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ECON 315 Money and Banking | Exam 3 Study Guide | 8/5/13 at 1 pm Chapters.

8 & 9

Chapter 8: An Economic Analysis of Financial Structure


Definitions:
Word Collateral Unsecured debt Restrictive covenants Mutual fund Liquidity services Asymmetric information Adverse selection Moral Hazard Definition Property that is pledged to a lender to guarantee payment in the event that the borrower is unable to make debt payments Credit card debt, is the most predominant form of household debt and is widely used in business borrowing too Bond or loan contracts are long legal documents with provisions that restrict and specify certain activities that the borrower can engage in A financial intermediary that sells shares to individuals and then invests the processed in bonds or stocks, buys a large number thus gets economies of scale Make it easy for customers to conduct transactions A situation that arises when one partys insufficient knowledge about the other party involved in a transaction makes it impossible to make accurate decisions Before the transaction potentially bad credit risks are the ones who most actively seek out loans After the transaction the borrower could engage in activities that are undesirable from the lenders POV because they are risky and increase the possibility that they will not be able to pay the lender back The analysis of how asymmetric information problems affect economic behavior When people who dont pay for information take advantage of the information that other people have paid for (equity capital) the difference between a firms assets (what it owns or is owed) and its liabilities (what it owes), can perform a similar role to that of collateral Common stock claims to a share in the profits and assets of a business A type of moral hazard, when managers (agents) own only a small fraction of the firm, stockholders (principal) own the majority. The separation of ownership and control involves the agents actin gin their own interest in mind Monitoring management of a firm Pool the resources of their partners and use the funds to help budding entrepreneurs start new businesses Incentives of the borrower align with those of the lender Banks owned by the government Not actual facts but closest thing to them in social science, simplified observations of a trend (1961) Nicholas Kaldor listed facts about the economy which led to the development of the Solow Growth Model

Agency Theory Free-rider Problem Net Worth Equity Contracts Principal-Agent Problem

Costly state verification Venture capital firm Incentive compatible State-owned banks Stylized Facts Kaldor Facts

Concepts:
8 Primary Facts about Financial Structure 1. Stocks arent the most important source of external financing for business 2. Issuing marketable debt and equity securities isnt the primary way in which businesses finance operations a. But bonds are bigger than stocks in external finance 3. Indirect finance, financial intermediaries, is many times more important than direct finances a. Majority of direct finance goes to insurance, pensions, and mutual funds 4. Financial intermediaries, banks, are the most important source of external funds used to finance business 1|Page

5. 6. 7. 8.

a. In other countries and in developing countries this is even more so The financial system is one of the most heavily regulated industries a. To promote provision of information, and ensure the stability of the economy Only large, well-established corporations have easy access to securities markets (primary/direct) Collateral is prevalent in debt contracts Debt contracts typically are extremely complicated legal documents to attempt and control the borrower through restrictive covenants

Transaction Costs: A major problem in financial markets, economies arent efficient if there are large financial frictions (time and expense) to allocate capital This makes it hard for an individual to diversify or buy many stocks since small investors the fees would be a large percentage of their total investment Financial intermediaries reduce this by mutual funds to bundle peoples funds to take advantage of diversification and economies of scale o Mutual funds call this a liquidity service, and some (money market mutual) even let depositors write checks against their shares Asymmetric Information Two components Adverse Selection and Moral Hazard Adverse selection makes it more probable that loans are given out to people that arent able to pay them back Example is the Lemons Problem with Used Cars, potential buyers cant assess the quality accurately and thus will only pay a price which reflects average quality o This is an adverse selection problem because the owner knows if the car is a lemon or not if it is a lemon then they would be happy to sell at average quality price. If it is a good quality car the owner would not want to sell at this price meaning the only cars left in the market are ones that are happy with this price which would only be cars with quality of average or below This example can be extended in to the equity (stock) and debt (bond) markets: o People cant distinguish between good firms with high expected profit and low risk and the alternative This helps explain fact 2 people wont buy things they arent sure of (on average) Tools to help solve Adverse Selection Private production and the sale of information o Reduce asymmetric information by supplying information o Standard and Poors, Moodys and Value Line o This is subject to the free-rider problem o Its difficult for firms to make a profit at this because other people see what the masses are doing and copy it even if they dont have a concrete reason for why Government Regulation to Increase Information o Government could produce the information politically difficult o Regulate securities in a way that encourages firms to reveal honest information o SEC requires audits o Adverse selection and moral hazard explain fact 5 most heavily regulated industry Financial Intermediation o Banks become experts in producing information about firms so they can tell which are of what quality. Using this information they can acquire funds from depositors and lend them to good firms making a higher return than they pass onto the depositors o This avoids the free-rider problem because other people cant see these loans to private businesses 2|Page

In developing countries this because hard to assess the quality of a firma and banks play an even greater role o Well known firms are trusted and thus less of a risk so people are willing to directly provide them with funds explaining fact 6 Collateral and Net Worth o Lenders are more willing to make financial deals with people that have more skin in the game in the form of collateral or net worth o Borrowers willing to supply collateral are less risky and make it more likely that they will get the loan and maybe and even better interest rate o If a firm has high net worth, the lender will trust them more that they will be paid back, or that they have assets that could be sold to pay them back

Moral Hazard in Equity Contracts, Principal agent problem how to solve? Production of information: monitoring o Auditing frequently is costly o Makes the equity contract less desirable and helps explain why they arent as prevalent of a role in external business finance Government Regulation to increase information o Laws to force firms to adhere to standard accounting principles o Strict criminal penalties on people who commit fraud or hiding/stealing profit Financial Intermediation o Venture capital firm receives equity share in the new business in exchange for the use of the funds private action thus no free-riders Debt Contracts o Contractual agreement to pay fixed dollar amounts, when the firm makes high profits the owners dont care what the actual number is. If they are hiding profits the lender doesnt care as long as they still make debt payments Moral Hazard in Debt Contracts Investors have incentive to pursue more risky practices that could jeopardize debt payments The problem of moral hazard still exists Tools to help solve? o Net Worth and Collateral Borrowers have more at stake because of their net worth or collateral is they have pledged moral hazard will be greatly reduced and they will behave as the lender expects them to o Monitoring and Enforcement of Restrictive Covenants Discourage undesirable behavior Keeping borrower from doing risky things Encourage Desirable Behavior Keep net worth high to keep moral hazard low Example is requiring life insurance on a house which pays back the mortgage value Keep Collateral Value Keep collateral in good condition and in possession Auto loans require certain insurance and dont let you sell the car Provide Information Periodic accounting and income reports Also have access to an audit whenever they want 3|Page

Financial Intermediation Restrictive covenants sill have the free-rider problem due to enforcement

Financial Development and Economic Growth Transition from communism leads to underdeveloped financial institutions which leads to slow economic growth o Called financial repression Property rights are poorly protected thus net worth and collateral doesnt work very good to alleviate moral hazard Its hard to determine good rom bad firms to lend money to Corrupt legal systems make it difficult to enforce restrictive covenants Government tend to incentivize chosen industries, not the most profitable ones and example of the free-rider problem State-owned banks have no profit motive so they have little incentive to allocate capital in the most productive way Underdeveloped economies also tend to have week systems of regulation Summary Asymmetric Information Problem Adverse Selection Tool to Solve Private Production and Sale of Information Government regulation to increase information Financial intermediation Collateral and net worth Production of Information: Monitoring Government Regulation to increase information Financial intermediation Debt Contracts Collateral and Net Worth Monitoring and Enforcement of Covenants Financial intermediation Explains Fact # 1,2 5 3,4,6 7 1 5 3 1 6,7 8 3,4

Moral Hazard (Equity)

Moral Hazard (Debt)

Equations (Ch. 7):


One Period Valuation of Stock Price

(Where:

is the current price; DIV is the next period dividend payment;

is the required return on equity)

General Dividend Valuation of Stock Price Gordon Growth Valuation

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Chapter 9: Financial Crises


Definitions:
Word Financial Crisis Definition Major disruptions in financial markets characterized by sharp declines in asset prices and firm failures; when information flows in financial markets experience a particularly large disruption, with the result that financial frictions increase and markets stop Problems that act as a barrier to efficient allocation of capital When an economy introduces new types of loans or other financial products Elimination of restrictions on financial markets and institutions As firms decrease in capital the financial instructions cut back on their lending to borrowerspenders Value based on realistic expectations of the assets future income streams The rise of assets prices above their fundamental value When net worth becomes negative Multiple banks fail simultaneously Banks selling off assets quickly to raise necessary funds, can cause asset prices to decline so much that the bank becomes insolvent Substantial unanticipated decline in the price levels sets in, leading to further deterioration of the firms net worth because of increased indebted ness through nominal liabilities The difference between the interest rate on loans to households and businesses to the interest rate on completely safe assets that are sure to be paid back like U.S. Treasury Bundling together small loans into debt securities Bundled high-risk mortgages into a standardized debt security Development of new, sophisticated financial instruments Pay out income streams from a collection of underlying assets, designed to have particular risk characteristics that appeal to investors with differencing preference Brokers making risky loans just to sell them off and not have to deal with the repercussions Mortgage brokers acted as agents and investors were the principals since the brokers earned their fee then sold the mortgage and didnt care if it ever got paid or not Large fees from writing financial insurance contracts, provide payments to holders of bonds if they default from AIG to write hundreds of billions of dollars worth of them U.S. raised homeownership to highest levels in history everyone has access to credit (pre financial collapse) The value falls below the amount of the mortgage Hedge funds, investment banks, and other non-depository financial firms which are less tightly regulated compared to banks Repurchase agreements, short-term borrowing that uses assets like mortgage-backed securities as collateral Additional amount of collateral to complete a repo transaction Economies in an earlier stage of market development that have recently opened up to the flow of goods, services, and capital from the rest of the world Countries eliminating restrictions on financial institutions and markets domestically and opening up their economies to the flows of capital and financial firms to other nations Difference between cash receipts and expenditures Speculators engage in massive sales of currency because they expect the value to fall in the near future An unanticipated depression or devaluation of the domestic currency increases the debt burden in domestic currency (nominal)

Financial Frictions Financial innovation Financial liberalization Deleveraging Fundamental economic value Asset-Price bubble Insolvency Bank panic Fire sales Debt deflation Credit spread Securitization Mortgage-backed securities Financial engineering Structured credit products Originate-to-distribute Principal-agent problem Credit default swap Democratization of credit Underwater Shadow banking System Repos Haircuts Emerging market Economies Financial globalization Cash flow Speculative attack Currency mismatch 5|Page

Concepts:
Dynamics of Financial Crisis in Advanced Economies 1. Initiation of Financial Crisis a. Mismanagement of financial innovation/liberalization i. Financial innovations are often the seeds of financial crisis ii. Government safety nets make people behave in a risky way iii. Losses on loans begin to mount as value falls relative to liabilities iv. Net worths plummet and fire sales reduce asset values which is a positive feedback loop v. Deleveraging begins and frictions increase b. Asset-price boom and bust i. Prices of assets are above their fundamental value ii. When the bubble bursts asset prices realign with their fundamental value and many companies balance sheets become messed up c. Increase in uncertainty i. A crash in the stock market or major financial institution failure fuel financial crisis ii. Financial frictions increase 2. Banking Crisis a. Insolvency makes it impossible for firms to pay off depositors or other creditors b. Information of creditworthiness of borrower-spenders disappears as frictions increase c. Public and private authorities shut down insolvent firms d. Financial frictions finally begin to diminish 3. Debt Deflation a. In economies with moderate inflation debt contracts with fixed interest rates and payments are fixed nominally thus making the payments more expensive as the currency deflates b. A steep decline in net worth of borrowers from a sharp drop in the price level causes an increase in adverse selection The mother of all financial crises: The Great Depression Stock Market Crash o In 1928 and 1929 prices doubled in the U.S. stock market. Federal Reserve officials viewed the stock market boom as excessive speculation, to curb this they tightened monetary policy to raise interest rates to limit the rise in stock prices Bank Panics o By the middle of 1930 stocks recovered almost half of their losses and credit market conditions stabilized Severe droughts in the Midwest led to a sharp decline in agricultural production, this led to farmers not being able to pay back their bank loans. This resulted in large loan losses on bank balance sheets in agricultural regions o The weakness of the economy and the banks in agricultural regions in particular prompted significant withdraws from banks - building to full-fledged panic in Nov. and Dec of 1930 o In march of 1933 President Franklin Roosevelt declared a bank holiday, a temporary closing of all banks "the only thing we have to fear is fear itself" however the damage was done, more than 1/3 of commercial banks failed Continuing Decline in Stock Prices o Increasing uncertainty from the unsettled business conditions created by the economic contraction worsened adverse selection and moral hazard problems in financial markets o Financial markets struggled and productive investment opportunities were left unfunded o Financial frictions made lenders charge businesses much higher interest rates to protect themselves Debt Deflation 6|Page

Ongoing deflation that started in 1930 led to a 25% decline in the price level - which short-circuited the normal recover process o The decline in net worth and resulting increase in adverse selection and moral hazard problems in the credit markets led to prolonged economic contraction International Dimensions o Bank panics in the U.S. spread to the rest of the world, and the contraction of the U.S. economy sharply decreased the demand for foreign goods o Worldwide depression caused great hardship, and resulting discontent led to the rise of fascism and WWII. The consequences of the Great Depression financial crisis were disastrous

Global Financial Crisis of 2007-2009 Causes of the 2007-2009 Financial Crisis o Financial Innovation in the Mortgage Markets Before 2000 only the most credit worthy people (prime) borrowers could obtain residential mortgages Advances in computer technology and statistical techniques - called data mining, led to enhanced, quantitative evaluation of the credit risk for a new class of more risky residential mortgages FICO - Fair Isaac Corporation, cores households to predict how likely they would be to default on their loan payments Lowering transaction costs, computer technology bundling together small loans (like mortgages) into debt securities is called securitization Subprime mortgages were securitized to reduce their risk since its unlikely that they will all fail and if they do you will still have left their collateral (house) Structured credit products pay out income streams from a collection of underlying assets, designed to have particular risk characteristics that appeal to investors with differing preferences CDO - Collateralized debt Obligation is the most notorious of these products o Agency Problems in the Mortgage Markets Mortgage brokers that originated the loans didn't make a strong effort to evaluate the borrowers default risk since they would quickly sell the loan to investors in the form of mortgage-backed securities Adverse selection becomes a major problem - risk-loving investors lined up to obtain loans to acquire houses that would be profitable if prices continued to rise knowing they could "walk-away" if the prices dropped Mortgage brokers encouraged households to take on mortgages they couldn't afford Compounding this problem was relaxed regulation of originators who didnt have to disclose information to borrowers that would have helped them to assess if they could afford the loans or not Commercial and investment banks, were earning large feed by underwriting mortgage-backed securities and structured products like CDOs, they had weak incentive to make sure the ultimate holders of the security would be paid off o Asymmetric information and Credit-Rating Agencies Credit-rating agencies contributed to the asymmetric information problem in financial markets Credit-rating agencies advised clients on how to structure complex financial instruments like CDOs at the same time they were rating these products Thus there was a conflict of interest, they charged large fees for advising clients on how to structure products and had no incentive to make sure their ratings were accurate This led to wildly inflated ratings that enabled the sale of complex financial products that were far riskier than investors recognized Effects of the 2007-2009 Financial Crises o Residential Housing Prices: Boom and Bust Aided by liquidity from huge cash inflows from China and India and low interest rates on residential mortgages, the subprime mortgage market took off after 2001 The asset-price boom in housing helped stimulate the growth of the subprime mortgage market 7|Page

High housing prices mean that subprime borrowers could refinance their houses with even larger loans when their homes appreciated in value - which was expected to happen quickly Increased demand increased the price of housing and led to a housing price bubble Profitability for mortgage originators and lenders was high as house prices rose - underwriting standards for subprime mortgages fell to lower and lower standards High-risk borrowers were able to obtain mortgages, and the LTV (loan-to-value) ratio rose sharply, to about 80% at the worst point As housing prices fell the rot in the financial system began to be revealed - many borrowers found their homes to be underwater Struggling homeowners have big incentives to walk away from the homes and send the keys to the lender Defaults on mortgages shot up sharply, eventually to millions of foreclosures Deterioration of Financial Institutions' Balance Sheets The value of mortgage-backed securities and CDOs collapsed, leaving banks and other Fis with lower value of assets and thus a decline in net worth Banks begin to deleverage, selling off assets and restricting the availability of credit to both households and businesses Run on the Shadow Banking System Funds from shadow banks flowed through the financial system and for many years supported the issuance of low interest-rate mortgages and auto loans Rising defaults on mortgages, the value of mortgage-backed securities fell which led to rising haircuts, at nearly 50% Fire sales were required to balance sheets, but this leads to a decline in asset value causing a positive feedback loop Massive deregulation results in a restriction of lending and decline of economic activity Global Financial Crisis Originated in the U.S. but the wakeup call was when the crisis hit Europe The run on the shadow banking system became worse and worse in all countries Huge injections of liquidity into the financial system by European Central Bank and the Federal Reserve cause banks to horde cash and unwilling to lend Drying up of credit causes the first major bank failure in the UK in over 100 years, Northern Rock which relied on the shadow banking, short-term borrowing in the repo market, collapsed in Sep. 2007 After a string of European financial institutions collapse Ireland was seen as one of the most successful countries in Europe but it was hit particularly hard Failure of High-Profile Firms Major players in the financial markets took drastic actions Bear Stearns (5th largest investment bank in U.S.) was heavily invested in subprime-related securities, had a run on its repo funding and was forced to sell itself to J.P. Morgan for less than 5% of its worth just a year earlier FED had to take over $30 Billion of Bear Stearns's hard-to-value assets Fannie Mae and Freddie Mac, two privately owned government-sponsored enterprises insured over $5 trillion of mortgages and mortgage-backed assets Were taken over by the government in September 2008 after suffering substantial losses Lehman Brothers (4th largest investment bank) filed for bankruptcy making it the largest bankruptcy in U.S. history at over $600 billion in assets and 25,000 employees Merrill Lynch (3rd largest investment bank) was sold to Bank of America for 60% less than its worth one year earlier AIG, insurance giant with assets over $1 Trillion, suffered a liquidity crisis when its credit rating was downgraded $400 Billion in insurance contracts (credit default swaps) that had to make payouts on possible losses from subprime mortgage securities

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FED gives them $85 billion to keep them afloat Height of the 2007-2009 Financial Crisis House of Representatives voted down a $700 billion dollar bailout package Emergency Economic Stabilization Act passed a week later The stock market crash accelerates with the worst weekly decline in U.S. history Credit spreads went through the roof, up to 5.5 percentage points (550 basis points) GDP falls by 6.4% annually in the next two quarters Called the "Great Recession" - worst economic contraction since WWII Government Intervention and the Recovery Economic contraction was far smaller in magnitude than during the Great Depression because of massive interventions by government to prop up financial markets and stimulate the economy FED took extraordinary actions to contain the crisis (using both monetary policy and liquidity provision) U.S. gov't engages in massive bailouts with over $150 Billion of loans to AIG and TARP (troubled asset relief plan) $700 billion purchases of the subprime mortgages by the Treasury to inject capital into institutions Federal deposit insurance was increased from $100K to $250K to limit withdrawals from the banks European bail outs were in the excess of $10 Trillion to prop up their banking systems Economic Stimulus Act of 2008 gave tax-rebates of $78 billion by sending $600 checks to individual taxpayers American Recovery and Reinvestment Act of 2009 - $787 billion fiscal stimulus package In March 2009 a bull market in stocks got under way and credit spreads began to fall

Dynamics of Financial Crises in Emerging Market Economies Stage 1: Initiation of Financial Crisis o Path A: Mismanagement of Financial Liberalization/Globalization Financial globalization = countries eliminating restrictions on financial institutions and markets domestically and opening up their economies to the flows of capital and financial firms from other nations Emerging markets have low regulations and not strong ability to screen potential borrowers This leads to especially risky lending practices Domestic banks borrow abroad High interest rates to attract foreign capital to increase their lending Lending booms still lead to lending crashes and massive losses on loans Adverse selection and moral hazard problems deepen as banks stop lending which causes financial frictions to increase Political principal-agent problem o Part B: Severe Fiscal Imbalance Financing governments spending can also place emerging market economies on a path toward financial crisis When large fiscal imbalances are present in an economy the government cajole or forces banks to purchase government debt Investors lose confidence in the gov't to repay the debt and unloads the bonds which causes prices to plummet Banks then have a huge amount of debt and a big decline in their net worth o Additional Factors Rise in interest rates from events abroad Cash flow = difference between cash receipts and expenditures A firm with sufficient cash flow can finance its projects internally, most common for businesses Increase in interest rates decreases cash flow thus firms have to raise funds from and external source, like a bank 9|Page

This increases financial frictions Asset markets are not as large in emerging market countries, they play a less prominent role in financial crises Asset-price declines in the stock market do have an effect on net worth of firms still though Worsened asymmetric information problems As prominent firms fail due to recession, people become more uncertain about the returns on investment projects which makes things more unstable when their political environment is also unstable Stage 2: Currency Crisis o The effects from step 1 build on each other, foreign exchange market senses and opportunity: they can make huge profits if they bet on a depreciation of the currency o Speculative attack As currency sale flood the market, supply far outstrips demand and the value of the currency collapses, and currency crisis ensues High interest rates abroad increase the uncertainty and falling asset prices play a big role o Deterioration of Bank Balance Sheets Triggers Currency Crisis Gov'ts have limited options to defend currencies, by raising interest rates - banks must pay more to obtain funds which decreases bank profitability which may lead to insolvency but could also bring in foreign currency Gov'ts usually give up and allow the currency to depreciate thus speculators seize an almost sure-thing bet because the currency can only go down in value at this point The country has to buy foreign currency to keep it from falling in value, and as speculators sell of theirs the countries reserves are quickly diminished The country has no choice but to allow the devaluation of currency o Severe Fiscal Imbalances Trigger Currency Crises When gov't budget deficits spin out of control, foreign and domestic investors begin to lose confidence in their ability to payback and they will start pulling money out of the country and selling domestic currency Stage 3: Full-Fledged Financial Crisis o Denominate debt contracts in foreign currency, not domestic, while their assets are denominated in domestic currency this leads to a currency mismatch is an unanticipated depreciation or devaluation of the domestic currency in emerging market countries increases the debt burden of domestic firms in terms of domestic currency It takes more pesos to pay back the dollarized debt o Deterioration of firms' balance sheets with sharply increased financial frictions -> currency and financial crisis at the same time called twin crises o Collapse of currency leads to higher inflation, central banks have little credibility as inflation fighters in emerging countries

Financial Crises in Mexico, East Asia and Argentina

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