Originally posted by: ironwing
How does any of this effect the company's ability to continue doing business in the manner it was prior to the run? The company has the same people, the same assets, the same customers, the same profits.
Why do companies offer stock for sale to the market? It's to raise cash. Even after floating on the market, if a company requires cash badly, they can hold a secondary offering, or issue preferred stock.
Consider a company with a large amount of debt. If a company has a huge market cap - as a result of a good stock price - then in the event that it is unable to meet its debt obligations, then it can turn to the market for additional capital. The larger the market cap, the less dilutive, and the easier it is to obtain more capital.
So, if a company has $10 billion of debt, but $100 bn of stock - it's would be virtually impossible for that debt to default, as the company would always have the option of a stock issue. As a result, the company can get a pristine credit rating.
Now consider if the company has $10 bn of debt, but there is a loss of confidence in the business +/- short selling, and the share price collapses, so the market cap is now only $10bn. If the company can't find cash to pay its loans, WTF does it do? Additional stock issues will be catastrophically dilutive to stock holders, and issuing preferred stock will require an astronomical yield. The company is now at real risk of having to restructure its debt committments, or sell assets in order to restore cashflow - the result ends up being a credit downgrade, which makes further loans to expand business difficult.
However, even that is potentially not the end of a world for a company.
The big problem in the current market, and what prompted the near collapse of AIG, is derivative exposure. Derivatives are only worth what the other party to the derivative can pay. As a result, both parties must put up collateral, and the amount of collateral depends on credit rating. If the share price drops, then it could potentially trigger a credit downgrade, which would require additional collateral to be posted.
This is what happened to AIG. AIG has enormous highly leveraged derivative exposure - through their sale of credit default swaps; a type of insurance against default against debt, and a type of insurance which is critically dependent upon their own credit rating (how can you insure someone elses's debt, when your credit rating is worse than theirs?) The catastrophic fall in share price which had previously hidden the implicit risk in their leveraged position by a good credit rating, meant a credit downgrade. SUddenly, they received a demand for an additional $10 bn cash for collateral for their derivatives. They didn't have $10 bn. Ergo, they were fux0red.
The problem here is that companies that are highly leveraged - either through high levels of debt, or through derivatives, are critically dependent upon credit rating. Due to the way financial companies operate, they typically have high levels of leverage which can make them vulnerable to rampant short selling. Businesses with less debt, and more 'hard' assets are more likely to be resistant to damage from short selling.
What's made this worse, is the USG's decisions to wipe out the stock holders, even when this may not have been warranted. Again, in the case of AIG, they offered a temporary loan (at about 12% APR!), but in return for the loan wiped out the stock. They could have wiped out the stock only if the company defaulted on teh emergency loan - but no, they just wiped it out - like they did with fannie and freddie. This has set a bad precedent - essentially, any financial company that runs into difficulty will have its stock immediately totaled by the USG. Just look at it from a short seller's point of view. You short a company and it gets downgraded - the goverment now totals the stock, and you've turned a nice profit into a goddam bonanza.