Monday, March 30, 2009

Case studies shine some light on the credit crisis

By John Authers, Investment editor
Published: March 27 2009 18:52 | Financial Times

MBAs get a bad press. The great ideas they learnt at business school are now held – with some justice – to have caused last year’s financial implosion.

But even if it is over-simplified, the business school case study has its merits as a way to learn. You are presented with a few typed pages, with some numerical exhibits. Often these are presented from one person’s point of view. You are the marketing manager and your product’s market share is declining. How do you respond? The case offers a few options for solving the problem.

Students split up into groups and argue through the case, aided by clear results from Excel spreadsheets. The professor ends by revealing what happened to the marketing manager in real life.

The attempts to deal with the financial crisis are at a delicate stage. The issues are mind-bendingly complex. How will business schools present it in years to come?

Tim Geithner is the US Treasury secretary. Confidence in the banking system has collapsed. Banks cannot trade so-called “toxic” assets; nobody knows how much these assets are worth. What should he do?

Students would have two choices, which are the same choices that policymakers have had for a year now. Either the government can decide which institutions are insolvent and take them over. Or it can buy toxic assets. This assumes that the problem is illiquidity – if only there were buyers in the market, there would be sellers, and there would be a price. If money enters, the market can resume.

How would MBA students approach it? They would start by going through the data on a spreadsheet. After a few hours, they would still have no clue what the assets were worth. This undercuts either approach – the government might be getting involved in a bottomless pit or it may be making a drastic intervention where none is needed. Investors may not get involved if they have no idea what an asset is worth.

They would also be convinced that nationalising is a last resort – the case material makes clear that it is a difficult operation.

So maybe there is a solution that straddles the two. Use government funds to buy toxic assets, but do it in a way that prompts the private sector to get involved. Banks open their assets for inspection and private sector fund managers can work out what the assets are worth. This will either solve the problem or show beyond doubt that something more drastic is needed. Either would represent progress.

Such a plan is what Mr Geithner unveiled this week, to a negative response from academics and a positive response from the stock market.

What would the professor say next? My greatest fear is that he would introduce the concept of “adverse selection”, the risk that arises when information is not shared equally between buyer and seller. For example, those who know they may need insurance are more likely to buy it.

Posterity may yet turn the Geithner plan into the definitive study of adverse selection. The risk is that banks will only put on offer the assets that they believe to be truly worthless and that buyers, fearing this, will not buy from them. If this happens, then the plan will merely have wasted time; if adverse selection can be overcome, then it should at least be a step towards ending the crisis.

Here is another case study. Jane Doe is an investor. It is the end of March 2009. How should she allocate her investments?

Over the past few months, MBA students have had a crash course in stock market history. Everyone now knows that moments when all hope has been abandoned (and such a moment occurred early in March) generally turn out to be the best long-term buying opportunities.

The rally since then has seen the S&P 500 rebound by almost 25 per cent in three weeks. March could be the best month for US stocks since 1974.

Commodity prices, led by oil and industrial metals, are recovering. So are cyclical stocks – both signs that the market is pricing in an economic recovery. The bond market is no longer priced for deflation.

But the case study has bearish points. Credit has barely recovered since the worst of the crisis last autumn and barely budged when the Geithner plan was announced. It is still pricing in unprecedented defaults.

MBA students also now know that the most reliable long-term indicators for market timing, such as cyclically adjusted price/earnings multiples, are not yet as cheap as they were at the bottom of previous bear markets.

Two weeks ago, short interest – the proportion of shares that had been borrowed and then sold, to bet they would go down – was as high as at any time since the crisis began. So this looks like a trading bounce, as traders take profits. History’s great bear markets have all been punctuated by big rallies.

So an MBA student would counsel caution, not making a big bet either way. Posterity will judge.

Ultimately, the solution to this case depends on the outcome of the first – if the Geithner plan gets closer to resolving the banking mess, stocks may never return to the lows of March. If it just delays progress, history shows that stocks could still go much lower.

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