Week 3 Flashcards
How do you create safe debt?
You would have a depositor, could just be a retail investor, it could be a small business. And the depositor would give dollars to the bank. That’s step A. And that’s the dollars that are flowing down from the depositor to the bank. The bank then takes those dollars and loans them out to a borrower. Let’s say somebody who needs the money for a mortgage for a house. The bank takes, onto their balance sheet, the arrow that coming up, which is a loan, which is an obligation of the borrower and an asset to the bank. What the bank gives back to the depositor is a savings account or a checking account which is insured. Which means in this case in the United States as of 2007, $100,000 by the depositor could be put into the bank and would be insured by the federal government.
Can the depositor take out money any time?
Yes, he can
Does the borrower have to give the money back to the bank ay time the bank wants?
No.
So, who has the long term debt and who has the short term debt?
The bank has a short term debt to the depositor and the borrower has a long term debt to the bank
Is it a safe thing for the depositor?
Yes, it is fairly safe since the government has said that it will pay no matter what.
Why can we not have insurance for everybody?
Because insurance is limited, in the case of the united states to 100 000
Why can we not make it unlimited?
Because then you would ensure the entire banking system by government. No matter how ich you are and how much risk the bank takes.
So what do you do with the rest of the money if you only can insure 100 000?
that is where shadow banking comes in
What are people called who give money to the institutional investors?
retail investors
What is an example of an institutional client that does not take any money from others?
sovereign wealth fund or a large corporation
Can the institutional investor give money directly to the bank?
No they cannot. They need some ways to make sure they get their money back
What is the difference for banks now?
Some of the money is not going to be insured. So the shadow banking systems there to insure that the money is insured somehow.
What is the first way of making sure the money is safe?
Instead of taking the mortgages on its balance sheet and saying this keeps us sat, they say let us put the money and put it into this box.
What is this box called?
Securization. So instead of putting money into a bank we put it into a box that we call securization.
So instead of the investor putting his or her money into a bank, what does he do?
He buys a slice of the securization directly. So now you do not need to worry a lot about what the bank is doing but rather about what your asset is doing.
So describe in a nutshell the first way to make things safe.
The bank takes the first slice of risk out of the assets and you ge the least risky part of it. So instead of giving the bank your money, you are just getting a bit of what used to be the banks portfolio. You take that slice and it becomes your collateral.
What is the second way to make your money safe?
A second way to do this is a little more indirect. Instead of going and just buying the securities by yourself, as the institutional investor. You say to the bank, I will give you my $1 million or $10 million deposit. But since you can only insure $100,000 of it, I would like you to give me some additional collateral that I can hold to make sure that I am safe.
what is collateral?
Collateral is a property or other assets that a borrower offers a lender to secure a loan. If the borrower stops making the promised loan payments, the lender can seize the collateral to recoup its losses. Because collateral offers some security to the lender in case the borrower fails to pay back the loan, loans that are secured by collateral typically have lower interest rates than unsecured loans. Read more: Collateral Definition | Investopedia http://www.investopedia.com/terms/c/collateral.asp#ixzz4BGlglGfn Follow us: Investopedia on Facebook
How does the collateral make the investor feel?
The collateral makes the investor feel extra safe.
Why is collateral useful?
Collateral is useful, because in normal times you can quickly sell it in the market and get all of the money back. It’s the best form of insurance that you can have, because of its speed.
What is the problem of collateral in times of panic?
You would not be able t sell collateral quickly
What is the process called by which the collateral insures an investor is called what?
The process by which the collateral insures an investor. And the money goes from the investor to the bank, or to whatever financial intermediary we have, is something called a Repurchase Agreement.
What are safe assets?
Something that an investor can put his or her money into and not have to worry about it
What is information insensitivity?
What it refers to is that when I enter into a transaction with you, I am not at all worried that you have an incentive to produce information to try to figure out whether the transaction that we’re entered into is going to be beneficial to you or me.
What is risk free?
Risk free which means under all circumstances this thing, the thing that we are exchanging will be worth exactly what we want it to be worth in buying goods and services.
Are government bonds risk free?
They’re not risk free. There’s some chance that in the future, interest rates will go up and the value of your bond will fall.
What is a coupon?
The annual interest rate paid on a bond, expressed as a percentage of the face value.
What is at at par?
At par is a term that refers to a bond, preferred stock or other debt obligation that is trading at its face value. The term “at par” is most commonly used with bonds.
Do financial instruments often trade at par?
Due to changing interest rates they almost never do
When interest rates go up the value of a bond…
falls.
What si the cleanest definiotn of a safe asset?
What’s important about long-term governments bonds is that right now, you kinda think these things are priced correctly. And that the person that you’re talking to and exchanging that bond with does not have any huge advantage, nor would they really have any way to come up with a huge advantage in figuring out what the bond is worth. That is going to be the cleanest definition that we have of a safe asset. One that is insensitive to information.
Why do we sometimes think of it as adverse selection?
Sometimes we also think of this as having no adverse selection. That’s a term in economics that has existed for a long time. Adverse selection just means two parties to a transaction. And at the time that those two parties are signing the deal, they have the same information as each other about the item that they’re transacting over.
What is an example of information sensitive to not information sensitive?
If the next day, you wake up and you hear some news that makes you think it’s not safe, it has suddenly gone from being information insensitive, where yesterday, you didn’t worry about it at all.
What is an example of not information sensitive?
First would be stocks. So, the stock market, it’s not that the stock market is rigged or unfair. It’s just that it’s quite clear that there’s a real benefit to going and studying and figuring out what a company is worth. And if I am an uninformed investor, and someone comes to me and wants to offer me equity in a company, I might be a little worried that that person knew more than I did about what the company was worth.
Are debt of third parties information sensitive?
The private debt of third parties would be another bad example. So the debt of a country? Stable, information insensitive if it’s a stable country. The debt of my friend John, if I gave you that debt and I said, look, John gave me this IOU. I don’t have any money in my pocket right now. Let me give you the IOU that John gave me, and now, you’ll have that instead of money. You would say, whoa, I don’t know John and even if I knew John, I’d have to spend a lot of time figuring out whether he was actually going to pay me back.
Did the demand for safe assets change over the years preceding the financial crisis?
Yes, it changed dramatically.
What happened to short term interest rates as opposed to long term interest rates?
between 2003 and 2007, short-term interest rates in the United States increased by four percentage points. But longer term tenure interest rates hardly moved.
What is the federal funds rate?
A short interest rate rate, it is controlled by the federal reserve.
What about the ten year treasury rate?
Does not really have large moves.
What is the gap between these two terms?
The gap between these two rates is a term spread. It’s the amount that you would need to pay extra, to borrow over ten years instead of federal funds, which would be borrowing a very short term. Perhaps overnight.
What did the FED expect when it raised interest rates in 2003?
that this would move the long term rates back up near the levels they were at the beginning of the 21st century.
WHAT WERE the cumulative investments of China in the US?
A little bit under a trillion.
What were global savings glut countries buying between 1998 and 2002?
Mostly agency debt
What was the result that we had so many foreign buyers?
it left no capacity for investors in the united States. They bought other AAA stuff - residential morgage backed securities
What type of investor was growing quite significantly in the years leading up to the crisis?
We also have institutional cash pools, large institutional investors, that are growing significantly over this time period.
What happens to the bank after it sold the assets to the trust?
It is out of the transaction
Morgage backed securoities were issued by whom ?
They were dominated by the agencies, the government sponsored enterprises of Fannie Mae and Freddie Mac until about 2003.
What is the most important thing about this picture?
The most important thing about this picture is to notice the gap between the dotted line and solid line that emerges after 2003. That gap is what you will hear called private label mortgage backed securities. So, not coming out through Fannie Mae and Freddie Mac, but rather through some other entity and not having any kind of government guarantee.
What is the difference between corporate bond and an asset backed security?
If instead, IBM, after making sales of computers and financing those sales to its customers, bundled all of the loans for those computer sales and put them into a trust, they could create their own vehicle, which effectively be an asset-backed security.
