2008 MACROFINANCE CRASH Explanations Questions Stock Crashes in

2008 MACROFINANCE CRASH Explanations & Questions

Stock Crashes in 20 th and 21 rst Centuries

U. S. Stock Crashes and Macroeconomic Events

Can Financial Events Cause Macroeconomic Problems? � “Payments crises” (liquidity crises) � Debtors (first level) stop payments � Lenders (first level) income drop, reduce payments on short term loans � Short-term (money market) lenders income drop, reduce payments … � Consumption/Investment effects � Wealth (balance sheet) effects: firms, households reduce consumption/investment as wealth decreases � Debt/Income ratios: solvent firms, household reduce consumption/investment to bring debt to income ratios down

Framework for Thinking about Debt and Macro Outcomes � Infinite Horizon Economy Budget Constraint: PV Income + PV Debt � “NPG” Condition: Over the long run income funds consumption (not debt) � � = Debt Service + PV Consumption Entire economy faces a budget constraint just as households or government Sustainable Long Run Relationship: Income – Consumption – Debt Service >= 0 � Income Growth > Interest Rate on Debt �

Example Calculations on Sustainable Debt/Income Ratios

Aggregate U. S. Debt and Debt/GDP Levels

Mortgage Debt only Part of the Story: Commercial Lending a Bigger Part

Debt Growth in 2000 s High Relative to Prior (growing) Trend

Case Study of U. S. Debt $11 Billion City Center Project Las Vegas – MGM Mirage Bank Loan/Bond Funded

1920 s Equity “Bubble & 2000 s Debt “Bubble”: Same Story, Different Financial Instruments � Whether Debt-instrument (bond, loan) funded or Equity (stock) funded, ultimate value is net revenue stream from project (Modigliani-Miller Theorem) � High Debt or Equity values imply high expected future net revenue � Consider 2 Scenarios for City Center (at $10 B nominal value) Case 1: $9 B in Shareholder Equity with $1 B in bank debt; � Case 2: $1 B in Shareholder Equity with $9 B in bank debt: � Actual PV of future net revenue of project = $5 T � With project bankruptcy: � Case 1: Bank claims bankruptcy value = $1 B � � Case 2: Bank claims bankruptcy value = $1 B � Original shareholders lose $9 B New shares issued worth $4 B Loss in balance sheets = $5 B Shareholders lose $1 B Bank loses $8 B in value up front; issues new stock and regains $4 B Loss in balance sheets = $5 B In both cases, assets on balance sheets over-valued by $5 T; purchases made with this “leverage”

1920 s: Stock Valuations Indicating Very High Net Revenues to Make Sustainable

Common Explanations � Long Run Problems: Mortgage markets overvalued � Fed & other gov’t guarantees (moral hazard) pushing mortgage markets � Fed supplied too much money to markets in early 2000 sseparating “systemic” v. non-systemic problems � Poor pricing models separating “systemic” v. nonsystemic problems pushing too much money into mortgage markets � Short Run Sparks � Uncertainty about Fed reaction � Lack of Fed reaction (2007 -08) � Marked-to-market accounting for mortgages

Evaluating “Policy Uncertainty” Thesis: Financial Stress Appearing Long Before Sept 08

Why So Much Attention on Mortgage Debt? � See mortgage debt as leading indicator, not as only cause � Fire analogy: room with fire in it first does not tell you about the fuel and match � Mortgage debt securitized-tradeable; � Quickly � reflecting change in valuations Commercial bank loans non-tradeable; � Held at bank estimated values for longer

Causes of Debt/GDP Expansion: Cheap Credit 9 8 7 6 5 1990 -99 2003 -07: 7 4 3 2 1 0 Prime AAA BBB Fed Funds Com. Paper

Cheap Credit: Fed Responsible?

Cheap Credit: Public Sector Supply

Cheap Credit: Private Sector Supply

Cheap Credit: Increasing Leverage

Cheap Credit: Inflow of Foreign Capital

Role of Foreign Capital?

Cheap Credit: Innovations? � Securitization, e. g. CDOs � Pooling � mortgage (other debt) risk (CDOs, SPVs) Credit Insurance � Transferring Risk (CDS) � Cochrane: can shuffle risk around, but not change total amount � Evaluation: � CDOs, CDS actually relatively small versus size of overall debt growth

Marked-to-Market Accounting? � � How big of an effect is possible from MTM pricing of banks? See SEC Dec. 2008 Study www. sec. gov/news/studies/2008/marktomarket 123008. pdf � 31% of bank assets MTM 22% of these impact income statement Part of this amount in Treasuries � Differences in MTM and “amortized cost” � If 20% difference, then 4. 4% impact on income � Currently, using “amortized cost” method Citi assets increase by apx. $3 B (out of $1. 2 T) Bo. A assets increase by apx. $9 B (out of $1. 4 T)

Solutions? � Cochrane: � Specify � systemic risk for Fed, limiting TBTF Stiglitz, … � Limit financial innovation � More stringent oversight � Poole, Bullard, BG, … � Raise equity standards � Limit financial firm size Charge insurance fee based on size Explicit size limitations

Higher Equity Standards the answer? Modigliani-Miller Theorem: Capital Structure Irrelevance � No difference of debt v. equity (ownership shares) financing of projects if � Asset prices move with statistical independence; � Asset prices are information based without systematic errors; � Taxes treatment of both sources is the same � Bankruptcy treatment of both is the same � No asymmetry of knowledge among borrowers, lenders, shareholders � Implies capital structure matters to the degree that these conditions matter

Debt-GDP Ratios 20 s/30 s v. 2000 s