advanced money exam 2

Money Market Cost Advantages

-money markets first gained popularity when interest rate regulations were set on banks to reduce competition among banks, limited how much interest they could pay on deposits and established rate ceiling. When inflation pushed short term rates above rates that banks were allowed to pay, people pulled money out and deposited into money market accounts. banks are important for intermediation, but their cost structure makes it hard to compete against money market for short term funds , as money market is less restricted

Money Market securities

-short-term debt securities that mature in less than a year from issuance -generally safe and liquid, and thus are a natural place for businesses and financial institutions to "warehouse" funds because they offer a higher yield than holding cash -Businesses borrow in the money markets (by issuing money market securities) because doing so is cheaper than obtaining bank loans

Asymmetric Information: Adverse Selection and Moral Hazard

Asymmetric Information- arises when one party's insufficient knowledge about the other party involved in a transaction makes it impossible to make accurate decision when conducting the transaction ex: managers know how well the business is doing & whether they are being honest better than stockholders do leads to adverse selection and moral hazard problems agency theory: analysis of how information problems affect economic behavior

How businesses finance their activities

Bank Loans: loans from depository institutions Nonbank Loans: loans by other financial intermediaries Bonds: Marketable debt securities (corporate bonds, commercial paper) Stock: new issues of new equity (stock market shares)

Real estate mortgage investment conduits (REMICs)

like CMOs authorized by the 1986 Tax Reform Act to allow originators to pass through all interest payments tax free. Only their legal and tax consequences distinguish REMICs from CMOs

discount bond

when bond sells for less than the par value

premium

when bond sells for more than par value

depreciation

when currency decreases in value

appreciation

when currency increases in value

3 elements to most mortgage loans

1. Originator packages the loan for an investor 2. investor holds the loan 3.servicing agent handles the paperwork 1-3 different intermediaries may provide these function for any particular loan

High PE Ratio

2 interpretations: 1. market expects earnings to rise in the future , this will return PE to a more normal level 2. indicate that market feels the firms earnings are very low risk and is therefore willing to pay a premium for them

Effect of Changes in Interest Rates on Equilibrium Exchange Rate

Changes in domestic interest rates iD are often cited as a major factor affecting exchange rates. a nominal interest rate such as iD equals the real interest rate plus expected inflation: i = ir + 𝜋e. The Fisher equation thus indicates that the interest rate iD can change for two reasons: Either the real interest rate ir changes or the expected inflation rate 𝜋e changes. The effect on the exchange rate is quite different, depending on which of these two factors is the source of the change in the nominal interest rate domestic real interest rate increases so that the nominal interest rate iD rises while expected inflation remains unchanged. In this case, it is reasonable to assume that the expected future exchange rate is unchanged because expected inflation is unchanged. In this case, the increase in iD increases the relative expected return on dollar assets, raises the quantity of dollar assets demanded at each level of the exchange rate, and shifts the demand curve to the right. When domestic real interest rates rise, the domestic currency appreciates. rise in expected domestic inflation leads to a decline in the expected appreciation of the dollar, which is typically thought to be larger than the increase in the domestic interest rate iD at any given exchange rate, the relative expected return on domestic (dollar) assets falls, the demand curve shifts to the left, and the exchange rate falls When domestic interest rates rise due to an expected increase in inflation, the domestic currency depreciates.

Supply Curve for Domestic Assets

domestic assets: U.S. dollar Foreign asset: Euro Quantity of dollar assets supplies is mainly the quantity of bank deposits, bonds, and equities in the United States. Fixed with respect to exchange rate Quantity supplied at ANY exchange rate does not change, so the supply curve is VERTICAL

registered bonds

dont have coupons replaced bearer bonds owner registers with firm to receive interest payments firms required to report to IRS name of person who receives interest income

Municipal Bonds: General Obligation

dont have specific assets pledges as security or a specific source of revenue allocated for their repayment backed by the "full faith and credit" of issuer issuer promises to use every resource available to repay bond as promised issues must be approved by taxpayers because the taxing authority of the government is pledged for their repayment

5. The financial system is heavily regulated

governments regulate financial markets primarily to promote the provision of information and to ensure the soundness (stability) of the financial system

Capital Market: Government

Federal gov issues Long Term notes and bonds to fund the national debt State and municipal governments issue LT notes and bonds to finance capital projects like building schools and prisons Government never issues stock because they can't sell ownership claims

Mortgage Interest Rate- Market Rates

LT market rates determine by supply and demand for LT funds, which are influenced by global, national, and regional factors mortgage rates tend to stay above less risky T-bonds but tend to track along with them

Mortgage Interest Rate- Term

LT mortgages have higher interest rates than ST mortgages usual lifetime: 15 or 30 yrs 20 yr is offered, but not very popular Interest-rate risk falls as term to maturity decrease, so interest on 15 yr loan will be much lower than interest on 30 yr loan

Perpetuity

current yield is an exact measure of the YTM LT coupon bonds are like perpetuities, which pay coupon payments forever. So, you can use current yield as YTM for LT bonds St coupon bonds behave less like perpetuities so we can't use current yield approximation

Over-the-Counter Markets

trading occurs over sophisticated telecommunications networks ex: NASDAQ provides current bid & ask prices on about 3000 securities dealers "make a market" in these stocks by buying for inventory when investors want to sell and selling from inventory when investors want to buy dealers provide small stocks with the liquidity that is essential to their acceptance in the market total volume on nasdaq ia usually lower than nyse, but growing and sometimes exceeds

Alternative Trading Systems (ATSs) and Multilateral Trading Facilities (MTFs)

trading systems that bypass traditional exchanges and allow buyers and sellers to deal directly with each other used for large transactions amongst institutional investors subset of trading facilities consists of Electronic Communications Networks (ECNs) which are ATSs that are fully electronic challenging nasdaq and organized excahnges for business recently

Subordinated Debentures:

unsecured like debentures, but even lower priorityy claim in event default, paid only after non subordinated bondholders have been paid in full greater risk of loss

Capital Market: Secondary Market

well-developed sale of previously issues securities most investors plan to sell long term bonds before they mature 2 types: Organized Exchange and Over- The Counter Exchange

Repurchase Agreements (Repo)

work similarly to fed funds -nonbanks can participate -firm can sell treasury securities in a repurchase agreement where firm agrees to buy back the securities as a specified future date -most repos are short term, 3-14 days -market for 1-3 month repo does exist, however

How Financial Intermediaries Reduce Transaction Costs: Expertise

Fin intermediaries are better able to develop expertise to lower transaction costs. Expertise in information technology allows them to offer convenient services like calling toll free # to see how investments are doing & write checks on accounts important outcome of low transaction costs: Also provide liquidity services, services that make it easier for customers to conduct transactions. ex: money market mutual funds pay high interest rates & allow them to write checks for convenient bill paying

Financial Intermediation

most used cars are not sold directly by one individual to another. Instead, they are sold by an intermediary, a used-car dealer who purchases used cars from individuals and resells them to other individuals. Used-car dealers produce information in the market by becoming experts in determining whether a car is a peach or a lemon. Once they know that a car is good, they can sell it with some form of a guarantee: either a guarantee that is explicit, such as a warranty, or an implicit guarantee, in which they stand by their reputation for honesty. People are more likely to purchase a used car because of a dealer's guarantee, and the dealer is able to make a profit on the production of information about automobile quality by being able to sell the used car at a higher price than the dealer paid for it. If dealers purchase and then resell cars on which they have produced information, they avoid the problem of other people free-riding on the information they produced. Financial Intermediary (bank) becomes expert in producing info about firms so it cans out out good and bad credit risks. Then it can get money from depositors and lend to good firms, earning higher returns on its loans than the interest it has to pay the depositors. This profit gives banks incentives to produce info. Avoids free rider problem by making private loans rather than buying securities that are traded in public market private loans aren't traded so investors can't watch what the bank is doing to drive up the loans price to the point where it makes no profit from producing info. Banks role as intermediary that mostly nontraded loans is key to its success in reducing asymmetric info in financial markets adverse selection analysis indicates that financial intermediaries and banks in particular, because they hold large amount of nongraded loans, play a greater role in moving funds to corporation than securities do, which explains FACTS 3 AND 4 , why indirect finance is more important than direct finance, and why bank are the most important source of external funds for financing business banks are more important in financial systems of developing countries when quality of info about firms I better, asymmetric info problem is less sever, and easier for firms to issue securities. Info about private firms is harder to collect in developing countries than in industrialized , so the smaller role of securities markets makes a greater role for financial intermediaries like banks. COROLLARY: as info about firms becomes easier to acquire, role of banks should decline. Huge improvement in info technology in U.S. which suggest lending role of banks should decline, which has happened Analysis also explains FACT 6 which ask why large firms are more likely to get funds from securities markets, a direct route, rather than indirectly (banks or financial intermediaries) The better known a corporation is, the more info about its activities is available in marketplace, making it easier for investors to evaluate its quality and tell if its good or bad. Investors have fewer worries about adverse selection with well-known corporation, so they will be willing to directly invest in their securities. This suggest that a pecking order for firms that can issue securities should be in place. The larger and more established a corporation is, the more likely it will be to issue securities to raise funds, this view is called "pecking order hypothesis" , which is supported in data and what fact 6 describes

par value

The same as face amount, the maturity value of the bond.

Exchange Rates

determined by interaction of supply and demand

Role of Asset Backed Commercial Paper in Financial Crisis

"A special type of commercial paper known as asset-backed commercial paper, or ABCPs, comprises short-term securities with more than half having maturities of 1 to 4 days. The average maturity is 30 days. ABCPs differ from conventional commercial paper in that they are backed (secured) by some bundle of assets. In 2004-2007 these assets were mostly securitized mortgages. The majority of the sponsors of the ABCP programs had credit ratings from major rating agencies; however, the quality of the pledged assets was usually poorly understood. The size of the ABCP market nearly doubled between 2004 and 2007 to about $1 trillion as the securitized mortgage market exploded. When the poor quality of the subprime mortgages used to secure ABCP was exposed in 2007-2008, a run on ABCPs began. Unlike commercial bank deposits, there was no deposit insurance backing these investments. Investors attempted to sell them into a saturated market. The problems extended to money market mutual funds, which found that the issuers of ABCP had exercised their option to extend the maturities at low rates. Withdrawals from money market mutual funds threatened to cause them to "break the buck," where a dollar held in the fund can be redeemed only at something less than a dollar, say, 90 cents. In September 2008 the Federal Reserve set up a guarantee program to prevent the collapse of the money market mutual fund market and to allow for an orderly liquidation of their ABCP holdings.2"

History of CD

"The bank offered the CD to counter the long-term trend of declining demand deposits at large banks. Corporate treasurers were minimizing their cash balances and investing their excess funds in safe, income-generating money market instruments such as T-bills. The attraction of the CD was that it paid a market interest rate. There was a problem, however. The rate of interest that banks could pay on CDs was restricted by Regulation Q. As long as interest rates on most securities were low, this regulation did not affect demand. But when interest rates rose above the level permitted by Regulation Q, the market for these certificates of deposit evaporated. In response, banks began offering the certificates overseas, where they were exempt from Regulation Q limits. In 1970 Congress amended Regulation Q to exempt certificates of deposit over $100,000. By 1972 the CD represented approximately 40% of all bank deposits. The certificate of deposit is now the second most popular money market instrument, behind only the T-bill. "

maturity

"The number of years or periods until the bond matures and the holder is paid the face amount."

Money market- Pension Funds

Maintain funds in money market instruments in readiness for investment in stocks and bonds -invest portion cash in money market so they can take advantage of investment opportunities that they may identify in the stock or bond markets -must have sufficient liquidity to meet their obligations -since their obligations are reasonably predictable, large money market security holdings aren't necessary

Global Financial Markets

Although the problem originated in the United States, the wake-up call for the financial crisis came from Europe, a sign of how extensive the globalization of financial markets had become. After Fitch and Standard & Poor's announced ratings downgrades on mortgage-backed securities and CDOs totaling more than $10 billion, on August 7, 2007, a French investment house, BNP Paribas, suspended redemption of shares held in some of its money market funds, which had sustained large losses. The run on the shadow banking system began, only to become worse and worse over time. Despite huge injections of liquidity into the financial system by the European Central Bank and the Federal Reserve, banks began to horde cash and were unwilling to lend to each other. The drying up of credit led to the first major bank failure in the United Kingdom in over 100 years, when Northern Rock, which had relied on short-term borrowing in the repo market rather than deposits for its funding, collapsed in September 2007. A string of other European financial institutions then failed as well. Particularly hard hit were countries like Greece, Ireland, Portugal, Spain, and Italy, which led to a sovereign debt crisis, which is described in the Global box, "The European Sovereign Debt Crisis." The global financial crisis in 2007-2009 led not only to a worldwide recession but also to a sovereign debt crisis that threatens to destabilize Europe. Up until 2007, all the countries that had adopted the euro found their interest rates converging to very low levels; but with the global financial crisis, several of these countries were hit very hard with the contraction in economic activity reducing tax revenues, while government bailouts of failed financial institutions required additional government outlays. The resulting surge in budget deficits then led to suspicions that the governments in these hard-hit countries would default on their debt. The result was a surge in interest rates that threatened to spiral out of control.* Greece was the first domino to fall in Europe. With a weakening economy reducing tax revenue and increasing spending demands, the Greek government in September 2009 was projecting a budget deficit for the year of 6% of GDP and a debt-to-GDP ratio near 100%. However, when a new government was elected in October, it revealed that the budget situation was far worse than anyone had imagined because the previous government had provided misleading numbers both about the budget deficit, which was at least double the 6% number, and about the amount of government debt, which was ten percentage points higher than previously reported. Despite austerity measures to dramatically cut government spending and raise taxes, interest rates on Greek debt soared, eventually rising to nearly 40%, and the debt-to-GDP ratio climbed to 160% of GDP in 2012. Even with bailouts from other European countries and liquidity support from the European Central Bank, Greece was forced to write down the value of its debt held in private hands by more than half, and the country was subject to civil unrest, with massive strikes and the resignation of the prime minister. The sovereign debt crisis spread from Greece to Ireland, Portugal, Spain, and Italy, with their governments forced to embrace austerity measures to shore up their public finances, while interest rates climbed to double-digit levels. Only with a speech in July 2012 by Mario Draghi, the president of the European Central Bank, in which he stated that the ECB was ready to do "whatever it takes" to save the euro, did the markets begin to calm down. Nonetheless, despite a sharp decline in interest rates in those countries, the countries experienced severe recessions, with unemployment rates rising to double-digit levels and Spain's unemployment rate exceeding 25%. The stresses that the European sovereign debt crisis produced for the Eurozone has raised doubts about the euro's survival

Junk Bond Market

Michael Milken @ Drexel Burnham Lambert noticed investors would be willing to take on greater risk if they were compensated with greater returns 2 problems: low liquidity/ no secondary market and real chance that issuers would default on payments Drexel agreed to make market for junk bonds. Stood ready to buy & sell bonds at all times, important bc most bondholders don't want to hold bond to maturity Milken acted as commercial bank for junk bond issuers to curb chances of default risk He would renegotiate firms debt or advance additional funds if needed to prevent firm from defaulting. his efforts worked, reduced default risk and demand for junk bonds increase early 80s: many firms took advantage of junk bonds to finance the takeover of other firms when a firm greatly increases its debt level by issuing junk bonds to finance the purchase of another firms stock, the increase in leverage makes the bonds high risk. sometimes part of acquired firm is sold to pay down debt incurred by issuing junk bonds Milken earned a 2-3% fee for each junk bond issue Drexel and Milken caught for insider trading, no longer able to support junk bond market The junk bond market had largely recovered since its low in 1990, but the financial crisis in 2008 again reduced the demand for riskier securities. This market behavior was rational, considering that in 2008 the default rate on speculative-grade bonds was three times that of investment-grade bonds.

Capital Market Trading

-occurs in primary market or secondary -well developed secondary market -money markets trade over the phone. Capital markets trade in organized exchanges

Interest Rates

- all money market instruments move closely together over time -bc all have low risk and short term -all have deep markets and competitive prices -bc they have similar risk and term characteristics, they are close subsititutes -if one rate temporarily departs from others, market supply and demand forced will correct eventually =responded rapidly to 07-08 recession, still at historic lows years later

book entry

-1976 treasury switched to BOOK ENTRY securities -no more engraved pieces of paper -ownership of treasury securities documented only in Fed's computer -ledger entry replaces actual security -reduces cost of issuing treasury securities & cost of transferring when bough & sold in secondary market

Interest Rate on Repos

-Collaterized with treasury securities, so low-risk, and low interest rates -rare, but losses have occurred in repo markets -07/08 crisis impacted repo market when value of the securitizing collateral came under scrutiny. -ability of borrowers to issue short-term debt was curtailed and market collapsed for a period of time

Other Eurocurrencies

-Eurodollar market is largest short term security market in the world -due to international popularity of U.S. dollar for trade -not just dollars -Account denominated in Japanese yen held in New York Bank, would be called Euroyen

Eurodollar Certificates of Deposit

-Eurodollars are time deposits with fixed maturities, so to a certain extent are ILLIQUID -Negotiable CDs created to combat that problem -Since most eurodollar deposits are short term to begin with, market for Eurodollar CDs is limited, makes up less than 10% of the amount of regular eurodollar deposits -market is still thin

Capital Market: Households and Individuals

-Largest purchases of capital market securities -frequently deposit funds in financial institutions that use the funds to purchase capital market instruments such as bonds pr stock

Risk

-T-bills have no default risk bc gov can always print more money if it ran out of money -risk of unexpected changes in inflation is also low bc of short term to maturity -deep and liquid market for t-bills -deep market: market with many buyers and sellers Liquid market: securities can be bought and sold quickly with low transaction costs -investors in deep and liquid markets have little risk that they won't be able to sell their securities when they want to

Negotiable Certificates of Deposit

-a bank issued security that documents a deposit and specifies the interest rate and the maturity date -term security, not a demand deposit -term security: specified maturity date -demand deposit: can be withdrawn at any time -also called BEARER INSTRUMENT, meaning whoever holds the instrument at maturity gets the principal and interest -can be bought and sold until maturity

Commercial Paper Terms and Issuance

-always has original maturity of less than 270 days, to avoid registering with SEC -to avoid registering with SEC, original maturity has to be less than 270 days and intended for current transactions -most commercial paper mature in 20-45 days -issued on discounted basis -60% of commercial paper is sold directly by issuer to buyer -balance is sold by dealer in commercial paper market -strong secondary market doesn't exist -dealer will redeem commercial paper for cash if emergency, but usually not necessary

Banker's Acceptances

-an order to pay a specified amount of money to the bearer on a given date -werent too big until international trade increase in 1960s -used to finance goods that have not yet been transferred from seller to buyer -Ex: Builtwell Construction Company wants to buy a bulldozer from Komatsu in Japan. Komatsu does not want to ship the bulldozer without being paid because Komatsu has never heard of Builtwell and realizes that it would be difficult to collect if payment were not forthcoming. Similarly, Builtwell is reluctant to send money to Japan before receiving the equipment. A bank can intervene in this standoff by issuing a banker's acceptance whereby the bank in essence substitutes its creditworthiness for that of the purchaser. -payable to bearer, so can be bought and sold until maturity -sold on discounted basis -dealers match up firms that want to discount a banker's acceptance (sell for immediate payment) with companies wanting to invest in bankers acceptance -low interest rates because low risk of default

Treasury Inflation-Protected Securities (TIPS)

-bond designed to remove inflation risk from holding treasury securities -inflation-indexed bonds -have an interest rate that does not change throughout the term of the security principal amount used to compute the interest payment does change based on the consumer price index At maturity, securities redeemed at the greater of their inflation-adjusted principal or par amount at original issue called inflation-indexed/ inflation-protected securities -give both individual and institutional investors a chance to buy a security whose value won't be eroded by inflation can be used by retirees who want to hold a very low-risk portfolio offered by Treasury in 5, 10, and 30 years

Terms of Negotiable Certificates of Deposit

-denominations range from $100k - $10 mil -Few are denominated below $1 million -CDs are so large because dealers have established the round lot size to be $1 million -Round lot: minimum quantity that can be traded without incurring higher than normal brokerage fees -maturity: 1-4 months, -sometimes 6 month maturity, but little demand for longer maturities

T-bill Auctions

-each week treasury announces how many and what kind of t-bills it will offer for sale -competetive and noncompetitive bidding -1976 treasury switched to BOOK ENTRY securities -auction I stock be highly competitive and fair. -to ensure competition, no one dealer can buy more than 35% of one issue. -40 primary dealers participate in auction

terms for fed funds

-fed funds usually overnight investments -banks analyze reserve position everyday and borrow or invest/lend depending on if they have excess or deficit reserves -bank sells excess funds to the bank that offers the highest rate -once agreement is reached, bank with excess funds tells Federal Reserve bank to take funds out of its account and put into borrowers account. -Next day, funds are transferred back and process begins again -borrowing are unsecured. -entire agreement is established by direct communication between buyer and seller

Purpose of Fed Funds

-federal reserve has set minimum reserve requirement that all banks must maintain -to meet requirements, banks have to keep certain % of their total deposits with the federal reserve -main purpose is to provide banks with an immediate infusion of reserves -banks can borrow directly from federal reserve, but fed discourages from regularly borrowing from it

Purpose of Capital Market

-firms and individuals use capital markets for long term investments -choose to borrow long term to reduce risk that interest rates will rise before they pay off their debt -reduction in risk comes at cost -Long term interest rates are higher than short term rates due to risk premiums -if borrowing with st securities, interest rate risk arises. -risk comes from the possibility of having to reissue at a high interest rate if interest rates increase after the securities have matured

Federal Funds Interest Rates

-forces of supply and demand set fed funds interest rate -gives indications of what is happening to short term rates -fed funds rate reported by press is effective rate, which is the weighted average of rates on trades through New York brokers -Federal Reserve can't directly control fed funds rates -Indirectly influences by adjusting level of reserves available to banks in the system -Fed can increase amount of money in the financial system by buying securities -When investors sell securities to Fed, the proceeds are deposited in their banks accounts at Federal Reserve. -These deposits increase supply of reserves in financial system and lowers interest rates -If fed removes reserves by selling securities, fed funds rates will increase _Fed usually announces intention to raise or lower fed funds rate in advance through FOMC. -doesnt really affect business or consumers -but indicates direction that Federal Reserve wants the economy to move in -T bill and Fed funds rate track together

Use of Repurchase Agreements

-gov securities dealers frequently engage in repos -dealer might sell securities to bank with promise to buy back the next day -essentially short term collaterized loan -dealers use the repo to manage their liquidity and to take advantage of anticipated changes in interest rates -Federal Reserve uses repos to conduct monetary policy -Fed adjusts bank reserves on a temporary basis. To do this, Fed buys or sells Treasury securities in repo market. -MATURITIES OF FEDERAL RESERVE REPOS NEVER EXCEED 15 DAYS

t-bill noncompetitive bidding

-investors only state the amount of securities they want -treasury accepts all noncompetitive bids -price is set as the highest yield paid to any accepted competitive bid -pay the same price as competitive bidders -guranteed to buy securities

t-bill competitive bidding

-investors state amount of securities desired & price they're willing to pay -accepts bids offering highest price -treasury accepts competitive bids in ascending order of yield until accepted bids reach the offering amount. -each accepted bid is then awarded at the highest yield paid to any accepted bid -may or may not end up buying securities

Call Provisions: 4 reasons

-issuer has the right to force the holder to sell bond back -usually requires waiting period between issuance and when it can be called -price bondholders are paid is usually set at bonds par price or slightly higher 1. if interest rates fall, price of bond rises. If rates fall enough, price will rise above call price and firm will call the bond -put a limit on amount bondholders can earn from appreciation bonds price, so investors dont like call provisions 2. makes it possible for issuers to buy back bonds according to terms of the sinking fund -sinking fund: requirement in bond indenture that firm pay off portion of bond issue each year -^attratictive to bondholders bc reduces probability of default when issue matures -sinking fund makes issue more attractive & reduces bonds interest rate 3. firms might have to retire bond issue if its covenants restrict firm from some activity that it feels is in best interest of stockholders. (WANTS TO BORROW MORE FOR A WAREHOUSE BUT BONDS COVENANT DOESNT ALLOW, SO IT HAS TO CALL BONDS EARLY SO IT CAN BORROW MORE TO BUILD THIS WAREHOUSE) 4. if firm wants to alter its capital structure. A maturing firm with excess cash flow might wish to reduce its debt load if few attractive investment opportunities are available BONDHOLDERS DONT LIKE CALL PROVISIONS SO CALLABLE BONDS MUST HAVE HIGHER YIELD THAN NONCALLABLE BONDS even though callable bonds cost more, most corporations still issue because of their flexibility

Eurodollars

-many contracts want U.S. dollars as payment bc of dollar's stability -many foreign companies and governments choose to hold dollars -before ww2, most of these deposits were held in New York money center banks -bc of Cold War, there was fear that deposits held on U.S. soil could be expropriated. -Some big London banks started offering to hold dollar-denominated deposits in British banks, called "Eurodollars" -eurodollar market grew rapidly -mainly grew bc depositors often receive higher rate of return on a dollar deposit in the Eurodollar market than in their domestic market. -Also, Borrower is able to receive more favorable rate in Eurodollar market than in their domestic market bc multinational markets are not subject to the same regulations restricting U.S. banks and bc they're willing and able to accept narrower spreads between interest paid on deposits and interest earned on loans

Treasury Bills

-most widely held & liquid -used to finance debt -4, 13, 26, 52 week maturities -$100 minimum denotation ($1000 before 2008) -Federal Reserve is Treasury's agent for distribution of all gov securities, set up a direct purchase option that people can use to buy t-bills online. started in 1998 to make t-bills more widely available -gov doesn't pay interest on t-bills, they are issued at a discount from par value. Investor's yield comes from the increase in value of security between time it was purchased and time it matures

Interest Rate on CDs

-rate is negotiated between bank and customer -similar to rate paid on other money market instruments because risk level is low -large money center banks can offer lower rates than other banks because many investors believe that the government would never allow one of the nation's largest banks to fail -this belief makes these banks obligations less risky

Bonds

-securities that represent a debt owed by the issuer to the investor -obligate issuer to pay specific amount at given date, with periodic interest payments -par/face/maturity value: amount that issuer must pay at maturity -coupon rate: rate of interest that issuer must pay -coupon payment: ^periodic interest payment rate: fixed for duration of bond, doesn't fluctuate with market rates If repayment terms of bond are not met, bondholder has claim on issuers assets

Federal Funds

-short term funds transferred (loaned OR borrowed) between financial institutions, usually for a period of one day -have nothing to do with federal gov -funds are held at the Federal Reserve bank -began in 1920s when banks with excess reserves loaned them to banks that needed them -interest rate for borrowing fed funds is close to rate that federal reserve charged on discount loans

Conversion

-some bonds can be converted into shares of common stock -allows bondholders to benefit if stock price rises convertible bonds will state that bond can be converted into certain # of common shares at discretion bondholder conversion ratio will be such that price of stock has to rise substantially before conversion is likely to occur issued to avoid sending negative signal to market in presence of asymmetric info, when firm issues stock market usually interprets as indicating that stock price is high or that its going to fall in future. market makes this interpretation bc it believes managers are most concerned with looking out for interests of existing stockholders and won't issue stock when its undervalued if managers think firm will perform well in future they can issue convertible bonds instead if managers are correct and stock price rises, bondholders can convert to stock at high price that managers think is fair bondholder can choose not to convert if managers end up being wrong about companies future bondholders like conversion feature, similar to buying just a bond but receiving both stock and bond option convertible bonds price is higher than nonconvertible higher price, so lower interest rate

T-bill interest rates

-t-bills very close to being risk free -since its risk-free, interest earned on t-bill is among lowest in economy -some years earnings dont even compensate for changes in purchasing power due to inflation -real rate o interest has occasionally been less than 0. -Many time inflation rate matched or exceeded t-bill rates. -thus, investing in t-bills is mainly for temporary storage of excess funds bc might not even keep up with inflation

Commercial Paper

-unsecured promissory notes -issued by corporations -mature in no more than 270 days -unsecured, so only largest & creditworthy corporations issue them -interest rate reflects firms level of risk

Commercial Paper Market

-used by nonbank corporations to finance the loans that they extend to customers -600-800 firms issue commercial paper, depending on interest rates -most firms use 1 of 30 commercial paper dealer who match up buyers and seller -some large issuers distribute securities with direct placements -direct placement: issuer bypasses dealer and sells directly to end investor, issuer saves .125% commission charge from dealer -most issuers back up paper with line credit at bank -if issuer can't pay off or roll over paper, bank will lend firm funds to do so -line of credit reduces risk to paper buyers and lowers interest rate -bank agrees in advance to make a loan to issuer if needed to pay off paper, bank charges 0.5-1% fee for this commitment. -issuers agree to fee bc they're able to save more than this in lowered interest costs by having the line of credit -commercial banks were original buyer of commercial paper -market has expanded to insurance companies, nonfinancial businesses, bank trust departments, gov pension funds. -relatively low default risk, short maturity, higher yields

Types of mortgage Loans

Conventional, Insured, ARM (Adjustable-Rate), GPM (Graduated Payment), Growing-Equity (GEM), Second, Reverse Annuity

How to find value of a security

1. Identify the CFs that result from owning the security 2. Determine discount rate required to compensate investor for holding the security 3. Find PV of CFs estimated in step 1 using discount rate determined in step 2

4 Problems trying to sell Mortgages

1. Too small to be wholesale instruments. Avg mortgage loan is $250000, Round lot for commercial papers in $5 mil. Most institutional investors dont want to deal in such small denominations 2. mortgages aren't standardized. different times to maturity, interest rates, and contract terms. Makes it difficult to bundle large # of mortgages together 3. Mortgages are costly to service. Lender must collect monthly payments, pay property tax, insurance, and service reserve accounts. Compared to bond, much more costly. dont have to do all that w bonds 4. mortgages have unknown default risk. Investors in mortgages dont want to expend energy evaluating credit of borrowers. All of these problems led to creation of mortgage-backed security. securitized mortgage

Summary Factors That Shift the Demand Curve for Domestic Assets and Affect the Exchange Rate

1. When the interest rates on domestic assets, iD, rise, the expected return on dollar assets rises at each exchange rate and so the quantity demanded increases. The demand curve therefore shifts to the right, and the equilibrium exchange rate rises 2. When the foreign interest rate iF rises, the return on foreign assets rises, so the relative expected return on dollar assets falls. The quantity demanded of dollar assets then falls, the demand curve shifts to the left, and the exchange rate declines, 3. When the expected price level is higher, our analysis of the long-run determinants of the exchange rate indicates that the value of the dollar will fall in the future. The expected return on dollar assets thus falls, the quantity demanded declines, the demand curve shifts to the left, and the exchange rate falls, 4. With higher expected trade barriers, the value of the dollar is higher in the long run and the expected return on dollar assets is higher. The quantity demanded of dollar assets thus rises, the demand curve shifts to the right, and the exchange rate rises, 5. When expected import demand rises, we expect the exchange rate to depreciate in the long run, so the expected return on dollar assets falls. The quantity demanded of dollar assets at each value of the current exchange rate therefore falls, the demand curve shifts to the left, and the exchange rate declines, 6. When expected export demand rises, the opposite occurs because the exchange rate is expected to appreciate in the long run. The expected return on dollar assets rises, the demand curve shifts to the right, and the exchange rate rises 7. With higher expected domestic productivity, the exchange rate is expected to appreciate in the long run, so the expected return on domestic assets rises. The quantity demanded at each exchange rate therefore rises, the demand curve shifts to the right, and the exchange rate rises

Factors that Affect Exchange Rates in the Long Run

4 major factors: relative price levels, tariffs and quotas, preferences for domestic vs foreign foods, and productivity Anything that increases demand for domestic goods appreciates domestic currency bc domestic goods will continue to sell even when value of domestic currency is higher Anything that increases demand for foreign goods depreciates domestic currency bc domestic goods will continue to sell well only if value of domestic currency is lower if a factor increases the demand for domestic goods relative to foreign goods, the domestic currency will appreciate; if a factor decreases the relative demand for domestic goods, the domestic currency will depreciate.

Money Market- Money Market mutual funds

Allow small investors to participate in the money market by aggregating their funds to invest in large-denomination money market securities

Mortgage Pool/ Securitization

An alternative to selling mortgages directly to investors in to create a new security backed/secured by a large number of mortgages assembled into what is called a MORTGAGE POOL A trustee, such as bank or gov agency holds the mortgage pool which serves as collateral for the new security. Process is called securitization mortgage pools became so popular bc they permitted the creation of new securities (like mortgage pass-throughs) that made investing in mortgage loans much more efficient. For example, an institutional investor could invest in one large mortgage pass-through secured by a mortgage pool rather than invest in many small and dissimilar mortgage contracts. The slump in the real estate market and losses to mortgage pool investors led to a sharp decline in their popularity after 2009, and this market has not yet recovered.

Why are exchange rates so volatile?

Asset Market Approach gives explanation Because expected appreciation of domestic currency affects expected return on domestic assets, price level expectation, inflation, trade barriers, productivity, import demand, export demand, and future monetary policy play important roles in determining the exchange rate. When expectations about any of these variables change, the expected return on domestic assets, and exchange rate, will be affected. Because expectations on all these variables change with just about every bit of news that appears, it is not surprising that the exchange rate is volatile. earlier models of exchange rate behavior focused on goods markets rather than asset markets, they did not emphasize changing expectations as a source of exchange rate movements, and so these earlier models could not predict substantial fluctuations in exchange rates. The failure of earlier models to explain volatility is one reason why they are no longer so popular. The more modern approach developed here emphasizes that the foreign exchange market is like any other asset market in which expectations of the future matter. The foreign exchange market, like other asset markets such as the stock market, displays substantial price volatility, and foreign exchange rates are notoriously hard to forecast.

Factors that Affect Exchange Rates in the Long Run: Trade Barriers

Barriers to free trade: tariffs and quotas tariff: taxes on imported goods quotas: restrictions on quantity of foreign foods that be imported U.S. increases tariffs or puts lower quota on Japanese steel Increase in trade barriers increases demand for American steel, dollar appreciates bc American steel will still sell well even with higher value of the dollar Increasing Trade Barriers causes a country currency to appreciate in the long run

Effect of a Rise in the Domestic Interest Rate as a Result of an Increase in Expected Inflation

Because a rise in domestic expected inflation leads to a decline in expected dollar appreciation that is larger than the increase in the domestic interest rate, the relative expected return on domestic (dollar) assets falls. The demand curve shifts to the left, and the equilibrium exchange rate falls from E1 to E2.

History of Commercial Paper

Commercial paper has been used in various forms since the 1920s. In 1969 a tight-money environment caused bank holding companies to issue commercial paper to finance new loans. In response, to keep control over the money supply, the Federal Reserve imposed reserve requirements on bank-issued commercial paper in 1970. These reserve requirements removed the major advantage to banks of using commercial paper. Bank holding companies still use commercial paper to fund leasing and consumer finance. The use of commercial paper increased substantially in the early 1980s because of the rising cost of bank loans. Figure 11.4 graphs the interest rate on commercial paper against the bank prime rate for the period January 1990-April 2016. Commercial paper has become an important alternative to bank loans primarily because of its lower cost.

T-Bill Auction Case

Every Thursday the Treasury announces how many 28-day, 91-day, and 182-day Treasury bills it will offer for sale. Buyers must submit bids by the following Monday, and awards are made the next morning. The Treasury accepts the bids offering the highest price. "The Treasury auction of securities is supposed to be highly competitive and fair. To ensure proper levels of competition, no one dealer is allowed to purchase more than 35% of any one issue. About 40 primary dealers regularly participate in the auction." "Salomon Smith Barney had broken the rules to corner the market cast the fairness of the auction in doubt. Salomon Smith Barney purchased 35% of the Treasury securities in its own name by submitting a relatively high bid. It then bought additional securities in the names of its customers, often without their knowledge or consent" "Salomon then bought the securities from the customers. As a result of these transactions, Salomon cornered the market and was able to charge a monopoly-like premium. The investigation of Salomon Smith Barney revealed that during one auction in May 1991, the brokerage managed to gain control of 94% of an $11 billion issue. During the scandal that followed this disclosure, John Gutfreund, the firm's chairman, and several other top executives with Salomon retired. The Treasury has instituted new rules since then to ensure that the market remains competitive."

CMO (Collaterized Mortgage Obligation)

FLHMC market innovation securities classified by when prepayment is likely to occur offered in different maturity groups help reduce prepayment risk, which is a problem with other types of pass through securities CMOs that are backed by a particular mortgage pool are divided into tranches (slices) When principal is repaid, investors in first tranche are paid first, then second, and so on. Investors choose a tranche that matches their maturity requirements. Ex: you need cash in a few years, buy tranche 1 or 2 CMOs. If you want a LT investment, buy CMOs from last tranche risk varies also tranches paid off first are less likely to see a default than those paid off last Even when investor buys CMO, there's no guarantee about how long investment will last. If interest rates fall, many borrowers might pay off their mortgages early by refinancing at lower rates

How Market Sets Security Prices

First, price is set by buyer willing to pay the highest price. The price is not necessarily the highest price the asset could sell for, but is greater than what any other buyer is willing to pay 2nd, market price will be set by buyer who can take best advantage of the asset, will be sold to the buyer who can put the asset to the most productive use. Consider why one company often pays a substantial premium over current market prices to acquire ownership of another (target) company. The acquiring firm may believe that it can put the target firm's assets to work better than they are currently and that this justifies the premium price. Superior information about an asset can increase its value by reducing its risk Buyer who has the best info about future cash flows will discount them at a lower interest rate than will a buyer who is very uncertain the investor with the lowest perceived risk is willing to pay the most for the stock the players in the market, bidding against each other, establish the market price. when new info is released about a firm, expectations change, and with them prices also change new info can cause changes in expectation about the level of future dividends or the risk of those dividends since market participants are constantly receiving new info and revising expectations, its reasonable that stock prices are constantly changing as well

Example Law of One Price Recently, the yen price of Japanese steel has increased by 10% (to 11,000 yen) relative to the dollar price of American steel (unchanged at $100). By what amount must the dollar increase or decrease in value for the law of one price to hold true?

For the law of one price to hold, the exchange rate must rise to 110 yen per dollar, which is a 10% appreciation of the dollar. The exchange rate rises to 110 yen so that the price of Japanese steel in dollars remains unchanged at $100 (11,000/110 yen per dollar). In other words, the 10% depreciation of the yen (10% appreciation of the dollar) just offsets the 10% increase in the yen price of the Japanese steel.

Types of Pass-Through Securites

GNMA pass-throughs, FHLMC pass-throughs, private pass throughs

Law of One Price

If 2 countries produce an identical good, and transportation costs and trade barriers are low, the price of the good should be the same throughout the world no matter which country produces it. Ex: American Steel costs $100 per ton. Japanese Steel costs 10,000 yen per ton. For Law of One Price to hold, exchange rate must be 100 Yen per Dollar, or $0.01 per yen So that one ton of American Steel sells for the price of Japanese steel and vice versa If exchange rate was 200 yen to $1, Japanese Steel would sell for $50 per ton in U.S. (half the price of American steel) American Steel would sell for 20000 yen per ton in Japan (twice the price of Japanese Steel) American steel is identical to Japanese steel but would be more expensive in both countries, so the demand for American steel would go to 0. Given a fixed dollar price for American Steel, the excess supply of American steel will only go away if exchange rate falls to 100 yen per dollar making the price of Japanese and American steel the same in both countries

Factors that Affect Exchange Rates in the Long Run: Preferences for Domestic vs Foreign Goods

If Japanese starts liking American oranges, the increased demand for American goods (exports) appreciates American dollar because American goods will continue to sell well even at a higher value for the dollar If Americans like Japanese Cars most, increased demand for Japanese goods (imports) depreciates the dollar Increased demand for a country's exports causes its currency to appreciate in the long run; conversely, increased demand for imports causes the domestic currency to depreciate.

excess demand

If exchange rate < equilibrium rate, quantity of dollars demanded will exceed quantity supplied (Excess Demand) more people want to buy dollar assets than want to sell them, the value of the dollar will rise until the excess demand disappears and the value of the dollar is again at the equilibrium exchange rate of 1 euro per dollar.

9/11 and stock market

In 2001 two big shocks hit the stock market: the September 11 terrorist attack and the Enron scandal. Our analysis of stock price evaluation, again using the Gordon growth model, can help us understand how these events affected stock prices. The September 11 terrorist attack raised the possibility that terrorism against the United States would paralyze the country. These fears led to a downward revision of the growth prospects for U.S. companies, thus lowering the dividend growth rate g in the Gordon model. The resulting rise in the denominator in Equation 5 should lead to a decline in P0 and hence a decline in stock prices. Increased uncertainty for the U.S. economy would also raise the required return on investment in equity. A higher ke also leads to a rise in the denominator in Equation 5, a decline in P0, and a general fall in stock prices. As the Gordon model predicts, the stock market fell by over 10% immediately after September 11. Subsequently, the U.S. successes against the Taliban in Afghanistan and the absence of further terrorist attacks reduced market fears and uncertainty, causing g to recover and ke to fall. The denominator in Equation 5 then fell, leading to a recovery in P0 and the stock market in October and November. However, by the beginning of 2002, the Enron scandal and disclosures that many companies had overstated their earnings caused many investors to doubt the formerly rosy forecast of earnings and dividend growth for corporations. The resulting revision of g downward, and the rise in ke because of increased uncertainty about the quality of accounting information, should have led to a rise in the denominator in the Gordon Equation 5, thereby lowering P0 for many companies and hence the overall stock market. As predicted by our analysis, this is exactly what happened. The stock market recovery was aborted and it entered a downward slide.

Debentures

LT unsecured bonds backed only by creditworthiness of issuer no collateral pledged to repay debt in event of default, bondholders have to go to court to seize assets collateral pledged to other debtors not available to holders of debentures have an attached contract that states terms of bond and management responsibilities indenture: contract attached to debenture lower priority than secured bonds if firm defaults higher interest rates

Capital Market LT Bonds

Long Term government notes and bonds, municipal bonds corporate bonds

Online Mortgages

One business area that has been significantly affected by the Web is mortgage banking. Historically, borrowers went to local banks, savings and loans, and mortgage banking companies to obtain mortgage loans. These offices packaged the loans and resold them. In recent years, hundreds of new Web-based mortgage banking companies have emerged. The mortgage market is well suited to providing online service for several reasons. First, it is information-based and no products have to be shipped or inventoried. Second, the product (a loan) is homogeneous across providers. A borrower does not really care who provides the money as long as it is provided efficiently. Third, because home buyers tend not to obtain mortgage loans very often, they have little loyalty to any local lender. Finally, online lenders can often offer loans at lower cost because they can operate with lower overhead than firms that must greet the public. The online mortgage market makes it much easier for borrowers to shop interest rates and terms. By filling out one application, a borrower can obtain a number of alternative loan options from various Web service companies. Borrowers can then select the option that best suits their requirements. Online mortgage firms, such as Lending Tree, have made mortgage lending more competitive. This may lead to lower rates and better service. It has also led lenders to offer an often confusing array of loan alternatives that most borrowers have difficulty interpreting. This makes comparison shopping more difficult than simply comparing interest rates. Borrowers using online services to shop for loans must be aware that scam artists have found this an easy way to obtain personal information. They set up a bogus loan site and offer extremely attractive interest rates to draw in customers. Once they have collected all the information needed to wipe out your checking, savings, and credit card accounts, they close their site and open another.

Discount Point Decision

Option 1: Interest=12%, no discount points Option 2: pay 2 discount points, interest= 12.5% Which to choose? First, compute EAR without discount points If loan is paid off early, not held until maturity, borrower will benefit from lower interest rate for a shorter length of time and the discount points are spread over a shorter period of time Effective interest Rate rises the shorter the time the loan is held before being paid

Why PPP can't fully explain Exchange Rates

PPP conclusion that exchange rates are determined solely by changes in relative price levels relies on assumption that all goods are identical in both countries and that transportation costs and trade barriers are low When this assumption is true, law of one price states that relative prices of all these goods (relative price level between the two countries) will determine the exchange rate. assumption that goods are identical works for American and Japanese steel, but not for American and Japanese cars. Toyota and Chevy different not identical, so prices dont have to be equal Toyotas can be more expensive than Chevys and Americans and Japanese will still buy toyotas Law of one price doesn't hold for all goods so Toyota price increase compared to chevy doesn't mean that Yen has to depreciate by the amount of the relative price increase of Toyotas over Chevys PPP theory does not take into account that many goods and services (whose prices are included in a measure of a country's price level) are not traded across borders. Housing, land, and services such as restaurant meals, haircuts, and golf lessons are not traded goods. So even though the prices of these items might rise and lead to a higher price level relative to another country's, the exchange rate would experience little direct effect.

Price Earnings Valuation Method

Price Earnings Ratio/ PE Ratio widely watched measure of how much market is willing to pay for $1 of earnings from a firm can be used to estimate the value of a firms stock firms in same industry are expected to have similar PE ratios in long run value of firms stock can be found by multiplying average industry PE time expected EPS (earnings per share) useful for valuing privately held firms and firms that dont pay dividends weakness: by using industry average PE ratio, firm specific factors that might contribute to a LT PE ratio above or below the average are ignored in the analysis. Skilled analyst will adjust PE ratio up or down to reflect unique characteristic of a firm when estimating stock price

Capital Market Participants

Primary issuers: federal & local gov, corporations

Financial Grantees for Bonds

Purchased by financially weaker issuers to lower risk of their bonds ensures that lender will be paid both principal and interest in the event the issuer default basically insurance policies to back bond issues, written by large well known insurance companies buyers dont have to be super concerned about financial health of issuing company, just in the strength of the insurer credit rating of insurer substituted for credit rating issuer reduction in risk lowers interest rate demanded by buyers issuers must pay fee to insurance company for the guarantee buying guarantees only makes sense when cost of the insurance is less than the interest savings that result Credit Default Swap (CDS) is another option

London Interbank Market

Some large London banks act as brokers in the interbank Eurodollar market. Recall that fed funds are used by banks to make up temporary shortfalls in their reserves. Eurodollars are an alternative to fed funds. Banks from around the world buy and sell overnight funds in this market. The rate paid by banks buying funds is the London interbank bid rate (LIBID). Funds are offered for sale in this market at the London interbank offer rate (LIBOR). Because many banks participate in this market, it is extremely competitive. The spread between the bid and the offer rate seldom exceeds 0.125%. Eurodollar deposits are time deposits, which means that they cannot be withdrawn for a specified period of time. Although the most common time period is overnight, different maturities are available. Each maturity has a different rate. The overnight LIBOR and the fed funds rate tend to be very close to each other. This is because they are near-perfect substitutes. Suppose that the fed funds rate exceeds the overnight LIBOR. Banks that need to borrow funds will borrow overnight Eurodollars, thus tending to raise rates, and banks with funds to lend will lend fed funds, thus tending to lower rates. The demand-and-supply pressure will cause a rapid adjustment that will drive the two rates together. At one time, most short-term loans with adjustable interest rates were tied to the Treasury bill rate. However, the market for Eurodollars is so broad and deep that it has recently become the standard rate against which others are compared. For example, the U.S. commercial paper market now quotes rates as a spread over LIBOR rather than over the T-bill rate. The Eurodollar market is not limited to London banks anymore. The primary brokers in this market maintain offices in all of the major financial centers worldwide.

indenture

The contract that accompanies a bond and specifies the terms of the loan agreement. It includes management restrictions, called covenants.

current yield

The coupon interest payment divided by the current market price of the bond.

Current Yield Summarized

The current yield better approximates the yield to maturity when the bond's price is nearer to the bond's par value and the maturity of the bond is longer. It becomes a worse approximation when the bond's price is further from the bond's par value and the bond's maturity is shorter. Change in Current yield ALWAYS signals change in same direction of YTM

"Collateralized Debt Obligations (CDOs)"

The creation of a collateralized debt obligation involves a corporate entity called a special purpose vehicle (SPV), which buys a collection of assets such as corporate bonds and loans, commercial real estate bonds, and mortgage-backed securities. The SPV then separates the payment streams (cash flows) from these assets into a number of buckets that are referred to as tranches. The highest-rated tranches, called super senior tranches, are the ones that are paid off first and so have the least risk. The super senior CDO is a bond that pays out these cash flows to investors, and because it has the least risk, it also has the lowest interest rate. The next bucket of cash flows, known as the senior tranche, is paid out next; the senior CDO has a little more risk and pays a higher interest rate. The next tranche of payment streams, the mezzanine tranche of the CDO, is paid out after the super senior and senior tranches and so it bears more risk and has an even higher interest rate. The lowest tranche of the CDO is the equity tranche; this is the first set of cash flows that are not paid out if the underlying assets go into default and stop making payments. This tranche has the highest risk and is often not traded. If all of this sounds complicated, it is. There were even CDO2s and CDO3s that sliced and diced risk even further, paying out the cash flows from CDOs to CDO2s and from CDO2s to CDO3s. Although financial engineering has the potential benefit of creating products and services that match investors' risk appetites, it too has a dark side. Structured products like CDOs, CDO2s, and CDO3s can get so complicated that it can be hard to value cash flows of the underlying assets for a security or to determine who actually owns these assets. Indeed, at a speech given in October 2007, Ben Bernanke, the chairman of the Federal Reserve, joked that he "would like to know what those damn things are worth." In other words, the increased complexity of structured products can actually reduce the amount of information in financial markets, thereby worsening asymmetric information in the financial system and increasing the severity of adverse selection and moral hazard problems. Not surprisingly, adverse selection became a major problem. Risk-loving investors lined up to obtain loans to acquire houses that would be very profitable if housing prices went up, knowing they could "walk away," i.e., default on their loans, if housing prices went down. The principal-agent problem also created incentives for mortgage brokers to encourage households to take on mortgages they could not afford or to commit fraud by falsifying information on a borrower's mortgage applications in order to qualify them for mortgages. Compounding this problem was lax regulation of originators, who were not required to disclose information to borrowers that would have helped them assess whether they could afford the loans. The agency problems went even deeper. Commercial and investment banks, which were earning large fees by underwriting mortgage-backed securities and structured credit products like CDOs, also had weak incentives to make sure that the ultimate holders of the securities would be paid off. Financial derivatives, financial instruments whose payoffs are linked to (i.e., derived from) previously issued securities, also were an important source of excessive risk taking. Large fees from writing financial insurance contracts called credit default swaps, which provide payments to holders of bonds if they default, also drove units of insurance companies like AIG to write hundreds of billions of dollars' worth of these risky contracts.

market rate

The interest rate currently in effect in the market for securities of similar risk and maturity. The market rate is used to value bonds.

face amount

The maturity value of the bond. The holder of the bond will receive the face amount from the issuer when the bond matures. Face amount is synonymous with par value.

Real Estate Bubble

The mortgage market was heavily influenced by the real estate boom and bust between the years 2000 and 2008. Between 2000 and 2005 home prices increased an average of 8% per year. They increased 17% in 2005 alone. The run-up in prices was caused by two factors. The first was the increase in subprime loans discussed previously. With more people now qualifying for loans, there was increased demand. This meant that over a very short period many new buyers were now qualified to purchase homes. While home construction increased, it could not keep pace with demand. Real estate speculators were a second driver of the price bubble. People of all walks of life started noticing that quick and apparently easy money was to be made by buying real estate for the purpose of resale. The ability to obtain zero down loans allowed them to buy property easily and with little committed capital. They could then resell the property at a higher price. Many development projects were sold out before they were even started. The buyers were often speculators with no intention of occupying the property. Condominiums were especially popular, since they did not require much upkeep by the owner until the next sale could be arranged. At times, speculators were selling to other speculators as the demand drove up prices. As with most speculative bubbles, at some point the process ends. Default rates on the subprime mortgages increased, and the extent of speculation started to make the news. Those left owning properties bought at the height of the market suffered losses, including lending institutions and investors in mortgage-backed securities. In the aftermath of a mortgage-fueled financial meltdown, lending policies have largely returned to selecting capable borrowers. One indication of this is the decline in global CDO issuance. It peaked at $520 billion in 2006. By 2009 it had fallen to $4.3 billion. The market recovered somewhat such that between 2013 and 2015 it was hovering around $100 billion.22 Source: http://www.sifma.org/research/statistics.aspx. The securitized mortgage was initially hailed as a method for reducing the risk to lenders by allowing them to sell off a portion of their loan portfolio. The lender could continue making loans without having to retain the risk. Unfortunately, this led to increased moral hazard. By separating the lender from the risk, riskier loans were issued than would have been had the securitized mortgage channel not existed. Individual firm risk may have been reduced, but systemic risk greatly increased.

coupon interest rate

The stated annual interest rate on the bond. It is usually fixed for the life of the bond.

2007-2008 financial crisis and stock market

The subprime financial crisis that started in August 2007 led to one of the worst bear markets in the past 50 years. Our analysis of stock price valuation, again using the Gordon growth model, can help us understand how this event affected stock prices. The subprime financial crisis had a major negative impact on the economy, leading to a downward revision of the growth prospects for U.S. companies, thus lowering the dividend growth rate (g) in the Gordon model. The resulting increase in the denominator in Equation 5 would lead to a decline in P0 and hence a decline in stock prices. Increased uncertainty for the U.S. economy and the widening credit spreads resulting from the subprime crisis would also raise the required return on investment in equity. A higher ke also leads to an increase in the denominator in Equation 5, a decline in P0, and a general fall in stock prices. In the early stages of the financial crisis, the decline in growth prospects and credit spreads were moderate and so, as the Gordon model predicts, the stock market decline was also moderate. However, when the crisis entered a particularly virulent stage, credit spreads shot through the roof, the economy tanked, and as the Gordon model predicts, the stock market crashed. Between January 6, 2009, and March 6, 2009, the Dow Jones Industrial Average fell from 9,015 to 6,547. Between October 2007 (high of 14,066) and March 2009, the market lost 53% of its value. Within a year the index was back over 10,000.

yield to maturity (YTM)

The yield an investor will earn if the bond is purchased at the current market price and held until maturity.

Factors that Change the Exchange Rate

Theory of Portfolio Choice tells us that changes in the relative expected return on dollar assets are the source of shifts in the demand curve Remember to understand which direction demand curve shifts, what happens to the relative expected return when the factor changes If relative return rises, demand curve shifts right If relative return decreases, demand curve shifts left

Why Do Conflicts of Interest Arise?

Three types of financial service activities have led to prominent conflicts-of-interest problems in financial markets in recent years: underwriting and research in investment banks, auditing and consulting in accounting firms, and credit assessment and consulting in credit-rating agencies.

TRADE

Trade Reporting and Compliance Engine opened bond market to scrutiny 2 missions: 1. Rules that say which bond transactions must be publicly reported 2. The establishment of a trading platform that makes transaction data readily available to the public under FINRA (Financial Industry Regulatory Authority) all companies that trade securities are required to be apart of FINRA most common violations of rules that result in fines or charges relate to anti-money laundering, distribution of securities, quality of markets, reporting and record keeping, sales practices, and supervision

Agency Bonds

U.S. agencies authorized by Congress, called Government-Sponsored Enterprises (GSEs) to issue these bonds Gov doesn't guarantee agency bonds, but investors think gov wouldn't let them default Issuers: Sallie Mae (student loans) Farmers Home Admin, Fed Housing Admin, Vet Admin, Fed Land Banks issued by agencies to raise funds that are used for purposes that Congress has deemed to be in the national interest. (Sallie Mae Student Lonas) -low risk - ^bc secured by loans made with the funds raised by bond sales -^ also bc fed agencies can use their lines of credit with Treasury if they can't make the payments -^also bc unlikely that fed gov would let their agencies default -ex is Fannie Mae and Freddie Mac bailout (bunch of subprime mortgage loans, were about to default on bonds, then gov stepped in to guarantee payment )

American Depository Receipts (ADRs)

U.S. bank buys the shares of a foreign company and places them in its vault Bank then issues receipts against these shares and the receipts can be traded domestically, usually on NASDAQ Trade in ADRs conducted entirely in U.S. dollars and bank converts stock dividends into U.S. currency advantage: allows foreign firms to trade in U.S. without them having to meet SEC disclosure rules As the worldwide recession of 2008 demonstrated, while volatility peculiar to one country can be reduced by diversification, the degree of economic interconnectivity among nations means that some risk always remains. Nevertheless, interest is particularly keen in the stocks of firms in emerging economies such as Mexico, Brazil, and South Korea.

discount or premium?

What determines whether a bond will sell for a premium or a discount? Suppose that you are asked to invest in an old bond that has a coupon rate of 10% and $1,000 par. You would not be willing to pay $1,000 for this bond if new bonds with similar risk were available yielding 12%. The seller of the old bond would have to lower the price on the 10% bond to make it an attractive investment. In fact, the seller would have to lower the price until the yield earned by a buyer of the old bond equaled the yield on similar new bonds. This means that as interest rates in the market rise, the value of bonds with fixed coupon rates falls. Similarly, as interest rates available in the market on new bonds fall, the value of old fixed-coupon-rate bonds rises.

Factors that Affect Exchange Rates in the Long Run : Relative Price Levels

When Price of American goods rise, demand for American good falls and dollar depreciates so that American goods can still sell well If Prices of Japanese goods rise so that price of American goods fall, demand for American goods rises and dollar appreciates bc American goods will keep selling well even with a higher value of domestic currency In the long run, a rise in a country's price level (relative to the foreign price level) causes its currency to depreciate, and a fall in the country's relative price level causes its currency to appreciate.

Currency Appreciation and Depreciation

When a country's currency appreciates (rises in value relative to other currencies), the country's goods abroad become more expensive and foreign goods in that country become cheaper (holding domestic prices constant in the two countries). Conversely, when a country's currency depreciates, its goods abroad become cheaper and foreign goods in that country become more expensive.

Factors that Affect Exchange Rates in the Long Run : Productivity

When countries productivity rises, usually rises in domestic sectors that produce traded goods rather than nongraded goods higher productivity is associated with a decline in price of domestically produced traded goods relative to foreign traded goods Demand for traded domestic goods rise, and domestic currency appreciates If countries productivity is lacking, its traded goods become expensive and currency depreciates In the long run, as a country becomes more productive relative to other countries, its currency appreciates. A country might be so small that a change in productivity or the preferences for domestic or foreign goods would have no effect on prices of these goods relative to foreign goods. In this case, changes in productivity or changes in preferences for domestic or foreign goods affect the country's income but will not necessarily affect the value of the currency. In our analysis, we are assuming that these factors can affect relative prices and consequently the exchange rate.

Domestic Interest Rate

When domestic interest rate on dollar assets increases, return on dollar assets increases, people will want mare dollar assets Quantity of dollar assets demanded increases at every value of the exchange rate. Rightward shift of demand curve Equilibrium exchange rate rises An increase in the domestic interest rate iD shifts the demand curve for domestic assets, D, to the right and causes the domestic currency to appreciate (E ↑). Conversely if iD falls, the relative expected return on dollar assets falls, the demand curve shifts to the left, and the exchange rate falls A decrease in the domestic interest rate iD shifts the demand curve for domestic assets, D, to the left and causes the domestic currency to depreciate (E↓).

Importance of Exchange Rates

affect the relative price of domestic and foreign goods dollar price of French goods to an American is determined by interaction of 2 factors: 1. price of French good in Euros 2. euro-dollar exchange rate A depreciation of the euro lowers the cost of French goods in America but raises the cost of American goods in France When a country's currency appreciates (rises in value relative to other currencies), the country's goods abroad become more expensive and foreign goods in that country become cheaper (holding domestic prices constant in the two countries). Conversely, when a country's currency depreciates, its goods abroad become cheaper and foreign goods in that country become more expensive. Depreciation of Currency makes it easier for domestic manufacturers to sell goods abroad and make foreign goods less competitive in domestic markets ex: U.S. dollar depreciated. U.S. industries sold more goods. But, foreign goods were more expensive for American consumers French wine and cheese more expensive bc weak dollar

Foreign Interest Rate

an increase in the foreign interest rate iF shifts the demand curve for domestic assets, D, to the left and causes the domestic currency to depreciate; a fall in the foreign interest rate iF shifts the demand curve D to the right and causes the domestic currency to appreciate. when foreign interest rate rises, return on foreign assets rises, expected return on dollar falls. Now people want less dollar assets and quantity demanded decreases at every value of exchange rate. Equilibrium Rate falls leftward shift of demand curve value of dollar decreases Conversely, decrease in foreign interest rate raises expected return on dollar assets, shifts demand curve right, and raises exchange rate

Real Exchange Rate

another way of thinking about purchasing power parity the rate at which domestic goods can be exchanged for foreign goods the price of domestic goods relative to the price of foreign goods denominated in the domestic currency Ex: Basket in NY: $50 Same Basket in Tokyo: $75 (bc it costs 7500 yen when exchange rate is 100 yen per dollar) So, real exchange rate is $50/$75 = 0.66 Real exchange rate (.66) is lower than 1.0, so its cheaper to buy basket in U.S. than in Japan. Rate indicates whether a currency is relatively cheap or not PPP predicts that Real exchange rate is always 1.0, so purchasing power of dollar is same as other currencies like yen or euro.

Gordon Growth model

assumes constant dividend growth useful for finding the value of stock, given a few assumptions: 1. Dividends are assumed to continue growing at a constant rate forever. As long as they're expected to grow at a constant rate for a Long period of time, doesn't have to be forever, model should yield reasonable results, bc errors about distant CFs become small when discounted to the present 2. Growth rate is assumed to be less than the required return on equity. if growth rate were faster than rate demanded by holders of the firms equity, in the long run the firm would grow impossibly large

Organized Exchange Operations

auction markets that use floor traders who specialize in particular stocks specialists oversee and facilitate trading in a group of stocks floor traders, representing various brokerage firms with buy and sell order, meet at trading post on exchange and learn about current bid and ask prices quotes calle out loud 90% of trades: specialist matches buyers with sellers other 10%: specialists might intervene by taking ownership of stock or by selling stock from inventory specialists duty to maintain orderly market in the stock even if it means buying stock in a declining market most orders filled electronically via SDBK (Super Display Book) system bypasses floor trader and routes the order directly to the specialist. System automatically matches buy orders with sell orders without intervention. Only complex institutional orders continue to be executed by floor traders on the exchange. System allows for rapid execution of high volume of trades made daily specialists who facilitate trading

FICO score

avg subprime mortgage FICO score: 624 prime mortgage FICO: 742 computed for every borrower computed by the different credit rating agencies as an index of credit risk each agency uses a slightly different algorithm, all include payment history, level of current debt, length of credit history, types of credit held, and the number of new credit inquiries made as criteria for rating creditworthiness

Municipal Bonds: Revenue Bonds

backed by cash flow of a particular revenue-generating project ex: revenue bonds might be issued to build toll road, with tolls pledged as repayment. If revenues aren't sufficient to repay bonds, might default, investors suffer loss issued most frequently

Unsecured Bonds

backed only by creditworthiness of issuer no collateral pledged to repay debt in event of default, bondholders have to go to court to seize assets Debentures, Subordinated debentures, Variable-rate bonds

Government National Mortgage Association (GNMA) (Ginnie Mae) pass-throughs

began guaranteeing pass-throughs in 1968 variety of financial intermediaries like banks and mortgage companies originate Ginnie Mae mortgages Ginnie Mae aggregates these mortgages into a pool and issues pass-through securities that are collaterized by the interest and principal payments from the mortgages also guarantees the pass-through securities against default minimum denomination for pass-throughs: 25000 minimum pool size: $1 million one pool may back up many pass-through securities

Treasury STRIPS

bonds in book entry form no physical document exists, issued and accounted for electronically separates the periodic interest payments from the final principal repayment each interest payment and the principal payment becomes a separate zero-coupon security each component has own identifying number and maturity and can be held or traded separately Ex: 5 yr Treasury note has 1 principal payment and 10 interest payments (1 every 6 months for 5 yrs) = 11 payments total When note is stripped, each payment becomes separate security. So, the single 5 yr note security becomes 11 securities that can be traded individually Also called zero coupon securities bc only time investor receives a payment during the life of each STRIPS component is when it matures. Before gov introduced STRIPS, private sector indirectly created early 80s: Merrill Lynch created TIGRS (Treasury Investment Growth Fund), purchased treasury securities and stripped them to make principal-only and interest-only securities.

Characteristics of Corporate Bonds

bonds used to be sold with attached coupons that owner clipped and mailed in to receive interest payments, were called "bearer bonds" bc whoever has physical possession of bond received the payment made tracking interest income difficult replaced by REGISTERED BONDS interest paid on bonds still called "coupon interest payment" interest payment/ par value = coupon interest rate

Borrower Qualification

borrower must fit certain guidelines loan payments including taxes and insurance should not exceed 25% of gross monthly income sum of all of borrowers monthly loan payments (car loans, credit cards, etc) should not exceed 36% of borrowers gross monthly income ex: yearly salary: 60k, monthly: 5k, no other debt, monthly mortgage can't go over 5000*.25= $1250 . At 4%interest, you qualify for $200000 loan Lenders also order credit reports credit score based on a model that weighs a number of variables found to be predictors of creditworthiness most common score: FICO When the competition to originate mortgage loans grew in the mid-2000s, a variety of mortgage loans were offered that circumvented traditional lending practices. For example, borrowers were offered No Doc loans (sometimes called NINJA loans for No Income, No Job, and No Assets) in which income or assets were not required on the loan application. The rationale for these loans was a mistaken belief that real estate prices would not decline and so the collateral was strong enough to justify the loans. These lending practices have been largely abandoned as the search for quality borrowers has replaced the need for loan volume.

Private Mortgage Insurance

borrower must purchase private mortgage insurance (PMI) insurance policy that guarantees to pay discrepancy between value of property and loan amount if a default occurs ex: Loan balance is 120000, property is worth $100000 at time of default, PMI takes care of $20000 difference default appears on borrowers credit but lending institutions saved usually required on loans that have less than a 20% down payment If LTV falls bc of payments being made or value of property increases, borrower can request PMI requirement to be dropped costs between $20-$30 a month or a $100000 loan Ideally, PMI should have protected investors against losses on mortgage investments, and it did until recently. As we will discuss later, relaxed lending standards led to a competitive mortgage market where lenders found ways to attract customers with questionable practices. One such method was to structure loans to avoid PMI. PMI is usually required only on the first mortgage. By structuring loans so that the first mortgage loan was set at 80% loan-to-value with a second mortgage covering the remaining 20%, PMI was avoided. Of course, the lender suffered the loss when the borrower defaulted.

standard mortgage contract

borrowers agree to make regular payments on the principal and interest interest rate significantly affects size of monthly payment

Mortgage Loan Amortization

borrowers agree to pay a monthly amount principal and interest that will fully amortize the loan by its maturity meaning the payments will pay off the outstanding indebtedness by the time the loan matures during early years of the loan, lender applies most of the payment to the interest on the loan and a small amount to the outstanding principal balance lot of borrowers find that after years of making payments, their principal balance dont drop much

The 2007-2009 Financial Crisis: Bailout of Fannie Mae and Freddie Mac

both encourage excessive risk taking; accident waiting to happen led to gov bailout of both companies, huge losses for American taxpayers when there is a government safety net for financial institutions, there needs to be appropriate government regulation and supervision to make sure these institutions do not take on excessive risk. Fannie and Freddie were given a federal regulator and supervisor, the Office of Federal Housing Enterprise Oversight (OFHEO), as a result of legislation in 1992, but this regulator was quite weak, with only a limited ability to rein them in. This outcome was not surprising: These firms had strong incentives to resist effective regulation and supervision because it would cut into their profits. This is exactly what they did: Fannie and Freddie were legendary for their lobbying machine in Congress, and they were not apologetic about it. In 1999 Franklin Raines, at the time Fannie's CEO, said, "We manage our political risk with the same intensity that we manage our credit and interest-rate risks."* Between 1998 and 2008 Fannie and Freddie jointly spent over $170 million on lobbyists, and from 2000 to 2008 they and their employees made over $14 million in political campaign contributions. "Their lobbying efforts paid off: Attempts to strengthen their regulator, OFHEO, in both the Clinton and Bush administrations came to naught, and remarkably this was even true after major accounting scandals at both firms were revealed in 2003 and 2004, in which they cooked the books to smooth out earnings. (It was only in July 2008, after the cat was let out of the bag and Fannie and Freddie were in serious trouble, that legislation was passed to put into place a stronger regulator, the Federal Housing Finance Agency, to supersede OFHEO.) With a weak regulator and strong incentives to take on risk, Fannie and Freddie grew like crazy, and by 2008 had purchased or were guaranteeing over $5 trillion of mortgages or mortgage-backed securities. The accounting scandals might even have pushed them to take on more risk. In the 1992 legislation, Fannie and Freddie had been given a mission to promote affordable housing. What better way to do this than to purchase subprime and Alt-A mortgages or mortgage-backed securities (discussed in Chapter 8)? The accounting scandals made this motivation even stronger because they weakened the political support for Fannie and Freddie, giving these companies even greater incentives to please Congress and support affordable housing by the purchase of these assets. By the time the subprime financial crisis hit in force, they had over $1 trillion of subprime and Alt-A assets on their books. Furthermore, they had extremely low ratios of capital relative to their assets: Indeed, their capital ratios were far lower than for other financial institutions like commercial banks. By 2008, after many subprime mortgages went into default, Fannie and Freddie had booked large losses. Their small capital buffer meant that they had little cushion to withstand these losses, and investors started to pull their money out. With Fannie and Freddie playing such a dominant role in mortgage markets, the U.S. government could not afford to have them go out of business because this would have had a disastrous effect on the availability of mortgage credit, which would have had further devastating effects on the housing market. With bankruptcy imminent, the Treasury stepped in with a pledge to provide up to $200 billion of taxpayer money to the companies if needed. This largess did not come for free. The federal government in effect took over these companies by putting them into conservatorship, requiring that their CEOs step down, and by having their regulator, the Federal Housing Finance Agency, oversee the companies' day-to-day operations. In addition, the government received around $1 billion of senior preferred stock and the right to purchase 80% of the common stock if the companies recovered. After the bailout, the prices of both companies' common stock were less than 2% of what they had been worth only a year earlier. The sad saga of Fannie Mae and Freddie Mac illustrates how dangerous it was for the government to set up GSEs that were exposed to a classic conflict-of-interest problem because they were supposed to serve two masters: As publicly traded corporations, they were expected to maximize profits for their shareholders, but as government agencies, they were obliged to work in the interests of the public. In the end, neither the public nor the shareholders were well served. With the housing market recovery, Fannie Mae and Freddy Mac have been able to pay dividends back to the government on its $187 billion investment. By October of 2016, the two agencies had paid $250 billion in dividends to the treasury.

Money Market- Individuals

buy money market mutual funds -when inflation rose and the interest rates that banks were offering were unattractive, people started going to brokerage houses that promoted money market mutual fund with much higher interest rates -banks couldn't raise rates bc of regulations, regulations were changed, bank rates increased which stopped the quick movement of large amount of $ to money market mutual funds, but they are still a very popular option -advantage of mutual funds is that they give investors with small amount of cash access to large denomination securities.

One-period Valuation Model

buy stock, hold for one period, then sell to value stock today, need to find the present discounted value of the expected cash flows (future payments) determine whether current price accurately reflects analysts forecast discount factor used to discount the cash flows in the required return on investments in equity cash flows consists of one dividend payment plus a final sales price, discounted back to present gives current price of stock

Variable-rate bonds

can be secured or unsecured financial innovation spurred by increased interest-rate variability in 80s and 90s interest rate on these securities is tied to another market interest rate, such as rate on Treasury Bonds, and is adjusted periodically interest rate on bonds changes over time as market rates change

Organized Exchange

capital market transaction- most popular measured by volume building where securities trade (bonds, stocks, options , futures) rules govern trading to ensure efficient and legal operation of exchange exchange board constantly reviews rules to ensure that they result in competitive trading

Secured Bonds

collateral attached ex: mortgage bonds used to finance specific project. building is collateral for bond issued for its construction if firm can't make payments, bondholders have right to liquidate the property in order to be paid bc they have collateral, less risky than unsecured bonds lower interest rates Equipment Trust Certificates: bonds secured by tangible non-real-estate property, such as heavy equipment and airplanes collateral backing these bonds is more easily marketed than the real property backing mortgage bonds. presence of collateral reduces risk of bonds and lowers interest rates

Problems with estimating growth

constant growth model requires the analyst to estimate the constant rate of growth the firm will experience estimates future growth by computing historical growth rate in dividends, sales, net profits fails to consider changes in the firm or economy that may affect growth rate competition will prevent high growth firms from being able to maintain their historical growth rate despite this, stock prices of historically high growth firms tend to reflect a continuation of the high growth rate result is that investors in these firms receive lower returns than they would by investing in mature, slower growing firms even experts have trouble estimating future growth rates

bond indenture

contract that states lenders right and privileges and borrowers obligation any collateral offered as security to bondholders is also described in indenture

Restrictive Covenants

corporations financial managers hired, fired, and compensated at direction of board of directors/stockholders so, managers more interested in protecting stockholders than bondholders moral hazard problem arises managers might not use funds from bonds in a way that bondholder prefer bondholders can't rely on managers for protection, so they impose rules on managers to protect bondholders interest called restrictive covenants -limit amount of dividends firm can pay (to conserve cash for interest payments to bondholders) -limit ability of firm to issue additional debt -mergers might be restricted -included in the bond indenture -the more restrictions, the lower the interest rate bc bonds considered "safer"

Federal Home Loan Mortgage Corporation (FHLMC) Pass-Through Freddie Mac

created to help savings and loan associations which can originate Ginnie-Mae guaranteed loans buy mortgages for its own account and issues pass-through securities called Participation Certificates (PCs) Pools contain conventional, nonguranteed mortgages, aren't federally insured, contain mortgages with different rates, larger (up to million of dollars), and have minimum denomination of $100000 innovation: CMO (Collaterized Mortgage Obligation)

Computing price of any business asset

current price is PV of all future cash flows if you have PV or future cash flow, you can reproduce that future cash flow by investing the PV amount at the discount rate value: current price must be such that the seller in indifferent between continuing to receive the cash flow stream provided by the asset and receiving the offer price prices/value always determined in the same way. Simply the PV of the future CFs. Concept applies to bonds, stocks, businesses, buildings, and any other investment

Expected Future Exchange Rate (more)

determinants of the exchange rate in the long run: the relative price level, relative tariffs and quotas, import and export demand, and relative productivity, these 4 factors influence the expected future exchange rate theory of purchasing power parity suggests that if a higher American price level relative to the foreign price level is expected to persist, the dollar will depreciate in the long run. A higher expected relative American price level should thus have a tendency to lower Et+1e, lower the relative expected return on dollar assets, shift the demand curve to the left, and then lower the current exchange rate. all of which increase the demand for domestic goods relative to foreign goods, will raise Et+1e: (1) expectations of a fall in the American price level relative to the foreign price level, (2) expectations of higher American trade barriers relative to foreign trade barriers, (3) expectations of lower American import demand, (4) expectations of higher foreign demand for American exports, and (5) expectations of higher American productivity relative to foreign productivity. By increasing Et+1e, all of these changes increase the relative expected return on dollar assets, shift the demand curve to the right, and cause an appreciation of the domestic currency, the dollar.

Buying Foreign Stocks

diversification of a portfolio reduces risk a fully diversified portfolio will hold securities across broad swatch of domestic industries, as well as around the world when once country is in a recession, another might be booming. if inflation in U.S. causes stock prices to drop, falling inflation in Japan might cause Japanese stocks to rise. most foreign companies are not listen on any of the U.S. stock exchanges so buying foreign shares is hard Intermediaries solve this by selling America Depositpry Receipts (ADRs)

Problems with estimating Risk

dividend valuation model requires the analyst to estimate required return for the firms equity price of a share of stock changes with different estimates of the required return stock price is highly dependent on the required return, despite our uncertainty regarding how it is found

ECN (Electronic Communications Networks)

electronic network that brings together major brokerages and traders so that they can trade among themselves and bypass middleman 4 main advantages: Transparency, Cost Reduction, Faster execution, After-hours trading 1. Transparency: all unfilled orders can be reviewed by ECN traders. Gives valuable info about supply and demand that traders can use to develop their strategy. Some exchange also provide this info, but ECNs is always better in terms of currentness and completeness 2. Cost Reduction: no middlemen and no commission costs cut from deal, so transaction costs lower for trades conducted across ECN. Spread is usually reduced and sometimes eliminated 3. Faster Execution: fully automated, so trades matched and confirmed faster than if people were to do it. Some people isn't a big deal for, but for those trying to trade on small price fluctuations, very important. 4. After-hours trading: before ECNS only institutional traders could trade after exchanges closed for the day. Many news reports and info comes out after exchange closes and small investors were locked out of making trades. ECNs never close, so trading can happen anytime Disadvantages: 1.work well only for stocks with substantial volume, 2. thinly traded stocks may go long intervals without trading since ECNs require a seller to match with a buyer major exchanges started making their own automatic trading system to compete

Federal Housing Administration

established to insure certain mortgage contracts made it easier to sell mortgages bc buyer didn't have to be concerned with borrowers credit history or the value of collateral similar insurance program set up through Veterans Administration to insure loans to veterans after WW2 advantage: required to be written on a standard loan contract

Division of Trading and Markets

establishes and maintains standards for an orderly and efficient market by regulating the major securities market participants reviews and approves new rules and changes to existing rules

Organized Securities Exchange

ex: NYSE, best known, larger, most liquid a specificfied location where buyers and sellers meet on a regular basis to trade securities using open-outcry auction model, As more sophisticated technology has been adapted to securities trading, this model is becoming less frequently used. The NYSE currently advertises itself as a hybrid market that combines aspects of electronic trading and traditional auction-market trading major organized stock exchanges around the world most active in the world: Nikkei in Tokyo to have a stock listed, firm must file an application and meet certain criteria set by exchange designed to enhance trading ex: NYSE encourages only largest firms to list so transaction volume will be high several ways to meet minimum listing requirements, usually firm must have substantial earnings and market value (greater than $10 million per year and $100 million market value) Regional exchanges are easier to list on some firms choose to list on more than one exchange, believing that more exposure will increase demand for stock and thus its price firms also believe there is prestige attached to being listed on major exchanges, but there isn't much evidence behind this belief.

excess supply

exchange rate > equilibrium excess supply occurs. quantity of dollar assets supplied is then greater than the quantity demanded more people want to sell dollar assets then want to buy them, so value of dollar will fall As long as exchange rate is above equilibrium exchange rate, excess supply of dollar assets, and dollar will fall in value until it reaches equilibrium rate of 1 euro per dollar

Short-Run behavior of exchange rates

exchange rate: the price of domestic assets (bank deposits, bonds, equities, etc denominated in the domestic currency) in terms of foreign assets (similar assets denominated in the foreign currency) i.e. price of one asset in terms another asset market approach heavy on theory of portfolio choice Long-run determinants of exchange rates also play important role in short-run asset market approach In the past, supply-and-demand approaches to exchange rate determination emphasized the role of import and export demand more modern asset market approach used here emphasizes stocks of assets rather than the flows of exports and imports over short periods because export and import transactions are small relative to the amount of domestic and foreign assets at any given time. "For example, foreign exchange transactions in the United States each year are well over 25 times greater than the amount of U.S. exports and imports. Thus, over short periods, decisions to hold domestic or foreign assets have a much greater role in exchange rate determination than the demand for exports and imports does."

foreign exchange market

financial market where exchange rates are determined most countries have their own currencies trade between countries involves mutual exchange of different currencies (usually bank deposits denominated in different currencies) When American firm buys foreign goods, services, or financial assets EX: U.S. Dollars (bank deposits denominated in U.S. Dollars) must be exchanged for foreign currency (bank deposits denominated in the foreign currency) trading of currencies and bank deposits denominated in particular currencies takes place in foreign exchange market transactions conducted in foreign exchange market determine the rates at which currencies are exchanged, which in turn determines the cost of purchasing foreign goods and financial assets

Preferred Stock

form of equity from a legal and tax standpoint receive fixed dividend that never changes share is much like a bond and stock since dividend doesn't change, price is relatively stable dont vote unless firm is unable to pay dividend hold a claim on assets with priority above common stockholders but after creditors (like bondholders) less than 25% of new issues are preferred stock 5% of all capital is raised using preferred stock dividends not tax-deductible like bond payments higher cost than debt

Exchange Traded Funds (ETFs)

formed when a basket of securities is purchased and a stock is created based on this basket that is traded on an exchange Features: 1. Listed and traded as individual stocks on a stock xchange 2. indexed rather than actively managed 3. value is based on the underlying net asset value of the stocks held in the index basket. Exact content of the basket is public so that intraday arbitrage keeps the ETF price close to the implied value resemble stock index mutual funds in that they track the performance of some index trade like stocks, so they allow for limit orders, short sales, stop-loss orders, and ability to buy on margin lower management fees than comparable index mutual funds no minimum investment amount disadvantage is that since they trade like stocks, investors have to pay broker commission every time they buy or sell shares cost disadvantage compared to mutual funds for those who want to frequently invest small amounts, such as through a 401(k) low cost way to diversify portfolio usually named after the index that it tracks or name of issuing firm

Secondary Mortgage Market

founded by federal government mortgage market collapsed during Great Depression, to boost economic activity gov founded agencies to buy mortgages Fannie Mae, Federal Housing Administration, Veterans Administration Standardization of Loan Contracts contributed to growth on Secondary Mortgage Market Mortgage Banks

CDOs

growth of the subprime mortgage was in part fueled by the creation of the structured credit products such as the collateralized debt obligation (CDO) provides a source of funds for high-risk investments. A CDO is similar to the CMO, except that rather than slice the pool of securities by maturity as with the CMO, the CDO usually creates tranches based on risk class. While CDOs can be backed by corporate bonds, real estate investment trust (REIT) debt, or other assets, mortgage-backed securities are common."

Standardization of Loan Contracts

insured loans required to be written on standard loan contract important factor in the growth of secondary market for mortgages

Growing- Equity Mortgage (GEMs)

helps borrower pay off loan in shorter period of time initial payments same as conventional mortgage, then increase over time the increase reduces principal more quickly than conventional payments do ex: level payments for first 2 years, payments increase by 5% per year for next 5 years, remain same until maturity, life of loan reduced from 30 yrs to 17 popular among borrowers who expect their income to rise in future gives benefit of small payment at beginning while still retiring debt early increase in payment REQUIRED most mortgage loans have no prepayment penalty so borrow can create its own GEM by just making extra principal payments and paying off mortgage early similar to Graduated Payment Mortgage (GPM) GPM is to help borrower qualify by reducing first few years payments, still pays off in 30 years goal of GEM is to let borrower pay off early Initial payment increases each year; loan amortizes in less than 30 years

Current Yield

if you buy bond and hold to maturity, you earn the YTM. -an approximation of the YTM on coupon bonds that is often reported bc it is easily calculated defined as yearly coupon payment/ price of security -if Bond Price= Par value, YTM = coupon rate current yield = coupon rate when bonds at par When bond price is at par, Current Yield = YTM The nearer the bond price is to the bonds par value, the better the current yield will approximate the YTM current yield negatively related to price of bond YTM negatively related to price of bond current yield and ytm always move together, rise in current yield signals rise in YTM

Reverse Annuity Mortgages (RAMs)

innovative method for retired people to live on the equity they have in their homes contract for a RAM has the bank advancing funds on a monthly schedule increasing-balance loan is secured by the real estate borrower doesn't make any payments against loan when borrower dies, borrowers estate sells the property to retire the debt allows retired people to use the equity in their homes without the necessity of selling it for retirees in need of supplemental funds to meet living expenses Lender disburses a monthly payment to the borrower on an increasing-balance loan; loan comes due when the real estate is sold

Mortgage Interest Rate- Discount Points

interest payments made at the beginning of the loan 1 discount point means borrower pays 1% of loan amount at closing (borrower signs loan docs and receives loan funds) in exchange for points, lender reduces interest rate on loan When deciding whether to pay points, borrower must determine whether the reduced interest rate over life of loan fully compensates for the increased up-front expense to make determination, borrower considers how long they will keep the loan. If borrower plans on paying off loan in 5 years or less, dont pay discount points, this is the breakeven point average home sells every 5 years

Fixed- Rate Mortgage

interest rate and monthly payment do not vary over life of mortgage preferred over ARMs do not benefit if rates fall unless refinanced Preferred by Borrowers

Adjustable Rate Mortageg (ARM)

interest rate is tied to some market interest rate and changes over time usually has limits, "caps", on how high o low the interest rate can move in one year and during the life of the loan. typical ARM might tie interest rate to the average Treasury bill rate plus 2% with caps of 2% per year and 6% over the life of mortgage Caps make ARMs more palatable to borrowers may cause financial hardship if interest rates rise Preferred by Lenders bc lessens interest rate risk interest rate risk- risk that rising interest rates will cause value of debt instruments to fall effect on value of debt is greatest when debt has long term to maturity mortgage value very sensitive to changes in interest rates bc long term lending institutions can reduce sensitivity of portfolios by making ARMs instead of fixed rate mortgages since borrowers prefer fixed rate mortgages, lenders must entice borrowers by offering lower initial interest rates on ARMs than on fixed rate loans Interest rate is tied to some other security and is adjusted periodically; size of adjustment is subject to annual limits

Credit Default Swap (CDS)

introduced by J.P Morgan another way to insure bonds provides insurance against default in the principal and interest payments of a credit instrument ex: You buy GE bond and want to insure yourself against any losses if GE has to default, you can buy CDS to provide this protection

Division of Enforcement

investigates the violation of any of the rules and regulations established by other divisions. conducts its own investigations into various types of securities fraud and acts on tips provided by sec's other divisions

Junk Bonds

investment grade: at or above BBB rating, low default risk BELOW BBB: speculative speculative grade also called junk bonds usually unsecured high risk of default no strong secondary market primary issues of junk bonds were rare, usually investment grade primary issues, if companies ran into financial difficulties then their rating would fall in the speculative range

Dow Jones Industrial Average (DJIA) History

is an index composed of 30 "blue chip" industrial firms "editors of the Wall Street Journal select the firms that make up the DJIA" They take a broad view of the type of firm that is considered "industrial": In essence, it is almost any company that is not in the transportation or utility business (because there are also Dow Jones averages for those kinds of stocks). In choosing a new company for DJIA, they look among substantial industrial companies with a history of successful growth and wide interest among investors. The components of the DJIA are changed periodically. For example, recently ATT and Bank of America were replaced with Apple and Nike. Most market watchers agree that the DJIA is not the best indicator of the market's overall day-to-day performance. Indeed, it varies substantially from broader-based stock indexes in the short run. It continues to be followed so closely primarily because it is the oldest index and was the first to be quoted by other publications. It continues to be popular because it tracks the performance of the overall markets reasonably well over the long run. Other indexes, such as Standard & Poor's 500 Index, the NASDAQ composite, and the NYSE composite, may be more useful for following the performance of different groups of stocks.

Capital Market: Corporations

issue both bonds and stock -decision: should it finance growth with debt or equity -capital structure: distribution of firms capital between debt and equity -use capital markets if they dont have sufficient capital to fund investment opportunities -use capital markets to preserve capital to protect against unexpected needs crucial to health of business sector -08-09 crisis: near collapse of bond & stock markets, funds for business expansion dried up. Reduced business activity, high unemployment, slow growth

Tresury Notes and Bonds

issued by u.s. treasury to finance national debt notes: 1-10 years maturity bonds: 10-30 years maturity prices quoted as a percentage of $100 face value free of default risk, still has risk just no default risk because government can always print more money. no default risk but not risk-free

Corporate Bonds

issued when corporations need to borrow for long period of time most are callable, meaning issuer can redeem bonds before mature AFTER a specified date risk varies, depends on companies health

Down Payments

lender requires borrower to make downpayment on property, i.e., pay a portion the purchase price balance of purchase price is paid by the loan proceeds intended to make borrower less likely to default on loan, if they didn't make a down payment they could walk away from the house and loan and lose nothing if real estate prices drop, balance due on loan will exceed value of the collateral down payment reduces moral hazard for the borrower amount of down payment depends on type of mortgage loan Beginning in the mid-2000s the required down payment was often circumvented with piggyback loans whereby a second mortgage was added to the first so that 100% financing was provided. We saw in the housing downturn beginning in 2006 that many borrowers recognized their property was worth less than they owed and default rates skyrocketed.

Subprime Lending

loans made to borrowers who dont qualify for loans at the market rate of interest bc of poor credit or the loan is larger than the amount their income will approve them for (can be subprime car loans or credit cards too) Subprime mortgages got popular bc of all the defaults when real estate values dropped in 2006 Before the securitized market made it easy to bundle and sell mortgages, if you didn't qualify with one of the major mortgage agencies you were out of luck strict qualifications, each one was verified Once it was possible to sell bundles of loans to other investors, different lending rules emerged and thus subprime mortgages avg subprime mortgage FICO score: 624 prime mortgage FICO: 742 lending practices that led to increase in lending to less creditworthy borrowers : 2/28 ARMs (sometimes called "teaser" loans) became popular. These loans freeze the interest rate for 2 years, and then it increases, often substantially, after that. Piggyback loans, No Doc, or NINJA (no income no asset loans), and variations on the graduated payment mortgage, as discussed in an earlier section, encouraged borrowers to commit to larger loans than they could realistically handle. When real estate values were rapidly increasing, borrowers could easily sell their property if they found themselves unable to make the payments. Once the real estate market cooled in 2006 and 2007, it became much more difficult to sell property and many borrowers were forced into default and bankruptcy. As discussed more fully in Chapter 8, subprime lending was ultimately a leading cause of the financial crisis of 2007-2008 and led to a global recession.

Second Mortgage

loans secured by same real estate used to secure first mortgage junior to original loan, meaning if borrower defaults second mortgage holder gets paid after first mortgage holder, only if there's enough money leftover from the sale of collateral 2 purposes. 1: give borrowers a way to use equity they have in their homes as security for another loan. alternative to second mortgage is refinancing at higher loan amount than is currently owed second mortgage is cheaper to get than refinancing 2: to take advantage of tax deduction interest in loans secured by residential real estate is tax deductible, no other personal loans have this banks also offer lines of credit secured by second mortgages bank doesn't really care about value of security. Borrowers want the line of credit to be secured so they can deduct interest on loan from their taxes a contributing factor in the mortgage market collapse was the use of second mortgage loans to reduce or eliminate the need for a down payment. Borrowers who had no real equity in the home were more willing to walk away once its value dropped or their income fell. An appropriate use of the second mortgage is where a borrower has had a home loan for a number of years and has built up real equity, meaning that the true market value of the home is much greater than the balance owed on the loan. Loan is secured by a second lien against the real estate; often used for lines of credit or home improvement loans

Mortgage

long term loan secured by real estate obtained to finance offices, homes, etc AMORTIZED- borrower pays off over time in some combination of principal and interest payments that result in full payment of debt by maturity

Characteristics of Residential Mortgage

lots of changes in past 20 years major: active secondary market 20 yrs ago savings & loan institutions and mortgage departments of large bank originates most mortgage loans. Some were maintained in house by originator while others were sold to one of a few firms closely tracked delinquency rates refused to continue buying loans from banks where delinquencies were very high recently, loan production offices arose that competed in real estate financing result of competition for mortgage loans, borrowers could choose from a variety of terms and options many organized around originate-to-distribute model where broker originated loan and sold to investor as quickly as possible. increase principal-agent problem since originator didn't care if loan was actually paid off

Treasury Bond Interest Rates

low interest rates bc no default risk above inflation rate and rate on money market securities bc of interest-rate risk -Rate of return on short term bill is below 20 yr bonds -ST rates more volatile than LT rates -ST rates more influenced by expected rate of inflation -Investors in LT securities expect super high or low inflation rates to go back to normal levels so LT rates dont change as much as ST rates

securities act of 1933 and 34

main purposes: 1) require firms to tell the public the truth about their businesses 2) require brokers, dealers, and exchanges to treat investors fairly established Securites and Exchange Commission (SEC) to enforce these laws

Problems with forecasting dividends

many factors influence dividend payout ratio including the firms future growth opportunities, and managements concern over future cash flows analysts aren't always super confident in their stock price projections, which is why stock prices fluctuate so much on news reports ex. info that the economy is slowing down causes analysts to revise their growth expectations When this happens across a broad spectrum of stocks, major market indexes can change short term fluctuations stock prices are expected and natural over long term, stock price will adjust to reflect the true earnings of the firm if high quality firms are chosen for portfolio, they should provide fair returns over time

Loan Servicing

many institutions making mortgage loans dont want a big portfolio of LT securities commercial banks get funds from ST sources. Investing in LT loans subjects the, to high interest rate risk also make money through fees earned by packaging loans for other investors to hold loan origination fees are usually 1% of loan amount, but varies w market once loan is made, lender usually sells it immediately to another investor borrower might not know that original lender transferred the loan by selling loan, originator frees up funds that can be lent to another borrower, generating additional fee income some originators also service loans. agent collects payments from borrowers, passes principal and interest to investors, keeps required record of transaction, and maintains reserve accounts reserve accounts- established for most mortgage loans to permit lender to make tax and insurance payments for borrower. Lenders prefer to make these payments because they protect the security of the loan loan servicing agents usually earn .5% / yr of the total loan amount for their efforts

Equilibrium in Foreign Exchange Market

market is in equilibrium when quantity of dollar assets demanded equals quantity supplied (1 euro per dollar) Suppose that the exchange rate is at 1.05 euros per dollar excess supply occurs. quantity of dollar assets supplied is then greater than the quantity demanded more people want to sell dollar assets then want to buy them, so value of dollar will fall As long as exchange rate is above equilibrium exchange rate, excess supply of dollar assets, and dollar will fall in value until it reaches equilibrium rate of 1 euro per dollar If exchange rate < equilibrium rate, quantity of dollars demanded will exceed quantity supplied (Excess Demand) more people want to buy dollar assets than want to sell them, the value of the dollar will rise until the excess demand disappears and the value of the dollar is again at the equilibrium exchange rate of 1 euro per dollar.

Over the Counter operations

market makers trade on an electronic network where bid and ask prices are set by market makers usually multiple market makers for any particular stock. each enter their bid and ask quotes once done, they're obligated to buy or sell at least 1000 securities at that price once trade has been executed, they can enter a new bid and ask quote market makers ensure there is continuous liquidity for every stock, even those with little transaction volume market makers compensates by the spread between bid price (price they pay for stocks) and ask price (price they sell stocks for). also receive commissions on trade

investment rate

more accurate representation of what investor will earn since it uses actual # of days per year and true initial investment in calculation when computing investment rate, treasury uses actual # of days in following year

FICO score

most common range from low of 300- 850 max above 720: good below 660: likely to cause problems obtaining loan score determined by payment history, outstanding debt, length of credit history, # of recent credit application, and types of credit & loans you have

Mortgage Pass-Through

most common type of mortgage backed security security that has the borrowers mortgage payments pass through the trustee before being disbursed to the investors in the mortgage pass through. If borrowers prepay loans, investors receive more principal than expected. For example, investors may buy mortgage-backed securities on which the average interest rate is 6%. If interest rates fall and borrowers refinance at lower rates, the securities will pay off early. The possibility that mortgages will prepay and force investors to seek alternative investments, usually with lower returns, is called prepayment risk.

Mortgage Interest Rates

most important factor for borrowers when choosing who and how much to borrow determine by 3 factors: current long term market rates, life of mortgage, and # of discount points paid

discounting

most money market securities dont pay interest -investor pays less for security than what it will be worth when it matures -the increase in price provides a return. -common to short term securities because it simplifies the distribution at maturity

Spot transactions

most popular immediate (two-day) exchange of bank deposits spot exchange rate: exchange rate for spot transaction

Mortgage Bank

new intermediary didn't accept deposits, so was able to open offices across the country originated the loans, funding them initially with its own capital after a group of similar loans were made, they would be bundled and sold, either to one of the federal agencies or to an insurance or pension fund several advantages bc of their size, able to capture economies of scale in loan origination and servicing also able to bundle loans from different regions, which helped reduce their risk increased competition for loans among these intermediaries led to lower rates for borrowers

Capital Market: Primary Market

new of issues of stocks and bonds are introduced. Investors, corporations, investment funds purchase. Issuer receives proceeds of sale Initial Public Offering (IPO): when when firm sells security for very first time -other sales of new bonds or stock to the public are primary transactions

brokerage houses

not all publicly traded stocks list on organized exchange or nasdaq those that trade infrequently or in one region of the country are usually handled by regional offices of various brokerage houses maintain small inventories of regionally popular securities Dealers that make a market for stocks that trade in low volume are very important to the success of the over-the-counter market. Without these dealers standing ready to buy or sell shares, investors would be reluctant to buy shares of stock in regional or unknown firms, and it would be very difficult for start-up firms to raise needed capital the more liquid an asset is, the greater its quantity demanded. By providing liquidity intervention, dealers increase demand for thinly traded securities.

Municipal Bond Risk

not default free, 0.63% default rate default rate higher when economy is weak local gov can't print money, there's limits on how high they can raise taxes without driving population away

Foreign Exchange trading

not traded on exchanges organized as an over the counter market. Several dealers (banks) stand ready to buy and sell deposits denominated in foreign currencies dealers in constant phone and computer contact, very competitive market most trades involve buying and selling bank deposits denominated in different currencies (not actually dollar bills are traded) "Bank buying dollars in foreign exchange market" means "Bank buying DEPOSITS denominated in dollars" large trading volume, over $5 trillion per day transactions in excess of $1 million We buy foreign currency in retail market from dealers such as American Express or from banks. Because retail prices are higher than wholesale, when we buy foreign exchange, we obtain fewer units of foreign currency per dollars. We pay a higher price for foreign currency than the exchange rates quoted in the newspaper show

The Great Depression

o Droughts in the 1930s caused farmers to default on their loans o The Fed was passive; took a hands-off approach to the bank failures and the banking panic o One third of US banks failed o The stock market fell by 90% o Unemployment rose to 25% o Price levels fell by 25%

Tools to partially solve the lemons problem:

o Private production and sale of information But the "free-rider" problem reduces the effectiveness of this o Government regulation of information o Financial intermediation- Financial intermediaries perform similar function as car dealers in the used car market o Collateral and net worth

Investing in Bonds

one of most popular LT alternatives to investing in stocks lower risk than stock bc higher priority of payment bondholders get paid before stockholders in times of financial difficulties if firm has to liquidate, bondholders paid before stockholders stock prices very volatile, scares investors. bond are an alternative relative security and dependable cash payments ideal for retired investors and those who want to live off their investments high-grade bonds seldom default; however, bond investors face fluctuations in price due to market interest-rate movements in the economy. As interest rates rise and fall, the value of bonds changes in the opposite direction. the possibility of suffering a loss because of interest-rate changes is called interest-rate risk. The longer the time until the bond matures, the greater will be the change in price. This does not cause a loss to those investors who do not sell their bonds; however, many investors do not hold their bonds until maturity. If they attempt to sell their bonds after interest rates have risen, they will receive less than they paid.

Common Stock

ownership interest in firm stockholders vote, receive dividends, hope stock prices rise various classes: type A, type B, etc. Type doesn't have standardized meaning across all companies differences among types: distribution of dividends, voting rights

Generalized Dividend Valuation Model

one period valuation model can be extended to any number of periods, concept remains same value of stock is the PV of all future CFs only CFs that investor receives is dividend and final sales price when stock is sold but, if final sales price is so far in future then all you need to worry about is the dividends stream so, the current value of a share of stock can be found as simply the PV of the future dividend stream only even if some stocks dont pay dividends, buyers of stock expect that the firm will pay dividends someday most of the time a firm institutes dividends as soon as it has completed the rapid growth phase of its life cycle stock price increases as the time approaches for the dividend stream to begin generalized dividend model says that we compute the PV of an infinite stream of dividends, something very difficult to do use Gordon growth model, which assumes constant dividend growth

how stocks are sold

organized exchange, over the counter, electronic trading

Mortgage History

originally there were laws that banks couldn't give mortgages so they would tie up funds in long term loans arranged between individuals with help of a lawyer available only to wealth and socially connected as demand increase, mortgage brokers increased originated loans in developing West and sold to banks and insurance companies in East streamlined operations by selling bonds to raise LT funds they lent. Gathered portfolio o mortgage contracts and used them as security for an issue of bonds that were sold publicly agricultural recessions led to defaults World War 1 banks became authorized to make mortage loans, caused real estate boom, mortgage lending expanded Great Depression led to defaults most mortgages in this period were balloon loans" borrower paid only interest for 3-5 years then had to pay the whole loan amount sometimes lender would reduce principal but if borrower was unemployed then lender wouldn't renew and borrow would default government recovery programs, gov took over loans and let people repay over long periods of time

Insured Mortgage

originated by banks or other mortgage lenders guaranteed by Federal Housing Administration (FHA) or Veterans Administration (VA) Applicants for VA and FHA loans must meet certain qualifications like having served in military or having income below a certain level and can only borrow up to a certain amount FHA or VA then guarantees the bank against any losses-- it will pay off loan if borrower defaults advantage to borrower: very low or 0 down payment required Loan is guaranteed by FHA or VA; low or zero down payment

Conventional Mortgage

originated by banks or other mortgage lenders not guranteed private mortgage companies now insure many conventional loans against default most lenders require borrower to obtain private mortgage insurance on all loans with LTV exceeding 80% Loan is not guaranteed; usually requires private mortgage insurance; 5% to 20% down payment

Division of Investment Management

oversees and regulates investment management industry includes oversight of mutual fund industry establishes rules governing investment companies

The Dollar and Interest Rates

plots measures of real and nominal interest rates and the value of the dollar in terms of a basket of foreign currencies (called an effective exchange rate index) the value of the dollar and the measure of real interest rates tend to rise and fall together. late 1970s, real interest rates were at low levels, and so was the value of the dollar. Beginning in 1980, however, real interest rates in the United States began to climb sharply, and at the same time so did the dollar. After 1984, the real interest rate declined substantially, as did the dollar. Our model of exchange rate determination helps explain the rise in the dollar in the early 1980s and its fall thereafter. As Figure 15.4 indicates, a rise in the U.S. real interest rate raises the relative expected return on dollar assets, which leads to purchases of dollar assets that raise the exchange rate. This is exactly what happened in the 1980-1984 period. The subsequent fall in U.S. real interest rates then reduced the relative expected return on dollar assets, which lowered the demand for them and thus lowered the exchange rate. The plot of nominal interest rates in Figure 15.8 also demonstrates that the correspondence between nominal interest rates and exchange rate movements is not nearly as close as that between real interest rates and exchange rate movements. This is also exactly what our analysis predicts. The rise in nominal interest rates in the late 1970s was not reflected in a corresponding rise in the value of the dollar; indeed, the dollar actually fell in the late 1970s. Figure 15.8 explains why the rise in nominal rates in the late 1970s did not produce a rise in the dollar. As a comparison of the real and nominal interest rates in the late 1970s indicates, the rise in nominal interest rates reflected an increase in expected inflation, not an increase in real interest rates. As our analysis in Figure 15.7 demonstrates, the rise in nominal interest rates stemming from a rise in expected inflation should lead to a decline in the dollar, and that is exactly what happened. If there is a moral to the story, it is that a failure to distinguish between real and nominal interest rates can lead to poor predictions of exchange rate movements: The weakness of the dollar in the late 1970s and the strength of the dollar in the early 1980s can be explained by movements in real interest rates but not by movements in nominal interest rates.

SEC (Securities and Exchange COmmsion)

primary mission of u.s. SEC is to protect investors and maintain the integrity of the securities markets ensures a constant, timely, and accurate flow of info to investors, who can then judge for themselves if a companies securities are a good investment primarily focused on promoting disclosure of info and reducing asymmetric info, not determining strength or well-being of a firm brings 400-500 civil enforcement actions against individual and companies each year in efforts to maintain quality of info provided to investors 5 divisions, 12 offices Division of Corporate Finance, Division of Trading and Markets, Division of Investment Management, Division of Enforcement, Division of Economic Risk and Analysis

Private Pass-Throughs (PIPs)

privately issued pass-through securities offered by intermediaries in private sector one mortgage market opportunity available to private institutions is for mortgages larger than the maximum size set by the government. these so called jumbo mortgages are often bundled into pools to back private pass throughs

Regulation of Stock Market

properly functioning capital markets are a hallmark of an economically advanced economy firms have to be able to raise funds to take advantage of growth opportunities as they become available firms raise funds in capital markets for markets to function properly, investors have to be able to trust the info that's released art the firms that are using them markets can collapse int he absence of trust (Great Depression) in 20s, $50 billion in new securities was offered, by 1932 half had become worthless. publics confidence in cap markets plummeted, lawmakers agreed that in order for economy to recover, public faith had to be restores congress passed securities act of 1933 and 34 established Securites and Exchange Commission (SEC) to enforce these laws

Division of Economic Risk and Analysis

provides data and analysis to all of the divisions as needed. advise devision about the economic impact of proposed rules

Shifts in the Demand for Domestic Assets

quantity of domestic (dollar) assets demanded depends on the relative expected return of dollar assets if the relative expected return of dollar assets rises, holding the current exchange rate constant, the demand curve shifts to the right. If the relative expected return falls, the demand curve shifts to the left.

Commodity Futures Modernization Act

removed derivative securities such as CDs from regulatory oversight preempted states from enforcing gaming laws on these types of securities. made it possible for investors to speculate on the possibility of default on securities they didn't own speculators could legally bet on whether a firm or security would fail in the future

Types of Corporate Bonds

secured, unsecured, junk usually distinguished by type of collateral that secures the bond and by the order in which the bond is paid off if firm defaults

Division of Corporate Finance

responsible for collecting documents that public companies are required to file annual reports, registration statements, quarterly filings,etc reviews filings to check for compliance with regulations DOES NOT VERIFY truth or accuracy of filings

Changes in Expected Future Exchange Rate

return on domestic assets depends on future resale price any factor that causes expected future exchange rate to rise increases the expected appreciation of the dollar higher relative expected return on dollar assets, which increases the demand for dollar assets at every exchange rate, rightwards shift in demand curve, equilibrium exchange rate rises A rise in the expected future exchange rate, Et+1e, shifts the demand curve to the right and causes an appreciation of the domestic currency. Using the same reasoning, a fall in the expected future exchange rate, Et+1e, shifts the demand curve to the left and causes a depreciation of the currency.

Municipal Bonds

securities issued by local, county, and state governments proceeds used to fund public interest projects like schools, utilities, transportation interest earned on the municipal bonds that were issued to pay for essential public projects are exempt from federal taxes. -allows the municipality to borrow at a lower cost bc investors will be satisfied with lower interest rates on tax-exempt bonds. 2 types: general obligation and revenue bonds recently low interest rates led to many municipal bonds issued in recent years

Federal National Mortgage Association (Fannie Mae)

set up by government set up to buy mortgages from thrifts so that these institutions could make more mortgage loans agency would fund these purchases by selling bonds to the public

Stocks

share of a stock in a firm represents ownership stockholder owns a percentage interest in a firm, consistent with the percentage of outstanding stock held investors earn return from stock in 2 ways: 1. Price of stock rises over time 2.firm pays the stockholder dividends usually earn return both ways stock is riskier lower priority than bondholders when firm is in trouble dividends less assured stock price increases not guranteed possible to earn a lot of money investing in stocks, not so much with bonds stock does not mature stockholders have certain rights regarding the firm has right of a residual claimant: stockholder have a claim on all assets and income left over after all other claimants have been satisfied. if nothing left over, they get nothing possible to get rich is firm does well most stockholders have right to vote for directors and on certain issues, such as amendment to corporate character and whether new shares should be issued

Demand Curve for Domestic Assets

shows quantity demanded at each current exchange rate most important determinant of quantity of domestic assets demanded (dollars) is the relative expected return of domestic assets low exchange rate implies that dollar is expected to rise more in value/appreciate The greater the expected rise (appreciation) of the dollar, the higher the relative expected return on dollar (domestic) assets theory of portfolio choice tells us that bc dollar assets are now more desirable to hold, the quantity of dollar assets demanded will rise if current exchange rate is even lower, there is an even higher expected appreciation of the dollar, a higher expected return, and larger quantity of dollar assets demanded demand curve is downward sloping, indicating that at lower current values of the dollar the quantity demanded of dollar assets in higher

2 types of exchange rate transactions

spot transactions (most popular) Forward transactions

oversight of bond markets

stocks normally sell in public markets where bid and ask prices are readily available and transparent bonds normally trade over the counter, where transaction details can be hidden from the public

Forward transactions

the exchange of bank deposits at some specified future date forward exchange rate: exchange rate for forward transaction

Liquidity

the liquidity of a security refers to how quickly, easily, and cheaply it can be converted into cash. Typically, the depth of the secondary market where the security can be resold determines its liquidity. For example, the secondary market for Treasury bills is extensive and well developed. As a result, Treasury bills can be converted into cash quickly and with little cost. By contrast, there is no well-developed secondary market for commercial paper. Most holders of commercial paper hold the securities until maturity. In the event that a commercial paper investor needed to sell the securities to raise cash, it is likely that brokers would charge relatively high fees. In some ways, the depth of the secondary market is not as critical for money market securities as it is for long-term securities such as stocks and bonds. This is because money market securities are short-term to start with. Nevertheless, many investors desire liquidity intervention: They seek an intermediary to provide liquidity where it did not previously exist. This is one function of money market mutual funds

interest rate risk in bond markets

the possibility of suffering a loss because of interest-rate changes is called interest-rate risk. The longer the time until the bond matures, the greater will be the change in price. This does not cause a loss to those investors who do not sell their bonds; however, many investors do not hold their bonds until maturity. If they attempt to sell their bonds after interest rates have risen, they will receive less than they paid.

theory of purchasing power parity

theory of PPP suggests that if one country's price level rises relative to another's, its currency should depreciate (the other country's currency should appreciate). if Japanese price level rises 10% relative to U.S. price level, U.S. dollar will appreciate by 10%

Theory of Purchasing Power Parity

theory of how exchange rates are determined states that exchange rates between any 2 currencies will adjust to reflect changes in the price levels of the 2 countries an application of the law of one price to national price levels theory of PPP suggests that if one country's price level rises relative to another's, its currency should depreciate (the other country's currency should appreciate). thinking of it through a concept called the real exchange rate predicts that the real exchange rate is always equal to 1.0 , so that the purchasing power of the dollar is the same as that of other currencies such as the yen or euro little predictive power in short run provides some guidance to long-run movements of exchange rate, not perfect useless for predicting short run

Stock Market Indexes

used to monitor the behavior of a group of stocks by reviewing average behavior of a group of stocks, investors gain insight as to how a broad group of stocks may have performed reported to give investors an indication of the performance of different groups of stocks most common: Dow Jones Industrial Average (DJIA), an index based on the performance of the stocks of 30 large companies

Graduated-Payment Mortgages (GPMs)

useful for home buyers who expect their incomes to rise lower payments in first few years, then payments rise early payments might not even be enough to cover interest, so principal balance would increase in this case as time passes, borrower expects income to increase so high payment won't be a burden advantage: borrowers will qualify for a larger loan than in conventional mortgage. helps buyers get good housing now and avoid need to move in future as family gets bigger disadvantage: payments increase regardless of whether or not borrowers income increases Initial low payment increases each year; loan amortizes in 30 years

Collateral

usually the real estate being financed has to be pledged as security lending institution will place a LIEN against property, remains in effect until loan is paid off Lien: public record that attaches to title of the property, advising that the property is security for a loan, and gives the lender rights to sell the property if loan defaults no one can buy the property and obtain title without paying off the lien if you try selling the property without paying off the loan, the lien will stay attached and no one will wanna buy it anyways bc lender has rights to seize the property is its lien is on the title Liens explain why title searches are important part of mortgage loan trasnaction during title search, lawyer or company searches public record for nay liens title insurance is then sold that grantees the buyer that property is free of Encumbrances, any questions about the estate of the title to the property, including the existence of liens

Corporate Bonds interest rates

varies with level of risk Bonds with low risk & high rating have lower rates than more risky bonds spread between differently rated bonds varies rate also depends on other features and characteristics

adverse selection

asymmetric info problem occurs before transaction potential bad credit risks are the ones who most actively seek out loans people most likely to produce undesirable outcome are the ones that most want to engage in the transaction ex: big risk takers/crooks will be most eager to take out loan because they know they aren't gonna pay it bck increases the chances that a loan might be made to a bad credit risk

wholesale markets

-money markets are this type -most transactions are very large, in excess of 1 million. -size of transactions prevents individual investors from directly trading in money markets -dealers & brokers from trading rooms of large banks and brokerage houses bring customer together -there are some ways for small investors to participate

Money Market transactions

-traders arrange transactions over the phone and are completed electronically. -active secondary market, easy to find future buyers after its initially sold -active secondary market, makes money market securities flexible instruments to use to fill short term financial needs

7. Collateral is a common feature of debt contracts

Collateral: property pledged to lender to guarantee payment in event that borrow can't make payments unsecured debt: credit card Collaterized/Secured debt is main form of household debt and widely used in business borrowing too most household debt Is collaterized loan like auto loan and mortgage commercial and farm mortgage make up 1/4 of borrowing by non financial businesses

Transaction Costs

You have $5000 to invest Investing in stock market: can only buy small # of shares, very small purchase brokerage commission will be very expensive, large % of purchase price Bonds: minimum denomination is $10000, so can't buy only 1/2 of American households own securities ALSO: small budget to invest, so you can only make small # of investments (large amount of small transactions would be too high transaction costs) So, you can't diversify so you will have lot of risk

Money market- Fiannce Companies (commercial leasing companies)

lend funds to individuals -raise funds mainly by selling commercial paper -then lend the funds to consumers for purchase of durable goods such as cars, boats, and home improvements

How Moral Hazard affects the choice between debt and equity contracts

moral hazard: asymmetric info problem that occurs after financial trasnaction takes place, when the seller of a security may have incentives to hide info and engage in a activities that are undesirable for the purchaser of the security. Moral Hazard has important consequences for whether a firms finds it easier to raise funds with debt than with equity contracts

money market participants

most money market participants operate on both sides of the market. Any large bank will borrow aggressively in the money market by selling large commercial CDs AT same time will lend short term funds to businesses through its commercial lending departments

The Financial Crisis of 2007-2009

o Financial innovation lead to a rapid expansion of home ownership Explosion of CDOs and mortgage-backed securities Reduction in underwriting standards for mortgages Mortgage brokers had an "originate to distribute" model, where they were compensated on volume and had little incentive to ensure that the home owners would be able to pay off their loans o Credit rating agencies had serious conflicts of interest: they did consulting work on structuring asset-backed securities, and they rated these very same assets The result is that there were a lot of highly rated asset-backed securities that were actually quite risky o Eventually, housing prices started to fall and homeowners began to default on their loans The value of the asset-backed securities plummeted Financial institutions' balance sheets were damaged Financial institutions cut back on their lending, harming businesses and reducing economic activity (leading to a recession)

Money markets 3 Characteristics

short term- & highly liquid securities (close to being money) -usually sold in large denominations -low default risk -mature in a year or less from original issue date. (Most money market instruments mature in less than 120 days)

3. Indirect finance is more important direct finance in terms of providing funds for businesses

since 1970, less than 5% of newly issued corporate bonds and less than 1/3 stocks have been sold DIRECTLY to households. Rest were bought by financial intermediaries like pension funds, insurance companies, mutual funds direct finance is used in less than 10% of external funding of American business Since marketable securities are used less in other countries, direct finance is even less important in other countries

Private Production and sale of information

solution to adverse selection problem: eliminate asymmetric info by providing lender-savers with full details about the borrowers/ firms seeking to finance investment activities one way to do this is by having private companies collect and produce information that distinguishes good from bad firms and then sell it S&P, Moody's in U.S> gathers info on firm balance sheets, investment activities, publish & sell to subscribers Creates "free-rider" problem- people who don't pay for info take advantage of the info that other people have paid for private sale of info is only partial solution to lemons problem Ex: you pay for the info that tells you good firms from bad firms your friend sees you buying the undervalued securities from good firms, so he does too (but he didn't pay for the info) if other people do the same, demand for that undervalued security increases , causing price to increase to its true value. Because of all the free riders, you can no longer buy the securities for less than their true value and make profit now since you can't make a profit you wish you never paid for the info.. if others feel the same way, private firms and individuals might not be able to sell enough info to make their efforts of gathering and producing the info worth it. Now since the private firms can't profit from selling info, less info will be produced in the market place, so adverse selection (lemons problem) will still interfere with the efficient functioning of securities market

1. Stocks are not the most important source of external financing for businesses

stock market accounts for only a small fraction of the external financing of American businesses and in other countries the percentage of external financing provided by stocks is based on the flows of external funds to corporations. When stock is issued, it raises funds permanently. When bond I issued, it raises funds temporarily until they're paid back at maturity. the firm raises $1000 by issuing stock once in a 30 year period, while it raises $1000 30 times in a 30-year period (issuing and repaying over and over again each year) to hold onto $1000 raised through debt, company has to issue a bond every year since the 1000 has to be repaid after one year so, it will look like debt is 30 times more important than stocks in raising funds, but they're actually equally improtant

credit spread

the difference between the interest rate on loans to households and businesses and the interest rate on completely safe assets that are sure to be paid back, such as U.S. Treasury securities

Money market- U.S. Treasury Department

-Sells U.S. Treasury securities to fund the national debt -always a demander of money market funds and never a supplier -largest borrower -issues T-bills and other popular securities -short term issues help gov raise funds until tax revenues are collected -also issue T-bills to replace maturing issues

sellers of money market securities

-money market provides low cost source of temporary funds -banks may borrow excess reserves to obtain funds in market to meet short term reserve requirement shortages gov funds large portion of u.s. debt with treasury bills -finance companies might enter money market to raise funds that it uses to make loans

Purpose of Money Markets

-well developed secondary market makes it an ideal place for a firm or fin institution to warehouse surplus funds until they're needed -low-cost source of funds for firms, gov, intermediaries that need a short term infusion of funds -goal is not to earn high returns, but just keep as interim investment that earns higher return than holding cash or keeping in a bank -market might not be good so dont want to buy stock, interest rates might rise so dont want to buy bonds -holding surplus cash is expensive bc it doesn't earn additional income for owner. Idle cash is an "opportunity cost" in terms of lost interest income. Money markets give way to invest idle cash and reduce opportunity cost -asset opportunity cost: amount interest sacrificed by not holding an alternative asset -investors hold funds in money markets to be able to act quickly and take advantage of investment opportunities, and to meet investment or deposit outflows

The Great Depression

1. Stock Market Crash: -prices doubled in U.S. stock market -Federal Reserve viewed stock market boom as excessive speculation so they tightened monetary policy to raise interest rates to limit the rise in stock prices -stock market crashed in October 1929, falling by 40% by end of 1929 2. Bank Panics: -By mid-1930 stocks recovered about half their losses and credit market conditions stabilized -but then severe droughts in midwest led to sharp decline in agricultural production, making farmers unable to pay back loans. -default on farm mortgages led to large loan losses on bank balance sheets in agricultural regions -weakness of banks and economy in agricultural regions prompted substantial withdrawals from banks, leading to a panic in Nov & Dec 1930, with stock market falling sharply -For over 2 years, Fed didn't do anything just watched each panic unfold after the other -Roosevelt declared bank holiday (temporary closing of banks) in March 1933 but damage had been done -1/3 of U.S. commercial banks and failed 3. Continuing Decline in Stock Prices: -stock prices kept falling. by mid-1932 stocks had declined by 10% of 1929 peak value -increase in uncertainty from unsettled business condition created by economic contraction worsened adverse selection and moral hazard problem in financial markets - With less financial intermediaries in business, adverse selection and moral hazard problems got worse -fianncial markets struggled to channel funds to borrower spenders with productive investment opportunities - outstanding commercial loans fell by half from 1929-1933, and investment spending fell by 90% from 1929 level -because of financial friction, lenders started charging businesses higher interest rates to protect themselves from credit losses. -increase in credit spread (the difference between the interest rate on loans to households and businesses and the interest rate on completely safe assets that are sure to be paid back, such as U.S. Treasury securities) 4. Debt Deflation -the ongoing deflation that started in 1930 led to a 25% decline in price level -deflation short circuited recovery process in recession -huge decline in prices triggered a debt deflation where net worth fell because of the increase burden of indebtedness borne by firms -decline in net worth and increase in adverse selection and moral hazard problems in credit markets led to a long economic contraction where unemployment rose to 25%. INTERNATIONAL DIMENSIONS: Great Depression started in the United States, it was not just a U.S. phenomenon. Bank panics in the United States also spread to the rest of the world, and the contraction of the U.S. economy sharply decreased the demand for foreign goods. The worldwide depression caused great hardship, with millions upon millions of people out of work, and the resulting discontent led to the rise of fascism and World War II.

8 Facts about the financial system

1. Stocks are not the most important source of external financing for businesses 2. Issuing marketable securities (stocks and bonds) is not the primary way in which businesses finance their operations 3. Indirect finance is more important direct finance in terms of providing funds for businesses 4. Financial intermediaries are the most important source of funds used to finance businesses 5. The financial system is heavily regulated 6. Only large, well-established corporations have easy access to securities markets to finance their activities 7. Collateral is a common feature of debt contracts 8. Debt contracts are typically complicated documents that restrict borrowers' behavior

Financial Crisis of 2007-2009

3 causes: 1. Financial Innovation in mortgage markets 2. Agency problems in mortgage markets 3. asymmetric info in credit-rating process

Collateral and Net Worth

Adverse selection interferes with functioning of financial markets only if lender suffers loss because borrower defaults and can't pay back loan collateral: property promised to lender if borrower defaults collateral reduces consequences of adverse selection because it reduces lenders losses in event of default. lender can sell collateral to make up for losses on loan lenders more willing to make loans secured by collateral ex. mortagage, can take and sell ur house if u default borrowers willing to supply collateral bc reduced risk for lender makes it more likely they will receive the loan and better interest rate. presence of adverse selection in credit markets provides explanation why collateral is important feature of debt contracts ( FACT 7) Net worth/equity capital: difference between firms assets and liabilities net worth performs similarly to collateral If firm has high net worth, even if it default on loan payments lender can take title to firms net worth, sell it, and recover some losses from loan. Also, the more net worth a firm has, the less likely it is to default because it has a cushion of assets it can use to pay off loans. so, when firms seeking credit have high net worth, consequences of adverse selection are less important and lenders are more willing to make loans "Only people who dont need money can borrow it"

Agency Theory and Definition of Financial Crisis

Agency theory: -analysis of how asymmetric info problems can generate adverse selection and moral hazard problems -basis for our definition of financial crisis Asymmetric info problems act as a barrier to financial markets channeling funds efficiently from savers to households and firms with productive investment opportunities. called FINANCIAL FRICTIONS When financial frictions increase, it is harder for lenders to ascertain creditworthiness of borrowers and have to charge higher interest rate to protect against possibility that borrower won't repay the loan, which leads to higher CREDIT SPREAD (difference between interest rate on loans to businesses and interest rate on default free assets like us treasury bonds) Financial crisis occurs when info flows in financial markets experience a large disruption, resulting in financial frictions and credit spreads increasing sharply and financial markets stop functioning. Then economic activity will collapse.

Auditing and Consulting in Accounting Firms

Auditor checks books of companies and monitors the quality of info produced by firms to reduce info asymmetry between firm managers and shareholders. threats to truthful reporting arise from several potential conflicts of interest most important: when an accounting firm provides its client with both auditing services and non audit consulting services such as advice on taxes, accounting, management info systems, and business strategy. Giving clients multiple services allows for economies of scale and scope but creates 2 potential conflicts of interest 1. Auditors may be willing to skew judgements and opinions to win consulting business from the same clients 2. Auditors may be auditing info systems or tax and financial plans put in place by their non audit counterparts within the firm and therefore may be reluctant to criticize the systems or advice. both of these may lead to biased audits, leading to less reliable info available in financial markets and investors finding it difficult to allocate capital efficiently. Another conflict of interest arises when an auditor provides an overly favorable audit to solicit or retain audit business

Financial Crisis of 2007-2009: Financial Innovation in mortgage markets

Before 2000, only most credit worthy borrowers could obtain mortgages Advances in computer technology & new statistical techniques like data mining led to enhanced quantitative evaluation of the credit risk for a new class of risky residential mortgages Households could now get a numerical credit score or FICO score that predicts how likely they would be to default on loan payments By lowering transaction costs, computer technology allowed the bundling of smaller loans like mortgages into standard debt securities (process called securitization). This made It possible for banks to offer subprime mortgages to borrowers with not so great credit records The ability to cheaply quantify default risk of the underlying high-risk mortgages and bundle them in standardized debt securities called mortgage-backed securities provided a new source of financing for these mortgages. Financial engineering, the development of new, sophisticated financial instruments, led to STRUCTURED DEBT PRODUCTS that pay out income steams from a collection of underlying assets, designed to have particular risk characteristics that appeal to investors with differing preferences. Most notorious one is Collateralized debt obligations

Financial Intermediation

Borrowers may be clever enough o find loopholes in restrictive covenants that make them ineffective Restrictive covenant is meaningless if borrower can violate it knowing the lender won't check up or is unwilling to pay for legal recourse. since Monitoring and enforcing restrictive covenants is costly, free-rider problem arises in bond/debt market as well If you know other bondholders are monitoring and enforcing restrictive covenant, then you can free ride. So can other bondholders and its likely there won't be enough resources devoted to monitoring and enforcing the restrictive covenants. Moral hazard therefore continues to be a problem for marketable debt. Financial intermediaries, like banks, have the ability to avoid free rider problem by making private loans. Private loans aren't traded so no one can free ride on the intermediary monitoring and enforcing restrictive covenants. Intermediary thus receives benefits of minoring and enforcement and will work to shrink the moral hazard problem inherent in debt contracts These are all reasons why financial intermediaries play a more important role in channelling funds from savers to borrower than marketable securities do, facts 3 and 4

Money market- Commercial Banks

Buy U.S. Treasury securities; sell certificates of deposit and make short-term loans; offer individual investors accounts that invest in money market securities -hold a percentage of us gov securities second to pension funds -banks aren't allowed to hold risky securities like stocks and corporate bonds -so, they buy treasury securities since they're allowed to (due to low risk and high liquidity) -major issuer of negotiable CDs, banker's acceptances, federal funds, and repurchase agreements -use money markets to manage own liquidity, also trades on behalf of their customers -only largest commercial banks called "money center banks" like Wells Fargo and Citi trade for their customer

Money market- Businesses

Buy and sell various short-term securities as a regular part of their cash management -buy & sell -usually only major corporations do it because of the large dollar amounts -used extensively to warehouse surplus funds and raise short term funds

Money market- Federal Reserve Sytem

Buys and sells U.S. Treasury securities as its primary method of controlling interest rates -holds large # of treasury securities that it sells if it believes interest rates should be raised -Will purchase treasury securities if it believes interest rates should be lowered -Fed's responsibility for interest rates makes it most influential participant in money market

Financial Crisis of 2007-2009: Asymmetric information and Credit-Rating services

Credit rating agencies were another contributor to asymmetric info in financial markets. The rating agencies advised clients on how to structure complex financial instruments like CDOs and at the same time were rating these identical products. The rating agencies were thus subject to conflicts of interest because the large fees they earned from advising clients on how to structure products they were rating meant that they didn't have sufficient incentive to make sure their ratings were accurate. The result was wildly inflated ratings that enabled the sale of complex financial products that were far riskier than investors recognized

Credit-Rating Agencies and the 2007-2009 Financial Crisis

Credit-rating agencies advised clients on how to structure complex financial instruments that paid out cash flows from subprime mortgages. At the same time, they were rating these identical products, leading to the potential for severe conflicts of interest. Specifically, the large fees they earned from advising clients on how to structure products that they were rating meant they did not have sufficient incentives to make sure their ratings were accurate. When housing prices began to fall and subprime mortgages began to default, it became crystal clear that the ratings agencies had done a terrible job of assessing the risk in the subprime products they had helped to structure. Many AAA-rated products had to be downgraded over and over again until they reached junk status. The resulting massive losses on these assets were one reason why so many financial institutions that were holding them got into trouble, with absolutely disastrous consequences for the economy, as discussed in the next chapter. the credit-rating agencies' models for rating subprime products were not fully developed and that conflicts of interest may have played a role in producing inaccurate ratings. To address conflicts of interest, the SEC prohibited credit-rating agencies from structuring the same products they rate, prohibited anyone who participates in determining a credit rating from negotiating the fee that the issuer pays for it, and prohibited gifts from bond issuers to those who rate them in any amount over $25. required more disclosure of how the credit-rating agencies determine ratings required to disclose historical ratings performance, including the dates of downgrades and upgrades, information on the underlying assets of a product that were used by the credit-rating agencies to rate a product, and the kind of research they used to determine the rating. In addition, the SEC required the rating agencies to differentiate the ratings on structured products from those issued on bonds. The expectation is that these reforms will bring increased transparency to the ratings process and reduce conflicts of interest that played such a large role in the subprime debacle.

Debt

Debt: Financing a business with debt (e.g., loans or bonds) also creates moral hazard problems Managers can have incentive to gamble The managers get all the upside of the gamble pays off; the lender is stuck with the downside if the gamble fails Tools to help solve this: Net worth and collateral o If the manager has "skin in the game," he/she is less likely to want to gamble and risk losing his/her existing assets Monitoring o Free-rider problem (bonds) o Banks can avoid the free-rider problem (they can easily monitor the firm's activity, and it's harder for others to "piggy-back" off of the bank's monitoring)

Step 2: Banking Crisis

Deteriorating balance sheets & tough business conditions lead some financial institutions into insolvency (net worth becomes negative) If they can't pay off depositors or other creditors, some banks go out of business and if its bad enough, can lead to a bank panic, where multiple banks fail at once. This happens because of asymmetric info. In a panic, depositors fearing for the safety of their deposits and are not sure of the quality of banks portfolios, so they withdraw their deposits to the point where banks fail Uncertainty about health of the banking system can lead to good and bad runs on banks, forcing banks to sell their assets quickly to raise funds. These FIRE SALES of assets might cause their prices to decline so much that the bank becomes insolvent, even if the resulting contagion can then lead to multiple bank failures and a full on bank panic With fewer banks operating, info about creditworthiness of borrower-spenders disappears. Increasingly severe adverse selection and moral hazard problems in fin markets increase financial frictions and deepen the financial crisis, causing declines in asset prices and the failure of firms throughout the economy that lack funds for productive investment opportunities Eventually, public and private authorities shut down insolvent firms and sell them off or liquid them. Uncertainty in financial markets declines, stock market recovers, and balance sheets improve. Financial frictions diminish and the financial crisis subsides. With the financial markets able to operate well again, the stage is set for economic recovery

What are conflicts of interest and why do we care ?

Economies of Scope many benefit fin institutions but also creates potential costs in terms of conflict of interest. Type o moral hazard problem that arise when a person or institution has multiple objectives (interests) and, as a result, has conflicts among those objectives. especially likely to occur when a financial institution provides multiple services. the potentially competing interests of those services may lead to individuals who work for financial institutions to conceal information or disseminate misleading information a substantial reduction in the quality of information in financial markets increases asymmetric information problems and prevents financial markets from channeling funds into the most productive investment opportunities. Consequently, the financial markets and the economy become less efficient.

2. Covenants to encourage desirable behavior

Encourage the borrower to engage in desirable activities that make it more likely that the loan will be paid off ex: Breadwinner in a household to carry life insurance that pays off the mortgage upon that person's death Encouraging borrowing firm to keep its net worth high because high borrower net worth reduces moral hazard and makes it less likely that the lender will suffer losses firm must maintain minimum holdings of certain assets relative to the firms size

Moral Hazard in Equity Contracts: The Principal-Agent Problem

Equity contracts such as common stock are claims to a share in the profits and assets of a business. Claim on profits in all situations, whether firm is making or losing money. Subject to moral hazard problem called principal-agent problem Principal agent problem- when managers own only a small fraction of the firm they work for, the stockholders who own most of the firm's equity (called the principals_ are not the same people as the managers of the firm, who are agents of the owners. Separation of ownership and control causes moral hazard problems- managers in control (agents) may act in their own interest rather than in the interest of the stockholder-owners (principals) because managers have less incentive to maximize profits than stockholder-owners do. Also risk that managers will hide profits from you and pocket it for themselves. Diverting funds for personal use. Managers might also pursue corporate strategies such as acquiring other firms to enhance their personal power but doesn't increase corporations profitability ex. you have 90% ownership, manager has 10% ownership, total profit if he did his job well is 50,000. your share is 45k, his is 5k. but manager buys frivolous things instead of being good manager bc he doesn't think 5k is worth working hard for, doesn't have enough incentive, so you dont make any profit bc of his poor management. He doesn't try to make any profit principal-agen problem wouldn't happen if owners of a firm had complete info about what managers were doing and could recent wasteful expenditures or fraud. Problem arises due to managers having more info about their activities than stockholders do. Information is asymmetric. Would not occur if ownership and control weren't separated, as owners being managers would make them want to work hard so they can maximize profits

Moral Hazard: Equity

Equity: Financing a business with equity (stock) reduces the managers' incentives to maximize firm value Much of the benefits from the increase in the firm's value go to the external investors, not the inside managers Managers can have incentives to shirk (not work as hard as is socially optimal) Tools to help solve this: Monitoring o But the free-rider problem hinders this Government regulation of information (disclosure) o But Enron Finanancial intermediaries (e.g. venture capitalists) o Venture capitalists avoid the free-rider problem Using debt (e.g., loans or bonds) instead of equity o But this creates other moral hazard problems

Government Regulation to Increase Information

Free-ride problem prevents private market from producing enough info to eliminate all the symmetric info that leads to adverse selection U.S. and many other countries around the world regulate securities markets by encouraging firms to reveal honest info about themselves so that investors can determine how good or bad the firms are In the U.S., SEC gov agency requires firms selling securities to have independent audits in which accounting firms certify that the firm is adhering to standard account principles and disclosing accurate info about sales, assets, and earnings these requirements dont always work (Enron collapse and accounting scandals of other corporations) Asymmetric info problem in adverse selection in financial markets explains why they are one of the most heavily related sectors in the economy (FACT 5). GOv regulation to increase info to investors is needed to reduce the adverse selection problem, which interferes with the efficient function of securities markets gov regulation lessens the adverse selection problem, but doesn't eliminate it. Even when firms provide info to the public, they still know more than the investors. More to quality of the firm than just statistics. Bad firms also have incentive to make themselves look like good firms in order to drive price of their securities up. Bad firms will alter the info they're required to provide to the public making it harder for investors to sort out good firms from bad

Step 3: Debt Deflation

If the economic downturn leads to sharp decline in price level, recovery process can be interrupted. Debt deflation occurs when a substantial unanticipated decline in the price level sets in, leading to a further decrease in firms net worth because of the increased burden on indebtedness In economies with moderate inflation, debt contracts with fixed interest rates are usually long term (10 yrs or more). Since debt payments are contractually fixed in nominal terms, an unanticipated decline in price level raises the value of borrowing firms liabilities in real terms (increases burden of debt) but doesn't raise the real value of borrowing firms assets. The borrowing firms net worth in real terms then declines. Ex: Firm in 2018 has $100 million in assets, $90 million long term liabilities, so net worth is $10 million. If price level falls by 10% in 2019, Real value of liabilities rises to $99 million (in 2018 dollars) and real value of assets stays at $100 million. Then, real net worth in 2018 dollars is now $1 million. The substantial decline in real net worth of borrowers from a sharp drop in price level causes an increase in adverse selection and moral hazard problems facing lenders. Lending and economic activity decline for a long time. ex: Great Depression These stages feed upon one another, and the cycle often repeats itself over and over until the crisis ends

Underwriting and Research in Investment Banking

Invest banks do 2 things: 1. research companies issuing securities 2. underwrite these securities by selling them to the public on behalf of issuing corporation Sometimes they do both because information synergies are possible, meaning info produced during one task is useful for the other task Conflict of interest arises when doing both underwriting and brokerage services bc the investment bank is attempting to serve two client groups: the security-issuing firms and the security-buying investors. They both have different information needs. Issuers benefit from optimistic research and investors need unbiased research. BUT, the same info will be produced for both to take advantage of economies of scope. If potential revenues from underwriting are more than the brokerage commission from selling the securities, the investment bank will have incentive to alter info provided to investors in favor of issuing firms needs or else risk losing the business to competing investment banks analysts in investment banks might distort research to please issuers This undermines the reliability of info that investors use to make financial decision and in turn diminishes the efficiency of securities markets Spinning is also a problem

Credit Assessment and Consulting in Credit-Rating Agencies

Investors use credit ratings that reflect probability of default to determine creditworthiness of particular debt securities. Debt ratings play major role in pricing and regulatory process Conflicts of interest arise when multiple users with divergent interest (at least in short term) depend on the credit ratings. Investors/regulators was well-research, unbiased assessment of credit quality. Issuers want favorable ratings Issuers pay a credit rating firm like S&P or Moody's to rate their securities. Because issuers are the ones who pay the credit rating agencies, investors and regulators worry that the agency may bias its rating upward to attract more business from the issuer. Another conflict of interest arises when: credit-rating agencies also provide consulting services debt issuers often ask rating agencies for advice on structuring debt issues to secure a good rating. In this situation, rating agencies would be auditing their own work and would experience conflict of interest similar to accounting firms that provide both auditing and consulting services. Also, credit rating agencies might give good ratings to get new clients for their consulting business. Possible decline in quality of credit assessments could increase asymmetric info in financial markets, diminishing their ability to allocate credit

Monitoring and Enforcement of Restrictive Covenants

Lender can be sure borrower uses funds for the purposes lender wants it to be used for by writing provisions (restrictive covenants) into the debt contract that restrict browsing firms activities. By monitoring firms activities to check if its complying with the restrictive covenants and enforcing the covenants if its not, you can make sure it doesn't take risks at your expense. Restrictive covenants are directed at reducing moral hazard either by ruling out undesirable behavior or by encouraging desirable behavior. 4 types: 1. Covenants to discourage undesirable behavior 2. Covenants to encourage desirable behavior 3. Covenants t keep collateral valuable 4. Covenants to provide info Debt contracts are complicated legal documents with numerous restrictions on the borrower's behavior (fact 8): debt contracts require complicated restrictive covenants to lower more hazard

Money market- Insurance Companies (property and casualty insurance companies)

Maintain liquidity needed to meet unexpected demands -must maintain liquidity liquidity bc of their unpredictable need for funds -to meet demand for funds, need to be able to sell money market securities for cash

Asset-Price Boom and Bust

Prices of assets like equity and real estate can be driven by investor psychology ABOVE their fundamental economic values (value based on realistic expectations of assets future income streams) The rise of asset prices above their fundamental economic value is an ASSET PRICE BUBBLE Asset price bubbles are also often driven by credit booms, where the large increase in credit is used to fund purchases of assets, driving up their price. When the bubble bursts and asset prices go back to their fundamental economic values, stock and real estate prices tumble, companies see their net worth decline, and the value of collateral they can pledge drops. At this point companies have less at stake and so they are more likely to make risky investments because they have less to lose, the problem of moral hazard. As a result, financial institutions tighten lending standards for borrower-spenders and lending contracts The asset-price bust also causes a decline in the value of financial institutions assets, causing a decline in their net worth and a deterioration in their balance sheets which causes them to deleverage, steepening the decline in economic activity

Remedy conflicts of interest

Sarbanes-Oxley Act 2002 Global Legal Settlement

Has Sarbanes-Oxley Led to a Decline in U.S. Capital Markets?

Section 404 requires both management and company auditors to certify the accuracy of their financial statements. There is no question that Sarbanes-Oxley has led to increased costs for corporations, and this is especially true for smaller firms with revenues of less than $100 million, where the compliance costs have been estimated to exceed 1% of sales. These higher costs could result in smaller firms listing abroad and discourage IPOs in the United States, thereby shrinking U.S. capital markets relative to those abroad. However, improved accounting standards could work to encourage stock market listings and IPOs because better information could raise the valuation of common stocks. it, as well as higher litigation and weaker shareholder rights, as the cause of declining U.S. stock listings and IPOs, but other factors are likely at work. As the importance of the United States in the world economy has diminished because of the growing importance of other economies, the U.S. capital markets have become less dominant over time. This process is even more evident in the corporate bond market. The global settlement had measures to improve the quality of information in financial markets: It required investment banks to make their analysts' recommendations public. Over a five-year period, investment banks were required to contract with at least three independent research firms that would provide research to their brokerage customers. The most controversial elements of the Sarbanes-Oxley Act and the Global Legal Settlement were the separation of functions (research from underwriting, and auditing from nonaudit consulting). Although such a separation of functions may reduce conflicts of interest, it might also diminish economies of scope and thus potentially lead to a reduction of information in financial markets. In addition, there is a serious concern that implementation of these measures, particularly Sarbanes-Oxley, is too costly and is leading to a decline in U.S. capital markets

"Inside The Fed Was the Fed to Blame for the Housing Price Bubble?"

Some economists—most prominently, John Taylor of Stanford University—have argued that the low-rate interest policy of the Federal Reserve in the 2003-2006 period caused the housing price bubble.* Taylor argues that the low federal funds rate led to low mortgage rates that stimulated housing demand and encouraged the issuance of subprime mortgages, both of which led to rising housing prices and a bubble. countered this argument.** He concluded that monetary policy was not to blame for the housing price bubble. First, he said, it is not at all clear that the federal funds rate was too low during the 2003-2006 period. Rather, the culprits were the proliferation of new mortgage products that lowered mortgage payments, a relaxation of lending standards that brought more buyers into the housing market, and capital inflows from countries such as China and India. Bernanke's speech was very controversial, and the debate over whether monetary policy was to blame for the housing price bubble continues to this day.

Spinning

Spinning is when an investment bank allocates hot, but underprices Initial Public Offerings (IPOs) --shares of newly issued stock-- to executive of OTHER companies in return for THEIR companies future business with the investment bank Because hot IPOs usually immediately rise in price after they're first purchased, spinning is a form of kickback meant to persuade executives to use that investment bank. When the executives company plans to issue its own shares, they will be more likely to go to the investment bank that issued the hot IPO shares, which is not necessarily the investment bank that will be able to get the highest price for the companies securities. This practice may raise cost of capital for the firm, therefore diminishing the efficiency of the capital market

Why do we need money markets?

The banking industry exists primarily to mediate the asymmetric information problem between saver-lenders and borrower-spenders, and banks can earn profits by capturing economies of scale while providing this service. However, the banking industry is subject to more regulations and governmental costs than are the money markets. In situations where the asymmetric information problem is not severe, the money markets have a distinct cost advantage over banks in providing short-term funds.

Is China a counter-example to the importance of ficnancial development?

The country's legal system is weak, so that financial contracts are difficult to enforce, while accounting standards are lax, so that high-quality information about creditors is hard to find. Regulation of the banking system is still in its formative stages, and the banking sector is dominated by large state-owned banks. Yet the Chinese economy has enjoyed one of the highest growth rates in the world over the past 20 years. How has China been able to grow so rapidly given its low level of financial development? China is in an early state of development, with a per capita income that is around one-fifth of the per capita income in the United States. With an extremely high savings rate, averaging around 40% over the past two decades, the country has been able to rapidly build up its capital stock and shift a massive pool of underutilized labor from the subsistence-agriculture sector into higher-productivity activities that use capital. Even though available savings have not been allocated to their most productive uses, the huge increase in capital combined with the gains in productivity from moving labor out of low-productivity, subsistence agriculture have been enough to produce high growth. As China gets richer, however, this strategy is unlikely to continue to work. high growth fueled by a high savings rate, a massive buildup of capital, and shifts of a large pool of underutilized labor from subsistence agriculture to manufacturing. During this high-growth phase, however, the Soviet Union was unable to develop the institutions needed to allocate capital efficiently. As a result, once the pool of subsistence laborers was used up, the Soviet Union's growth slowed dramatically and it was unable to keep up with the Western economies.

Deterioration of Financial Institutions Balance Sheets

The decline in U.S. housing prices led to rising default on mortgages. As a result, the value of mortgage-backed securities and CDOs collapsed, leaving banks and other financial institutions with a lower value of assets and thus a decline in net worth. With weakened balance sheets, these banks and other financial institutions began to deleverage, selling off assets and restricting the availability of credit to both households and businesses. With no one else able to step in to collect information and make loans, the reduction in bank lending meant that financial frictions increased in financial markets.

moral hazard

arises after transaction occurs lender runs the risk that borrower will engage in activities that are undesirable from the lenders poverties because they make it less likely that the loan will be paid back lowers the probability that a loan will be repaid ex. once borrower obtains loan, may take on big risks (possible high returns but also greater risk of default) because they're playing with someone else money

Height of the 2007-2009 Financial Crisis

The financial crisis reached its peak in September 2008 after the House of Representatives, fearing the wrath of constituents who were angry about bailing out Wall Street, voted down a $700 billion bailout package proposed by the Bush administration. The Emergency Economic Stabilization Act finally passed nearly a week later. The stock market crash accelerated, with the week beginning October 6, 2008, showing the worst weekly decline in U.S. history. Credit spreads went through the roof over the next three weeks, with the spread between Baa corporate bonds (just above investment grade) and U.S. Treasury bonds going to over 5.5 percentage points (550 basis points) "The impaired financial markets and surging interest rates faced by borrower-spenders led to sharp declines in consumer spending and investment. Real GDP declined sharply, falling at a -1.3% annual rate in the third quarter of 2008 and then at a -5.4% and -6.4% annual rate in the next two quarters. The unemployment rate shot up, going over the 10% level in late 2009. The recession that started in December 2007 became the worst economic contraction in the United States since World War II and as a result is now referred to as the "Great Recession." Starting in March 2009, a bull market in stocks got under way, and credit spreads began to fall. With the recovery in financial markets, the economy started to recover but, unfortunately, the pace of the recovery has been slow. The financial market recovery was aided by the U.S. Treasury's requirement announced in February 2009 that the nineteen largest banking institutions undergo what became known as the bank stress tests (the Supervisory Capital Assessment Program, or SCAP). The stress tests were a supervisory assessment, led by the Federal Reserve in cooperation with the Office of the Comptroller of the Currency and the FDIC, of the balance sheet position of these banks to ensure that they had sufficient capital to withstand bad macroeconomic outcomes. The Treasury announced the results in early May and they were well received by market participants, allowing these banks to raise substantial amounts of capital from private capital markets. The stress tests were a key factor that helped increase the amount of information in the marketplace, thereby reducing asymmetric information and adverse selection and moral hazard problems.

Failure of High Profile Firms

The impact of the financial crisis on firms' balance sheets forced major players in the financial markets to take drastic action. In March 2008, Bear Stearns, the fifth-largest investment bank in the United States, which had invested heavily in subprime-related securities, had a run on its repo funding and was forced to sell itself to J. P. Morgan for less than 5% of what it had been worth just a year earlier. To broker the deal, the Federal Reserve had to take over $30 billion of Bear Stearns's hard-to-value assets. In July Fannie Mae and Freddie Mac, the two privately owned government-sponsored enterprises that together insured over $5 trillion of mortgages or mortgage-backed assets, were propped up by the U.S. Treasury and the Federal Reserve after suffering substantial losses from their holdings of subprime securities. In early September 2008 they were then put into conservatorship (in effect run by the government). On Monday, September 15, 2008, after suffering losses in the subprime market, Lehman Brothers, the fourth-largest investment bank by asset size with over $600 billion in assets and 25,000 employees, filed for bankruptcy, making it the largest bankruptcy filing in U.S. history. The day before, Merrill Lynch, the third-largest investment bank, which had also suffered large losses on its holding of subprime securities, announced its sale to Bank of America for a price 60% below its value a year earlier. On Tuesday, September 16, AIG, an insurance giant with assets of over $1 trillion, suffered an extreme liquidity crisis when its credit rating was downgraded. It had written over $400 billion of insurance contracts (credit default swaps) that had to make payouts on possible losses from subprime mortgage securities. The Federal Reserve then stepped in with an $85 billion loan to keep AIG afloat (with total government loans later increased to $173 billion).

Financial Crisis of 2007-2009: Agency problems in Mortgage Markets

The mortgage brokers that originated the loans didn't make strong efforts to evaluate whether the borrower could actually pay off the loan since they would quickly sell the loans to investors in the form of mortgage-backed securities. This ORIGINATE-TO-DISTRIBUTE model was exposed to the principal-agent problem , where mortgage brokers acted as agents for investors (principals) but didn't have their best interest at heart. Once mortgage brokers earn their fee, broker doesn't really care if borrower makes their payment, as the more volume the broker originates, the more they make

Step 2 Financial Crisis

The next stage is often a banking crisis, followed by a potential period of deflation

Run on the Shadow Banking System

The sharp decline in the value of mortgages and other financial assets triggered a run on the shadow banking system, composed of hedge funds, investment banks, and other nondepository financial firms, which are not as tightly regulated as banks. Funds from shadow banks flowed through the financial system and for many years supported the issuance of low-interest-rate mortgages and auto loans. These securities were funded primarily by repurchase agreements (repos), short-term borrowing that, in effect, uses assets like mortgage-backed securities as collateral. Rising concern about the quality of a financial institution's balance sheet led lenders to require larger amounts of collateral, known as haircuts. For example, if a borrower took out a $100 million loan in a repo agreement, it might have to post $105 million of mortgage-backed securities as collateral, and the haircut is then 5%. With rising defaults on mortgages, the value of mortgage-backed securities fell, which then led to a rise in haircuts. At the start of the crisis, haircuts were close to zero, but they eventually rose to nearly 50%.3 The result was that the same amount of collateral would allow financial institutions to borrow only half as much. Thus, to raise funds, financial institutions had to engage in fire sales and sell off their assets very rapidly. Because selling assets quickly requires lowering their price, the fire sales led to a further decline in financial institutions' asset values. This decline lowered the value of collateral further, raising haircuts and thereby forcing financial institutions to scramble even more for liquidity. The result was similar to the run on the banking system that occurred during the Great Depression, causing massive deleveraging that resulted in a restriction of lending and a decline in economic activity. The decline in asset prices in the stock market (which fell by over 50% from October 2007 to March 2009, as) and the more than 30% drop in residential house prices, along with the fire sales resulting from the run on the shadow banking system, weakened both firms' and households' balance sheets. This worsening of financial frictions manifested itself in widening credit spreads, causing higher costs of credit for households and businesses and tighter lending standards. The resulting decline in lending meant that both consumption expenditure and investment fell, causing the economy to contract.

Step 1: Finaancial Crisis

They often begin with a credit boom and bust, an asset price boom and bust, and/or increases in uncertainty o Credit boom and bust Financial innovation: introduction of new types of loans or financial products Can increase economic welfare, but can also result in credit being given too freely If credit is given too freely, loans will default, harming financial institutions' balance sheets Financial institutions often cut back on their lending when their balance sheet is weakened ("deleveraging") When businesses can't obtain financing, economic activity declines, which can cause a recession o Asset price boom and bust When asset prices fall significantly, this hurts financial institutions' balance sheets They then cut back on lending (deleveraging), which can reduce economic activity o Increases in uncertainty General uncertainty about which businesses and financial institutions are in good condition and which are in danger of bankruptcy or insolvency

Global Legal Settlement 2002

arose out of lawsuit brought by New York attorney general Eliot Spitzer against 10 largest investment banks directly reduced conflicts of interest: -required investment banks to sever the links between research and securities underwriting -banned spinning Incentives for investment banks not to exploit conflicts of interest: -imposed $1.4 billion of fines on the accused investment banks

Tyranny of Collateral

To use property, such as land or capital, as collateral, a person must legally own it it is extremely expensive and time consuming for the poor in developing countries to make their ownership of property legal. Obtaining legal title to a dwelling on urban land in the Philippines, for example, involved 168 bureaucratic steps and fifty-three public and private agencies, and the process took thirteen to twenty-five years. For desert land in Egypt, obtaining legal title took seventy-seven steps, thirty-one public and private agencies, and five to fourteen years. To legally buy government land in Haiti, an ordinary citizen had to go through 176 steps over nineteen years. These barriers do not mean the poor do not invest: They still build houses and buy equipment even if they don't have legal title to these assets. By De Soto's calculations, the "total value of the real estate held but not legally owned by the poor of the Third World and former communist nations is at least $9.3 trillion."* Even when people have legal title to their property, the legal system in most developing countries is so inefficient that collateral does not mean much. Typically, creditors must first sue the defaulting debtor for payment, which takes several years, and then, once obtaining a favorable judgment, the creditor has to sue again to obtain title to the collateral. This process often takes in excess of five years. By the time the lender acquires the collateral, it is likely to have been neglected or stolen and thus has little value. In addition, governments often block lenders from foreclosing on borrowers in politically powerful sectors of a society, such as agriculture. When the financial system is unable to use collateral effectively, the adverse selection problem will be worse because the lender will need even more information about the quality of the borrower to distinguish a good loan from a bad one. Little lending will take place, especially in transactions that involve collateral, such as mortgages. In Peru, for example, the value of mortgage loans relative to the size of the economy is less than one-twentieth that in the United States. The poor in developing countries have an even harder time obtaining loans because it is too costly for them to get title to their property and they therefore have no collateral to offer, resulting in what Raghuram Rajan, the governor of India's central bank, and Luigi Zingales, of the University of Chicago, refer to as the "tyranny of collateral."** Even when poor people have a good idea for a business and are willing to work hard, they cannot get the funds to finance it, making it difficult for them to escape poverty.

Money market- Investment Companies (brokerage firms)

Trade on behalf of commercial account -large diversified brokerage firms -primary function of dealers is to "make a market" for money market securities by maintaining an inventory from which to buy or sell. -very important to the liquidity of the money market bc they ensure that sellers can readily market their securities

Increase in uncertainty

U.S. financial crises usually begin in periods of high uncertainty such as after the start of a recession, crash in stock market, or failure of a major financial institution With info hard to come by in a period of high uncertainty, financial frictions increase, reducing lending and economic activity

Net Worth and Collateral

When borrowers have more at stake because their net worth (difference between assets and liabilities) is high or the collateral they have pledged to the lender is valuable, the risk of moral hazard will be reduced because the borrowers themselves have a lot to lose. Borrowers will take less risk at lenders expense When borrower has more money (net worth) in the business, lender is more likely to give loan the solution that high net worth and collateral provides to the moral hazard problem is it makes the debt contract incentive compatible-- aligns incentives of borrower with those of the lender. The greater the borrowers net worth and collateral pledged, the greater the borrowers incentive to behave in a way that the lender expects and desires, the smaller the moral hazard problem in the debt contract, and the easier it is for the firm or household to borrow. Conversely, when the borrowers net worth and collateral are lower, the moral hazard problem is greater and it is harder to borrow

Sarbanes-Oxley Act of 2002

also called Public Accounting Reform and Investor Protection Act increased supervisory oversight to monitor and prevent conflicts of interest : -Established a Public Company Accounting Oversight Board (PCAOB) overseen by the SEC, to supervise accounting firms and ensure that audits are independent and controlled for quality -increased SEC's budget to supervise securities markets directly reduced conflicts of interest: -made it illegal for a registered public accounting firm to provide any non audit services to a client contemporaneously with an audit (as determined by the PCAOB) provided incentives for Investment banks to not exploit conflicts of interest: -beefed up criminal charges for white-collar crime and obstruction of official investigations measures to improve quality of info in financial markets: -required a corporations CEO, auditors, and CFO to certify that periodic financial statement and disclosures of the firm (especially regarding off-balance sheet transactions_ are accurate (section 404) -required members of the audit committee (subcommittee of the board of directors that oversees companies audit) to be "independent" they cannot be managers in the company or receive any consulting or advisory free from the company

agency theory

analysis of how asymmetric information problems affect economic behavior

2. Issuing marketable securities (stocks and bonds) is not the primary way in which businesses finance their operations

bar chart shows that bonds are more important source of financing than stocks but still, combined, only make up 43% (marketable securities) of external financing. They supply less than half of external funds corporations need to finance their activities other countries have a much smaller share of external financing through marketable securities

How Moral Hazard Influences Financial Structure in Debt Markets

because debt contract requires the borrower to pay out a fixed amount and lets them keep any profits above this amount, borrower has incentive to take on investment projects the are riskier than the lenders would like Borrowers have strong incentive to undertake riskier investment with money borrowed because their gains would be so large if they succeeded. Lender is unhappy because if they are unsuccessful, all money is lost. If they are successful, lender doesn't share in this success because the principal and loan payments are fixed

8. Debt contracts are typically complicated documents that restrict borrowers' behavior

bond/loan contracts are long legal docs with provisions (restrictive covenants) that restrict and specify certain activities that the borrow can engage in. not just a feature of debt contracts for businesses car loans and mortgages have covenants that require borrower to maintain sufficient insurance on car or house purchased with loan

3. Covenants t keep collateral valuable

collateral is an important protection for the lender encourage the borrower to keep the collateral in good condition and make sure that it stays in the possession of the borrower car loans require car owner to maintain a minimum amount of collision and theft insurance and prevent the sale of the car unless the loan is paid off Recipient of home mortgage must have adequate insurance on the home and must pay off the mortgage when the property is sold

Stage 1 on financial crisis: Initial Phase

can begin in several ways: credit and asset-price booms and busts or a general increase in uncertainty caused by failures of major financial institutions

Why does gov and corporations need to get hand son funds quickly?

cash inflows and outflows aren't synchronized gov tax revenues only come once a year, but expenses incur all year round. gov borrows short term funds for expenses that it will pay back when tax revenues are collected. businesses revenues and expenses happen at different times as well.

Lemons in Stock and Bond Markets

common stock: potential buyer of securities can't tell between good firm with high expected profit and low risk & bad firm with low expected profit and higher risk investor will only want to pay average price between value of security from good firm and bad firm if owner/manager of good firm has better information about firm than does the investor, and knows that they are a good firm, then they know that securities are undervalued and won't sell to investor at the price he's willing to pay. only bad firms will sell to the investor because his price is higher than that the securities value securities market will not work very well because few firms will sell securities in it to raise capital Bonds: investor will buy bonds only if interest rate is high enough to compensate for the average default risk of good and bad firms trying to sell the bonds; good firms realize they will be paying higher interest rate so they are unlikely to issue bonds/debt only bad firms will be willing to borrow/issue bonds few bonds will sell in this marker, not a good source of financing EXPLAINS FACT 2 AND PARTIALLY 1 the presence of the lemons problem keeps securities markets from being effective in channelling funds from savers to borrowers No asymmetric information---> No Lemons Problem If buyers know as much about the quality of used cars as sellers, so that all involved can tell a good car from a bad one, buyers will be willing to pay full value for good used cars. Because the owners of good used cars can now get a fair price, they will be willing to sell them in the market. The market will have many transactions and will do its intended job of channeling good cars to people who want them. Similarly, if purchasers of securities can distinguish good firms from bad, they will pay the full value of securities issued by good firms, and good firms will sell their securities in the market. The securities market will then be able to move funds to the good firms that have the most productive investment opportunities

Effects of the 2007-2009 Financial Crisis

consumer and business suffered 5 key areas: 1. U.S. residential housing market 2. Financial institutions balanc esheets 3. shadow banking system 4. global financial markets 5. headline-grabbing failures of major firms in financial industry

Debt Contracts

contractual agreement by the borrower to pay the lender FIXED dollar amount at periodic intervals. When firm has high profits, lender receives contractual payments and doesn't need to know exact profits of the firm. If managers are hiding profits or engaging in activities that personally benefit them, lender doesn't care as long as they are still able to make contractual payment son time Only if firm can't make its debt payments, aka goes into default, then lender needs to verify state of firms profits only in that situation do lenders need to act like equity holders to get their fair share, now they need to now how much income the firm has Less frequent need to monitor the firm and lower cost of state verification explains why debt contracts are used more than equity contracts to raise capital. Moral hazard thus helps explain fact 1, why stocks are not the most important source of financing for businesses Also, our tax code. Debt interest payments are a deductible expense for American firms, while dividend payments to equity shareholders are not

1. Covenants to discourage undesirable behavior

designed to lower moral hazard by keeping the borrower from engaging in undesirable behavior of undertaking risky investment projects. Some covenants mandate that a loan con only be used to finance specific activities, such as particular equipment or inventories Other restrict the borrowing firm from engaging in certain risky business activities such as purchasing other businesses

Credit Boom and Bust

financial crisis usually happens when an economy introduces new types of loans or financial products aka financial innovation or when countries engage in financial liberalization, eliminating restrictions on financial markets and institutions. Long run: fin. liberalization can promote financial development and lead to a well run in system that allocates capital efficiently short fun: fin. liberalization can make financial institutions go on a lending spree or "credit boom" During credit boom, lenders might not have the expertise or incentive to manage risk properly in these new lines of business. Credit booms eventually outstrip the ability of institutions and gov regulators to screen and monitor credit risks, leading to overly risky lending Government safety nets like deposit insurance weaken market discipline and increase the moral hazard incentive for banks to take on larger risk than they normally would. Since lender-savers know that government guaranteed insurance protects them from losses, they will even give undisciplined banks funds. Banks and fin. institutions can can make risky high interest loans to borrower spenders. If they repay, they have nice profits. If they dont pay, they can still rely on gov insurance Without proper monitoring, risk taking grows unchecked Eventually, losses on loans builds up and value of loans (on asset side of balance sheet) falls relative to liabilities, driving down net worth/capital of banks and other fin institutions With less capital, financial institutions start leveraging (cut back on lending to borrower spenders) Also, with less capital, banks nd other fin institutions become riskier, causing lender-savers and other lenders to these institutions to pull out their funds fewer funds means fewer loans to fund productive investment opportunities and a CREDIT FREEZE: the lending boom turns into lending crash When financial institutions stop collecting info and making loans, financial frictions rise, limiting financial systems ability to address asymmetric info problems of moral hazard and adverse selection As loans become scarce, borrower-spenders can no longer fund their investment opportunities, decrease their spending, causing economic activity to contract

Enron Implosion

firm that specialized in trading innerly market oct 2001 announced a third-quarter loss of $618 million and disclosed accounting "mistakes" SEC formally investigated Enron's financial dealings with partnerships less by its former finance chief. Found that Enron was engaged in a complex set of transactions by which it was keeping substantial amount of debt and financial contracts offer the balance sheet, hiding its financial difficulties. declared bankruptcy in dec 2001 illustrates that gov regulation can lessen asymmetric info problems, but can't eliminate. Managers have tremendous incentive to hide their companies problems, making it hard for investors to know true value of the firm

Government Regulation to increase information

gov has incentive to reduce moral hazard problem, further supports fact 5 that financial system is heavily regulated government everywhere have laws to force firms to adhere to standard accounting principles that make profit verification easier. Also pass laws to impose stiff criminal penalties on people who commit the fraud of hiding and stealing profits. However, these measures are only partially effective. Catching this type of fraud isn't easy and fraudulent managers have incentive to make very hard for gov agencies to find or prove fraud

Financial Intermediation : VENTURE CAPITAL FIRM

have the ability to avoid the free-ride problem in the face of moral hazard, and is another reason that indirect finance is so important (fact 3) VENTURE CAPITAL FIRM is a fin intermediary that helps reduce moral hazard problem arising from principal agent problem Venture Capital Firms pool resources of their partners and use the funs to help budding entrepreneurs to start new businesses. In exchange for use of venture capital, the firm receives an equity share in the new business. To ensure verification of earnings and profits, venture capital firms have many of their own people on the managing body of the firm, the board of directors so they can keep close eye on firms activities. When venture capital firm provides start up finds, equity in the firm is PRIVATE, not marketable to anyone except the venture capital firm. Therefore, other investors can't take a free ride on the venture capital firms verification activities. As a result of this arrangement, venture capital firm is able to garner the full benefits of its verification activities and is given the appropriate incentives to reduce the moral hazard problem. Important in high tech sector in U.S. resulting in job creation, economic growth, and increase international competitiveness Venture capital firms invest in new businesses and then when company matures sells the shares to the public Private equity firms solve free ride problem and work similarly. Take older public companies private by purchasing all publicly traded shares and retire them. Then they exercise control over the company using similar methods as venture capital firms

Financial Development and Economic Growth

important reason many developing countries experience very low rates of growth is that their financial systems are underdeveloped.* two important tools used to help solve adverse selection and moral hazard problems in credit markets are collateral and restrictive covenants. In many developing countries, the system of property rights (the rule of law, constraints on government expropriation, absence of corruption) functions poorly, making it hard to use these two tools effectively. a poorly developed or corrupt legal system may make it extremely difficult for lenders to enforce restrictive covenants. Thus, they may have a much more limited ability to reduce moral hazard on the part of borrowers and so will be less willing to lend. Again the outcome will be less productive investment and a lower growth rate for the economy. The importance of an effective legal system in promoting economic growth suggests that lawyers play a more positive role in the economy than we give them credit for. Governments in developing countries often use their financial systems to direct credit to themselves or to favored sectors of the economy by setting interest rates at artificially low levels for certain types of loans, by creating development finance institutions to make specific types of loans, or by directing existing institutions to lend to certain entities. As we have seen, private institutions have an incentive to solve adverse selection and moral hazard problems and lend to borrowers with the most productive investment opportunities. Governments have less incentive to do so because they are not driven by the profit motive and thus their directed credit programs may not channel funds to sectors that will produce high growth for the economy. The outcome is again likely to result in less efficient investment and slower growth. banks in many developing countries are owned by their governments. Again, because of the absence of the profit motive, these state-owned banks have little incentive to allocate their capital to the most productive uses. Not surprisingly, the primary loan customer of these state-owned banks is often the government, which does not always use the funds wisely for productive investments to promote growth. government regulation can increase the amount of information in financial markets to make them work more efficiently. Many developing countries have an underdeveloped regulatory apparatus that retards the provision of adequate information to the marketplace. For example, these countries often have weak accounting standards, making it very hard to ascertain the quality of a borrower's balance sheet. As a result, asymmetric information problems are more severe, and the financial system is severely hampered in channeling funds to the most productive uses. The institutional environment of a poor legal system, weak accounting standards, inadequate government regulation, and government intervention through directed credit programs and state ownership of banks all help explain why many countries stay poor while others, unhindered by these impediments, grow richer.

6. Only large, well-established corporations have easy access to securities markets to finance their activities

individuals and smaller business are less like to raised funds by issuing marketable securities, will obtain financing from banks

How Financial Intermediaries Reduce Transaction Costs: Economies of Scale

one solution: bundle funds of many investors together to take advantage of economies of scale, reduces costs for the individual investors economies of scale: reduction in transaction costs per dollar of investment as the size/scale of transactions increase total cost of carrying out a transaction in fin markets increases only a little as the size of the transaction grows ex: cost of arranging purchase of 10000 shares of stock is not much greater than purchase of 50 shares financial intermediaries Arose because of economies of scale ex: mutual fund- fin intermediary that sells shared to individuals and then invests the proceeds in bonds or stocks. Buys large block of bonds & stocks so lower transaction costs. most savings are then distributed to individual investors after mutual funds takes its cut for management fees for administering their accounts mutual funds is also large enough to buy diversified portfolio of securities, reducing investors risk economies of scale also lower costs of information technology . Ex; once a telecommunications system is establishes, system can be used for large number of transactions at a low cost per transaction

4. Financial intermediaries are the most important source of funds used to finance businesses

primary source of external funds for business around world is loans made by banks and other nonbank financial intermediaries (pension funds, finance companies, insurance companies) In other industrialized counties, bank loans are the largest category of sources of external finance banks in these countries have the most important role in financing business activities in developing countries, banks play an EVEN MORE important role in financial system than they do in industrialized countries

Tools to Help Solve the Principal-Agent Problem: PRODUCTION OF INFORMATION: MONITORING

principal agent problem arises because managers have more info about their activities and actual profits than stockholders do can reduce this moral hazard problem by engaging in information production if the form of monitoring firms activities: auditing the firm frequently and checking what management is doing. This can be expensive in terms of time and money, called "costly state of verification", makes the equity contract less desirable and explains why equity is not a more important element in financial structure. Free-ride problem reduces amount of info production undertaken to reduce the moral hazard problem as it decreases monitoring. If you know that other stockholders are monitoring the companies you have invested in, you can take a free ride. Other stockholders might do this too and then it ends up with not many stockholders monitoring the firm. The moral hazard/principal-agent problem for shares of common stick will then be severe, making it hard for firms to issue them to raise capital

financial intermediaries

reduce transaction costs and allow small savers and borrowers to benefit from financial markets

4. Covenants to provide info

require borrowing firm to provide info about its activities periodically in the form of quarterly accounting and income reports, thereby making it easier for the lender to minor the firm and reduce moral hazard lender has the right to audit and inspect the firms books at any time

The Lemons Problem: How Adverse Selection Influences Financial Structure

resembles lemons in used-car market used car buyers can't tell if the used car they're considering will be good or a "lemon" (bad) So, the price that buyer pay must reflect AVERAGE quality of cars in the market, somewhere between low value of lemon and high value of good car owner of used car better knows if car is a peach(good) or lemon (bad) If car is bod/lemon, owner is willing to sell at average price, which will be higher than lemon's value If car is peach, the owner knows that the car is undervalued at the price the buyer is willing to pay, to owner might not want to sell Result of adverse selection is that few good used cars will come to the market. average quality of car in market will be low bc few people want to buy a lemon, sales will also be low. Used-car market will function poorly.

Residential Housing Pries: boom and bust

the subprime mortgage market took off after recession ended in 2001. by 2007, had become trillion dollar market encouraged by politicians because it led to "democratization of credit" and helped raised u.s. home ownership rates to the highest levels in history asset-price boom in housing which took off after the 2000-2001 recessions s over also helped stimulate the growth of the subprime mortgage market high housing prices meant subprime borrowers could refinance their houses with even larger loans when their homes appreciated in value with housing prices rising, subprime borrowers were unlikely to default because they could always sell their house to pay off the loan, making investors happy because the securities backed by cash flows from subprime mortgages would have less risk and higher returns. the growth of the subprime mortgage market in turn increased the demand for houses and fueled the boom in housing prices resulting in a housing price bubble low interest rates on residential mortgages also stimulated the housing market, this was a result of: 1. huge capital inflows into the U.S. from countries like china and india 2. congressional legislation that encouraged Fannie Mae and Freddie Mac to purchase trillion of dollars of mortgage backed securities 3. easy federal reserve monetary policy to lower interest rates the resulting low cost of financing housing purchases then further stimulated the demand for housing, pushing up housing prices. As housing prices rose and profitability for mortgage originators and lenders was high, the underwriting standards for subprime mortgages fell to lower and lower standards. High-risk borrowers were able to obtain mortgages, and the amount of the mortgage relative to the value of the house, the loan-to-value ratio (LTV), rose. Borrowers were often able to get piggyback, second, and third mortgages on top of their original 80% loan-to-value mortgage, so that they had to put almost no money down. When asset prices rise too far out of line with fundamentals—in the case of housing, how much housing costs if purchased relative to the cost of renting it, or the cost of houses relative to households' median income—they must come down. Eventually, the housing price bubble burst. With housing prices falling after their peak in 2006, the rot in the financial system caused by questionable lending practices began to be revealed. The decline in housing prices led to many subprime borrowers finding that their mortgages were "underwater"—that is, the value of the house fell below the amount of the mortgage. When this happened, struggling homeowners had tremendous incentives to walk away from their homes and just send the keys back to the lender. Defaults on mortgages shot up sharply, eventually leading to millions of mortgages in foreclosure."

Conflicts of interest

we saw how financial institutions play an important role in the financial system. Specifically, their expertise in interpreting signals and collecting information from their customers gives them a cost advantage in the production of information. Furthermore, because they are collecting, producing, and distributing this information, financial institutions can use the information over and over again in as many ways as they would like, thereby realizing economies of scale. By providing multiple financial services to their customers, such as offering them bank loans or selling their bonds for them, they can also achieve economies of scope; that is, they can lower the cost of information production for each service by applying one information resource to many different services. A bank, for example, can evaluate how good a credit risk a corporation is when making a loan to the firm, which then helps the bank decide whether it would be easy to sell the bonds of this corporation to the public. Additionally, by providing multiple financial services to their customers, financial institutions develop broader and longer-term relationships with firms. These relationships both reduce the cost of producing information and increase economies of scope.