Quiz 2 Flashcards
Capital markets snapshot - debt vs equity
Globally $102T of debt vs $54T of equity. So almost double the amount of debt to equity.
Debt security: like a legal IOU (fixed maturity) with specific cash flows. Contract to repay an agreed-upon face value, on a particular maturity date, often following some immediate payments.
A-L = Equity. Left side of the B/S has the project. Right side has the debt and equity
Equity security: denotes ownership, with a residual claim to cash flows (infinite maturity). After debt holders have been fully paid, the leftover cash flows are paid to shareholders of the firm. Residual claimant in capital structure, everyone else paid first.
Essentially all forms of economic activity require financing.
Debt Markets by country
Looking at where the debt comes from - general government, financial corporations, or non-financial corporations.
The US has the most debt, then China, then japan, then Great Britain. US accounts for about 40 percent of global debt outstanding. Significantly more than any other country.
US is mostly composed of general government (about 50%), then financial corporations (about 35%), and then non-financial corporations (about 15%). Similar ratios for China, but way smaller total amount (about 10% of world debt vs 40% for us)
Japan has basically no non-financial corporations. Same w Great Britain very little NFC
Kayman Islands has only financial corporations. Most countries are general government most and nfc least.
Global equity market cap
Us has about 40% of equity. EM (emerging markets) next with 15% then EU with 11% and China with 8%. Then bunch of other countries.
US bull market in the 1920s
Securities issuance and broad ownership took off.
Corporate loans went down.
Security issuance (debt and equity) went up
Stock ownership of individuals went up: directly or as “trusts” (early mutual funds)
Margin lending: up to 80% of a security’s price could be borrowed.
Compare 1920 bank balance sheet to post crash 1929 B/S
1920s:
Assets: reserves + securities + real estate loans - corporate loans
Liabilities: deposits, capital, debt&equity
Deposits and debt are fixed obligations. Equity isn’t fixed. Value of securities go down in bad times, so does equity.
1929: balance sheets shrink
Assets: reserves - securities - real estate loans - corporate loans
Liabilities: deposits, capital, debt, and equity
Securities values go down. Bank lending goes down. To meet deposit withdrawals, banks sell assets below value. Balance sheet size shrinks.
Consider a $500M project which can be financed with:
A. $100M equity and $400M debt or
B. $250M equity and $250M debt
Consider 2 outcomes:
- Good. Firm value rises to 1B
- Bad. Firm value falls to 300M
What are the leverage ratios, and what happens to debt and equity holders and return on equity in each case
Suppose interest rate is 10 percent
Leverage ratio is assets to equity. For A it is 500/100 = 5 and for B it is 500/250=2
Consider A:
- Good outcome - debt holders get their 400 back plus 10% interest is 440. Equity holders get the rest (1000-440=560). Return on equity is (560-100)/100 = 460%
- Bad outcome. Debt holders get all 300, equity holders get 0, return on equity is -100%
B. 1. Good outcome. Debt holders get 250 back plus 25 interest so 275. Equity gets the rest. This is 725. Return on equity is (725-250)/250 = 190% which isn’t as good as above but is still good.
2. Bad outcome. Debt holders get their 275. Equity holders get the other 25. Equity return is (25-250)/250 = -90%. Which isn’t as bad as before.
Leverage ratio impacts return a lot!
Incentives
For the borrower/firm, relatively higher debt issuance (leverage) means:
1. Relatively higher equity returns if the project does well, and
2. Relatively lower equity returns if it does poorly (but never <100%)
Debt financing boosts the volatility of equity returns
For the investor, fundamental difference between debt and equity:
- Creditors cannot share in upside of profits (just the claims fixed payoff). Incentivized to reduce downside risk of the issuer
- Equity providers fully share in the upside potential. Willing to accept higher risk.
—> Leverage thus increases equity upside potential and also downside risk
Borrower/firm perspective
Wants to raise money (capital)
So can do three things
1. Bank financing - borrow from the bank
2. Approach the market directly. (Fin tech to match borrower/lender)
3. Capital market (securities issuance). Here, can either hire bank/dealer as underwriter (as Shaw of Iran did) or can approach the market directly.
Primary market refers to capital market, hiring bank/dealer, and partially to approaching market directly. See two slides for more on primary market.
Corporate debt financing vs bank loans
Debt financing of non-financial corporations in 2018:
In the US, 80% debt securities, 20% bank lending
In the EU, 27% debt securities and Japan is 20% debt securities with rest bank lending.
Shows that there is a lot more debt in the US relative to bank lending. Bigger part of the US market culture and riskiness. US has historic relation with well developed capital markets. And much more fragmented and smaller markets in other places. Us has non government debt too.
Primary market
Brings new security to market for investors, single clearing price
- Underwriting (debt and equity):
- for fee, intermediation between security issuers and investors
- advise issuer and sell new issuance to raise capital
- bear risk of selling new securities - Fintech:
- gains to efficiency for traditional underwriting participants: banks and investors (e.g. automation of information distribution and order submission, records all interactions (audit trail), real time updates for clients, reduces scope for error)
- non-bank electronic platform intermediation can bypass banks - Auction:
- typically non-bank, and today often under the fintech umbrella
- a means to bypass the underwriting process
- allows market participants to determine issue prices directly: debt or equity.
- Salomon case gives example of this.
US capital markets gross issuance (flow)
Looking at debt vs equity gross issuance in the US since 2004. Debt has gone up since 04, lowest in 08 and has been pretty high since 09. Slight dips in 11 and 14 but debt up from about 6000 in 04 to 7500 in 18
Equity has been significantly less than equity. No more than 5%. Very small. Increased in 08 and 09. Has gone back down. About the same level now as in 2004. Very small compared to debt, can’t even see the number.
US capital markets outstanding (stock)
In 2004, equity was about 15 and debt about 25. Both have gone up since then. In 2018, equity about 30 and debt about 40
So see that both equity and debt have gone up. Proportionately about the same. Slight increase in equity but not really. Much more equity here than in the previous graph.
Net US debt issuance in $B (1981-2019)
Confused by this graph
Most today is from treasury then corporate debt then mortgages then money markets. Also have asset backed and federal agency
Has increased from 1981 to 2009 then fallen a lot. Back up in 2017 but back down now.
Secondary market
Post-issuance security transaction, at market price.
1. Exchange traded: centralized trading and clearing, transparent pricing
Ex: equities, futures, options (exchanges - NYSE, nasdaq, cboe)
-rules govern trading and info flow for all participants in the market
-securities must be standardized in order to trade on an exchange
-typically integrated with clearing facilities
Clearing: post-trade to settlement (e.g. confirmation of trade terms, margin, netting)
Settlement: ultimate transfer of security and/or cash
September 2017: SEC implemented t+2 settlement for most securities (e.g. stocks and corporate bonds - had been t+3)
- Over-the-counter (otc): securities not traded on an exchange
Examples: bonds, repos, swaps, Fx (non exchange platform - tradeweb, brokertec, ebs)
-decentralized: equivalent trade price may differ by participant on either side
-transaction price availability and transparency varies. Can make valuation difficult
-more scope for trading products with non-standard (bespoke) terms
-standardized otc contracts are increasingly centrally cleared (post Dodd-Frank)
Some conclusions
- US is largest debt and equity market globally
- securities issuance and trading has long history, evidenced in the relatively small bank loan segment - Debt security holders prefer low leverage bc they will not share in upside potential
- nonetheless, it is their contribution to the firms capital structure that allows for leverage - Security issuance is higher for debt than equity bc of the finite maturity
- some secondary markets are highly regulated and organized. Some are not.
US government debt/GDP
Total debt in 2020: $23T. $17T is publicly held (can potentially buy as security in market). Total debt was 12T in 2009 and 6T in 1999. So massive increase recently
Looking at graph (y axis is debt/gdp percent) see that during wars It increases. Revolutionary war and civil war and world wars way up. But after civil war goes down to basically zero% of gdp by 1910. Then wwi increases it. Goes down and then comes back up. Peaks in WWII at about 100%. Back down. Valley in the 1980s. Up in the 1990s then slightly back down and has soared since mid 2000s
About 40% to about 70-80% today. By 2050, supposed to soar to about 175%
Government debt and fiscal policy
How the firms, government, households, and financial intermediation are all interconnected
Previously we looked at how households and firms interact with financial intermediation. Now add government to this picture
Government: taxes firms and people, and provides some infrastructure
Government borrowing: allows spending to exceed income today (tied to future revenue)
Firms interact with financial intermediation through corporate borrowing and saving. Firms pay the government corporate taxes. Firms also interact with households through household income/consumption
Households interact with financial intermediation through household borrowing/saving. Interact with government through household taxes/benefits. Interact with firms thru household income/consumption
Government receives government borrowing from financial intermediation. They interact with households thru household taxes and benefits. Interact with firms thru firms paying government corporate taxes.
Us treasury securities are issued to the market in a similar way.
First public debt issued in the colonies
1690, colonial Massachusetts: to pay soldiers after an unsuccessful plunder (trying to steal property), government issued paper “notes”
Promised:
1. Notes redeemable for gold/silver from future tax revenue
2. No more notes to be issued, ever
1691:announce the previous note issue had been too small to fully pay debts. Increased issuance of notes by more than 6 times the original size. Promised ni more notes to be issued, ever
Problem is that keep making these promises and breaking them.
Issue value not equal to post-issue market value - These were pretty worthless(market value) once government issued a ton of these.
Flow: deficit/GDP since 1970
Debt = stock, deficit = flow
Primary deficit doesn’t account for interest payments. Total deficit does. Defecit relative to gdp from 1970 to 1995. Surplus for a few years. Deficit in 2000. Massively down in recession. Has gone back up to pre recession levels. Will get worse (back down) as go into the future.
Primary defecit not as bad since doesn’t include interest.
Another graph that just shows total deficit to gdp. 4.6% deficit in 2020.
US treasury securities market
Highly liquid market (high trading volume, low transactions costs, well functioning)
- largest market of single issuer
- can easily replicate cash flows within the market
Generally considered risk free
Maintains benchmark status: reference to price riskier securities. Important for transmission of monetary policy
Security types by original-issue maturity
- Bonds: issued with >10 years to maturity
- Notes: issued with 2-10 years to maturity
- Bills: issued with <=1 year to maturity
- issued at discounts pays face at maturity
- no coupons
- single cash flow
Most common original issue (OI) maturities: 2,5,10 year. 30 year not issued from 2002-06. Treasury announced 1st 20-yr to be issued in 2020 (first since 1986)
3 primary identifiers of fixed income securities
- Maturity date (T): date when security pays principal (also called face value or par value) and final coupon
- Face (par) value (V): principal amount paid at maturity
- Coupon rate (C): $s interest paid each year per $100 face value
Example: 5-yr note issued on July 31, 2017. Coupon rate of 1.50%. Matures on July 31, 2022. Suppose you purchase $100 face value
Purchase price: initial outlay. $100
Coupon payments: coupon rate is expressed as a percent of face value. US government pays semi-annually, so 1.5%/2*100 = 75 cents of interest each half year.
Principal (and last coupon) paid at maturity: $100 + .75
Coupon and principal payments are promised future cash flows. If security is risk free, then promised = expected.
For 9 periods from July 17 till July 21, get the 75 cents. 10th period on Jan 22, get the 100.75. Don’t forget final coupon!!!
Weighted average remaining (time-to) maturity graph since 1980
60.1 months is the historical average during this period
Overall trend has been massive increase.
In 1980, was about 43 months. Increased to 65 months by 1990. Then went back down in late 90s gradually then peaked in 02. Then down from 02 till 04. Then hover around 55.
Fell during the recession from about 55 to 48 bc government issued w ton of short term bills as recession began. It then picked back up and has been increasing since. At 69.9 months at end of 2019
Gross issued v gross matured v net issuance of bills, notes, and bonds
Looking at graph of bills, notes, and bonds gross issued and gross matured (difference is the net issuance) since 2000. Find that not of gross issuance replaces redemptions ($B)
Mostly issuing bills, as have to replace them after each yr bc 1 year maturities. And mostly maturing are bills for same reason.
Net issuance has a little bit of bills but not much. Mostly is notes, as more notes have been issued. Little bit bonds. Highest total net was 08, 09, and 2010. Has fallen since then.
What’s issued and not matured is net issued. Added that year. Trying to give market good risk free time structure.
Debt outstanding vs net change ($B)
Looking at net issuance from the previous graph vs the amount of debt outstanding - consisting of bills, notes, and bonds.
See that most outstanding is notes followed by bonds and bills. Debt outstanding up from about $2T in 2000 to $14T in 2019
Net issuance up as well, from just over 0 to about $.7T
So the net issuance is way smaller than the outstanding amount across all the years. Even when net issuance was highest in the financial crisis, still way short of the debt outstanding.
Demand (US treasury holders, $B)
Who wants US treasuries? Looking since 1996. Has mainly consisted of international investors. And they have driven the increase. Invest in the US for low risk asset with decent return (these euro countries now have such low returns - not worth it)
To weaken your currency: sell your currency and buy some other currency. Then invest in something. Foreign investors may weaken their own currency by doing this.
Pension funds, central bank, mutual funds, individuals, banks, municipal governments, and insurers all also invest (in that order in 2019)
Indiviudal’s increasing bc more risk averse.
Overall trend has been massive increase in demand. Up from 4T in 1996 total to 18T in 2019
International breakdown of demand for US treasuries
Japan and China are two largest. UK, Brazil, Ireland, Luxembourg, Switzerland, Hong Kong, cayman, bunch of other smaller ones. Insane amount of countries is the overall trend. Large slice devoted to “other” even though so many are already called out by name
Secondary market liquidity premia: on the run vs off the run
A security’s original-issue maturity never changes, but its time to maturity declines each day
On the run: most recently issued of a particular maturity. Ex: the 5 yr note, issued on 7/31/18, was on the run until the next 5 year note was issued, on 8/31/18.
Once that issuance happens, the July one becomes first off the run.
Then another issuance at end of September, the August one becomes first off the run and the July one becomes second off the run.
There is far greater quantity of off-the-run securities outstanding
However, most trading volume is in on the run securities. (65% trading volume is on the run, 10% is when-issued (for the next on-the-run), and the rest (25%) is all the off the run combined.)
Reason why is liquidity concentration with newly issued security.
Retire price anomaly with on the run vs first off
Looking at 10-year on-the-run premium from 1995 to 2017. See that there has pretty much always been a premium, although declining recently and wasn’t a premium in early 2010s. During recession the premium went massively up’ to about 60 bps
In the secondary market, after they’re already issued, on the run securities tend to trade at a premium to comparable off the run securities (liquidity premium)
This premium diminishes as soon as the next security is auctioned.
Some conclusions
US government is the single largest debt issuer
- size of us government debt = face value of treasury securities outstanding
- government debt issuance is fiscal policy (us treasury department)
- debt = stock; deficit = flow
- net issuance = 1st differences of outstanding
Treasury market is deep and liquid
- original-issue maturity= time to maturity at issuance
- on the run securities tend to trade at relatively higher prices
Overhaul of financial regulation
Attributed 1930s banking crisis to securities speculation
1933 banking act (Glass Stegall):
- securities’ business taken out of banks: limit securities’ holdings and no underwriting.
- Required separation of insurance, commercial banking, and investment banking. At this time, Lehman cut its deposit base.
- illegal for a depository institution (a bank) to have any securities business.
1933 and 1934 securities acts:
-aimed for prevent market manipulation/fraud in primary and secondary markets (which was what they blamed the crisis on). And non-bank focus looked at orderly markets.
-securities and exchange commission (SEC) established. Joe Kennedy was first chair. Enforcement authority to respond quicker to developments than congress. Required registration and disclosure of securities and securities trading firms.
Defined:
Broker: transacting securities for the account of others (agency execution)
Dealer: buying and selling securities for own account (principal execution)
- financial industry regulation authority (FINRA, formerly NASD - est 1939): self regulatory organization (SRO) for securities’ firms (overseen by SEC)
1986: 1934 act modified to give treasury authority over treasury markets.
Central bank as fiscal agent of federal government
Looking at financial intermediation, federal reserve, households, firms, and US treasury and how they interact
Start in the top left with financial intermediation. They interact with households thru household borrowing/saving. They interact with firms thru corporate borrowing/saving.
And they interact with the federal reserve. Debt issuance: fiscal agent has money going from financial intermediation to federal reserve. And reserves (monetary policy) with money going both directions.
The fed also interacts with the US treasury. Gives them money thru government borrowing
Firms interact with financial intermediation thru corporate borrowing and saving. And pay corporate taxes to us treasury
Households interact with financial intermediation thru household borrowing and saving and with the treasury w household taxes/benefits.
Treasury interacts with firms by collecting corporate taxes, with households thru household taxes/benefits, and with the fed by collecting money in the form of government borrowing.
Main point here is the Fed is in the middle between monetary and fiscal policy.
Primary dealers
Subset of securities dealers
Required to participate “pro rata” in Treasury debt auctions
- officially designated as trading counterparties to the Fed reserve
- bid for own account
- periodically reviewed on performance
Salomon was a primary dealer. Helped in allowing access to auctions and get more info.
Pros: you trust primary dealers bc need to qualify thru criticaría and watched more. Gives credibility.
But risk is that if buy and decrease in value, can lose money. Inventory, carry, price risks.
1929: first treasury bill auction
Auction allows market to determine the issue price directly.
Notes and bonds were issued via underwriters until the 1970s
By 1976, all treasury securities issued by auction
Graph showing how many primary dealers over time. 20 in 1960. Peaks with about 45 in 1988. Falls to about 15 in the crisis. Back up to about 24 now.
2 types of bids at auction
- Competitive bids: Q and P
A. Direct bidder (Salomon in the case)
- bid directly with the fed on behalf of own account
Principal to principal transaction
May be a large institutional investor or securities dealer (ex. PIMCO, Morgan Stanley, China since 2009)
B. Indirect bidder
- bid indirectly, via a direct bidder
- institutional or foreign investors
- ex: Warburg was indirect thru Salomon in the case but also bid himself. Also bank of Japan, pimco are examples. PIMCO is both indirect and direct
- Non-comeptitive bids: Q but no P
- small investors and institutions
- maximum size of $5M
Auction cycle
- Auction schedule: gives auction date, settlement, and original-issue maturity months in advance (322 auctions occurred in 2019, $12T of securities issued)
- Auction announcement: details upcoming auction
- released 1-2 weeks prior to auction
- reveals: security issue size - “When-issued” trading: begins once announcement is made.
- these are forward contracts, meaning agree on price today to buy/sell at some future date. occurs in other markets too, like ipos or corporate bonds
- important for price discovery
- settles after auction date
Single price Auction vs multi price
Single price auction: all bidders receive the same yield, which is the stop out.
- Common format, used in various markets (equity IPOs, auction rate securities, credit default swap settlement)
- became treasury standard in 1992, after Solomon scandal
- single price rationale- encourages aggressive bidding because winners don’t risk overpaying
Multi-price: everyone gets their bid. Could have winners curse where bid lower rate than everyone else and win, but paying more than everyone else.
Auction steps
- Noncomp bidders submit Quantity
- comp auction size = announced auction size - noncomp bids - Competitive bidders submit quantity and yield
- May enter multiple bids for own account (direct) and/or customers (indirect)
- limited by NLP
- most bids given just before auction closing time (by 1 pm,bid must be in box. Not anymore, but used to be like this) - Bids are ranked, most attractive (lowest yield) to least
-bids accepted (filled) until Q bid = Q offered
-stop out is the highest accepted yield.
Within 2 minutes of auction closing time, results are released
The issuers want low bids, as have to pay less interest.
Side note: price up, yield down.
Bid to cover ratio
Total quantity bid / auction size
If higher than 1, then enough bids to cover the auction amount
If less than 1, then not enough bids
Indicator of demand. Higher number shows more demand.
Number in itself, as long as greater than 1, doesn’t impact the auction.
Auction stop out rate
Example where total comp auction size is 1000 and the stop out rate is 1.45
Each bidder submits an order amount and a bid rate. The lowest bid rates get fulfilled first
Up to 1.45, 900 has been allocated.
At 1.45, 3 bidders bid - 50, 50, and 100. But there is only 100 to give. So give proportionately. There is exactly half, so each bidder gets 1/2 (25,25,50)
Formalizing this, the bidders’ share at the stop out rate = (auction Q - cumulative Q prior to stop-out rate) / total Q at stop out rate
I.e. here: (1000-900)/200 = .5. So there is .5 left to give - proportionately give 50% to each bidder
Note: coupon is the stop out rate rounded down to nearest eighth. Set to make auction price close to face value
Salomon manipulation 1: manipulative in spirit
June 1990: John meriwether is the head of the arbitrage group and fixed income
They bid $30B for a $10B issue - want to get as much as possible of the auction
Trade offs in punishing aggressive auction behavior - value of Solomon is that they are a large player, help cover the auction (guarantee sufficient bidding, bid to cover high enough from them alone, can give away everything), take risk of large positions, aggressive bids makes financing debt cheaper
But: need multiple dealers to keep price competitive. Don’t want to deter competition.
Response: treasury gives a warning. But Solomon does it again
So, they then limit bid size to 35% (including when issued long or short positions)
Today, the net long position limit still exists.
Manipulation 2: illegally using client account
February 1991: put in bids for their customer (Warburg) but didn’t inform him. Point here is so Solomon can get more than 35%, just go thru their customer.
Flaw here was that Warburg submitted his own bid, which Solomon didn’t know. Warburg bid over the 35% total (direct and indirect via Solomon)
Response:
- Treasury sent letter to all parties saying legal NPL (net long position) is 35%.
- Treasury imposed written customer confirmation requirements of large indirect auction awards before securities would be transferred
- today: written confirmation is required for awards > $500M
Manipulation 3: cornering the market
May 1991:
34% bid for Solomon, 17% for Tiger, and 35% for Quantum
Tiger sells to Salomon post auction
Received $10.6B of the $12B auction size
Tiger sell to Salomon: Salomon and quantum control 86% of issue
So clear that there is some collusion here
Note:
When-issued (WI) sale implies delivery by:
- winning the note at auction
- buying or borrowing the note from a successful auction bidder
How to corner a market
In order to engineer a higher price after auction:
- bid low auction rate (high price) in large quantity to ensure
1. Are filled and
2. Win large share of auction
Then, sell at even higher price in secondary market to the WI shorts, who didn’t expect issue to be squeezed at auction
Profit t to t+1 = -Pt for the auction + Pt+1 for the secondary
WI market: other dealers agree to sell to customers at Po
Vertical supply and downward demand intersect at Po
Auction: Salomon squeezes supply, others must pay up to cover WI shorts. Supply shifts left, price therefore increases.
So, pay for full supply, then re-sell at higher price bc other banks need the securities
Treasury’s approach to regulation
First, do no harm
Trade-offs in market efficiency and regulation:
- specific rule: 35% position limit in a new issue
- vague authority: address activities interpreted as “manipulative”
- treasury switched to single price auction partly bc believe was less subject to squeeze
- established treasury market surveillance group (require dealer position reporting)
- policy of re-opening an issue if supply becomes tight
Benefit of being big in that lots of information from large customer base, and less risk of being stuck with inventory
Simulation: leverage and returns to debt and equity
Equity returns vary much more at higher leverage ratios. Equity returns vary more as outcome rises. Range tilted toward upside, because downside limited to initial investment (can’t be worse than -100%)
Debt returns are more stable, mostly affected at higher leverage ratios. Debt return is capped at promised obligation.
Ex: say we have a project with a 10% interest rate and it costs $100
If the project outcome is $90, say we have a .1 leverage ratio. So 10 of debt, get their interest, so get 11. Get a 10% return. But equity holder gets only 79, so lose 12%
Now say we have a .7 ratio, debt gets 77, gets the 10 percent return, equity only gets 13. Equity return down to -57%
Now say .9 leverage ratio, debt gets 90, getting their money back, equity loses full 100%
So, when doing badly, higher leverage ratio results in worse return for equity and same for debt until can’t repay at which point gets worse
Now say project gets a positive outcome, say 120. Then debt return is always 10% and equity returns rise with more leverage
With more leverage, equity gets more extreme results
With more leverage, debt has more of a chance to not get the full return (note the full debt return is the interest rate)
Simulation for auction stop out
Start with total auction size. Subtract non comp Q bid. That gives you competitive auction size.
Maximum bid size is 35% of competitive auction size.
Bid to cover ratio is total cumulative orders in competitive auction / competitive auction size.
Goal of the bidders is to bid a low enough rate to win part of the auction but to bid high enough rate so can resell at a profit afterwards.
Note that bidders at stop out rate receive auction quantity remaining after all other bids are filled. Remaining quantity is allocated to bidders in proportion to their order size.
