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Finance Research is relevant
Nationally
Indexing and passive investing
Creation of the options market
Option back-dating Mutual fund scandal
Collusion among Nasdaq traders
Departmental Research
Index changes and returns Merger efficiency
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Why Investments?
Income and expenses don¶t match. ± As a student, your expenses exceed your income
± Once you start earning, your income will exceedyour expenses
± Kids, home, kids¶ education etc. puts a strain onyour budget
± After that your income again exceeds your expenses
± Upon retirement, you must depend on your savings bc no cash inflows
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Why Investments? Must learn to manage your wealth so that it maximizes your
income at the right time with the right level of risk.
Decisions are being passed on to individuals Partial privatization of social security- we heard about this 4-5 years
ago then it died away Means you still pay amount of SS you have, but conceptually it says well let
you take money and let you decide where to invest it just like you would inan IRA or 401K you make the decision
Individuals depending on how much they contribute, would allow them tomake own investment decisions instead of the government choosing Downside: If its the governments money, what do I care? I can take all the
risk I want. It could allow people to take more risk than they generally world.Also, a lot of people dont know how to manage their money so itd bemostly passive management
Will probably see it again bc administration changes republicancongress/president would probably hear more about it partial private as away to save SS
Defined contribution plans instead of defined benefit plans Defined benefits: pensions- if you work for 30 years here is what youre going
to get. You dont have to do anything and youll get it for rest of your life.However, this is extremely expensive!
Defined contributions: 401 K, 403B, simple, scep, then its up to you. Sameidea as partial privatization except its full based on YOu contributing andwhatever you contribute/invest in/grows to is what you get in the end to beable to pull out
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Financial Markets
Securities allow exchange between
periods. Saving during one period
can be used as an expense duringanother period.
Bonds
Stocks
Real Estate
Etc.
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Importance of Smart Investing
Salary: $50,000 per year
Accumulated Assets: $250,000 Income from investments = $12,500
@5%
Income from investments = $25,000
@10%
Difference in income constitutes 25%of salary.
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Markets are Competitive Risk-Return Trade-Off
Efficient Markets Active Management
Finding mispriced securities- look at PE ratio, big indicator Fundamental or relative analysis- to see is this thing worth more
Looking at financials of company: PE, EPS, etc
Timing the market- trying to get in at bottom or top;speculators, technical analysis look for floors and ceilingsand movement along a trend line. This is a way of investing.
Looking at historical trends
Passive Management
No attempt to find undervalued securities No attempt to time the market
Holding a highly diversified portfolio or indexing, investingin index
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The Players Business Firms net borrowers
Households net savers
Governments can be both borrowers andsavers
Financial Intermediaries
Investment Companies
Banks
Insurance companies- huge player in bondmarket; tend to invest in longer term.People tell them their liabilities and have areasonable idea of what cash flows shouldbe
Credit unions- operate under a different setof rules
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The Players Continued
Investment Bankers
Perform specialized services for
businesses: m&a, mezanine funding,
second round funding, private equity
groups raises money from investors
and go out and invest in companies
Markets in the primary market theybring companies public for the first
time in IPO market
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Table 1.4 Balance Sheet of
Nonfinancial U.S. Business, 2007
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Recent TrendsGlobalization
American Depository Receipts (ADRs)
Foreign securities offered in dollars
Mutual funds that invest internationally
Instruments and vehicles continue to
develop (WEBs)
Exchange Traded Funds (ETFs)- EX:Spyders, leveraged ETFs show a lot of
volatility in the market. Buy a sector
but trade it like a stock.
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Recent TrendsSecuritization
Mortgage pass-through securities
Other pass-through arrangements
Car, student, home equity, credit card loans EX: airplane leases
Any asset you can find, you can pool ittogether, take that pool, divide intoseparate investments, sell to investors, and
when people make payment on assets,payment goes to purpose that holdssecuritized instrument
MBS: mortgage backed securities
Offers opportunities for investors and
originators
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Securitization
Securitization & Credit Enhancement Offers opportunities for investors and originators
Transfer risk bank can originate loan and take loan off their books and put it in
with fannie or freddie or whoever is securitize/packages it
Loan is not held by bank anymore, no more risk of someone not paying the
loan Makes lending more available. Become less strict and if I package them together
than statistically theres not going to be a lot of defaults.
Changes in financial institutions and regulation
Improvement in information capabilities Credit enhancement and its role
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Asset-backed Securities
Outstanding
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Financial Crisis of 2008-09
Background
What happened?
Mid 90s- push to make housing affordable for all. Goal of
several administrations, but mainly the focus of Clinton. Tomake it easy and accessible for everyone to get into
affordable housing
Likely causes
Possible solutions Economic Outlook
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Background
Securitization Started in the early 1980s.
Process of converting household assets into marketable securities. Same assets, value, default rate, put them together
Asset Backed Securities (ABS), Collateralized Debt Obligations (CDO)
Mortgages constitute the largest fraction of the market MBS, CMO
(collateralized mortgage obligations Makes it easier if youre the government and your pushing a quasi
government entity (fannie or freddie) push them to make loans, pool themtogether and sell off to investors, we have an asset to sell.
Background: we wanted to make housing affordable, we wanted to makeloans to people to buy houses so we started setting it up back in the 90s
MBS we created allow investors take advantage and individuals getting the
loan bc if administration is pushing for loans to be made I dont need thesame credentials that I had before; dont have to have a sterling credential
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Mortgage-Backed Securities
Creation of MBS
Original lenders resell home
mortgages to financial institutions.
Create a pool of mortgages that is
well-diversified: geographic, size,
borrower risk diversification.
Pool of assets is subdivided intotranches.
Each tranche is rated and sold as a
separate MBS/CMO.
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Securities
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Securitization
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Securitization
Useful innovation:Reduces liquidity risk by making loans
marketableSpread between Treasury bonds and
mortgage rates narrowed
Home owners got loans at better rates
than without securitization.
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Securities
Private sector
Financial Institutions create the pooland divide into MBS (tranches).
MBS are rated by S&P, Moody¶s, etc. May be insured by MBIA, Ambac, AIG, etc. against default, raise rating ± called CDS.
MBS are sold by banks to the
investors. Investors buy MBS based on ratings
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Securities
Government Sponsored Entities
Fannie Mae, Freddie Mac
GSEs guarantee loan paymentsprovided the loan is conventional.
Collect a premium from the loan
originators.
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Popularity of CDOs
CDOs became very popular:
Banks, insurance companies, hedgefunds, pension funds, all liked CDOs.
CDOs gave a higher return than
corporate bonds, for similar ratings.
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What happened?
Mortgage defaults increased more thanin the past, in particular, subprime
mortgages. Insurance companies called in to pay for
defaults depleting capital.
Impaired financial condition of insurance companies meant thatinsurance provided for other derivativeswas uncertain.
Greater incidence of default led todowngrading of MBS by rating agencies.
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Likely Causes
Co-conspirators
Rating Agencies
Fannie Mae, Freddie Mac; Congress Insurance companies
Investors
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Likely Causes
Rating Agencies main contributor.CMOs rated too high by rating agencies.
W
hy? Models based on short history of CMOs.
Confused total risk with systematic risk.
Inherent conflict of interest. Sponsor pays
rating agencies to rate their CMOs.
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Likely Causes
Fannie, Freddie; Congress
Fannie, Freddie should have reviewed the
mortgages more closely. But Congress wanted GSEs to increase
home ownership by making/supporting
loans.
Fannie, Freddie saw this as a way of making
easy money and satisfy the politicians.
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Likely Causes
Investors, Insurance Companies
Investors found that AAA-rated CMOs
generated higher returns than AAA-rated
corporate bonds.
Bought CMOs instead of corporate bonds.
Lack of transparency. Institutions knew
that the risk of CMOs was unknown. However, investors and insurance
companies believed the ratings, without
due diligence
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Likely Causes
Exploding demand for CMOs
Because of higher returns.
Origination of loans exploded to keep pace Loan originators did not care about the
borrowers because no one seemed to care.
Rating agencies mistakenly rated them too
high.
Banks were selling. Investors were buying.
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UntilUntil someone defaultedsomeone defaulted
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Possible Solutions
Like a run on a bank!
Ordinarily, markets limp back to normalcy
But markets are frozen due to lack of trust
and lack of knowledge regarding the true
value of assets
Need government intervention.
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Possible Solutions
Facilitate mergers of weak banks.
Buy institutions that are too big.
Increase liquidity by making more money
available.
Buy commercial paper so that companies keep
running.
Cut interest rates.
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Economic Outlook
Financial crisis spreads to corporations
Unable to borrow funds for operations.
Declining supply, and declining demand
from consumers.
Lower retail sales, job losses, etc.
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Economic Outlook
Grim outlook for global and U.S. economy
Q4 growth was very negative.
Q1, Q2 growth will be negative.
World economic growth below 3%(recession).
Possibility of a rebound
If the financial problems can be containedonWall Street, trust and confidence couldreturn quickly.
Still far away.
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