ch1-background of the financial crisis

8/3/2019 Ch1-Background of the Financial Crisis

http://slidepdf.com/reader/full/ch1-background-of-the-financial-crisis 1/34

Finance Research is relevant

Nationally

Indexing and passive investing

Creation of the options market

Option back-dating Mutual fund scandal

Collusion among Nasdaq traders

Departmental Research

Index changes and returns Merger efficiency



Why Investments?

Income and expenses don¶t match. ± As a student, your expenses exceed your income

± Once you start earning, your income will exceedyour expenses

± Kids, home, kids¶ education etc. puts a strain onyour budget

± After that your income again exceeds your expenses

± Upon retirement, you must depend on your savings bc no cash inflows



Why Investments? Must learn to manage your wealth so that it maximizes your

income at the right time with the right level of risk.

Decisions are being passed on to individuals Partial privatization of social security- we heard about this 4-5 years

ago then it died away Means you still pay amount of SS you have, but conceptually it says well let

you take money and let you decide where to invest it just like you would inan IRA or 401K you make the decision

Individuals depending on how much they contribute, would allow them tomake own investment decisions instead of the government choosing Downside: If its the governments money, what do I care? I can take all the

risk I want. It could allow people to take more risk than they generally world.Also, a lot of people dont know how to manage their money so itd bemostly passive management

Will probably see it again bc administration changes republicancongress/president would probably hear more about it partial private as away to save SS

Defined contribution plans instead of defined benefit plans Defined benefits: pensions- if you work for 30 years here is what youre going

to get. You dont have to do anything and youll get it for rest of your life.However, this is extremely expensive!

Defined contributions: 401 K, 403B, simple, scep, then its up to you. Sameidea as partial privatization except its full based on YOu contributing andwhatever you contribute/invest in/grows to is what you get in the end to beable to pull out



Financial Markets

Securities allow exchange between

periods. Saving during one period

can be used as an expense duringanother period.

Bonds

Stocks

Real Estate

Etc.



Importance of Smart Investing

Salary: $50,000 per year

Accumulated Assets: $250,000 Income from investments = $12,500

@5%

Income from investments = $25,000

@10%

Difference in income constitutes 25%of salary.



Markets are Competitive Risk-Return Trade-Off

Efficient Markets Active Management

Finding mispriced securities- look at PE ratio, big indicator Fundamental or relative analysis- to see is this thing worth more

Looking at financials of company: PE, EPS, etc

Timing the market- trying to get in at bottom or top;speculators, technical analysis look for floors and ceilingsand movement along a trend line. This is a way of investing.

Looking at historical trends

Passive Management

No attempt to find undervalued securities No attempt to time the market

Holding a highly diversified portfolio or indexing, investingin index



The Players Business Firms net borrowers

Households net savers

Governments can be both borrowers andsavers

Financial Intermediaries

Investment Companies

Banks

Insurance companies- huge player in bondmarket; tend to invest in longer term.People tell them their liabilities and have areasonable idea of what cash flows shouldbe

Credit unions- operate under a different setof rules



The Players Continued

Investment Bankers

Perform specialized services for

businesses: m&a, mezanine funding,

second round funding, private equity

groups raises money from investors

and go out and invest in companies

Markets in the primary market theybring companies public for the first

time in IPO market



Table 1.4 Balance Sheet of

Nonfinancial U.S. Business, 2007



Recent TrendsGlobalization

American Depository Receipts (ADRs)

Foreign securities offered in dollars

Mutual funds that invest internationally

Instruments and vehicles continue to

develop (WEBs)

Exchange Traded Funds (ETFs)- EX:Spyders, leveraged ETFs show a lot of

volatility in the market. Buy a sector

but trade it like a stock.



Recent TrendsSecuritization

Mortgage pass-through securities

Other pass-through arrangements

Car, student, home equity, credit card loans EX: airplane leases

Any asset you can find, you can pool ittogether, take that pool, divide intoseparate investments, sell to investors, and

when people make payment on assets,payment goes to purpose that holdssecuritized instrument

MBS: mortgage backed securities

Offers opportunities for investors and

originators



Securitization

Securitization & Credit Enhancement Offers opportunities for investors and originators

Transfer risk bank can originate loan and take loan off their books and put it in

with fannie or freddie or whoever is securitize/packages it

Loan is not held by bank anymore, no more risk of someone not paying the

loan Makes lending more available. Become less strict and if I package them together

than statistically theres not going to be a lot of defaults.

Changes in financial institutions and regulation

Improvement in information capabilities Credit enhancement and its role



Asset-backed Securities

Outstanding



Financial Crisis of 2008-09

Background

What happened?

Mid 90s- push to make housing affordable for all. Goal of

several administrations, but mainly the focus of Clinton. Tomake it easy and accessible for everyone to get into

affordable housing

Likely causes

Possible solutions Economic Outlook



Background

Securitization Started in the early 1980s.

Process of converting household assets into marketable securities. Same assets, value, default rate, put them together

Asset Backed Securities (ABS), Collateralized Debt Obligations (CDO)

Mortgages constitute the largest fraction of the market MBS, CMO

(collateralized mortgage obligations Makes it easier if youre the government and your pushing a quasi

government entity (fannie or freddie) push them to make loans, pool themtogether and sell off to investors, we have an asset to sell.

Background: we wanted to make housing affordable, we wanted to makeloans to people to buy houses so we started setting it up back in the 90s

MBS we created allow investors take advantage and individuals getting the

loan bc if administration is pushing for loans to be made I dont need thesame credentials that I had before; dont have to have a sterling credential



Mortgage-Backed Securities

Creation of MBS

Original lenders resell home

mortgages to financial institutions.

Create a pool of mortgages that is

well-diversified: geographic, size,

borrower risk diversification.

Pool of assets is subdivided intotranches.

Each tranche is rated and sold as a

separate MBS/CMO.



Securities



Securitization



Securitization

Useful innovation:Reduces liquidity risk by making loans

marketableSpread between Treasury bonds and

mortgage rates narrowed

Home owners got loans at better rates

than without securitization.



Securities

Private sector

Financial Institutions create the pooland divide into MBS (tranches).

MBS are rated by S&P, Moody¶s, etc. May be insured by MBIA, Ambac, AIG, etc. against default, raise rating ± called CDS.

MBS are sold by banks to the

investors. Investors buy MBS based on ratings



Securities

Government Sponsored Entities

Fannie Mae, Freddie Mac

GSEs guarantee loan paymentsprovided the loan is conventional.

Collect a premium from the loan

originators.



Popularity of CDOs

CDOs became very popular:

Banks, insurance companies, hedgefunds, pension funds, all liked CDOs.

CDOs gave a higher return than

corporate bonds, for similar ratings.



What happened?

Mortgage defaults increased more thanin the past, in particular, subprime

mortgages. Insurance companies called in to pay for

defaults depleting capital.

Impaired financial condition of insurance companies meant thatinsurance provided for other derivativeswas uncertain.

Greater incidence of default led todowngrading of MBS by rating agencies.



Likely Causes

Co-conspirators

Rating Agencies

Fannie Mae, Freddie Mac; Congress Insurance companies

Investors



Likely Causes

Rating Agencies main contributor.CMOs rated too high by rating agencies.

W

hy? Models based on short history of CMOs.

Confused total risk with systematic risk.

Inherent conflict of interest. Sponsor pays

rating agencies to rate their CMOs.



Likely Causes

Fannie, Freddie; Congress

Fannie, Freddie should have reviewed the

mortgages more closely. But Congress wanted GSEs to increase

home ownership by making/supporting

loans.

Fannie, Freddie saw this as a way of making

easy money and satisfy the politicians.



Likely Causes

Investors, Insurance Companies

Investors found that AAA-rated CMOs

generated higher returns than AAA-rated

corporate bonds.

Bought CMOs instead of corporate bonds.

Lack of transparency. Institutions knew

that the risk of CMOs was unknown. However, investors and insurance

companies believed the ratings, without

due diligence



Likely Causes

Exploding demand for CMOs

Because of higher returns.

Origination of loans exploded to keep pace Loan originators did not care about the

borrowers because no one seemed to care.

Rating agencies mistakenly rated them too

high.

Banks were selling. Investors were buying.



UntilUntil someone defaultedsomeone defaulted



Possible Solutions

Like a run on a bank!

Ordinarily, markets limp back to normalcy

But markets are frozen due to lack of trust

and lack of knowledge regarding the true

value of assets

Need government intervention.



Possible Solutions

Facilitate mergers of weak banks.

Buy institutions that are too big.

Increase liquidity by making more money

available.

Buy commercial paper so that companies keep

running.

Cut interest rates.



Economic Outlook

Financial crisis spreads to corporations

Unable to borrow funds for operations.

Declining supply, and declining demand

from consumers.

Lower retail sales, job losses, etc.



Economic Outlook

Grim outlook for global and U.S. economy

Q4 growth was very negative.

Q1, Q2 growth will be negative.

World economic growth below 3%(recession).

Possibility of a rebound

If the financial problems can be containedonWall Street, trust and confidence couldreturn quickly.

Still far away.

ch1-background of the financial crisis

Documents