highlighting a few key ideas and issues. m&m: equity = debt value of firm projects matters a...
TRANSCRIPT
M&M: Equity = Debt
Value of firm projects matters a lot more than small differences in costs of funds
Breaks down at high debt/income ratios
1970s: Changes in earnings (numerator) is the driver
2000s: Changes in risk (denominator) is the driver
Manager Warnings Rapid shifts over time possible with variable
denominator P-E Ratios (or P/GDP) as Long Run Predictor
▪ High P/E = current risk assessment overly optimistic▪ Low P/E = current risk assessment overly pessimistic
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SP500/GDP (left scale)
SP500/Earnings (right scale)
Fed & Rates: Taylor RuleTarget Rate = 2 + 0.5*(Actual Inflation – Target Inflation)
+ 0.5*(Actual GDP – Potential GDP)
Markets & Rates: Fisher EquationObserved Rates = Real Rates + Expected Inflation
▪ Real Rates influenced by economic growth (higher when growth higher)▪ Estimate of Real Rate: TIPS (See Bloomberg Rates)
▪ Expected inflation influenced by Fed actions and velocity of money
Policy Limits: No interest rate “knob” for Fed; influences with money creation “Insurance” for system-wide panics
The Treasury Yield Curve: Steep: High growth or inflation expected Flat/Inverted: Low growth or inflation
expected
US Treasury Site
"Living Yield Curve"
Response: Limit risk; increase liquidity; cash in fixed price assets; no new projects; secure longer term deals; …
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$ per AU$FX per US$
Cheap Credit Public Sector Backing (Fannie, Freddie,
Homeownership) High Leverage (Assets/Equity) for Investment
Banks (Bear, Lehman, Merrill …) + AIG Banks Lending on 25 years of
growth/repayment Foreign Investment in US
NOTARIETY BUT TOO SMALL ▪ Securitization (Collateralized Debt: CDOs)▪ Derivatives (Credit Default Swaps)▪ Market-to-Market Accounting
Mortgage-related securities marked-to-market daily Immediately begin to reflect deteriorating
conditions in 2007 Commercial loans on bank books valued by banks
at their PV of expected cash flow Widespread writing down of these loans doesn’t
begin until 2009, giving appearance that mortgage market problems causing these problems
Problems already developing coincidental with mortgage problems in 2007-08