1. Highlighting a Few Key Ideas and Issues

2.  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

3.  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

6.  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)(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

7. 1970s: Impact of expected inflation 2008: Real rates collapse

8. Responses: Limit new projects; Put off new hires; Pull back credit …

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

12. Response: Limit risk; increase liquidity; cash in fixed price assets; no new projects; secure longer term deals; …

19. Nominal 10- Inflation Indexed Rate Nominal Rate

27.  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

28.  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