The Ascent of Money

The Evolution of Money and the Banks

Historical
What the Spaniards in Bolivia did wrong was they excavated more and more of silver which they were using as their currency for money and started using it as their ,the silver was in such excess that it lost value In Pisa the problem was there was seven different coins in circulation. The roman numerical were very difficult to do complex calculations for the Europeans and then entered Fibonacci.

Credit & debit system

Credit derived from Latin word credo which means I believe Since early times the merchants were charged interest for the money given to them for voyages The Church condemned the charging of interest so taking interested for money given for credit was prohibited.

CONCEPT OF BANKS
In the early 14th century, Italy was the main financial hub of the world. One family, the Mediccis in particular, made a huge impact on the Renaissance. They were foreign exchange dealers who started to use the Bills of Exchange in a big way. If a sum could not be paid in cash until the conclusion of a transaction, the creditors could draw a bill on the debtors. Creditors could use the bill as a means of payment or obtain cash at a discount from a banker willing to act as a broker. The Church condemned the charging of interest, but accepted bill discounting transactions. Indeed, bill discounting proved to be a good source of profit

 Despite the hostility and resistance the Mediccis rode to success by making their banks bigger and more diversified. The Italian banking system soon became a model for other countries in Northern Europe The next wave of financial innovation occurred in Amsterdam, London and Stockholm. The Amsterdam Exchange Bank, set up in 1609, pioneered the system of cheques and direct debits/transfers. A merchant could make a payment to another simply by arranging for his account at the bank to be debited and the counterpartys account to be credited

 The Bank of England was set up in 1694 to assist the British government with war finance. The bank had a partial monopoly on the issue of bank notes. These were promissory notes that did not bear interest and were designed to facilitate payments without the need for both parties in a transaction to have current accounts. The Bank of Englands discount rate soon became the benchmark money market interest rate. With the increasing acceptance of cashless transactions, fractional reserve banking and central bank monopolies on note issue, the nature of money changed as did banking. Credit was quite simply the total of the banks assets .Several kinds of banks emerged in Europe. Some banks helped finance domestic and international trade by discounting the bills of exchange drawn by one merchant on another.

 The US did not have a central bank for a long time. The country followed a laissez faire model till the Federal Reserve System was set up in the 1913. This fragmented system with large numbers of under capitalized banks was a recipe for financial instability. Panics were a regular feature of American economic life, especially in the Great Depression, when a major banking crisis was aggravated by wrong monetary policy. The introduction of deposit insurance in 1939 went a long way towards preventing bank runs. However, the American banking sector remained fragmented till 1976 when inter state banking was legalized.

Why people still have not lost faith in money

It's simple: Because paper money is so easy to use. It gives people an exchangeable commodity and a mathematical unit that is standardized and generally accepted. That's something we're willing to accept a certain amount of inflation for.

Why no more relation between gold and currencies

Because it proved to be an extremely inflexible system. If the overall volume of money depends on the availability of precious metals, it can't simply be increased. So a shortage of gold or silver can limit economic growth. The link to gold brings with it a danger of deflation, in other words a constant drop in prices which would hobble the economy. The gold standard was one of the causes of the deflation Germany suffered in the early 1930s, for example

The Ascent of Money

The Bond Market

Time to get into BOND-AGE

Birth of the bond market Today bond markets play a central role in the management of the economy
long term interest rates for the economy as a whole. Relatively liquid Safe Options Most of our savings lands up in the bond market.

Triggers For Evolution Of Bond

It was wars that fuelled the rise of bond markets

Italian cities 14th Century Financing war through citizen's money for Government debt By the mid 18th century, London had a thriving bond market

MR BOND: NATHAN ROTHSCHILD

Preferred investment bank to place many bond issues of European governments Buying of a tranche of bonds outright from a government and charging a commission for distributing these bonds to a network of brokers and investors throughout Europe An important role in deciding the outcome of the American Civil War, by sitting on the sidelines and deciding not to back the south

Does Bond has presence only in critical times for GOVT. Nathan Rothschild : Fund Manager for war of waterloo as he had strong bank network then Collections of piles of cash Rather than selling gold decided to buy government bonds After 1 year sold at 40% profit

Dynamics Of Bond
Argentina Cotton traded bonds in middle of 18th century Effort to manipulate the cost of Bond by restricting supply of cotton to British cloth industry Pressure on Britain on other side rise in price of Bonds Discovery of New cotton markets in India , Maleshiya Loss of monopoly by Argentina and price fall in Bond Market Hyper Inflation in Argentina

What is Bond
A bond is a debt security when you purchase a bond, you are lending money to a government, municipality, corporation, federal agency or other entity known as the issuer.

The issuer Principal amount Specified interest rate Date of maturity Maturity Short Term and Long Term Redemption Features - CALL Option and PUT Option Credit Quality Interest Rate-Fixed, Floating and Payable at Maturity Price - discount and premium Yield-Current and Yield to maturity

Variables that Effect Value

Evolution of Bond
In certain areas like India Band Market is not yet evolved
IDBI, Inflation Bond

Some other areas like U.S. it has evolved substantially.

Year 1963

1971

1978 1981 1981 1982 1985 1986 1988 1991 1993 1998 1999 2000 2001 2009 2009

Event Competitive bidding by syndicates of securities dealers and banks was introduced for Treasury bonds. Only 2 such syndicate sales were conducted, both in 1963. Congress provided $10 billion of relief from 4 -1/40 interest rate ceiling on bonds maturing in more than 7 years. For the first time since 1965, when longer-term market interest rates rose above 4-1/4%, Treasury issued a bond maturing in more than 7 years. Since then, the bond authority has been increased several times, and an issue of bonds has been a regular feature of Treasury mid-quarter coupon refunding. 15-year, 1-month bond issues began at the beginning of each calendar quarter to mature on regular mid-quarter refunding dates as an alternate for regular quarterly issues of 5-year notes. Depending on market conditions, a 5year or a 15-year issue was sold. 20-year, 1-month bond issues replaced regular issues of 15-year bonds for settlement early in the first month of each calendar quarter, to mature on mid-quarter refunding dates. Mid-quarter refunding operations were standardized to regular issues of 3, 10, and 30-year area maturities. The 30year bonds were callable after 25 years. Bearer form was eliminated for new Treasury notes and bonds in connection with 1982 changes in the tax law. Noncallable 30-year bonds, which are more attractive for stripping than callable bonds, became a regular feature of mid-quarter refunding operations. Regular quarterly issues of 20-year Treasury bonds were eliminated. Congressional restrictions on the par amount of Treasury bonds held by the public with interest rates exceeding 41/4% were eliminated. The noncompetitive award limit for Treasury notes and bonds was increased to $5 million from $1 million. May 3, 1993: Offerings of 30-year bonds were pared back to semi-annually from quarterly, with offerings in August and February, but not in May or November. April 1998: Begin offering of 30-year inflation indexed bond. August 4, 1999: Treasury announced that the 30-year bond will no longer be issued in November, but will continue to be issued in February and August. 30-year bond issuance was changed. Original issues were offered in February and then later reopened in August. October 2001: Treasury announces discontinuance of 30-year bondsboth nominal and inflation-adjusted. March 2009: Reopening of the 30-year bond announced at February quarterly with the first auction taking place in March. July 2009: Additional reopening of the 30-year bond announced during the May quarterly. 30 year bonds were now issued quarterly with one reopening taking place one month after the original issue and the second reopening taking place two months after the original issue.

The Ascent of Money

The Stock Market Bubbles

 After the advent of banking and the birth of the bond market, the next step in the story of the ascent of money was the rise of the joint-stock, limited-liability corporation. Enables thousands of individuals to pool their resources for risky, long-term projects that require the investment of vast sums of capital before profits can be realized.

1. Displacement: Some change in economic circumstances

Pattern of Financial Bubbles

creates new and profitable opportunities for certain companies. 2. Euphoria or overtrading: A feedback process sets in whereby rising expected profits lead to rapid growth in share prices. 3. Mania or bubble: The prospect of easy capital gains attracts first-time investors and swindlers eager to mulct them of their money. 4. Distress: The insiders discern that expected profits cannot possibly justify the now exorbitant price of the shares and begin to take profits by selling. 5. Revulsion or discredit: As share prices fall, the outsiders all stampede for the exits, causing the bubble to burst altogether

The Advent of Company

John Law of Edinburgh The Dutch East India Company Issue of shares The worlds first Stock Exchange

The Oldest Share

The First Bubble

French Government on the brink of bankruptcy for the third time in a century. The birth of the Mississippi Company. The run up to the French Revolution.

May 1719 to November 1720

12,000

10,000

May 1719-Nov 1720

1,500,000,000

1 ,000,000,00 8,000

1,500,000,000 6,000

1,000,000,000 4000 500,000,000 2,000

The Great Depression of 1930

Output collapsed by a third. Employment reached a quarter. Over 10,000 banks failed.

The Enron Bubble

Kenneth Lay, chief executive of Enron. Thought of creating an energy bank.

The Recession of 2008

Over lending by banks. The housing bubble.

The Bombay Stock Exchange

The Ascent of Money

Risk Management: Insurance, Welfare State and Hedge Funds

Risk
The most basic financial impulse Wrong Place : New Orleans Wrong Time : hurricane Katrina
Are you Insured ?

Risk Management incase of disaster

St. Bernard
No Home Insurance zone

Blue collar community All homes insured Refusal to pay even genuine claims

Limits of private insurance exposed

Roots of Insurance
1744: Setting up of 1st Insurance Funds 2 Ministers of the Scotland Church
Robert Wallace and Alexander Webster
Unhappy on seeing the state of widows and children of the fellow clergymen

The Plan
Huge amount of calculations Careful Assumptions
Max number of widows and orphans

The Key Point:

Not just the money in-out concept Premium to create a Fund
Invest the funds

What was required for this scheme to work ?

Accurate Projections Scottish Ministers Widows Fund-A milestone in Financial History Size Matters
Easier to predict pay outs for each year

Precise calculation of life-expectancy

Call the Actuarists !!!

The Welfare State

Japan
Nationalize the risk

October 1947: British economist, William Beveridges Idea

Government will provide

By 1970: A miracle of effectiveness

The Downside
Fatal Flaw in design: 1976: Milton Friedman
Nobel Prize in Economics Chile: output collapsing, inflation rising
Welfare state bankrupt

The Conservative Economic Revolution

Friedman and Chiles Economists
Cut government spending by 27% Balance the Budget Tighten money supply Liberalize Trade

The Pension Scheme

Is there any other way

Hedge Funds
Futures Options

Size: $ 598 trillion Downside ORInvest in a house?

The Ascent of Money

The Real Estate Market

In finance, the conventional wisdom is that there is nothing safer than lending money to people with property. By the end of 2006, American owner occupiers owed a sum equal to 99% of US GDP, compared to 38%, about 50 years back. Before the 1930s, only about 40% of American households belonged to owner occupiers.

ROOSEVELTS NEW DEAL

A new Home Owners Loan Corporation was set up to refinance mortgage on longer terms upto 15 years. A Federal Home Loan bank Board, set up in the 1932. This gave birth to a new breed of institutions called Savings and Loans that took deposits and lent to home buyers. Federal Housing Administration (FHA) sought to encourage large fully amortized and low interest loans which laid the foundation for a national secondary market. As the average monthly payment on a mortgage reduced, home ownership became a realizable dream for many Americans.

CONTINUING REFORMS
Government Sponsored Enterprises (GSE) was set up. As a pert of GSE, Fannie Mae was set up to issue bonds and use the proceeds to buy mortgages from Savings and Loans. In 1968, Fannie Mae was split into:

Ginni Mae to serve poor borrowers like military veterans. Redefined Fannie Mae which could buy conventional as well as government guaranteed mortgages.

In 1970, the Federal Home Loan Mortgage Corporation (Freddie Mac) was set up. Community Reinvestment Act of 1977 put American banks under government pressure to lend to the poorer minority communities.

FALL OF S&LS
Under Paul Volcker, in a bid to cut inflation, the S&Ls were at the receiving end. Started losing money on long term fixed mortgages. Started losing fixed deposits to higher interest paying money market funds. Many S&Ls collapsed because of reckless lending. The final cost of the S&L crisis between 1986 and 1995 was $153 billion or 3% of GDP of which tax payers had to foot $124 billion. This was the most expensive financial crisis since the Depression.

SECURITIZATION

Lewis Ranieri of Salomon Brothers pioneered the concept by bundling thousands of mortgages together as the backing for new securities that could be sold as alternatives to government and corporate bonds. Since a majority of the mortgages enjoyed an implicit guarantee from Fannie Mae, Freddie Mac and Ginnie Mae, the bonds used to securitize were perceived as government or investment grade bonds. Between 1980 and 2007, the volume of GSE backed mortgage backed securities grew from $200 million to $4 trillion. In 1980, only 10% of the home mortgage market had been securitized. By 2007, this had risen to 56%.

ROLE OF POLITICS
President George Bush signed the American Dream Down payment Act of 2003 to subsidise first time house purchases by lower income groups. Lenders were encouraged not to press borrowers for full documentation. Pressure was also put on Fannie Mae and Fraddie Mac to support the sub prime market.

THE FINAL WORDS

It looked as though securitization was allocating risk to those best able to bear it. But actually, it was being passed on to people who understood the least about it. The real estate market saw a big bubble which had to burst at some point of time. In cities all over the world, house prices soared above levels and politicians fuelled the boom by encouraging home ownership and introducing suitable policy measures. The tendency of many middle class households to put virtually all their income into a highly leveraged investment defies the basic principles of risk management. The key to financial security should be a properly diversified portfolio of assets.