Chapter 1: Overview of Financial Managment and Financial Enviroment Flashcards
Attributes considered for “most admired companies”
- innovativeness
- quality of management
- long-term investment value
- social responsibility
- people management
- quality of products and services
- financial soundness
- use of corporate assets
- effectiveness in doing business globally
Three attributes of successful companies
- have skilled people at all levels (create high value for customers)
- have strong relationships with groups outside the company (suppliers and customers)
- have enough funding to execute their plans and support their growing operations (investments to raise funds)
Basic of finance
Providers of cash now = entities with more cash than they presently want to spend (investors)
Users of cash now = entities with opportunities to generate cash in the future (borrowers or investment opportunities)
giving cash to user gives provider claim on (potentially risky) future cash
financial markets
way of connecting providers of cash today with users of cash (by exchanging the cash now for claims on future cash)
means for trading securities once they have been issued
financial analysis
set of tools for evaluating (potentially risky) opportunities to exchange cash now for claims on future cash
Evaluating future cash flow
proprietorship
unincorporated business owned by one individual
advantages of proprietorship
- easy and inexpensive to start
- relatively unregulated by government
- pays no corporate income tax (included in proprietors taxable income)
Limitations of proprietorship
- Difficult for a proprietorship to obtain funding needed for growth
- proprietor has unlimited personal liability for business debts
- life of proprietorship is limited to life of its founder
partnership
whenever two or more persons or entities associate to conduct a noncorporate business for profit
partnership agreement defines structure
similar advantages and disadvantages to proprietorship
limited partnership
a partnership in which limited partner’s liabilities, investment returns, and control are limited (general partners have unlimited liability and control
not widely used
Limited liability partnership
LLP
combines the tax advantages of a partnership with the limited liability advantage of a corporation
a flow-through entity for taxes
Limited liability company
LLC
combines the limited liability advantage of a corporation with the tax advantages of a partnership.
no double taxation but liability limited to investment
Corporation
A legal entity created under state laws, separate and distinct from its owners and managers
Major advantages of a corporation
- unlimited life (survives beyond the individual)
- easy transfer of ownership interest (stock, also ease of raising funds)
- is it’s own legal entity (leads to limited liability)
- limited liability
combine to improve ease of raising money and growing the company
Disadvantages of corporate form
- potential double taxation of corporate earnings distributed as dividends
- complexity and potential cost of setting up corporate structure
- regulations
- agency costs: potential conflict of interest between shareholders and managers
Corporate Charter
The legal document that is filed with the state to incorporate a company
includes:
- name of the proposed corporation
- types of activities it will pursue
- amount of capital stock
- number of directors & their names and addresses
Once approved corporation exists and the required quarterly and annual reports must be filed with the state/federal government
Corporate bylaws
A set of rules drawn up by the founders of the corporation to specify how it will be governed.
- how and when directors are elected
- rights of existing shareholders (first right to buy newly issued shares)
- procedures for changing the bylaws
Professional Corporation
PC
Has most of the benefits of incorporation (limited financial liability) but the participants are not relieved of professional (malpractice) liability
Professional Association
PA
Professionals have most of the benefits of incorporation but are not relieved of professional (malpractice) liability
S corporations
Can elect to be taxed as if the business were a proprietorship / partnership (flow-though entity) if corp meets certain size/ number of stockholder requirements
Closely held stock
Stock in a closely held company - not actively traded and is owned by only a few people (usually the company’s managers)
Closely held corporation
companies that are so small that their common stocks are not actively traded - rather owned by only a few people (only the company’s managers)
Prospectus
Summarizes information about a new security issue and the issuing company. Part of the S-1 registration statement filed with the SEC in order to trade stock on a public market
Listed stock
a company’s stock that an SEC-registered stock exchange accepts for listing after the company has registered with the SEC to have its stock traded publicly. A company can be listed on only one exchange, but can be traded on many
Investment bank
A firm that assists in the design of an issuing firm’s corporate securities and in the sale of new securities to investors in the primary market
brokerage firm
a company that employs registered brokers to buy and sell stocks on behalf of clients
broker
person or organization that registers with the SEC to buy and sell stocks on behalf of clients. Must follow state and industry licensing and registration requirements
oversubscribed
the demand for shares of a company at the offering price exceeds the number of shares issued. large institutional investors tend to be favored
seasoned equity offering
additional shares of stock by a public company after its initial public offering
Free cash flow
Cash flow actually available for distribution to a company’s investors (shareholders and creditors) after the company has made all investments in fixed assets and working capital necessary to sustain ongoing operations.
Net operating profit after taxes, minus investment in total net operating capital
Properties of cash flows that determine a company’s value
- size of expected future cash flows
- timing of expected future cash flows
- risk of cash flows (uncertainty )
Free cash flow equation
= sales revenues - operating costs - operating taxes - required investments in new operating capital
Weighted average cost of capital
Investors rate of return from a company’s point of view.
The weighted average of the after-tax component costs of capital -debt, preferred stock, and common equity. Each weighting factor is the proportion of that type of capital in the optimal (target) capital structure
Relationship between a firm’s value, it’s free cash flows, and it’s cost of capital
Value =( FCF 1 / (1+WACC ) 1) + (FCF 2 /(1 + WACC) 2 ) + (FCF 3/ (1+WACC)3) + onto to (FCF infinity/ (1+ WACC) infinity)
FCF = free cash flow
WACC = working average cost of capital
rate of return
compensation to cash providers for the timing and risk inherent on their claims in the future cash flows of a corporation
fundamental value
aka intrinsic value
value of company or financial security (such as a share of stock) that incorporates all relevant information regarding future cash flows and risk
should be the same as market price if investors have all relevant information
= present value of the firm’s expected free cash flows, discounted at the weighted average cost of capital
insiders for purposes of corporate finance
Officers, directors, and employees at a publicly traded company
Privately traded company: includes stockholders
Agency problem
Occurs when owners, managers, employees and creditors can act to benefit themselves at the expense of others (others being stockholders)
corporate governance
set of rules to control the company’s behaviors towards its directors, managers, employees, shareholders, creditors, customers, competitors and community.
supposed to prevent agency problems of insiders acting in own best interest instead of company’s
stakeholders
all parties that have an interest, financial or otherwise, in a company. includes employees and the communities in which the company does business
fiduciary duty of most U.S. corporations
Maximizing shareholder wealth (unless company charter states differently)
U.S. companies that fail in this duty can be sued by their stockholders
B-corp
Benefit corporation
a corporate form that expands directors fiduciary responsibilities to include other interests than the shareholders
required to report their progress in meeting the charters’ objective
business ethics
the tendency of a firm’s employees, from the top down, to adhere to laws and regulations as well as basic ethics (which i’ve never seen a capitalist firm do)
SOX protector for whistleblowers
employees who report corporate financial wrongdoing and are subsequently penalized by the company can ask for an OSHA investigation. If OSHA finds the employee was improperly penalized the company can be required to reinstate the person along with back pay and a sizable penalty award.
SEC Office of the Whistleblower
Established by Dodd-Frank act. Awards for whistleblowers based on SEC fines on the wrongdoing corp.
providers and users of cash
individuals
financial organizations (banks and insurance companies)
nonfinancial organizations
governments
aggregate net providers
Individuals
aggregate net users
(borrowers)
Nonfinancial corporations
Governments (US at least)
financial corporations (only by a small margin)
capital
Cash users receive from providers
How transfers of capital occur (providers to users)
- direct transfer of money and securities (stock, debt)
- through an investment bank
- through a financial intermediary
Direct transfer capital allocation
Users of capital sells securities directly to providers of capital
capital allocation via investment bank
investment bank underwrites the issue of securities - serves as middleman and facilitates issuance
User of capital sells stock or bonds to investment bank
investment bank sells stock or bonds to providers of capital
“Primary” market transaction
Primary market transaction
in which new securities are involved and a corporation receives the proceeds of their sale
Allocation of capital via financial intermediary
Financial intermediary (bank, mutual fund) obtains funds from providers of capital in exchange for its own securities or ownership of savings account
intermediary then uses this capital to purchase securities from the users of capital
Creation of new types of securities by intermediaries
Features of the capital allocation process
- Financial securities are created
- different types of financial institutions act as intermediaries between providers and users of financial capital
- these activities occur in a variety of financial markets
Financial instrument
Any claim on a future cash flow
Financial security
a claim on future cash flows that is standardized and regulated by the government
(Documents with contractual provisions that entitle their owners to specific rights and claims on specific cash flows or values)
generally classified by type of claim (debt vs equity) and the time until maturity
Financial Securities: Debt instruments
typically have specified payments and a specified maturity
Capital market security
debt security that matures in more than a year
money market security
debt security that matures in less than a year
Financial Securities: Equity instruments
Claims upon a residual value
no maturity date = capital market security
Prime rate (of return)
The rate U.S. Banks charge to their most creditworthy customers
LIBOR
London Interbank Offered Rate
the rate that UK banks report for loans made to other UK banks
authority regulating plans to cease regulation (current plan June 2023)
Secured Overnight Financing Rates
SOFR
based on actual overnight loans between banks that use treasury securities as collateral
Major types of financial instruments
- U.S. Treasury bills (sold by U.S. Treasury, default free)
- commercial paper (issued by financially secured firms to large investors, low default risk)
- money market mutual funds (invested in short-term debt, held by individuals and businesses, low degree of risk)
- commercial loans (loans by banks to corporations, risk depends on borrower)
- U.S. Treasury notes and bonds (issued by US Gov, no default risk but price falls if interest rates rise)
- Mortgages (loans secured by property, variable risk)
- Municipal bonds (issued by state and local governments to individuals and institutions, riskier than gov bonds but mostly tax exempt)
- Corporate bonds (issued by corps to individuals and institutions, risk depends on issuer)
- Preferred stocks (issued by corporations to individuals and institutions, riskier than corporate bonds)
- Common stock (issued by corporations to individuals and institutions, riskier than preferred stocks, return = dividends and capital gains )
Derivatives
Securities whose values depend on (are derived from) the value of some other traded assets
include options and futures contracts
claims on other financial securities
hybrid securities
securities that are a mix of debt, equity, and derivatives
Securitization
the process whereby financial instruments that were previously thinly traded are converted to a form that creates greater liquidity. ex; junk bonds
also applies to the situation where specific assets are pledged as collateral for securities (creates asset-backed securities) ex: mortgage-backed securities
process of securitization (for loans)
- individual signs loan contract
- bank pools a large number of individual loan contracts into a portfolio and transfers pool to a trust (separate legal entity)
- trust creates new financial instruments that pay out a prescribed set of cash flows on the pool, registers the securities and sells them
Bank receives: proceeds from the sale (cash received more quickly), also transfers risks to purchasers
Purchasers receive: claim on cash flow generated by pool of loans
Required rate of return
The rate of return that fairly compensates an investor for purchasing or holding a particular investment after considering it’s risk, timing, and the returns available on other similar investments. (promise more money in the future for giving up some money today)
investor’s rate of return = user’s cost of capital aka “cost of money” or “price of moeny”
interest rate
Rate of return on debt instruments aka the price of financing with debt
Cost of equity
The price of using equity capital (investors rate of return on equity investments)
made up of dividends and capital gains
Fundamental factors that affect required rate of return (aka cost of money)
- production opportunities
- time preferences for consumption
- risk
- inflation
Production opportunities
Activities that require cash now but have the potential to generate cash in the future (prospect of future cash flows)
size and likelihood of future cash flow puts an upper limit on the amount that can be repaid
Time preference for consumption
Providers choice to use current funds for consumption or saving (consumption later –> expect to consume more in the future)
if preference is for consumption now then higher rate of return required for investment
Risk and required rate of return
If future cash flows are very uncertain providers will require a higher expected return to induce them to risk their capital
real rate of return
r sub r
the rate of return on investment after inflation is removed
(real increase in purchasing power)
Nominal rate of return
stated rate of return/ rate of return without considering inflation
affect of expected inflation on nominal rate of return
if inflation increases nominal interest rate must increase to maintain real interest rate
Economic conditions and policies that affect required rate of return (cost of money)
- federal reserve policy
- federal budget deficit or surplus
- level of business activity
- international factors
How federal reserve policy affects cost of money
Fed purchases Treasury securities held by banks: increases banks funds and lowers interest rates. demand for treasury securities increases, prices go up, and interest rates go down.
Net reduction in interest rate supposedly stimulates the economy (also leads to long-term increase in expected inflation and an eventual interest rate increase)
Fed sells securities to banks: reduces banking reserves, increases short term interest-rates and decreases long-term inflationary pressures
How federal budget deficits or surpluses affect the cost of money
Deficit = government must borrow more money (increases supply of treasury securities –> lower prices –> higher interest rates) or print more money (increases money supply –> increase expectation of future inflation –> increased interest rates)
larger deficits = higher interest rates
interest rates and recessions
interest rates and inflation typically rise prior to a recession and fall afterward
- consumer demand slows during recession, fewer price increases, reduces price inflation
- hiring cut-backs, reduces wage inflation
- reduced consumer AND corporate demand for loans
puts downward pressure on inflation and interest rates (+ fed tries to stimulate economy by driving down interest rates)
Foreign trade balance
levels of imports relative to exports
Deficit: US imports more goods than exports
Surplus: US exports more goods than imports
How foreign trade balance affects the cost of money
Trade deficits must be financed and are usually financed by debt
increased borrowing –> increased interest rates
also if US debt is riskier than foreign then investors require higher rates in order to hold it. so if Fed lowers the rates below rates abroad international investors sell off US bonds, depressing bond prices and increasing interest rates
large trade deficit hinders the fed’s ability to reduce interest rates (US rates are influenced by international rates)
factors influencing foreign interest rates
international changes in tax rates
regulations
currency conversion laws
currency exchange rates
Role of investment banks
- help companies raise capital
- underwrite security offerings
- often provide brokerage services for institutions and individuals
- advise corporations regarding the design and pricing of new securities
- buy securities from the issuing corporation
- resell above securities to investors`
Primary market transaction (banker as intermediary)
- bank buys securities from corp.
- bank sells sells securities to investors
Leveraged
Using debt to pay for investments.
makes money as long as investments pay at higher rate than owed on debt
Deposit-taking financial intermediaries
Take deposits from savers and lend most of the deposit to borrowers
- savings and loan associations (S&Ls)
- credit unions
- ## commercial banks
Savings and Loan associations
Accept deposits from many small savers and lend the money to home buyers and consumers
(Mutual savings banks are similar)
today have mostly been acquired by banks
credit unions
Cooperative associations that take deposits from members and then make loans only to other members. (usually individuals)
members tend to be linked by a similar attribute
often cheapest source of funds for individual borrowers
Commercial banks
A financial intermediary whose primary purpose is to take deposits and make loans to businesses and individuals
Raise funds from depositors AND by issuing stocks and bonds to investors
generally highly leveraged (owe more to depositors and creditors than to stockholders)
highly regulated due to higher risk than nonfincial firms
Equity capital
= assets - liabilities
FDIC bank insurance
up to $250,000 per depositor
exists to avoid bank runs where depositors all withdraw funds at once (great depression)
Investment funds
funds where savers have an ownership interest in a pool of funds
Mutual Funds
A corporation that sells shares in the fund and uses the proceeds to buy stocks, long-term bonds, or short-term debt instruments. The resulting dividends, interest, and capital gains are distributed to the fund’s shareholders after the deduction of operating expenses.
some funds specialize in certain types of securities, different funds designed to meet the objectives and risk tolerance of different savers
mostly belong to a larger company’s family of funds (economies of scale)
traditionally only allow investors to redeem their share of the fund only at close of business
Passively managed funds
mutual fund that holds a group of stocks in a particular category and minimizes expenses by rarely trading
Index funds
passively managed fund designed to replicate the returns on a particular market index (S&P 500)
Actively managed funds
mutual funds with higher fees than passively managed funds - seeks to invest in undervalued securities within a particular category, such as growth stocks
Money market funds
a mutual fund that invests in short-term debt instruments and offers investors check-writing privileges. (essentially an interest bearing checking account)
not required to be insured, so are riskier than bank deposits
Exchange-traded fund
special type of mutual fund that allows investors to sell their shares at any time during normal trading hours
usually have very low management expenses
Hedge fund
private limited partnership whose purpose is to raise money from investors and engage in a variety of investment activities
limited to institutional investors and a small number of high-net-worth individuals
less regulated than mutual funds
some “hedge” more than others
hedging (re “hedge funds”)
to hedge bets by forming portfolios of conventional securities and derivatives in such a way to limit potential losses without sacrificing too much potential gain
(some do more than others. others hedge less, take more risk for more potential reward)
Private equity funds
(PE)
funds that own stock (equity) in other companies and often control those companies. will purchase a large portion or even all of a company
“private equity” because stock is not traded in public markets after it is bought out
generally have their partners sit on the company’s board and guide their strategy with a goal of later selling the company for profit (often via IPO)
like hedge funds, often belong to a larger company’s family of funds
Life insurance companies
Take premium paid and invest them in securities, real estate, and mortgages to make payments to beneficiaries (may also offer tax-deferred savings plans)
Pension funds
invest primarily in bonds, stocks, mortgages, hedge funds, private equity, and real estate
plan administrator determines how to invest the funds (vs 401k where individual directs investment and bears all the risk)
Glass- Steagall act
passed in 1933 by congress with the intent of preventing another great depression. fully repealed in 1999
- created FDIC to insure bank deposits
- imposed constraints on banking activities
- separated investment-banking from commercial banking
repeal allowed for creation of financial services corporations that own many different financial companies
physical asset markets
“tangible” or “real” asset markets
market for tangible assets
Financial asset markets
trade financial instruments (stocks, bonds, notes, mortgages, derivatives, etc…)
spot markets
markets where assets are being bought or sold for “on-the-spot” delivery (within a few days)
Futures markets
markets for assets whose delivery is at some future date
money markets
markets for short-term, highly liquid debt securities
capital markets
markets for corporate stocks and debt maturing more than a year in the future (New York stock exchange)
Debt market time periods
Short term = < 1 year
Intermediate term = 1-5 years
long term = > 5 years
Mortgage markets
for loans on residential, agricultural, commercial, and industrial real estate
consumer credit markets
lending for consumer use (cars, appliances, education etc..)
Private markets
markets in which transactions are worked out directly between two parties and structured in any manner that appeals to them (bank loans)
Transactions called “Private placements”
private placements
the sale of stock to only one or a few investors, usually institutional investors. Advantages : lower flotation costs, greater speed (shares issued not subject to SEC registration)
public markets
where standardized contracts are traded on organized exchanges. public securities tend to be more liquid than private
Primary markets
markets in which newly issued securities are sold for the first time - IPOs or original sale of bonds
proceeds from transaction go to company selling security
Secondary markets
markets in which existing, already outstanding securities are traded among investors. (cost of security paid to previous investor)
company’s whose securities are being traded in a secondary market are not involved in the transaction
importance of secondary markets
- liquidity for investors who need cash want to change investments
- foster entrepreneurship (entrepreneur can sell personal shares of company stock for faster cash rather than waiting on company cash flow)
- value to buyers and sellers in ease of comparing different investments
Trading venue
a site (geographical or electronic) where secondary market trading occurs
classified on dimensions of location (physical vs electronic) and the method of matching orders
computer/ telephone [trading] network
operates over phone or computer. may or may not automatically execute trades (NASDAQ)
ways orders are matched
- open outcry auctions
- dealer markets
- automated trading platforms
Open outcry auction
a method of matching buyers and sellers in which the buyers and sellers stand face-t-face all stating a price at which they will buy or sell. (may be verbal or hand signals)
upon agreement transaction is reported to org managing the auction
Dealer Market
Market where a dealer holds an inventory of a security and makes a market by offering to buy or sell. others who wish to buy or sell can see the offers made by the dealers and can contact the dealer to arrange a transaction
dealer = market maker
bid quotes and ask quotes - prices at which they are willing to buy and sell
Automated matching engine
part of a computer system in which buyers and sellers post orders and let the computer automatically match and execute trades (computer determines if match exists)
Automated trading system
Computer system in which buyers and sellers post orders. trades are automatically executed by the computer for matching orders
bid price
amount buyer bids to pay
limit order
buyer specifies limits of order’s price and duration
order book
a trading venue’s record of all limit orders still in effect
highest bid ranked at top so first sellers get the highest bid
lowest ask ranked at top so buyers get lowest price
updated each time a new order arrives or a limit order expires
ask price
price seller is asking for share
lowest ask price will be at the top of the order book
bid-ask spread
The difference between the ask price and the bid price
market order
order asking the broker to trade at the current market price
major stock exchanges
NYSE (new york stock exchange)
NASDAQ (NASDAQ stock market)
NYSE MKT (formerly American Stock Exchange)
each stock can only be on one exhange
(about a dozen total exchanges, the rest much smaller)
reason for decrease in number of companies listed on an exchange
- mergers and acquisitions
- increasing availability of funds to private companies
consolidated tape system
a computer network that collects all exchange-listed stock transactions (price and volume)
Market price
most recent trade price for stock
Regulation National Market System
Reg NMS
a set of rules designed by the SEC to protect investors and foster competition among exchanges and other trading venues.
requires all stock exchanges to report their best (highest) bid price and best (lowest) ask price for each stock in their order books
computer identifies and reports overall best bid and best ask
Includes order protection rule, intended to prevent an investor from buying or selling stock on one exchange when a better price is available on another exchange
National Best Bid and Offer
NBBO
overall best (highest) bid price and best (lowest) ask price from all collected exchanges
best available price at which an investor could buy or sell
reflects market conditions but may not be representative of actual supply and demand quantities
Order protection rule
a Reg NMS rule
requires trading venues to execute any market order (order to buy and sell at market price) at a price that is at least as good as the NBBO quotes
however quote may only apply for a certain number of shares and may change after that number
types of trading venues
different levels of SEC regulations and reporting requirements
- standard broker-dealer networks
- alternative trading systems
- registered stock exchanges
order routing
when a broker determines where to send a trade order from an investor
Broker-dealer
a broker that is also registered so that it can but and sell for itself when it acts as a market maker
may be individuals, companies, subsidiaries of larger companies
tend to hold stock for short periods, profit of buying and selling is compensation
Off- exchange transaction
the purchase or sale of a stock or other security that is not executed through a registered exchange (aka “over-the-counter” trade)
when broker-dealers execute trades among themselves
broker-dealer network
a network in which a broker-dealer makes a market, usually bypassing stock exchanges. The broker-dealer can trade for its clients or itself.
less regulated than stock exchanges: must report transactions (price and quantity) but not required to report information about limit orders not yet filed
Process of broker-dealer network trades
- investor gives broker-dealer an order
- broker-dealer attempts to fill order in-house (with another client)
- if no in-house match, may act as a dealer and fill order from own inventory. or may send to a “wholesale” broker-dealer who will combine many orders and look for a match
price improvement
occurs when a broker’s client gets a better deal than the posted NBBO quotes would indicate
(space between lowest ask and highest bid allows for broker to make a profit)
Internalization
a pair of trades in which a broker-dealer is the counterparty for both clients - the broker-dealer buys from one client and sells to the other
retail trading
trading by individual investors
Block trade
quantities of at least 10,000 shares
can imbalance supply and demand and make price fall so institution may place many small orders to sell instead of one single large order. OR enlist a broker-dealer to locate a large counterpart (“upstairs” trade)
Alternative trading system
ATS
system where buyers can trade directly with sellers
a type of trading venue that can be registered with the SEC but that does not have as stringent requirements as a registered stock exchange
tend to run on subscription fees due to infrastructure cost for automated matching engine
dark pools
common name for alternative trading systems because they do not have to report pre-trade quotes
still have to comply with order protection rule and report COMPLETED transactions to consolidated tape system
Registered stock exchange
a trading venue that is registered as a stock exchange with the SEC. must display quotes as well as report transactions
Required by SEC to “operate in a way that promotes orderly trading and fair dissemination of information”
now most trading done via automated trading platforms
investors
purchase stock with intent of owning it until it is no longer a good investment or they need cash for another purpose
High-frequency trading
HFT
occurs when a trader buys (or sells) stock and immediately sells (or buys) it, usually within milliseconds. Do not provide any infrastructure or other direct services for other buyers and sellers
requires expensive computer systems so mostly done by firms created for the purpose - they pay the exchanges to let them place computers close to exchange computers so that they receive data first
front running
when a HFT sends an order that, due to speed of connection, gets in front of a broker order they expect to occur because they noticed it at another exchange. can then profit from the broker order
impact of HFT on financial markets
- total dollar volume of trading grown = more potential liquidity (not if HFT slows when markets fall)
- average bid-ask spread shrunk to pennies (reduces costs to investors/ profits to dealers)
- potential destabilization of the stockmarket
- some HFT revenues (front running) are direct costs to investors
S&P 500 index
a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S.
supposedly a gauge of stock market performance
mortgage market securitization
- buyer gets signs mortgage papers to get money from an originator to purchase a house
- originator sells mortgage to a securitizing firm
- securitizing firm bundles mortgages into pools to sell claims on the pools cash flow (slices of pool called tranches)
- some tranches recombined and subdivided into Collateralized Debt Obligations (and some further subdivided into CDOs squared) may be rated by risk but doesn’t change TOTAL risk inherent in mortgages - spread a little bit of each mortgage risk to many different investors, hard to determine the aggregate risk
sub-prime mortgages
riskier mortgages that prior to the mid 1990s would not have qualified to be securitized
deregulation supposedly to make home ownership more available to lower income people
riskier mortgages being securitized and sold to investors
How the fed fueled the sub-prime mortgage crisis
- Fed took interest rates low post 9/11
- this made mortgages seem more affordable
- housing prices skyrocketed
Adjustable rate mortgage
ARM
interest based on a short term rate (which, early in the 2000s was very low) + a couple percentage points
increase in market interest rates cause increase in mortgage monthly patments
Option Adjustable rate mortgage
borrower has options to make payments in first years that don’t even cover interest. Payments later reset to current market rate (with higher loan balance)
even riskier than ARM
mortgage broker vs S&L
S&L/ banks held mortgage for the entire life of the mortgage –> gave reason for them to be careful to verify credit
Mortgage broker receives commission, doesn’t care if borrower can make payment
real estate appraisers and the sub-prime crisis
assumed housing prices would keep going up so appraised homes at unreasonably high prices (broker had to have appraisal showing house value > loan amount)
paid for services, not for accuracy
Credit default swap
CDS
Derivative in which a counterparty pays if a specified debt instrument goes into default (like insurance on a bond)
makes mortgage-backed securities more attractive
were sold (bet the CDO wouldn’t default) or purchased (bet that the CDO will default)
unregulated market so could not know actual values
Reasons for sub-prime mortgage crisis
regulations relaxed allowing for sub-prime mortgages to be securtized
Fed lowered interest rates after 9/11 making Adjustable rate mortgages appealing
potential lack of understanding of ARM structure/ predatory lending/ belief that home prices would rise
Mortgage brokers & real estate appraisers paid by fee, not incentivized to be careful
Originators and securitizing firms had incentive to generate volumes of securities rather than quality securities since they sold them off before mortgages defaulted
Conflict of interest with rating agencies also consulting on designing securities
Credit default swap insurance being sold as speculative investment. no regulations existed to know if counterparties could fulfill obligations
Experts assumed high growth rates for real estate prices would continue, causing high CDO prices
Investors buying low rated debt and ignoring risk
as borrowers defaulted on mortgages, CDOs defaulted on payments and bankrupt counterparties that had insured them
housing prices fell (houses worth less than loans)
market for securitized mortgages died owner’s stuck with useless paper
why sub-prime bubble bursting spread throughout economy
securitization allocates sub-prime risks to many investors/ institutions
banks more vulnerable after deregulation (commercial and investment banks in same institution, investment banks being massively leveraged)
massive losses to financial institutions from mortgage defaults and credit default swap positions led to defaults on other instruments
concerned with basic survival banks stopped proving credit/ began calling in loans reducing money in the economy and leading to job cuts
Trouble asset relief plan
TARP (2008)
authorized US Treasury to purchase mortgage related assets from financial institutions
originally intended for financial institutions but subsequently modified for non-financial as well
Emergency Economic Stabilization Act of 2008
Allowed the treasury to purchase preferred stock in banks (whether bank wanted the investment or not) to inject cash into the system
originally intended for financial institutions but subsequently modified for non-financial as well
American Recovery and reinvestment act of 2008
$700 billion in direct stimulus spending for federal projects and aid for state projects
Government measures to address sub-prime meltdown
- TARP
- EESA
- American Recovery and Reinvestment Act of 2009
- temporary social security tax cut
- quantitative easing via Fed Reserve purchase of long-term t-bonds from financial institutions
Quantitative easing
a form of monetary policy in which a central bank (like the federal reserve) increases the money supply in the banking system (as by purchasing bonds from banks)
purchases securities on the open market to reduce interest rates and increase money supply
Dodd-Frank wall street reform and consumer protection act
passed in 2010 to prevent future financial crises leading to recession
- consumer financial protection bureau
- Volcker rule to limit a bank’s proprietary trading (limitations on making leveraged bets on risky assets)
- increase transparency and reduce risk from derivatives trading (oversight of hedge funds and credit-rating agencies) standardized swaps to be traded in public markets
- regulation of too-big-to fail institutions
Consumer financial protection bureau
objective to:
- try and help borrowers more fully understand terms and risks of mortgage contracts
- ensure that mortgage originators verify the borrower’s ability to repay and maintain an interest in the borrowers
- watch over other potential predatory lending practices
Regulation of swaps
- swaps standardized and made by either a designated contract market or a swap execution facility (automated), information provided about the trades for greater transparency
- all swap transactions to registered derivatives clearing organization (DCO), clears transaction by agreeing to ensure payments if one of the swap party defaults (requires collateral from the parties) and is regulated and monitored
Dodd-frank oversight of financial institutions
- too-big-to-fail institutions including all banks with 50billion + in assets and other institutions deemed systemically important
- can require additional capital or reductions in leverage
- institutions must prepare plans that would make it easier for regulators to liquidate the institution should it fail
