Wk 1: Lessons from Financial History Does finance matter ...eanh_class_notes.s3.amazonaws.com/FHcomp.pdfD.Chambers, LFFH, TRIN07 3 ….or does it? financial depth empirical evidence

Wk 1: Lessons from Financial History

Does finance matter for growth?

David Chambers

Dept of Economics

Oxford University

D.Chambers, LFFH, TRIN07 2

It doesn’t matter!

� Robinson: “By and large… where enterprise

leads finance follows”

� Lucas: “overstressed”

� NEC President: “engineers on top,

accountants on tap!”


….or does it?

� financial depth

� empirical evidence

x-countries and x-industries

� banks vs markets

finance and innovation

� why does it matter for growth?


Financial depth

� Financial depth = Banks + Markets

Markets = Equities + Govt Debt + Corp Debt

� McKinsey study 1980-2004

financial assets +10.6%, GDP +6%

markets grown faster than banks

Eurozone 350% Latam 50%

� Derivatives not included


Financial depth: 1980-2004

0%

50%

100%

150%

200%

250%

300%

350%

1980 1993 1999 2004

Source: McKinsey


Financial depth: 1880-1929

Source: Rousseau&Wachtel


Financial depth: banks vs mkts

29%32%45%Banks

1355312Total Assets $tril

17%19%18%Govt debt

25%23%14%Private debt

29%26%23%Equities

200419931980

Source: McKinsey


Financial depth: banks vs mkts

40%29%19%39%33%24%Banks

11%18%12%15%21%20%Govt debt

18%28%35%8%26%29%Corp debt

31%25%34%38%20%27%Equities

EmergingEurUSEmergingEurUS

20041993

Source: McKinsey


Finance and growth accounting

� basic growth accounting relationship:

∆GDPPC = Capital Accum. + TFP

� capital deepening or TFP growth

� modern sector (textiles/steam/ICT)

∆y/y = sm∆km/km + so∆ko/ko + ∆am/am + ∆ao/ao

where sm , so are output shares


Empirical evidence: overview

� x-country regressions

� time-series data, VAR and causality tests

� finance and industry growth

- externally-financed industries

- R&D intensive industries

- stage of development


Empirical evidence: King-Levine

� Xi = α*Fi,1960 + β*Zi,1960 + ui for i= 1,….,77 countries

X = growth 1960-89 (income, capital stock,TFP)

F = financial depth in 1960 (DEPTH, BANK, PRIVY)

Z = 1960 control variables for convergence, HK etc.


Empirical evidence: King-Levine


Empirical evidence: Levine-Zervos

� stock markets

aggregate info, diversify risk, takeovers

� share turnover/mkt cap

� US/Jpn 50%; Bangladesh/Chile/Egypt 6%

� liquidity +30% � growth +0.8%

mkt cap not important


Empirical evidence: Levine-Zervos


Empirical evidence: causality

� wealthy demand financial services

financial markets discount future growth

� initial values, non-overlapping 5yr periods

� instrumental variables eg legal origin

� VARs; Granger causality tests

� depth leading role, no evidence of feedback

see Rousseau & Wachtel; Burhop; Sylla & Rousseau


Finance and industry growth

� Rajan&Zingales thesis:

1. finance dependence varies x-industries

2. hi-dependent industries grow faster in more financially-developed countries

� 1980s 36 industries 42 countries

� machinery grew 1.3% pa faster than beverages in Italy (98%) vs Philippines (46%)


Finance and industry growth

Source: Rajan&Zingales

%


Finance and innovation

� Schumpeter:

“The banker, therefore, is not primarily a

middleman….He authorises people in the

name of society….(to innovate)”

but equity markets do a better job!

� rewards innovative firms

� promotes rapid technology diffusion


British Railways: equity finance raised

0

20

40

60

80

100

120

140

1826

1827

1828

1829

1830

1831

1832

1833

1834

1835

1836

1837

1838

1839

1840

1841

1842

1843

1844

1845

1846

1847

1848

1849

1850

Source: Gayer Rostow &Scwartz

£M

Authorised Share Capital £M


British Railways: the new new thing!

05

1015202530354045

1843

1845

1847

1849

1851

1853

1855

1857

1859

1861

1863

1865

1867

1869

Passenger Receipts (£m) Freight Receipts (£mn)

Source: Crafts


British Railway: share price mania

0

20

40

60

80

100

120

140

160

1826

1828

1830

1832

1834

1836

1838

1840

1842

1844

1846

1848

1850

Source: Crafts Jun 1840=100


Steam and productivity

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

0.45

1760-1800 1800-30 1830-50 1850-70 1870-1910

Source: Crafts

Total contribution of steam to labour productivity growth % p.a.


Banks vs markets: hypotheses

� equity finance

disclosure�info production�price discovery

� bank concentration

imitative, less-technology intensive industries

� ownership concentration

cash-rich mature firms require large shareholder


Banks vs markets: model

� Carlin&Mayer model:


Banks vs markets: results


Banks vs markets: results

� equity-dependent industries in advancedcountries:

better disclosure and less concentrated banks promote industry growth and more R&D activity

� bank-dependent industries in developingcountries (N=4):

more concentrated banks promote growth and R&D

� equity markets better at innovation


Summary: does finance matter?

� depth seems to matter

� equity markets and innovation

� banks and catch-up

� econometrics but role for case studies


Case studies (week 2)

� Dutch Revolution and VOC shares

pooling, risk diversification and financing innovation

� England and Glorious Revolution

� Hoares Bank and Industrial Revolution

� German Universal Banking

� US Financial Capitalism


Remaining questions

� is there a downside?

� when do you transition from bank-centric catch-up mode?

� do you need your own market?

� what drives finance-growth linkage?


Does market location matter?

INVESTBX WILL “APPEAL TO PEOPLE WITH LOCAL KNOWLEDGE, WHO, FOR EXAMPLE, PASS BUSINESSES THEY WOULD LIKE TO INVEST IN ON THE WAY TO WORK”, SAID MICK LAVERTY, DEPUTY CHIEF EXECUTIVE OF AWM.

THE LONG-DEFUNCT BIRMINGHAM STOCK EXCHANGE IS SET TO BE REBORN THIS SUMMER AS AN ONLINE TRADING FACILITY IN THE SHARES OF WEST MIDLANDS COMPANIES THAT ARE TOO SMALL TO LIST IN LONDON.

THE AIM … IS TO PROVIDE SHARE CAPITAL IN SLUGS OF BETWEEN £500,000 AND £5M, A FUNDING CATEGORY IN WHICH THE TREASURY HAS IDENTIFIED AN “EQUITY GAP”.

Financial Times March 29, 2007

Come back for part two…

“WHAT EXPLAINS FINANCIAL DEVELOPMENT?”

Lessons from Financial History

Wk 2: What explains financial development?

David Chambers

Dept of Economics

Oxford University

D.Chambers/LFFH/TRIN07 2

The problem

� Bangladeshi bamboo basket maker

Stanford B-School search fund

� what makes the difference?

� how do these “institutions” develop?


What explains financial depth?

� structural hypotheses:

legal origin

trust/social capital

endowments

� politics

Roe

“the great reversal” hypothesis


Law & Finance: LLSV hypotheses

� legal origin

differs x-countries

exogenous

� origin � investor protection (IP)

� IP � larger capital markets

more dispersion


Law & Finance: LLSV98

� empirical question: 49 countries in 1999

� share dispersion

mean % shares held by top 3 investors in 10 largest private quoted firms

� which laws?

minority shareholder rights

creditor rights


Anti-director rights

1. proxy vote by mail

2. no shares deposit before AGM

3. BoD representation (cum. voting/PR)

4. oppressed minority mechanism

5. call an EGM

6. pre-emptive rights

note: excludes 1 share 1 vote (only 22%)


Creditor rights

� secured senior creditor

� liquidate or reorganise?

1. no automatic stay on assets

2. secured paid first (before govt, workers)

3. restrictions on managers unilaterally opting for reorganisation (Chapter 11)

4. managers in place pending reorganisation



� British Common law

private property rights vs Crown

case law by judges

� French Civil law

state restraint of interfering judiciary

codified by legal scholars

� “exported” and imitated



� British common law (18)

UK US Can Aus Ind Pak S.Africa HK Sing

� French civil law (21)

Fr Sp Port Bel Lux It Latam Indochina AfricaxSA

� in-between:

German civil law (6): Ger Austria Jpn Kor TaiwScandinavian (4)


Law & Finance: better outcomes

1.58

3.11

Creditor

rights

1.8

6.6

Firm Mkt Cap

(US$bil)

2.33

4

Anti-director

rights

54%French

43%English

ConcLegal

origin

Source: LLSV98


Law & Finance: share dispersion

10%

15%

20%

25%

30%

35%

40%

45%

50%

55%

UK

US

Ger

man

y

Japa

n

Sca

ndin

avia

n

Fra

nce

Spa

in

Por

tuga

l

c

Source: LLSV98




Law & Finance: the story so far

� “financial markets do not prosper when left to market forces alone”

� which (securities) laws? (LLSJoF06)

standardised disclosure re insider$$, %equity, contracts, transactions

private litigation: liability rules - misleading vs. gross negligence

not public enforcement


Law & Finance: challenges

� history matters not just through legal origin

� share ownership in 20thC Britain

� bad laws: US deposit insurance

� trust and social capital

� endowments

� politics

Roe thesis: US-centric

Rajan and Zingales “great reversals” thesis


Share ownership in 20thC Britain

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

55%

60%

65%

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

C3i C3o

Source: Franks Mayer & Rossi 04


Investor protection in 20thC Britain

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

pre-1929 1929 1948 1967 1986

IP Public Enforcement


Investor protection in 20thC Britain

� 1948 Act major watershedaccounting disclosureproxy by mail10% to call EGM

� 1929 Act importance overstatedRoyal Mail scandal1928 new issue boom

� so why?


US bank crises 1865-1913

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

1.2%

1.4%

1.6%

1.8%

186

51

867

186

91

871

187

31

875

187

71

879

188

11

883

188

51

887

188

91

891

189

31

895

189

71

899

190

11

903

190

51

907

190

91

911

191

3

0

50

100

150

200

250

300

350

#fails %assets


US banking 1900-40: deposit insurance

� early solutions to bank crises

clearing houses

branch banking: 1900 in 17 states, 1939 in 36

deposit insurance: 8 states 1908-30

� state branching : diversify risk, scale , competition

� what about deposit insurance?


US banking 1900-40: deposit insurance

0.029*** -0.050*** 0.030*** Mfg. value added per capita %

0.021** -0.13*** 0.025* Growth of state loans %

after 1920 before 1920 National banks)

Branching Deposit Ins. Deposit Ins. (Table 5: Fixed effects,

Source: Deheja&Lleras-Muney03


US bank crises: 1921-2001

0

200

400

600

800

1000

1200

1400

1600

1921

1925

1929

1933

1937

1941

1945

1949

1953

1957

1961

1965

1969

1973

1977

1981

1985

1989

1993

1997

2001

#fails


Law & Finance: deposit insurance

� deposit insurance not a substitute for regulation and monitoring

� politics: small country banks vs. large city banks

� developing countries (Barth Caprio & Levine)


Trust and Social Capital

� Lavington (1921:“local knowledge on the part of the investor ensured that securities were sold at prices fairly near their investment values”

� 19thC New England banks (Lamoreaux)Provincial Stock Exchanges

� Italy (Guiso et al)China (Allen et al)


Kinship Banks: Lamoreaux

� banks addressed indivisibilities and inter generational survival in 19thC New England

� kinship overcame information gaps

� Massachussets Bank est. 1780s

lent to directors & kinship group members

founding family diluted but kept BoD control

� how was crony capitalism avoided?


New England Banks 1790-1860

0

100

200

300

400

500

600

1790 1800 1810 1819 1830 1837 1850 1860


Social Capital: Guiso et al

� voter turnout in referenda 1946-89

# blood bags collected per inhabitant 1995

� check usage, equity investment and credit availability

� social capital substitutes for laws


Endowments matter

� Acemoglu et al (AER01) thesis:

how you were colonised matters, not just legal origin

colonisers settle or extract depending climate

institutions either protect private property (US,ANZ)

or empower local elite (Congo, Ivory Coast, Latam)

power of local elite post-independence


Endowments matter: Beck et al 03

� SETTLER mortality during colonisation

min 2.2 max 8.0 deaths per 1000

� STKMKT/GDP = C– 0.16*SETTLER – 0.23*FRLEGAL N=70 (adj R-sqd 36%)

� 2stdev drop in SETTLER � +50% STKMKT/GDP

� more important than legal origin but complementary


Politics matters: the Roe view

� “strong managers, weak shareholders”

� politics of public distrust and Federalism

� financial institutions constrained:

banks – Glass Steagall 1933

insurance co.s - NY state law

mutual funds - Inv. Co. Act 1940

pension funds - ERISA 1974


Politics matters: Rajan & Zingales

� financial development not linear over time

� power of incumbents

� competition and openness

� reversals 1929 and 1980


The Great Reversals

9533518112049JAPAN

39

109

53

1913

3530152535GERMANY

15246335675US

2253877114138UK

19991980195019381929StkMkt/GDP%


Openness over the 20thC

2.1 %

1980s

2.6 %1.4 %1.6 %3.2%3.8%

1990s1950-791930s1920sPre-1913

World Current Account/GDP%


Case study: Japanese banks

� bank concentration1920: 2000+ banks; zaibatsu 21% mkt share1945: 65 banks and 46% zaibatsu share

� Bond Committee 1933Euromarket competition 1980s

� creative destruction vs. economic stability e.g. Mazda/Sumitomowould private bondholders have liquidated?


Case study: Glass-Steagall Act 1933

� 1920s competition in securities underwriting

� Pecora claims:

conflict of interest

too risky

� “the 7% solution”

� commercial banks:

no conflict (Krosner&Rajan AER94)

not riskier (White EEH86)

� repealed 1999


Case study: Glass-Steagall Act 1933

Source: Krosner&Rajan94


Rajan & Zingales: summary

� openness is key determinant

� lesson of 1930s: social safety net

� policy prescription for developing countries:

open up despite weak institutions


Concluding comments

� LLSV important but some gaps

� history matters!

� trust

� policy questions

how to transition

risk of financial crisis

Come back next week for…

EARLY CAPITAL MARKETS


Wk 2: Early Capital Markets

David Chambers

Dept of Economics

Oxford University

D. Chambers/LFFH/TRIN07 2

Financial innovation

� loans (shares)

� futures

� negotiability/transferability


Early Capital Markets

• Dutch East India Company

• English Financial Revolution

Glorious Revolution

South Sea Bubble

• Finance during the Industrial Revolution

• Hamiltonian Revolution


Dutch Financial Revolution: VOC

� Amsterdam in 1595-1612 (Gelderblom&Jonker)rise of Asian trade: scale, risk, illiquidity

� VOC shares (1602)pooling of savings

risk diversification transferability

clearing

� collateral

� forwards and options


Dutch Financial Revolution: liquidity


Dutch Financial Revolution: collateral


Dutch Financial Revolution: benefits


Dutch Financial Revolution: summary

� Bank of Amsterdam (1609)

credible currency & payments system

� VOC a success but…

no more issues and only 2 other companies floated

no centralised securities or govt debt market

� technology transfer


English Financial Revolution



� Phase 1: 1689-1705

fiscal credibility

share trading

� Phase 2: South Sea Bubble 1720

govt debt consolidation

wider investor base

� contribution of Industrial Revolution



� fiscal reform

Parliament’s credibility

regicide=ultimate deterrent

liquid market

� decline in interest rates: 1694 8% � 1750 3%

� stimulus to private credit?

� War vs France 1690-97


Early bank micro-histories


English Financial Revolution: Phase 1

� Quinn’s hypotheses:

if there was a fall in govt risk premium, then either

1. crowding out: portfolio switch into govt debt;

2. lower systemic risk � rise in supply of private

credit; or

3. lower systemic risk � lower hurdle rate � rise in

demand for private credit








English Financial Revolution: summary

� initial crowding out (1690-97)

� golden age of investment (1698-1705)

term structure

loan volume

collateral

� first “Big Bang”

BoE, EIC = debt swap schemes

� govt debt market emerged but fragmented


South Sea Bubble 1720: Phase 2

� debt for equity swaps

� conversion terms not fixed

surplus shares sold by company

� IPO boom � Bubble Act





Source: Neal


South Sea vs Dotcom bubbles

Source: Temin&Voth, AER


South Sea Bubble: summary

� limited fallout due to investor compensation

� long-term benefits

debt consolidated � liquid Consols 1750s

investor base

� investor over-exuberance or justified by fundamentals?

� compare Mississippi bubble in France

investors suffered and no govt debt mkt emerged


Long-term interest rates 1700-1880


Relative borrowing costsGovernment debt rates: Britain vs Holland 1692-1795

Source: Sussman&Yafeh


Deeper financial markets

Government Debt per Capita: Britain vs Holland 1698-1795

Source: Sussman&Yafeh


Market “efficiency”

� integration across space

international capital market from 1720s

“national” capital market not until late 18th C

� and across time

Consol prices 1821-60 followed random-walk


Finance and Industrial Revolution

� low growth +0.2% 1760-1800 +0.5% 1800-30

and not very K-intensive GDFCF 6%�12%

� but revolutionary changes

formal competitive and impersonal markets

modern technology sector

industrial organisation


Contribution: traditional view

� national credit market after 1770

� negotiable bills of exchange

overdrafts/advances

� country banks

� pecking order theory

probably not finance-constrained


Contribution: revisionist view

� ex ante demand for funds?

survival bias

� usury laws and credit rationing

crowding out

� proto-venture capital


Impact of usury laws: Temin&Voth04


Impact of usury laws:

Temin&Voth04


Impact of usury laws: Temin&Voth04

� higher loan concentration

top 20: pre-1714 40% post-1714 80%

� more collateral

1690s 75% pre-1714 10% post-1714 67%

� shorter duration


Crowding out: Temin&Voth05


Proto-venture capital: Praed & Co

Source: Brunt 2007


Proto-venture capital: Praed & Co

• concentrated portfolios

• copper industry knowledge

• high risk - steam engine; volatility

But

• why no run before 1846?

• lack of upside

5% real but capped

• did British banking take a wrong turn in 1826?


US: Federal Revolution 1789-91

� federal taxes and debt

� Bank of United States

common currency

� ltd liability banks

� federal debt + BUS + banks� stock market

� Buttonwood Agreement 1792 � NYSE 1817


US: Federal Revolution 1789-91

� 1825 financial depth

2.4x bank capital

similar stock mkt cap

� but numerous and frequent bank crises

state vs national; branch vs unit banking

no central bank


US Bank Expansion 1790-1850

Source: Rousseau&Sylla


US Stock Market 1790-1850

Source: Rousseau&Sylla


Early Capital Markets: summary

� lessons from early capital markets

fiscal credibility and risk-free rate “anchor”

liquid secondary market

collateral � private credit

� contribution to Industrial Revolution probably limited

compare railroads mid-19th C

� technology transfer


Wk 3: US Financial Capitalism

David ChambersDept of Economics

Oxford University



Outline

Finance and investment

German universal banking

US financial capitalism

relevance1980s Japan1990s short-termism debate2000’s private equity debate


Functions of stock markets

raising finance

acquisition currency

disciplining mechanism

providing an exit


Finance and investment

industrial scale and technology change of late 19th/early 20th C’s

did developing capital markets provide enough finance to industry?

aggregate ex ante demand for finance?

portfolio diversification


World growth %pa

1500-1820: 0.32

1820-1870: 0.93

1870-1913: 2.11

1913-1950: 1.82

1950-1973: 4.90

1973-2001: 3.05


Gerschenkron thesis

catch-up

role of banks:“The German investment banks – a powerful invention, comparable to that of the steam engine – were in their capital-supplying functions a substitute for the insufficiency of the previously created wealth willingly placed at the disposal of entrepreneurs”

See Fohlin (2006), p.308


German universal banking

functions(i) financelong-term lendingissued, underwrote & broked industrial issuesshareholders and trustees(ii) monitoring via BoD membership

benefits(i) credible implicit long-term contracting(ii) better screening & governance (iii) lower cost of capital via economies of scope


Why German universal banking?

equipment/assets 1912-13 Ger 26% US 13%

direct issue costsGermany 5% 1893-1913 (small firms 6%)US 6-8% 1925-29

Capital/GDP(x) 1850 1913Ger 5.0 4.8US 1.7 2.7

Source: Calomiris


German universal banking: criticisms

how supportive is the evidence?industrialisation pre-187010-20% bank systemlimited evidence that firms grew fasterbut could have helped modern sector (Burhop ‘06)

disadvantagesconflicts of interestrent extractionindustrial cartelsbank crisesinability to “creatively destruct” (GE vs Siemens)


US financial system in 1900

lightly regulated and fragmented banking system

NYSE, Regional SX’s, OTC market, curb market

1890 lists=rails + coal + textiles

Sherman Act & 1893 collapse mergers, reorganisations


Why did firms start issuing equity?

late 19thC problems with overleveraging

families desire to exit

preference stock (shares)

1920s rise of common stock (ordinary shares)Liberty bondsE.L. Smith, Keynesinstitutional investmentdoor-to-door selling


Challenges to external finance

asymmetric information: investors: how to trust managers? managers: how to avoid the lemons discount?

managerial incentives & incomplete contracts

solutions:trustdisclosure and regulation“financial capitalism”


US Financial Capitalism pre-1913

Davis thesis (EHR 1966): scale and technology-driven demand for capitalunderdeveloped financial system (cf. Britain)

role of honest broker: (1) monitoring (2) certification

18 private banks controlled assets worth more than 50% of GNP

recruited in waves 1893-94, 1901-02, 1907



Pujo Hearings 1913

Untermyer: Is not commercial credit based primarily upon money or property?

Morgan: No, sir, the first thing is character.

Untermyer: Before money or property?

Morgan: Before money or anything else. Money cannot buy it. ... Because a man I do not trust could not get money from me on all the bonds in Christendom.


Did Morgan’s men add value?

benefit (1) firm valuation:“Morgan premium” of 30% (DeLong)

Cantillo Simon asked:effective monitoring? cartelisation? or stock-picking?

event study Jan 1914 :Pujo hearings led to Morgan resigning 30 BoD’s

post-event window returns





TR -6.2% = 6% gross value addedNR not stat significant

COMP -3% = cartellisation effect

remaining 3% - stock picking or effective monitoring?

case studies: Aitchison Topeka, Chicago Great Western (in Ramirez)



benefit (2): Morgan-affiliated firms’ investment plans less cash flow-constrained (Ramirez)

hypothesis: Morgan firms’ investment not sensitive to cash flow

other examples:Japanese keiretsu firms (Hoshi et al 1990)Pre-1914 German universal banking (Fohlin)


German universal banking again!

Fohlin: did 9 “great” banks ease finance constraint of client firms?

interlocking directorates

finding: no empirical support for universal banks

how well does cash flow sensitivity really measure finance constraint?e.g. Rostocker Strassenbahn AG


Death of US financial capitalism

1914 Clayton Act: interlocking directorates

1920s commercial bank affiliates

1932-34 Gray-Pecora hearings

Glass Steagall Act

Roe’s “strong managers weak shareholders”


Alternative solutions to AI problem

improved disclosure 1933,1964 Acts

institutional investors but monitoring problem

venture capital 1970sLBO’s 1980sprivate equity 1990sshareholder activism 1990s


Britain was different again

strong banking system post 1878

developed stock exchange but weak regulation

Barings, Rothschilds focus on foreign issues

1929 not as cataclysmic

post-1945 similar path


No domestic investor bias


No domestic investor bias


Different governance systems

US: fragile banking system; financial capitalism; strong managers, weak shareholdersBritain: conservative banking system; developed but “atomistic” stock marketGermany and Japan: late industrialisers dependent upon bankspath-dependenceAnglo-US “outsider” vs Continental European “insider” systemrecent convergencemodest empirical support


World stock markets (%GDP)

Rajan & Zingales 2003


Corporate Finance 1970-98

% Ger Japan UK US

Internal 79.8 76.1 92.5 96.4Bank 12.4 17.4 13.9 12.6Bonds -0.5 4.8 6.5 16.0Equity 0.4 3.8 -6.3 -10.6Other 8.3 -2.2 -6.6 -14.3


Comparison of ownership & control

Britain US Germany

concentration% low low highpyramids N Y Yfamily N N Ydual class N Y Y


Summary

was German universal banking beneficial?case non-proven

US financial capitalism was a solution to AI problems but rent-seeking behaviour?

Britain market-centricinvestors vulnerable until post-1945

disclosure, VC, LBOs/private equity, activism



Wk 4: Mergers & Acquistions


Oxford University



Overview

rise of Anglo-US equity marketswhy do mergers happen?merger “waves”do mergers create value?


Anglo-US stock markets over 19th C

LSE NYSE

estd. 1802 1817

listing rules 1825 1869

ltd liability 1856-62 1830s

first IPO boom rails 1840s rails 1880s

second IPO boom breweries 1880s voting trusts; industrials 1890s

competition Provincial SX’s Regional SX’s, curb mkt


Rise of equity finance

preference shares were a response to late 19thC overleveraging e.g. US rails and British brewers

1920s rise of “the equity culture”

advocacy: E.L. Smith, Keynes

door-to-door selling (US)

institutional appetite

voting rights


Mergers stylised facts

merger activity exhibits waves

correlation with stock market run-ups

clustering by industry reflecting “shocks”

stock deals popular around market peaks


US Merger Waves over 20th C


Why do mergers happen?industrial logichorizontalverticalconglomerate“bootstrap” game

shocksfrom regulation to deregulationtechnology

disciplinary (hostile mergers)

going private


US Merger Waves1895-1902 1920s 1980s

horizontal, vertical

“bustups”,horizontal

regulatory shock

Sherman Act Clayton Act Cellar-Kefauver Act,Continental

Can

Airlines, ATT breakup

banks

technology shock

mass production

radio, autos, chemicals

financial, managerial

junk bonds,LBOs

internet

economicshock

1893 depression

1920s boom 1960s boom oil crises, globalisation

globalisation

RJR NabiscoGM/Fisher Body

horizontal

US Steel

1960s 1990s

merger type

conglomerate strategic

dealexample

ITT/Hartford AOL/Time Warner


US mergers 1895-1956

Harford JFE05

first wave 1895-1902 (Nelson, Lamoreaux)capital-intensive industries pursuing scale1893 depressionstock marketmarket power (at least 70%) but many inefficient

Nelson thesis: stock prices plus industry/ technology factors


US mergers 1960s onwards

before mid-1960s M&A was “ a matter of quietly selling family-owned businesses to public companies” (Endlich, Goldman Sachs)

1974 INCO/ESC hostile bid

disciplining mechanism

technology transfer to UK 1980s


“Bootstrap game” of the 1960-70s

World Environment (pre-acqn)

Muck & Slurry World Environment(post-acqn)

eps $2 $2 $2.67

price $40 $20 $15

per 20x 10x 5.6x

profits $200K $200K $400K

shout 100K 100K 150K

mkt value $4M $2M $6M

Brearley & Myers


US mergers in deregulated industries

Andrade Mitchell & Stafford JEL2001


Rise of junk bond market

Baker JoF1992


Mergers and “new era thinking”

1901 US steel: “a new era has come, an era of community of interest whereby it is hoped to avoid ruinous price competition” NY Times

1920s: Irving Fisher “stock prices have reached what looks like a permanently high plateau”

1960s: “nifty fifty” growth stocks

1980s: Jensen “eclipse of the public corporation”

1990s: “the new new thing”


Can we model merger waves?

neoclassicalindustry shocks (Harford JFE05)Q-theory: hi-lo quality firm valuation spread widens during boom (Jovanovic&Rousseau AER02)behaviouralacquirors’ overvalued during boom (Shleiffer & Vishny JFE03) macro-liquidity (Shleiffer&Vishny JoF92)no deals in recessions because cash flows weak, buyers credit-constrained, sellers cannot get fair value


Do mergers create value?13 large mergers 1899-1901

9-year relative returnsUnited Shoe Machinery+23% US Cotton Duck -15%6 underperformed

(Nelson pp98 Table 53)


Do mergers create value?



Do mergers create value?



UK Merger Waves over 20th C

0

5000

10000

15000

20000

25000

30000

35000

1895

1900

1905

1910

1915

1920

1925

1930

1935

1940

1945

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

domestic x-border

No. deals; Index 1895=100

Source: Hannah; ONS


UK mergers: comparison

similar “waves” to USbut significant differences:“national” champions 1950s-70scross-border dealsshift from US to Europeanti-trust late to develop (1965 Act)more transparent takeover mechanism


UK mergers: transparency

1948 Companies Act hostile bids egSamuel /Savoy 1953

shift in BoE attitude during 1950s

LSE discourages dual class shares

1967 takeover code:fair pricedisclosure of toeholdstimetable


M&A markets compared today

US UK

Two-tier bids

Technical barriers

Business judgement rule

Entrenchment problem?

Equal price treatment

No technical barriers

Board no power to frustrate bid w/o approval

Commitment problem?


SummaryUS (and UK) exhibit merger waves over very long-run

horizontal/vertical/conglomerate/bustups/strategic/private equity

shocks

industry-level activity explicable but aggregation process remains a puzzle

mergers create short-term value for target shareholders… but long-run benefits questionable


Appendix: US merger characteristics



Wk4: The development of the IPO market

David ChambersDept of EconomicsUniversity of Oxford


Introduction3 key questions:

when do firms decide to go public? [IPO waves]are IPOs a good investment? [long-run performance]do entrepreneurs get a fair price? [underpricing]

how persistent are these “anomalies”?

IPO Waves


US and UK IPO waves 1919-59

0102030405060708090

100110120130140150160

1919

1922

1925

1928

1931

1934

1937

1940

1943

1946

1949

1952

1955

1958

UK US


US and UK IPO waves 1919-2003

0

100

200

300

400

500

600

700

800

900

1000

1919

1924

1929

1934

1939

1944

1949

1954

1959

1964

1969

1974

1979

1984

1989

1994

1999

US UKLowry_JFE03


US IPO waves since 1960


Why IPO waves?

capex demands and business cycle

information asymmetry

investor sentiment

(Lowry JFE03)


IPO waves: empirical evidence (Lowry)Annual IPO vol 1960-96


IPO waves: further evidencePagano Panetta & Zingales JoF98

139 Italian IPOs 1986-97unique dataset includes firms that chose not to IPOfirms go public when industry average MV/BV high but after period of hi investmentInvestor sentiment not business cycle


Firms going public successful time the market

Lowry_JFE_03


IPO wave hypotheses: summarybusiness cycle and investor sentiment “window of opportunity”

some evidence firms can time decision to go public

does this apply to pre-1960 IPO waves?

IPO long-run performance


Ritter claims underperformance…

Source: http://bear.cba.ufl.edu/ritter/IPOs2005-5years.pdfNote: Equally-weighted BHAR

http://bear.cba.ufl.edu/ritter/IPOs2005-5years.pdf


…in all periods since 1970Geometric meansYears 1-5

1970-79 1980-89 1990-99 2000-03

IPO firms +10.8% +6.9% +13.7% +9.8%

Rel to Size & MV/BV matched

-3.7% -2.3% -1.8% -6.1%

Source: http://bear.cba.ufl.edu/ritter/IPOs2005-5years.pdfNote: Equally-weighted BHAR

http://bear.cba.ufl.edu/ritter/IPOs2005-5years.pdf


Do IPOs underperform in the long-run?

challenged Brav&Gompers (JoF97) re post-1972Gompers&Lerner (JoF03) re 1935-72measurement problems:

what is the relevant benchmark? biases: rebalancing, skewness, new listing, pre-survivor (see Jenkinson&Ljungqvist p161-166)buy and hold (BHAR) vs cumulative (CAR)event-time vs. calendar-timeequal weight vs value weight


US IPO long-run performance pre/post-1933 Act


IPO waves and long-run performance

Lowry_JFE_03


Long-run IPO performance: summaryunderperformance result not robust

1933 Act benefited non-NYSE IPOs but small sample1930-33 anomaly

IPO underpricing


US and UK underpricing since 1960

US UK#IPOs Ret% #IPOs

13.9 551285871672302206

11.77.314.865.011.7

Ret%1960-69 2661 13.41970-79 1640 9.91980-89 1982 17.51990-98 3396 12.51999-2000 803 70.72001-03 210 14.8



IPO underpricing on LSE 1917-2004

-5%

0%

5%

10%

15%

20%

25%

30%

35%

WW1 22 26 30 34 38 47 51 55 59 63 67 71 76 80 84 88 92 96 00


Underpricing theoriesinformation gaps

information revelation (Benveniste-Spindt’89)book-building rewards information production

agency problemsinvestment banksmanagement incentives

other

price support, litigation risk, behavioural explanations


Possible explanations

changing risk composition

change in issuer objective function

bank monopsonistic power

increased investor heterogeneity

decline of Provincial stock exchanges


Company age and length of track record

0

10

20

30

40

50

60

70

WW1 21 24 27 30 33 36 39 47 50 53 56 59 62 65 68 71 74/5 78 81 84

AGE TRACK


Usage of reputable underwriters

0%

20%

40%

60%

80%

100%

WW1 21 24 27 30 33 36 39 47 50 53 56 59 62 65 68 71 74/5 78 81 84

Underwritten by a promotor, brokeror any other such syndicate

Underwritten by a member of theAccepting Houses Committee


Increasing investor heterogeneity

30%

36%

48%

58%60%

54%

47%

38%

28%

20%

16% 17%15% 14%

20%

0%

10%

20%

30%

40%

50%

60%

1963 1969 1975 1981 1991

INSTITUTIONS RETAIL OTHER


US underpricing and IPO waves 1960-2001


ConclusionsIPO waves: cycle plus sentiment=window of opportunity

long-run underperformance claims contentious and evidence US-centric[IPOs in hi volume periods tend to underperform]

underpricing persistent since 1960costs of investors becoming informed or rents to i-bankers and institutional investors?

high underpricing leads to increase in firms going public


Wk 6: Bubbles and Crises


Oxford University

Chambers/LFFH/TRIN07 2

Introduction

was there a bubble in 1720?

was there a bubble in 1929?why was the Crash so devastating?how did the US recover?

why was 1987 so different?

lessons unlearnt? Asian crisis 1997-98

Was there a bubble in 1720?


Bubbles – rational or irrational?

irrational“the relationship of an asset to its market fundamentals simply breaks down because of overzealous trading or an unrealistic appraisal of the value of a stock” (Neal)

rationalthe “greater fool” theory of investingPastor&Veronesi thesis (see below)


South Sea Share Price 1720


Was there a bubble?subscription pricesDale: irrational exuberanceShea: multi-stage options

share price overvalued?60% at peak (Garber); intangibles? growth option?Hutcheson’s tablesHoare’s trading whilst tightening margin lending (Temin&Voth)

why did a bubble develop?no short sale constraint (but lending against own stock)noise trader risk or synchronisation risk

Was there a bubble in 1929?


Booms and Busts over the 20th CSource: Dimson Marsh & Staunton


Real S&P Composite Index

3.5

4

4.5

5

5.5

6

6.5

7

7.5

8

18711881189119011911192119311941195119611971198119912001

Oct 1929

Sep 1987

Sep 2000

Jan 1973

Source: Shiller


S&P PER & real interest rates

05

101520253035404550

1881189119011911192119311941195119611971198119912001

0

2

4

6

8

10

12

14

16

PER (lhs) Real Int.Rate (rhs)

Peak PER 44x

Peak PER 33x

Source: Shiller

Trailing 10 yr earnings


Real S&P Composite Index

1925=100


Most investors are suckers! They have a short memory, think money equals

intelligence and fall for new era thinking


1929 “bubble” ingredients

new era thinkingcommon stock investingnew technologiesmodern firmnoise traders – closed end fund premialiquidity – broker loanslimits to arbitrage


“Fisher Says Stock Prices Are Low”NY Times 22 Oct 1929

R&D60% of largest firms1920s patent grants highest since 1789radio

management scienceFordismmanagerial capitalism

“the dividends of prohibition”


Closed-end fund premia 1928-32Seasoned Closed-end funds only

Source: De Long & Shleifer


Closed-end fund premia 1965-85


Closed-end fund issues 1928-29


Closed-end fund issues 1928-29

“Fiscal incest” (Galbraith)

Goldman Sachs Trading Corp Dec 1928

Shenandoah Corp

Blue Ridge Corp

leverage- pref/common- margin trading


Liquidity: brokers’ loans

Source: White


Liquidity: brokers’ loans

Source: White


Revisionist view: Fisher was right!

1921 1931

corporate R&D labs 521 1620

refrigerators: 5,000 906,000

households with a radio 0 12mil


Field: “The most technologically progressive decade of the 20th C”

Kendrick estimatesannual TFP growth%:

1919-29 +21929-41 +2.31941-48 +1.3

Gordon estimatesannual TFP growth%:

1913-29 +1.421928-1950 +1.901950-1964 +1.471964-1972 +0.891972-1979 +0.161979-1988 +0.591988-1996 +0.79Source: Field_AER2003


Revisionist view: Fisher was right!

Shiller: FV = PV of future dividendssee Flood&Hodrick JEP90

McGrattan & Prescott: FV = KT + KI

Nicholas: patents and the “institutionalisation of innovation”


Revisionist view: McGrattan&Prescott

FV = KT + KIcorporate profits = rT KT + rI KIintangibles KI = 61% KT in 1929 FV = 1.9x GNP versus MV= 1.7x GNP

alternatively,rT = 5.9% vs actual 4.7%

KT is a residual, no direct evidence


Truman Fuller’s Invention of an Electrical Contact


Revisionist view: patents

Source: Nicholas


Revisionist view: patents

RCA: patents valued at 100% physical assets

citation-weighted score: # times patents granted between 1910-39 are cited in patents granted post-19751920s patents 20% share; 1930s 30%

annualised excess returns to 1sd + in citations:1928-29 +13.0%1930-32 - 6.3%1933-39 +3.5%


Revisionist view: rational bubble

Source: Pastor&Veronesis _wp2007


Source: Pastor&Veronesi


Source: Pastor&Veronesi


Summary: was there a bubble?

irrational: closed-end funds, broker loans

fairly valued if intangibles included

rational stock price reaction to technological uncertainty

who gains from technology shocks?


How could I get it so wrong? It’s not logical. It must be those

investor “animal spirits”!

Why was the 1929 Crash so devastating?


When the tide goes out, then you discover who is wearing no trunks!


US stock market: crashes compared

1929 1973/4 1987 2000

Crash -81% -54% -27% -42%

31

Hi Oct-29 343 Jan-73 527 Sep-87 546 Aug-00 1485

Lo May-32 67 Dec-74 245 Dec-87 396 Feb-03 867

#mths 32 24 3


How bad was it?

stock market fell 81%

real GNP fell 35% 1929-331 in 4 workers unemployed in 1933 1 in 5 banks failed

very slow recovery


Slow economic recovery

Romer_JEH92


Even slower market recovery

0

50

100

150

200

250

300

350

400

450

500

1918.12 1928.12 1938.12 1948.12 1958.12

Oct 1929 Apr 1956

$100 invested Dec 1918: dividends not reinvested

Source: Shiller


What caused the Great Depression?

consumption shock (Romer)

monetarist (Friedman& Schwartz)

nonmonetary effects (Bernanke,Mishkin)

gold standard (Eichengreen, Temin)


Consumption shock

wealth effects?stock market losses $180bil Sep29-Jun306 cents on the $ (Ando & Modigliani), 10 cents todaybut only 500K serious investors in 1929

uncertainty hypothesis (Romer)stock market volatilitypostpone durables consumption1930 durables -32% perishables -2%


Monetarist: Friedman & Schwartz

bank panics 1930-32: Bank of US - Creditanstalt -Midwest&West Coast banks↓hi-powered money ↓money supply ↓real output

Fed policy ineptdeath of Benjamin Strong

but why did decline turn into depression?


Nonmonetary effects (Bernanke/Mishkin)

banks sufferedadverse selection (AS)moral hazard (MH)susceptibility to runs

real effects:↑uncertainty → ↑AS, MH↑int. rates → ↑AS↓stk mkt plus debt deflation* →↑ AS, MH *unanticipated deflation → ↑ real debt → ↓net worth + ↓collateral value


Nonmonetary effects: evidence

banks refusal to lend loan ratio 85% 1929 60% 1933

banks more risk averseBaa-govt bond spread 2% 9/29 8% 5/32

households, farmers and small business

1933-38 lack of credit persisted


Nonmonetary effects: evidence


Golden Fetters! (Eichengreen)Gold Standardfixed exchange ratesfree flow of goldprice specie flow mechanism

interwar problemspolicy asymmetryno international co-ordinating organisation

WW1 shock shift from Britain & Germany to US

Britain off GS Sep-1931; but US Apr-1933

Fed hands tied (Temin)


Golden Fetters!

05

101520253035404550

1921 1925 1931 1932 1933 1934 1935 1937

No of countries on Gold 1921-37

Source: Palyi


Golden Fetters!

Mean log changes 1931 1932 1933 1934 1935

Money Supply -ON GS-OFF GS

-.094-.076

-.088-.060

-.045+.007

-.013+.028

-.067+.046

-.065-.002+.068+.078

Wholesale prices -ON GS-OFF GS

-.140-.084

-.133-.011

-.037+.033

-.038+.036

Mfg production -ON GS-OFF GS

-.117-.113

-.173-.057

+.025+.120

-.001+.008

Bernanke JMCB95 Table2.2


Why did the economy recover?

not fiscal policy

monetary expansion (C.Romer)quit gold standardno sterilisation led to monetary stimulus not trade competitiveness

underlying dynamism of 1930s (Field)


Why did the economy recover?Fiscal Policy Monetary Policy

% %

Fiscal surplus/deficit to GNP Deviations of monetary growth from trend

Romer_JEH92


1929 and 1987 compared

Source: White


What was different about 1987?Greenspan 20 Oct 1987:“readiness to serve as a source of liquidity to support the economic and financial system”

less uncertainty (Romer)

stronger, regulated banking system (ex S&L’s)

minimal asymmetric information problem (Baa spread +50bp to 2.5%)

flexible exchange rates

but no technology shock; clearing/settlements crisis



Summary: why the depression?

weak central banks

weak banking system

leverage and non-monetary effects

inflexibility of gold standard

isolate economy from stock market falls

Lessons unlearnt?Asian Crisis 1997-98


Why did crash turn into crisis?weakly regulated banks

fixed exchange rates

nonmonetary effects

lack of a credible LOLR


Asian bank regulation (pre-crisis)CAPITALADEQ

LOANCLASS’N

FOREIGNOWNER

OVERALLSCORE

SING 1 1= 2 1

HK 2 4= 1 2

MAL 4 4= 4 3=

PHIL 3 1= 3 3=

KOR 5= 4= 6 5

INDONESIA 5= 3 5 6

THAI 5= 7 7 7

Source: Crafts OxREP1999


Nonmonetary effects

weak banks + crony capitalism + weak LOLR

excessive risk taking NPLs

pegged XRs carry trades

XR depreciation NPLs (banks and firms)

stock market falls net worth/collateral


No credible LOLRAsian central banks not independent

no credible inflation-fighting recordpoor failed bank resolution processinability to punish bank owners/mgmt

IMF failingsausterity rather than LOLRmicro not macro problem


Crisis costsGreat Depression below trend growth 1929-41

Asian Crisis1997 real GDP restoredKorea 1999Thai 2001Indonesia 2002



Summary: Asian crisisnonmonetary effects and XR regimes again

which capitalism? relationship or arms-length

faster recovery (no plunge to autarky)


Wk 7: Globalisation, Capital Markets and Financial Stability


Oxford University


Questions

global capital market integration

is it inevitable?

what is the policy trilemma?

does it raise the incidence of crises?

Is global capital market integration inevitable?


Measures of integration

quantitytrade openness and foreign capital flows extent of portfolio diversificationFeldstein-Horioka puzzle

pricecovered interest rate parityconvergence of real returnssecurity market correlations

Lucas Paradox and the Great Divergence

limits to globalisation – Stulz; James


Trade opennessExports plus Imports as % Output


Foreign Capital Stock

0%

20%

40%

60%

80%

1870 1914 1938 1960 1980 1995

Assets/World GDP Assets/Sample GDP Liabilities/World GDP

Source: Obstfeld&Taylor


Emerging debt markets

Mauro et al QJE02: in 1905 30% of sovereign bonds listed on LSE issued by 16 emerging borrowers

no issues 1929 to early 1990s- capital controls- bank loans

re-emergence 1990s


International diversification benefits

Optimal Portfolio = 70% US 30% Foreign


Home bias of US investors today


British investors less biased in 1913

Nominal value of securities quoted on LSE 1873 1913

All foreign 37% 59%

Govt, State, Municipal 21% 33%

Railways 16% 26%Source: Morgan & Thomas


Feldstein-Horioka Puzzle

0%10%20%30%40%50%60%70%80%90%

100%

GoldStd

1920s 1930s BW Post-BW

Savings-retention coefficient

Source: Obstfeld & Taylor 2004, Table 2.3


Interest rate parity

interest rate parity: return on a risk-free £ deposit in London should be identical to return on a equivalent $$ exchanged spot, deposited in New York and sold forward for £

(1+i£)= (1+i$)e/f where e = spot £/$

f = forward £/$

commissions & stamp duty pre-1914


NY-London covered interest parity

Obstfeld_JEP_98


Security correlations 1860-2000

Source: GoetzmannLi&Rouwenhorst

Mean off-diagonal correlation; 60-mth rolling window


Stylised view of global integration

1860 1880 1914 1918 1929 1945 1960 1980 2000

Gold Standard1880-1914

Bretton Woods1946-71

Interwar Turmoil1919-39

Hi

Lo

Adapted from Obstfeld&Taylor

Post-BW


Lucas Paradox

Source: Taylor_nber_w7394

Foreign investment/GDP %


Lucas Paradox

0%5%

10%15%20%25%30%35%40%45%

<20 20-40 40-60 60-80 >80

19131997

Share of Global Foreign Capital Stock

Relative income per capita of recipient (US=100)

Source:Obstfeld&Taylor


The Great Divergence over the 20th C

0

5,000

10,000

15,000

20,000

25,000

30,000

1870 1913 1950 1973 1998

Western Offshoots Africa

GDPPC 1990 international dollars

Source: Obstfeld & Taylor 2004, Table 2.9


Limits to globalisation

Stulz 2004


“The End of Globalisation” (H.James)

anti-globalisation backlash

protectionism

capital controls

immigration controls

what’s next?


Summary: market integration

not inevitable

more integrated today than 1913:foreign capital stocktighter no-arbitrage bandshigher security market correlations

less integrated: lead global investor less diversified savings-retention coefficient lowerLucas Paradox

limited by twin agency problems

The political economy of the policy trilemma


Policy Trilemma

every government would like to be able to:avoid XR uncertaintyenjoy monetary and fiscal policy autonomyattract foreign capital

but something has to give…


Origins of Gold Standard

England took lead role because:1717 Newton and Gresham’s law1816 steam-powered presstrading partners

bimetallism

network externalities


Gold Standard

Gold Std Bretton Woods Post-1971

XR regime fixed

MP autonomy no

Capital controls no


Periphery and Gold Standard pre-W1

Source: Bordo&Rockoff

Source:Bordo&Rockoff


Attractions of Gold Standard

capital exported by “core” to developing “periphery”

simple and transparent “rules of the game”- deflate/inflate when BoP deficit/surplus- international cooperation- short-run (gold points) vs long-run (parity)- stabilising capital flows

benefits- XR stability- credible commitment mechanism

core/periphery


Gold Standard pre-1914

Source: Bordo&Rockoff


A good housekeeping seal of approval


A good housekeeping seal of approval


But…not for everyone!


Reputation mattered


Interwar turmoil 1919-39

gold standard could not cope with the Depressionno policy autonomydestabilising capital flowsshift in economic power from Britain to US

democratisation and rise of organised labourwelfare state (Obstfeld & Taylor fig 1.5)



05

101520253035404550

1921 1924 1931 1933 1937

No. of countries on Gold Standard

Source: Palyi 1972





Britain and US: rival bankers to world

0%10%20%30%40%50%60%70%

1870 1914 1938 1960 1980 1995

Britain US


Gross Foreign Assets/World GDP%


Bretton Woods 1946-71

Gold Std Bretton Woods Post-BW

XR fixed pegged

MP autonomy no yes

Capital controls no yes

tripartite agreement (Eichengreen)

restore free trade

US dollar


Bretton Woods: focus on Trade

Average tariffs on manufactured goods

Source: BordoEichengreen&Irwin


Bretton Woods 1946-71

unprecedented international cooperation

but problems

US inflationary policy undermined US$

perverse incentives of pegs

rising capital flows due to current account convertibility, MTNs, financial innovation (euro-$ markets)

end of tripartite agreement


Bretton Woods: US under pressure

ObstfeldShambaugh&Taylor_w10396


Bretton Woods: currency speculation

Source: ObstfeldShambaugh&Taylor_w10396

0.00

1.00

2.00

3.00

4.00

5.00

6.00

1870

1880

1890

1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

Pegged XRs

1949 devaluation

1967 devaluation

1971 floated



Post-Bretton Woods: 1973-present

Gold Std Bretton Woods Post-BW

XR fixed pegged float

MP autonomy no yes yes

Capital controls no yes no

central banks stranded like King Canute!commitment devices

- central bank independence- currency boards


Post-Bretton Woods: floating XR’s


0.00

1.00

2.00

3.00

1870

1880

1890

1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

2000

4.00

5.00

6.00

FloatingXR


Post-Bretton Woods: policy autonomy


Volcker’s anti-Inflation policy


Post-Bretton Woods: capital flows


Summary: Policy Trilemma

trilemma explains two great reversalsnot inconsistent with R&Z thesis

lessons from pre-W1 Gold standardbenefit: commitment device

lessons from interwar Gold Standardcosts: no policy autonomy

lessons from Bretton Woodsbenefit: cooperation; costs: pegs and mobile capital impossible

Are we more Crisis-prone today?


Crises more frequent today

Period Bank XR Twin All

1880-1913 2.3 1.2 1.4 4.91919-1939 4.8 4.3 4.0 13.21945-1973 0 6.9 0.2 7.01973-1997 [N=21] 2.0 5.2 2.5 9.71973-1997 [N=56] 2.3 7.5 2.4 12.2

Source: Eichengreen&Bordo 2002

Unconditional probability of crisis in one country in any given year, %


and no less severe

Output losses %

1880-1913N=21

1919-39N=21

1945-71N=21

1973-97N=21

1973-97N=56

Core 9.0 17.9 4.4 8.0 7.7

Periphery 13.1 21.4 9.1 14.9 12.0

Source: Eichengreen&Bordo


Emerging debt (Mauro et al QJE02)

spreads in 1990s more volatile and more correlated than pre-1913large spread changes in more than one ctry twice as likely

Asia (Oct97), Russia crisis (Aug98) spreads rise >2% in ALL mkts; Baring crisis (1890) only Argentina, Venezuela

why?commitment: Gold Standardenforcement: CFB; gunboat diplomacyinvestor behaviour; trading technology


Summary: Crises

Eichengreen&Bordo: more frequent due to currency problems and no less costly

Mauro et al: shocks to emerging debt markets more contagious in 1990s than pre-1913

Lessons from Financial History, 24th May 2007:

The equity risk premium 1900–2006

Professor Elroy DimsonLondon Business School

Guest session for David Chambers’ MBA/MFE CourseDepartment of EconomicsOxford University

Portfolio theory

Asset pricing theory

The equity premium

The equity premium puzzle

What is the equity premium?

What does history reveal?

Size, dividends and value

Concentration, currency and correlations

What can we learn from financial history?

Copyright 2007 © Elroy Dimson, Paul Marsh and Mike Staunton 3

Efficientfrontier

Minimumrisk

portfolioMinimumriskfrontier

Individualassets

Risk

Expectedreturn

The efficient frontier


Expectedreturn

Risklessrate of interest

Super-efficientportfolio

Cash plus shares

Borrowing plusshares

Risk

The efficient portfolio

Lower risk for the same expected return

Higher expected return for the same risk


Market risk

Riskless rate of

interest

Expected market return

Beta x Market riskpremium

Risklessreturn

Beta=1(= Risk of the market)

Expected return

Capital Asset Pricing Model

Expected return = Riskless rate + Beta x Market risk premium

Beta=0(= Risk of Treasury bills)

Equity risk premium


Equity risk premium: Definition

Reward required for equity market risk

Relative to risk-free investment

Prospective reward needed to

Compensate for risk

Because investors are risk averse

The “price” of risk


Premium relative to bills vs Premium relative to bonds

Historical risk premium vs Expected future risk premium

Geometric mean (GM) vs Arithmetic mean (AM)

GM is difference in annualised equity and riskfree returns

AM is simple average of annual premia

AM > GM

For discount rates we need expected premium, i.e. the AM

Equity risk premium: Variants


Equity risk premium: Importance

Drives future equity returns

Guides asset allocation

Determines cost of capital

Central to valuing companies/shares

Crucial in project appraisal

Fair returns for regulated utilities

The most important number in Finance


The equity premium puzzle

We define the equity premium like this

Premium = (1+Rm) / (1+Rf) – 1 ≈ Rm − Rf

The premium economists say we “ought” to get

0.35% (Mehra-Prescott, 1985)

1% (Mehra-Prescott, 2003)

The premium we actually did get

6.2% (Mehra-Prescott, 1985)

8.3% (26 years subsequent to Mehra-Prescott research)


Resolving the puzzle

1.Revisit the theory:Explanations involve “deep modifications to the standard models… Every quantitatively successful current story for the equity premium still requires astonishingly high risk aversion”

(Cochrane, 1997)

2.Revisit the evidence:• In 1792, Dutch and UK markets were 190 and 94 years old

The NYSE was 1 day old. Share of global equities was 0%• In 2007, US share of global equities is 48%

Is it surprising that the US equity premium has been large?• Should we not look beyond the US? And over a long period?


US and UK premia may be anomalous

“There were 36 active stock markets in 1900, so why do we look at only two? I can tell you: because many of the others don’t have a 100-year history, for a variety of reasons.”

Zvi Bodie, Financial Times, 2002

Few studies cover long-term non-US, non-UK data:

• Mehra-Prescott, 2003 – other countries post-1970 only

• Ibbotson, 2006 – other countries post-1970 only

• Siegel, 2002 – only 2 other countries pre-1970

• Jorion-Goetzmann, 1999 – only 4 countries pre-1970


The consensus equity premium has declined

AcademicsJagannathan-McGrattan-Scherbina (2000), Dimson-Marsh-Staunton (2000), Fama-French (2002)

Fund managers and advisorsArnott and Ryan (2001), Arnott and Bernstein (2002)

Investors, CFOs and analystsSharpe-Amromin (2005), Graham-Harvey (2005), Brav-Lehavy-Michaely (2005)

Finance professorsWelch (2000, 2001), Fernandez (2004)

Opinions are “too sensitive” to market fluctuations

Recent vs long-run evidence

Global stock market history

The historical premium

From the past to the future







21st Century UK investment returns

4.4

-1.0

28.0

32.1

18.219.7

2.85.2 5.7

9.7 9.9

3.24.7

16.413.913.2

4.73.2

12.1 12.6

-5

0

5

10

15

20

25

30

35

Inflation All equities

Tbills Long bonds

Index-linked

Small-caps

Mid- caps

Houses Invest.property

Micro- caps

2006

2000-2006

Annualised return (%)


We can’t draw inferences from recent data

-5

0

5

10

15

Bel Ita Ger Fra Spa Jap Nor Swi Ire Den Neth UK Wld Can US SAf Aus Swe

2000–20061990–1999

2.6 2.6 3.3 3.7 4.0 4.5 4.5 4.6 5.0 5.3 5.4 5.6 5.8 6.3 6.67.97.87.5

1900–2006

Annualised percentage real return


Equities turn £100 into £2.1m (in nominal terms)

21,174

264193

65

0

1

10

100

1,000

10,000

100,000

1900 10 20 30 40 50 60 70 80 90 2000

Equities 9.8% per year

Bonds 5.4% per year

Bills 5.0% per year Inflation 4.0% per year

Index value (start-1900 = 1.0; log scale)


A 324-fold real increase from UK equities

324.5

4.1

3.0

0

1

10

100

1,000

1900 10 20 30 40 50 60 70 80 90 2000

Equities 5.6% per year Bonds 1.3% per year Bills 1.0% per year



Distribution of UK equity returns 1900–2006

2006200419981996

1976 19881962 19871961 19851956 19811952 19791951 19781947 1972

2000 1945 19651994 1927 19551970 1926 1950 20051966 1923 1946 20031964 1918 1944 19991960 1917 1943 19971957 1916 1942 19951948 1913 1941 19931940 1912 1936 1992

2001 1939 1911 1935 19911990 1938 1910 1934 19861969 1921 1909 1928 19841949 1915 1908 1925 1983 19891937 1914 1906 1924 1982 1980 1977

2002 1930 1907 1905 1922 1963 1971 19681973 1929 1903 1902 1919 1953 1967 1959

1974 1931 1920 1901 1900 1904 1933 1932 1958 1954 1975

-50 -40 -30 -20 -10 0 10 20 30 40 50 60 . . . 140 150

Percentage return


Our 107-year dataset

USA 45%

UK 10%Japan 9%

Switzerland 3%

Canada 3%

Other GIRY 4%

Other 11%

Australia 3%Spain 2%Italy 2%Netherlands 2%

France 5%

Germany 3%

Coverage by market value in

2007


Markets have sometimes performed exceptionally

113

279

206255

431

516

4094

372

0

100

200

300

400

500

600

700

800

900

1990s/tech boom WWI recovery Expansionary 1980s WWII recovery

World index

Best country

Real returns (%)

1990–99 1919–28 1980–89 1919–28

US

USJap

Ger=


But markets have a downside too

-12-18

-44-47

-54

-100

-80

-60

-40

-20

0

WWI WW2 Tech crash Oil shock Wall Street Crash1914-18 1939-48 2000-02 1973-74 1929-31

World index

Real returns (%)

-66 -65

-73-79

-96

Worst: peak to trough

Ger

Jap

Ger

UKUS

WldWld

WldWld

Wld


Equities beat bonds everywhere

2.6 2.63.3

3.74.0

4.5 4.5 4.65.0

5.3 5.3 5.4 5.65.8

6.3 6.6

7.57.8 7.9

-0.2

-1.8 -1.8

-0.3

-1.3

2.4

1.41.81.92.0

1.61.31.31.1

3.0

1.1

2.6

1.61.3

-4

-2

0

2

4

6

8

Bel Ita Ger Fra Spa Jap Nor Swi Ire Den WxU Net UK Wld Can US SAf Aus Swe

Equities

Bonds

Annualised percentage real return


Historical equity risk premium

3.33.7 3.8

4.0

4.7 4.8

5.65.9

6.46.6 6.7

6.97.2

3.0

4.3

3.0

4.64.3 4.5

0

1

2

3

4

5

6

7

Bel Den Nor Spa Swi Ger Ire WxU UK Can Net Wld US Swe SAf Jap Ita Fra Aus

Equity premium vs. bills

Equity premium vs. bonds

Annualised percentage return


Decomposition of the equity risk premium

1 + ERPt = (1+ Real returnt) / (1 + Real Rft)

≡ (1 + Yt) (1 + Gdt) (1 + GPDt) (1 + Xt) / (1 + Rft)

Real exch rate changeXt = inflation-adjustedcurrency appreciation

Annualised mean dividend yieldYt = Dt / Pt

Rate of expansion of P/D multipleGPDt = PDt / PDt-1 – 1

Growth rate of real dividendsGdt = dt / dt-1 – 1


The historical equity premium

= Growth rate of real dividends

+ Growth rate in the P/D multiple

+ Excess of dividend yield over risk-free rate

Components of historical premium

‘World index’ vs bills

4.8%

0.9%

0.7%

3.2%

Was this the annualised premium that investors expected?


The worldwide equity premium

All markets provided a positive historical equity risk premium

But the equity premium is less than was previously thought…

because our indexes are long term, unbiased, and less prone to survivor or to success bias

We have not solved the equity premium puzzle

However, our estimates of the equity premium are smaller

From: The Worldwide Equity Premium: A Smaller Puzzle

The small-firm effect

Value vs growth investing

The impact of dividends

Combining size and value







Small has been beautiful since 2000

-2 0

10

16

-3

3

6 7 7 7 8

10 10

1213

16 1617

2

4

8

3

6

4

-1

18

1112

5

-6

2

5

-10

-5

0

5

10

15

20

Nor Bel Ger Can Aus UK Jap Fra Ita Swi Wld Neth Ire US Swe Spa Den

2006

2000–06

Size premium (% per annum)

-12-21


There were ten lean years…

7.8

14.216.0

6.0

20.2

-8.1-10

-5

0

5

10

15

20

HGSC launch: 1955–1986 Ten lean years: 1989–1998

HGSC FTSE All-Share HGSC premium

Annualised percentage return


…but size triumphed over the long run

13,747

2,930

776

1

10

100

1,000

10,000

100,000

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005Start of year

UK micro-caps 20.1% p.a.

UK small-caps 16.6% p.a. UK market 13.6% p.a.

Cumulative value (log scale)


‘Value’ grew faster than ‘growth’

46

9 9 9 10 10 11 12

17

29

5

15

4

12 12 12

8

14

-5

12

-2

11

31 1

-5

9

11

0-2

1-2

-10

-5

0

5

10

15

20

25

30

Swi Nor Bel Aus SAf Net UK Wld US Den Spa Ire Fra Jap Ita Ger Can Swe

2000–06

2006

Value premium (% per annum)

= -16


Sector returns and value

Sector returns (%) March 2000 to end-2006

177

233

0

511

-63

-50

-40

179

345

498

468

416

348

667

-38

-26

-94

-88

-67

-53

-62

-100 0 100 200 300 400 500 600 700

Hardware

Software

Mobile telecoms

Fixed line telecoms

Media

Real estate

Industrial metals

Construction

Mining

Household goods

Personal goods

Tobacco

Five best world sectors

Five best UK sectors

Five worst world sectors

Five worst UK sectors


Dividends matter

21,53621,174

231161

0

1

10

100

1,000

10,000

100,000

1900 10 20 30 40 50 60 70 80 90 2000Start of year

US: total return 9.8% p.a. UK: total return 9.8% p.a. US: capital gain 5.2% p.a. UK: capital gain 4.9% p.a.


Impact ofdividends


Dividend growth and re-rating over the long run

4.5

2.6 2.63.3

3.7 4.0

5.4

4.55.0

4.6

5.6 5.35.8

7.5

6.3 6.6

7.8 7.9

5.3

3.1

1.51.41.11.0.9.7.6.4

-.1-.2-.2-.3-.5-.7-1.3-1.4-1.5

-2.4-3

-2

-1

0

1

2

3

4

5

6

7

8

9

Jap Bel Ita Ger Den Fra Spa Net Nor Ire Swi UK WxU Wld SAf Can Aus US Swe

Real equity return Change in price/dividend ratio Real dividend growth

Annualised return (%)


A century of value investing

95,322

21,174

4,279

1

10

100

1,000

10,000

100,000

1900 10 20 30 40 50 60 70 80 90 2000

High yield 11.3% p.a.

Market 9.8% p.a.

Low yield 8.1% p.a.

Cumulative value (log scale)


Size or Value or Size and value?

26,098

4,024

778

207

1

10

100

1,000

10,000

100,000

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005Start of year

Small-Value (21.8% p.a.)

Big-Value (17.5% p.a.) Small-Growth (13.8% p.a.)

Big-Growth (10.9% p.a.)

Index value (mid-1955 = 1.0; log scale)






Stock market concentration

Long-run PPP

Impact of exchange rates

Equity-bond correlations


Concentration in the UK market

Top 5: 24%

Stocks 6–10: 11%

Stocks 11–20: 13%

Smallest 50 FTSE 100: 12%

Non-FTSE 100: 22%

Stocks 21–30: 8%

Stocks 6–13: 9%


Concentration in national markets

6 7 7 9 8 12 916 16

2015 19 20

26 2429

54

3

8

1419

21 22 23 24 26

3337

4245

50 5256

667064

0

10

20

30

40

50

60

70

US Jap Can UK Aus SAf Fra Ger Swe Ita Neth Swi Spa Bel Nor Ire Den Fin

2nd + 3rd largest stocks

Largest stock Largest 3 stocks

Start-2007 weighting (%) in FTSE All-World country index

xx


Extract from OXIP presentation on 21 May 2007

31 Dec 1988 (%) 31 Dec 1995 (%) 31 Mar 2007 (%)

British Petroleum 7.0 Glaxo Wellcome 5.6 British Petroleum 7.0

British Telecom 6.9 British Petroleum 5.2 HSBC 6.7

Glaxo 3.6 British Telecom 3.9 GlaxoSmithKline 5.3

BAT Industries 3.1 BAT Industries 3.1 Vodafone 4.7

ICI 3.1 HSBC 3.1 Royal Bank of Scotland 4.1

Total 23.7 20.9 27.8

“The UK market is now more concentrated than it used to be”


History tells you more about concentration…

47

22

7.6

0

10

20

30

40

50

60

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000Start of year

Largest 10 stocks Largest 3 stocks Largest stock

Concentration within UK top 100 index (%)

2007


Currency mattered a lot in 2006

-10

-2

8

1

8

12

14

7

12

12

12

12

12

12

2

12

8

9

12

16

9

12

9

3

16

17

22

22

37

-1

0

0

0

7

39

27

58

33

31

50

38

41

117

33

26

24

23

23

23

22

20

25

16

17

21

41

3

45

46

47

124

72

57

51

48

44

41

39

39

39

38

37

37

36

34

34

33

31

30

27

23

22

18

16

16

2

-10 0 10 20 30 40 50 60 70

JapanUS

KoreaCanada

World

TaiwanSouth AfricaSwitzerland

DenmarkUK

AustraliaNetherlands

FinlandFrance

GreeceItaly

Hong KongGermany

IndiaBelgium

SingaporeNorwayIrelandMexico

SwedenBrazilSpain

RussiaChina

Depreciation versus dollar

Appreciation versus dollar

Dollar return

Total return (%)

xx

xx Local currency returnxx

Depreciation versus dollar

Appreciation versus dollar

Dollar return

xx

xx Local currency returnxx


And over the 21st century so far…

-9

-26 -26 -27-31

-32 -32-35 -35

-41

1615

-17 -18-20 -20

-23 -24 -24 -24

-50

-40

-30

-20

-10

0

10

20

JPY GBP CHF CAD NOK DKK EUR SEK AUD ZAR JPY ZAR AUD GBP CAD SEK NOK CHF DKK EUR

2002-2006 2000-2006

Change in value of dollar versus currencies of other GIRY countries (%)


But what about currency over the very long run?

0.00

0.01

0.10

1.00

10.00

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000Start of year

SwiNetUSCanDenNorSweUKIreAusBelS ASpaJapFraItaGer

US dollars per unit of local currency (rebased)


Real exchange rates barely changed

0.1

1.0

10.0

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000Start of year

SwiBelDenJapNetNorIreGerItaUSSpaUKCanSweFraAusS A

US dollars per unit of local currency (rebased)


Currency barely impacted the long-term premium

2.6

3.7 4.0

5.6

6.3 6.6

7.57.8

5.45.3

4.64.54.5

3.3

2.6

7.9

5.0

.11

-.05

.08

-.17

.00.36.57.37

.77.32.28.10

-.04

.33.20.71

-.87-1

0

1

2

3

4

5

6

7

8

Bel Ita Ger Fra Spa Jap Nor Swi Ire Den Neth UK Can US SAf Aus Swe

Local domestic return

Real dollar return

Real exchange rate vs $

Real returns, 1900–2006 (% per year)


Are recent equity-bond correlations high or low?

-.40

-.30

-.20

-.10

.00

.10

.20

.30

.40

.50

.60

.70

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

United States United Kingdom

Correlation between equity and bond returns


ConclusionsWhy do we need a historical perspective?

A year (or even a decade) is a short time in the market

Need long-run evidence to understand lasting relationships

Set the present in the context of the past: a guide to the future

What have we learned?The equity risk premium is fundamental to finance

The equity premium was positive in 17 markets over 106 years

It was smaller than would be inferred from the US experience

There was also a long-term small-cap and value effect

Market concerns over concentration may be overstated

20 YEARS of M & A

in the

ENERGY SECTOR

Tony Durrant

Presentation : Oxford 10/05/07

Themes and Issues

1. Why do mergers happen?

- Waves and clusters

- Top or bottom of the cycle

- Other drivers

2 Do mergers create value?

- Methodology

- Practicalities

3. Do mergers drive markets or vice versa?

- Recent changes in financial markets

Why Do Mergers Happen?

Source : John S Herold

Clear evidence of clusters of transactions.Total Worldwide Transaction Value (Energy Sector)

1950 1960 1970 1980 1990 2000

Humble Oil & Refining Standard Oil (NJ) Socony Vacuum Superior Oil Anglo-Iranian Oil Standard Oil (Ohio) Pan American Dome Petroleum Atlantic Refining Richfield Sinclair Supron Energy Union Sulfur & Oil Anderson Pritchard Royal/Dutch Shell Shell Union The Texas Company Tidewater Pacific Western-Getty Skelly Gulf Standard Oil (CA) Standard Oil (KY) Union Oil Pure Oil Cities Service Occidental Vintage Petroleum Phillips Aminoil General American Oil

Continental Oil Burlington Resources Sun Oil Sunray-Sunray DX Midcontinent Texas Pacific Plymouth Oil Ohio Oil Texas Oil & Gas Amerada Petroleum Hess Oil and Chemical Total Petroleum PetroFina Fina Inc Elf Aquitaine Deer Creek Energy

Significant Historic Consolidation Phases

Unocal

USX

Sun Oil

Chevron

Getty Texaco

Union Texas (IPO)

Atlantic Richfield

AmocoBritish Petroleum

BP Amoco

MobilExxon

Standard Oil (Indiana)

(Shell Oil)

Allied Chemical/Signal

(Marathon)

DupontPhillips Conoco

(Conoco)

ChevronTexaco

Why do mergers happen?

0

10

20

30

40

50

60

70

80

1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008

Oil Price ($/bbl)

0

40

80

120

160

200

240

280

320

M&A ($ Bn)

Oil Price

M&A Activity

Changing Geographic Landscape

Internationalisation

Cross border

Transaction

1980s

BP

Exxon

Privatisation

De-regulation

EU

1990s

Total

ENI

Public markets

for all;

NOCs on

world stage

2000s

Gazprom

ONGC

CNOOC

Private Equity?

Hedge Funds?

Periods of industry consolidation

?

2010+

ERA of ?

Key Players

NOCs Push Into International M&A

Threefold increase in NOC international M&A transaction value, Chinese NOCsparticularly active despite failure to land Unocal ($20 billion)

Domestic consolidation of Russian players significantly added to NOC spend in 2005

International majors facing extraordinary competition around the globe from NOCs

.

.

.

Major Transactions by BP

Date Merger/Acquisition Strategic Rationale Outcome

1998 Amoco Corporation

Develop US refining and marketing positionEstablish international gas business

Success in both respects though some weaker assets later sold

1999Atlantic Richfield(ARCO)

Targeting West Coast presence, Asian business and UK gas

Forced to sell Alaskan and UK gas by competition authorities; premium hard to justify

2000 Burmah Castrol

Acquire Castrol lubricants brandDevelop speciality chemicals division

Strong brand growth for Castrol. Chemicals sold at knock-down prices

2003 TNKFoothold in RussiaKey Russian partners

Jury still out. Partners seeking exit

-

-

-

-

-

--

-

-

-

-

An M&A Checklist

The “Board Room” Discussion

Does it have a strategic fit?

Is the transaction accretive to earnings and cash flow?

Can the premium be justified by synergies?

How should I finance the acquisition?

Do I need a deal this year?

How is my newsflow looking?

Is Company X available?

Will I win?

Who gets the management slots?

When is their CEO/Chairman due to retire?

Is his pay-off embarrassingly large?

Where will the Head Office be?

Will it change the shape of my shareholder register?

The “Management” Discussion

Current Market Issues Impacting M&A

Recent Developments

Level of M&A sophistication

“The wall of money”

Hedge Fund mentality

Built-in premia

Arbitrage activity

Consequences

No surprises

Growing role of Private equity

Volatility of trading in bid stocks

Lower exit premia

Once in play, you’re dead

Documents

Wk 1: Lessons from Financial History Does finance matter ...eanh_class_notes.s3.amazonaws.com/FHcomp.pdfD.Chambers, LFFH, TRIN07 3 ….or does it? financial depth empirical evidence