Chapter One
The Investment Environment
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Role of financial assets in the economy: Real vs. financial assets
Risk–return trade-off and the efficient pricing
Financial crisis 2008
Connections between the financial system and the “real” side of the economy
Lessons learned for evaluating systemic risk
Chapter Overview
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Real Assets vs. Financial Assets
Real Assets
Determine the productive capacity and net income of the economy
Examples: Land, buildings, machines, knowledge used to produce goods and services
Financial Assets
Claims on real assets, do not contribute directly to the productive capacity of the economy.
Examples: Stocks, bonds
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Fixed income or debt
Promise either a fixed stream of income or a stream of income determined by a specified formula
Common stock or equity
Represent an ownership share in the corporation
Derivative securities
Provide payoffs that are determined by the prices of other assets
Financial Assets
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Investment in currency
Investment in real assets through commodity futures
Corporations invest in the commodity futures to hedge the risk
Other Types of Investment
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The Informational Role
Capital flows to companies with best prospects
Consumption Timing
Use securities to store wealth and transfer consumption to the future
Allocation of Risk
Investors can select securities consistent with their tastes for risk, which benefits the firms that need to raise capital as security can be sold for the best possible price
Financial Markets and the Economy
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Separation of Ownership and Management
Agency problems arise when managers start pursuing their own interests instead of maximizing firm's value
Mechanisms to mitigate agency problems:
Tie managers' income to the success of the firm (stock options)
Monitoring from the board of directors
Monitoring from the large outside investors and security analysts
Takeover threat
Financial Markets and the Economy
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Corporate Governance and Corporate Ethics
Accounting Scandals
Examples – Enron, Rite Aid, HealthSouth
Auditors: Watchdogs of the firms
Analyst Scandals
Arthur Andersen
Sarbanes-Oxley Act
Tighten the rules of corporate governance
Financial Markets and the Economy
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Portfolio: Collection of investment assets.
Asset allocation
Choice among broad asset classes
Security selection
Choice of securities within each asset class
The Investment Process
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“Top-down” approach
Asset allocation followed by security analysis to evaluate which particular securities to be included in the portfolio
“Bottom-up” approach
Investment based solely on the price-attractiveness, which may result in unintended heavy weight of a portfolio in only one or another sector of the economy
The Investment Process
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Risk-Return Trade-Off
Higher-risk assets are priced to offer higher expected returns than lower-risk assets
Efficient Markets
In fully efficient markets when prices quickly adjust to all relevant information, there should be neither underpriced nor overpriced securities
Markets Are Competitive
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Passive Management
Holding a highly diversified portfolio
No attempt to find undervalued securities
No attempt to time the market
Active Management
Finding mispriced securities
Timing the market
Markets Are Competitive
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Demanders of capital – Firms
Suppliers of capital – Households
Governments – Can be both borrowers or lenders
The Players
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Financial Intermediaries: Pool and invest funds
Investment Companies
Banks
Insurance companies
Credit unions
The Players
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Universal Bank Activities
Investment Banking
Underwrite new securities issues
Sell newly issued securities to public in the primary market
Investors trade previously issued securities among themselves in the secondary markets
Commercial Banking
Take deposits and make loans
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Antecedents of the Crisis:
“The Great Moderation”: A time in which the U.S. had a stable economy with low interest rates and a tame business cycle with only mild recessions
Historic boom in housing market
Financial Crisis of 2008
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Figure 1.1 Short-Term LIBOR and Treasury-Bill Rates and the TED Spread
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3-month LIBOR 35091 35122 35151 35182 35212 35243 35273 35304 35335 35365 35396 35426 35457 35488 35516 35547 35577 35608 35638 35669 35700 35730 35761 35791 35822 35853 35881 35912 35942 35973 36003 36034 36065 36095 36126 36156 36187 36218 36246 36277 36307 36338 36368 36399 36430 36460 36491 36521 36552 36583 36612 36643 36673 36704 36734 36765 36796 36826 36857 36887 36918 36949 36977 37008 37038 37069 37099 37130 37161 37191 37222 37252 37 283 37314 37342 37373 37403 37434 37464 37495 37526 37556 37587 37617 37648 37679 37707 37738 37768 37799 37829 37860 37891 37921 37952 37982 38013 38044 38073 38104 38134 38165 38195 38226 38257 38287 38318 38348 38379 38410 38438 38469 38499 38530 38560 38591 38622 38652 38683 38713 38744 38775 38803 38834 38864 38895 38925 38956 38987 39017 39048 39078 39109 39140 39168 39199 39229 39260 39290 39321 39352 39382 39413 39443 39474 39505 39534 39565 39595 6.05 6.1 6.29 6.39 6.6199999999999966 6.78 6.72 6.68 6.8199999999999976 6.76 6.74 6.4 5.52 5.0999999999999996 4.88 4.3199999999999976 4 3.79 3.68 3.4870000000000001 2.597 2.2319999999999998 2.08 1.883 1.862000000 0000001 1.9200000000000004 2.0309999999999997 1.91 1.9 1.86 1.82 1.82 1.81 1.7000000000000004 1.43 1.3800000000000001 1.35 1.34 1.29 1.31 1.28 1.1164000000000001 1.117599999999999 1.141999999999999 1.1597999999999991 1.1657 1.1700000000000008 1.157 1.131999999999999 1.125 1.111 1.175999999999999 1.3080000000000001 1.6040000000000001 1.6950000000000001 1.7900000000000005 2.0049999999999999 2.1579999999999999 2.403 2.5579999999999998 2.7440000000000002 2.9099999999999997 3.0994999999999981 3.2107000000000001 3.3291999999999997 3.5045000000000002 3.6949999999999998 3.8719999999999977 4.0549999999999962 4.2519999999999998 4.4139999999999997 4.5297999999999998 4.6795 4.8192000000000004 4.9898000000000033 5.1479999999999961 5.2335000000000003 5.5084999999999997 5.4889000000000001 5.4014000000000024 5.3724999999999996 5.3728999999999996 5.3684999999999965 5.3599999999999977 5.3599999999999977 5.3597999999999999 5.3478999999999965 5.3554999999999975 5.3594999999999997 5.3593000000000002 5.3597000000000001 5.4837000000000033 5.4939 5.1464999999999996 4.9620999999999986 4.9794000000000036 3.9175999999999997 3.0876000000000001 2.7825000000000002 2.7947000000000002 2.6923999999999997 2.7654000000000001 2.7921 2.806299999999998 3.1217000000000001 4.0586000000000002 2.2791000000000001 1.829399999999999 1.2107999999999992 1.242599999999999 1.266699999999999 1.1062000000000001 0.81659999999999999 0.62070000000000058 0.51529999999999998 0.42450000000000027 0.29800000000000026 0.28310000000000002 0.2681 0.25310000000000005 0.25010000000000004 0.2505 0.26840000000000008 0.31160000000000027 0.45850000000000002 0.53690000000000004 0.51029999999999998 0.3626000000000002 0.29140000000000027 0.28880000000000022 0.28690000000000027 0.30270000000000002 0.30340000000000023 0.31190000000000023 0.30840000000000023 0.28140000000000021 0.26070000000000004 0.2478000000000001 0.24990000000000018 0.29320000000000002 0.35020000000000001 0.40650000000000008 0.47530000000000022 0.55570000000000042 0.5659000000000004 0.50319999999999998 0.47330000000000022 0.46680000000000021 0.46650000000000008 3-month T-bill 35091 35122 35151 35182 35212 35243 35273 35304 35335 35365 35396 35426 35457 35488 35516 35547 35577 35608 35638 35669 35700 35730 35761 35791 35822 35853 35881 35912 35942 35973 36003 36034 36065 36095 36126 36156 36187 36218 36246 36277 36307 36338 36368 36399 36430 36460 36491 36521 36552 36583 36612 36643 36673 36704 36734 36765 36796 36826 36857 36887 36918 36949 36977 37008 37038 37069 37099 37130 37161 37191 37222 37252 37283 37314 37342 37373 37403 37434 37464 37495 37526 37556 37587 37617 37648 37679 37707 37738 37768 37799 37829 37860 37891 37921 37952 37982 38013 38044 38073 38104 38134 38165 38195 38226 38257 38287 38318 38348 38379 38410 38438 38469 38499 38530 38560 38591 38622 38652 38683 38713 38744 38775 38803 38834 38864 38895 38925 38956 38987 39017 39048 39078 39109 39140 39168 39199 39229 39260 39290 39321 39352 39382 39413 39443 39474 39505 39534 39565 39595 5.53 5.6199999999999966 5.72 5.6599999999999975 5.48 5.71 6.03 6.13 6.05 6.1899999999999986 6.03 5.73 4.8599999999999977 4.7300000000000004 4.2 3.86 3.55 3.57 3.46 3.3 2.3499999999999988 2.0099999999999998 1.7500000000000004 1.7100000000000004 1.7300000000000004 1.7600000000000005 1.7600000000000005 1.7400000000000004 1.7100000000000004 1.6700000000000008 1.6800000000000008 1.6600000000000001 1.54 1.42 1.2 1.2 1.159999999999999 1.1800000000000008 1.1200000000000001 1.1100000000000001 1.0900000000000001 0.89000000000000024 0.9400000000000003 9 0.96000000000000041 0.93 0.94000000000000039 0.91 0.93 0.9 0.94000000000000039 0.93 0.96000000000000041 1.06 1.31 1.42 1.57 1.6800000000000008 1.87 2.2000000000000002 2.1800000000000002 2.48 2.72 2.73 2.84 2.9299999999999997 3.06 3.34 3.44 3.4699999999999998 3.8899999999999997 3.86 3.9899999999999998 4.37 4.51 4.5199999999999996 4.6499999999999977 4.74 4.87 4.9700000000000024 4.92 4.7699999999999987 4.95 4.9000000000000004 4.8899999999999997 4.99 5.01 4.9000000000000004 4.79 4.5999999999999996 4.68 4.8199 999999999976 3.9099999999999997 3.72 3.84 3.08 3.29 1.9200000000000004 1.81 1.36 1.41 1.85 1.87 1.6500000000000001 1.6900000000000008 0.9 0.44000000000000011 1.0000000000000009E-2 0.11000000000000003 0.2400000000000001 0.26 0.2100000000000001 0.14000000000000001 0.14000000000000001 0.19000000000000006 0.1800000000000001 0.15000000000000011 0.14000000000000001 5.0000000000000017E-2 6.0000000000000039E-2 6.0000000000000039E-2 8.0000000000000071E-2 0.13 0.16000000000000006 0.16000000000000006 0.16000000000000006 0.1800000000000001 0.15000000000000011 0.14000000000000001 0.16000000000000006 0.12000000000000002 0.17 0.12000000000000002 0.15000000000000011 0.15000000000000011 9.0000000000000052E-2 4.0000000000000036E-2 6.0000000000000039E-2 3.0000000000000009E-2 0.1 2.0000000000000018E-2 2.0000000000000018E-2 1.0000000000000009E-2 1.0000000000000009E-2 1.0000000000000009E-2 3.0000000000000009E-2 9.0000000000000052E-2 8.0000000000000071E-2 8.0000000000000071E-2 9.0000000000000052E-2 TED spread 35091 35122 35151 35182 35212 35243 35273 35304 35335 35365 35396 35426 35457 35488 35516 35547 35577 35608 35638 35669 35700 35730 35761 35791 35822 35853 35881 35912 35942 35973 36003 36034 36065 36095 36126 36156 36187 36218 36246 36277 36307 36338 36368 36399 36430 36460 36491 36521 36552 36583 36612 36643 36673 36704 36734 36765 36796 36826 36857 36887 36918 36949 36977 37008 37038 37069 37099 37130 37161 37191 37222 37252 37283 37314 37342 37373 37403 37434 37464 37495 37526 37556 37587 37617 37648 37679 37707 37738 37768 37799 37829 37860 37891 37921 37952 37982 38013 38044 38073 38104 38134 38165 38195 38226 38257 38287 38318 38348 38379 38410 38438 38469 38499 38530 38560 38591 38622 38652 38683 38713 38744 38775 38803 38834 38864 38895 38925 38956 38987 39017 39048 39078 39109 39140 39168 39199 39229 39260 39290 39321 39352 39382 39413 39443 39474 39505 39534 39565 39595 0.52 0.4800000000000002 0.56999999999999995 0.72999999999999943 1.139999999999999 1.07 0.68999999999999928 0.55000000000000004 0.77000000000000024 0.56999999999999895 0.71000000000000041 0.67000000000000071 0.65999999999999959 0.36999999999999944 0.68000000000000038 0.46 0.45 0.22000000000000006 0.22000000000000006 0.18 700000000000011 0.24700000000000011 0.22200000000000006 0.33000000000000035 0.17300000000000001 0.13200000000000001 0.16000000000000006 0.27100000000000002 0.17 0.19000000000000006 0.19000000000000006 0.14000000000000001 0.16000000000000006 0.27 0.28000000000000008 0.23 0.1800000000000001 0.19000000000000006 0.16000000000000006 0.17 0.2 0.19000000000000006 0.22640000000000007 0.17760000000000001 0.18200000000000011 0.22980000000000006 0.22570000000000007 0.26 0.22700000000000006 0.23200000000000001 0.18500000000000011 0.18100000000000011 0.21600000000000011 0.24800000000000011 0.29400000000000021 0.27500000000000002 0.22000000000000006 0.32500000000000023 0.2880000000000002 0.20300000000000001 0.37800000000000022 0.26400000000 000001 0.19000000000000006 0.36950000000000022 0.37070000000000008 0.39920000000000022 0.44450000000000012 0.3550000000000002 0.43200000000000022 0.58500000000000019 0.36200000000000027 0.55400000000000005 0.53979999999999995 0.30950000000000022 0.30920000000000097 0.46980000000000022 0.49799999999999944 0.49350000000000027 0.6385000000000004 0.51890000000000003 0.48140000000000027 0.60250000000000004 0.42289999999999944 0.46850000000000008 0.47000000000000097 0.37000000000000022 0.34980000000000033 0.44790000000000013 0.5655 0.75949999999999995 0.67930000000000046 0.5397000000000004 1.5736999999999992 1.7738999999999996 1.3065 1.8821000000000001 1.6894 1.9975999999999996 1.2775999999999992 1.4224999999999992 1.3847 0.84240000000000004 0.8954000000000002 1.1420999999999999 1.1163000000000001 2.2216999999999998 3.6185999999999998 2.2690999999999999 1.7193999999999996 0.97080000000000022 0.98260000000000003 1.0567 0.96619999999999995 0.67660000000000076 0.43070000000000008 0.33530000000000038 0.27450000000000002 0.15800000000000011 0.2331 0.20810000000000001 0.19310000000000005 0.1701 0.12050000000000002 0.10840000000000002 0.15160000000000001 0.29850000000000027 0.35690000000000022 0.36030000000000023 0.22260000000000005 0.13139999999999999 0.16880000000000006 0.11690000000000003 0.18270000000000011 0.15340000000000012 0.16190000000000007 0.21840000000000018 0.24140000000000011 0.20069999999999999 0.2178000000000001 0.14990000000000012 0.2732 0.33020000000000027 0.39650000000000035 0.46530000000000021 0.54570000000000041 0.53590000000000004 0.41320000000000001 0.39330000000000037 0.38680000000000037 0.37650000000000022
Interest Rates (%)
Figure 1.3 The Case-Shiller Index of U.S. Housing Prices
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CSXR 1987.0833333333314 1987.1666666666679 1987.25 1987.3333333333314 1987.4166666666686 1987.5 1987.5833333333314 1987.6666666666679 1987.75 1987.8333333333314 1987.9166666666686 1988 1988.0833333333314 1988.1666666666679 1988.25 1988.3333333333314 1988.4166666666686 1988.5 1988.5833333333314 1988.6666666666679 1988.75 1988.8333333333314 1988.9166666666686 1989 1989.0833333333314 1989.1666666666679 1989.25 1989.3333333333314 1989.4166666666686 1989.5 1989.5833333333314 1989.6666666666679 1989.75 1989.8333333333314 1989.9166666666686 1990 1990.0833333333314 1990.1666666666679 1990.25 1990.3333333333314 1990.4166666666686 1990.5 1990.5833333333314 1990.6666666666679 1990.75 1990.8333333333314 1990.9166666666686 1991 1991.0833333333314 1991.1666666666679 1991.25 1991.3333333333314 1991.4166666666686 1991.5 1991.5833333333314 1991.6666666666679 1991.75 1991.8333333333314 1991.9166666666686 1992 1992.0833333333314 1992.1666666666679 1992.25 1992.3333333333314 1992.4166666666686 1992.5 1992.5833333333314 1992.6666666666679 1992.75 1992.8333333333314 1992.9166666666686 1993 1993.0833333333314 1993.1666666666679 1993.25 1993.3333333333314 1993.4166666666686 1993.5 1993.5833333333314 1993.6666666666679 1993.75 1993.8333333333314 1993.9166666666686 1994 1994.0833333333314 1994.1666666666679 1994.25 1994.3333333333314 1994.4166666666686 1994.5 1994.5833333333314 1994.6666666666679 1994.75 1994.8333333333314 1994.9166666666686 1995 1995.0833333333314 1995.1666666666679 1995.25 1995.3333333333314 1995.4166666666686 1995.5 1995.5833333333314 1995.6666666666679 1995.75 1995.8333333333314 1995.9166666666686 1996 1996.0833333333314 1996.1666666666679 1996.25 1996.3333333333314 1996.4166666666686 1996.5 1996.5833333333314 1996.6666666666679 1996.75 1996.8333333333314 1996.9166666666686 1997 1997.0833333333314 1997.1666666666679 1997.25 1997.3333333333314 1997.4166666666686 1997.5 1997.5833333333314 1997.6666666666679 1997.75 1997.8333333333314 1997.9166666666686 1998 1998.0833333333314 1998.1666666666679 1998.25 1998.3333333333314 1998.4166666666686 1998.5 1998.5833333333314 1998.6666666666679 1998.75 1998.8333333333314 1998.9166666666686 1999 1999.0833333333314 1999.16 66666666679 1999.25 1999.3333333333314 1999.4166666666686 1999.5 1999.5833333333314 1999.6666666666679 1999.75 1999.8333333333314 1999.9166666666686 2000 2000.0833333333314 2000.1666666666679 2000.25 2000.3333333333314 2000.4166666666686 2000.5 2000.5833333333314 2000.6666666666679 2000.75 2000.8333333333314 2000.9166666666686 2001 2001.0833333333314 2001.1666666666679 2001.25 2001.3333333333314 2001.4166666666686 2001.5 2001.5833333333314 2001.6666666666679 2001.75 2001.8333333333314 2001.9166666666686 2002 2002.0833333333314 2002.1666666666679 2002.25 2002.3333333333314 2002.4166666666686 2002.5 2002.5833333333314 2002.6666666666679 2002.75 2002.8333333333314 2002.9166666666686 2003 2003.0833333333314 2003.1666666666679 2003.25 2003.3333333333314 2003.4166666666686 2003.5 2003.5833333333314 2003.6666666666679 2003.75 2003.8333333333314 2003.9166666666686 2004 2004.0833333333314 2004.1666666666679 2004.25 2004.3333333333314 2004.4166666666686 2004.5 2004.5833333333314 2004.6666666666679 2004.75 2004.8333333333314 2004.9166666666686 2005 2005.0833333333314 2005.1666666666679 2005.25 2005.3333333333314 2005.4166666666686 2005.5 2005.5833333333314 2005.6666666666679 2005.75 2005.8333333333314 2005.9166666666686 2006 2006.0833333333314 2006.1666666666679 2006.25 2006.3333333333314 2006.4166666666686 2006.5 2006.5833333333314 2006.6666666666679 2006.75 2006.8333333333314 2006.9166666666686 2007 2007.0833333333314 2007.1666666666679 2007.25 2007.3333333333314 2007.4166666666686 2007.5 2007.5833333333314 2007.6666666666679 2007.75 2007.8333333333314 2007.9166666666686 2008 2008.0833333333314 2008.1666666666679 2008.25 2008.3333333333314 2008.4166666666686 2008.5 2008.5833333333314 2008.6666666666679 2008.75 2008.8333333333314 2008.9166666666686 2009 2009.0833333333314 2009.1666666666679 2009.25 2009.3333333333314 2009.4166666666686 2009.5 2009.5833333333314 2009.6666666666679 2009.75 2009. 8333333333314 2009.9166666666686 2010 2010.0833333333314 2010.1666666666679 2010.25 2010.3333333333314 2010.4166666666686 2010.5 2010.5833333333314 2010.6666666666679 2010.75 2010.8333333333314 2010.9166666666686 2011 2011.0833333333314 2011.1666666666679 2011.25 2011.3333333333314 2011.4166666666686 2011.5 2011.5833333333314 2011.6666666666679 2011.75 2011.8333333333314 2011.9166666666686 2012 2012.0833333333314 2012.1666666666679 2012.25 2012.3333333333314 62.82 63.39 63.87 64.569999999999993 65.56 66.59 67.540000000000006 68.25 68.86999999999999 69.42 69.76 0000000000005 70.22 70.45 70.77 71.11999999999999 71.649999999999991 72.48 73.63 74.81 75.7 76.400000000000006 76.900000000000006 77.28 77.58 77.989999999999995 78.36 79.11999999999999 79.83 80.52 81.239999999999995 81.66 82.08 82.25 82.440000000000026 82.43 82.35 82.29 82.149999999999991 82.02 82.05 82.01 82.19 82.1 81.86 81.39 80.84 80.09 79.38 78.53 77.77 77 76.86 77.31 78.02 78.61 78.930000000000007 78.88 78.679999999999978 78.31 77.989999999999995 77.739999999999995 77.510000000000005 77.31 77.36 77.61999999999999 77.940000000000026 77.95 77.989999999999995 77.760000000000005 77.45 77.09 76.679999999999978 76.56 76.28 75.910000000000025 75.83 76.040000000000006 76.510000000000005 76.61 76.59 76.47 76.22 76.02 75.709999999999994 75.709999999999994 75.63 75.73 76.03 76.489999999999995 77.040000000000006 77.400000000000006 77.64 77.569999999999993 77.5 77.23 76.989999999999995 76.819999999999993 76.64 76.38 76.36 76.599999999999994 76.940000000000026 77.260000000000005 77.47 77.430000000000007 77.260000000000005 76.95 76.679999999999978 76.56 76.440000000000026 76.489999999999995 76.84 77.33 77.78 78.099999999999994 78.36 78.36999999999999 78.36 78.23 78.11999999999999 78.08 77.98 78.290000000000006 78.760000000000005 79.42 80.25 80.86 81.410000000000025 81.569999999999993 81.83 81.98 82.31 82.7 83.13 83.86999999999999 84.69 85.77 87.03 88.14 89.01 89.58 89.8 89.76 89.82 90.06 90.48 91.31 92.55 93.69 95.1 96.28 97.31 97.990000000000023 98.48 98.94000000 0000026 99.51 100 100.81 102.24000000000002 104.01 105.98 107.83 109.02 110.07 110.9 111.75 112.6 113.56 114.58 115.45 116.69 117.94000000000005 118.94000000000005 120.03 121.01 121.99000000000002 122.89 123.46000000000002 123.78 123.64 123.93 124.45 125.92 127.95 130.33000000000001 132.76 135.04 137.04 138.62 140.12 141.26 142.18 142.86000000000001 143.59 144.84 146.44999999999999 148.16999999999999 149.69999999999999 151.65 153.60999999999999 155.76999999999998 157.70999999999998 159.55000000000001 161.26999999999998 162.9 164.82000000000011 167.91 171.58 175.43 179.45000000000007 182.69 184.95000000000007 186.91 188.65 190.08 191.42000000000004 193.35000000000011 195.87 199.20999999999998 202.51 205.76 208.86 211.65 214.13 216.76999999999998 219.07 220.81 221.91 222.46 223.38000000000011 223.75 224.99 225.99 226.29 226.17 225.54 225.1 224.73999999999998 223.94 222.39000000000001 221.31 220.46 219.67 218.94 218.34 217.37 216.3 214.63 212.73 209.76 205.26 200.67 196.07 190.6 186.12 183.35000000000011 181.56 180.52 178.67 176.70999999999998 173.35000000000011 169.67 165.95000000000007 162.09 157.96 154.60999999999999 151.47999999999999 150.44 151.19 153.35000000000011 155.94999999999999 158.07 158.76999999999998 158.68 158.33000000000001 158.16 157.87 156.85000000000011 156.20999999999998 157.35000000000011 159.41 161.06 162.23999999999998 162.01 161 158.9 157.5 156.04 154.36000000000001 152.38000000000011 150.91 151.78 153.33000000000001 154.87 156.33000000000001 156.51 155.60999999999999 153.54 151.41 149.60999999999999 148.04 146.69999999999999 146.51 148.4
Index (January 2000 = 100)
Changes in Housing Finance
Old Way
Local thrift institution made mortgage loans to homeowners
Thrift’s major asset: A portfolio of long-term mortgage loans
Thrift’s main liability: Deposits
“Originate to hold”
New Way
Securitization: Fannie Mae and Freddie Mac bought mortgage loans and bundled them into large pools
Mortgage-backed securities are tradable claims against the underlying mortgage pool
“Originate to distribute”
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Securitization: Buying mortgage loans from originators and bundling them into mortgage-backed securities
Replacement of low-risk conforming mortgages with nonconforming “subprime” loans
Trend toward low-documentation and then no-documentation loans and rising allowed leverage on home loans (loan-to-value ratio)
Low adjustable-rate mortgages (ARMs) that “maxed out” borrowers' paying capacity at low rates
Changes in Housing Finance
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Figure 1.4 Cash Flows in a Mortgage Pass-Through Security
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Collateralized debt obligations (CDOs)
Mortgage pool divided into slices or tranches to concentrate default risk
Senior tranches: Lower risk, highest rating (AAA)
Junior tranches: High risk, low or junk rating
Estimated ratings significantly underestimated the inherent risk
Mortgage Derivatives
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Default probabilities were estimated on the historical data covering the rising housing market
Geographic diversification did not reduce risk as much as anticipated
Agency problems with rating agencies
Why Was Credit Risk Underestimated?
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A CDS is an insurance contract against the default of the borrower
Investors bought sub-prime loans and used CDSs to insure their safety
Some big swap issuers did not have enough capital to back their CDSs when the market collapsed resulting in the failure of CDO insurance
Credit Default Swap (CDS)
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Systemic Risk: A potential breakdown of the financial system in which problems in one market spill over and disrupt others.
One default may set off a chain of further defaults
Waves of selling may occur in a downward spiral as asset prices drop
Potential contagion from institution to institution, and from market to market
Rise of Systemic Risk
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Banks had a mismatch between the maturity and liquidity of their assets and liabilities
Liabilities were short and liquid
Assets were long and illiquid
Constant need to refinance the asset portfolio
Banks were very highly levered, giving them almost no margin of safety
Rise of Systemic Risk
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Investors relied too much on credit enhancement through structured products like CDS
CDS traded mostly over-the-counter, with no posted margin requirements and little transparency
Opaque linkages between financial instruments and institutions
Rise of Systemic Risk
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2000-2006: Sharp increase in housing prices caused many investors to believe that continually rising home prices would bail out poorly performing loans
2004: Interest rates began rising
2006: Home prices peaked
2007: Housing defaults and losses on mortgage-backed securities surged
The Shoe Drops
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2008: Troubled firms include Bear Stearns, Fannie Mae, Freddie Mac, Merrill Lynch, Lehman Brothers, and AIG
Money market breaks down
Credit markets freeze up
Federal bailout to stabilize financial system
The Shoe Drops
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INVESTMENTS | BODIE, KANE, MARCUS
Mechanisms to mitigate systemic risk
Stricter rules for bank capital, liquidity, and risk management practices
Increased transparency, especially in derivatives markets (eg.: standardize CDS contracts so they can trade in centralized exchanges)
Office of Credit Ratings within the SEC to oversee the credit rating agencies
The Dodd-Frank Reform Act
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INVESTMENTS | BODIE, KANE, MARCUS