Ch.1 investment Background and Issues

1. Ch.1 investment Background and Issues

2. Investment is commitment of current resources in the expectation of deriving greater resources in the future. 1.1 Real Assets vs Financial Assets • Real assets: assets used to produce goods and services. E.g) land, buildings, equipment. • Financial assets: claims on real assets or income generated by real assets. E.g) stock, bond, CD, etc • While real assets generate net income to the economy, financial assets simply define the allocation of income or wealth among investors.

3. 1.2 Financial Assets. • Three broad types of financial assets: debt, equity and derivatives. • 1) fixed-income or debt securities promising either a fixed stream of income or a stream of income that is determined according to a specific formula. • - money market: fixed income securities that are short term, highly marketable, and of low risk. E.g) T-Bill and CD • - capital market: long term fixed income. E.g) T-Bonds

4. 2) Equity : an ownership share in a corporation. Equity owners are not promised any particular payment. Dividend is paid. Value of equity relate to success of the corporation and assets. E.g) common stock • 3) Derivatives: Securities providing payoffs that depend on the values of other assets. E.g) options, futures contracts, etc. • - using to hedge or transfer risks to others.

5. 1.3 Financial Markets and the Economy Financial markets play an important role in facilitating the deployment of capital resources to their most productive use. • Financial assets and the markets play several crucial role in the developed economy. • 1) Informational role: the price of security reflects various analysis and investors’ collective judgment. • 2) Consumption timing: financial markets allow individuals to shift current consumption over the course of lifetime. • 3) Allocation risk: financial markets allow individuals to bear various types of risk, depending on their risk preference.

6. 4) Separation of ownership and management • Financial assets and the ability to buy and sell those assets in the financial markets allow for easy separation of ownership and management. • Agency problem: conflicts of interest between managers and stockholders. • How to mitigate potential agency problem; (1) compensation plan, (2) board of directors forcing our underperforming management, 3) outsiders such as institutional owners, 4) threat of takeover

7. 5) Corporate governance and ethics: • In order to facilitate the deployment of capital resources, the financial market should be transparent. • BUT….. • - misstatements in F/S: Enron, World com, Rite Aid, etc • - misleading and over optimistic research reports by stock market analysts who were compensated not for their accuracy or insight, but for their role in garnering investment banking business for their firms. • - auditing and consulting of accounting firms • - in 2002, Sarbane - Oxley

8. 1.4. Investment process • After a portfolio is established, it is continuously updated or rebalanced. • Investors make two types of decisions in constructing their portfolios: • 1) asset allocation decision - choice among investment asset classes, e.g) stocks, bonds, real estate, etc . • 2) security selection decision – choice of which particular securities to hold within each asset class.

9. How to construct a portfolio? • (1) top-down: portfolio construction starts with asset allocation. • (2) bottom-up: portfolio construction starts with security selection. • 3) Security Analysis: valuation of particular securities that might be included in the portfolio.

10. 1.5 markets are competitive • Investors always look for free lunch which means underpriced securities in the market. • Implications of competitive markets • Risk-Return Trade Off: The higher risk, the higher return. • Efficient Market: The market process all relevant information about securities. Security prices reflect the information relevant to security valuation. • Passive management: without attempting to identify mispriced securities, buying and holding a diversified portfolio • Active management: attempting to identify mispriced securities or to forecast broad market trends.

11. 1.6. The Players 1) Firms are net borrowers. 2) Householders are typically net savers. 3) Governments can be borrowers or lenders. Additional players stand among them 4) Financial intermediaries: institutions that connect borrowers and lenders by accepting funds from lenders and loaning it to borrowers. E.g.) pension funds, mutual funds, insurance, banks, etc.

12. Their financial statements tend to have smaller amount of real assets. • Benefits of diversification by lending to various borrowers, expertise and economy of scales and scope. 5) Investment companies: firms pooling and managing money for investors. E.g) mutual funds with diversification benefit. - Hedge funds: pool and invest money of many clients. But they are open only to institutional investors or wealthy individual.

13. - investment bankers: firms specializing in the sale of new securities to the public, typically by underwriting the issue in the primary market. • - venture capital (VC): VC means the equity investment in young or start-up companies. The source comes from angel investors (wealth individuals) and institutions (pension funds). • - private equity : investments focusing on distressed firms or firms that may be bought up, improved, and sold for a profit.

14. 1.7 The Financial Crisis of 2008 • Due to High –tech bubble in 2000-2002, Federal Reserve responded to an emerging recession by aggressively reducing interest rates. It was successful. Recession was short lived. The spread between LIBOR (bank borrowing rates) and T-Bill rate (government borrowing rates) is low. This spread is a common measure of credit risk in the banking sector (often referred to as the TED spread). • But it fed a historical boom of housing market.

15. Changes in Housing Financing: Prior to 1970s, most mortgage loans came from a local lender or thrift institutions (saving banks, credit union, etc). They have a portfolio of long term (30 year) home loans as a major assets, while its major liability would be the accounts of its depositors. This landscape began to change when Fannie Mae and Freddie Mac began (government agencies) buying these long term mortgage and bundle them to sell to the financial market. The bundled mortgage was called “mortgage backed securities,” and the process was called “securitization.”

16. 1) Mortgage Backed Securities (Pass Through) Home Owners P&I $100 K Originator P&I – service fee $100 K Agency (Freddie Mac or Fannie Mac) P&I – service fee $100 K • Guarantee fee Investor (Here P&I: principal and interest. Service fee means charged fee for collecting P&I. Guarantee fee means charged fee for guaranteeing default and credit risk covered )

17. Until the last decade, the vast majority of the mortgage that have been securitized by Freddie Mac or Fannie Mae were low risk conforming mortgage (the ratio of loan to house value is no more than 80%). Once this became popular, private firms started to securitize unconforming “subprime” loans with high default risk. • Difference between government agency pass through and private pass through: Investors of private pass through would bear the risk of house owners’ default. Originating mortgage brokers do not have much incentives to do due diligence on the loan as long as private pass through is sold. • There were trends toward low documentation or no documentation loans entailing borrowers’ ability to pay back. And increasing popularity of Adjustable rate mortgage (ARM). It will increase interest borrowers’ interest expenses if market increases an interest rate. A wide spread belief that housing price will go up more.

18. Starting in 2004, increasing interest rate began to diminish the ability of refinancing. Then housing price started to decrease. In 2007, housing default rates began to surge. • 2) Mortgage Derivatives • Who was willing to buy all of these risky subprime mortgage?

19. New risk shifting tools such as securitization, restructuring, and credit enhancement provides a big part of answer. They enabled investment banks to carve out AAA rated securities from original issue “junk” loans. • CDOs (collateralized debt obligations) were among the most important and damaging of tools. CDOs were designed to concentrate the credit risk of a bundle of loans on one class of investors by prioritizing claims on loan repayments. They divide the pool into senior versus junior slices (tranches). For example, if a pool were divided into two tranches (70% senior and 30% junior). Senior tranches are repaid in full as long as 70% or more of the loans in the pool performed or as long as default rate is below 30%. Practically, it is unlikely to have more than 30% default rate in the pool. Senior tranches were commonly granted the highest (i.e. AAA). However if overall market goes down, this prioritization or related diversification does not work.

20. Why had the rating analysts dramatically underestimated credit risk in these subprime securities? • - default probabilities estimated by unrepresentative period. • - wrong exploration of historical data to new loan product (zero down-payment loans, etc) • - agency problem: rating agencies were paid from the issuers of the securities not from investors.

21. 3) One of tools: Credit Default Swap (CDS) insuring against the default of one of more borrowers. The purchaser of CDS at OTC market will pay an annual premium (per $100 of debts) and be protected from credit risk. The investor could improve the quality of BB rated bonds to the effective quality of AAA by buying CDS. In this case, CDS is priced by yield spread between YTM of AAA and YTM of BB rated bonds.

22. 4) Rise of systematic risk • Due to low and short term interest rates, financial institutions dramatically increased short term financing to invest high-yielding, long-term, and illiquid assets. It indicates a lack of financial buffering. • Wide spread reliance on credit protection. But it ignores that insured assets are typically very illiquid. Furthermore CDS does not require margin accounts or collaterals to either side. An insurance sellers simply can/may not afford the losses of the purchasers. • Systematic (spill over) risk. These promoted the risk of spill over risk. That is, any risk housing market would generate a chain effect in other sectors.

23. 5) Shoe Drops • By Fall of 2007, housing price went down. Delinquency rate increased. Stock market entered down fall. • The crisis peaked in September of 2008. • - On Sept 7, Fennie Mae and Freddie Mac were put into conservatorship (failure). Next week, Lehman Brothers and Merrill Lynch investing mortgage backed securities were on the verge of bankruptcy. • - On Sept 14, Merrill Lynch was sold to BoA. Next day, Lehman Brother filed bankruptcy. Government lent $85 billion to AIG largely selling CDS. • - Bankruptcy of Lehman Brother largely raising funds by issuing short term and unsecured commercial papers. It directly and negatively hit money market funds who are major investors in commercial papers. Simultaneously the hit dried out money in the short term financing market. Financial institutions tending to rely on short term financing can not raise money.

24. 6) Dodd-Frank Reform Act • The act calls for strict rules for bank capital, liquidity, and risk management, as banks become larger and their potential failure would threaten other institutions. • The act mandates increased transparency, especially in derivative market (CDS). • - standardizing CDS and CDS margin requirement • - Volcker Rule: limits a bank’s trade for its own account and to own or invest in a hedge fund or private equity fund. • - unifying and clarifying lines of regulatory authority and responsibility • Claw-back provision: taking back executive compensation if it is based on inaccurate financial statements. • Creation of an Office of Credit Rating within SEC to over see credit rating agencies.