Costly External Finance, Corporate Investment, and the Subprime Mortgage Credit Crisis

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Costly External Finance, Corporate Investment,
and the Subprime Mortgage Credit Crisis

• Ran Duchin, Oguzhan Ozbas and Berk Sensoy

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Motivation

• Real effects of the financial crisis.
• In particular, corporate investment.
• Role of internal resources (cash) during a supply
  shock.

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August, 2007
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Motivating Figure 1Cash
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Motivating Figure 2 Cash and Returns
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This Paper

• Non-financial firms cut investment following the
  onset of the crisis.
• More so when less cash on hand.
• More so when financially constrained or dependent
  on external financing.
• Some evidence of an interaction, especially
  between cash and external finance dependence.

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Empirical Strategy

• Differences-in-differences
• Before (Q3 2006- Q2 2007) vs. after (Q3 2007 Q2
  2008).
• Response as a function of cash reserves
• Firm fixed effects
• Control for Q, cash flow
• Standard errors clustered by firm

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Endogeneity

• Cash holdings may be endogenous to investment
  opportunities.
• Use lagged cash as an instrument.
• Measure cash as of Q2 2006.

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Timeline
Cash Reserves 2006Q2
Subprime Mortgage Credit Crisis
Before 2006Q3 2007Q2
After 2007Q3 2008Q2
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Key Result Investment
After -0.104 0.023 -0.143 0.031
After x Cash 0.323 0.100
Q 0.157 0.033
Cash Flow -0.090 0.155
Firm Fixed Effects Yes Yes
Firm Clustered SE Yes Yes
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Endogeneity

• What if even lagged cash proxies for
  susceptibility to demand shocks?
• We provide direct evidence against this idea.
• We also provide cross-sectional evidence based on
  financial constraints and external finance
  dependence, consistent with a supply effect.

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Direct Evidence Placebo Regressions
(1) (2) (3) (4)
After -0.399 0.026 0.108 0.030 0.027 0.033 -0.038 0.032
After x Cash Reserves -0.116 0.079 0.106 0.102 -0.286 0.101 -0.047 0.099
Q 0.146 0.022 0.136 0.034 0.150 0.041 0.213 0.035
Cash Flow -0.139 0.115 0.049 0.116 -0.040 0.131 -0.037 0.132
Placebo Crisis Date 9/11 2004Q2 2005Q2 2006Q2
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Placebo Conclusions

• Relation between lagged cash and investment is
  not a general feature of the data.
• It is also not a feature of the data in bad times
  that are mostly demand-driven.

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Cash Reserves and Investment
(1) (2) (3) (4) (5) (6)
After -0.104 0.023 -0.147 0.030 -0.145 0.031 -0.143 0.031 -0.143 0.083
After x Cash 0.209 0.099 0.293 0.100 0.323 0.100 0.269 0.127 0.323 0.096
Q 0.142 0.030 0.157 0.033 0.172 0.034 0.157 0.038
Cash Flow -0.090 0.155 -0.071 0.153 -0.090 0.158
Firm Fixed Effects Yes Yes Yes Yes Firm Ind-Qtr Yes
Firm Clustered SE Yes Yes Yes Yes Yes Double
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Magnitudes

• Column 1 Quarterly investment by the average
  firm declined by 0.104 percentage points
  following the onset of the crisis.
• Column 2 0.147 percentage point decline in
  investment for a firm with no cash reserves, and
  no decline for a firm holding 70.3 of assets in
  cash.
• Average quarterly investment is 1.7 of assets,
  so about 10 of the pre-crisis amount.

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Magnitudes

• After x Cash coefficient is about 0.3.
• Sample average Cash is 0.23, with standard
  deviation 0.26.
• One-standard deviation increase in Cash is
  associated with 0.07 percentage points greater
  investment, almost offsetting the average decline
  (-0.10).

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Cash Reserves, Financial Constraints and
Investment
Panel A Change in investment Panel A Change in investment Panel A Change in investment Panel A Change in investment Panel A Change in investment Panel A Change in investment Panel A Change in investment Panel A Change in investment Panel A Change in investment
Kaplan-Zingales Kaplan-Zingales Whited-Wu Whited-Wu Bond Ratings Bond Ratings
Low High Low High High Low
After -0.049 0.026 -0.138 0.042 -0.024 0.019 -0.114 0.038 0.002 0.024 -0.135 0.027
Panel B Change in investment conditional on cash reserves Panel B Change in investment conditional on cash reserves Panel B Change in investment conditional on cash reserves Panel B Change in investment conditional on cash reserves Panel B Change in investment conditional on cash reserves Panel B Change in investment conditional on cash reserves Panel B Change in investment conditional on cash reserves Panel B Change in investment conditional on cash reserves Panel B Change in investment conditional on cash reserves
After -0.095 0.036 -0.174 0.051 -0.032 0.027 -0.250 0.058 -0.010 0.036 -0.203 0.038
After x Cash 0.226 0.109 0.429 0.276 0.206 0.117 0.573 0.129 0.294 0.187 0.398 0.138
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Cash Reserves, External Finance Dependence and
Investment
Change in investment Change in investment Change in investment Change in investment Change in investment Change in investment Change in investment Change in investment Change in investment
External Finance Dependence External Finance Dependence Equity Dependence Equity Dependence Information Asymmetry Information Asymmetry
Low High Low High Low High
After -0.012 0.033 -0.272 0.054 -0.051 0.035 -0.223 0.052 -0.062 0.043 -0.243 0.049
After x Cash 0.113 0.104 0.540 0.184 0.182 0.101 0.445 0.209 0.212 0.219 0.456 0.114
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Excess Cash and Investment
(1) (2) (3) (4)
After -0.100 0.023 -0.075 0.023 -0.101 0.023 -0.074 0.023
After x Excess Cash 0.187 0.099 0.237 0.096 0.119 0.096 0.166 0.096
Q 0.152 0.031 0.155 0.032
Cash Flow -0.155 0.150 -0.103 0.150
Excess Cash Measure Baseline Baseline Extended Extended
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Cash Reserves and Other Investment
(1) (2) (3) (4)
After -0.028 0.030 -0.128 0.047 -0.081 0.040 -0.247 0.105
After x Cash Reserves 0.661 0.152 0.789 0.191 0.438 0.106 1.591 0.384
Investment Measure SGA RD Inventory DNWC
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Conclusion

• Corporate investment declines following the onset
  of the crisis.
• Decline mitigated by cash reserves, including
  seemingly excess cash.
• Decline worse for financially constrained,
  external finance dependent firms.
• Some evidence of an interaction, especially
  between cash and external finance dependence.

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Conclusion

• Evidence consistent with a supply effect.
• Campello, Graham, and Harvey (2009) survey
  corporate managers and find that they are
  foregoing investments because of financing
  constraints.
• Tong and Wei (2008) find that financially
  constrained firms exhibit worse stock-price
  performance during the crisis.

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Conclusion

• Contributions are threefold.
• Help understand the real effects of the crisis.
• Add to the literature on financial constraints,
  external finance dependence and investment.
• Deepen our understanding of the role of corporate
  cash holdings
• Bright-side of seemingly excess cash.

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Nonparametric Evidence
Before After D (t-stat)
Low Cash 1.886 1.725 2.092
Medium Cash 1.929 1.828 1.281
High Cash 1.691 1.642 0.555

Low ST Debt 2.053 1.973 0.814
Medium ST Debt 1.762 1.673 1.213
High ST Debt 1.691 1.548 2.018
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What Do We Know About Cash?

• Theory
• Benefits of cash
• Precautionary motive (Keynes 1936)
• Costs of cash
• Agency (e.g., Jensen 1986)
• Evidence
• Precautionary cash holdings (Opler et al. 1999
  Bates et al. 2008)
• Agency costs of (excess) cash (Harford 1999
  Dittmar and Mahrt-Smith 2007)

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Measuring Financial Constraints

• Kaplan-Zingales Index -1.002Cash Flow
  0.283Q 3.319Debt 39.368Dividends
  1.315Cash
• Whited-Wu Index -0.091Cash Flow
  0.062Dividend Dummy 0.021Long Term Debt
  0.044Size 0.102Industry Sales Growth
  0.035Sales Growth
• Bond Ratings Indicator variable equal to 1 if
  the firm has a bond rating

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What Do We know About Investment And The Supply
Of Capital?

• Theory (Credit Rationing )
• Information Asymmetry (Jaffee and Russell (1976)
  , Stiglitz and Weiss (1981))
• Moral hazard (Holmstrom and Tirole (1997))
• Evidence
• Investment-Cash Flow Sensitivity (e.g., Fazzari,
  Hubbard, and Petersen (1988), Hoshi, Kashyap, and
  Scharfstein (1991), Kaplan and Zingales (1997))
• Inventory (Kayshap, Lamont and Stein (1994))
• Credit supply shocks (e.g., Lemmon and Roberts
  (2007), Tong and Wei (2008)

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Measuring External Finance Dependence and
Information Asymmetry

• Following Rajan and Zingales (1998), we compute
  the following industry measures
• External Finance Dependence Proportion of
  capital expenditure that cannot be financed by
  funds from operations
• External Equity Dependence Ratio of the net
  amount of equity issued to capital expenditures.
• Information Asymmetry Dispersion in
  productivity growth (to measure idiosyncratic
  firm performance)

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A Standard Model of InvestmentWith Costly
External Finance

• Choose I, E
• When C is sufficiently high
• When C is sufficiently low

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Model (Cont.)

• Effect of cash on investment
• Effect of financing constraints on investment