453 - Exam 2

Question 1

Exam 2

Answer 1

Oct. 3 on

ch. 6, 7, 11, 12

Question 2

Bond

Answer 2

any fin. arrangement involving the current transfer of resources from a lender to a borrower, with a transfer back at time in the future

• -car loans, home mortgages, credit card balances (all have loan from fin. intermediary to an individual making a purchase)
• -when companies need to finance operations - sell bonds
• -when gov. needs o borrower - sells onds

Question 3

After the crisis…

Answer 3

coroporations wanted to decrease debt, but in 2012 US bonds outstanding was more than $10 T and increasing

• -byt 2016 gov. had more than $22T in debt
• -1500s - monarchs (spain) borrowed internationally and defaultes = increase int. rates
• -Dutch 1st invented modern bonds to finance the war
• -Hamilton brings to U.S. - He consolidated all debt remaining from revolutionary war in 1789 - result was 1st US. gov. bonds

Question 4

3 Important things with bonds

Answer 4

1. inverse relationship btwn bond prices and int. rates
2. S&D in bond market determine bond prices
3. why bonds are risky

Question 5

Bond prices - 1. zero cpn. bonds

Answer 5

How much to be willing to pay depends on bond’s characteristics

1. zero-cpn bonds - single future pmt. (US treasury bill)
   - -T bill - promise from US gov. to pau $100 at fixed future date…also called “pure discount bonds” - bc PV much < FV
   - -ex. pv = $96, then the $4 is interest (pmt. for making the loan)

T-bills always < 1 yr. to maturity
–shoter = more willing to pay for it now

Question 6

bond prices - 2. fied pmt. loans, 3. CPN bonds, 4. Consols (perpetuities)

Answer 6

pg. 136 - regular mortgage vs. ARMs
2. fixed pmt. loans
- -car loans/mortgages (fixed regular pmts.)
- -amortized - borrower pays off principal + interest over life

VA fixed = sum of PV of all future pmts.

3. coupon bonds
   –series of cpn. pmts. + principal @ maturity
   VAcb = sum of PV of all cpn. pmts. + the PV of the FV at maturity
4. consols (perpetuities) - only int. pmts. to infinity
   –British gov. sold consols in 2015…US gov. did in 1900 - not today
   P = ann. coupon pmt. / int. rate

Question 7

Bond yields

Answer 7

yield = measure of cost of borrowing and reward for lending
–YTM - yield to bondholders if hold to maturity
P = FV then CPN = YTM
P > FV then CPN > YTM
P < FV then CPN < YTM

capital gain - rise in value (if price below FV, return is above CPN)
–capital loss - (YTM < CPN, PV > FV)

current yield = ANN CPN / Price paid (PV) - measures return solely from cpn. pmts. (ignored cap. gain/loss) estimate of YTM
–if P decreases the CY incraese, and P=FV then CY = CPN

PFV — CPN > CY > YTM

Question 8

Holding period return

Answer 8

some ex. too simple bc assumes investor holds to maturity - usually buy, hold, then sell
– have to account for change in price over the period you held it for

ex. p = $100, 6% CPN, FV = 100, n = 10
- -buy 10 year bond and later sell 1 yr. later – becomes a 9 year bond
- -over one year int. rate falls from 6% to 5%

1 yr. HPR = (6/100) + (107.11 - 100)/100 = (13.11/100) = .1311

Or if YTM inc. to 7%, then P falls
(6/100) + (93.48 - 100)/100 = -.52/100 = -.0052

HPR = (ann cpn./price paid) + change in P of bond / price paid

HPR = current yield + capital gains

when bond price changes always is cap. gains or loss - int. rate change and bond price change create risk
–higher n means more risk

Question 9

2. Bond mkt. an determination of interest rates (READ PG. 142-143 “Tools of trade”
   - -bond supply curve

Answer 9

if assume investor plans to buy 1 yr. bond and hold to maturity - incestor has a 1 yr. investment horizon – then HPR = YTM (both are determined from Price)

P = 100 / (1 + i) —–> i = 100 - P / P

bond prices are determined by S & D

bond supply curve = relatioship btw D & Q of bonds ppl are willing to sell

• -Inc. bond price = inc. quantity supplied
• -investores – inc. P = Inc. desire to sell what they hold, comp. inc. price - inc. funding they desire

upward slope – P = $90 and P = $95, more supplied at $95

Question 10

bond demand curve

Answer 10

relationship btwn price and Q of bonds investors demand
–dec. P = reward of holding bond increases so D increases
P = $90, $95 - more demand at $90
–when D increases the yields inc. (bc decreases price and Price and Y inversely related)
–if P is too high, S > D so excess supply (means suppliers can’t sell bonds they want to at current price) so puts downward pressure on P
–P too low, D > S - ppl who want to buy bonds cannot get all the want - upward pressure on P

IMP!!!!
When QD and QS shift because change in P = MOVING ALONG CURVE
–but at given P, still change = shifts entire curve and changes the yield

Question 11

Factors that shift supply

Answer 11

PAGE 146-147 show charts with shifts of S and D

1. change in gov. borrowing
   - -change in tax policy and adjustments in spending – lead to change in gov. need to borow
   - -inc. gov. borrowing = inc. # bonds and S curve shifts RIGHT
   - -D = constant – S increases and P decreases so int. rates increase
2. change in general business conditions
   - -if bus. is good = firms want to invest and borrow to do it = debt increases and quantity of bonds inc. - as business conditions improve S curve shifts RIGHT, p dec. and int rates increase
   - -also shows why weak economy leads to price increases and lower int. rates
3. change in EXPECTED inflation
   - -(REAL cost of borrowing)
   - -at nominal int. rate constant – inc. inflation and dec. REAL interest rate
   - -dec. int. rate leads to fewer real resources required to make pmts. promised by bonds
   - -expeced inflation increases, cost of borrowing decreases and desire to borrow increases
   - -INC. in expected inflation – S curve shifts RIGHT = Inflation inc. and price dec. and inc. rate inc.
4. change in corporate taxation - req. gov. legislation (not often)
   - -tax income – but gov. creatse tax subsidies that make corp. investments less costly – so inc. supply shift RIGHT and dec. Price and inc. int. rates

Question 12

Factors that shift demand

Answer 12

LOOK AT PAGE146-147!!!!!!!!

1. wealth – econ. grow and inc. wealth = inc. investment
   - -wealth INC. so D inc. and shifts RIGHT – P inc. and int. rates fall
   - -economic expansion
   - -in recession, wealth dec., D dec., P decreases, and raise int. rates
2. expected inflation
   - -affect inv. willingness to buy bonds
   - -dec. expected inflation means pmts. promised by bond issuer have more value than buyers thought so bonds are more attractive
   - -exp. inflation FALLS then D increases and shifts RIGHT
   - -P inc. and int rates fall
3. Expected returns and expected int. rates
   - -E[r] INC. relative to other alternative investments, D inc. and shifts RIGHT
   - -conclude bond prices are connecte dto stock mkt. – P inc. and int. rates fall
   - -also when int. rates expected to change, bond prices adjust immediately
   - -HPR = cpn. pmt. + cap gains/loss
   - -int. rates dec., P expected to Inc. so expect cap. gain = bonds attractive
   - -exp. int. rates dec. = D inc. = P inc. and int. rates fall (cap. gains expect)
4. risk relative to alternatives
   - -risk requires compensation – less risky = higher price willing to pay for it
   - -if bond is less risky relative to alernatives, D inc. and shifts RIGHT - P inc. and int. rates fall
5. liquidity relative to alternatives
   - -liquid can sell without large loss in value - more liquid = inc. D and shift RIGHT

Question 13

Change in equilibrium

Answer 13

change in expected inflation affects both S and D

• -inc. expected inflation = S shifts RIGHT bc decreases real cost of borrowing
• -BUT D shifts left because dec. real return to investors
• -equilibrium - dec. P and inc. int. rates (in case of inflation)

if both shift same direction, P can rise or fall (difficult to predict)

• -change in business conditions also impacts both - bus. cycle downturn dec. inestment opportunity so S curve shifts left and dec. wealth so D also LEFT
• -in this case i think P inc. and int. rate falls

Question 14

why bonds are risky

Answer 14

1. default risk - issuer may not make promised pmts. on time
2. inflation risk - inflation higher than expected = dec. real return on holding the bond
3. int. rate risk - int. rates may inc. btwn time bond is purchased and time sold = dec. bond price (cap. loss)

risk arises from fact that an investment has many possible payoffs during horizon for which it is held

• -to assess risk look at possible payoffs and likelihood of occurring
• -look at impact of risk on bond’s return relative to rf rate

Question 15

1. default risk

Answer 15

ignore with T-bonds (gov. issued - can print money)

• -list all the possibilties and payoffs that might occur with their probabilities
• -then calculate expected value of promised pmts. - then can find bond’s price and yield

ex. rf = 5%, n = 1 yr. FV = $100 - promise to pay $105 in one year
price = (if risk free and pmt. was certain) = 100 + 5/1.05 = 100

–but what if 10% possibility that company goes bankrupt before pmt. and if defaul investor gets nothing – means 2 possibile payoffs
possibiltiies = full pmt., payoff = $105, probability 90% —> payoff times probability = $105 * ,9 = $94.50

–or 2. default, payoff = $0, probability = 10% —> payoff times probability = 0 * .1 = 0

so expected value of pmt. of bond is $94.50 —> but if pmt. made it is one year from now so need to find P willing to pay today - use risk free rate

P = 94.50 / 1.05 = $90

what is YTM? bond sells for $90 and promised pmt. is $105
i = 105/90 -1 = .1667

default risk premium = promised YTM - rate
–16.67 - 5 = 11.67%

shows investore receives compensation for risk
–inc. default risk = inc. probability bondholders do not receive pmt. = dec. expected value = dec. P and inc. Int. rate

Question 16

2. inflation risk

Answer 16

bondholders interested in REAL intereat rate - not just nominal - and don’t know inflation
–int. rate has 3 components: real int. rates, expected inflation, and compensation for inflation risk

ex. real int. rate = 3%, but not sure on inflation
- -expected inflation = 2% with st. dev. of 1%
- –means nominal int. rate = 3% real interest + 2% expected inflation + compensation for inflation risk
- -inc. inflation risk = inc. compensation

LOOK AT CHART EXAMPLE - cases of expected inflation
–if has higher standard deviation = more risk = more compensation

Question 17

3. interest rate risk

Answer 17

arises fromfact that investors don’t know HPR for long-term bonds

• -int. rates change = bond prices change —> longer term of bond = larger PRICE change for every given change in real int. rate (duration)
• -when there is mismatch btwn inv. horizon and bonds maturity, there is int. rate risk

ex. 2016 i = 8/75%, t-bond that matures 2020 - traded at $132.16 (FV = 100) - when issued in 1990, P = 98.74
- -person who bought and sold 26 years later earned cap. gain of 24%
- -but inv. bought 2.75% cpn 30 yrear bond at 100.69 when issued in 2012 and sold 3 years later in 2016 for 98.31 had cap. loss of 2%

Question 18

Ch. 7 - interest rate spreads

Answer 18

range of inc. and dec. int. rates - change has huge effect on borrowing costs to corporation

• -ex. Ford and GM - 2009 –> closer to bankruptcy, inc. risk = dec. price ppl willing to pay –led to inc. in interest rates and inc. cost of auto comp. to borrow
• -the bonds we study (gov. and corp) differ in 2 respects: 1. identity of issuer and 2. time to maturity

1. default risk - can’t avoid, but mitigate by credit rating
   - -used to be NRSROs (national recognized stat. rating organizations) – in 2010 after Dodd Frank wall st. reform and consumer protection act…change to reduce reliance on agencies

Question 19

Moody’s and standard and poors

Answer 19

2 best bond rating services

• -earn high rates with 1. low levels of debt, 2. high profitability, 3. sizeable arm of cash assets
• -both systems based on letters - AAA highest
• -AAA - BBB inv. grade, BB-B (speculative), CCC-D (highly speculative)

inv. grade = low default risk - usually gov. or stable company

dec. inv. grade = JUNK BONDS - “igh yield bonds” - reminder to get high yields take on lost of risk
- -two types of junk bonds
- -1. fallen angels - were once inv. grade butissuers fell hard (can be corp. or soveriegn (gov.))
- -2. when little is known about issuer

ratings downgrade (upgrade) - dec. rating when business or country is having problems

CP rating char (pg. 169)
1. inv. or prime grade – Moodys (P1-P3)/ S&P (A+1, A-3) - Coca cola, general electric, proctor and gamble

2. speculative, elow prime grade = no moody, S&P (B-C)
3. defaulted - no moody, S&P (D)

Question 20

commercial paper

Answer 20

is a short term version of a bond (both corp. and gov.)

• -unsecured bc no collateral (only most credit worthy issuers can use)
• -BaML and Goldman use majority of it
• -issued at DISCOUNT (like T-bill) - zero cpn. with no cpn. pmts.
• -usually mature < 270 days
• -1/3 of all commercial paper held by money-mkt. mutual funds (req. short term assets with immediate liquidity
• -sometimes 5-45 days = short term financing

Question 21

impact of ratings on yields

Answer 21

bond ratings designed to reflect default risk = inc. P (compensation for risk)
–inc. risk = dec. D = shift left = INC. YIELD

Benchmark bonds - US treasury bc little default risk so use to COMPARE
–yields on other bonds are measured in terms of “spread over treasuries” (risk is measured relative to a benchmark - use US treasury bonds for bonds)

bond yield = US treasury yield + default risk premium
bond yield = risk spread

looked at structure of int. rate groups (pg. 171) shows inc. rates inc. and so did Aaa Baa yields

when a comp. bond rating decreases, the cost of funds goes up - impairing the comp. ability to finance new ventures (bc inc. int. rates - more expensive to borrowers but cheaper bond price to lenders) (pg. 171)

Question 22

2. taxes

Answer 22

bondholders pay income tax from income received from privately issued bonds - TAXABLE BONDS
–But cpn. pmts. on bonds issued by state/local gov. are tax exempt (municipal or tax-exempt bonds)

RULE: interest income on bonds issued by one gov. is not taxed by another gov.
–fed usually taxes for US treasury (but state and local do not)

investors use the AFTER-TAX YIELD to base decisions

tax-exempt bond yield = taxable bond yield (1-tax rate)

inc. tax rate = inc. gap btwn yields on tax and tax-exempt bonds

Question 23

3. maturity term structure of int. rates

Answer 23

term structure of int. rates = relationship among bonds of same risk characteristics but diff. maturities

pg. 174 - compare 3 mo. (blue line) to at year (green) and make conclusions on treasury yields

1. int. rates of diff. maturities tend to move together
2. yields on short term bonds are more volatile than yields on long term bonds
3. long term yields tend to be higher than short term yields

2 reasons to explain

Question 24

reason 1 - expectations hypothesis

Answer 24

certainty means bonds of diff. maturities are perfect substitutes for each other - so bc bond yield is rf rate + D.R.P. (CAPM) - we have certainty on rf it will return the same whether 1 or 2 yr. (indifferent)

so when int. rates are EXPECTED to inc. in future, long term int. rates are higher than short term – so YIELD CURVE will slope up

• -int. rates expected to fall, yield curve decreases
• -expected to be the same - yield curve = flat

the three graphs with x axis time to maturity and y axis YTM

• -if int. rates expected to rise, upward slope
• -expected to stay same = flat line
• -int. rates expected to fall = downward slope

Question 25

review this part again - the int. rate formula

Answer 25

if indifferent between A and B (one 2 yr. bond or 2 one yr. bonds)

find ave. int. rate by taking the average of the current and the expected

1. int. rates of diff. maturities move together (if int. rate on year changes, all yields at higher maturities change with it)
2. yields short term more volatile than long (bc long term are just a sequence of average future short term rates) - if 3 year change, small impact on 10 year
3. cannot explain why long-term yields are > short term
   - -does not explain why YIELD CURVE slopes upward
   - -bc ignores risk and assumes short and long are perfect substitutes
   - -know long termare riskier than short term (bc liquidity problem)

Question 26

reason 2. Liquidity problem

Answer 26

liquidity premium thoery - even if default-free bonds are risky bc of uncertainty with inflation and future int. rates

• -risk explains #3 in prev. card —> the UPWARD SLOPE
• -long term int. rates > short term bc long term is risker (read all about this again ch. 7)

Question 27

real return

Answer 27

inv. want to know REAL return - to determine as maturity drawn out bc do not know future inflation
- -uncertainty about inflation = uncertainty about bond’s real return = risky investment
- -INFLATION RISK on bond increases as time to maturity INCREASES

liquidity premium theory of term structure
(long formula again…re learn)
—expected hypothesis explains the risk free part and the liquidity premium theory explains the second part of the equation

rp = risk premium, >risk = > risk premium

• -estimate rp by looking at the average slope on long timer period
• -bc risk premium inc. with time to maturity, explains why yield curve usually slopes upward

Question 28

risk term structure of int. rates

Answer 28

valuable info. about economic conditions

• -econ. dec. = strains bus./comp. – unable to meet fin. obligations
• –in recession, inc. risk premium on privately issued bonds (but not change risk of holding gov. bonds)
• -impact on high bond rated comp. = small (spread btwn US treasuries and AAA not likely to move much)
• -but decrease. initial rate of bond, more default risk premium INC. as general econ conditions fall spread btwn US treaury and junk bonds widens the most

Question 29

STAR yield curve and info. on term structure

Answer 29

info. on term structure (slope of yield curve) helps us forecast economic conditions
- -expected hypothesis - long term int. rates contain info. about expected short term int. rates and liquidity theory says yield curve usually slopes upward
- -on RARE occasions, the short term int. rates > long term yields = INVERTED and yield curve slopes downward

INVERTED YIELD CURVE = helps predict an economic dowturn bc it signals an EXPECTED fall in short-term int. rates
–often monetary policy makers adjust short term rates to influence real economic growth and inflation

Question 30

ch. 11 the economics of fin. intermediation (fin. institutions purpose)

Answer 30

fin. crisis 07-09 - alerted everyone that general economic well-being is closely tied to the health of fin. institutions
- -fin. institutions intermediate btwn savers and borrowers so A & L are fin. instruments

category = banks, brokerage firms, investment comp., insurance comp. pension and mutual funds
–pool funs from ppl/firms who save and lend to ppl/firms who need to borrow –> put surplus of savers $ in mortgages, business loans, and investments

involved in DIRECT FINANCE - borrowers can sell DIRECTLY to lenders
–and INDIRECT FINANCE - 3rd party issues claims to fund providers and acquirers claims those who use them

= inc. inv. opp. and economic growth while decreasing inv. risk and economic volatility

Question 31

role of financial intermediaries

Answer 31

look at chart on pg. 2272!!!! and table 11.1

• -US loans to securities (by anks) = total loans/stock + debt = .79 — D& E fin. > loans
• -but in other countries > 1 (loans/fin. institutions very IMP)

IMP because intermediaries lend (banks) but also determine who has accesss to the stock and bond markets
–fin. institutions imp. bc INFORMATION - don’t have to worry about 1. transaction costs or 2. info costs (Checking credit worthiness) bc bank does it for us

Question 32

5 main functions financial institutions perform

Answer 32

–can do all 5 bc specialization - helps banks provide service and decrease costs of providing them

1. pooling the resources of small investors
2. providing safekeeping and accounting servies and access to pmts. system
3. supply liquidity - by converting savers balance directly to a means of pmt. when needed
4. provide ways to diversify risk
5. collect and process information in ways that decrease info. costs

Question 33

fin. institutions functions 1. pooling the resources of small investors

Answer 33

• -of many small savers - accept small deposits to empower them to make large loans
• -so have to show savers their funds are safe - large safes or today reputation and gov. guarantees

Question 34

fin. institutions functions 2. providing safekeeping and accounting services and access to pmts. system

Answer 34

• -store wealth in bank for safety
• -offer internet/mobile access, ATM, credit/debit cards, checks, mo. bank stmts. – access to pmts. system (network that transfers funds from one account to another) - also dec. transaction costs

COMPARABLE ADVANTAGE

• -specialize in what you do best andn most efficiently and where opp. cost is lowest
• -leads to inc. trading — inc. fin. transactions – keeps transactions cheap

accounting

• -helps us manage our finances - note all our various transactions
• -banks use ECONOMIES OF SCALE - in writing legal contracts and standardizing them – ave. cost of producing good falls as quantity increases (bc have costly lawyers but standard for al customers an echeaper than if indiv. lawyer hired for each person)

Question 35

fin. institutions functions 3. Supply liquidity - by converting savers balance directly to a means of pmt. when needed

Answer 35

high liquidity bc have ability to transform assets to cash at low cost (ATMs) - efficient and beneficial

• -keep enough Short term fin. instruments on hand but lend out the rest
• -offer a LINE OF CREDIT - pre approved loan that can be drawn on whenever a customer needs funds
• -home equity lines of credit, credit card cash advances, and business lines of credit —> allow access to liquidity in emergency

Question 36

fin. institutions functions 4. provides ways to diversify risk

Answer 36

• -banks take deposits from thousands of individuals and make 1000s of loans with them - very small share in each of the 10,000 loans so diversify risk
• -so in ex. each indiv. deposit really only contributes 10 cents to a loan (but bc have SO amny can do that) and dec. risk
• -ex. mutual fund offers small investors a low-cost way to purchase diversified portfolio of stocks and dec. risk and bc SPECIALIZATION costs remain low

Question 37

fin. institutions functions 5. collect and process information in ways that decrease info. costs

Answer 37

we indiv. do not have time or skill to collect info. and decide which borrowers are trustworthy

• -info. asymmetry problem (borrowers have info. that lenders do not)
• -fin. institutions screen applicants and monitor them

Question 38

info. asymmetries and info. costs

Answer 38

• -hinders operation of fin. mkts. bc borrowers (firms) know more about bus. prospects than lenders or investors (buyers)
• -Ebay ex. - quality? picture? real? - solved by insurance policy for those who don’t receive packages and feedback forum to RATE
• -asymmettric info. poses 2 obstacles to smooth flow (adverse selection and moral hazard)

Question 39

1. adverse selection

Answer 39

arises BEFORE transaction occurs

• -used car market
• -used car - grandma selling care in good condition bc barelt drove it and wants $20,000 - teenager drove recklessly and would sell for $8000 but bc buyers do not know diff. — settle in middle for 15,000
• -grandma wants 20,000 so she taks good care and leaves market (peach = good car)
• -so only the worst care (LEMONS) are left in the market
• -info. asymmetry brings down the entire used car mkt. as a whole

can solve by CARFAX service - provide detailed history of accidents - also car dealer reputation, pay for mechanic to check condition
–same in fin. markets - borrowers know more about the projects they wish to finance than their lenders

2 companies - one good and one bad - can’t tell diff. btwn so willing to pay ave. price

• -good firm feels their stock is undervalued to they choose not to issue stock (leave market)
• -only leaves bad prospects in market

Same in bond market - risk req. compensation - inc. risk. = inc. premium - so more risky the borrower = higher cost to borrow

• -can’t tell who is good or bad, so lender takes average
• -good credit risk comp. do not want to pay so high (bc know they are low risk) so leave market
• -means company will pass up good investments

Question 40

solve adverse selection

Answer 40

1. create more info. for investors - public comp. (sEC filings and fin. stmts)
   - –but hard bc can have unethical accountans who distort info. on fin. stmts.
2. provide guarantees in fin. contracts os owners suffer with investors if firm does poorly

free rider problem - someone who doesn’t pay info. costs but gets the benefit - free riding the stock market
–ex. follow a friend’s lead - she subscribes to WSJ and ges info. but friend just follows

can also solve by making lenders compensated even if borrowers default (collateral) (unsecured loan if no collateral)

• -back or secure
• -or NET WORTH - owners stake in the firm (A-L) if defaults can make a claim against owners net worth

Question 41

2. moral hazard problem

Answer 41

insurance comp. realized insurnace changed the BEHAVIOR of the person insured (auto insurance –> reckless driving)
–working hard? even though get paycheck regardless

moral hazard is AFTER transaction

• -when we cannot observe ppl’s actions and so cannot judge whether a poor outcome was intentional or just bad luck
• -hidden actions
• -ex. inv. in stock - don’t know if company who issued you wil use invested funds in a way that is best for you
• -leads to PRINCIPAL-AGENT problem (manager benefits > stockholders)

Question 42

Ch. 12 - nondepository institutions

Answer 42

diff. btwn depository instit. is their primary source of funds (liabilities on BS)
- -depository institutions accept deposits and make loans to borrowers
- -commercial banks, savings and loans, and credit unions
- -deliver services in ch. 11

intent: to profit from each transaction

2009-2015 - approx. 500 US banks failed, and > 1300 mrged

bank mgmt. SO important –> in 1990s US made profits and Jap had lossed - Jap. econ. frew at 1% and US grew at 3%

• -fin. problems in Jap banks played large role in poor economic performance
• -depends on source of liabilities and management of assets

Question 43

The balance sheet of commercial banks

Answer 43

sources of funds (liabilities) and uses to whcihc funds are put (Assets)
–assets - from indiv. depositors/businesses and from borrowing from fin. sintitutions through fin. mkts.

A-L = bank’’s net worth (bank’s capital) - profits come from service fees and the diff. btwn what banks pays for L and return it receives

ASSETS - 4 categories: cash, securities, loans and others)
–other is mostly buildings and equipment – also collateral from borrowers who defaulted

Question 44

Commercial banks assets 1. cash

Answer 44

Cash - 3 types

1. reserves
   - -hold bc regulations req it - includes cash in bank’s vault and ATM machiens (vault cash) - also bank’s deposits in the Fed
   - -cash is most liquid bc need with withdrawal requests
   - -includes cash in bank’s vaults, (currency and ATMs called “valut cash”) and the reserves in vaults of Fed
2. cash in process of collection
   - -when deposited paycheck takes a couple days to get dunds from employer - the uncollected funds are your bank’s asset bc expecting to receive it
3. balances of accounts the bank holds at other banks
   - -small banks have deposit accounts at large banks (correspondent bank deposits)

Dec. 2015,banks hold approx. 1% in cash, but before fin. crisis only held about 3% – min. bc earns les interest than in loans and securities – but changed bc needs liquidity

Question 45

Commercial banks assets 2. securities

Answer 45

2nd largest assets

• -other country banks hold stocks but US banks hold only bonds (split btw US gov. bonds and agency securities)
• -over 1/2 of securities are mortgage backed (10.8% of assets)
• -most of these securities are very liquid - so sometimes called SECONDARY RESERVES
• -usually around 20% of banks assets are securities

Question 46

Commercial banks assets 3. loans

Answer 46

primary asset for modern comercial banks (over 1/2 of assets)

1. business loans (C&i - consmer and industrial loans)
2. real estate loans (home mortgages and home equity loans)
3. consumer loans (auto and credit card)
4. interbank loans (among banks)
5. other (loans for security purchases)

diff. fin institutions specialize in diff. loans
- –commercial banks - business
- -savings and loans - mortgages
- -credit unions - consumer

curing crisis, commercial banks inoved in REAL ESTATE
–bc creation of mortgage backed securities = reduced risk of holding an illiquid asset

Question 47

Liabilities of commercial banks - sources of funds

Answer 47

get from savers and from borrowing in fin. mkts.
2 types of deposit accounts: transaction (checkable) and non transaction

1. checkable deposits - “demand deposits”
   - -usually offer diff. options to consumers for checking accounts
   - -“sight deposits” bc can show up to withdraw when bank is in sight
   - -used to be 40% of total L in 1970s, now 17% in 2015 0 bc checking accounts pay little to no interest - low cost source funds for banks but low return investment for depositors
   - -not as popular bc ppl want high returns
2. nontransaction deposits
   - -savings and time deposits
   - -as of 2015, over 1/2 of liabilities
   - -CD - set maturity date when you get it back (early = banks charge huge penalty0
   - -small CD = 100,000 or less
   - -large - 100,000+, FV negotiable - bought and solf within fin. mkts.
   - -when a bank needs funds, can issue large CDs

Question 48

commercial bank liabilities - borrowings

Answer 48

2nd most imp. source of bank funds

• -< 15% of sources
  1. borrow from Fed (called discount loans) - borrow from gov.
  2. borrow from intermediares (banks with excess reserved lend their surpus funds to banks in interbank mkt. called federal funds mkt.)
  3. borrow from foreign banks
  4. repurchase agreement (repo) - agreement to reverse transaction at set future date (usually next day) - overnight loan

Question 49

bank capital and profitability

Answer 49

bank’s net worth = A-L - called bank’s capital (equity capital)
–insurance against insolvency = or in case asset value drops

LOAN LOSS RESERVES - amt. the bank sets aside to cover potential losses from defaulted loans - gives up hope of loan being repaid and writes it off from balance sheet - then dec. loan loss reserve by amt.

2015 D/E ratio was 8 to 1 in commercial bank BS - means bank borrows $8 to every $1 in capital – risk and E[r] inc.

ROA = net profit after taxes / total assets

ROE = net profit after taxes / bank capital

large banks ROE > small banks

• -greater leverage
• -riskier mix of assets
• -economies of scale

capital is cushion against unexpected libaility withdrawals!!

Question 50

net interest income (net interest margin)

Answer 50

bank’s interestrate spread (weighted) - ave. diff. btwn the interest rate received on assets and the interest rate paid for liabilites (closely related to its ROA)
–if bank is wel lrun, HIGH interest rate incom ena dhigh net interest margin (usually high net profit margin is sign of inc. profitability in the future)

Question 51

off balance sheet activities

Answer 51

banks generating fees (to dec. transaction costs and info. costs and transfer risk) - when perform services, banker want to be compensated

• -ex. credit line - offer customers with lines of credit - banks rec. fee
• -so agreement signed, bank rec. pmt. and firm receives LOAN commitment - but not until loan is made (firm draws credit in) does transaction appear on balance sheet
• -but bank is compensated in the mean time for the dec. in transaction and info costs

also ex. - tellers of credit - guarantee that customer of bank will be able to make promised pmt. (importer send letter to guarantee to Chinese exporter they will rec. pmt.)
–in sending letter, bank takes on imposter’s risk at a fee

EX. STANDBY LETTER OF CREDIT - issued to firms and gov. that wish to borrow in fin. mkts. - form of insurance
–says that bank promises to repay lender if issuer (firm./gov.) defaults

off BS activties create risk and skew interpretations of fin. stability

Question 52

Bank risk - 1. liquidity risk

Answer 52

very highly leverages and exposed to many risks

1. liquidity risk - risk of sudden demand of liquid funds
   - -especiall off BS - promised to fund in future
   ex. 10% req. reserves, so if have $100M in deposits, bank must hold $10M in reserves…if have $15M, then $5M is excess reserves
2. one way to control liq. risk is to hold excess reserves - but opp. cost bc forego higher interest that can be earned on loans or deposits
3. adjust BS - can’t pull from req. reserves - but quickest is to sell securities (US treasuries - quick and low cost)
4. or can sell some of its loans to another bank
5. or refuse to renew customer loan that has come due
   - -refuse to extend loan to longer date (but can drive customers to another bank
   - –also do not like to dec. L side bc can earn profit from turning L to A - so want a big balance sheet
6. so prefer to just inc. liabilites to find more funds (from fed or other bank) - OR attract additional deposits

Question 53

Bank risk - 2. Credit risk

Answer 53

profit from int. rate they pay and int. rate they rec. from borrowers (ROA > cost of liabilities)
–borrowers must repay laons for bank to profit

credit risk = risk loans won’t be paid

1. diversification - many loans to spread risk
2. credit risk analysis

Question 54

Bank risk - 3. Interest rate risk

Answer 54

2 sides of balance sheet don’t match (liabilities are short term and Assets are long term) = diff. maturities

• -as int. rates rise, bond value falls, longer term = > P change to any change in int. rates
• -so since A longer, when int. rates rise = banks face risk that value of assets will fall more than value of liabilities =reduce bank capital
• -reduce revenues relative to expenses

int. rate sensiivit analysis - those that a change in int. rates change revneue produced by an asset
- -short term bonds that are constantly maturing and belig replaced produce int. rate sensitive revenue
- -assets assume 20% in int. rate sensitive and 80% not
- -in liabiltiies –> assume 50/50 (1/2 deposites earn int. rates so costs associated with them move with mkt) - includes int. bearing checking accounts
- -rest of liabilities (like time deposits) - have fixed int. rates

to make profit, int. rate on liabilities must be lower than int. rate on assets
–if bank’s libailities are more int. rate sensitive than its asets, inc. in int. rates will cut bank’s profits

Question 55

Managing int. rate risk

Answer 55

1. manage by understanding sensitivity of bank’s BS to int. rate changes
   - -gap analysis - estimate change in bank’s profit for every 1% change in int. rates
   - -ex. A-L = gap = (20% - 50%) = -30%
   - -multiply gap by projected change in int. rate yields in bank’s profit
   - -ex. -30 says 1% inc. in int. rate will dec. bank’s profit by 30 cents per $100 in assets
2. make long-term loans at a floating int. rate (Adjustable rate mortgages (ARMS) - not fixed
   - -dec. int. rate risk but inc. credit risk bc adds strain to borrowers to inc. likelihood of default
3. derivatives (int rate swaps) - agreement to make fixed int. rate pmts. in exchange for floating int. rate pmts. (Transfers int. rate risk to another party(

Question 56

bank risks. 4. trading risk

Answer 56

mkt. risk - banks use capital to hire traders to buy/sell securities, loans and derivatives - risky
- -traders split profits and in case of losses, bank pays moral hazard problem (bc traders have incentive to take on more risk than banks want)
- -1. measure. risk of traders with st. dev. and variance - limit amt. of risk traders can assume and monitor daily

Question 57

other bank risks

Answer 57

foreign exchange risk - holding assets denominated in one currency and liabilities denominated in another
–ex. US bank has dollar L but buys Jap bond (A = yen) - diff. when dollar-yen exchange rate moves

sovereign risks - foreign borrowers may not repay loans, NOT bc unwilling but bc gov. will not allow them to

• -redonomination risk
  1. solve soverign by diversification (distributing loans throughout world) to avoid too much exposure in one country where crisis could arise
  2. refuse to do business in certain country
  3. use derivatives to hedge risk

operational risk - computer systems fail or buildings burn down/blow up (9/11)
–diff. to forecast and prepare for

Question 58

In class - why bonds more imp. than stocks?

Answer 58

bonds are most IMP. fin. instrument in fin. system (remember system makes specialization and exchange possible)

capital mkt. outstanding

• -showed us that in 2017 (pie chart) - debt was about 56% at $37M and equity was 44% at $32M
• -of cap. mkt.
• -biggest E actually in long time bc bull mkt. - equity usually a lot smaller
• -shows bond mkt. is biger than equity in mkt. value

then pie chart of issuance in 2017 - Bonds were 97% and equity was 3%

• -lots of diff. entities involved in bond mkt. (biggest issuers: fed gov.)
• -but stock mkt. has only 3-4 entities involved
• -So shows change in bond mkt. impacts MORE entities than stock mkt.

AND most IMP reason is that int. rates are determined in the bond mkt.

• -involved in every valuation in denominator (WACC, DCF)
• -affects fund flows — likelihood to invest
• -impacts which projects are taken on (+ NPV analysis)
• -impacts FAI (I on GDP) - indirect impact on NC bc affects value of currency

Question 59

class notes supply of bonds

Answer 59

value bond formula = shows inverse relatinoship btwn P and YTM

• -in mkts. usually solve for YTM bc know price
• -context to be able to predict Y and P of bonds

S&D - Quantity on X axis and Price on Y - S upward slope and D downward

factors that affect supply (sellers, issuers, borrowers) - if sell/issue bond you are borrowing $

1. gov. spending relative to tax revenue (Deficit)
   - -need more money
   - -so S inc. and shifts RIGHT
   - -impact: inc. deficits
2. general economic conditions
   - -Shift S right! - during economic expansion (comp. with growth strategies)
3. Expected inflaiion
   - -S shifts Right
   - -have a locked in fixed rate o the loan
   - -borrowers like inflation
   - -nominal rate = inflation = real rate
   - -so if inflation inc. then real rate is decreasing
   - -inc. inflation — ppl want to borrow and people want to sell if they already have one
4. selling activity of Fed (Central bank)
   - -S shifts RIGHT
   - -if Fed inc. selling activity

Question 60

Factors that shift Demand (buyers and lenders) - lend to bond issuers

RTA = relativ to alternatives

Answer 60

1. wealth
   - -D shifts right
   - -when INC. wealth
2. Expected (inflation)
   - -D shifts right
   - -when inflation DEC
   - -nominal rate is locked in
   - -nominal = inflation + real rate (my real rate/retirm will go up if inflation falls
3. Expected return bonds RTA
   - -D shifts right when inc. return
4. risk of bonds RTA
   - -D shifts right
   - -when risk FALLS
5. liquidity risk of bonds RTA
   - -D shifts right
   - -when inc. liquidity
6. buying activity of Fed
   - -D shifts rght
   - -when Fed inc. buying activity

Question 61

Ex. to think about period of 2009-2016 and go through each variable to see how impacted P and Y (net effect)

Answer 61

how it IMPACED S & Y
SUPPLY
1. defecit INC = SUPPLY SHIFT RIGHT (UP)
2.Econ. conditiong inc. = Supply dhift RIGH = UP
3. E(inflation) = constant
4. selling activity of Fed…we don’t know so constant
–NET EFFECT ON SUPPLY = SHIFT RIGHT

DEMAND

1. wealth = up
2. E(inflaiton) = constant
3. expected return = down
4. risk = don’t know
5. liquidity = don’t know
6. Buyingof Fed = INC
   - –net effect is UP on Demand
   - -so both S and D shifted right = P inc. and yields dec.

our estaimte for next year
–S we sayd ALL 4 up

Question 62

Bonds - bond myth #1

Answer 62

rn unemployment lowest since 1969 - Tbill raes inc.

2 BOND MYTHS
#1 - Bonds are safe 
#2 - all bonds are the same 

1. default risk (changes over time - graph is volatile)
   - -bond specific? YES - diff. depending on bond type/issuer
2. inflation risk (changes over time - graph is volatile)
   - -bond specific? - No, MACRO factor - affects all of them
3. Interest rate risk (risk dec. as gets closer to maturity…so downward sloping graph)
   - -BOND SPECIFIC yes - bc length of bond and cpn rate are specific to bonds
   - -risk that yields will change = changing prices
4. pt. - if holding bonds, do NOT want YTM to inc. bc then P drops (capital loss)
5. quantity magnitude of change (duration) - how long the lever is what maters
   - -“lever” is taling about the picture of a teeter toter with YTM on one side and p on the other - Longer side is going to move a lot for little changes in short see
   - -so the length of the lever is the int. rate risk - long on P side = HUGE changes if any small changes in YTM…or if short just small changes

what determines duration?

1. time to maturity = n INC = Duration INC
2. Cpn rate = inverse (Dec. cpn = inc. duration)

want O cpn, LONG bonds - rigt when yields will drop and prices rise!!

what determines int. rate risk? = duration!!!!!

Question 63

bond myth #2

Answer 63

all bonds are the same

1. categorized based on ISSUER
   - -dimensions to categorize bonds
   - -(a) gov. there are 2 types
   - —-sovereign - (bow) answer to no one - also have power to print $
   - —-municipal gov. - gov. that answers to aonther gov. - rule –bond issued in one gov. cannot pay taxes to another gov. (SL county answers to UT state gov. which answers to fed)
   - -(b) corporations
   - -(c) agency bonds - entity that is birthed by a gov. but is run independent of gov. (still has ties to gov. - a little less risky bc implicitly baced by gov. (Sally May - takes student loans and issues as bonds)
2. categorized by CREDIT RATING
3. categorized by bond CHARACTERISTICS
   - -collateralized

AAA, Baa almost 1 correlated (.98)

• -but during the crisis, correlation btwn 10 yr. treausyr and Baa was -.18 (move in opp. directions)
• -MOST NOT THE SAME DURING A CRISIS
• -Can’t just assume all bonds are the same

Question 64

don’t buy bonds when yields about to go up

Answer 64

during 70s - for 2 years inflation rate was double digits

• -as high as 14.6% in 1980
• -more risky - and risk req. compensation so yields were high

bond buy 3 years - 1978-81 (sell 3 years later)
y = 9% then y becomes 15%
–net capial loss was 11%
(he adjusted by making it 30 year and zero cpn - assumptions made it more dramatic but still huge loss bc yields change = int. rate risk)

DO NOT BUY BONDS WHEN YIELDS ABOUT TO INC. (bc of the 1st two risks!!)

Question 65

money in bond mkt.

Answer 65

best way to make $ in bond mkt. - buy zero cpn. with long maturit when yields are high and sell when they drop (buy low sell high)
–yields are high if their next move are a drop

put $ in short duration bonds –measures int. rate risk

ex. last c;ass – late 70s,80s (exp. stagflation) - inflation 14% - double digit inflation for 2 years
- -causes: fed wanted to stimulate and create inflation…but econ. not responding

2007-2009

• -why did AAA corp. with strong balance not change - ppl were confindent in their investments
• -why did Baa yields go UP? - BC inv. grade most liekly to default
• -why did US treasury go down? - most sovereign bonds do not have any default risk bc gov. can print $ in short run (D shfits RIGHT - P inc. and yilds dec.) - move outof stocks to safehaven assets (T-bills and gold)

from bond mkt. get 2 of the most reliable info: concurrent indicator and leading indicator

Question 66

Credit spread

Answer 66

from bond mkt. get 2 of the most reliable info: concurrent indicator and leading indicator
–can’t see info. - but PRICE change gives information

1. Credit spread!!! (RN) = YTM (proxy bond) - YTM (benchmark bond)
   - -the YTM of proxy bond must be representative of change in econ. - sensitive to aggregate default risk
   - -the YTM of benchmark is bond that is immune to default risk (10 year treasury)
   - -called the Riktor scale to medium to sever recessions - bc predicts earthquakes by telling us how much the ground is currently moving (concurrent)
   - -credit spread is a measure of aggregate default risk

water and cruise ship ex. (with the waves diff. boats make?)
–rapid INC. in credit spread = inc. default risk

According to credit spread - crisis started in Jan. 2008 - but GDP said 4th quarter 08

• -NOT A LEADING INDICATOR - it is CONCURRENT - tells you “the ground is shaking”
• -usually as proxy take a baket bc can be more general - basket of the ave. YTM Baa rates inv. grade corp. bonds

Question 67

credit spread clarification

Answer 67

constructed that way can be a concurrent indicator of a recession

• -NOT a leading indicator - CONCURRENT
• -GP is the worst concurrent indicator (bc so delayed) - credit spread is better than GDP as concurrent indivicator of moderate to severe recessions

Question 68

yield curve for uS treasury

Answer 68

x axis is the time to maturity of current treasuries (180 days to 30 years) and y axis is the yield - upward curving slope

• -usually a fairly FLAT yield curve
• -if the yield curve INVERTS (slope goes neg.) means we are going in to a recession
• -very RELIABLE indicator

spread btwn 10yr. and 3 mo. treasury - leading indicator
–looking at the yield curve (in picture)

1. yields of bonds with diff. time to maturity tend to move together
   (10 yr. yield inc., then the 3 mo. also inc.)
2. YIELDS of short term bonds are more volatile than long-term bonds
   - -diff. than bc have more yield movement than long term -
3. Yield curve tends to slope upwards
   - -Duration is a measure of int. rate risk and risk req. compensation - so since LT bonds have longer duration = more int. rate risk and higher yields to compesnate for it

Question 69

reasons for yield curve #1 and #2

Answer 69

2. liquidity preference theory

1. expectations hypothesis. says yield curve can go any way (up, down)
   - -explains #1 why they move togehter and #2 bc if jump up 1 yr. yield to 4% = big jump – not as much change on the 5 year bond
   - -does not explain #3 – slopes upward, 5 yr. = 1.8 and 1 yr. = 1.5 in ex…but this behaves according to short term expectations of where short term yields are going

• -risk req. compensation, m inc. = duration inc. so risk inc.
• -so if yield curve misbehaves (inverts)
• -it is not bc LPT - it has to be th eexpectations hypothesis brings it down
• -bc liquidity preference theory says it sould always slope up - bc longer duration req. more compensation so higher yields

Question 70

inverted yield curve

Answer 70

driven by the expecations hypothesis – tells us we think yields in mkt. are going down A LOT - means P inc. - whic happens if D inc. or S dec.
–more speculative estimation: if yields are going down then inflation will drop (drops most during recession) - bc income controls so less dollars chasing goods and services

inflation = fixed rate and if inflatio drops = inc. real return to buyers

yield curve = self fulfilling prophecy - yield curve is the best leading indicator bc the panic of a recession bc of the YV actually is what causes the recession

• -inverted YC shows that recession started Feb. 2007
• -credit spread didn’t show until Q2 08
• -GDP showed Q4 08

Question 71

Laffer curve

Answer 71

x axis is tax rate and y axis is tax revenue

• -Laffer force
• -republicans = as tax rate dec. should cute taxes
• -tax revenue is actually going up

new idea

1. transaction costs —beest way to avoid is with economies of scale in fin. institutions (solve 1st problem)
2. info. asymmetries
   - —1. aderse selection - before transaction
   - ——maybe bigger impact bc have choice to walk away and leave mkt…so only have bad options in the mkt.
   - –2. moral hazard - info. asymetry AFTER transaction

Question 72

adverse selection class

Answer 72

happiness i love
–harvard study where tracked lives of 30 ppl from 1930s

used car mk. 0 what to do to overcome adverse selection

buyers
--carfax
test drive
--mechanic
--go to a reputable dealer
--Kelly bluebook
--review of the seller

sellers

• -offer warranties (sellesr wil pay cost problem)
• -certification

how to overcome?

• -date long
• -ask friends, family to take a look
• -talk to exes, mission comps.

Question 73

2 ways to overcome adverse selection (info. asymmetry)

Answer 73

1. get information (ACT, GPA)
2. Get protection from loss
   - -or option to walk away from the transaction

to be successful - hard work > intelligence

• -if PASSIONATE about it work is not work
• -successful ppl know how to compliment - buil others up - stop worrying so much about grades

adverse selection - INTERMEDIARIES play a huge role
–ppl rarely engage in direct transactions - go through an intermediary, who become information specializers

Question 74

Moral hazard

Answer 74

happens AFTER transaction - much more dificult

• -marriage exampe - trying to get spouse to work out
• -blindsides you
• -owners at corp. ddon’t run the business - shareholders elect board who elect managers, but anagers aren’t the owners
• -have to give them incentives
• -CEO misusing fuds to get persona famle and wealth

ex. Dennis Koslowski at Tyco - legal issues for agnecy problems - CEO misusing funds

principle agent problem

• -align manager and hareholder incentives with stocks, not options
• -warren bugget argues - only options aligns incentives on the upside —if there isa downturn, managers chose not to exercise optoin and shareholders bear all costs

moral hazard - how to align incentives (wife and weight)

1. monitoring
2. keeping monagaers on SHORT LEASH - do not give them very much cash (so cab’t usys them)
   - —1. with high dividends
   - —2. withinc. debt
   - —want ot minimize avaiable cash

APPLE = lost of cash on hand (not paying div.)

—3. or make yourself a takeover target (bc takeover usually 1st thing is replacemgmt.) constantly accepting offers from PE shops

Question 75

The Crisis cliff (look at powerpoint slides)

Answer 75

can start at multiple points in history (don’t know one thing that started crisis)
–he chose to start with .co bubble
1. fed lowering int. rates
2. real estate revs up
—the big short
—should only invest in an asset class if you understand the risk - ppl in real estate mkt. that should have never been there
3. loan originations sky rocket
4. subprime organizations sky rocket
—low/wno down
—low credit scores
—adjustable rate mortgages (give discount for Set time (1 yr) then go to mkt. rates “teaser rate”)
—states income (don’t have to prove income just walk in and they accept it) - very easy to get loans
5. Securitization goes crazy (MBS/CDO)
—-bc ppl with good credit would go to bank and they had already given out all liquid funds

LOOK AT SLIDES

Question 76

MBS, CDO, CDS

Answer 76

MBS - mortgage backed securities
CDS - credit default swaps
CDO - collateralized debt obligations

So if look at MBS binds
—have tronches “slices” of A B C D by default rates (ex. B 10%, C 7.5%, D 5%)
—the money comes from pools of mortgage pmts
—so D tronches weren’t being used to took all the D tronches of (bad MBS) and out then together into a collateralized debt obligation AAA - investment grade but funded by D tronch MBS
—Michael burray is big short realized MBS that funded inv. Grade CDOs we’re funded by 30% sub prime mortgages
—CDS on CDO

Question 77

.com bubble

Answer 77

Priceline stock price dropped from $900 to $8
—mortgage graph - blue bars = volume and red = % of all mortgages that were sub-prime (during crisis btwn 18-20% of all loans were sub prime)

Rule: don’t buy a house more than 3x your annual income
—during crisis up to 5x income

11.3% = delinquency rates on mortgages

WATCH THE BASICS OF BANKING VIDEO

Question 78

Adverse selection graph timeline

Answer 78

Consumer wants house and quick profit / go to mortgage broker (where volume = profit) - dont cafe about quality of loan - just bring together buyers and sellers)

Consumer —> mortgage broker —> commercial bank (also volume = profit - will sell and hold some mortgages)
—> Investment bank (vol = profit - will sell some MBS/CDO and hold some
—> ratings agency ( Vol = profit $ per bond they provide rating for (10-30 thousand for each)
—> investor (searching for yield, AAA suggests safety, complex product - has no idea of probability of omg. (MBS/CDO)
–problem was iinvestors didnt know what MBS ad CDOs consisted of

Question 79

The bail out

Answer 79

US gov. Takes over
—fin. Companies (AIG, Fannie Mae, Freddie Mac
—non fin. Companies (GM)

Us gov. Orchestrated deals to save
—fin. Companies (Merrill Lynch)
—non. Fin. - Chrysler, dodge, Jeep

Chairman of fed, treasury -/ put in charge of the bail out - gov. Comes in and took care of imp. Companies

bad? insurance cotracts change behavior - moral hazard - if companies think they have insuranc they take more risk

Lehman brothers went down - sacrificed on the atlar of moral hazard
–he thinks ben Bernanky were here he would say they should have saved Lehman brothers - let them fail to send the message that gov. won’t always bail out cmopanies

Question 80

In video - int rate risk

Answer 80

int. rate risk - deposit rates (bank liabilities) very volatile and freq. changing so if bank does not rase rates to meet mkt., customers will move to another bank – so change to mee demands but assets are FIXED rates (5 year car loan) so L could be higher than A – insolvent and no rofits

2 ways to deal with risk

1. bear a cost (pay someone to take it away)
2. transform it into a diff. risk - that you are more comfortable with

cannot really get out of risk entirely - in derivatives can mitigate yourselfes to int. rate risk but can also expose yourself to trading risk

–or can mitigate int. rate risk with floatin int. rate but expose yourself to credit risk

Nick Leeson -trading risk ex. in London

• -as a result - we implemented more regulations in America to avoid it
• -lost Barings 1.3B

Question 81

ways to deal with 3 risks

Answer 81

1. liquidity risk
   - -holding treasuries (US loans)
   - -reserves
   - -withdrawal limits
2. credit risk
   - -screening - monitoring
   - -diversift among diff. types of loans
   - -mbs? AAA MBS has 1000s of mortgages - less risky han one single mortgage and also more liquid
3. int. rate risks
   - -inc. customers –so have more depostits
   - -derivatives - floating rates - CDS

money mkt. accounts - higher rate but only 6-ish withdrawals allowed (move savings to here)

also solve int. rate problem by matching maturity dates - Get L that ar longer (CDs) and transform A to be more short term (adjustable rate mortages)

Question 82

A&L of commercial banks in US

Answer 82

ASSETS
Loans = 9.4T
cASH = 2000b (2t)
–17t

LIABILITIES
biggest source by far - 10.3T –1.6 t are large time deposits (CDs_

total assets BAML = 2.2T
–MBS = 10% (and loans by far were biggest asset)

Question 83

numbers to know

1. bonds/equity % of mkt. share
2. 2016 new securities issued (D/E)
3. when did recession start according to diff. indicators
4. average net return if held bonds in late 70s early 80s (3 year holding ex.)
5. CDS market during fin. crisis
6. who did gov. bail out
7. what company was sacrificed by gov.

Answer 83

Bonds 58% of Market Share, Equity is 42%

2016 New Securities: 97% bonds, 3% equity

Q4-2008: 1st quarter of recession

1978-1980 30 year bonds YTM 9.2% to 15.14%, average net return -10.97%

CDS Market - $65 Trillion

Know who the gov’t bailed out - AIG, Indy Mac, Fannie Mae and Freddie Mac, GM

Lehman Bros - sacrifice to prevent moral hazard

Question 84

Lessons learned throughout history about bonds (especially late 70’s/early 80’s and 2008 financial crisis)

Answer 84

• -Bonds aren’t necessarily safe

- -lessons learned from 1978-1980, inflation increased so much that even bonds had a negative return

Question 85

int. rate risk and duration

Answer 85

Interest rate risk- this problem arises when our holding period is different than the time to maturity. For example, if we buy a bond, and interest rates increase, the price of the bond decreases and we incur a capital loss.

Duration: the measure of interest rate risk (length of the lever). As time to maturity increases, duration increases. As coupon rate decreases, duration increases.

Duration (interest-rate risk)-How much of a price swing will occur with a 1% change in YTM, greater duration = bigger price swing, duration is a function of time to maturity and coupon rate (inverse correlation - low coupon rate, higher duration)

Question 86

Taxable equivalent yield

Answer 86

How much a bond needs to yield above a tax-free bond to make it equivalent

Question 87

credit ratings

Answer 87

S&P’s
Investment Grade: AAA to BBB-
Junk bonds: BB+ or lower

Moody’s
Investment Grade: Aaa to Baa
Junk Bonds: Ba or lower

Question 88

risk structure vs. term structure

Answer 88

Risk structure - Ratings and interest rates move together, Quality

Term structure - longer the bond, the higher the yield, time

Question 89

yield curve 2 - crystal bal for esimating recessions

Answer 89

Expectations hypothesis: Long-term bond’s yield should be average of short-term yields average over the same period. Long-term and short-term bonds yields move together, YTM on short-term is more volatile than long-term, long-term will have more volatile price movements (long-term will have higher duration) This only explains first two stylized facts.

Liquidity Premium theory: yield curve generally slopes up, longer-term bonds have more interest-rate risk and bond holders need to be compensated more. This explains the 3rd.

Question 90

ex. from book to overcomr adverse selection and moral hazard

Answer 90

Adverse Selection

• –Disclosure of information
• –Collateral: something of value pledged by the borrower
• –Net worth: owners’ stake in the firm

Moral Hazard

• –Align incentives (i.e. restricted stock that vests over time)
• –Restrictive covenants (limit risk)

Question 91

Major contributors to the financial crisis of 2008

Answer 91

Dot com bubble pops –> FED keeps rates low –> Real Estate revs up –> Loan originations sky rocket –> sub-prime originations mushroom –> Securitization goes crazy (MBS/CDO) –> CDS Market Balloons –> Real Estate Peaks/softens

Question 92

Analysis bank managers use to estimate impact of interest rate risk

Answer 92

gap analysis

Question 93

general commercial bank balance sheet

Answer 93

$17 trillion in assets

• —Cash $2 trillion ~12%
• –Secondary reserves $750 Billion ~5%
• –Loans - $9.5 trillion ~50%
• —MBS - $1.8 trillion ~10%

$12 trillion in deposits (liabilities)
—$1.7 trillion in time deposits (liability)

Loans are biggest asset on balance sheet

Question 94

Basics of banking video

Answer 94

Real estate at center of fin. Crises and he had a picture of a heart, thinks of commercial banks as the heart of fin. System
—heart takes blood that has been de-oxygenated and sends it to the kings which turns it into oxygenated blood that is then sent to the muscles and brain (which all require oxygen to function)
—banks suck in the money in the form of deposits and then redirect and send it out in the form of loans

Understand magnitude of money involved
—go to federal reserve site and look at aggregate balance sheet for commercial banks in US
—rn $14T in assets on balance sheet (and US GDP is about 16T, so majority of economy is in commercial banks)

We are going to create a bank
—have to understand that there are 2 types of people in economy - people with excess wealth and people who want to obtain wealth (to consume or invest or launch their idea or company) called the “haves” (lenders) and the “have nots” (borrowers)

Bank capital = bank equity (just call it capital in banking environment)

Banks attract deposits by providing services - safekeeping, pmt. and accounting services
—deposits are borrowing for a bank bc borrowing money from depositors to lend it out at a higher int. Rate

Before deposits, ROA was equal to ROE — but The deposits caused an inc. in Leverage which caused the ROA to drop to 4% and ROE to raise to 46% - had 90% debt to assets!!!!

But not crazy bc look at fed page on aggregate commercial bank balance sheet - had asset of $14.1T but liabilities were $12.6T!! - so debt to capital ratio pretty accurate

Problem was liquidity risk - gave out all liabilities in loans (2 forms of liquidity risk)

1. Bank runs - too many people demanding their withdrawals - option is to take car loans and sell to IB who will give you liquidity in exchange for asset backed securities
2. To meet liquidity demand, selling off assets at low price to get quick cash

Also credit risk - bc some people will not be able to repay loans (this shrinks our assets on balance sheet) —> insolvency when Liabilities are greater than assets

All interest rates spin off the yield curve of US treasuries - so problem with banks is they have LONG TERM ASSETS and SHORT TERM LIABILITIES
—so 1st problem is volatility of interest rates - loans (assets) are fixed rates, but bc liabilities are short term, if interest rates tick up…the depositors are going to demand higher rates or move their money to another bank - so interest you are paying on liabilities will go up, but int. You are earning on loans goes up much more slowly

MAIN PROBLEM WITH INT. RATE RISK is inverted yield curve (so short term treasuries have high rates and long term have low rates)
—so shows that banks would be paying a very high rate on deposits and receiving the lowest rate on their assets (loans)
—recipe for insolvency bc making much less than you are paying
—inverted yield curve is most destructive and damaging part of interest rate risk

Question 95

Yield curve

Answer 95

Crystal ball for recessions

We can’t see over the wall, but some analysts can and make decisions that are reflected in prices - lots of info. About macro economy reflected in Prices

In bond market - two tools that we use to make inferences from prices or yields about macro economy

1. Credit spread
2. Yield curve

Question 96

The relationship among bonds with the same risk characteristics but different maturities is called the __________________ of interest rates

Answer 96

term structure

Question 97

The key to understanding why the yield curve generally slopes upwards is the fact that longer-term Treasury bonds have higher __________ than shorter-term Treasury bonds and bills

Answer 97

inflation and interest rate risk

Question 98

The risk (credit) spread __________________.

Answer 98

Measures the difference between the yields of US Treasury bonds and corporate bonds
Is a reliable concurrent signal of moderate to severe recessions
Offers more frequent data than GDP reports
–the clearest concurrent indicator of the 2007-09 recession was the risk spread

when yield curve is inverted…economy tends to go into a recession roughly a year later

Question 99

Which of the following is an example of adverse selection in the financial markets?

Answer 99

When considering lending to two potential borrowers, a bank cannot tell which of the two borrowers is a higher credit risk

private info. services face a FREE RIDER

Question 100

The separation of ownership and management is known as ________________________ and is a prime example of moral hazard in equity contracts.

Answer 100

principle agent problem

Question 101

Most companies seeking to raise capital in the stock or bond markets would be unsuccessful without the assistance and reputation of a well-known investment bank (such as Goldman Sachs or JP Morgan) backing them up. This is an example of financial intermediaries providing ____________ to reduce adverse selection.

Answer 101

certification

Question 102

One of the common ways that CalPERS monitors the companies in which it invests is by _________________.

Answer 102

placing CalPERS reps on board of directors

Question 103

loan loss reserves

Answer 103

set aside in case borrowers default on their loans