Real Effects of the Subprime Mortgage Crisis: Is it a Demand Or a Finance Shock?
We develop a methodology to study whether and how a financial-sector crisis can spill over to the real economy, and apply it to the case of the ongoing subprime mortgage crisis. If there is a spillover, does it manifest itself primarily by reducing consumer confidence and consumer demand? Is there also a supply-side channel through a tightened liquidity constraint faced by non-financial firms? Since most firms appear to have much larger cash holdings than in the past, some suggest that a liquidity constraint is not likely to be a significant factor for non-financial firms. We propose a methodology to estimate the importance of these two channels for spillovers. We first propose an index of a firm's sensitivity to a shock to consumer confidence, based on its response to the 9/11 shock in 2001. We then construct a separate firm-level index on financial constraint based on Whited and Wu (2006). As a robustness check, we also construct an alternative sector-level index of a firm's intrinsic demand for external finance, based on the work of Rajan and Zingales (1998). We find robust evidence suggesting that both channels are at work, but that a tightened liquidity squeeze appears to be economically more important than reduced consumer confidence or spending in explaining cross-firm differences in stock price declines.
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Alternative Measure of Financial Dependence
TED Eurodollar bond over Treasury Bond spread around September 11th
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2001 terrorist attack beta Book/Market ratio change in stock Column commodity price indexes commodity price movement constraint and demand consumer confidence consumer demand contraction contraction of consumer currency and commodity degree of liquidity demand for external demand shock dependence on external drop in stock ex ante exchange rates exposures to exchange External Finance Dependence fall in stock Federal Reserve financial constraint firm’s sensitivity George Soros HH portfolio interest rate International Monetary Fund intrinsic dependence July 31 key regressors log stock price loss of consumer measure of liquidity negative coefficient non-financial firms percent level percentage changes placebo test point estimates R-squared Rajan and Zingales rates and commodity real economy regressions robustness check RZ index sample period sector-level sensitivity to consumer sensitivity to demand September 11 statistically significant stock price change stock price declines subprime crisis period subprime mortgage Table tightening liquidity constraint Tobin's q U.S. dollar Whited and Wu Whited-Wu index