Highlighting a Few Key Ideas and Issues

 M&M: Equity ≈ Debt  For Corporate Finance: ▪ Value of firm projects (revenue, costs) matters a lot more than small differences in costs of funds ▪ Maybe liquidity issues at very high debt/equity ratios  For Macroeconomic Risks ▪ Aggregate risk of projects (viability of revenue/income streams) more critical than whether equity financed or debt financed (compare 1920s v. 2000s) ▪ Maybe liquidity issues at very high debt/equity or asset/equity ratios, especially in financial firms

 1970s Thinking: Changes in expected earnings (numerator) is the driver  2000 Thinking: 2000s: Changes in risk (denominator) is the driver  2008 Crisis demonstrates the importance of the evaluation of risk to asset prices in the aggregate  Managerial Implications  Rapid shifts over time possible with variable denominator  P-E Ratios (or P/GDP) as Long Run Predictor ▪ Very High P/E = current risk assessment overly optimistic ▪ Very Low P/E = current risk assessment overly pessimistic

 Fed & Rates: Taylor Rule Target Rate = *(Actual Inflation – Target Inflation) + 0.5*(Actual GDP – Potential GDP) ▪ Phillips Curve concept built-in  Markets & Rates: Fisher Equation Market Rates = Real Rates + Expected Inflation ▪ Real Rates influenced by economic growth (higher when growth higher) ▪ Estimate of Real Rate: TIPS (See Bloomberg Rates)(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

 Even for Governments:  Expected PV of Liabilities = Expected PV of Assets  Liabilities = Money + Bonds  Assets = Discounted PV of Tax Revenue – Spending  When Markets Come to Evaluate M + B issuance much greater that PV(T-G)  Debt-Currency-Inflation Crisis ▪ Germany 1920s, Mexico 1990s, Greece now, Italy? Spain?, Japan?, US?  Views/markets tend to switch all at once – “peso problem” so current market evaluation

 Debt/GDP ratio must be viewed in relation to GDP growth potential, assets & savings, and likelihood of expenditure adjustments  Implications: Likelihood of low U.S. Treasuries through Japan issues

 Implication: U.S. Treasuries

Managerial Actions: Limit new projects; Put off new hires; De-leverage …

 The Treasury Yield Curve:  Steep: High growth or inflation expected  Flat/Inverted: Low growth or inflation expected US Treasury Site "Living Yield Curve"

Few False Positives or False Negatives Recession in Grey

Managerial Actions: Limit risk; increase liquidity; cash in fixed price assets; no new projects; secure longer term deals; … Remember: Individual market indicators often not very good at assessing turning points; looking for tell-tale indications

Nominal 10- Inflation Indexed Rate Nominal Rate

 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