FINANCIAL & ECONOMIC SITUATION

Where We Have BeenWhere We Are

Where We Are Going

Stock Crashes in 20th and 21rst Centuries

Time Frame DJIA Change (Real) Length

1907-08 -40% 13 months

1919-20 -46% 15 months

1929-33 -83% 43 months

1937-38 -49% 15 months

1946-48 -35% 21 months

1973-75 -51% 25 months

1978-82 -37% 48 months

1987-88 -28% 5 months

2000-01 -18% 16 months

2007-09 -53% 16 months…

U.S. Stock Crashes and Macroeconomic Events

Time FrameStock Market Change (DIJA) Length

GDP Change (Real)

Stock Change/ GDP Change

Highest Unemp. Rate

1907-08 -40% 13 months -5% 8 8.00%

1919-20 -46% 15 months -23% 2 11.30%

1929-33 -83% 43 months -29% 3 25.20%

1937-38 -49% 15 months -7% 7 19.10%

1946-48 -35% 21 months -5% 7 4.00%

1973-75 -51% 25 months -5% 10 9.00%

1978-82 -37% 48 months -7% 5 10.80%

1987-88 -28% 5 months >0% NA 5.80%

2000-01 -18% 16 months -1% 18 6.10%

2007-2009 -53% 16 months -4% 13 10.10%

Income & Debt Constraints Infinite Horizon Economy Budget Constraint:

PV Income + PV Debt = Debt Service + PV Consumption

“NPG” Condition: Over the long run income funds consumption (not debt) Entire economy faces a budget constraint just as households or

government Sustainable Long Run Relationship:

Income – Consumption – Debt Service>=0

Can Financial Events CauseMacroeconomic Problems?

Valuation of Stock, Debt (Firm Value) PV = Expected ∑ {Earnings/(1+r)} High valuations with either high earnings

expected or low risk expected (low discounts) Values in traded exchanges or part of story

Impacts of large overvaluations: Payments crisis Consumption/Investment effects

Wealth (balance sheet) effects Debt/Income ratios

High Valuations: (Leverage in different forms)1920s Equity “Bubble, 2000s Debt “Bubble”

JC: “If we tried to hold equity or corporate debt in highly leveraged entities funded by short-term debt, we would have the same problems. Actually, we did, back in the 1930s.”

“Leverage” often used as synonym for debt, but, equity can be overvalued and lead to financial pinches when it falls in value by large amounts; regardless of debt v. equity, the long run value is PV of income from them (Modigliani-Miller)

Consider 2 Scenarios for City Center (at $10T nominal value)

Case 1: $9T in Shareholder Equity with $1T in bank debt; Case 2: $1T in Shareholder Equity with $9T in bank debt: Assume “true” PV of future income = $5T

With project default: Case 1: Bank takes residual value = $1T

Original shareholders lose $9T New shares issued worth $4T Loss in balance sheets = $5T

Case 2: Bank takes residual value = $1T Shareholders lose $1T Bank loses $8T in value up front; issues new stock and regains $4T Loss in balance sheets =$5T

In both cases, balance sheets over-valued by $5T; purchases made with this “leveraged”

1920s: Stock (equity) Valuations Not Sustainable(beginning month = 1.0)

0.4

0.8

1.2

1.6

2.0

5 10 15 20 25 30 35 40 45 50

Oct 1927-Oct 1931

Nov 2005-Nov 2009

2008 Crisis & Aftermath Cause/Effect

What is the gasoline, what is the match? “Root causes” v. “Point-of-failure” causes versus

“root causes” Fed/Treasury actions

Water or gasoline?

2008 Root Cause?Debt Values Unsustainable

1.0

1.5

2.0

2.5

3.0

3.5

4.0

0

10000

20000

30000

40000

50000

60000

20 30 40 50 60 70 80 90 00

U.S. Debt -- right scale

Debt/GDP - left scale

“Poster” for Huge Non-Mortgage Debt

$11 Billion City Center ProjectLas Vegas – MGM MirageBank Loan/Bond Funded

How Much is Too Much?Debt-Income Ratios in Simulations

Long Run Debt-Income Ratio

Income Growth - Interest Rate for PV (Y-C-rb)>=0

3.5 0.60%3 -0.40%

2.5 -1.80%Assumptions: 75-year Horizon

APC = 0.80 (NIPA est.)

Post WWII

Variable Actual Post WWII Values Income Growth - Interest RateIncome Growth 6.70%10-year Treasury 6.45% 0.25%

AAA Bond 6.75% -0.50%BBB Bond 7.67% -1.00%

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

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

50 55 60 65 70 75 80 85 90 95 00 05

Total Debt/GDP

Non-house-govt/gdp

House-debt/gdp

Govt Debt/gdp

Debt Growth in 2000s High Relativeto Prior (growing) Trend

2.6

2.8

3.0

3.2

3.4

3.6

3.8

00 01 02 03 04 05 06 07 08

Actual Debt/GDP

Forecast Debt/GDP(Based on 1980-99, AR(4) Model)

Common Explanations Moral Hazard-“Too Big to Fail”

Point-of-failure: Uncertainty about Fed action created spark

Long run problem: Fed guarantees, separating “systemic” v. non-systemic problems and some by instruments that veiled genuine risks

Taylor variant: Fed supplied too much money to markets in early 2000s

Variant: point of failure problems enhanced/created by MTM

Hamilton: Above may be true but partial Point-of-Failure: Oil prices summer of 2008 Long run: huge increases in mortgage debt put system

at risk; much more vulnerable to point-of-failure issues

Role of Moral Hazard/Policy Uncertainty

Moral Hazard Thesis Long Run: Existence of Fed creates a moral hazard; greater risk

taken in banking/finance sector Cochrane: bank run externality requires something like Fed, and some

moral hazard Moral hazard too great because market expects Fed to cover

everything (over given size) Incremental impact of moral hazard?

Private firms/stockholders/execs bore a huge cost, even if not all the cost Isn’t this tradeoff of having a Fed as Lender of Last Resort (insurer)?

Policy Uncertainty Thesis Short Run: policy uncertainty is the match

In Sept 08, Fed let’s Lehman fail, saves AIG Spurs crisis by statements about conditions Prisoner’s dilemma for Fed

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

-2

-1

0

1

2

3

4

5

6

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

90 92 94 96 98 00 02 04 06 08

TED (Libor -TB3) KCFSI

-1

0

1

2

3

4

5

6

07M01 07M07 08M01 08M07 09M01 09M07

TED KCFSI

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

Prime AAA BBB Fed Funds ComPaper0

1

2

3

4

5

6

7

8

9

1990-992003-07:7

Cheap Credit:Fed Responsible?

-8

-4

0

4

8

12

16

20

82 84 86 88 90 92 94 96 98 00 02 04 06 08

Inflation Rate & Smoothed (HP Filter)

Cheap Credit: Public Sector Supply

1000

2000

3000

4000

5000

6000

7000

8000

9000

90 92 94 96 98 00 02 04 06 08

GSE Assets + Govt-MBS(in Billions $)

Cheap Credit: Private Sector Supply

Cheap Credit: Increasing Leverage

Cheap Credit:Inflow of Foreign Capital

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

.000

.004

.008

.012

.016

.020

.024

.028

.032

50 55 60 65 70 75 80 85 90 95 00 05

CAPINYHP DEBTY

Foreign Capital Inflow/GDP

Debt/GDP

Capital Inflows (Smoothed) and Debt Growth

Role of Foreign Capital?

-.01

.00

.01

.02

.03

.04

.05

.06

97 98 99 00 01 02 03 04 05 06 07 08 09

U.S.

Euro Area

Capital Inflows Relative to GDP

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/marktomarket123008.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. $3B (out of $1.2T) BoA assets increase by apx. $9B (out of $1.4T)

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

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

1.2

1.6

2.0

2.4

2.8

3.2

3.6

5 10 15 20 25 30 35 40 45 50

Debt-GDP Ratio 2001-09

Debt-GDP Ratio 1923-1931

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