Download M&M: Equity = Debt

Highlighting a Few Key Ideas and Issues

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
50
20
2000
45
40
14
1929
30
12
1901
25
10
1966
Price-Earnings Ratio
20
21.92 8
15
6
1921
10
5
0
1860
4
Long-Term Interest Rates
1880
1900
2
1920
1940
Year
1960
1980
2000
0
2020
Long-Term Interest Rates
Price-Earnings Ratio (CAPE)
16
1981
35
18
.35
70
SP500/GDP (left scale)
.30
60
.25
50
SP500/Earnings (right scale)
.20
40
.15
30
.10
20
.05
10
.00
0
20
30
40
50
60
70
80
90
00
10

Fed & Rates: Taylor Rule
Target Rate = 2 + 0.5*(Actual Inflation – Target Inflation) +
0.5*(Actual GDP – Potential GDP)

Markets & Rates: Fisher Equation
Observed 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
1970s: Impact of expected inflation
2008: Real rates collapse
Responses: Limit new projects; Put off new hires; Pull back
credit …

The Treasury Yield Curve:
 Steep: High growth or inflation expected
 Flat/Inverted: Low growth or inflation expected
US Treasury Site
"Living Yield Curve"
5
4
3
2
1
0
-1
-2
-3
60
65
70
75
80
85
90
95
00
05
10
Response: Limit risk; increase liquidity; cash in fixed price assets; no new
projects; secure longer term deals; …
6
FannieFreddie
5
LehmanBear
Stearns AIG
4
3
2
1
KC-FSI
LIBOR-Tbill
0
-1
2006
2007
2008
2009
4
3
07-08
2
Kuwati Invasion
Asian Debt
1
0
-1
90
92
94
96
98
00
02
04
06
08
10
Nominal 10Nominal Rate
Inflation Indexed Rate
200
160
120
80
180
170
40
160
0
1975 1980 1985 1990 1995 2000 2005 2010
150
140
130
120
110
100
90
08M01
08M07
09M01
09M07
10M01
1.1
130
1.0
$ per AU$
FX per US$
0.9
120
110
0.8
100
0.7
90
0.6
80
0.5
70
0.4
60
90
92
94
96
98
00
02
04
06
08
10
4.0
60000
3.5
50000
3.0
40000
2.5
30000
Debt/GDP - left scale
2.0
20000
1.5
10000
U.S. Debt -- right scale
1.0
0
20
30
40
50
60
70
80
90
00
4.0
3.5
Total Debt/GDP
3.0
2.5
2.0
Non-house-govt/gdp
1.5
1.0
House-debt/gdp
0.5
Govt Debt/gdp
0.0
50
55
60
65
70
75
80
85
90
95
00
05

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
