Lecture 3 - Secured/Unsecured Debts, Bankruptcy, Derivatives and Financial Crises

Question 1

What is limited liability?

Answer 1

Separates the assets of a company from the assets of its owners and managers.

Prevents creditors of the company from reaching the personal assets of the company’s owners

Question 2

What is the Insurance Model Equilibrium?

Answer 2

Marginal Benefit of Insurance (Demand) = Marginal Cost of Insurance

Question 3

5 ways to get out of contracts:

Answer 3

1. Agree to Terminate (Shareholder “walks away” from a company by selling their shares)
2. Renegotiate (Chapter 11)
3. Reorganize (Chapter 11)
4. Bankruptcy (Asserting limited liability against claimants)
5. Breach of Contract

Question 4

What is the right of lenders that common law recognizes?

Answer 4

They are able to “contract” their own remedies in the agreement that accompanied the loan.

Provides a legal title to the firm’s assets to be transferred to the lender for the duration of the loan.

Question 5

The probability and cost of potential bankruptcy…

Answer 5

adversely effects the value of the firm

Question 6

What do competing creditors do in a economy within a relatively costly bankruptcy procedure?

Answer 6

They might seize assets critical to the corporation’s operation and worsen an already suboptimal situation

Question 7

The overall drawback of bankruptcy

Answer 7

Bankruptcy kill the business (finality)

Question 8

What is Chapter 11 (U.S.) / Corporation Creditors Arrangement Act (Canada)?

Answer 8

Allows corporations to freeze creditor action while reorganization

Lenders are treated as “Secured Lenders” with the highest priority over other creditors

Question 9

What two procedures occurs in the right to seize collateral?

Answer 9

1. Liquidation
2. Corporate Reorganization

Question 10

What are S&L companies?

Answer 10

A saving and loan company (“S&L” or “thrift”) is a small company that accepts savings deposits and makes mortgage, car and other personal loans to individuals.

Question 11

What caused the S&L Crisis?

Answer 11

1. Interest rate mismatch
2. Availability of derivative financing causing moral hazard among loan officers
3. Availability of bank deposit insurance
4. Intense competition among rival S&L firms for market share
5. Deregulation and “after the fact” bailouts

Question 12

What is leveraged buy outs?

Answer 12

Acquiring firms took on more debt at the risk of selling downgraded for bonds known as junk bonds)

Question 13

When did the S&L Crises occur?

Answer 13

The failure of approximately one third of S&Ls in the U.S. occurred from 1986 to 1995.

Question 14

What is control fraud?

Answer 14

The CEO of a company is uniquely placed to remove the checks and balances on fraud within a company through selective hiring and firing.

Also positions the executive in a way to engage in accountancy fraud and embezzle money, hide shortfalls or otherwise defraud investors, shareholders, or the public at large.

Question 15

What fuelled the mortgage-back securitization in the late 1970’s?

Answer 15

1. The demand by baby boomers for home ownership
2. High inflation and interest rates that triggered the flight of deposits out of the S&L thrifts

Question 16

What did the mortgage-back security allow?

Answer 16

Allowed Wall Street to collect mortgages, bundle them by the thousands, and resell the bundle in pieces to investors.

Question 17

What are Credit Default Swaps (CDS)?

Answer 17

An insurance policy against the possibility of default.

An “insurer” sells the CDS to the bank for a fee.

In the event of a default, the insurer pays the loan loss to the bank while throughout the loan remains on the books of the original lender.

Question 18

Events of the 2008 Meltdown

Answer 18

1. JP Morgan acquires Bear, Stearns (May 2008)
2. Bank of America buy Merrill Lynch (September 2008)
3. Bankruptcy of Lehman Brothers (September 2008)
4. U.S. Federal Reserve loaned money to AIG to prevent AIG’s collapse (September 2008)
5. Followed by the European debt crisis.