FE 442 Final Exam

Troubled Asset Relief Program (TARP)

1. A $700B bailout and a series of other targeted programs to help prop up the financial market 2. Called for removing bad assets from bank balance sheets and replacing them with cash, which would strengthen bank financials and thaw out frozen credit markets

Critics of virtue ethics

1. A virtue to one person may be a vice to another 2. Virtues can change over time

Government Bonds

1. A+ credit rating 2. Lowest market and credit risk

Municipal Bonds

1. A- credit raing 2. Medium market and credit risk 3. Securities issued by state, local, and county governments 4. Proceeds are used to pay for public interest projects and are therefore exempt from government tax 5. Have default risk, higher in economic weakness 6. Two types -general obligation bonds -revenue bonds

Strengths of the Dodd-Frank Act

1. Acknowledges and attempts to address the systemic risk problem 2. Creates a new oversight group - FSOC and CFPB 3. Gives FDIC resolution authority 4. Attempts to tackle "too-big-to-fail" 5. Elevates corporate governance standard and executive compensation 6. Increases oversight of the Fed 7. Improves transparency in the derivatives market and gives CFTC a clearer mandate 8. Creates an Office of Credit Ratings and SEC held to higher standard 9. Increases reporting on shadow banking system activities including hedge funds and private equity firms

Weaknesses of the Dodd-Frank Act

1. Act attempts to regulate by institution type and not by product type 2. Portions of the Act will not be fully implemented for up to 12 years 3. Gives Fed and SEC greater authority without having them demonstrate they corrected past oversight deficiencies 4. Little focus on improving weak credit standards that helped trigger the Great Recession 5. Strength of Act will hinge on rulemaking by regulators and their willingness to enforce laws 6. FSOC and the OFR are new organizations and are untested 7. Unclear how CFPB warning label system for financial products will work 8. Capital standard uniformity is important yet Basel III will not be fully implemented until 2019 9. If Dodd-Frank had been in place in 2008, some argue the Great Financial Crisis would still have occurred

What Can You Do to Promote Ethical Behavior in Your Firm?

1. Adopt a code of ethics 2. Talk about ethics within your team and firm 3. Reflect on your dilemmas 4. Act on your reflections

September 15

1. After a unanimous board vote, Lehman filed for bankruptcy 2. Merill Lynch rescued by BOA

September 13

1. After less than 48 hours of due diligence, BOA agrees to buy Merill Lynch 2. AIG on life support

Improve transparency and accountability in derivatives market #5

1. Allow CFTC and SEC to regulate the over-the-counter derivatives market 2. Central clearing and exchanges for derivatives that can be cleared 3. Increased reporting of trading activities 4. Dealers and swap participants held to higher margin, capital standards and code of conduct

Current Yield

1. An approximation of the yield to maturity on coupon bonds that is often reported because it is easily calculated 2. The yearly coupon payment divided by the price of the security 3. i = C/P

May 2008

1. Anger grows 2. May 21, 2008 -Einhorn questioned Callan's credibility in Lehman's accounting for real estate investments 3. Lehman was "full of shit and shorting the stock, betting that Lehman stock would fall" 4. Einhorn appeared on CNBC and shared his bearish view on Lehman

April 2008

1. Anger sets in 2. Naked Short selling -illegal because it can cause market imbalance, putting downward pressure on stock prices 3. SEC relaxing rules made firms vulnerable to stock attacks 4. Paulson suggested finding a buyer for Lehman, which upset Fuld

Mojo Coffee

1. Annie - entrepreneur 2. Operation: North shore, Massachusetts 3. Family recipe 4. Father in restaurant business 5. Worked at Lehman Brothers 6. Cold Brew 7. 3 employees 8. Brews coffee beans in cold water 9. Competition -Starbucks and DD

Volker

1. Applies to all banking entities including BHCs, banks, thrifts, S&Ls and affiliates 2. US operations of foreign banks are also included 3. Nonbanks are also restricted from similar activities. 4. FSOC will conduct further studies and recommendations to provide guidance 5. Policy reflects a view (correct or not) that banks have moved too far away from traditional banking activities putting greater depositor money at risk 6. Could take from 3 to 12 years to implement e.g., 2022 7. Rule does not take effect until FSOC recommendations are finalize and the Fed has commented. Completed 2012 8. After Fed comment period, Act gave banks an additional 2 years to comply e.g., 2014 9. Fed can also offer banks up to three 1 years extensions. End 2017. 10. Additional extensions up to 5 years allowed for certain "illiquid" fund scenarios e.g., 2022 11. Even delayed divestiture is a radical change for the largest US Banks

Federal Reserve System

1. Assets -government securities -discount loans 2. Liabilities -currency in circulation -reserves

Gordon Growth Model

1. Assumptions -Dividends are assumed to continue growing at a constant rate forever -The growth rate is assumed to be less than the required return on equity, K 2. Po = Do x (1 + g)/ (k - g) 3. Po = D1/(k - g)

Consumer protection

1. Asymmetric information -consumers don't have enough information to protect themselves 2. Consumer Protection Act of 1969 -requires all lenders to disclose information about APR interest rates

Corporate Bonds

1. BB+ credit rating 2. Highest market and credit risk

What firms will fall under FSOC regulation?

1. Bank Holding Companies (BHC) greater than $50 billion 2. TARP Takers BHC's - Hotel California Provision 3. Nonbank financial companies -If meet 85 percent test where revenue or assets are financial in nature 4. Non-U.S. businesses forced to comply

September 14

1. Barclays agreed to buy Lehman 2. Deal blocked by Financial Services Authority (FSA) 3. Cox (SEC chairman), Geithner, and Paulson push for a Lehman board vote for bankruptcy

What can be done about the too-big-to-fail problem? future regulation?

1. Break up large, systemically important financial institutions 2. Higher capital requirements 3. Leave it to dodd-frank

Attempts to address "Too-Big-To-Fail" problem #3

1. Claim's taxpayers will not be responsible to bailout failed banks yet FDIC insurance increased to $250,000 2. FSOC will make recommendations to the Fed for increased restrictions on leverage, capital and liquidity 3. "Living will" provision systemically risky firms have to plan their funeral 4. Requires Treasury, Fed and FDIC vote to liquidate a company

Reserves

1. Consist of deposits at the Fed plus currency that is physically held by banks 2. Assets for the banks, but liabilities for the Fed

Dodd- Frank Wall Street Reform

1. Consumer Protection: consumer financial protection bureau that is funded through the Fed, increases FDIC to $250,000 2. Resolution Authority: authority over systemic financial firms 3. Systemic Risk Regulation: created a financial stability oversight council + living will requirements 4. Volcker Rule: limits of proprietary trading 5. Derivatives: required derivative trading to go through clearinghouses and traded on exchanges

Credit Rating Agency Reform #7

1. Create an office of Credit Ratings at the SEC 2. Annual examinations of S&P, Moody's and Fitch and independent information considered 3. Investors can bring legal action against rating agencies for "knowing or reckless failure" to perform duty 4. Half of board needs to be independent

Office of Financial Research (OFR)

1. Created to assist FSOC 2. Located in treasury department 3. Collect industry data, issue reports and identify systemic risk threats 4. Help shape FSOC agenda

Grief Stages

1. Denial 2. Anger 3. Bargaining 4. Depression 5. Acceptance

March 2008

1. Denial (of poor financial health) 2. Fuld felt the Bear rumors were just scare tactics and that Lehman was too profitable and successful to be concerned 3. Closed its subprime lending factory 4. Did not take $20B in existing mortgages and related securities off its book 5. Fundamental lesson: inventory sold today is worth more than inventory that sits on the shelf tomorrow 6. Mixed message: sell subprime but keep doing commercial real estate deals 7. Bought at the top of the market and failed to diversify its bets 8. Lehman's stock was overvalued 9. In 1998, less than 2% of the firm's equity was exposed to LTCM or Russian-related bonds 10. By 2008, 4 times Lehman's equity was exposed to a plummeting real estate market

July-August 2008

1. Depression 2. Employees began to feel helpless as their life savings evaporated 3. Lehman cut 6% of its workforce 4. Size of bets 3x greater than Bear 5. Growth of the firm's prime brokerage operation mirrored the rapid growth of the hedge fund industry 6. Management sent out an email prohibiting employees from selling Lehman stock

Republic of Congo Provision

1. Diamonds caused the Great Financial Crisis of 2008 2. Proof - The Act requires all SEC registered firms who use Congo derived minerals in manufacturing to disclose due diligence method used

Why was time running out for Lehman?

1. Dick fuld had no friends 2. Market tells him that Lehman wasn't worth what he thought it was

Stockholders

1. Do what creates shareholder wealth 2. Milton Friedman -purpose of business is to return value to its shareholders

BOD (Enablers)

1. Duty should be to protect shareholders 2. Paid $365,000+ 3. Too busy with other obligations 4. Old 5. Not knowledgable about derivatives

Accountants (Enablers)

1. EY was the accountant for Lehman 2. Did not issue an ongoing concern letter that would have alerted the investment public to issues of financial stability 3. Should have flagged toxic assets earlier

The SEC (Enabler)

1. Eliminated the uptick rule 2. Did not enforce laws to prohibit short-selling activities 3. Failed to slow down excessive risk taking

September 12

1. Emergency meeting to save Lehman 2. Bankers had their own self-interests 3. Fuld resigns as director of NY Fed

Stakeholders

1. Employees, customers, suppliers, and the community also have a stake in the activities and the success of the firm 2. Edward Freeman -firm should be managed in the interest of the broader spectrum of its constituents

FSOC Meeting/Voting

1. FSOC will only meet periodically 2. 2/3 vote would require certain non-bank to be regulated by the Fed 3. 2/3 vote would trigger the break up of large firms deemed hazardous to US financial stability 4. FDIC given crisis-management powers to seize control and liquidate firms whose failure would trigger systemic risk

Two new financial overseers created because of Dodd-Frank

1. Financial Stability Oversight Council (FSOC) 2. Consumer Financial Protection Bureau (CFPB) 3. Greater regulatory oversight is triggered for firms at $10 to $15 billion

FSOC

1. Financial stability oversight council 2. Goal is to create an advanced warning system against systemic risk posed by large, interconnected companies, products and activities 3. A regulatory framework established to isolate and regulate systemically risky institutions 4. Designated systemically important firms will be subject to FSOC risk rules and regulated by the Fed 5. Oversight power resides in 15 member council (10 federal financial regulators and 5 non-voting members) 6. Chaired by the Treasury Secretary 7. Other voting members include Fed, OCC, FDIC, SEC, CFTC, National Credit Union Adm., Fed Housing Finance Agency and the newly created consumer protection agency etc..

Microprudential supervision

1. Focuses on the safety and soundness of individual financial institutions 2. Looks at each institution and assesses riskiness of its activities and whether it complies with disclosure requirements

Macroprudential supervision

1. Focuses on the safety and soundness of the financial system in the aggregate 2. Seeks to mitigate systemwide fire sales and deleveraging by assessing the overall capacity of the financial system to avoid them

Karma

1. GS did little to help Bear 2. Anything to do with Cayne's actions when LTCM was on Fed's operating table 3. Bear did not participate in the rescue of LTCM 4. Fifteen firms would not forget what Bear had done

SEC Reform #10

1. Gives SEC additional powers to enforce fiduciary duty on brokers 2. Creates a stronger program to encourage whistleblowers 3. Independent review of the SEC and annual assessment of inner workings 4. Provide SEC with a larger budget to meet resource needs 5. Investment Advisory Committee to advise the SEC on regulatory practices

Forms of regulation

1. Government safety net 2. Restrictions on asset holdings 3. Capital Requirements 4. Prompt corrective action 5. Chartering and examination 6. Assessment of risk management 7. Disclosure requirements 8. Consumer protection 9. Restrictions on competition 10. Macroprudential supervision 11. Microprudential supervision

Firms deemed systemically risky will be subject to new risk rules (FSOC)

1. Greater credit reporting 2. Enhanced capital and leverage restrictions 3. Liquidity and contingent capital provisions 4. Concentration risk limits 5. Resolution plan "living will"

Bear Stearns

1. Grew into top-5 investment bank dependent on fixed-income revenue 2. Lehman's less refined sibling 3. Relied on cheaper, shorter-term and less stable funding sources 4. Involved in subprime real estate, MBS, and hedge funds 5. The market mauled bear stearns

Hedge Fund and Private Equity Regulation #6

1. Hedge funds and private equity firms must register with the SEC 2. Trade data will be shared with FSOC 3. Increases state supervision of investment advisors new threshold increased to $100 million 4. Theory - States have proven to be a better watchdog than the SEC

Bear's hedge fund havoc

1. High-grade structured credit fund 2. High-grade structured credit strategies enhanced leveraged fund 3. Used leverage to increase size form $6M to $6B 4. To increase leverage, bear obtained loans from banks and other lenders who allowed mortgages to be used as collateral 5. Borrowed money used to buy more subprime ABS 6. Bought CDS's 7. Funds collapsed, Bear's reputation harmed, took too much risk 8. Cayne was in a bridge tournament the day of the crisis 9. Collapse of funds was a warning signal for Lehman

Hot Tip

1. If the market is efficient, the stock will already be priced so that its expected return will equal the equilibrium return. 2. Tip not particularly valuable 3. If market participants got the information before you, it would not give you an edge on the rest of the market

World Com Case

1. Illustrates how unethical behavior escalates over time 2. Fraud and earning management share a common soil: a culture of aggressive growth 3. The shields against fraud are a culture of integrity, strong governance and strong financial monitoring

Lehman CFO

1. In 14 years, there had been 6 different CFO's 2. Fuld hired Erin Callan -not a trained accountant -no experience in Lehman's finance or treasury department 3. Orchestrated a blitzkrieg on short sellers

Lessons to Lehman from Bear

1. In times of trouble, raise excess capital and dump bad assets 2. Get out in front of market rumors, stomp them out and protect stock price 3. Last-minute deals should be avoided because they are difficult to execute and struck at deep discounts 4. The federal government will be there to help bail you out

Restrictions on competition

1. Increase moral hazard in order to maintain profit levels 2. And although regulating competition as helped the health of banks they have also lead to higher charges for consumers and decreased the efficiency of banking institutions that don't have to compete as vigorously

IPO

1. Initial public offering 2. Firm sells securities for the very first time 3. Subsequent sales of a firm's new stocks or bonds to the public are simply primary market transactions

G-Sibs

1. JP Morgan 2. Bank of America 3. Wells Fargo 4. Citigroup 5. Goldman Sachs 6. Morgan Stanley 7. BNY Mellon 8. State Street

September 11

1. JP Morgan cut off Lehman credit 2. JP Morgan froze $17B in cash and securities

Dick Fuld (Enabler)

1. Leadership was the reason for Lehman's failure 2. Didn't understand the mechanisms being used to generate lavish profits (derivatives) 3. Chairman & CEO

September 16

1. Lehman bankruptcy uncorks systemic risk 2. Capital markets become unhinged beginning with money markets, repo markets, and commercial paper markets 3. AIG is taken over by the gov't at $180B 4. Barclays buys Lehman's US operations for $1.7B 5. Nomura buys the Asian and European operations for $230M

Basel Pillar 1

1. Links capital requirements for large, internationally active banks more closely to actual risk of 3 types: market, credit, and operational risk 2. Allows largest banks to use internal-rating approach and their own models of credit-risk

Discount loans

1. Loans to other institutions 2. Appear as liabilities on financial institutions; balance sheets 3. Leads to an expansion of reserves, which can be lent out as deposits, thereby leading to an expansion of the monetary base and the money supply 4. When a bank repays its discount loan and so reduces the total amount of the discount lending, the amount of reserves decreases along with the monetary base and the money supply 5. Most changes in the discount rate have no effect on the federal funds rate

March Madness

1. March 10, 2008 - rumors circulated on Wall Street that Bear was having liquidity problems 2. Bear's leverage ratio: 35:1 3. March 11, 2008 - Goldman Sach's disclosed to its hedge fund clients that Bear's credit was too risky to insure 4. March 12, 2008 - hedge funds with deposits totaling $25B left bear 5. Stock dropped by 40% on March 14. 6. Emergency meeting in NY -Fed concerned about impact of 5th largest investment bank collapsing and its impact on the economy 7. JP Morgan bought Bear for $2 a share -upped share offer to $10 to appease shareholders 8. Treasury secretary Hank Paulson instrumental in engineering the $2 rescue plan

Capital Requirements

1. Minimize moral hazard of financial institutions by having "more to lose" if high risk taking occurs 2. Also acts as a cushion if bad shock occurs 3. More safe & sound

Restrictions on asset holdings

1. Minimizing moral hazard 2. Greater restrictions on banks holding of risky assets

Credit Rating Agencies (Enabler)

1. Moody's, S&P, Fitch 2. Assigning AAA on billions of dollars in mortgage debt 3. Sending false signals to the market 4. Downgraded thousands of mortgages, forcing banks to take billions of dollars in write-downs 5. Focused on revenue 6. Employee discussed that he was ignored if his guidance meant making less money 7. IB's become largest customers

What is "good"?

1. More right, or less wrong 2. How will my action affect others? What are the consequences? 3. What are my motives? What is my duty here? How does this decision affect them? 4. Does this action serve the best that I can be?

Progress on required rulemakings in select categories

1. Most progress made on derivates 2.Least progress on executive compensation and corporate governance

Death of Investment Banking

1. Move away from bulge bracket firms 2. Morgan Stanley and Goldman Sachs became bank-holding companies -tighter regulation -held to higher capital standards -required to reduce firm leverage 3. 2008 big 5: GS, ML, MS, Lehman, Bear Stearns 4. 2009: GS no longer an IB, ML bought by BOA, Lehman gone, MS no longer an IB, Bear stearns bought by JPM

Creates the Consumer Financial Protection Bureau (CFPB) #2

1. New agency and independent head 2. Budget paid by the Fed 3. Pertains to all banks and credit unions over $10 billion and all mortgage-related entities 4. Consolidates authority to exam and enforce regulation

SEC Policy on short-sellers (Decider)

1. No penalty was imposed to violators 2. Lack of SEC enforcement allowed naked short-sellers to become active in Lehman stock and push it down

Congress (Enabler)

1. Oversight of Freddie Mac and Fannie Mac was through the Office of Federal Housing Enterprise Oversight -lacked staff and $ needed to be in effective control 2. Created Freddie Mac & Fannie Mae, over promoted home ownership to unqualified income

Right and wrong as defined by virtues

1. Personal happiness flowed from being virtuous and not merely comfort (utility) or observance (duty) 2. Make sure everything you do can be on the front of the WSJ

Regulatory arbitrage

1. Practice in which banks keep on their books assets that have the same risk-based capital requirement but are relatively risky, Basel lead to this and actually increased risk taking 2. Ex: Rating agencies during the MBS bubble

Uptick Rule

1. Prevents short-selling of securities except on a price uptick 2. Eliminated by SEC in July 2007

What was Lehman's Real Estate Bet and race to the bottom?

1. Race ot the bottom: FICO score standards declined from 2001-2007 --> Prime was 640 but then lowered to 620 which increased credit risk 2. NINJA -no income, no job, no asset verification mortgage 3. Real Estate Bet: Lehman thought real estate industry was sound --> Put a lot of capital in RMBS + CMBS because it was their main growth model 4. In the 2000's, Lehman was the largest buyer and seller of MBS 5. Lehman was a speculative real estate hedge fund disguised as an investment bank

Three-pronged survival plan

1. Raise capital by selling Neuberger Berman - asset management business 2. Spin off its troubled commercial real estate assets 3. Slash its dividend from 68 cents to 5 cents

Jim Cramer

1. Raved that Bear was fine and a worthy investment 2. Investors who listened ended up losing big 3. Immortalized as the poster child of irresponsible financial journalism

Federal Deposit Insurance Corporation Improvement Act of 1991

1. Recapitalized the Bank Insurance Fund of the FDIC 2. Reform the deposit insurance and regulatory system so that taxpayer losses would be minimized 3. Risk-based insurance premiums 4. Prompt corrective actions 5. Increased incentives for banks to hold more capital and reduce risk

Preferred Stock

1. Receive fixed dividend that never changes 2. Similar to a bond 3. Stable price 4. Does not vote unless firm failed to pay dividend (dividend can be taken away) 5. Higher risk 6. Issuing preferred stock usually costs the firm more than issuing debt

Basel Committee on Banking Supervision

1. Regulates risk-base capital requirements (Basel Accord) 2. Four categories of off balance sheet activities based on degree of credit risk 3. Limitations of the accuracy of the risk stipulated vs. actual risk the bank faced 4. 3 pillars of regulation

Too-big-to-fail problem

1. Regulators are reluctant to close down large financial institutions and impose losses on to its depositors and creditors because doing so might precipitate a financial crisis 2. Increases the moral hazard incentives for big banks 3. Banks taking on more risk

Lobbyists (Enabler)

1. Repeal of Glass-Steagall Act may have been the ultimate act of lobbyist power 2. Allowed Citigroup and others to fulfill dreams of becoming financial supermarkets 3. Deregulation in CDS' 4. Part of the growing shadow bank system

The Media (Enabler)

1. Reporting should have been more timely and comprehensive 2. Peter Schiff the only good one -seen as an alarmist -warned us in 2006

Common Stockholders

1. Represents an ownership interest in the firm 2. Vote 3. Receive dividends (not guaranteed) 4. Lower risk 5. Double taxation

Goal of Dodd-Frank Act

1. Restore responsibility and accountability in our financial system 2. Reality: Act has addressed some system weaknesses but not all ... 3. It misses an important component - Reform in Washington D.C. 4. Overall Score: B

FED Reform #4

1. Restricts Fed's emergency lending authority 2. Lending cannot be made to insolvent firms 3. Collateral needs to be adequate to protect taxpayers 4. One time audit of the Fed 5. Conduct a study of how Fed directors are elected and improve governance

Executive Compensation and Corporate Governance #8

1. SEC is charged with playing a lead role 2. Shareholder say on executive pay and golden parachutes 3. Greater access allowing shareholder board nominations on proxy materials 4. Restrictions on brokers voting customer shares with no prior authority 5. Compensation committees must have only independent directors 6. Disclosure of why firms have separate or combined chairman/CEO role 7. Compensation claw back for financial lies - development, implemented and disclosed 8. Federal regulators required to create and enforce compensation standards

Treasury Strips

1. Separate Trading of Registered Interest and principal securities 2. Depository institution bonds in book entry form 3. No physical document exists; security is issued and accounted for electronically 4. Separates the periodic interest payments from the final principal repayment 5. Each interest payment and the principal payment becomes a separate zero coupon security

Prompt Corrective Action

1. Separates banks into capitalized groups 2. FDIC required to take action and requiring banks to submit a capital restoration plan

June-July 2008

1. Serious bargaining 2. Called Warren Buffet -Lehman would get $5B in needed capital and Buffet would get the value in preferred shares yielding 9%, able to be converted at a stock price of $40. -Fuld declined the offer 3. Paulson urged Fuld to find a partner -encouraged Barclays 4. Fuld met with BOA and wanted $25/share 5. The firm was not worth as much as Fuld thought 6. String of failed deals

The Fed (Enabler)

1. Should be independent of the interests of the commercial banks its regulates 2. Increased risk-taking activities in mortgage securitization 3. Did not embrace Basel II 4. Supported repeal of Glass Steagall Act in 1999 -encouraged greater risk taking by commercial banks eager to expand into investment banking 5. Thought the subprime market was contained

Dodd-Frank Act

1. Signed into law on July 21, 2010 2. The official name - "Dodd-Frank Wall Street Reform & Consumer Protection Act" 3. Act consists of over 2,300 pages, more than 300 new rules, 60 studies, 90 reports and 10 major provisions 4. Phase in period is over numerous years e.g., to 2022 5. Still most sweeping change in financial regulation since the Great Depression 6. Act has broad implications for financial services sector and beyond 7. For example, Federal regulation of corporate governance standards could affects all public corporations 8. Greatly expanded the power of existing federal regulators (Fed, SEC & CFTC) 9. Despite poor track record, regulators such as the Fed that missed growing risk trends that caused the Great Recession of 2008 have been given greater authority

Jimmy Cayne

1. Started off as a salesman for Bear in 1969 2. Bridge player - card addict 3. Hired by Greenspan 4. Joined Bear same year Dick Fuld joined Lehman 5. 1988 - promoted to president but wanted to be CEO and eventually convinced the BOD to make him CEO and also chairman of the board 6. Executives who appeared too capable for Cayne's or Fuld's liking seemed to disappear 7. 2007 Net Worth: $1B

January Effect

1. Stock prices have tended to experience an abnormal price rise from December to January 2. Inconsistent with random walk 3. Due to tax issues 4. Sell stocks at end of December and take capital losses on their tax return and reduce their tax liability 5. When new year starts in January, repurchase the stocks, driving up their prices and producing abnormally high returns

For whose interest are you working?

1. Stockholders 2. Stakeholders

Why should one care about ethics in finance?

1. Sustainability 2. Ethical behavior builds trust 3. Builds teams and leadership, which underpin process excellence 4. Higher standard than laws and regulations 5. Reputation and conscience

2010 Midterm Election + Trump win

1. The battle over Dodd-Frank has begun 2. The Republican house will target dismantling parts of Dodd-Frank 3. Barney Frank, the outgoing chairman of the house banking committee, has vowed to defend it 4. Act restrictions on bank profit taking has generated incentives to lobby aggressively and water down the Act

Random Walk

1. The movements of a variable whose future changes cannot be predicted because, given today's value, the variable is just as likely to fall as to rise 2. Future changes in stock prices should be unpredictable 3. Can't anticipate information flow 4. Just because a stock goes up, doesn't mean it will go down

Efficient market hypothesis

1. The prices of securities in financial markets fully reflect all available information 2. Market is semi-strong 3. Emotion drives market 4. Quantitative forces

Open Market Operations

1. The purchase and sale of gov't securities that affect both interest rates and the amount of reserves in the banking system) 2. Where decisions about TIGHTENING of monetary policy (a rise in the FFR) or an EASE of monetary policy ( a lowering of the FFR) is made 3. An open market purchase leads to an expansion of reserves and deposits in the banking system and hence to an expansion of the monetary base and the money supply 4. An open market sale leads to a contraction of reserves and deposits in the banking system and hence to a decline in the monetary base and the money supply 5. An open market purchases causes the federal funds rate to fall, whereas an open market sale cause the federal funds rate to rise 6. The interest rate paid on reserves sets a floor for the federal funds rate

Assessment of risk management

1. The quality and oversight provided by management and board of directors 2. The adequacy of policies and limits for activities that present risk 3. The quality of the risk measurement monitoring systems 4. The adequacy of internal controls to prevent fraud

Reserve Requirement

1. The regulations making it obligatory for depository institutions to keep a certain fraction of their deposits as reserves with the Fed 2. When the Fed raises reserve requirements, the federal funds rate rises 3. When the Fed decreases reserve requirements, the federal funds rate falls 4. When the federal funds rate is at the interest paid on reserves, a rise in the interest rate on reserves raises the federal funds rate

Hank Paulson (Decider)

1. The ultimate decider 2. Not saving Lehman made the crisis worse 3. American taxpayers would have benefitted from a bailout 4. Did not grasp the severity of the problem soon enough 5. Not finding a way to save Lehman increased moral hazard 6. Made an egregious error as the head of the US Treasury

June 2008

1. Time to bargain 2. S&P downgraded Lehman from A+ to A 3. Callan fired and replaced by Lowitt 4. Email about upper management taking blame 5. Joe Gregory let go -focused on firms culture not risk management

Government Safety Net

1. To reduce risk of bank failures (bank runs) and improve quality of information about the bank to depositors 2. FDIC (est 1934) insures up to $250,000 (payoff method) and the purchase and assumption model (other banks) 3. Most serious drawback is moral hazard -reckless drivers don't care because of insurance 4. "Heads i win, tails the taxpayer loses"

Academics (Enabler)

1. Trained in theory on how the markets worked 2. Roubini -warned us in 2006 but was labeled a lunatic 3. Stuck to models

Henry Kaufman (Enabler)

1. VaR 2. Expert trader but didn't apply knowledge to Lehman 3. Low risk management experience

Recommendations

1. We must acknowledge systemic risk exists 2. The Fed needs to regain credibility at home and abroad 3. An independent systemic risk regulator makes sense 4. Higher capital levels should be mandated 5. Leverage constraints must be in place 6. Smarter compensation schemes are critical 7. Boards must exercise better oversight 8. Regulations need to remain current 9. A firm policy stance on moral hazard should be taken and articulated 10. Greater executive accountability *6, 9 and 10 have not been put in place

Consumers (Enabler)

1. Willingness to plunge deeper into debt contributed to crisis 2. Increased ratio of debt to disposable income 3. Consumers were the ones who agreed to the terms

Right and wrong as defined by duty or intentions

1. You should treat a person as an end, never as a means 2. If everyone behaved this way, what kind of world would we have?

Valentine's Day Massacre

1. Zurich headquarters of UBS - February 14, 2008 2. Switzerland's largest and most conservative bank was about to drop a bombshell with Q4 results -got into subprime mortgage market -used Dillon Reed to set up subprime funds that collapsed -loss of $11.3B 3. Mortgages were now seen as liabilities 4. RMBS, CMBS and ABS now considered "toxic sludge" 5. Write downs by UBS triggered an industry-wide chain reaction as other firms were forced to re-mark the value of their mortgage securities position 6. Turned the lending business into the losing business 7. Death of an industry that Bear and Lehman relied heavily on

What were the humble roots of Lehman Brothers?

1850 Started out as Dry goods store in AL --> Started accepting Cotton as payment --> Cotton Traders --> Civil war broke out --> 1868 Lehman moves to NYC --> Becomes IB

Bank Failure

A bank is unable to meet its obligations to pay its depositors and other creditors and must go out of business

Feedback loop

A credit boom drives up asset prices, which in turn fuels the credit boom, which drives asset prices even higher and so on

Noncallable bond

A financial security that cannot be redeemed early by the issuer

Off-balance-sheet activities

Activities that involve trading financial instruments and generating income from fees, which do not appear on bank balance sheets but nevertheless expose banks to risk

September 17-19

After turmoil related to AIG, Lehman, Merill Lynch, and others, the Dow drops more than 1,000 points

Credit easing

Altering the composition of the Fed's balance sheet in order to improve the functioning of particular segments of the credit markets

Excess reserves

Any additional reserves the banks choose to hold

Financial Accounting Standards Board (Decider)

Banks become balance sheet insolvent and were forced to deeply discount their assets even if they had no plans of selling them due to adhering to the FASB fair-value accounting rules

Stress Testing

Calculates losses under dire scenarios

The Big Uncertainty

Congress has delegated interpretation, rulemaking and enforcement to federal regulators

Government securities

Covers the Fed's holdings of securities issued by the US Treasury

Jensen

Defines overvalued stock as occurring when the performance necessary to produce that price cannot be attained except by good fortune

Asset-Price Bubble

Easier credit can be used to purchase particular assets and thereby raise their prices

Systemic Risk

Failure of a company could threaten U.S. financial stability

Financial derivatives

Financial instruments whos payoffs are linked to previously issued securities

Basel Pillar 3

Focuses on improving market discipline through increased disclosure of details about a banks credit exposures, its reserves, and capital, and who controls the bank, and the effectiveness of its internal credit systems

Basel Pillar 2

Focuses on strengthening the supervisory process, in assessing the quality of risk management in banking institutions and evaluating whether they have adequate procedures to determine how much capital they need

CAMELS Rating

Given by bank examiners 1. Capital adequacy 2. Asset quality 3. Management 4. Earnings 5. Liquidity 6. Sensitivity to market risk

Lehman's Achille's heel

Heavy reliance on the overnight repo market to support daily operations

Uncertainty period

Interpretation and rulemaking is still underway

Deciders

Involved in the years, months, and weeks immediately before Lehman declared bankruptcy 1. Financial Accounting Standards Board 2. SEC Policy on short-sellers 3. Hank Paulson

Callable Bond

Issuer can repurchase the bond

Treasury Note

Matures in 1 to 10 years

Treasury Bond

Matures in 10 to 30 years

Treasury Bill

Matures in less than 1 year

VaR

Measure the size of loss on a trading portfolio that might happen 1% of the time over a 2 week period

Disclosure requirements

Needed to limit incentives to take on excessive risk and to upgrade the quality of information in the marketplace so that investors can make informed decisions

Semi-Strong Form Efficiency

Past + today

Strong Form Efficiency

Past + today + future (public) + private

Weak Form Efficiency

Past information

One-Period Valuation Model

Po = (Div1/1 + K) + (P1/1 + K)

Chartering

Preventing adverse selection, proposals for new institutions are screened to prevent undesirable people from controlling them, can lead to cease and desists orders

On-site exams

Reduce moral hazard, allow regulators to monitor whether the institution in complying with capital requirements and restrictions on asset holding. (CAMEL RATINGS )

Required reserves

Reserves that the Fed requires banks to hold

Volcker Rule (2 Rules) #9

Rules 1. Restriction on proprietary trading -Banks prohibited from trading in securities, derivatives and other financial instruments for its own account 2. An ownership ban on certain hedge funds and private equity activities -Ownership needs to be 3 percent or less of total fund -Ownership needs to be 3 percent or less of the bank's Tier I capital

Small-Firm Effect

Studies show that small firms have earned abnormally high returns over long periods of time, even when the greater risk for these firms have been taken into account

Technical Analysis

Study past stock price data and search for patterns such as trends and regular cycles

Congressional Committee (Enabler)

Supposed to make sure financial institutions are following laws and regulations

Leverage ratio

The amount of capital divided by the banks total assets (must exceed 5%)

Contagion Effect

The failure of one bank can hasten the failure of others

Message to the market

The government will not reward firms that take excessive risk

Federal Funds Rate

The interest rate on overnight loans of reserves from one bank to another

Monetary base

The sum of the Fed's monetary liabilities and the US Treasury's monetary liabilities

Enablers

Those responsible for the crisis (Lehman's failure); sow the seeds of the housing bubble 1. Dick Fuld 2. BOD 3. Henry Kaufman 4. Congress 5. Congressional Committees 6. The Fed 7. The SEC 8. The Media 9. Academics 10. Accountants 11. Credit Rating Agencies 12. Lobbyists 13. Consumers

Right and wrong, as defined by consequences

Utilitarianism = greatest good for greatest # of people

Deleveraging

When financial institutions with less capital cut back on their lending to borrower-spenders