I’m often asked about how firms respond to recessionary pressures, and what role strategy plays in such an environment. While I couldn’t possibly comment on the specific responses of each and every firm, there are some general comments that can be made about firm strategy during economic slowdowns.

We often think of firm strategy (whether at the business level or corporate level) as a forward-looking, planned set of actions and behaviors. Now if we’ve anticipated the slowdown, then presumably we’ve already prepared and planned our strategy appropriately. If so, there should be very little change to our strategy in a recessionary environment because we’ve predicted it, and adjusted our strategy to it well in advance.

Too bad things in the real world aren’t so simple. Economists can’t even agree that we’re in a recession, let alone whether one will eventually occur (I’m going to go out on a limb here and say that we’re currently in one). If economists who focus on these things can’t agree on whether or not we’re in a recession, how can we have planned for something that as little as 6 months ago we could not even have foreseen? That’s a good question. So for all those firms that didn’t expect the slowdown/recession, what impact might it have?

It’s important to recognize that during recessions, some industries are hit harder than others. Moreover, some firms feel it more. For firms in the healthcare industry, recessions often have less of an impact, especially because people don’t stop getting sick when the economy sours. However, even within healthcare, there are expenditures which are more discretionary (e.g., it would be nice to have that corrective eye surgery) versus non-discretionary (e.g., I need the open heart surgery because if I don’t, I might die). Therefore, we might expect firms that specialize in corrective eye surgery to be impacted more than firms that specialize in open heart surgery.

But the issue of industry/firm heterogeneity aside, strategy during a recession can become about delaying and postponing activities while continuing to exploit current operations, especially for firms that are fundamentally sound. For example, a firm may have devised, and planned, a strategy for growth through acquisition. However, once a recession takes shape, they realize that credit may be unavailable to pursue their strategy. Although equity prices usually drop during a recession, making target firms cheaper in nominal terms, the aquirer may not be able to finance any purchase because there might not be anyone willing to underwrite it (or at least underwrite it at an attractive rate). What happens in such a case? Well, you put your plans on hold in the near term. Does this fundamentally change your strategy? Not really, you might just have to delay its execution. In the meantime, the firm focuses inward - turning its attention to managing its current operations (or portfolio of businesses) efficiently and slowing its rate of growth (reducing the rate of investment/expansion in current businesses and reducing the rate of new hires).

In some cases however, especially for those firms that have less sound balance sheets (e.g., too much debt), strategy becomes more about holding on for dear life just to weather the storm. For example, during economic slowdowns, demand for a firm’s goods often wanes in the near-term. For some, an unexpected negative shock of this sort can come as a big surprise. For these firms, forget postponing acquisitions or growth activities. They’ve got more important things to worry about, like remaining solvent. Paying their bills becomes priority number one. Firms in this situation may not have the financial flexibility to withstand a recessionary shock, and might be forced into multiple rounds of layoffs to eliminate costs as quickly as possible, in the hope that costs will decrease faster than the revenues - all in an effort to remain current on their obligations. Interestingly though, for these firms, so many divisions, business lines, and people (talented human resources) are lost during the process that even if the firm is able to survive in some form, it comes out in a much weaker position than it went in - having to re-plan, and re-build its strategy again from the ground up.

As I have pointed out in the past (see The Future of Corporate Performance), unfortunately there are currently many more firms in the latter situation (financially unsound as judging by the historically high percentage of bond issues with non-investment grade ratings - 48% in 2007) than the former. This should usher in a difficult period of above-average default economy-wide, …and a period of strategy on the fly for many firms. I am left only to hope that a good deal of firms have accurately predicted, and prepared for, the slowdown…

The Economist today published its first ranking of distance-learning MBA programs (see The Socratic E-mail). I found this ranking rather fascinating.

In the interest of full disclosure, I have to say that I haven’t fully kept abreast of the distance-learning movement in higher education. I know that it’s there, but I thought it hadn’t quite caught on. I remember that it was all the rage for awhile - circa 1997-2000; however, I thought that most schools had come down in favor of the face-to-face education paradigm - arguing that the quality of the face-to-face model exceeded that of the distance model. For this reason, I was shocked to see some really reputable universities on that list.

But it also made me wonder: Is there an economic difference in the value of a distance-learning MBA degree versus a face-to-face MBA degree? I think it would be really interesting to examine some of the issues. There are several really interesting, and fruitful, angles to explore, including some of the following considerations:

1. cost differential to earnings differential - Is any difference in price between the two forms of education offset by ex post earning differentials? That is, distance-learning degrees might cost less, but are the benefits/salaries upon graduation significantly different?

2. quality of enrollees - Is there a difference in the “quality” of the “typical” student that enrolls in distance programs versus face-to-face programs? This might have an impact on ex post earning potential as we would expect higher quality inputs to receive higher quality outcomes. In economic parlance, this is a selection effect. If higher quality students are overwhelmingly choosing (selecting) to go to face-to-face programs, this can cloud our interpretation of any earning differential we find as we would, of course, expect higher quality students to eventually earn more money. Thus, it would not be the difference in the programs (distance versus face-to-face) that determines the outcomes but the ex ante sorting (the matching of high quality students with face-to-face programs and lower quality students with distance programs) that drives the results.

3. quality of curriculum - Is there any discernible difference in the quality of the offerings between the two programs? Do students in one program “learn” more than students in the other?

4. signaling value of the type of degree earned - Might there be any stigma among employers toward students who graduate with one type of degree versus another? Do the schools that offer the distance MBA programs require graduates of that program to reveal that their MBA is somehow different? Is the actual diploma that they earn different? Should it be different?

5. reputational impact of offering distance-learning programs - Do the schools that offer distance-learning programs bear any reputational costs? For example (and not to say that this is true, just a hypothetical), let’s assume for a moment that the students that do go to distance programs are somehow inferior on some quality metric. Now, you have two sets of graduates (distance graduates and face-to-face graduates) from the same school carrying the same brand (both sets of students went to Florida let’s say, which by the way is an exceptional institution). Now let’s assume that for whatever reason, the distance graduates end up doing poorly ex post - they aren’t as successful, their employers find them less capable, etc. Does that have a negative impact on the school? Also, does that have a spillover effect on the face-to-face graduates, who, when others find out they graduated from Florida, are then painted with the same brush as the face-to-face students. Face-to-face students who fork over big bucks to attend their MBA programs understand very well that the school’s overall reputation impacts them, and the value of their degree. So they should be concerned about the school’s distance offerings.

And Finally, and in my opinion one of the most interesting angles to pursue,

6. value of the social networks - It has been argued that one of the most valuable parts of receiving an MBA is the opportunity to network with, and befriend, the future captains of industry while on campus. Developing a strong social network can be extremely powerful for future business opportunities. One of the interesting things about distance-learning programs versus face-to-face programs is that it seems that the opportunities to network with classmates, professors, and industry-types who visit campus are greater for face-to-face students. So the question then becomes, to the extent that ex post earning differentials exist, what portion of those earning differentials could be associated with the added-value of the social networking benefits provided by face-to-face programs?

Anyhow, these are just a sampling of some of the interesting considerations associated with distance-learning programs. I’m sure there are many, many more.

Although U.S. equity markets were closed today in celebration/recognition of the life and accomplishments of Martin Luther King, Jr., foreign equities markets were not. It was a wild day for equities across the globe (see European, Asian Markets Plunge), and stock futures are pointing to an equally wild day for U.S. equities tomorrow (see U.S. Stock Futures Point to Major Decline on Re-open).

So what should we make of the synchronized activity across markets? Well, consistent with my post from Friday (see Executives Not Optimistic About 2008), I think market participants around the globe are starting to come to terms with the fact that a recession in the U.S. will lead to a more general slowdown across economies far and wide. Why? Because the U.S. still accounts for the lion’s share of global economic activity (25% of global GDP), and the world is just too interconnected for it not to happen. As I mentioned in my previous blog, spillovers from the U.S. economy to foreign economies have happened through consumption (e.g., declines in U.S. consumption of U.S. final goods leads to declines in consumption of foreign intermediate goods). Likewise, domestic consumption of foreign goods is impacted by exchange rate fluctuations (i.e., a weak U.S. dollar leads to decreased demand for foreign goods). And while I do believe that there will be something of an export substitution effect (i.e., accompanying the U.S. dollar weakness will be an increase in foreign demand for U.S. goods), I believe that the decrease in U.S. consumption will swamp any increased demand for U.S. goods from abroad. Finally, it is not only U.S. banking and financial institutions that have suffered as a result of the credit crunch, but foreign banking and financial institutions as well - e.g., first in Europe, and gasp, now in China too (see Bank of China May Report Subprime-Related Write-Down, hat tip Calculated Risk)!! For this reason, we should expect money to become tighter across many markets - and consumer and business borrowers to feel the pinch as a result.

Now again, I’m not a macro-economic specialist; therefore, I would call your attention to some of those who discuss these issues with greater precision (Krugman, Setser, Roubini, and others in my blogroll). However, I do study firm-level strategy and performance. And privately, I’ve been hearing from executives at various corporations that this economic slowdown looks different to them than the most recent slowdowns they recall (1990-1991; 2000-2002). They have suggested that in this particular crisis they are being hit on both sides of the ledger at once - from consumers who are tapped out, and with little discretionary income left to spend; and from financial institutions that are reticent to lend, making things more tenuous from an operational/investment perspective (see Earnings Won’t Bail Out Market This Time). As I’ve pointed out on this blog, I expect this crisis to spread from U.S. financial, housing-related (durable goods inclusive), and retail firms more broadly across businesses in many U.S. industries. I think we can now safely add another prediction - expect those spillovers to extend to financial and non-financial, housing and non-housing, and retail and non-retail firms in foreign countries.

Several weeks ago, the Economist released its global business barometer for 2008 (See Outlook No So Good, or click on the picture below). They polled 1,000 executives to get a sense of how those executives feel about the global economy. In that sense then, you can think of it as akin to a consumer confidence index for business.

Now, I’ve heard many arguments over the past several months that credit problems were largely contained to over-leveraged U.S. homeowners and banks. In some form, analysts had argued that this crisis had been about housing, mortgages, and bank earnings. Many analysts claimed that the corporate sector was sound, that corporate earnings had been solid, and that business investment would therefore keep us out of recession.

We’ve learned since that there have been spillovers from housing to other sectors of the U.S. economy - autos, durable goods, retail. But again, the argument (and a weak one at that) had been that we needn’t worry because corporate profits and corporate investment, and a strong global economy (outside the US) would save us.

Well, this barometer is pretty striking in that:

1. Business executives (outside the financial/housing industry) do not think they are immune. Readings are negative across all industries with the exception of IT.

2. Because this survey measures global sentiment, the so-called “strong” global economy is not likely to remain strong for long.

In my opinion, spillovers will be felt broadly, on both the supply-side and the demand-side. On the demand-side, faltering consumers will have an impact on the earnings of corporations of all types - either directly or indirectly. For example, retailers are directly impacted. However, the second order effect will be that firms in the textile industry will be affected as a result of decreased demand for retail clothing. Many of these textiles come from abroad. We should therefore expect more demand-side spillovers to a broader set of industries and a broader range of economies in 2008.

In addition to demand-side pressures, corporations will come under supply-side pressures in the form of access to capital from banks and other financial institutions. With less money coming into banks, there is less money to go out. Therefore, look for corporations of all types to have difficulty raising capital to fund business investment and ongoing operations. And with the banks and financial institutions throughout the globe (not just in the U.S.) feeling the pinch, lending will tighten in many countries.

All of this makes for a rocky Credit Crunchy© 2008 - whether at home or abroad.

If you’ve been following my blog, you’ve known that I have a side interest in how practice perceives business schools (see Ever and Easy Target, Practically Irrelevant, and/or On Managerial Relevance).

The latest piece from the Financial Times (see Why Business Ignores Business Schools) seems especially damning (hat tip, Kenneth Amaeshi).

There are three main criticisms in this article. First, the article claims that business practitioners rarely show up at academic business conferences, unlike their counterparts in law and medicine. Now I don’t much attend academic law or medical conferences, but I certainly agree that I don’t meet many practicing managers at the academic conferences that I do attend.

Is that necessarily a bad thing?

I’m not sure I see academic conferences as the type of venues in which we should exchange information with practicing managers. In our field, we have specialized, practitioner conferences for the purposes of engaging in dialog with practice, and for distilling the knowledge that we’ve created in a manner that can be translated for, and transmitted to, managers.

The second criticism is that practitioners pay little attention to us. The author writes:

Chief executives…pay little attention to what business schools do or say.

That sounds about right. But to be fair, I’d be hard pressed to think of a CEO who has much time for anything outside her responsibility to run her company. If I were a shareholder, I’d be very skeptical of my CEO if she spent much time attending and/or participating in academic business conferences. So that begs the question, are CEO’s really our target audience? Probably not. In many ways, our true target audience (depending upon what discipline within the business school you are in) is middle-level managers and/or consultants. It is the middle-level manager or consultant who is the consumer/user of our information who, in turn, impacts the behavior of organizations at the highest levels.

Finally, the article claims that we academicians write in an arcane, technical, jargon-laden manner that obfuscates whatever nugget of useful information that may exist in our research. I’ve seen this done before, so I understand the criticism. And quite frankly, I’m a little tired of all the jargon too. It doesn’t bother me that business school researchers write in this manner per se (after all, I understand most of it). However, what sticks in my craw is that a researcher should be able to explain his research in a way that makes it clear to any practitioner, and many cannot. If he cannot explain his research in a simple and accessible manner, then it is not clear to me that the he understands the phenomena well enough to explain why the phenomena should be important to managers. For me, this is the ultimate litmus test for a successful academic in the field of business - one who can at once produce, and explain, academic research.

I do agree in principle with some of the criticisms levied at business schools, and in particular, at our research. However, I think it would be unfair to categorize our research as uninfluential. For example, ask the folks from the investment community and hedge fund universe if business school professors have had any impact on their practice. Ask government employees at the Justice Department whether business school economists have had any impact on the cases they bring and/or the outcomes of those cases. Ask CPA’s whether accounting faculty have had an impact on how they practice their craft.

Although the full impact of our research on practice varies depending upon the business school discipline (accounting, finance, economics, marketing, strategy, organizational behavior, operations management, etc.), I’m sure I could find an example of some profound impact that an academician from each discipline has had on practice.

So my reaction to this article is consistent with that which I’ve expressed in the past: I think the stories of our demise have been greatly exaggerated. I think we do have a profound influence on practice, although not always in ways that are widely recognized, and in ways that are often difficult to quantify.

I came across the following article (hat tip Calculated Risk) about analyst predictions for corporate defaults (see Citi and J.P. Morgan Predict a Buffet of Defaults). The author writes:

With credit flowing to practically any company in need of cash in recent years, the rate of defaults for U.S. high-yield companies fell to just 0.34% in December, according to a J.P. Morgan Chase analysis. The J.P. Morgan analyst, Peter Acciavatti, predicts that is about to rise drastically, to 4% by the end of 2009, and he isn’t alone. As BreakingViews points out today, Citigroup expects the default rate to surge to 5.5%, as easy credit becomes a distant memory.

It has been my expectation for several months now that defaults would tick up (see here and here and here for my explanations for why, and by how much). I find it interesting that the Morgan and Citi analysts predict an uptick of only 4-5.5%. I still find that a little on the optimistic side. As the full extent of the current credit crisis becomes clearer, I think these figures will represent more of a best case scenario.

I am expecting an increase in the default rate in the 10% range. How did I arrive at 10% you might ask?

1. The historical default rate is around 3%. We’ve been running at around 1% for the last few years. If we revert to the mean, we could plausibly expect somewhere in the 5% range for the next several years. However, business cycles don’t often work like that. We usually enjoy several good years punctuated by a more brief and intense bad period. Therefore, I would expect something greater than 5% for a shorter period (2 years or so rather than 3 years), maybe something like 7% one year and then 10% the following.

2. I used the 2000-2002 slowdown as a benchmark. If I remember correctly, following the doctom bust the default rate exceeded 12%. My expectation is that the current cycle won’t reach those extremes. The dotcom bust was more of a business, investment-led recession whereas the current slowdown (I hesitate to call it a recession, at least not officially yet, although I do believe that we currently are in one) represents a housing, consumer-led slowdown. The balance sheets of businesses are stronger now than they were in 2000.

3. Boy, haven’t the banks been uber-optimistic of late? It’s all contained, what credit crisis, we have ample reserves, the underlying assets still have substantial value, and so on. With the accuracy of analysts’ predictions in 2007, a higher number just seems like a lay-up.

So there you have it. My expectation is for an increase in defaults to 10%.

This is not to say I won’t be wrong. I could absolutely miss the mark on this one. And I’m not sure with what level of confidence I can conclude 10% (i.e., where the confidence intervals would lie around that mean). However, if anything, I would be more surprised to see my estimate miss to the upside than to the down.

I just came back from vacation yesterday. I had a wonderful time with my family in San Diego and Los Angeles. I consider myself very lucky to have been able to go on the trip. Although I spent far too much time (and money) in theme parks, I did have a tremendous amount of fun with my wife and children, and even got some quality time in with close family and friends. What more could I ask for? I’m now refreshed, and ready for 2008.

Anticipating the months ahead, perhaps Credit Crunchy©™ (changed from copyright to trademark upon the advice of my lawyer) will be this year’s theme. That’s why it’s in the title. Your guess is as good as mine. We shall see how this blog thing evolves…

You also might be wondering why I told you about my vacation. After all, this is supposed to be a blog about strategy. Well, the vacation provides a nice segue into today’s topic.

When I go on vacation, I try to make a habit of reading an interesting book - be it fiction or non-fiction. I try to take a break from the academic articles that I read on a regular basis. And I try to take a break from writing. I find that this helps me recharge the batteries and clear my mind. Well, this vacation, I went back to a book I hadn’t thought about in many years. I decided to pick it up again because I remembered that it was about trading, I remembered that it had some interesting snippets about bond versus equity trading, and I remembered that it told the story of the heyday of Salomon Brothers (of which I’m not one - ok, technically I am, but not of those “Brothers”). I also remembered that it had something vaguely to do with mortgage-backed securities, which are at the center of today’s credit crunch. The book I’m talking about is Liar’s Poker, by Michael Lewis.

I’m assuming that most of you (especially those interested in trading) have read the book at some point. It’s a really detailed, poignant, and accurate account of life as a trader. Frankly, it’s a classic (my commissions are payable in Yen, Pounds, or Euros Mr. Lewis)!

In reading the book, the part that struck me about the whole mortgage-backed securities business is that it almost never was!

According to Michael Lewis’ account, Salomon had the only real, fully-staffed mortgage-backed securities desk when they exploded, giving them a virtual monopoly on the business from 1981-1984. Prior to that, there was extreme skepticism on Wall Street as to whether mortgage-backed securities made any sense at all. Many bankers saw no potential buyers for the assets, and couldn’t understand why anyone would want to own them. In fact, most of Salomon’s competitors (the usual suspects on Wall Street) had given up on mortgage-backed securities and had closed their shops prior to 1980. Salomon’s was the only one left standing. And it too was on the brink. According to Lewis’ account, it was probably only several months away from being shuttered.

And then came the Savings and Loan Tax Relief Act (I can’t remember the exact name) of 1981 1979 (or the exact year). In any event, according to Lewis’ account, this one act almost immediately created both sellers and buyers for mortgages, as S&L’s looked to get troubled loans off their books, and buy back the loans of other troubled S&L’s in order to book losses and earn tax credits.

In light of the current credit crunch, all this made me wonder: Would we be where we are today had another few months passed and had Salomon actually closed it’s shop, or had Congress never passed that ill-fated act? If so, there might not have been any market for mortgage products. Maybe the investment world would have decided that mortgages do not make for very good securitized, traded assets. As a result, perhaps the financial disintermediation in mortgage markets never would have occurred, and mortgages might still be held the old-fashioned way - by the banks that originated them, …potentially reducing future moral hazard in the lending/securitizing business.

That’s one view of the world.

The alternative is that it might have happened anyway. In the end, somebody somewhere in the market would have eventually realized the value in securitizing and trading these things, freeing up the capital of the banks to lend again thereby increasing the multiplier and opening the possibilities of homeownership to many, many more people who might otherwise be shut-out of homeownership.

I’m not sure where I stand yet, but it’s probably somewhere in the middle (such a political answer, I know). I do believe that there is a place for mortgage-backed securities in today’s market. However, better oversight of the entire process (from lending to securitizing to trading to insuring) might have helped it function better, perhaps averting today’s excesses.