observations and Consequences

Michael A. Mazzeo

Department of Finance



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



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



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.



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



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?



Corporate CashCorporate Cash

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

• What we observe:

– Acquisitions have increased

– Share repurchases

Documents

The Eli Broad Graduate School of Management, Michigan State University, 2008 Lessons from the Financial Crisis Charles J. Hadlock Department of Finance,