Costly External Finance, Corporate Investment, and the Subprime Mortgage Credit Crisis

Ran Duchin, Oguzhan Ozbas and Berk Sensoy

Motivation Real effects of the financial crisis. In particular, corporate investment. Role of internal resources (cash) during a

supply shock.

August, 2007

Motivating Figure 1:Cash

10

15

20

25

Cas

h (p

erce

ntag

e of

tota

l ass

ets)

1985 1990 1995 2000 2005 2008Year

Average Cash/Assets (%)

Motivating Figure 2: Cash and Returns

-.05

0

.05

.1

.15

.2

Cu

mul

ativ

e A

bno

rmal

Re

turn

Mar Jun Sep Dec2007

High cash Low cash H - L

Cash Sorted Portfolio Returns

This Paper

Non-financial firms cut investment following the onset of the crisis.

More so when less cash on hand. More so when financially constrained or

dependent on external financing. Some evidence of an interaction, especially

between cash and external finance dependence.

Empirical Strategy Differences-in-differences

Before (Q3 2006- Q2 2007) vs. after (Q3 2007 – Q2 2008).

Response as a function of cash reserves Firm fixed effects Control for Q, cash flow Standard errors clustered by firm

itititiiit CFQCashAfterAfterI 4321

Endogeneity Cash holdings may be endogenous to

investment opportunities. Use lagged cash as an “instrument”.

Measure cash as of Q2 2006.

Timeline

Before2006Q3 – 2007Q2

After2007Q3 – 2008Q2

Subprime MortgageCredit Crisis

Cash Reserves2006Q2

Key Result: Investment

After -0.104

[0.023]

-0.143

[0.031]

After x Cash 0.323

[0.100]

Q 0.157

[0.033]

Cash Flow -0.090

[0.155]

Firm Fixed Effects Yes Yes

Firm Clustered SE Yes Yes

Endogeneity What if even lagged cash proxies for

susceptibility to demand shocks? We provide direct evidence against this idea. We also provide cross-sectional evidence based

on financial constraints and external finance dependence, consistent with a supply effect.

Direct Evidence: Placebo Regressions

(1) (2) (3) (4)

After -0.399

[0.026]

0.108

[0.030]

0.027

[0.033]

-0.038

[0.032]

After x Cash Reserves -0.116

[0.079]

0.106

[0.102]

-0.286

[0.101]

-0.047

[0.099]

Q 0.146

[0.022]

0.136

[0.034]

0.150

[0.041]

0.213

[0.035]

Cash Flow -0.139

[0.115]

0.049

[0.116]

-0.040

[0.131]

-0.037

[0.132]

Placebo Crisis Date 9/11 2004Q2 2005Q2 2006Q2

Placebo Conclusions Relation between lagged cash and investment

is not a general feature of the data. It is also not a feature of the data in bad times

that are mostly demand-driven.

Cash Reserves and Investment(1) (2) (3) (4) (5) (6)

After -0.104

[0.023]

-0.147

[0.030]

-0.145

[0.031]

-0.143

[0.031]

-0.143

[0.083]

After x Cash 0.209

[0.099]

0.293

[0.100]

0.323

[0.100]

0.269

[0.127]

0.323

[0.096]

Q 0.142

[0.030]

0.157

[0.033]

0.172

[0.034]

0.157

[0.038]

Cash Flow -0.090

[0.155]

-0.071

[0.153]

-0.090

[0.158]

Firm Fixed Effects Yes Yes Yes YesFirm & Ind-Qtr

Yes

Firm Clustered SE Yes Yes Yes Yes Yes Double

Magnitudes Column 1: Quarterly investment by the

average firm declined by 0.104 percentage points following the onset of the crisis.

Column 2: 0.147 percentage point decline in investment for a firm with no cash reserves, and no decline for a firm holding 70.3 of assets in cash.

Average quarterly investment is 1.7% of assets, so about 10% of the pre-crisis amount.

Magnitudes After x Cash coefficient is about 0.3. Sample average Cash is 0.23, with standard

deviation 0.26. One-standard deviation increase in Cash is

associated with 0.07 percentage points greater investment, almost offsetting the average decline (-0.10).

Cash Reserves, Financial Constraints and Investment

Panel A: Change in investment

Kaplan-Zingales Whited-Wu Bond Ratings

Low High Low High High Low

After -0.049

[0.026]

-0.138

[0.042]

-0.024

[0.019]

-0.114

[0.038]

0.002

[0.024]

-0.135

[0.027]

Panel B: Change in investment conditional on cash reserves

After -0.095

[0.036]

-0.174

[0.051]

-0.032

[0.027]

-0.250

[0.058]

-0.010

[0.036]

-0.203

[0.038]

After x Cash 0.226

[0.109]

0.429

[0.276]

0.206

[0.117]

0.573

[0.129]

0.294

[0.187]

0.398

[0.138]

Cash Reserves, External Finance Dependence and Investment

Change in investment

External Finance Dependence

Equity Dependence

Information Asymmetry

Low High Low High Low High

After -0.012

[0.033]

-0.272

[0.054]

-0.051

[0.035]

-0.223

[0.052]

-0.062

[0.043]

-0.243

[0.049]

After x Cash 0.113

[0.104]

0.540

[0.184]

0.182

[0.101]

0.445

[0.209]

0.212

[0.219]

0.456

[0.114]

Excess Cash and Investment(1) (2) (3) (4)

After -0.100

[0.023]

-0.075

[0.023]

-0.101

[0.023]

-0.074

[0.023]

After x Excess Cash 0.187

[0.099]

0.237

[0.096]

0.119

[0.096]

0.166

[0.096]

Q 0.152

[0.031]

0.155

[0.032]

Cash Flow -0.155

[0.150]

-0.103

[0.150]

Excess Cash Measure Baseline Baseline Extended Extended

Cash Reserves and Other Investment

(1) (2) (3) (4)

After -0.028

[0.030]

-0.128

[0.047]

-0.081

[0.040]

-0.247

[0.105]

After x Cash Reserves 0.661

[0.152]

0.789

[0.191]

0.438

[0.106]

1.591

[0.384]

Investment Measure SG&A R&D Inventory NWC

Conclusion Corporate investment declines following the

onset of the crisis. Decline mitigated by cash reserves, including

seemingly excess cash. Decline worse for financially constrained,

external finance dependent firms. Some evidence of an interaction, especially

between cash and external finance dependence.

Conclusion Evidence consistent with a supply effect. Campello, Graham, and Harvey (2009)

survey corporate managers and find that they are foregoing investments because of financing constraints.

Tong and Wei (2008) find that financially constrained firms exhibit worse stock-price performance during the crisis.

Conclusion Contributions are threefold.

Help understand the real effects of the crisis. Add to the literature on financial constraints,

external finance dependence and investment. Deepen our understanding of the role of corporate

cash holdings Bright-side of seemingly excess cash.

Nonparametric EvidenceBefore After (t-stat)

Low Cash 1.886 1.725 2.092

Medium Cash 1.929 1.828 1.281

High Cash 1.691 1.642 0.555

Low ST Debt 2.053 1.973 0.814

Medium ST Debt 1.762 1.673 1.213

High ST Debt 1.691 1.548 2.018

What Do We Know About Cash? Theory

Benefits of cash Precautionary motive (Keynes 1936)

Costs of cash Agency (e.g., Jensen 1986)

Evidence Precautionary cash holdings (Opler et al. 1999; Bates et

al. 2008) Agency costs of (excess) cash (Harford 1999; Dittmar and

Mahrt-Smith 2007)

Measuring Financial Constraints Kaplan-Zingales Index = -1.002*Cash Flow + 0.283*Q

+ 3.319*Debt – 39.368*Dividends – 1.315*Cash Whited-Wu Index = -0.091*Cash Flow +

0.062*Dividend Dummy + 0.021*Long Term Debt – 0.044*Size + 0.102*Industry Sales Growth – 0.035*Sales Growth

Bond Ratings = Indicator variable equal to 1 if the firm has a bond rating

What Do We know About Investment And The Supply Of Capital?

Theory (Credit Rationing ) Information Asymmetry (Jaffee and Russell (1976) ,

Stiglitz and Weiss (1981)) Moral hazard (Holmstrom and Tirole (1997))

Evidence Investment-Cash Flow Sensitivity (e.g., Fazzari,

Hubbard, and Petersen (1988), Hoshi, Kashyap, and Scharfstein (1991), Kaplan and Zingales (1997))

Inventory (Kayshap, Lamont and Stein (1994)) Credit supply shocks (e.g., Lemmon and Roberts

(2007), Tong and Wei (2008)

Measuring External Finance Dependence and Information Asymmetry Following Rajan and Zingales (1998), we

compute the following industry measures: External Finance Dependence =

Proportion of capital expenditure that cannot be financed by funds from operations

External Equity Dependence = Ratio of the net amount of equity issued to capital expenditures.

Information Asymmetry = Dispersion in productivity growth (to measure idiosyncratic firm performance)

A Standard Model of InvestmentWith Costly External Finance Choose I, E

When C is sufficiently high

When C is sufficiently low

IECts

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01)()( CIkIf SBSB

Model (Cont.) Effect of cash on investment

Effect of financing constraints on investment

0)()(

)(

CIkIf

CIk

dC

dISBSB

SBSB

0)()(

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CIkIf

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