Costly External Finance, Corporate Investment, and the Subprime Mortgage Credit Crisis Ran Duchin, Oguzhan Ozbas and Berk Sensoy

Motivation  Real effects of the financial crisis.  In particular, corporate investment.  Role of internal resources (cash) during a supply shock.

August, 2007

Motivating Figure 1:Cash

Motivating Figure 2: Cash and Returns

This Paper  Non-financial firms cut investment following the onset of the crisis.  More so when less cash on hand.  More so when financially constrained or dependent on external financing.  Some evidence of an interaction, especially between cash and external finance dependence.

Empirical Strategy  Differences-in-differences Before (Q Q2 2007) vs. after (Q – Q2 2008). Response as a function of cash reserves Firm fixed effects Control for Q, cash flow Standard errors clustered by firm

Endogeneity  Cash holdings may be endogenous to investment opportunities.  Use lagged cash as an “instrument”. Measure cash as of Q

Timeline Before 2006Q3 – 2007Q2 After 2007Q3 – 2008Q2 Subprime Mortgage Credit Crisis Cash Reserves 2006Q2

Key Result: Investment After [0.023] [0.031] After x Cash0.323 [0.100] Q0.157 [0.033] Cash Flow [0.155] Firm Fixed EffectsYes Firm Clustered SEYes

Endogeneity  What if even lagged cash proxies for susceptibility to demand shocks? We provide direct evidence against this idea. We also provide cross-sectional evidence based on financial constraints and external finance dependence, consistent with a supply effect.

Direct Evidence: Placebo Regressions (1)(2)(3)(4) After [0.026] [0.030] [0.033] [0.032] After x Cash Reserves [0.079] [0.102] [0.101] [0.099] Q0.146 [0.022] [0.034] [0.041] [0.035] Cash Flow [0.115] [0.116] [0.131] [0.132] Placebo Crisis Date9/112004Q22005Q22006Q2

Placebo Conclusions  Relation between lagged cash and investment is not a general feature of the data.  It is also not a feature of the data in bad times that are mostly demand-driven.

Cash Reserves and Investment (1)(2)(3)(4)(5)(6) After [0.023] [0.030] [0.031] [0.031] [0.083] After x Cash0.209 [0.099] [0.100] [0.100] [0.127] [0.096] Q0.142 [0.030] [0.033] [0.034] [0.038] Cash Flow [0.155] [0.153] [0.158] Firm Fixed EffectsYes Firm & Ind-Qtr Yes Firm Clustered SEYes Double

Magnitudes  Column 1: Quarterly investment by the average firm declined by percentage points following the onset of the crisis.  Column 2: percentage point decline in investment for a firm with no cash reserves, and no decline for a firm holding 70.3 of assets in cash.  Average quarterly investment is 1.7% of assets, so about 10% of the pre-crisis amount.

Magnitudes  After x Cash coefficient is about 0.3.  Sample average Cash is 0.23, with standard deviation  One-standard deviation increase in Cash is associated with 0.07 percentage points greater investment, almost offsetting the average decline (-0.10).

Cash Reserves, Financial Constraints and Investment Panel A: Change in investment Kaplan-ZingalesWhited-WuBond Ratings LowHighLowHigh Low After [0.026] [0.042] [0.019] [0.038] [0.024] [0.027] Panel B: Change in investment conditional on cash reserves After [0.036] [0.051] [0.027] [0.058] [0.036] [0.038] After x Cash0.226 [0.109] [0.276] [0.117] [0.129] [0.187] [0.138]

Cash Reserves, External Finance Dependence and Investment Change in investment External Finance Dependence Equity Dependence Information Asymmetry LowHighLowHighLowHigh After [0.033] [0.054] [0.035] [0.052] [0.043] [0.049] After x Cash0.113 [0.104] [0.184] [0.101] [0.209] [0.219] [0.114]

Excess Cash and Investment (1)(2)(3)(4) After [0.023] [0.023] [0.023] [0.023] After x Excess Cash0.187 [0.099] [0.096] [0.096] [0.096] Q0.152 [0.031] [0.032] Cash Flow [0.150] [0.150] Excess Cash MeasureBaseline Extended

Cash Reserves and Other Investment (1)(2)(3)(4) After [0.030] [0.047] [0.040] [0.105] After x Cash Reserves0.661 [0.152] [0.191] [0.106] [0.384] Investment MeasureSG&AR&DInventory  NWC

Conclusion  Corporate investment declines following the onset of the crisis.  Decline mitigated by cash reserves, including seemingly excess cash.  Decline worse for financially constrained, external finance dependent firms.  Some evidence of an interaction, especially between cash and external finance dependence.

Conclusion  Evidence consistent with a supply effect.  Campello, Graham, and Harvey (2009) survey corporate managers and find that they are foregoing investments because of financing constraints.  Tong and Wei (2008) find that financially constrained firms exhibit worse stock-price performance during the crisis.

Conclusion  Contributions are threefold. Help understand the real effects of the crisis. Add to the literature on financial constraints, external finance dependence and investment. Deepen our understanding of the role of corporate cash holdings  Bright-side of seemingly excess cash.

Nonparametric Evidence BeforeAfter  (t-stat) Low Cash Medium Cash High Cash Low ST Debt Medium ST Debt High ST Debt

What Do We Know About Cash?  Theory Benefits of cash  Precautionary motive (Keynes 1936) Costs of cash  Agency (e.g., Jensen 1986)  Evidence Precautionary cash holdings (Opler et al. 1999; Bates et al. 2008) Agency costs of (excess) cash (Harford 1999; Dittmar and Mahrt-Smith 2007)

Measuring Financial Constraints  Kaplan-Zingales Index = *Cash Flow *Q *Debt – *Dividends – 1.315*Cash  Whited-Wu Index = *Cash Flow *Dividend Dummy *Long Term Debt – 0.044*Size *Industry Sales Growth – 0.035*Sales Growth  Bond Ratings = Indicator variable equal to 1 if the firm has a bond rating

What Do We know About Investment And The Supply Of Capital?  Theory (Credit Rationing )  Information Asymmetry (Jaffee and Russell (1976), Stiglitz and Weiss (1981))  Moral hazard (Holmstrom and Tirole (1997))  Evidence  Investment-Cash Flow Sensitivity (e.g., Fazzari, Hubbard, and Petersen (1988), Hoshi, Kashyap, and Scharfstein (1991), Kaplan and Zingales (1997))  Inventory (Kayshap, Lamont and Stein (1994))  Credit supply shocks (e.g., Lemmon and Roberts (2007), Tong and Wei (2008)

Measuring External Finance Dependence and Information Asymmetry  Following Rajan and Zingales (1998), we compute the following industry measures:  External Finance Dependence = Proportion of capital expenditure that cannot be financed by funds from operations  External Equity Dependence = Ratio of the net amount of equity issued to capital expenditures.  Information Asymmetry = Dispersion in productivity growth (to measure idiosyncratic firm performance)

A Standard Model of Investment With Costly External Finance  Choose I, E  When C is sufficiently high  When C is sufficiently low

Model (Cont.)  Effect of cash on investment  Effect of financing constraints on investment