3 Stages of Financial CrisisStage 1: Initiation of a financial crisis

Caused by:o Mismanagement of financial liberalization or innovation and eliminating rest. On fin.

Institutions or mkts, or introducing new types of productso Government interference

Sarbanes-Oxley Act (enron) Created more restrictive accounting hiring practices to prevent fraud;

overreacted to what happened Dodd-Frank

Created in reaction to ’07 crisis, regulates derivatives Glass-Steagall Act

Limits activities between commercial banks and security firms Pendulum swings back and forth between much/little restrictions Removal of restrictions

Allows capital to flow effectively Short-run creates credit boom leading to:

o Too much lending, crash, hammers economic activityo Attitude around moral hazard and gov’t guarantees lead to more risko Bad loands = writeoffs = less lending

Paul Krugman (economist) believes low interest rate environment created the bubble by making loans cheap

Stage 2: Banking Crisis When consumers/business both do poorly so do banks that loan to them

o Writeoffs weaken the balance sheets Bank panic can happen = domino effect Solved when bank regulation close down/take over weak institutions (FDIC)

increasing payout limit to build depositor confidenceo TARP (Troubled Asset Relief Program)

Government purchase of assets and equity from financial institutions to strengthen financial sector

Stage 3: Debt Deflation Falling prices a concern in slowdown in economic activity

o Banks sell loans at lower prices to stimulate demando If sold @ fixed, as prices rise, banks squeezed by higher borrowing costs of their owno Margins squeezed leading to pull back on lendingo Can create asset bubbles

Irrational exuberance Tech bubble of late 1990s, housing bubble of 2008

When bubble bursts, lenders draw back when borrowers default2007-2010 Financial Crisis

Financial innovation in mortgage markets Defaults at Bear Stearns/ Lehman Brothers due to drops in val. Of housing related securities Lenders froze up and pulled out so feds funds mkt froze Fear of failure caused consumer withdrawal from mkt and lower borrowing Falling housing asset value makes matters worse Deterioration of financial institution balance sheets, global financial market contagion Schiller index

o Found housing vals rebounded and are rising rapidly, prices rising due to inflation, if looking like 2007, gget out or if people feel the same now as they did in 2007- like CPI mes.

Tulipamania In 1593 tulip bulbs were brought from Turkey to Holland. Everyone wants some. In some cases the same bulb changed hands 10 times in a day. Supply could not keep up with demand because of the geography of supply. Speculation rampant. One day prices collapsed leading to a recession in Holland

Great Depression Easy credit = rampant speculation with borrowed money Prevailing attitude that stock prices rise indefinitely and can borrow against higher val = invest FED inc. interest rates worried about higher demand bringing on inflation Banks called in loans and investors liquidated stocks to repay = lower stock prices 25 years to get back to 1929 as banks failed etc.

Asian Crisis of 1997 Investment in developing nations soared by promised higher returns; rapid influx of

capital/growth in GDP Rel estate/construction projects boomed with higher property values Exports from basic materials to semiconductors Gov’t invest. In infrastructure soared = unrealistic demand projections = wild investment 1997, property developer failed = others same = lenders fail = largest Thailand bank declaring

bankruptcy Dot.Com Crash

Easy credit stim. Wild investment in startups in late 1990s early 2000s Xcelera.com- startup holding company stock go from 30c to $223 Nasdaq index doubled in one year, interest rates ticked up Many companies exposed for fraud, confidence waned, funding stopped, mkt crashed, recession

Common traits in bubbles Asset booms- high demand Easy credit and low interest rates

o Excess demand for borrowing lowered CoC and caused money to chase unwise invest. Degradation of credit standards Some gov’t safety nets increased moral hazard = more risk As banks take writeoffs, delay or cut back on lending = downturn as profits drop due to delivering Pain from stock mkt threatens consumer confidence as they see wealth shrink

2001-2010 Crisis Easy credit/low int. rates = borrowing to purchase homes, incl. speculators Originators paid by deal- originate to distribute- Countrywide Financial, no down payment Securitization mkt developed allowing pooling of mortgages Rating agencies not doing job well, invest. Banks structuring for fees not success Builders/contractors take advantage of easy money Credit standards ignored- subprime interest mkt grows exponentially

Money Markets Money market instruments

o Mature in < 1 yr (Capital > 1 yr)o Used by companies since cash flows don’t always line upo Originate from gov’t and corporate sales of money mkt instruments to meet short term

needs Characteristics:

o SLY: Treasurers mantra (Safe, Liquid, Yield)o Large denominations with low default risk and early maturityo Low transaction costs done electronically, very liquid and active secondary mkt

Auction rate securities

o Maturities of 30 yrs but interest rate resets weekly, practical maturity of 7 dayso Highest yield of a 7 day security o No bidders = 30 yr bond paying 7 day yield = lack of liquidityo Since 2008, largely frozen o IB agreed to repurchase most @ par

Treasury Billso Essentially default risk free

Downgrade due to flight to quality- moving money to safer place = yield down American bonds increase in default risk with a downgraded rating, fear in Europe

stabilizes US rates/reduces risk Benchmark for all other security pricing Refinancing debt/gov’t deficit – Tax Timing: knowledge of tax revenue influences

how much debt gov’t issues sold @ weekly auctions Traditional maturities: 13 & 26 weeks

Have been selling as short as 5 days recently, sold @ discount, starting to issue floating rate ones

Treasury Auctionso Competitive: bidders on price and quantity specifying yield desired, bidders yields

accepted from lowest to highest Not yield conscious so bid higher and guarantee you have best bond. Must give

price/ quantity they want at price Drives interest rates to lowest possible

o Noncompetitive: agree to pay clearing price and certain quantity to guarantee purchase, agrees to take yield determined at auction

Stacks highest to lowest @ bond that splits the bonds in half. If you bid above it, you get clearing price. Above = winners, below = losers

If you bid you will receive Stipulation is quantity, not payment Price is determined by the market

Federal Fundso Overnight loans between banks based on one party’s excess reserves o Unsecured loans between banks

Betting on bank to return moneyo FED sets the lending rate rangeo Federal Funds rate is the rate at which depository institutions actively trade balances held

at the Federal Reserve Repurchase Agreements (REPOS)

o Sale of securities between two parties with agreement to repurchase at a set date and timeo Most collateralized with gov’t securities, usually treasury billo Collateral differentiates from Fed Funds- safer and cheaper

Yields on REPOs should be less, less default premium, competition in Fed Funds mkt high so rate can go below

Normal maturities of 1-14 days as long as 90 Major funding tool among Euro Banks

Commercial Paper (CP)o Unsecured promissory note issued by a corporationo Held to maturity by investors from overnight to 270 days o Purchaser gets internal credit approval on issuer and returno Company est. CP, dealers take to mkt, issuers do research and put people on list of

investors where dealers accept to purchase if default @ discount basis o Good credit corps can issue CP backed by letters of credit, expensive but cheaper than debt

Negotiable CDso Bank issued promissory notes with specific maturity and fixed rate

Issued by lending institution- buying your money and re-lending it Trades in security mkt at negotiated price, not set rate Unsecured with maturities of 14-360 days Large source of funding for banks, secondary is thin, between you and bank, 2

months before maturity you want out, with big credit mkt, banks get aggressive Bankers Acceptances (BAs)

o Promised future payment accepted and guarantted by bank, specifying amt, date, recipient of payment

o Becomes unconditional liability of the banko Holder can sell for cash @ a discount with a secondary marketo Allows imports/exports business through use of bank-backed price to guarantee paymentso Allows supplier to take BA the day they receive it and take it to their bank to exch. For cash

International Use:o Provides diversification o Flight to qualityo LIBOR primary lending rate calculated using 10 currencies quoted as spread over LIBOR

changing every day o Avg interest rate by leading banks in London/ corps can get better deal here than t-bills

Bonds and Fixed Income Markets Bonds- capital mkt instrument with maturities > 1 yr offering interest @ set time and princ @ mat Treasury securities

o 28% of bonds mkt, issued to finance national debt w/ interest earned exempt from state tax, not federal

o Paid semi-annually, sold @ auction like Tbills @ par TBills mat. <1yro Treasury notes- 1-10 yrs bonds- 10-30 yrs, default free, not risk freeo Treasury Inflation Protected Securities (TIPS)

Principal adj. based on inflation TIP demand> non-inflation protected securities, concern for inflation, no inf. =under

o Treasury Strips Allow investors to buy strip out of security w/ principal pmt @ maturity, int

payments separated and sold as individual pmts to investors Time inflows of interest with payment obligations

Municipal bonds- o 18% of total bond mkt issued by state/local gov’t exempted from both taxes

allows issuer to pay lower nominal interest rateo General obligation- backed by taxing power of issuer, requires voter approval, no assets as

collateral o Revenue bond- backed by rev. generating projects, can go bankrupt

= what muni bond pays/ (1-tax) = equiv. corp bond = tax shield for investor

Corporate Bonds-o 54% of total mkt, issued for LT funding w/ rating agencies playing role in pricing. Most

unsecured but have levels of seniority and can be tied down to an asset o Sinking fund- agreement by issuer to set aside cash to pay off principal @ maturity= lower

interest rate/risk o Convertible bonds- lower rate of return because of embedded stock option- hung converts

never convert because prices don’t go high enough Rating Agencies-

o Moodys, S&P, Fitcho Changes happen due to acquisitions, changes in bus. Practices, bus. Climateo Assess issuer’s default risk

Considers covenants, collateral, issuer ability to pay, business risk, financial risk , corp. governance, financial guarantees- CDS

CDS (Credit Default Swaps)o Insurance policies for default issued by banks and insurance cos. Rating downgrade = more

val for CDS International bonds

o Sovereign bond- issued by national gov’t within given country @ foreign currency Unstable country issues bonds in stable currency (Euro,Samaurai,Yankee)

Selling debt in the primary market Shelf registration

o Allows company to issue a statement about intent to raise capital/pre-clearance to get financials in order/sell @ point in next two years

o Rating agencies look at this to give prelim rating o Major events- must amend shelf to reflect needs of company

Red herringo Primary prospectus filed to SEC containing company/business des. Rep. offering

specifics and risks Final Prospectus

o Includes all red herring plus interest rate and price of offering- most is risk factors Indenture

o Final doc outlining specifics of offering- covenants, interest pmt dates, maturity, redempt. Reference doc for buyers if something goes wrong

Actual Sale- o Best efforts underwriting-

NO guaranteed price to seller, invest. Bankers sell at best prices they can get (best for firms that come to mkt frequently)

o Firm commitment underwriting- IB buys whole issue and breaks up in primary mkt next day assuming risk. Mkt

changes can change dramatically overnight- common with local/state gov’to Private placement-

Seller is not well-known- private companies Sophisticated buyers that agree to a locked in time-frame Non SEC registered to avoid legal expenses w/low liquidity

o First time borrowers mkt securities in a road show use comps to value companies with seasoned offerings to take adv. Of mkt and profit on their stocks

Equity financing (IPO)o Initial filing made w/ SEC detailing ops., history, projectionso Company chooses underwriters and where shares will be listed

o Prospectus- allow company to articulate risks- issuer/underwriter det. #/ shares/ pxo Allocated to primary mkt and traded in secondary

Equity represents residual ownership in company- cap. Structure rep. by common/pref. stock IPO

o A broadening mkt- need to make more money by going publico Unknown company- reveal and issue financial statements to publico Underest in. price- company loses pot. Money o Overestimate- investors lose money

Common stock- 98% of listed stock exchange come with voting rights, sometimes dividendso Low/no dividend- growth stock (risk investors)o Class A vs B- B has more voting rights than A o Used by family owned companies for maintaining control

Preferred Stock-o Always includes a dividends as % of par o Effected more by interest rates than mkt forces or earningso Convertible- converted to common stock after IPO o Cumulated- occurs when company stocks pay dividends for brief period

Stock buyback- o Instead of granting a dividend, will buy back stock with retained earningso Reduces outstanding shares and increases EPS and stock priceo No risk with issuing a dividend and way company can boost stock value

Double taxation-o Taxed on earnings and investor is taxed on dividends

Stock markets: NYSE vs. NASDAQo Compete based on fees for companies to be listed on exchangeo Mkt order-request to buy @ mkt price, limit order request to buy at set priceo NYSE-

Trade occurs on trading floor- blue chip Auction mkt- everyone buys and sells with one another- highest bidding price

matched with lowest ask Specialist acts as facilitator to match – more established- for value-oriented

stocks – more expensiveo NASDAQ-

Trades occur online- Dealer market- everyone goes through the dealer (mkt maker) for more volatile,

growth stocks. Cheaper costso Indices-

Down Jones-price weighted index, rep. ¼ of stock mkt 30 of world’s lg comps S&P 500- Rep. 70% of value in US Stock mkt- mkt weighted index- good

indicator of US Stock mkt as a whole Wilshire 5000- over 7000/10000 securities traded in US mktplace

All companies with the HQ in US in index- companies from every industry but not a mkt indicator- value weighted

Russell 3000- 3000 largest US traded stocks, 2000- 2000 smallest stocks of 3000 Best known indicator for daily perf. Of small companies, diversified

MSCI- world index of 1606 world stocks- common benchmark for global stock funds

Risk

Hedgers- transfer risk- strong balance sheet since there is counterparty risk if firm is on other side of bet, used to transfer risk to someone who has an offsetting mkt outlook

Speculators- seek to profit from risk SWAPS- exchange of one financial instrument for another

o If firm in separate countries, comparative advantages on interest rates, swap can benefit both firms

o Can assign a fixed rate to a floating rate instrument traded otc between private parties Caps- highest rate an ARM can rise in a given time period- safeguard in case interest rates rise

dramatically in a short period of time; not on a mkt- includes counterparty risk Floors- Lowest acceptable limit restricted by controlling parties- pay someone to take downside

exposure Collar- Buy a cap, sell a floor and lock in a return- Premium on floor pays for the cap to prevent

upside risk Contracts-

o Spot- Agree today on price paid and quantity of currency and make transfer todayo Forward- Agree on price and quantity today for exchange made in the future to allow you

to close risk now- counterparty risk!o Future- ETF forward contract traded on formal exchange guarantees no default- Purchaser

agrees on upfront price, quantity, date matched with seller by exchange Requires daily mark-to-market and margin requirement to post collateral

Options-o Contracts give holders right to buy/sell underlying asset at pre-specified price for a specific

timeo Call options- right to buy a stock from option writer @ strike priceo Put options- right to sell underlying stock @ strike price- you want stock to drop below

strikeo If stock doesn’t reach, you lose premiumo If spot>strike, exercise option or sell if for a profit o Options for protection- limit downside risk, buy a put option to put a floor on investment

Securitization and Mortgage Markets- Mortgages- loans to purchase real property – home, land, building – subcategory of cap. Markets

o 75% for single family dwellings-size-standard, jumbo, term-maturity, interest rate, collateral

o Qualification- Credit history, income, down-payment- banks can attach liens until you pay off mort Don’t like to have fixed rates because lenders want to be able to borrow at same as

costo Amortization overhead- arm rates created so banks don’t get stuck with mort. On low end

when interest rates are high- start out at rates lower than market Low DOC/No DOC loans- don’t req. rigorous proof of income Securitization- allows banks, issuers, and investors to diversify risk Advantages: banks diversify away local risks, reload and do it again, investors diversify risk Disadvantages: risk gets passed on to final purchase of bond, secondary mkt very scarce leading to

poor liquidity for investors, big investors dive rate and don’t need return

CWABS – 2006-07o A subprime mortgage bond issues in June 2006o Made up entirely of mortgages issued by Countrywide Financial. Totaled

5,954 mortgages with interest rates as high as 15% but averaging 8.5%. 43 of the mortgages were from California and Florida

o By the summer of 2009, slices of this bond were selling at 50 cents on the dollar.

o Many of the original mortgage holders have defaulted, walking away from their homes. Some number have had their mortgages restructured under government programs.

o Home values have rebounded allowing some owners to sell their home for more than the mortgage value and move on

o The result is that a core group of homeowners still remain who are “good”o Values of the bonds now approach 91 cents on the dollaro Real estate values went up so the bondholders survived the bad time with

patience

Subprime Mortgage Crisiso Discipline in applications failedo Accountability too widely distributedo Assumptions regarding potential changes in the economy were unrealistic

(housing values)o Role of rating agencies changeso Investment houses became too actively involved in formation of packages

and marketing of same (global)o Weakening economyo Moral hazard regarding government guarantees

If we didn’t have credit to go with our housing market it would be much more

expensive and constrained