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What We Learned from H-E-D-G-E

What We Learned from H-E-D-G-E. Introduction to Business Transactions November 27, 2007. University of Tennessee College of Law Professor Robert M. Lloyd. Merle Hazard. Merle Haggard Moral Hazard. Moral Hazard. Leaving your insured car in a bad neighborhood Executive stock options

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What We Learned from H-E-D-G-E

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  1. What We Learned fromH-E-D-G-E

  2. Introduction to Business TransactionsNovember 27, 2007

  3. University of TennesseeCollege of LawProfessor Robert M. Lloyd

  4. Merle Hazard • Merle Haggard • Moral Hazard

  5. Moral Hazard • Leaving your insured car in a bad neighborhood • Executive stock options • Hedge fund managers’ compensation • The “Greenspan put”

  6. Derivative A security whose value depends on another financial instrument Mortgage-backed bonds Options

  7. Options Put – a contract giving the right to sell a security at a set price Call – a contract giving a right to buy a security at a set price

  8. Swap “I’ll pay yours if you’ll pay mine.” Different currencies Fixed rate for floating rate

  9. Hedge • An investment made for the specific purpose of reducing the risk on another investment. • Examples • Buying Exxon and shorting British Petroleum • Farmer selling corn futures

  10. Hedge Fund • Private investment partnership • Individual partners must have net worth of $1 MM or income of $200 K • Can invest in variety of vehicles • Name comes from fact can hedge • Managers typically receive a generous percentage of the profits.

  11. Margin Call • Buying stocks with borrowed money is “buying on margin” • Federal regulations limit the amount of leverage you can have • When the price of your stock drops so much you are overlevered, you get a “margin call” • If you don’t put up more cash, they sell your stock

  12. Leveraged 10 to one • Can mean ratio of debt to equity is 10:1 • Or can mean ratio of assets to equity is 10:1

  13. CDO • “Collateralized Debt Obligation” • A mortgage-backed (or similar) security in which there are several “tranches” offering different levels of risk and reward.

  14. Moody’s get the ratings wrong • Moody’s (and other similar organizations) rated the risk of CDO tranches • They screwed up—big time

  15. Goldman Sachs • The most successful investment bank • Former head Robert Rubin was Treasury Secretary under Clinton I • Former head Hank Paulson is present SecTreas • Only major bank not to suffer big losses on sub-prime

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