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Investments: Background and Issues#1Real versus Financial AssetsNature of InvestmentReduce current consumption for greater future consumptionReal AssetsUsed to produce goods and services: Property, plants and equipment, human capital, etc.Financial AssetsClaims on real assets or claims on real-asset incomeFIN3710: Investment Analysis1-##2Balance Sheet, U.S. Households, 2011Assets $ Billion% TotalLiabilities and Net Worth$ Billion% TotalReal assets Real estate18,11725.2%Mortgages10,21514.2% Consumer durables4,6656.5%Consumer credit2,4043.3% Other3030.4%Bank and other loans3840.5% Total real assets23,08532.1%Security credit3160.4%Other5560.8% Total liabilities13,87519.3%Financial assets Deposits8,03811.2% Life insurance reserves1,2981.8% Pension reserves13,41918.7% Corporate equity8,79212.2% Equity in noncorp. business 6,5859.2% Mutual fund shares5,0507.0% Debt securities4,1295.7% Other1,5362.1% Total financial assets48,84767.9%Net worth58,05880.7% TOTAL71,932100.0%71,932100.0%FIN3710: Investment Analysis1-##3Real versus Financial AssetsAll financial assets (owner of the claim) are offset by a financial liability (issuer of the claim)When all balance sheets are aggregated, only real assets remainNet wealth of economy: Sum of real assetsFIN3710: Investment Analysis1-##4Domestic Net Worth, 2011Assets $ Billion Commercial real estate14,248 Residential real estate18,117 Equipment and software4,413 Inventories1,974 Consumer durables4,665 TOTAL43,417Note: Column sums may differ from total because of rounding error.

SOURCE: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, June 2011.

FIN3710: Investment Analysis1-##5Financial AssetsMajor Classes of Financial Assets or SecuritiesFixed-income (debt) securitiesMoney market instrumentsBank certificates of deposit, T-bills, commercial paper, etc.BondsPreferred stockCommon stock (equity)Ownership stake in entity, residual cash flowDerivative securitiesContract, value derived from underlying market conditionFIN3710: Investment Analysis1-##6Financial Markets and the EconomyInformational Role of Financial MarketsDo market prices equal the fair value estimate of a security's expected future risky cash flows?Can we rely on markets to allocate capital to the best uses?Other mechanisms to allocate capital?Advantages/disadvantages of other systems?FIN3710: Investment Analysis1-##7Risk AllocationInvestors can choose desired risk levelBond vs. stock of companyBank CD vs. company bondRisk-and-return trade-offFinancial Markets and the EconomyFIN3710: Investment Analysis1-##8Corporate Governance and Corporate EthicsBusinesses and markets require trust to operate efficientlyWithout trust additional laws and regulations are requiredLaws and regulations are costlyGovernance and ethics failures cost the economy billions, if not trillionsEroding public support and confidenceFinancial Markets and the EconomyFIN3710: Investment Analysis1-##9Corporate Governance and Corporate EthicsAccounting scandalsEnron, WorldCom, Rite-Aid, HealthSouth, Global Crossing, QwestMisleading research reportsCiticorp, Merrill Lynch, othersAuditors: Watchdogs or consultants?Arthur Andersen and EnronFinancial Markets and the EconomyFIN3710: Investment Analysis1-##10Corporate Governance and Corporate EthicsSarbanes-Oxley Act:Requires more independent directors on company boardsRequires CFO to personally verify the financial statementsCreated new oversight board for the accounting/audit industryCharged board with maintaining a culture of high ethical standards

Financial Markets and the EconomyFIN3710: Investment Analysis1-##11The Investment ProcessAsset AllocationPrimary determinant of a portfolio's returnPercentage of fund in asset classesStocks 60%Bonds 30%Alternative assets 6%Money market securities 4%Security selection and analysisChoosing specific securities within asset classFIN3710: Investment Analysis1-##12Markets Are CompetitiveRisk-Return Trade-OffAssets with higher expected returns have higher risk

Stock portfolio loses money 1 of 4 years on averageBonds Have lower average rates of return (under 6%)Have not lost more than 13% of their value in any one yearAverage Annual ReturnMinimum (1931)Maximum (1933)StocksAbout 12%46%55%FIN3710: Investment Analysis1-##13Markets Are CompetitiveRisk-Return Trade-OffHow do we measure risk?How does diversification affect risk?FIN3710: Investment Analysis1-##14Markets Are CompetitiveEfficient MarketsSecurities should be neither underpriced nor overpriced on averageSecurity prices should reflect all information available to investorsChoice of appropriate investment-management style based on belief in market efficiency FIN3710: Investment Analysis1-##15Markets Are CompetitiveActive versus Passive ManagementActive management (inefficient markets)Finding undervalued securities (security selection)Market timing (asset allocation)Passive management (efficient markets)No attempt to find undervalued securitiesNo attempt to timeHolding a diversified portfolioIndexing; constructing efficient portfolio

FIN3710: Investment Analysis1-##16The PlayersBusiness Firms (net borrowers)Households (net savers)Governments (can be both borrowers and savers)Financial Intermediaries (connectors of borrowers and lenders)Commercial banksInvestment companiesInsurance companiesPension fundsHedge fundsFIN3710: Investment Analysis1-##17The PlayersInvestment BankersFirms that specialize in primary market transactionsPrimary marketNewly issued securities offered to publicInvestment banker typically underwrites issueSecondary marketPreexisting securities traded among investorsFIN3710: Investment Analysis1-##18The PlayersInvestment BankersCommercial and investment banks' functions and organizations separated by law 1933-1999Post-1999: Large investment banks independent from commercial banks Large commercial banks increased investment-banking activities, pressuring investment banks profit margins September 2008: Mortgage-market collapseMajor investment banks bankrupt; purchased/reorganizedFIN3710: Investment Analysis1-##19The PlayersInvestment BankersInvestment banks may become commercial banksObtain deposit fundingHave access to government assistanceMajor banks now under stricter commercial bank regulationsFIN3710: Investment Analysis1-##20Balance Sheet of Commercial Banks, 2011Assets$ Billion% TotalLiabilities and Net Worth$ Billion% TotalReal assetsLiabilities Equipment and premises110.40.9% Deposits8,674.671.4% Other real estate46.60.4% Debt and other borrowed funds1,291.810.6% Total real assets157.01.3% Federal funds and repurchase agreements499.14.1% Other308.42.5% Total liabilities10,773.988.6%Financial assets Cash1,066.38.8% Investment securities2,406.119.8% Loans and leases6,279.151.6% Other financial assets1,153.99.5% Total financial assets10,905.489.7%Other assets Intangible assets373.93.1% Other721.05.9% Total other assets1,094.99.0% Net worth1,383.411.4% TOTAL12,157.3100.0%12,157.3100.0%Note: Column sums may differ from total because of rounding error. SOURCE: Federal Deposit Insurance Corporation, www.fdic.gov, July 2011.FIN3710: Investment Analysis1-##21Balance Sheet of Nonfinancial U.S. Business, 2011Assets$ Billion% TotalLiabilities and Net Worth$ Billion% TotalReal assetsLiabilities Equipment and software4,10914.6% Bonds and mortgages5,32118.9% Real estate7,67627.2% Bank loans5381.9% Inventories1,8766.7% Other loans1,2274.4% Total real assets13,66148.5% Trade debt1,8636.6% Other4,55916.2%Financial assets Total liabilities13,50947.9% Deposits and cash1,0093.6% Marketable securities8993.2% Trade and consumer credit2,3888.5% Other10,23936.3% Total financial assets14,53551.5% TOTAL28,196100.0% Net worth14,68752.1%28,196100.0%Note: Column sums may differ from total because of rounding error. SOURCE: Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, June 2011.FIN3710: Investment Analysis1-##22The PlayersVenture Capital and Private EquityVenture capitalInvestment to finance new firmPrivate equityInvestments in companies not traded on stock exchangeFIN3710: Investment Analysis1-##23The Financial Crisis of 2008Changes in Housing FinanceLow interest rates and a stable economy created housing market boom, driving investors to find higher-yield investments1970s: Fannie Mae and Freddie Mac bundle mortgage loans into tradable pools (securitization)Subprime loans: Loans above 80% of home value, no underwriting criteria, higher default risk

FIN3710: Investment Analysis1-##24The Financial Crisis of 2008Mortgage DerivativesCDOs: Consolidated default risk of loans onto one class of investor, divided payment into tranchesRatings agencies paid by issuers; pressured to give high ratings

FIN3710: Investment Analysis1-##25The Financial Crisis of 2008Credit Default SwapsInsurance contract against the default of borrowersIssuers ramped up risk to unsupportable levelsAIG sold $400 billion in CDS contractsFIN3710: Investment Analysis1-##26The Financial Crisis of 2008Systemic RiskRisk of breakdown in financial system spillover effects from one market into othersBanks highly leveraged; assets less liquidFormal exchange trading replaced by over-the-counter markets no margin for insolvency protectionFIN3710: Investment Analysis1-##27The Financial Crisis of 2008The Shoe DropsSeptember 7, 2008: Fannie Mae and Freddie Mac put into conservatorshipLehman Brothers and Merrill Lynch verged on bankruptcySeptember 17: Government lends $85 billion to AIGMoney market panic freezes short-term financing marketFIN3710: Investment Analysis1-##28The Financial Crisis of 2008Dodd-Frank Reform ActCalled for stricter rules for bank capital, liquidity, risk managementMandated increased transparencyClarified regulatory systemVolcker Rule: Limited banks ability to trade for own accountFIN3710: Investment Analysis1-##29