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  • Feldstein on Europe's Reluctance to Let Greece Default

    Martin Feldstein calls Greece's mix of overwhelming government debt and a free-falling economy an "otherwise impossible situation." Greece will default, as Feldstein argues that is the only way out. But after it defaults, will it leave the euro zone? Having its own currency just might open more options. Feldstein argues there are two reasons that the key influencers in the Euro zone (Germany and France) do not want Greece to leave. At least not just yet. From Project Syndicate : First, the banks and other financial institutions in Germany and France have large exposures to Greek government debt, both directly and through the credit that they have extended to Greek and other eurozone banks. Postponing a default gives the French and German financial institutions time to build up their capital, reduce their exposure to Greek banks by not renewing credit when loans come due, and sell Greek bonds to the European Central Bank. The second, and more important, reason for the Franco-German struggle to postpone a Greek default is the risk that a Greek default would induce sovereign defaults in other countries and runs on other banking systems, particularly in Spain and Italy. This risk was highlighted by the recent downgrade of Italy’s credit rating by Standard & Poor’s. A default by either of those large countries would have disastrous implications for the banks and other financial institutions in France and Germany. The European Financial Stability Fund is large enough to cover Greece’s financing needs but not large enough to finance Italy and Spain if they lose access to private markets. So European politicians hope that by showing that even Greece can avoid default, private markets will gain enough confidence in the viability of Italy and Spain to continue lending to their governments at reasonable rates and financing their banks. Read Europe’s High-Risk Gamble here .

  • Warren Buffett on Mistaking Market Value for Cost

    The latest letter from Warren Buffett to Berkshire Hathaway investors reveals once again Buffet's distaste for the behavior of investment bankers as advisers during acquisitions. He is particularly annoyed at the way these advisers deal with purchases made with stock. Buffet writes that the bankers are always game to talk about the value of what is being acquired, but never about the real value of what you are "giving." When a deal involved the issuance of the acquirer’s stock, they simply used market value to measure the cost. They did this even though they would have argued that the acquirer’s stock price was woefully inadequate – absolutely no indicator of its real value – had a takeover bid for the acquirer instead been the subject up for discussion. And then he shares this story: I can’t resist telling you a true story from long ago. We owned stock in a large well-run bank that for decades had been statutorily prevented from acquisitions. Eventually, the law was changed and our bank immediately began looking for possible purchases. Its managers – fine people and able bankers – not unexpectedly began to behave like teenage boys who had just discovered girls. They soon focused on a much smaller bank, also well-run and having similar financial characteristics in such areas as return on equity, interest margin, loan quality, etc. Our bank sold at a modest price (that’s why we had bought into it), hovering near book value and possessing a very low price/earnings ratio. Alongside, though, the small-bank owner was being wooed by other large banks in the state and was holding out for a price close to three times book value. Moreover, he wanted stock, not cash. Naturally, our fellows caved in and agreed to this value-destroying deal. “We need to show that we are in the hunt. Besides, it’s only a small deal,” they said, as if only major harm to shareholders would have been a legitimate reason for holding back. Charlie’s reaction at the time: “Are we supposed to applaud because the dog that fouls our lawn is a Chihuahua rather than a Saint Bernard?” The seller of the smaller bank – no fool – then delivered one final demand in his negotiations. “After the merger,” he in effect said, perhaps using words that were phrased more diplomatically than these, “I’m going to be a large shareholder of your bank, and it will represent a huge portion of my net worth. You have to promise me, therefore, that you’ll never again do a deal this dumb.” Yes, the merger went through. The owner of the small bank became richer, we became poorer, and the managers of the big bank – newly bigger – lived happily ever after. Of course, there is much more in the investor's letter than this telling anecdote. You can read it online here .

  • The weak get weaker: Corporate liquidity, asset sales, and the extensive use of bank lines of credit at lower-rated firms

    Each quarter the Duke University / CFO Magazine Global Business Outlook Survey polls thousands of chief financial officers around the world. The most recent survey concluded February 27 and reflects the views of 1,268 CFOs in the U.S., Europe, and Asia. This entry by John R. Graham of Duke University's Fuqua School of Business draws on the February 2009 and November 2008 surveys. The credit crisis of late 2008 has spilled into 2009, and the lack of funding has hampered the ability of many corporations to make the ideal operating and investment choices. We recently completed an in-depth study of how tight credit is affecting corporate activity. When a company is able to invest in positive net present value (NPV) projects, this means that the project returns more than the company's cost of capital, thereby increasing firm value in the long run. When credit is tight, as it is now, companies are not always able to obtain the necessary financing to pursue positive NPV projects. Due to the current credit crunch, more than half (55 percent) of U.S. companies tell us that they have recently had to cancel or postpone positive NPV projects. European and Asian companies are in a similar situation. This is bad for the economy in the long run because it spreads the effects of the current credit crisis into the future - less cash flow will be produced one or two years from now due to the cancellation of good projects today. Limited liquidity can hurt any company, but the problems are most acute among firms with poor credit ratings. For these firms, credit markets have nearly shut down. When external borrowing is limited, a company must rely more on internal funds, such as profits, asset sales, or cash on the balance sheet. For low-rated firms, profits are often poor, further limiting options. In our analysis, we found that struggling U.S. firms started 2008 with cash and marketable securities on the balance sheet equal to about 15 percent of total assets but ended the year with cash and marketable securities amounting to only 12 percent of assets. These financially constrained firms burned through a startling one-fifth of their cash holdings in just one year's time. Again, similar patterns are observed in Europe and in Asia. On the bright side, companies that are stronger financially were able to maintain cash of about 15 percent of asset value. Ironically, this indicates that most financially strong firms should not need to borrow extensively from credit markets, even though these are the only firms for which credit markets remain fairly open. In contrast, low-rated firms are burning through their internal reserves, while at the same time finding limited access to external sources of funding. What can a poorly performing firm do if it has limited profits, shrinking cash reserves, and little access to external capital? One option is to sell assets in order to obtain funds. Among firms that tell us they have experienced problems accessing credit markets, an astounding 56 percent indicate that they have sold assets in order to free up funds for other uses. While it is possible that some companies are finally shedding underperforming divisions (which would be a good thing), when you consider the depressed state of asset markets, it is likely that many of these recent asset sales have occurred at fire sale prices. Thus, asset sales have provided little relief. Firms that are struggling to access new capital can also rely on previously established lines of credit. Normally, credit lines are used for temporary "bridge" loans or as a short term substitute for cash. Today, we find evidence that lines of credit are instead serving as a "last resort" source of funds. U.S. firms have lines of credit with maximum borrowing capacity equal to about 23 percent of total asset value on average. We also find evidence that credit lines do in fact substitute for cash in that firms that have less cash on the books have a tendency to maintain larger credit line capacity. What is most astonishing about our credit line analysis is the degree to which they are currently drawn down. The typical U.S. company has drawn about 38 percent of the maximum allowable borrowing on its credit line. Companies with credit ratings of A or higher have drawn down less than 30 percent of maximum on average, while companies rated BBB or BB have drawn nearly 40 percent of the maximum allowed by their credit lines. Notably, companies rated B or lower have drawn nearly 70 percent of their line of credit capacity. This is alarming because it indicates that poorly rated firms have nearly used all available debt capacity. This draw down on credit lines among poorly rated firms has been exacerbated by a "just in case" phenomenon at some companies. That is, many poorly rated companies are drawing on their credit lines now as a precaution, fearing that their banks will eliminate their credit lines in the future (if, for example, the...