FIN410 Exam 2 Study Guide
FIN410 Exam 2 Study Guide FIN410
Popular in Financial Institutions and Markets
Popular in Finance
This 24 page Study Guide was uploaded by Alexandra Morales on Sunday February 15, 2015. The Study Guide belongs to FIN410 at University of Miami taught by Sanders in Fall. Since its upload, it has received 187 views. For similar materials see Financial Institutions and Markets in Finance at University of Miami.
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Monetizing the De cit 0 Will hear from conservatives that this liberal government has these huge excessive spending programs and the government just prints money to pay for the deficit that is monetizing the deficit 0 Explosion in money supply that will lead to runaway in ation and will destroy the economy and the currency 0 Classic conservative argument 0 Do governments do this No they borrow to pay for the domestic budget deficit expenditure tax revenues 0 That is the reason that the national debt is so high 0 Because they re not monetizing the deficit we don39t have any record of monetizing the deficit 0 Conservatives will say that the FED covered some of the deficit yes but it was a small amount of this 0 Treasury has periodic treasury auctions 0 Treasury looks at budget deficit and comes to a number they have to raise 0 It issues new treasury securities bonds notes and bills 0 Treasury auction off new securities and institutional investors enter the auction and buys them when auction is over most of it is sold 0 The small part that is not sold the FED buys the treasury notes and pays for them and in a very small degree monetizes the deficit 0 Will also hear that the primary purpose of the FED is to print money to finance the whole deficit simply not true 0 If that was the case we would not have this debt bubble Crowding Out 0 Measure this from time to time think it39s a phenomenon that comes and goes 0 Government has a domestic budget deficit spending more in national budget than taking in in tax revenue internal balance deficit and it needs to borrow money by issuing treasury debt in order to finance the excess spending the debt levels rise all over the country 0 Reason we are in so much debt is because we have had to spend on shovel ready job programs to keep the economy a oat 0 What s happening here is the government is going into the capital markets with a securities action and the capital markets are obliged to buy this treasury issue which can be rather large banks and other fixed income investors 0 Private sector is also in the capital markets raising money for expansion 0 Treasury is coming in with a large treasury issue and soaking up the available capital it crowds out the private sector I Not enough money for expansionl cost of capital rises discount rate rises and net present value drops more projects have negative NPVs less expansion of the economy slows economy I Crowding out measure is something the government has to be aware of because it disrupts the expansion of the economy I Conservative will say I can see why we increase spending to protect economy and stimulate demand more I Conservative radical will say liberals in office are adding all sorts of pork and spending to gather votes 0 Cannot blame political class for adding pork special local programs because it is important to voters 0 Without the pork the candidate has no chance of getting elected certain amount of pork that is necessary to be reelected voter is sensitive to this 0 Therefore not surprised that a certain portion of spending involves pork but the conservative radical will exaggerate this International Crowding Out 0 This has been measured from time to time I US has big treasury auction and have measured crowding out in European capital markets because US treasury security is an essential invested in by everyone 0 Foreigners have a big appetite for US treasuries I US capital market is very large compared to any other country s capital market 0 Isn t much in these markets compared to US 0 Since everyone wants US treasuries when the treasury does an issue all these foreigners are also bidding on the treasury auction so its pretty easy to see that some of this available capital abroad could starve out to some degree local capital raising cost of capital lowering number of positive NPVs and to some degree perhaps slowing these foreign economies a little Neoclassical Economics I Chicago School of Economics Milton Friedman 0 Friedman was running things for a while as the scholar 0 Monetary lags found that there were these lags of 812 quarters O Stimulate and the money works its way through the system and eventually hits GDP takes a long time 0 His study was quite a shock to the quantity theory of money I You re at the bottom of the trough in a recession and you think you can turn it by expanding the money supply by for example increasing the money supply by 400B to increase GDP by 05 the problem with this is the lag I So you stimulate the money supply at bottom of the trough and meanwhile the economy on its own begins to recover economy is in early stage recovery on its own I Then a money balloon shows up during the early stages of recovery and there is much more money there than the economy can use and a lot of it goes to prices because money is not being used by the economy 0 FED cannot allow for this in ation I What Friedman is question is if you want the FED to come in here during the early stage of recovery and contract the money supply just at the time when the economy is beginning to recover I This is Friedman s criticism of discretionary monetarv DOliCV carried out by the FOMC using the quantity theory of money 0 Friedman says this stimulation of the money supply to stimulate GDP using the quantity theory of money causes great difficulty with in ation in the early stages of recovery and it should not be done I Instead keep a constant increase in the money supply to facilitate long term growth I Do not fine tune the money supply do not increasedecrease the money supply through quantity theory of money I What should this constant amount be Friedman would say have the amount of money that would give you a long term of about 4 unemployment and 325 in ation on the Phillips curve 0 This is the full employment point 0 Whatever money that is required to maintain that point don39t vary it 0 Meanwhile the business cycles will go up and down but maintain the same amount of money for long term economic growth steady monetary expansion Rational Expectations 0 Idea that if you increase the money supply the labor unions will assume that the increase in money will go right to prices and the existing nominal wage with suddenly higher prices will mean that the real wage will drop 0 Since the labor union s business is to maintain a real wage level for its members it will strike and force an increase in wages to compensate for the anticipated increase in prices frustrates the central bank s increase to the money supply 0 With the increase in wages the increase in the money supply will never reach GDP it frustrates from M to Q because wages have gone up 0 If expanding the money supply in anticipation of companies expanding their plan 0 And if the companies suddenly see an increase in their costs due to higher wages then the companies will not expand their plans 0 Increase in M will never reach Q 0 Frustrating the well functioning quantity theory of money Business Cycle Theory 0 Upcycle typically lasts about 35 years and down cycle lasts 15 years new business cycle every 5 years O Idea of a recession down cycle is good because it is cleaning out over pricing in products of real estate markets over optimism expressed by the consumer hubris in the society that this upcycle will never end 0 Have a down cycle to bring everyone back to earth and clean out overpricing 0 Then system goes up and down again in a very healthy process These are vital markets with an infinite amount of money moving around globally 0 When markets turn into recessions they get very nervous and everyone is selling stocks real estate so they don39t get cleaned out in price 0 Since everyone in a recession in selling in markets there is a danger that if the government doesn39t step in FED and treasury and increase the money supply a little bit to make sure the market psychology doesn39t fall apart I There is a proper place for government as business cycles turn to make sure the psychology does not spin out of control and end up with a depression I But the government cannot turn the recession up or prevent it I Government could not have prevented the bust of 2008 We are in the early stages of a bubble in real estate 0 There are claims that Miami real estate is back to its pre2008 prices 0 Prices are getting close to levels pre2008 0 We are worried about intervening bubbles 1518 years before 2008 While business cycles are supposed to turn about every 35 years what we think happened is that in this case the FED intervened caused a soft landing and the business cycle never turned it just went up again 0 The FED intervened again and caused another soft landing 0 All this helpful clean out of the excess was not allowed to occur 0 The FED thought it was defeating the business cycle 0 So by 2008 our business cycle was way above where it was supposed to be I Did not have intervening recessions in the years before 2008 I So naturally we are not going through all of the accumulated decline bringing us back to where we are supposed to be I This recession is an accumulation of all the recessions that did not occur in the 1518 years before 2008 I We can see that the helpful cyclical recessions were not allowed to occur if there was a mistake made then maybe it was made by the FED If cant prevent recessions then how did they keep them from intervening during the 15 18 years prior to 2008 O FED perfected its monetary model and figured out they could actually produce what is called soft landings put in a little stimulation and then withdraw it a little and created soft landings 0 Got the model right triumph of economic technology 0 Monetary models were so good that they were able to produce this result Idea that business cycle recessions are evil liberal thought 0 Central criticism of capitalism is that you must have recessions and unemployment cyclically O Marxist will say that if you convert to a socialistic system there are no business cycles and there is a remarkable stability in jobs fairness and distribution 0 P122 Kondratieff long waves 60 year long waves with 30 year up cycle and 30 year down cycle upon which business cycles are superimposed O Kondratieff is a Russian economist 0 The street thought we were in the down cycle of a long wave 1980s I Very concerned about this I Brought in climatologists and long wave theorists to explain how all of this works Well known phenomenon At the downturn of the 60 year cycle the recessions are longer and the bull markets are short At the upturn the booms are long 35 and the recessions are short 15 In about the 1980s we had turned down markets were concerned and this needed to be explained P181 Is It For Real This Time A Marxist View Kondratieff s academic theory what the European Marxists think there is a period of capitalistic robustness and there is a decline in capitalism and then a rise in capitalism and so on and so forth I These long wave upcycles occurred because of major events 0 0 Opening of the American west Expansion of the American railroad west Development of mass production of automobiles by Ford There have been about 46 major upwaves dating back to the early 1800s that they have measured this stuff has been under intense academic criticism Then we had big computer the laptop the cell phone In other words these are major technological break through that go through an economy and cause the long wave to go up these big technological breakthroughs which are characteristic of capitalism The current upswings seem to be driven by technology or ideas I The capitalistic systems will have their time but after about 30 years this technological breakthrough runs its course and peters out and then you have a downturn for 30 years Business cycles superimposed on the long wave gives you longer recessions Then the next technological breakthrough occurs and we get a 30 year upcycle maybe I Criticism of capitalism have to have these breakthroughs because capitalism depends on it and as the technological breakthrough peters out there must be another one capitalism is not a selfsustaining system because it always depends on the next breakthrough The argument is that there is going to come a time when we are going to be a the bottom of a long wave down cycle and there are going to be no breakthroughs at that point this will be the final defeat of capitalism and the socialistic model will then take over and that39s the ultimate equilibrium model 0 How could a system have these breakthroughs in perpetuity O Stalin did not like that there needed to be a period of capitalistic prosperity so he was sent to Siberia 0 Central argument on p 132 next breakthrough that is necessary will not occur and that will be the end of it 0 Self Correction Theorv 1800s 0 EXOgenous shock theorv a business cycle will not self correct it will keep going up indefinitely until there is a shock O No automatic adjustment mechanism 0 Think this theory explains what happened in 1974 the big recession cycle had been going so long that there was no selfcorrection process and then oil embargo by the Arabs caused this shock and kicked it down 0 Another example Japanese tsunami 0 Sun snots theory occur every 1011 years 0 Observed that this is fairly predictable and have seen recessions occurring coincidentally with the sun spot activity 0 Idea is that on the sun there are spots that appear in its atmosphere that block out a certain amount of radiation and light causing temperatures on Earth to drop some several degrees I As the Earth cools by a number of degrees because of the sun spots it affects agricultural yields causing agricultural commodity prices to rise and causing the business cycle to turn 0 Idea of sun spots is based upon a manufacturing economy that uses commodity inputs may be less relevant today because we have moved away from a manufacturing economy to a service economy Bond Market Collapse and Hedge Funds p 139 birth of the hedge fund industry 0 1994 there was a huge bond market crash as large as any stock market crash 0 Immergence of the hedge fund market 0 Hedge fund defined 0 Typically is a money management firm 0 Hedge fund investor must have a huge net worth because he will be subject to vast uctuations indicating the risk of investing in hedge funds and losses but in the long term will make excessive amounts of money must understand this as an investor and must be able to play through it 0 Idea of investing is that its average return is 2030 a year but will have periods where you lose 150 but the secular line will be a tremendous return I Not all hedge funds have been able to produce this and many have gone down I Investors must be able to sustain these tremendous collapses from time to time in order to receive the high returns over the long term I The common public cannot stand this so net worth requirements for investors must be very high 0 Designed to invest in a super safe security e g GM ExxonMobile and the only way that they can make those returns is to use some extreme leverage hedge fund is highly levered I Might have 200M of subscriber money and investing 2030B they borrow the rest from commercial banks I GM might produce 8 return but when use the leverage you are gaining 2030 on GM I There is all sorts of variation in this today as they become more and more sophisticated they can take on riskier basic underlying cash investments I But the main idea is leverage to magnify the returns and naturally when things go down you magnify the losses 0 Called hedge funds because when they are long in something with leverage they are supposed to set up a certain amount of hedges by puts against the long position offset some of the losses I Don39t hedge out the entire position but hedge out enough of it I Derivatives are very intrinsically powerful and costs very little Bond Massacre of 1994 hedge funds were operating in government bonds playing the yield curve 0 This all came to a head and collapsed in 1994 O This was the carry trade I Yield curve Xaxis maturity yaXis interest rates and upward sloping curve I A yield curve between the 30 year and the 9 day Tbill is 300 basis points normal yield curve of treasury I If yield curve is atter than normal that indicates that the economy is slowing the demand for credit is slowing and anticipated to slowless bidding up of interest rates as the demand for credit cools off I If yield curve is unusually vertical more than 300 BPs economy that has a lot of demand for credit and has anticipated even higher demand for credit in the future interest rates anticipate this higher demand for credit in an overheated economy can expect carry trade to start I See carry trade when there is more than 300 basis points between bottom and top of yield curve I Since this is considered to be an overheated position its anticipated that the FED will try to make this into a more normal yield curve everyone knows the FED is going to do this but we don39t know when I During this period they were waiting for this FED action short in the carry trade at the bottom of the yield curve aka borrowing the money say at 3 and longing at the top of the yield curve at 65 earning this spread while waiting for the FED to cause the yield curve to rotate 0 Short position is a way of financing something when you short you get proceeds use the proceeds to buy the long bond 0 If borrowing cheap and investing big you have a big spread between the cost of bonds and investment income arbitrage because no investment of own money using short of Tbill to finance Investors don39t think there is a lot of risk because the carry trade knows that the yield curve must normalize 0 Anticipation is that the FED will rotate the yield curve at an axis the bottom of the yield curve will go up short term interest rates rise and the top will go down long term interest rates fall 0 Short term interest rates rise FED pushes them up at the short endprices fallwe were short so we make a capital gain 0 Long term interest rates dropbond prices rise our long position also makes a capital gain 0 We exit the carry trade as the yield curve normalizes 0 Rotation at the axis is critical The reason this rotates to a normal yield curve is because the short term interest rate increase using FOMC tool pushes short term interest rates up long term interest rates respond because the long term interest rates are assuming that the economy is going to cool some that the tightening by the FED at the short end will mean that there will be less demand for credit in the future farther out interest rates will drop far end of the yield curve is just endogenous to the effect 0 This is what the FED has always done and is supposed to happen 0 What happened in 1994 What was different There were hedge funds and they were new the newness was that they used extreme amounts of financial leverage by a treasury greatly magnifies the returns using debt leverage Government didn39t realize the change that had occurred or the effect it would have FED tried to normalize the yield curve during the carry trade by doing what it had always done 0 The FED always operates at the short end of the yield curve 0 Since long rates are derived from short rates if the FED pushes up the short term interest rate by contracting the money supply we expect the yield to rotate properly 0 What happened here is that it did not rotate Hedge funds were invested long using debt leverage 0 As the FED pushed the short term interest rate up but the long term interest rates also went up had a somewhat parallel shift it did not rotate properly and this is what caused the problem 0 FED increased the short term interest rates hedge funds saw the FED slowing the economy they panicked and with all this leverage they started to unload these long bonds pushing down the price 0 As interest rates rose hedge funds saw their losses greatly magnify so they panicked 0 As they sold the long bond the price dropped and the interest rates rose further 0 And they continued to sell in their panic and this continued to happen even further causing the yield curve to rise in a semiparallel fashion P 160 this panic selling caused the mutual funds industry to lose 4045B insurance to lose 2025B life insurance companies to lose 50B worldwide fixed income portfolios to lose 15T largest fixed income losses in history all had to do with hedge funds P192 Greenspan What did I do wrong to cause these kinds of losses 0 New industry out there hedge fund industry that was playing the government bond markets in a spectacularly levered fashion 0 Panicked and sold and completely distorted the rotation of the yield curve All these losses in the bond markets primarily in the hedge fund market p160 146 0 Greatest loss in the bond markets than we had ever seen before due to the presence of these hedge funds Outer end of the yield curve was not allowed to be endogenous rather it shifted up in interest rates as prices were being sold down and there was a parallel shift up not totally parallel but the yield curve shifted out instead of rotating Federal Funds amp Commercial Paper Markets 0 Federal Funds Market 0 O 0 Primary borrowing market for banks FED is working on monetary policy trying to affect short term interest rates it is actually working on the federal funds market interest rate as the basic interest rate in the market Federal funds are the ultimate short term interest rate overnight borrowing FFMM is often misunderstood Doesn39t the FED control interest rates Isn t this a federal funds rate 0 BUT the federal funds rate is a market determined rate that moves up and down depending on the supply and demand for credit 0 The FED confirmsdoes not confirm what the federal funds rate is doing through the rediscount rate I Just because it is federal funds does not mean that the FED controls it 0 Federal funds market is now being replaced by the eurodollar rate as we become more global O FFMM is a way of settling overnight interbank borrowings I During the day a Bank A is going into deposits and making loans and in the afternoon someone makes an analysis that there were more deposits coming in than loans going out excess money turned over to a federal funds clerk this federal funds clerk enters the interbank markets for the night as a lender and arranges a loan with another bank to be paid back overnight I Bank B had a huge amount of loan demand and not that much deposits so it must borrow money to fund its excess loans for the day Bank B borrowing funds in the interbank market and paying it off the next day I Banks can be a borrower one day and a lender the next it shifts around I The settlement of these loans and repayment is done through the commercial banks accounts at the federal reserves 0 Have reserve requirements at the federal reserves 0 Commercial Paper Market 0 Another source of credit for banks 0 While the federal funds market is interbank the commercial paper market includes banks and industrial companies I Industrial companies from time to time have excess money 0 During the first smell of trouble in an economy these markets freeze no commercial paper and no federal funds 0 The lenders in these markets are really risk averse 0 Problem is a bank or an industrial corporations cannot roll over its money or loan as the market is frozen this is what causes the emergency situations in banks and industrial corporations 0 This is why the FED has to step in and replace this financing with basic treasury financing bank bailout O FED always has to be ready to step in must be ready to rescue in order to prevent a depression Quantitative Easing QEs 0 QE1QE2QE3 0 This yield curve was actually quite at after 2008 recession attened yield curve 0 FED typically works at the short end with M1 and M2 targeting as discussed in the carry trade 0 What was different with the QEs was that the FED was working at the mid section of the yield curve for the first time 10 Tapering FED knew this was speculative and knew it could not do much to turn a recession but it could try FED knew that it might be able to work on the real estate market which constitutes about 13 of the economy because it is so sensitive to interest rates FED bought mortgage backs securities that were priced somewhere in the middle of the yield curve buying pressure will go up medium term interest rates will drop lower interest rates will stimulate real estate construction and development maybe help stimulate the economy Hoping to twist called operation twist the yield curve down a little so that medium term interest rates would be lower and this would stimulate construction Tried 3 times and it did not have much of an effect QEs had a Keynesian approach to them 0 Since the QEs did not show much evidence of turning this around there are claims that the FED doesn39t know what its doing or understand how this works This criticism might be valid if you believe that the primary purpose of the QEs was to turn the business cycle But that was just one small part of the QEs purpose small part of operation twist The bigger part of the QEs was to ood the money supply because we were in trouble quantitative easing of the money supply 0 Quantity of money rose dramatically as everyone is worried about the money bubble out there 0 This was depression fighting and a small part of it was operation twist If the QEs did prevent a depression then could we say they were unsuccessful Maybe it is time to start taking some of this money away as the economy cannot use all of this money the question is are we on safe enough ground FED wants to see firm improvement in economic numbers before it is going to take much away and it has not seen the degree of improvement that it wants tapering has not really happened because the FED is still scared If the FED starts to do some serious tapering that means the FED is confident in the recovery On the Rise Handout p207a New millenials this is our generation how we think Marketers do not fight this they say Here is the new consumer What does he want How is he going to be marketed to How does he think Politicians do the same 11 Burning Up Article p155 0 2000 a year before the dotcom bubble burst and 911 0 Initial dotcoms so much frenzy and excitement that by the hundreds these companies had not yet brokeneven and they were already going public and people were just frantic to buy their stock 0 There was never a PE or earnings per share because EPS were negative so how could we have a price earnings ratio So could we value these stocks 0 We don t value them based upon earnings potential projection of earnings like we value all other public companies because these companies don t have any earnings 0 How they were valued what is the sales to price ratio I Since don39t have any earnings needed to have another ratio I Trying to derive valuation based upon sales to price nuts 0 Barron s said they were burning up the money and would run out of it in months The DotCom Bubble 0 And it burst and we had a huge market collapse in the equities market 0 A pretty big shock as many of the companies went down 0 A year later 911 events occurred 0 These events happened right after another 0 We thought we were in a lot of trouble 0 Greenspan was the chairman of the FED 0 There was market panic markets tanked I First thing the FED did was open the fire hydrants and the country was awash with money great increase in the money supply to staunch market panic I Greenspan kept money owing until it sort of settled I It took quite a while for the markets to adjust for the psychology to relax for the government to understand that there was not an organized siege of the government markets settled but FED was still very nervous so Greenspan continued to increase the money supply for 3 years I With all this money around interest rates went down and mortgages became cheaper every year 0 Monthly payments continued to reduce and the prices just by the decline of the interest rate I So real estate went through a huge acceleration in value during the early 2000s 0 This all culminated in the bust of 2008 I Greenspan in his book said perhaps I kept the money supply going for too long not saying he was scared to death as no FED agent can say 0 This is why we do not see tapering occurring today because the FED is still scared 12 Term Structure of Interest Rates p 159 0 Yield curve xaxis maturities yaxis interest rate 300 basis points normal lt300 economy is slowing and the yield curve is getting atter gt300 economy is getting over heated and the FED will intervene and cause the yield curve to become normal People follow the shape of the yield curvel major forward looking indicator I As the yield curve attens becomes at and then humps down there has always followed a recession with a couple of exceptions I If in recession and start to see the yield curve atten this might indicate recovery is coming goes from downward hump to at 3 elements of yield curve I 1 Expectations component 0 O 0 Can take the existing term structures of interest rates and use them to forecast future rates example in written notes How do we come up with longterm interest rates What determines a threeyear interest rate We think interest rates are determined based upon forecasts O O 0 If I want to come up with the rate on a 4year security 7 I would base it upon forecasts If the 1 year is 4 1 year expected in 1 year is 6 1 year expected in 2 years is 8 and the 1 year expected in 3 years is 10 I All 1 year rates forecasted in the future I Got these forecasts from some exogenous source I Can subscribe to interest rate forecasting services which will tell you this information using econometric techniques From these forecasts of 1 year rates we can develop a 234 year etc rate I The 4 year rate is not 10 I A long term interest rate is simply an average of expected short term rates I Lets say from this data I want a 2 year interest ratel going to be 5 that is if I bought a 1 year for 4 and roll it over for another 1 year it is 6 so the average is 5 I A 3 year rate I could buy a 1 year at 4 roll over for another year at 6 and roll over for another year at 8 OR could buy a 3 year at 6 I This is how we get longterm rates average of the short term rates What is not so easy is to get these independent 1 year forecasts using econometric forecasting services 13 I What is even more significant is that we can look at the market at any particular time and pick out these interest rates going up to 30 years these represent a consensus of thousands of traders as to what is likely to happen in the future 0 What the market has done by looking at existing term structure is decide selfsubjectively what is likely to happen this is very significant because then we can take an easily observable cross section of those treasuries and we can boot strap the individual one year rates implied by the term structure and then we can extract explicit interest rate forecasts thus extract what kind of economy the market thinks we are in I If extract that short term interest rates are rising slowly then in a slowing economy I If extract that short term interest rates are rising quickly then in a growing economy interest rates rise with the expansion of the demand for credit 0 Boot strapping example Year Nominal Rates Subtract Liquidity Extract Expected 1 Year Quoted Premium Expectations Rates Forward Component Rates 1 4 4 BP 396 2 525 6 BP 519 643 3 7125 9 BP 7035 1083 4 90625 10 BP 89625 1495 103961x 105192 x2643 1 year rate expected in 2rld year 10396106431x 1070353 x31083 1 year rate expected in 3rd year 1039610643110831x 10896254 x41495 1 year rate expected in 4th year 0 When we talk about interest rates we are referring to short term interest rates that is not what is shown here nominal rates we want to see that dynamic what is really expected by this term structure Everyone around the world is trading government securities what do they think Take nominal rates quoted and subtract out liquidity premium I Consensus that 1 year might be 4 BP 2 year 6BP etc I Trying to extract the expectations component I What we want to do is extract the one year rate in the second year I These 1 year interest rates are going up dramatically extremely bullish economy 14 0 If the interest rates were very at that would indicate that the economy is moving slowly 0 These are what we call forward rates expected 1 year rates I 2 Liquidity premium relatively stable Enhancement of the coupon demanded by the investor for holding a longer maturity bond because it has more price risk than a shorter maturity bond Nominal yield curve looks like its slightly upward sloping 0 But if we take out a liquidity premium then the expectations is at 0 So to be precise must take out liquidity premium to see what actual expectations are 0 Difficult to isolate empirically but to get real interest rate forecasting we need to subtract the liquidity premium So if interest rate goes up 25 BP the Tbill goes down in price a tiny bit and the Tbond goes down in price a lot more 0 While we think government securities are riskfree in terms of credit risk they are hardly riskfree in terms of price risk Tbond filled with price risk going out 2030 years 0 So if going to ask investor to buy Tbill he has a little price risk so will charge a little liquidity premium but with the Tbond there is a lot more liquidity premium demanded 39 3 Segmentation hypothesis not so stable The actual yield curve empirical yield curve is very curvy when we actually connect the data points of the treasury cross section at a point in time the curve is very wavy and unstable 0 But this is smoothed out and this is what is printed in the paper 0 The smoothed version is not the actual yield curve The actual yield curve is a moving snake it moves around during the trading day when everyone is trading government securities This segmentation hypothesis is not primarily important to the economist but is important to a bond trader who is trying to determine how the thing will wiggle during a very short time period to make his trade 0 Trader plays the shifting wiggle of the empirical yield curve Since the wiggles of the empirical yield curve are generally smoothed out they are not particularly important in the overall implications of what is happening to the yield curve but should know these effects are going on inside the actual curve I The expectations component dominates and the other two are more minor 15 I The fact that the yield curve is changing its shape indicates that expectations are changing because expectations dominate the yield curve I As the yield curve is changing expectations are dominating even though there are other elements 0 People assume this when they watch the shape of the yield curve changing Financial Crisis of 2008 p209 0 What is new monetary settlements are not enough need corporations to admit guilt Largest US corporate penalty yet no villains O O 0 Generally corporations do not agree with this Senator Elizabeth Warren is the leader in all this Corporations are run by people so if the corporations are admitting guilt then we need to have felony claims on the executives that they criminally acted wrong need to have not only corporations paying settlements and admitting guilt but also have executives convicted of felonies and doing the time I John Taylor s Reply to Alan Blinder Taylor Rules on FED actionFED should operate under much greater oversight O O O O FED should operate under certain rules no secretive monetary decisions FED must be much more open Need to take away FED independence and secrecy That in fact the FED is not doing well I FED saw this coming in 2008 and did nothing this is the essence of this tremendous avalanche of criticism of Bernanke didn t know what he was doing I Had the FED been competent knowing it was coming it should have used its tools and prevented it I Since they did not prevent it and they have all these powerful tools then they must not know what they re doing I Since they don t know what they re doing the government has to come in and make sure the FED is doing what it is supposed to be doing Taylor rules comes with the idea that therefore since the FED is not very good at what it does we need congressional oversight rules committees and bring the FED out into the open in order to watch over it and make sure it operates more effectively I Many attempts to legislate these rules under the idea that the days of the independent FED are over and it needs much more political oversight I They could have but didn39t prevent the recession of 2008 I Moreover with all these powerful tools they have not turned this around I Therefore they do not know what they are doing and the government must step 1n 16 O Blinder believer of an independent FED it knows what it is doing and does not have as powerful tools as the critics say I FED was in no position to prevent the recession in 2008 or turn it around I The problem here if there is one at all is that the tools are not that effective I That being the case the FED has done a reasonably good job with their limited powers independent FED policy is still the right way to go and Taylor Rules are too hampering and restrictive to an effective FED P210 Nov 20 2010 O O 0 Letter written to Uncle Sam from Warren Buffet The only counter force to the crumbling economy was government intervention Buffet s view government with all of its money stepped in and prevented a depression in the markets P214 Accounting contribution to the crisis 0 O O O SFAS 157 is the mark to market accounting rule so that mortgages have to be marked to market if mortgage valuations are dropping then all mortgages have to be marked to market Early on in the fall Citicorp had a certain quantity of mortgages and portfolios which had dropped in value dramatically they wanted to clean out their balance sheet so they basically sold them at a 4060 discount SFAS 157 accounts said this was an example of a real transaction so the auditors came into the banks and said you have to mark down all of your mortgages by this amount because you need to marktomarket and this is the market price auditors forced the banks and there was a massive accounting writedown Suddenly all these banks had these huge markdowns of mortgages valuations I They had never intended to sell these mortgages they were going to hold them but the markedtomarket accounting caused a massive writedown I This got into the stock market and the stock market panicked on bank stocksbank stocks collapsedpulled down the industrial stocks the stock market went from 14000 to 65 points that was the financial crisis I Started with the banks and leaked out into the industrial sector P216 Wikipedia explanation P221 accounting and market values 0 O O O 0 History of the subprime mortgage P229 Wikipedia subprime mortgage crisis P230 subprime and adjustable rate mortgages are 68 of the mortgage market but 43 of foreclosures Between 19972006 house prices increased by 124 By Jan 2008 25 of subprimes and adjustable rate mortgages were delinquent P232 NINJA loans no income no assets no jobs and you qualified P233 30 second approvals P234 Amendments to the Community Reinvestment Act dramatically raised unqualified borrowers and allowed for securitizationIorigins of the subprime came from the Community Reinvestment Act and then enhanced by Clinton and W Bush 17 0 Basic idea of the CRA is that certain sectors of society were underserved homeownership these lower classes deserved home ownership this is fair housing ideas and the banks were keeping them out of houses The CRA was legislated through its various amendments to allow these lower class to get mortgages The banks and Fannie Mae fought this but they were forced by the government to do it Fannie Mae was ordered to lower underwriting standards Banks had to comply with the law and so the subprime mortgages were invented As they went bad as everyone knew they would the congress ran and as they did so they pointed to the banks P240 Moral Hazard O O O A view that since the banks knew that they were supported by government and whatever they did they would be bailed out by tax payers the banks could make all sorts of improper loans for the purpose of greed because they always had much larger interest rates without any consideration of risk Moral hazard lending and giving money away irresponsibly because they knew they would be bailed out by tax payers if there was a bust Therefore it is necessary to tighten the regulation of the banks because look at their performance and what happened P247 Emails show that risk managers at Freddie Mac warned about lower underwriting standards in vain for today 0 O The turning point was the springsummer of 2004 I Fannie Mae and Freddie Mac had kept their exposures low to loans with little or no documentation owing to their internal risk management guidelines that limited such lending I In early 2004 they realized that the only way to meet the political mandates was to massively cut underwriting standards I Risk managers complained especially Freddie Mac which is shown through the emails wherein they refused to endorse the move In other words if the mortgage underwriting standards at Freddie and Fannie circa 2008 had remained in place nothing like the magnitude of the subprime prices would have occurred according to this writer P 249 NY Times September 1999 P251 Basic argument banks should not be rescued no such thing as too big to fail O O 0 Banks should feel the market for their incompetent behavior should feel market discipline Therefore too big to fail is an inoperative theory Banks should be allowed to fail since they acted in such a malfeased manner conscious of moral hazard knowing that whatever they did they would be bailed out tax payers Should meet the results of their irresponsible behavior and the markets will punish them 18 O Counterpoint to this government will say can we allow major American banks to fail which will then extrapolate themselves into Europe and are we sure that this won t cause a depression I Are you sure we can let so many banks go and let the cracking of psychology happen and not have a depression I That is a pretty big chance to take I Can t take a chance and let big banks fail 0 These are the arguments about too big to fail 0 Michael Lewis Bloomberg article 0 Everyone has focused the blame on this middlelevel employee at Goldman Sachs but senior management must have made these decisions 0 So why is senior management getting away with this 0 P 25 8a Dec 2012 DoddFrank Financial Reform Act generally what the act was trying to do 0 P 260 Goldman Sachs penalized 500M by SEC for Abacus deal fraud case largest penalty ever affixed on a bank 0 Blankfein trader and senior guy at Goldman Sachs 0 GS doesn t care what the market does as long as it is stable in that direction they will make money 0 P267 SEC vs Goldman Sachs 0 Government regulation of financial markets is supposed to be strictly for the average consumer it is not intended to protect banks or sophisticated investors but limited to the protection of the average consumer 0 So what is the SEC doing in this deal 0 Why is the SEC trying to regulate a commercial institutional trade That is overreach by government which exceeded the basic premise of financial regulation 0 P289 The London Whale another example of the lack of control of rogue traders P 290b David Stockman on capitalism what has happened to American capitalism Goldman Sachs and Abacus Deal P260 occurred prior to 2008 0 Reason for brining this up is because the SEC extracted a penalty of several hundred million dollars from Goldman Sachs for this deal largest penalty ever from a regulator 0 SEC claims this deal was a breach of regulatory rules which caused Goldman Sachs to be guilty and therefore assessable to this penalty 0 Purpose of financial regulation and all the laws thereof is to protect the retail investor and not the wholesale investor big institutional traders and firms do not need to be protected because they are supposed to be smart enough to take care of themselves 0 So the grand tradition of financial regulation has never been to reach into institutional trades l9 Abacus deal is an institutional trade SEC decided that it should get involved and it was assessing a penalty 0 SEC knew that these banks do not fight regulatory question they simply negotiate a settlement so that the regulators go away pay them what they want and get rid of them not interested in proving innocence so do not want to go to court 0 These banks neither admit nor deny wrongdoing just pay the penalty idea is that these penalties are sufficient warning to the street that they need to be careful and that they are being regulated 0 Senator Margaret Warren has intruded on this tradition of neither accepting or admitting blame but simply paying the penalty I Sen Warren is insisting that with these deals the firms admit wrong and the SEC is instructed by the senate to not settle unless there is an open admission of wrongdoing I This is what has changed 0 Liberal press has seized upon this as an open admission by the street that they basically malfeased during the financial crisis before and therefore by implication was a major cause of it I Here is a widespread admission of guilt as well as paying the penalty what further evidence do we need that these people were the cause of this crisis Asks the liberal press I This is what Sen Warren is after 0 Puts banks in a difficult position because they don39t believe that they were wrong but they just are unwilling to go through a long dirty multiyear civil trial to prove their innocence Does the SEC have any business in this deal because there is no retail investor 0 The activity in the center of the SEC has now been brought into open question SEC has been politicized 0 Commissioners and secretaries are now appointees and they are supposed to deliver on what the political class wants 0 Therefore its reputation has gone down dramatically in the markets The Abacus deal involves a synthetic CDS collateralized debt security 0 CDS is credit insurance 0 A commercial bank with commercial loans could buy protection from someone who is selling it I Bank with a loan outstanding to a company might buy CDS insurance protection buyer I Another bank or AIG insurance company might be protection sellers A lot of CDS were sold prior to 2008 collapse 0 If the market value of bank loan to a company drops because of a deterioration of the financial condition of this company the bank could make a call on its CDS purchase and get a settlement from the CDS seller 0 These securities are established legitimate over the counter securities 0 AIG insurance went down during the 20082010 crash 0 20 I Had a right to sell insurance they sold credit insurance and the banks were on the other side of this I When things went bad mortgage portfolios protected by CDS the protection buyer banks made claims on AIG legitimate claims that were paid I Problem at AIG is that they were only on one side of the transaction only selling protection Supposed to balance their books If selling protection should also buy protection from other banks 0 Square books to have no net exposure 0 Creating balanced positions net exposure not substantial AIG did not balance their books all on one side selling protection So when the crash came and all these loans went bad and all these mortgage backed securities went down banks made claims at AIG and AIG also went down Had to be rescued by the treasury through taxpayer s dollars and AIG was re oated 0 Banks were taking quite a beating from this because how could they make claims on AIG if taxpayers were rescuing AIG I How could banks make claims against the taxpayers of America I This is the argument made by the political class 0 Banks had a legal right but look bad making claims while the taxpayers rescue AIG 0 Political class has spun this to the detriment of the banks as being a contributor to the failure of AIG 0 If you re a seller of CDS insurance and you re on one side books are lopsided you might want to sell part of your exposure I Go to an investor typically a hedge fund and they will take this portfolio of sold CDSs and tranche them into CDOs collateralized debt obligations I Tranche A B Cl idea is that you have junior tranches If have 100M notional value CDS portfolio tranche A 80M B 10M C 10M Would say that tranche A which has most of the exposure which the bankinsurance company is trying to sell out through a CD0 structure has credit enhancement of 20M Tranche A buyer will say that he has 20M of protection so the first 20M of the underlying will be written off before tranche A is even hit Credit enhancement of 20M could be sufficient incentive for an institutional buyer to buy tranche A 21 0 The buyer of tranche A would have 20M of credit enhancement because they are getting the full 100M in notional 0 This structure is called a synthetic CDO because it s synthetic it s made up it s derived from something else because the underlying is a CDS which itself is a derivative 0 Underlying itself is not a bond or asset not a cash CDO which has underlying real securities it is a derivative 0 Therefore the underlying is a synthetic security a security built upon something else I Attraction of 80M tranche A is that since these are derivatives their cost is minimal I These CDSs charge fees to the insured which are derivative fees small fees but considering the cash investment in tranche A was so small the percent returned to an investor buying tranche A could be impressive perhaps in 20 I A hedge fund which has to take full advantage of all risks might be interested a tranche A in a synthetic CDO Abacus deal was what we call a shelf product with generic documentation already set up Goldman Sachs was approached by Paulson hedge fund which was interested in constructing an actual portfolio of CDSs using the documentation of Abacus 0 Paulson was a protection buyer but not hedging anything 0 Paulson would make money if the underlying mortgages which the CDSs were protected fell in value and failed because their position was short 0 Paulson approached Goldman Sachs and said they were interested in this Abacus documentation and insisted they choose the underlying mortgages and the CDSs O Paulson thought the mortgage market was not sustainable took a short position everyone else thought this upcycle was going to go on forever 0 Goldman Sachs went out and found 2 other mortgage institutional investors to take the long side of this deal ACA and IKB German mortgage investor I Negotiated the principles as to the content of the underlying portfolio I Talking about tranche A I These sophisticated mortgage investors thought the mortgage markets was going to continue to go up forever being long was a no brainer everyone believed the way they believed I They entered the transaction 0 2008 the mortgage market collapsed and Paulson won making over a billion dollars in profits on a tiny investments and these two institutional mortgage investors lost 0 This was the abacus deal SEC looked at this for 2 years looking for anything they could find 0 Looking at Goldman Sachs as being the bank to attack because they were trying to blame the financial crisis on the banks 22 0 SEC was under intense criticism by the congress in not having previously tightened regulations on the banks that could have prevented this collapse in 2008 they think Therefore the SEC is trying to make up for lost time and looking for somewhere to place the blame to show that they are active in regulation looking for banks that did wrong Came upon the idea that Goldman Sachs did not inform these long buyers that Paulson was on the short end and that withholding information worked to the detriment of the long buyers and thus Goldman Sachs went violated the law What is so controversial about this decision by the SEC is that the custom is that you never divulge who is on the other side because the sophisticated shortlong should be able to look at the transaction in it of itself and decide what they want to do Nonetheless the SEC thought Goldman Sachs breached its fiduciary responsibility by not divulging this info and thus they were guilty What is extra suspicious was that the SEC released its decision and fine during the early weeks of congressional debate on passing the DoddFrank Financial Reform Act 0 O O 0 Liberals in congress were having a lot of trouble getting this passed the conservatives were trying to block it they fought it with the idea that it was an interference of the markets In this debate it was felt that there was something suspicious about the timing of the release of this questionable fine by the SEC Nonetheless the release was politically effective and caused the conservatives to move over and vote for the passage of the DoddFrank Financial Reform Act Some claim that this was politics not righteous financial market regulation Goldman Sachs as the house bank has the option to take a piece of the deal if they want they took a substantial long piece they lost substantially from this too collected an underwriting fee but they lost a lot P265 Washington Post P267 Wall Street Journal 0 0 First of all does the government have any right to stick its nose in a strict institutional trade Is that even what a regulator is supposed to do Second they are suspicious of the timing of the SEC decision coming out at a critical time in a debate in congress where the liberals were having trouble getting the DoddFrank Financial Reform Act passed I When this hit the press the republicans resisting this vote were forced to vote for it I DoddFrank Financial Reform Act had a bipartisan vote Winners in this are the political class 0 O This is how you do your business to get your vote to get the legislation that you want So whatever we might think about the methods used these methods were successful and they got the DoddFrank Financial Reform Act passed Banks never fight the government because dealing with cardinal political power if want to make bank survive then you do whatever the government tells you 23 P280 Michael Lewis for Bloomberg News 0 Attacking this French midlevel vice president Fabrice Tourre shows how organization will try to settle the blame on an individual 0 FED claimed he did not divulge who the parties were and therefore he is going through a criminal trial 0 Goldman Sachs paid all his legal bills 0 SEC offered Tourre a deal I If Tourre never entered securities market again he could get off with a certain penalty which Goldman Sachs would certainly pay I But he rejected it and said he would go through a full trial to prove his innocence The London Whale p289 Trader for JP Morgan that lost about 2021M at a particular point The regulators looked at this and said that after all we ve said to you and all the political fallout from the bad press are you still willing to take these kinds of risks and lose this kind of money Liberal press said they were not regulated Therefore there is a need for financial regulations because banks are not controlling their positions government needs to step in and control JP Morgan had a big year in that market that trade went bad another trade went good and they were trading volatility so they had a great year JP Morgan did not see anything wrong some of the bets go well some go bad but on the average you make money But the political class seized upon the size of that loss as evidence that there is no control 24
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