This Week In Finance

"Of Hedge Funds and Credit Crunches"

As Finance professors, you have undoubtedly been following the Long-Term Capital Management debacle. Unfortunately, the tenor of much of the coverage in both the popular and the business press is reflected in this week's "Quote of the Week" (taken from Alan Abelson's weekly Barron's column of October 5th).

From the viewpoint of one whose job is to attempt to explain the "big picture" to undergraduates, (well, at least to the extent that I can figure it out), the more interesting (albeit less sexy) story is the effect of the hedge fund bailout (and other world events) on the availability of credit.

The Wall Street Journal of October 7th contained a front-page story entitled "Credit Crunch: Investors' Fear of Risk Translates into a Curb On Credit for Business." The story paints a rather frightening scenario of what we in academia began to call the "contagion effect" many years ago.

Consider the headlines of these stories within the main story: "Junk-Bond Market is Drying Up, Hitting Companies Big and Small," "Emerging Market Bonds Tumble as Russia Spooks Investors." "Property Prices Fall Victim to Sell-Off in Mortgage Debt." Ouch!

I would urge you to obtain a copy of the article (pages A1, A18, and A19). A reading of the article clearly illustrates both the interrelatedness of financial markets both internationally, as well as across various types of instruments. Further, the article notes the broad effects of market disruptions: "[A]s nervous bond market investors, and to a lesser extent some bank lenders, shy away from risks that they welcomed just a few months ago, some businesses with no links to Asia or Russia or hedge funds are getting squeezed.

"That is paradoxical, because many interest rates are going down. Banks have just lowered their prime lending rates . . . [b]ut in today's economy, companies rely increasingly on financial markets, not banks, to provide their credit needs. And in recent weeks, the financial markets have been avoiding all but the safest securities. Prices for many risky bonds have been falling. The market for high-yield bonds has virtually shut down."

The discussion opportunities are wide-open! Ask students to consider the following issues:
(1) How might these credit market changes impact the capital-raising decisions of corporate decision-makers?
(2) Does the evidence suggest that investors have become more risk-averse? If so, has the slope of the risk-return trade-off increased? (This is a particularly tricky question.)
(3) Looking farther out in time, does this market situation have any implications for capital expenditure decisions one, two, or three years from now (with the attendant effects on manufacturers, job creation, etc.)?

I think these questions will generate a great deal of discussion - as always, the point is as much to generate thought and teach students to apply financial theory to contemporary issues, as well as discussing the issues themselves!

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