Costello Research Financial Crises

When CEOs are haunted by memories of past recessions

Jennifer Anzaldi — Tue, 12 Nov 2024 19:43:41 +0000

When CEOs are haunted by memories of past recessions Jennifer Anzaldi Tue, 11/12/2024 - 14:43

In This Story

The economy, we’re often reminded, is cyclical. But we all hope our careers won’t be. That means those of us who make it to the very top—CEOs, for instance—may be unduly influenced by memories of prior economic go-rounds. David Koo, assistant professor of accounting in the Donald G. Costello College of Business at �鶹��Ƶ, has found that memories of past recessions, triggered by recent ones, can weigh on chief executives’ decisions, literally for years.

Koo’s paper, co-authored by Isabel Wang of Michigan State University and Shuting Wu of Cal State Fullerton, is forthcoming in Management Science.

David Koo

The paper was inspired by trends in research outside the accounting field. “In the economics area, they have started looking at how executives’ memories of recessions can affect important decision-making right now,” Koo says. “We are trying to connect these emerging trends to the accounting area by focusing on pessimistic bias in their outlook of the company’s performance.”

The researchers adopted the 2008 financial crisis as a key moment for triggering veteran CEOs’ memories of prior financial downturns. They analyzed annual management earnings forecasts for U.S. public companies for the period 2002-2018, alongside the characteristics and career histories of the CEOs who issued them. “We used the first forecast of the year for each year, because on average these are more optimistic,” Koo explains. “Usually, nobody wants to say anything negative at the beginning of a year.” The final data-set comprised 3,678 earnings forecasts from 466 CEOs.

Koo and his co-authors discovered that CEOs who had previously led companies through at least one past recession issued significantly more pessimistic forecasts post-2008 than they had before the crisis. As a general rule, the more recessions a CEO had undergone in their tenure at the top, the more pessimistic their post-crisis forecasts tended to be.

The same pessimistic pattern was not evident for CEOs who had not experienced a recession before 2008. Translating their findings into economic terms, the researchers concluded that one standard deviation of the memory-triggered pessimism effect was equivalent to 0.23-0.29 percent of share price.

Further, the post-crisis pessimism did not make the forecasts more accurate. It’s safe to say, then, that the memory-triggered CEOs were, knowingly or not, displaying excessive caution and conservatism in their earnings forecasts. To be sure, anyone’s outlook can darken with age, independent of their real-world experience. So the researchers performed subsequent checks to determine whether the increased pessimism was more closely related to growing older, or to specific memories of past recessions.

“Our takeaway is, if we have two same-age CEOs, one who has experience navigating recessions as a CEO and one who does not, the first one will become more pessimistic after the crisis,” Koo says.

The more highly skilled CEOs (as measured by a widely accepted scale for managerial ability) exhibited less memory-induced pessimism, while CEOs who led more complex firms with a lot of moving parts were more prone to pessimism. “We expected that the manager-specific effect would be more significant when managers were under more demanding pressure or had more discretion,” Koo explains.

As the 2008 financial crisis itself faded into memory, seasoned CEOs gradually let go of their pessimistic bias. But it took three years, on average, for their forecasts to fully recover. We normally think of past experience as an aid to learning, but here it seems that the opposite was the case: Memories of past experiences with recessions slowed down CEOs’ post-crisis learning process.

“Prior research has found that past experiences can help people more rationally and then more wisely handle an ongoing crisis,” Koo says. “But at the same time, executives are also human beings. They may be scarred by their experiences and that can induce them to be excessively negative or pessimistic when they go through a financial crisis.”

Of course, that doesn’t mean that the veteran CEOs were less effective at guiding their firms through post-crisis recovery. Koo emphasizes that his findings do not capture whether, and how quickly, companies bounced back from the 2008 recession.

“Memory may not be the most dominant factor in our decision-making, but it still can influence executives even in their managerial decision-making,” Koo advises.

The lesson, then, is one for investors and other market players to store in their own memories for the next economic downturn: Take CEOs’ post-crisis predictions with at least a grain of salt.

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Risky investment choices, not COVID, put U.S. hospitals in the red

Marianne Klinker — Thu, 02 Mar 2023 15:49:57 +0000

Risky investment choices, not COVID, put U.S. hospitals in the red Marianne Klinker Thu, 03/02/2023 - 10:49

Financially troubled U.S. hospitals are petitioning for more support from the federal government, but handouts won’t fix the underlying problem.

As the United States takes steps to move past the pandemic, its health care system is in a fragile financial state. At the end of 2022, about half of U.S. hospitals were in the red—making it the worst year for the industry since the start of the pandemic. No wonder, then, that hospitals are petitioning Congress for help and protesting the pending cessation of COVID funding from the federal government.

At first glance, the industry’s pleas appear justified. After all, COVID hit hospitals like a tidal wave, filling beds with patients requiring arduous, expensive care. At the same time, hospitals suffered from the same supply chain and workforce issues as virtually every other public-facing facility. And since the vaccine rollout, COVID’s waning lethality has produced an influx of patients who had delayed seeking treatment during the height of the pandemic—and whose health problems may have worsened in the interim.

Seb Demirkan

However, Sebahattin Demirkan, an associate professor of accounting at �鶹��Ƶ, says that the true source of the industry’s financial woes may lie beyond COVID. For Health Affairs Forefront, Demirkan and co-authors Ge Bai of Johns Hopkins University and Christopher M. Whaley of RAND Corporation took a deep dive into the most recent financial reports issued by ten of the U.S.’s largest nonprofit health care systems.

Contrary to the COVID-caused-it narrative, they found that, on average, revenue from patient care actually increased (albeit by less than 1 percent) between 2021 and 2022. Investment revenue, on the other hand, declined by a disastrous 185 percent over the same period. These are heavy but not totally surprising losses, seeing as how 2022 was the worst year for financial markets since the Great Recession. However, they cast doubt on the contention that hospitals’ financial struggles are primarily due to operational challenges brought on by the pandemic.

Without understanding the primary driver of hospitals’ financial strain, policymakers cannot make evidence-based decisions that benefit hospitals and patients in the long run.

For Demirkan, getting the origin story right is critical for policymakers weighing the current situation. As the article states, “Without understanding the primary driver of hospitals’ financial strain, policymakers cannot make evidence-based decisions that benefit hospitals and patients in the long run.” Clearly, if the health care system’s exposure to downside risk is to blame, more federal funding alone wouldn’t resolve the issue. Even if federal bailout money were restored to 2020 levels, hospitals would be in danger of yet further losses via their investment portfolio.

Demarkan’s main concern is for the taxpayers who may be stuck with the bill, through increased taxes and/or rising patient fees and insurance premiums. “While hospitals are critical for patients and communities, resources used to pay for hospital care come from those same patients and communities,” the article states.

He points to a possible contradiction between the non-profit status of these institutions and their investment strategy, which he says resembles that of a hedge fund. Such an approach is likely to reap outsized gains in bull markets—in bear markets (as in 2022), above-average losses. “If they behave like any other for-profit company or financial company, then it is not going to serve the entire nation, the taxpayers or people. All stakeholders will be hurt, basically,” Demirkan says.

As one possible remedy, he suggests regulators could insist that non-profit hospitals limit risk exposure across their portfolio as a precondition for public assistance. “They may say, ‘if you want to invest extra cash, invest in ETFs or mutual funds. FedEx, Amazon etc.—less volatile and less risky financial instruments and stocks.” Still, Demirkan acknowledges that attempts to ratchet up oversight or accountability would run afoul of the influential health care lobby.

At the very least, therefore, he advises the government not to “with blind eyes, give away money to these hospitals, and just look at how they use that money if they are nonprofit hospitals. And basically, use your judgment accordingly.”

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The distress anomaly: Where finance theory breaks down

Jennifer Anzaldi — Thu, 22 Sep 2022 13:54:03 +0000

The distress anomaly: Where finance theory breaks down Jennifer Anzaldi Thu, 09/22/2022 - 09:54

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Alexander Philipov

Exceptions may prove the rule, but they must first be explained. That is why finance researchers are drawn to the distress anomaly-- a well-documented phenomenon that challenges the risk-return paradigm in equity markets. Generally, higher-risk investments are expected to yield higher returns than safer, more stable securities. In recent years, however, studies have shown that high-credit-risk securities for companies in distress – i.e. when their already-low credit rating is being downgraded -- realize abnormally low returns compared to non-distressed securities of the same or lower risk.

Academics have proposed a range of rationales for this puzzle. Alexander Philipov, finance area chair and associate professor at �鶹��Ƶ, says they mainly fall into two categories. One is risk-based, stating that the pattern could be explained by time-varying risk (e.g. having low risk in bad times), or by hidden value transfers during bankruptcy, when equity holders could extract value from other stakeholders. The other rationales look at possible investor biases, such as investors having lottery type preferences and chasing after sky-high returns in an unlikely recovery from distress. Other psychological biases, such as tendencies to hold on to losing stocks in the hope they would turn around may also be at play. These biases would be exhibited by retail investors while institutional investors are not likely susceptible to them. As yet, there is no consensus among academics on which rationales, if any, get closest to the truth of the distress anomaly.

Philipov’s recent paper in Review of Finance[1] is the first to show that the distress anomaly extends to corporate bonds. In addition, the anomaly is associated with potentially severe implications for the real economy. The researchers documented this by comparing the stock and bond portfolios of distressed firms with those of other portfolios.

Corporate bonds help evaluate existing rationales because their payoff structure, liquidity, and investor base are different from those of stocks. The study shows that existing rationales for the distress anomaly are inconsistent with the return patterns of corporate bonds. Specifically, rationales involving value transfers from bondholders to stockholders are inconsistent with the data showing that both bonds and stocks of distressed firms are similarly overpriced. Furthermore, the anomaly is more pronounced in market downturns, as is the distressed stocks and bonds’ risk—evidence against the time-varying risk story.

The study also finds the distress anomaly implies real distortions in the real economy because corporate decisions are undertaken based on incorrect asset prices. These suboptimal decisions may include excess investments, and over issuance of debt and equity. “We provide suggestive evidence that real distortions are not only economically significant but also severely understated if measured based on equity mispricing alone (as in previous studies). Adding bonds brings new light to the magnitude of these distortions,” says Philipov.

Based on the new bond evidence, the most coherent rationale for the distress anomaly appears to be underreaction to financial distress, even by the most sophisticated investors. The researchers conclude that the distress anomaly is an unresolved puzzle, deeper than previously thought.

Philipov suggests that future research on the distress risk anomaly may focus on alternative ways of measuring risk or on new advances in behavioral finance, such as cumulative prospect theory which focuses on how investors under- or overestimate probabilities. Clues may also lie in the investment strategies of smart market actors. “If there are many investors with biases, especially biases that you could possibly predict, you should be able to find market players which are exploiting these biases,” Philipov says. Lack of evidence of such profit-taking activity may imply that trading frictions may be too high to take advantage of pricing misalignments. Yet another promising research strategy could be to look beyond the data, into what really goes on behind the scenes at distressed companies. “Maybe what those public investors are losing, there are some players that are gaining from it,” Philipov says. “But we’re not able to observe that.”

He further suggests that interdisciplinary work may be able to tackle questions such as, “Do distressed companies advertise more or less? Do they allocate less for research? What do their operations look like? Are they trying to apply new management techniques or are they quickly losing talent?”

Academics are drawn to find explanations to market phenomena like the distress anomaly where theory breaks down. “We should be trying to explain what’s going on, because that’s where you get new insights: studying corners where things aren’t working as general theory dictates,” Philipov says.

[1] Co-authored by Doron Avramov of ISC Herzliya, Tarun Chrodia of Emory University and Gergana Jostova of George Washington University.

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