Chaos Theory

McCombs Scholars Weigh in on Turbulent Times

Texas magazine invited three McCombs faculty members to weigh in on the nuances of the economic crisis. David Spence, professor of business law, examines the politics behind the historic initial bailout of U.S. financial institutions; Rob Adams, management lecturer and Moot Corp director, offers practical advice to business owners on how to survive recessionary periods; and Accounting Professor Lisa Koonce takes aim at those who would blame fair-value accounting practices.

The economy has been front and center at McCombs since late September of 2008, when the crisis, with its roots in the subprime mortgage meltdown, hit alarm stage as Wall Street crashed, longstanding financial institutions failed and unemployment soared. As expected, the crisis became the most prominent subject in and out of the classroom at McCombs. Professors and students debated the causes, placed blame and proposed solutions, as the media looked to faculty to help explain the crisis to their audiences.

In early October, Dean Tom Gilligan convened two panel discussions to analyze the wider implications of the economic crisis. The first took place in front of an audience of 400 and featured six Finance Department faculty members looking at the systemic problems in our financial system that led to the crisis and exchanged thoughts on proposed taxpayer-funded rescue plans (see photo above). The second brought together career services experts from McCombs to advise students on how to best manage their career search in an uncertain employment climate. The panel stressed that students should take advantage of the extensive resources available to them at McCombs, and that, as graduates of a top business school, they will have access to jobs if they are willing to be flexible and forward-thinking about their career trajectories. Both events can be viewed on video at http://blogs.mccombs.utexas.edu/mccombs-today/.

THE STRANGE POLITICS OF THE FINANCIAL BAILOUT

by David B. Spence

The political process that led ultimately to the passage of the Troubled Asset Relief Program Act of 2008—better known as the “Wall Street bailout”—was a strange one. By the time the mortgage crisis was fully understood, enormous amounts of bad debt had found their way onto the books of many of the world’s major financial institutions. By Labor Day, it had become clear that credit markets were drying up, endangering the ”real economy,” which depends on short-term credit to keep the wheels of commerce greased.

On Sept. 19, the Treasury Department asked Congress to allocate $700 billion to purchase the banks’ bad debts, a response it hoped would give faltering banks the confidence to lend again. The Administration’s bill contained no real standards governing how Treasury would spend the $700 billion, and it prohibited those spending decisions from being reviewed by the courts. The proposal was nothing short of a political minefield for members of Congress, particularly those members who were up for reelection (all members of the House and one third of the Senate).

The notion of a “bailout” for banks was unpopular, pitting taxpayers against Wall Street. The bill didn’t seem to offer much protection to struggling homeowners, and Congressional Democrats were not predisposed to delegate such broad authority to an unpopular administration for such an unpopular purpose. The Administration had already racked up enormous amounts of debt prosecuting the Iraq war, and now it was proposing to double the size of the budget deficit in one fell swoop. Meanwhile, in the presidential campaign, Republicans were calling the Obama tax plan “socialist,” a charge that would ring hollow if they supported bailout legislation that might lead to increased government ownership of privately owned banks.

Nevertheless, support for the bill did not break down along party lines. While neither party wanted to be identified with the bill, both recognized that a vote against the bailout legislation would be easier to explain to their constituents than a vote in favor. Both parties recognized that doing nothing entailed political costs as well. The emergency was acute: banks were failing, home foreclosures were threatened and more doom was forecast.

When members of Congress want to do something that is wildly unpopular, one potential solution is to enlist the least electorally vulnerable members of Congress— those in so-called “safe” seats—to vote for the unpopular thing on behalf of those more electorally vulnerable members who cannot. It appears that this is what congressional leaders tried to do when the bailout bill first came up for a vote in the House of Representatives.

The parties tried to cobble together a bipartisan majority in favor of the bill by (i) eliminating the provision prohibiting judicial review of the Treasury Department’s decisions, (ii) adding a section providing that the government could take part ownership in banks that received government funds and (iii) adding provisions limiting executive pay at banks participating in the program. Leaders of both parties were hopeful that this new package could command majority support in Congress, but the fragile coalition disintegrated when the House voted in late September. As the bill went down to defeat, the Dow Jones Industrial Average fell more than 700 points.

After the House vote, the political dynamic changed. First, the stock market crash highlighted the costs of inaction to politicians and voters alike. Second, both presidential candidates were more vocal and unequivocal in their support for the bill. Finally, all the bill’s proponents began to do a better job making the case for its passage, referring to it as a “stabilization plan” rather than a “bailout,” and explaining its rationale more clearly. Meanwhile, Congressional leaders went to work buying additional support by loading the bill with “earmarks”—specific spending provisions benefiting specific members of Congress who agreed to support the bill in return. On Oct. 1, the Senate passed a version of the bill that included hundreds of millions of dollars in spending or tax breaks for auto racetrack owners, the rum industry, wool fabric producers and more. The House passed the bill shortly thereafter.

The crisis offered us a rare opportunity to observe Congress under extreme pressure. It eventually took action, but in a crucible of intense political pressure, along the way transforming the Treasury Department’s original three-page bill into the 451-page behemoth that Congress finally enacted into law.

David B. Spence, a political scientist and regulatory lawyer, is an associate professor of law, politics and regulation. His research and teaching focus on regulation of business (particularly energy and environmental regulation) and business-government relations issues.

FAIR-VALUE ACCOUNTING: A BETTER REFLECTION OF REALITY

By Lisa Koonce

Lately, much discussion has centered around the underlying causes of the financial crisis, and some have suggested that current accounting rules must shoulder some of the blame. Specifically targeted by critics is the focus by the Financial Accounting Standards Board (FASB), the accounting standard- setters in the United States, on fair-value accounting for American firms.

As an accountant who teaches fair-value accounting, I would like to address the issue.

Fair-value accounting prices an asset based on its current value. So, for example, if my stock investment, purchased for $1,000, falls in value to $400, then fair-value accounting would show that investment on my financial statements at $400, not the original cost of $1,000.

Those who contend fair-value accounting exacerbated the financial crisis argue that it brought turbulence to the financial system because companies were forced to take billions in write-downs on their balance sheets, as housing prices fell and mortgage- backed securities crashed. These reduced valuations caused financial institutions to look less solid to bank regulators. It was argued, by some, that if banks did not have to follow fair-value accounting (and thus avoid those write-downs), then this crisis would have been averted.

However, this is simply a case of blaming the messenger. Fair-value accounting is not the cause of the current crisis. Rather, it communicated the effects of such bad decisions as granting subprime loans and writing credit default swaps. Even with the difficult issues surrounding measuring the fair value of loans and investments in an illiquid market, as we have seen recently, fair-value accounting only brings transparency to the market. The alternative, keeping those loans on the books at their original amounts, is akin to ignoring reality.

Lisa Koonce is the Deloitte & Touche Professor of Accounting at McCombs.

SURVIVING “INTERESTING TIMES”

By Rob Adams

The Chinese might have been prescient about the current world situation when they coined the phrase “may you live in interesting times.” However, most entrepreneurs and business owners are finding these times a little too interesting for comfort, and they are looking for insight on how to manage their businesses through the choppy economic waters ahead.

How can businesses survive this economic downturn? As in all complex situations, there are no easy answers. Yet this isn’t the time to look for complex solutions. In fact, my advice is to get back to basics and trust your business instincts.

If you are a business owner, your primary focus should be on cash flow. This is something businesses should be doing all the time, but now it is more important than ever.

How? First of all, keep in mind that profitability and cash flow are not synonymous. Be ready to forgo some profitability in an effort to increase cash flow. Reduce your inventory and work-in-process to free up cash. Go to your suppliers and negotiate deeper discounts in exchange for exclusivity or longer term commitments, and turn around and offer your customers deeper discounts based on the same types of commitments. Provide discounts to any customer who pays early. Learn from Dell’s business model: collect payments early, assemble and ship your product, then pay your suppliers later.

Meanwhile, brace for lower revenues, especially if your business relies on consumer discretionary spending on items such as vacations and non-essential goods and services. Consumer spending at chains like the Gap, Best Buy and Home Depot will also see a downturn. Retailers that combine consumer staples and discount retailing, such as Wal-Mart, should do well. Health care, education and government spending will continue to be reliable.

Expect college applications to increase as people seek safe harbor from the storm. Plan on more government spending to stimulate the economy—and from this, plan on inflation.

Further cut back on expenses by holding back enhanced features for your product or service from the market. Stick with what you have now. In times like these, customers will gladly take the old price with the current features. Not only does this keep your prices stable, you may be able to offer further discounts. Scrub your budget from the bottom up to eliminate expenses not directly related to revenue generation. Take a page from a company I worked with that survived the dotcom bust: They outsourced their entire product development process for a percentage of future revenues, eliminating their up-front cash outlay and matching payment to correspond with revenue.

With less access to business credit, expect reduced capital purchases. However, this also means businesses will increase spending on parts and services to extend the useful life of their existing capital investments.

After scrubbing expenses and bracing for reduced spending, focus on generating revenue. Is cash flow best generated by keeping those expense cuts in the company or spending more on customer acquisition? Answer the question “How much incremental revenue can I generate from another dollar of sales or marketing budget?” Can you acquire more customers with some of the product strategies previously discussed? Are your competitors letting go of seasoned sales or marketing talent that you can hire? Aggressive companies with resources will go out and acquire newly available, experienced sales people, train them and reap the rewards of more feet on the street as the economy recovers. This could be you.

So what does this all come down to? Something savvy business owners already know—focus on your customers, manage cash flow and trust your instincts. In the coming quarters, count on some business Darwinism. If you aren’t showing your customers some love, you can be sure your competitors are.

As far as government help goes, “Helicopter” Ben Bernanke, chairman of the Federal Reserve, got his nickname for his willingness to “helicopter drop” money into the economy. Unfortunately, the chances of standing where that money falls are pretty slim. Listen to the experts, trust your instincts and form your own opinions— the only person to rely on is you.

Rob Adams is the director of Moot Corp and on the faculty of the McCombs School Management Department.