Stanley M. Zimmerman Professor of Economics and Finance, University of California, Los Angeles
Paper: "Measuring the Financial Soundness of U.S. Firms, 1926-2012" (with Andrea Eisfeldt and Pierre-Olivier Weill)
Describe kind of the set of questions you're asking in the paper, what your findings are, and what you mean by financial soundness.
The paper's main takeaways,
according to Atkeson:
- Mechanically, what went on in 2008 and in the Great Depression was what we call kind of an explosion of the market's perception of risk.
- And so if you're a banker or if you're someone regulating a bank, you should think in terms of what will happen to me as a banker if all of my credits get downgraded by eight notches and how will my institution survive.
- That is really kind of fundamentally what you're facing in a crisis as a banker because you've lent all these credit risks. And, as a regulator, you can work with a banker to ask that question.
- I think that's a very different stress test than what's currently being administered.
- Right now, the stress test is you should think in terms of unemployment goes to 8 percent or GDP falls by a certain amount. They're saying what's the implication of that for credit? Usually not much. In a crisis, it's a very distinctive event. Every firm all of a sudden looks like a much riskier credit bet.
Clearly in this last financial crisis, I would say many firms looked like they were financially distressed. What we're trying to do is systematically measure the level of financial distress that firms are facing, then go back through history and ask questions like: How many times has this happened in the past?
The comparison we find most interesting is between 2008 and the Great Depression. There are a lot of theories about the importance of financial distress in business cycles and macroeconomic fluctuations, not only in the Great Depression and 2008, but in other postwar recessions, and we hope to make a contribution in measurement to kind of see how important this factor might have been.
So we have to first start with how we define financial soundness. We're taking a perspective that is rooted in 30-year-old models of the credit risk that firms present to a creditor. And, so, if you're lending to a firm and you're thinking about the credit risk it presents, according to the kind of standard models in corporate finance, you think about two main features of the firm: the leverage it already has and the risk in the firm's underlying line of business in the assets that it has. And if you're evaluating credit risk, you'll be inclined to say that a firm that has a relatively safe line of business can safely sustain a high level of leverage. A firm that has a very risky line of business, you can't lend it very much for fear it will default soon. What we're looking to measure firm by firm for every publicly traded firm in the United States over this time period is their leverage adjusted for the degree of business risk.
We argue this is something that's done. Moody's Analytics does it. They have a product they sell called Expected Default Frequency. The academic literature does this. But they do it typically with a combination of a sophisticated model and a lot of accounting data. We're trying to find a shortcut so we can go all the way back to the Great Depression, when you don't have accounting data and maybe you're not so sure of your sophisticated model.
Our primary innovation is to say that you can actually do this by looking at the equity volatility of a firm. Once we take that step, we can use the statistic (the inverse of a firm's equity volatility), compute it every month for all the publicly traded firms in the United States, go monthly back to 1926 and ask what the cross-section distribution of leverage adjusted for asset volatility looks like over this whole time period.
The main findings that we have, I would say, are really three. One is there are three what we called distinctive crises in this time period in U.S. history that are roughly the same magnitude: the Great Depression, '32/'33; again in the fall of 1937, which is the second main recession in the Depression; and then 2008.
So when Ben Bernanke says that his impression was that the economy, the financial crisis of 2008, was as bad as the Great Depression, we are finding that. We're finding also, though, that this really is not that big a factor in the other postwar U.S. business cycles. It's not nearly as big as what happens in these three episodes. So our first finding is that something very distinctive is happening in what we would call these kinds of financial crisis-driven recessions.
The second main finding has to do with the main driver of these movements in firms' financial soundness. The standard stories that macroeconomists and many people tell have to do with a combination of creditors getting lax and people building up leverage, then something happening so asset values fall, housing values fall and the stock market falls. And because of the fall in the stock market, house values or the values of underlying businesses, firms all of a sudden look very levered. That's the standard story. And then we're in this situation where the firms look financially very fragile because they raised their borrowing, an asset boom occurs and then the asset prices go down, and now these firms are in trouble.
We're not finding that that's what happened in the Depression or in 2008. The main thing that we're finding—at least it's what the stock market appears to be perceiving-is that the risk of the underlying businesses dramatically increased. In 2008, we have accounting measures of firms' leverage so we can see how much that moved, and we can see although, obviously the S&P 500 fell a lot, it didn't move nearly as much as the risk in firms' underlying businesses.
Even if you look at firms that didn't have any long-term debt, they also look like they're getting in financial distress. And you might ask: How can a firm that doesn't have debt get in distress? I like to use the example of BlackBerry, RIM, right now. If you look at RIM's income statements, they have a lot of fixed costs. They have very high sales and general operating expenses and a very high R&D budget. So the way that they're losing money is that they've got this fixed cost that acts economically as if they had leverage, and so we call that operating leverage. Firms with operating leverage or financial leverage will get in distress either way when the risk of their underlying business goes up.
In the recent crisis, changes in leverage account for about 20 percent of the deterioration in the distribution across firms of their financial soundness. But the majority of the move, about 80 percent of the move, we find is due to changes in underlying business risk.
The third main finding is probably the most controversial. With our method, we can ask what was going on with the financial soundness of financial firms, particularly big banks, and with the financial soundness of nonfinancial firms. And we can compare them.
One thing that's certainly talked about a great deal is that in the U.S. we went through a period of deregulation—going back to the '80s—of financial firms. This allowed these firms to take on more leverage relative to the risks that they were taking. This process accelerated with deregulation in the late 1990s. And the story a lot of people tell about this crisis— Lehman, etc.—is that these firms levered up to a dangerous extent by 2006 or 2007.
And what we're finding from data on their equity, from their bond spreads, from their credit default swap spreads is that the market's perception was that even though these firms were levering up, the underlying business risk was reducing so that their credit risk was actually going down. And by the time we get to 2007, the market is saying they're at a level of financial safety that is almost a historical high. So it's exactly the opposite of what we're now saying ex post. And then starting right in August of 2007, bad things began to happen.
But if you compare large financial firms—particularly even the banks that failed or the ones that are the stress-test banks— and you go back to, say, 1962 to July of 2007, the financial soundness of these large financial firms tracks that of, say, the 50 largest nonfinancial firms. They're dead on each other. And it raises in our minds the question: Are the stories that we tell about the impact of changes in financial regulation on financial firms' risk taking actually there in the data? We're not finding that.
Does your theory have anything to say about the desirability of the Fed's emergency lending facility and whether it should be targeted?
Personally, I'm beginning to try to think of financial regulation and the Fed's role in the following context. In California, we face a risk, very infrequent, that a large earthquake will occur. And when that happens, we don't want all the buildings to fall down and kill everybody. So, we put in building codes that in normal times look like they're very severe. And a builder might say this is very expensive for me to comply with these building codes for an event that's going to come every 30, 40 years. But we go ahead with that because we know the event can be very bad. We're seeing these financial crises as being like earthquakes. You can't really predict them. We had two in the Great Depression and one in 2008, so we had three in a century. And when they come, I'll put it this way, all the buildings fall down.
I would see the role of the Fed or the banking regulators as coming in and saying: Can we design building codes that for banks look excessive perhaps in normal times? But the stress test we want to put on the banks is a credit event that's similar to what happened in these three episodes. Bankers will complain the same way I'm sure builders in California complain. But you have to say we're waiting for these very large, unpredictable events. And so I would be curious how that goes if you were to embrace that view of regulation and try it out.
It's interesting that you used the analogy of earthquakes, which I guess I would take to be acts of nature. Do you believe that this is just the way it is or that these so-called earthquakes are somehow a byproduct of the underlying economic institutions? Or are they just unavoidable consequences of people interacting with each other?
I can't answer that. The reason I emphasize earthquakes is that I would say a lot of what I read about the thrust of financial regulation, even in the Dodd-Frank Act, takes the perspective that the regulators should try to foresee a crisis or a risk building up somewhere and take action in advance to deal with that risk. When you deal with earthquakes and building codes, you accept that you're not going to foresee it. It's going to happen sometime, you don't know when. And so you don't invest a lot of resources in trying to predict a crisis. You invest your resources in figuring out how we can design buildings that don't fall down.
It's a larger, at this stage perhaps, metaphysical question as to whether it's an act of nature or something that could be dealt with. But I just meant in kind of a more practical way. So the example I would give is Canada's banks. If you look at them with this measure and other market measures, they were much healthier than U.S. banks. And so you could ask: What are the Canadians doing with regulation that we're not doing, and could we use some of their ideas to strengthen our banking system?