I got on a plane to Motor City at 4 pm Thursday and the market was up 380 points. I wonder where it will close…(UPDATE: Obviously lots has happened since then!)
There are many, many lessons from this ongoing financial crisis. We professors of the dismal science, especially those of us who dabble in financial economics, will have plenty to talk about for years to come. Adverse selection, a concept that has to be part of any explanation, will have to be resurrected in many an MBA curriculum.
There is a fair amount of talk about the greed and stupidity of Wall Street managers. I think we should be a little careful in doling out blame as a result of what might be more of a perfect storm, a truly once-in-a-hundred years type event. Does some behavior of the past few years at this point look really stupid? Yes. Will it always be possible to find evidence of stupid behavior after a crisis? Yes.
One specific point that I have been thinking about is this: how could the principals in investment banking have thought that putting $30 of risky assets on top of $1 of equity be a reasonable idea?
We should hesitate just a bit, right? These are smart people, with great educatons, who even if they did not have huge ownership stakes (most of them did) it was pretty clear that their income depended on their firm surviving. That is, incentives were aligned and ability was certainly there. (There might be some issue around overpowered equity incentives, creating incentives to swing for all or nothing, but I would have to be convinced on this one.)
So leaving aside the question of how they got to a balance sheet of $25 billion of equity and $750 billion of risky assets, let’s just think for a minute of how you get out of the situation (these are roughly the Lehman numbers).
The $750 billion of assets is yielding a cash profit stream based on a spread, say borrowing at 5% and lending at 5.005% (yes, a very thin spread, but on a huge asset base). That yields $3.75 billion of spread, which along with some fee income etc., and a capitalization factor of 6.67 yields a market value of equity of the $25 billion.
Now all of a sudden those assets paying 5.005% lose two percent of their value. The two percent loss of value is $15 billion, so over half of your market value of equity is gone, and your leverage has increased even more.
So, why don’t the managers work out of this situation? Well, suppose they sell half of the assets remaining. But that leaves only about $368 billion of assets, with the cash flow stream from that spread now only $1.84 billion, which with the same capitalization factor of 6.67 yields an equity value of $12.3 billion. Selling any of the remaining assets takes away more equity value, which is going to be hard to swallow.
What I am saying is that once you suffer the loss in asset value, to deleverage by selling assets can be quite painful, as it gets rid of assets that are contributing cash flow, and , with lack of information from outsiders, market value as well. Holding on to the assets, while they continue to pay cash, is going to be real tempting.
And of course, getting more equity to deleverage is also difficult, as the new equity providers will see the new economics of the situation – that the old spread of .005 is no longer around. New equity will demand onerous terms, making old equity quite upset.
Do we see why we might try to hold on and see if times will get better?
I am trying to come up with a good metaphor. Maybe: it’s like asking a man dying of gangrene that has gone from his toe up his leg and is now attacking his whole body – why didn’t you cut that little toe off when it turned black?