Financial Markets Evolution: Junk Bonds and Financial Innovation

1. Financial Markets and Institutions FIN 712

2. I. General Introduction

3. Course Objectives • Dynamic picture of markets (interest rates) • Structural evolution of markets • Financial innovation (and regulatory response) • Why market has its current structure

4. Managerial implications • Level and structure of interest rates • Impact on financing decisions? • Structure of financial sector: Why so many financial instruments ? • Which one is best suited?

5. Some sources of data • Wall St. Journal: “Markets Data Center” http://online.wsj.com • St. Louis Fed (data repository of system) http://research.stlouisfed.org/fred2/ • Federal Reserve: Board of Governors http://www.federalreserve.gov/

6. TANSTAFL

7. The Answers • Gains from Trade • Consumer/producer surplus • “Win – Win” • Transaction costminimization

8. The Answers • Gains from Trade • Differences lead to gains from trade • Instruments exist to realize gains from trade • Transaction cost • Transactions are structured to minimize cost

9. GFT & Transactions Costs • Tell us directly why instruments and intermediaries exist. • Are also central to understanding the behavior of interest rates • Because understanding supply and demand for an instrument requires us to understand how it creates GFT

10. Introduction: How markets change Junk Bonds: An Example of Financial Innovation

11. Key ideas related to finanial innovation: • Benefits of markets (and financial innovations) economic concept of Gains-from-Trade • Hazards – unintended results of financial innovation and how they are handled. • Market responses – design changes implemented by market participants (further innovations) • Regulatory responses – continuing interaction of regulators and participants • Continuing cycle of innovation and reaction

12. One innovation: The case of ‘junk’ bonds • “Junk” bonds • These are below investment grade: rated BB or lower, also called “high yield” bonds. • Traditionally existed only when originally investment grade bonds were downgraded – “fallen angels”.

13. The innovation • Beginning about 1980, Michael Milken began encouraging corporate borrowers to sell bonds rated below investment grade at issue. • Clients who could not qualify for an investment grade rating, • Or issues deliberately structured to have a lower rating.

14. The sell side: bond issuers Junk bonds were particularly attractive to: • Issuers not well known to the market • e.g. new technologies of the time • “disintermediation” of the 1970s had reduced banks’ willingness to fund less well-know borrowers. • Later became a popular means to finance corporate takeovers – creating leveraged buy-outs.

15. Building the buy side of the market:the sales pitch • Milken asserted aggressively that the default probability for these bonds was much lower than what was allowed for by their higher yield. • He argued the ratings agencies were irrationally conservative in their evaluation of risk. • Initially, the data seemed to support him.

16. Building the buy side (2):providing liquidity • Milken assured buyers that Drexel Burnham Lambert would always make a market – be willing to buy or sell – bonds they placed. • Promised liquidity increased the value of the bonds to purchasers.

17. Building the buy side (3):Result: Market concentration • As a result, both the primary market (initial issue) and secondary market (trading after issue) were concentrated in Drexel. • Milken had an unassailable informational advantage about who held what, who was willing to buy what. • Reinforced the his advantage in placing newly issued bonds and controlling the market.

18. Market growth during 1980s • The market grew rapidly • Junk bonds outstanding 1979 $ 10 billion • In 1989 $189 billion • Financed growth of emerging industries • Turner Broadcasting • MCI Telecommunications • Widely used to finance corporate takeovers • Leveraged Buyouts (LBOs)

19. Late 1980s • Default experience began to deteriorate • Michael Milken was investigated • for insider trading related to some of the junk bond financed LBOs. • for market manipulation of junk-bond prices.

20. End of the decade • The junk bond market collapsed as Michael Milken’s legal problems mounted: • Indicted 1989 • In a plea bargain, pled guilty to securities violations • Fined, spent almost 2 years in jail, barred from the securities industry for life. • Junk bond issuance in 1990 – virtually zero

21. Junk bond market since 1990 • Junk bonds outstanding • 1979 $ 10 billion • 1989 $189 b • 1990 $181 b • 1999 $567 b • Similar magnitude today

22. Junk Bonds: Further Question • Why has the market continued to grow since 1990? • Benefit to borrowers? • Benefit to investors?

23. Case Summary Key Issues for Any Financial Innovation Application to Junk Bonds • Benefits derived from markets • Purpose or reason markets exist • Drivers of financial innovation • Potential problems with market functioning • Ethical or “moral hazard” issues • Other issues

24. Case Summary (continued) • Consequences of these problems, including financial crises • Appropriate responses • Market driven responses • Regulatory responses

25. II. Loanable Funds Theory(The Fisher Model )

26. The Fisher Model • We begin with the simplest possible case: the market for generic loans • Questions addressed: • What determines the overall level of interest rates in the economy? • What is the source of GFT in this market? Why is the economy better off when there are capital markets?

27. Example: history of interest rates http://research.stlouisfed.org/fred2/series/GS1?cid=47

28. Fisher Assumptions • No inflation • No taxes • No uncertainty • Two-period world • No transaction costs

29. This list of assumptions is also an outline for the first part of the course: • Relaxing each one in turn lets us examine another dimension of the structure of interest rates. • It also reveals an additional source of gains from trade.

30. Fisher ModelOutline of Topics • Demand for loans (business) • Differences and Gains from Trade (GFT) • Supply of loans (households) • Summary and lessons

31. Simple numerical example:Business demand for loans • How business demand for loans is determined (PV maximizing borrowing) • Key lesson: What information governs this decision • What shifts the demand curves/interest rate • What are sources of GFT

32. Numerical example: informationProductive Opportunity

33. Numerical example: information Endowment: E = 1 Market interest rate: 100% r = 1.00 r = interest rate/100 if B = borrowing, repayment = B*(1+r)

34. Numerical Example • What level of borrowing maximizes profit (value of firm)?

35. Lessons from the numerical example • Optimal decision rule: MP(B) = 1 + r Decision rule determines: • Choice of how much to borrow • Quantifiable gain from being able to trade on the market (borrow or lend).

36. From decision rule to demand curve • MP(B) = 1 + r • Diminishing returns How does borrowing respond to changes in r? Why?

37. Definition: demand curve • Demand curve shows desired quantity of borrowing as a function of the interest rate. • Or, the other way around: Demand curve shows the interest rate at which a given quantity of borrowing is optimal. • Either way, demand curve relates interest rate and amount of borrowing

38. Lessons from numerical example (2) • Optimal decision rule generates the firm’s demand curve for loans • Note that this can become a supply curve when interest rates are high enough. • Demand curve affected (only) by factors influencing firm’s borrowing decision • Production opportunity • endowment

39. Algebraic version of exampleinformation Endowment: E = 1 Production opportunity: MP = 6 – I [This is the derivative of the production function Q=6I – 0.5I2] MP = marginal product I = investment Q = output

40. Algebraic example:Deriving demand curve Decision rule MP = 1+ r Production opp. 6 - I = 1+ r Budget constraint requires I = E + B, so 6 – E – B = 1+ r With E = 1, this solves to B = 4 – r or r = 4 - B

41. Graphical representationB = 4 – r or r = 4 - B

42. Algebraic example:factors affecting demand curve r = 5 – E – B as endowment increases, quantity demanded at any interest rate decreases (the demand curve shifts in or down)

43. Algebraic example:factors affecting demand curve r = MP - 1 As productive opportunities improve - MP increases for each amount of investment - quantity demanded at each interest rate increases (the demand curve shifts out or up)

44. Algebraic example:quantity demanded • Given any interest rate, the demand curve determines the desired quantity borrowed. • For example, if r = 1 (interest rate = 100%) B = 4 - 1 = 3

45. Algebraic example: Gains from trade Demand curve r = MP – 1 • The height of the demand curve at any point is (essentially) marginal product of investing one more dollar. • The market interest rate is cost of borrowing • The difference is the gain from borrowing and investing that dollar.

46. Graphical example: quantity demanded

47. Graphical example: gains from trade

48. Algebraic example: Gains from trade calculation Area of a triangle = (1/2)*base*height GFT triangle GFT = 0.5*B*(4 – r) Calculation: GFT = 0.5*3*3 = 4.5

49. Lessons from algebraic example • Demand curve for loans • What factors can shift the demand curve • GFT can be quantified from the demand curve • The same factors affect GFT

50. Supply Curve of Loans • Depends on household behavior