GS5 Flashcards
Understanding the role of debt in the financial system.
What are the similarities between a pawn shop and repo market?
Agreement where a seller agrees to buy it back from a buyer (investor) at a higher price on a specified date. No need for price discovery.
Understanding the role of debt in the financial system.
What should the information be in the money markets?
SYMMETRIC. Not necessary transparent - better if opaque.
Understanding the role of debt in the financial system.
Why is debt an optimal contract?
Because it avoids
1) a precise assessment of the collateral value at the time of signing the contract (just need to know that is is way above face value);
2) the cost of price discovery whenever debt is paid in full.
Understanding the role of debt in the financial system.
In what aspects debt is information-insensitive?
1) Debt is information-insensitive to private information if
it is deep in the money.
2) Debt is a contract which is most resilient to information acquisition.
3) The value of debt is least sensitive to public information -> debt is the best collateral
Understanding the role of debt in the financial system.
When does information-insensitivity increase?
When a) collateral is less risky b) duration of debt is reduced c) FV of debt Is reduced d) more collateral is added.
Understanding the role of debt in the financial system.
Name some examples of avoiding transparency in practice.
1) In car auctions buyers are allowed to inspect cars only externally -> increased speed of the actions and
reduced adverse selection (the value of cars is more or less the same across buyers).
2) Money market mutual funds report the Net Asset Value (NAV) only quarterly and with a 1-month lag à
opacity gives MMMFs time to adjust to fluctuations in daily NAV and prevent investors from running.
3) Coarse bond ratings promote “commonality of beliefs” -> reduced adverse selection.
4) Money is very opaque about the underlying collateral because no one knows exactly what backs up
government issued money -> all the market participants are “symmetrically ignorant”
5) During bubbles no one is likely to have private information about when prices will collapse -> symmetric ignorance can make them a safe place to park money, at least for a short period of time.
Understanding the role of debt in the financial system.
How panics are created and what are the consequences?
Panics happen when information-insensitive debt becomes information-sensitive.
Investors begin to ask questions about the underlying
collateral.
Private information becomes relevant and shatters the shared understanding and beliefs.
Understanding the role of debt in the financial system.
What drove the demand for new products and the growth of shadow banking?
1) The global savings accumulation
2) The US had sophisticated securitization technology that could activate and make better use of collateral
3) The US had a large pool of assets
Understanding the role of debt in the financial system.
What are the solutions for getting out of the crisis?
1) A crisis ends when confidence returns → back to the “no questions asked” state (Recapitalization of the banking system, “we will do whatever it takes” - lack of specific info)
2) Higher capital requirements and regular stress tests
The safe assets shortage conundrum.
Safe assets’ characteristics?
- Safe assets can be transacted without concern for adverse selection (information insensitivity)
- Safe assets have special value during economic crises (“simple” asset)
- Asset is safe if others expect it to be safe (strategic complementarity)
The safe assets shortage conundrum.
What are the aspects that determine a country’s capacity to produce safe assets?
- the level of financial development
- constraints in the financial system
- fiscal capacity of the sovereign (ability to payout bond)
- exchange rate and price stability
The safe assets shortage conundrum.
What is the reason for the shortage?
The collective growth rate of advanced economies < the world’s growth rate
The safe assets shortage conundrum.
Describe the modern version of the paradox of thrift.
With real safe rates unable to decrease further to
clear markets, demand for safe assets remained too
elevated and the economy had to slow down and
operate below its potential.
The safe assets shortage conundrum.
How a safety trap differ from a liquidity trap?
1) exit from a safety trap requires an increase in the supply of, or a reduction in the demand for,
safe assets, regardless of the demand and supply of other assets
2) very persistent or even permanent despite the presence of long-lived assets
The safe assets shortage conundrum.
What are the solutions to restore equilibrium?
1) Exchange rate appreciation of the currencies in which safe assets are denominated;
2) Issuance of public debt.
Depends on two factors:
i) the fiscal capacity of the government to borrow (& ability to commit to raising future taxes)
ii) the risk that increased provision of public safe assets may crowd out provision of private-sector safe
assets (raising taxes may reduce private sector’s capacity to issue safe assets).
2*) Pooling and trenching infrastructure investment among quasi-safe countries;
3) Production of private safe assets;
4) Reducing the (Net) Demand for Safe Assets.
The safe assets shortage conundrum.
How can banks solve the problem of holding safe assets for exchange rate stability?
Could be partially replaced by more powerful global risk-sharing arrangements (swap lines, credit facilities backed by IMF or the World Bank, and reserve sharing agreements).
The economics of structured finance.
What were the reasons for the expansion of structured finance in 2000s?
1) CDOs offered attractive yields (despite being AAA-rated) in the period of low interest rates
2) CDOs were rated using the same scales as bonds (easy to compare)
3) Strong economic growth and few defaults
4) Minimum capital requirement
The economics of structured finance.
What are the 3 parts of manufacturing?
- Pooling
- Tranching
- Overcollateralization (the degree of protection offered by the junior claims)
The economics of structured finance.
What is a key factor determining the ability to create tranches that are safer than the underlying
collateral?
The extent to which !defaults are correlated! across the underlying assets
The economics of structured finance.
What are the problematic features of CDOs?
- Structure amplifies errors (default probabilities and correlations)
- Largely diversifiable risks were substituted for highly systematic risks.
- Do not offer large enough of a yield spread to compensate for the actual systematic risks they bear.
The economics of structured finance.
Why valuation models of CDOs were biased?
1) overlap in geographic locations (actual correlations between mortgages were higher)
2) errors in assumptions about default probabilities and recovery values (fire sales drove down the asset values)
3) valuation based on wrong or not fully correct assumptions (constantly rising housing prices)
4) pricing of systematic risks in the same way as diversifiable ones
The economics of structured finance.
Who is to blame for the fall of the market?
- Credit rating agencies
- Investors (outsource due diligence; fFueling the growth of CDO market even understanding that it would end)
- Regulation (tied bank requirements to credit ratings)
Credit default swaps and the credit crisis.
What are the two main differences from insurance contract?
1) you do not have to hold the bonds to buy a credit default swap on that bond (the amount
you insure is then called the notional amount)
2) insurance contracts (mostly) are not traded - credit default swap contracts do trade over the counter
Credit default swaps and the credit crisis.
Benefits of CDS?
- increases transparency in the pricing of
credit (improved price discovery ); - reduced the cost of capital for firms;
- CDS market is often more liquid than bonds market;
- Alternative to short selling.
Credit default swaps and the credit crisis.
Drawbacks of CDS?
- Less incentives in loan monitoring
- Perverse incentives of investors
- Investors take riskier positions
- Lower regulatory capital requirements in case of
protection by CDS - Web exposure
- short positions destabilize the market
Credit default swaps and the credit crisis.
How use of clearinghouses for OTC trading could decrease risks?
1) A clearinghouse can diversify and manage risks associated with the failure of individual investors→ counterparty risk reduced
2) If a single clearing house is used, it can net out all the dealer’s exposure → counterparty exposure reduced
3) A clearinghouse can monitor the exposure of counterparties and prevents them from taking additional exposures
Credit default swaps and the credit crisis.
2 reasons that drove the crisis…
1) Investors and financial institutions did not expect such a dramatic fall in real estate prices
- > large falls and in the value of mortgages-backed securities
2) Many financial institutions were operating with extremely high levels of leverage in investing in subprime securitizations → losses on these investments made market participants insolvent
Larger CDS market might have benefited the financial system if it was even larger (and more robust)→ more useful information about the development of the market
Exchange-traded funds 101 for economists.
How does ETF work?
• Does not interact with capital markets directly
• ETF manager is in a legal contract with “Authorized
Participants” – typically large financial institutions who
interact with the market
Investors mostly do not trade the fund directly. Instead,
they trade on an exchange or with Authorized Participants -> no transactions in the underlying securities -> reduced transaction costs
Trades occur at a market-determined price (Mutual fund - net asset value)
Exchange-traded funds 101 for economists.
What are the potential issues for ETFs?
1) Investors may have poor financial knowledge to distinguish between the types of ETFs (e.g. levered funds, or based on unsecured debt)
2) Intraday liquidity can cause “too much” trading. Investors who trade actively suffer lower returns than those who trade less.
3) Rapid growth in index investing poses challenges for ordinary investors.
Exchange-traded funds 101 for economists.
Types of ETFs?
- Equity ETFs (Market cap based ETFs, Sector ETFs, Smart Beta ETFs);
- Fixed income ETFs;
- Commodity ETFs.
Exchange-traded funds 101 for economists.
What are the reasons for the recent growth in bond ETFs?
1) Bond ETFs are traded on electronic exchanges –
convenient (unlike opaque OTC markets for
traditional bonds)
2) Offer higher transparency - bid/ask quotes are readily available
3) Offer greater liquidity and diversification
Exchange-traded funds 101 for economists.
What are the main concerns and misconceptions about ETFs?
1) Closures of exchange-traded funds (the price should converge to its NAV - if debt obligations are secured)
2) Short selling of ETFs (number of simultaneous redemptions would exceed available assets to be redeemed)
3) Liquidity mismatch (ability of Authorized Participants (APs) to acquire the underlying assets and transfer
them to the ETF. The chance that an AP steps away in a crisis may pose systematic risk).
Exchange-traded funds 101 for economists.
What is the impact of ETFs on underlying markets?
• Index trackers are typically based on market capitalization weighted schemes ->
pricing errors in underlying stocks might feed on themselves
• Index funds are price-takers, not price-makers
• The impact of a “basket” security on liquidity and distortion of prices of the underlying market is unclear
• Relative scale of index investing is fastly growing
Is the US public corporation in trouble?
What are three main reasons for a public firm to delist?
1) it no longer meets the listing requirements, which is typically due to financial distress
2) it has been acquired (There is evidence that mergers are the dominant reason for delisting)
3) it voluntarily delists
Is the US public corporation in trouble?
What are the trends for The Number and Age of Public Firms ?
1) The number of listed firms is decreasing;
2) Public firms are more old than private
Is the US public corporation in trouble?
Trend for Valuation and Concentration of Public Firms…
1) firms have become larger (increase by 290% in the 18 years since 1997);
2) concentration within industries can increase, which could possibly adversely affect competition. Herfindahl Index: industries are on average much more concentrated now than 20 years ago, but less than 40 years ago
Is the US public corporation in trouble?
What is the trend for Investment?
1) The increase in the importance of intangible assets: listed firms have a much lower average ratio
of capital expenditures to assets and a much higher ratio of R&D expenditures to assets in 2015.
2) Inventory holdings fall due to the introduction of just-in-time production processes.
3) Hold more cash – especially firms with more intangible assets and more R&D expenditures.
Is the US public corporation in trouble?
What is the trend for Profitability?
- Larger firms have a higher ratio of cash flow to assets à
firms have been performing poorly on average, except for the largest firms. - A dramatic increase in the concentration of the profits and assets of US firms - top 30 firms earn 50% of the total earnings of the US public firms.
Is the US public corporation in trouble?
How Capital is Provided and Rewarded?
1) leverage falls dramatically
2) asset weighted book leverage ratio rises but drops sharply after the financial crisis
3) “net leverage ratio” (debt minus cash over total assets) - falls steadily and in almost all
years since 2003, !the average public firm has more cash than debt!
- bank loans have become less important.
Is the US public corporation in trouble?
What is the trend for Ownership ?
Institutional ownership of common stock is much higher now.
Is the US public corporation in trouble?
What are the results/implications?
Fraction of small public firms has dropped dramatically. May be due to:
1) firms don’t want to disclose their projects
2) public markets have become dominated by institutional investors (small firms don’t have enough scale)
3) developments in financial intermediation and regulatory changes have made it easier to raise funds as a private firm (from PE and VCs)
4) economies of scope hypothesis: small firms have become less able to grow on their own
5) increased concentration could also make it harder for small firms to succeed on their own
6) difficult for small firms to grow without acquiring patents
7) it has become easier to put a new product on the market without hard assets -> Via renting & outsourcing, capex is smaller -> no need to go public & raise large amounts
