Mini Case Study

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Mini Case Study

• Financial Mess!
• http//video.pbs.org/video/1082087546/

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Shocking headlines, but

• Cool cartoons!

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Where to begin!

• Several corporate-finance issues in play with the
  government response to the financial crisis
  (i.e., govt bailouts)
• Risk of leverage
• Implicit too big to fail put option
• Agency/moral hazard issues
• Seniority of financial claims
• Consolidation in industries

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Background (entering fall 2008)

• Total mortgage debt in U.S. 10-12T
• Fannie Mae and Freddie Mac are publicly-owned
  government sponsored enterprises (GSE)
• They make home loan guarantees and bundle
  mortgages to provide liquidity to the mortgage
  market
• Allows securitization of mortgages (a secondary
  market)
• Allows more mortgages to be undertaken at lower
  interest rate
• Fannie and Freddie own or guarantee about one
  half of the mortgage market!

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Background (continued)

• Implicit government bailout guarantee what if
  Fannie and Freddie fail? Will housing market be
  allowed to collapse?
• How will this affect the rate at which these
  companies can borrow?
• How will this affect capital structure choice of
  these companies?

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Background (continued)

• In 2007, subprime-mortgage crisis begins
• More and more borrowers defaulting on their
  mortgages (too lenient standards for the original
  loan and home equity evaporating with decline in
  housing prices)
• Losses for Fannie and Freddie have guaranteed
  these mortgages would be paid (further losses
  from mortgage-backed securities they own)

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Problem!

• Fannie and Freddie have extremely high leverage
  (debt ratio of roughly 95 at end of 2007)
• Little room for error, easy to get into a
  liquidity crisis, easy to have actually negative
  value of book equity as write-down value of
  assets
• In August, rating agencies downgrade rating of
  the preferred stock of both companies

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Solution for Fannie and Freddie
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First Big Government Bailout

• September 7, 2008 U.S. government takes over
  Fannie and Freddie
• CEOs and Boards fired (but CEOs leave with
  golden parachutes)
• U.S. buys 1B of preferred stock in each company
  (senior to existing preferred stock) with 10
  annual dividend (rises to 12 if miss dividend
  payment)
• U.S. gets warrants for purchase of 79.9 of
  common stock of each company
• Dividends on common and old preferred stock
  eliminated
• U.S. pledges to provide as much as 200B of
  additional capital as companies deal with more
  mortgage defaults

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Why Preferred Stock?

• Why did the government ask for preferred stock in
  exchange for the capital infusion instead of
  bonds or common stock (at least right away)?

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What happens in markets?

• Fannie and Freddie stock?
• Fannie and Freddie preferred stock?
• Fannie and Freddie debt?
• U.S. equity market?

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Market Reaction

• Fannie and Freddie common stock prices
  substantially lower on the Monday (9/8) following
  the Sunday govt takeover
• Fannie falls from 7.04 to 0.73 (37.46 on
  1/2/08)!
• Freddie falls from 5.10 to 0.88 (32.74 on
  1/2/08)!
• Old preferred stock further downgraded (is at
  junk level) on takeover news
• However, long-term Fannie and Freddie bonds
  maintain an SP rating of AAA
• U.S. equity markets up (SP 500 up 2.1)
• But market falls 3.4 the next day!

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Further concerns

• Half or mortgage market backed up by Fannie and
  Freddie
• But half is not!
• The half that is not will typically be riskier
  mortgages
• Financial institutions that sold or bought
  mortgage-backed securities of these riskier
  mortgages in really big trouble!

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A Tale of Two FirmsLehman Brothers and AIG
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Lehman Brothers

• Historic Wall Street investment bank
• Extensive holdings of mortgage assets
• Financial holdings fell substantially in value,
  still had to service its debt
• Could not raise external capital and difficult to
  raise cash by selling off its depreciating
  financial assets
• Government did not bail out with emergency loan
• Declared bankruptcy (Chapter 11)

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Credit Default Swaps (CDS)

• Credit default swaps are contracts that act like
  insurance against debt default
• Buyers make regular payment to sellers, sellers
  in turn promise to make a big payout to the buyer
  if the underlying bonds go into default
• The CDS market has grown substantially, CDS have
  been written for over 62T worth of bonds and
  loans entering fall 2008 (covering both corporate
  debt and mortgage-backed securities)
• 100 times larger market than it was in 2000!

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AIG

• American International Group Inc. (AIG)
• One of the worlds biggest insurers, largest U.S.
  insurer by assets
• Stock price plunged from around 56 at start of
  year to 3.75 at close 9/15/08
• Firm on verge of financial collapse

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What Going on at AIG?

• AIG more aggressive than most insurance companies
  in expanding its operations beyond life and
  property/casualty insurance
• AIG jumped into the market for credit default
  swaps (providing insurance to investors against
  default in a wide range of assets)
• AIG had business unit that made mortgage loans to
  consumers and another that provided insurance to
  lenders if the borrower defaulted on the mortgage

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AIG Financials

• AIG sold protection on 441B of fixed income
  assets (58B in securities tied to subprime
  mortgages)
• Losses of 18B during last 3 quarters
• At end of 2nd quarter, assets exceeded
  liabilities by 78B (but most of assets held by
  insurance subsidiaries as reserve requirements
  for insurance claims)

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Tumultuous Monday 9/15/08 for AIG

• Credit downgraded by Moodys and SP 9/15/08
• As a result, may need to post an additional
  14.5B in collateral and pay out 5.4B to
  terminate certain contracts
• Unable to receive private financing, not enough
  time to liquidate assets to meet its liquidity
  crunch
• Need a lender/investor! of last resort

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Another Govt Bailout

• Federal Reserve Act (1913) allows the Federal
  Reserve to make loans to non-banks under unusual
  and exigent circumstances
• Government bailout hammered out night of 9/16/08
• Receives infusion of up to 85 billion dollars
  from U.S. govt
• Two-year loan with interest rate of Libor plus
  8.5 percentage points
• U.S. also effectively gets 79.9 ownership of AIG
  equity through warrants received
• U.S. has right to veto any payments of dividends
  to common and preferred shareholders
• AIG must fire current CEO

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Why Bailout?

• Many mutual funds and banks (in U.S. and abroad)
  held AIG bonds in their portfolios
• If AIG failed, AIG bond value falls substantially
• Value of these bonds is written off, purchasers
  of these bonds may themselves fall into financial
  distress
• And the downward spiral continues!

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Moral of Story

• Bigger is better!
• Consolidation has increased likelihood of bailout!

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Other Government Policies
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Short-Sale Restrictions

• September 2008, U.S. banned short sales in nearly
  1,000 financial stocks from 9/18/2008 to
  1/16/2009
• Goal To stabilize stock price of financial
  stocks
• Good or bad idea?

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Insurance for Bank Deposits

• FDIC provides insurance for bank deposits
• Used to be 100,000 per depositor
• Increased to 250,000 per depositor during
  October of 2008 (through 12/31/2013)
• Good or bad idea?

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Mini Case Study Volatility!

• Implications for Corporate Finance

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Volatility first how measure it?

• Realized Volatility
• Implied Volatility from option prices
• VIX is implied volatility of SP 500 Index

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What does volatility mean?

• Suppose stock has 10 expected return and 25
  volatility (and normal returns)
• There is roughly a 68 chance that the realized
  stock return will fall in a range of -15 to 35
  (which corresponds to /- one-standard-deviation
  range of outcomes)
• There is roughly a 95 chance that the realized
  stock return will fall in a range of -40 to 60
  (which corresponds to a /- 1.96-standard-deviatio
  n range of outcomes)

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Historical Volatility Fall 2008

• VIX at all time high (data goes back to 1990)
• Reached level of 80.1 on October 27, 2008 (was
  11 in January 2007 typically around 25 or so)
• Realized equity market volatility reached levels
  of 1987 Black Monday and great Depression (both
  in U.S. and abroad) fall 2008
• 10-year U.S. Treasury rates most volatile since
  data available in 1962
• Foreign exchange volatility (Dollar vs. Euro or
  Dollar vs. Yen) was also high
• Oil price volatility also above average, but
  higher in other periods (like first Gulf War)

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Corporate Finance Reaction?

• How should corporate managers react to an
  environment when asset markets are showing high
  degrees of uncertainty about the future global
  economy?
• Discount Rates?
• Capital Structure (debt vs. equity and
  convertible bonds)?
• Real Options?
• Mergers and Acquisitions?
• Executive Compensation?