Sequence of a Financial Crisis

1. Initial Phase 2. Banking Crisis 3. Debt Deflation

What are ways a financial crisis can begin? (Initial Phase)

1) Credit Boom and Bust 2) Asset-Proce Boom and Bust 3) Increase in Uncertainty

Credit Boom and Bust

• Mismanagement of financial innovation can lead to elimination of restrictions, new financial products • Both can lead to a credit boom - Government safety nets weaken incentives for risk management - Depositors ignore bank risk-taking • Loan losses accrue and eventually asset values fall, leading to a reduction in capital • Financial institutions cut back lending (called deleveraging), and bank funding falls as well • As institutions cut back on lending, financial system loses primary solution to information asymmetry • Economic spending contracts as loans become scarce

Asset-Price Boom and Bust

• Pricing bubble starts when asset values exceed their fundamental values • When the bubble bursts and prices fall, corporate net worth falls as well • Moral hazard increases as firms have little to lose • Institutions also see fall in their assets, leading again to deleveraging

Increase in Uncertainty

- Periods of high uncertainty can lead to crises (stock market crashes, failure of financial institutions) - 1857: Ohio Life Insurance & Trust Company failed - 2008: ALG, Bear Sterns, and Lehman Brothers failed - Moral Hazard and adverse selection problems increase, reducing lending and economic activity

Stage 2: Banking Crisis

- Deteriorating balance sheets lead financial institutions into insolvency. If severe enough, can lead to a bank panic • Panics occur when depositors are unsure which banks are insolvent • As a result, depositors withdraw all funds from all institutions immediately • As cash balances fall, institutions must sell assets quickly • Snow-ball effect leads to further deterioration of balance sheets • Adverse selection and moral hazard become severe—it takes years for a full recovery

Stage 3: Debt Deflation

• If crisis leads to sharp decline in prices, debt deflation can occur • Asset prices fall but debt levels do not adjust, which increases debt burdens • Leads to increase in adverse selection and moral hazard • Economic activity remains depressed for (potentially) long time

Great Depression

• In 1928 and 1929, stock prices doubled in the United States • The Fed tried to curb excessive speculation with tight monetary policy • Led to a stock market collapse of more than 20% in October 1929, additional 20% by end of 1929 • Severe droughts in 1930 in the Midwest led to a sharp decline in agricultural production • Between 1930 and 1933, one-third of U.S. banks went out of business because of agricultural shocks • For more than 2 years, the Fed sat idly by through one bank panic after another • Adverse selection and moral hazard in credit markets became severe • Firms with productive uses of funds were unable to get financing • Deflation during the period lead to a 25% decline in price levels • Prolonged economic contraction led to an unemployment rate around 25%

Financial Crisis (2007 - 2009)

1. Financial innovation in mortgage markets: • Less-than-creditworthy borrowers purchased homes via subprime lending (nonexistent until 2000s) • Financial engineering developed new products to distribute risk away from mortgage lending 2. Agency problems in mortgage markets: • Mortgage originators did not hold actual mortgage -> sold notes in secondary market • Mortgage originators earned fees from volume of loans produced, not quality • In the extreme, unqualified borrowers bought houses they could not afford through either creative mortgage products or outright fraud (such as inflated income) 3. Rating agencies didn’t help: • Agencies consulted with firms on structuring products to achieve highest rating, creating clear conflict • Rating system was not designed to address complex nature of structured debt designs • Result was meaningless ratings that investors had relied on to assess quality of their investments

Financial Crisis (2007 - 2009) Timeline

• August 2007: $10-billion downgrade in mortgage-related products, French investment house suspends redemption of money market funds • March 2008: Bear Sterns fails and is sold to JP Morgan for 5% of its value 1-year prior • September 2008: Freddie Mac and Fannie Mae are put into conservatorship • September 2008: Lehman Brothers files for bankruptcy, Merrill Lynch sold to Bank of America at "fire" sale prices, AIG experiences liquidity crisis • 2009: Real GDP and unemployment impact almost all participants in the economy

Origins of the Federal Reserve System

• Fear of centralized power and distrust of moneyed-interests guided central bank activities in the 19th century • The First Bank of the United States was disbanded in 1811 • The Second Bank of the United States was disbanded in 1836 when President Andrew Jackson vetoed its renewal • As a result, banking panics became regular events, culminating in the panic of 1907 • Widespread bank failures and depositor losses convinced the United States that a central bank was needed

Federal Reserve Act of 1913

• A compromise that created the Federal Reserve System, including elaborate checks and balances • 12 branches are spread across the country to make sure all regions are represented in policy deliberations • The banks are quasi-private institutions, promoting a concern with regional issues

Federal Reserve System Functions

Main function: Fed has dual mandate to pursue economic goals of Maximum Employment and Price Stability In addition, member banks perform general functions: • Clear checks • Issue new currency and remove damaged currency • Administer and make discount loans to banks in their districts • Evaluate bank mergers and expansions • Liaison between local community and the Federal Reserve System • Perform bank examinations • Collect and examine data on local business conditions • Conduct research related to monetary policy

Structure of the Federal Reserve System

Design was intended to diffuse power along the following dimensions: • Regions of the United States • Government and private sector interests • Needs of bankers, businesses, and the public Current system includes: • Twelve Federal Reserve Banks • Board of Governors (BOG) of the Federal Reserve System • Federal Open Market Committee (FOMC) • Federal Advisory Council • Member Banks (around 2,000) Three policy tools: • Open market operations • Discount rate • Reserve requirements

Board of Governors

• 7 governors are appointed by the President and confirmed by the Senate • Serve 14-year terms on a rotating schedule • All Board members are members of the F OMC • Sets reserve requirements and effectively sets the discount rate at which banks borrow • Advises the President, represents the US in foreign economic matters • Other duties as established by legislation (e.g., Regulation Q, Credit Control Act of 1969) • Set margin requirements for stock purchases • Sets salaries of FRB presidents and officers, reviews each bank’s budget

12 Federal Reserve Banks

- Twelve districts each have a main Federal Reserve Bank and at least one branch office - Banks are “quasi-public” • Owned by district's member commercial banks • Member banks elect 6 directors, Board of Governors appoints 3 directors • Directors represent professional bankers, prominent business leaders, and public interests (3 from each group) • Each Bank's president is elected by the 9 directors

FRB of New York

• Responsible for oversight of some of world's largest financial institutions • Houses "open market desk" – handles all open market operations (discussed soon) • President of NY Fed is only permanent member of the FOMC (serves as vice-chair) • Only Fed member of Bank for International Settlements (close contact with foreign central banks)

FED Research Staff

Federal Reserve System employs over 500 research economists. What do all these researchers do? • Offer insight on incoming economic data • Forecast where economy is heading • Provide briefs for formal meetings on economic outlook of country • Support supervisory staff in decisions about bank mergers, lending activities, technical advice • Produce reports on developments in major foreign economies • Public education

Federal Open Market Committee (FOMC)

• 12 Members: 7 members of BOG + President of NY Fed + 4 Presidents from other Fed Banks • Make decisions regarding open market operations, which influences the monetary base • Open market operations is Fed's most important tool for controlling money supply • Other tools include reserve requirements and the discount rate • All actions are directed by the FRB of New York, where securities are bought and sold as required

FOMC Meetings

Meet eight times each year to • Reports on open market operations (foreign and domestic) • National economic forecasts are presented • Discussion of monetary policy and directives • Formal policy directive made • Post-meeting announcements, as needed

Chairperson of the Federal Reserve System

• Spokesperson for the entire Federal Reserve System • Supervises the Board of Governor’s staff • Negotiates, as needed, with Congress and US President • Effective control over the system – no legal authority to exercise control

Instrument Independence

The ability of the central bank to set monetary policy instruments

Goal Independence

The ability of the central bank to set the goals of monetary policy

Should the Fed be independent? -> Case for Independence

• Strongest argument: political pressure tends to add an inflationary bias to monetary policy • Stems from short-sighted goals of politicians • For example, high money growth lowers interest rates in short-run but leads to higher inflation in long-run • Idea of the political business cycle stems from the previous argument • Expansionary monetary policy leads to lower unemployment and lower interest rates – a good idea just before elections • Leads to higher inflation and interest rates post-election – effects that hopefully disappear (or are forgotten) by next election • Other arguments for independence: • Treasury may seek to finance the government through bonds purchased by the Fed – leads to inflationary bias • Politicians have repeatedly shown inability to make hard choices for good of the economy • Allows the Fed to pursue policies that are politically unpopular, yet in the best interest of the public

Should the FED be Independent? -> Case against Independence

• Some view Fed independence as “undemocratic” – an elite group controlling an important aspect of the economy but accountable in few ways • If this argument seems unfounded, then why not let the other aspects of the country be controlled by an elite few? • For example, are military issues any less complex? • We hold the President and Congress accountable for the state of the economy, yet they have little control over one of its most important tools • Further, the Fed has not always been successful – made mistakes during the Great Depression and inflationary periods in the 1960s and 1970s • Lastly, the Fed can succumb to political pressure regardless of any state of independence – pressure may be worse with fewer checks and balances

Monetary Policy

Refers to the management of the money supply

Reserves

Deposits at the Fed + currency physically held by banks

Reserves are divided into two categories

1. Required Reserves (which are now zero) 2. Excess Reserves

Required Reserve Ratio

Portion of deposits banks mush hold in cash

Excess Reserves

Any reserves beyond the amount of the required reserve ratio

How do Open market operations affect the money supply?

- Buying bonds increase the money supply - Selling bonds decreases the money supply

How do discount loans affect the money supply?

- Making discount loans increases the money supply - Restricting discount loans decreases the money supply

Discount Rate

Rate the Fed charges member banks for loans to meet reserve requirements

Federal Funds Rate

Rate member banks charge each other for uncollateralized, overnight loans - "Target interest rate" the Fed talks about that is influenced by many different economic factors

Open Market Operations

- Most important tool at Fed's disposal Power to change banking system's reserves, entire monetary base Advantages: 1. Fed has complete control 2. Flexible and precise 3. Easily reversed 4. Implemented quickly

Repurchasing Agreements (Repos)

- The Fed purchases securities but agrees to sell them back within ~ 15 days - Thus, desired effect is reversed when the Fed sells the securities back - Good for defensive strategies

Matched sale-purchase transaction

Essentially a reverse repo where the Fed sells securities but agrees to buy them back

Nonconventional Monetary Policy Tools

1) Liquidity Provisions 2) Quantitative Easing

Liquidity Provisions

The Fed undertook the following actions to increase liquidity: • Discount window expansion – discount rate lowered several times • Term auction facility – another loan facility, offering another $400 billion to institutions • New lending programs – included lending to IBs, and lending to promote purchase of asset-backed securities

Quantitative Easing

- Large-scale asset purchases by the Fed: • 11/2008 – QE1 established, purchasing $1.25 trillion in MBSs • 11/2010 – QE2, Fed purchases $600 billion in Treasuries, lowers long-term rates • 09/2012 – QE3, Fed commits to buying $40 billion in MBSs each month - Powerful force to stimulate economy • QE programs dramatically increases the Fed’s balance sheet… • …but perhaps also leads to inflation?

Goals of Monetary Policy

- Price Stability has become a primary goal • Policymakers must establish a nominal anchor which defines price stability • For example, “maintaining an inflation rate between 2% and 4%” might be an anchor • An anchor also helps avoid the time-inconsistency problem Other goals: • High employment • Want demand = supply, or natural rate of unemployment • Economic growth (natural rate of output) • Stability of financial markets • Interest-rate stability • Foreign exchange market stability Goals are often in conflict…pursuing one goal may hurt another!

Fed Dual Mandate

The Fed uses a dual mandate, where “maximizing employment, stable prices, and moderate long-term interest rates” are all given equal importance

Securities in the Market

• Are short-term and are very liquid – so close to being money! • Are usually sold in large denominations ($1,000,000 or more) • Have extremely low default risk • Mature in one year or less from their issue date • Most mature in less than 120 days

Purpose of Money Markets

They provide a way to solve cash timing problems since cash inflows and outflows are not well synchronized

Money Market Instruments

Treasury Bills • Federal Funds • Repurchase Agreements • Negotiable Certificates of Deposit • Commercial Paper • Banker’s Acceptance • Eurodollars

Treasury Bills (T-Bills)

- T-bills are short-term debt issued by the US government - Have maturities from 28 days through 12 months - Typically priced through "Discounting": • Investor pays less for security than its value at maturity • Increase in price provides a return • Common to short-term securities because they often mature before issuer can mail out interest checks!

Negotiable Certificates of Deposit

• Bank-issued security • Documents a deposit and specifies the interest rate and the maturity date • Denominations range from $100,000 to $10 million Great way to store a few million bucks for a short period of time!

Commercial Paper

Unsecured promissory notes that mature in no more than 270 days, issued by corporations

Banker's Acceptance

• An order to pay a specified amount to the bearer on a given date if specified conditions have been met, usually delivery of promised goods • These are often used when buyers/sellers of expensive goods live in different countries • There is an active secondary market for banker’s acceptances until they mature (terms of note indicate that the bearer, whoever that is, will be paid upon maturity)

Eurodollar

US dollar-denominated deposits held in foreign banks

Participants in Money Markets

- U.S Treasury Department - Federal Reserve System - Commercial Banks - Businesses - Investment Companies (Brokerage Firms) - Finance Companies (commercial leasing companies) - Insurance companies (property and causality insurance companies) - Pension Funds - Individuals - Money Market Mutual Funds

Capital Markets

Original maturity is greater than one year, typically for long-term financing needs

Best known capital market securities:

Stocks and Bonds

Primary issuers of securities:

• Federal and local governments: debt issuers • Corporations: equity and debt issuers

Largest purchasers of securities:

You and me – mostly in secondary (not primary) markets

Bonds

Securities that represent debt owed by the issuer to the investor. Typically include specified payments on specific dates, including maturity

Treasury Notes and Bonds

• Very low interest rates – T-Bill often considered the risk-free rate - Treasury Bills mature in < 1 year - Treasury Notes mature in 1 - 10 years - Treasury Bonds mature in 10 to 30 years

Municipal Bonds

• Issued by local, county, and state governments • Used to finance public interest projects • Interest is exempt from Federal income taxes

What are the two types of municipal bonds?

1. General Obligation: Funds general operations of municipality 2. Revenue: tied to revenues of specific project

Corporate Bonds

• Typically have a face value of $1,000 (sometimes $5,000 or $10,000) • Pay interest semi-annually (sometimes annually or not at all) • Only redeemed at maturity – unless specific call feature allows early retirement • Level of risk varies with each bond and even among bonds issued by same company • Required interest rate (yield) varies with the level of risk • Risk ranges from low-risk (AAA) to higher risk (BBB) • Bonds rated below BBB are considered sub-investment grade ("junk" bonds)

Characteristics of Corporate Bonds

Registered Bonds • Replaced “bearer” bonds • IRS can track interest income this way Call Provisions • Higher required yield • Mechanism to adhere to a sinking fund provision • Interest of the stockholders • Alternative opportunities Restrictive Covenants • Mitigates conflicts with shareholder interests • May limit dividends, new debt, financial ratios, etc. • Usually includes a cross-default clause Conversion • Some debt may be converted to equity • Similar to a stock option, but usually more limited

Indenture

Contract that accompanies a bond; specifies the terms of the loan agreement, including restrictive covenants and special features

Face Value

Maturity value of the bond – bondholder will receive the face value from the issuer when the bond matures; synonymous with par value

Market Value

Current price of the bond (the amount you could buy or sell the bond for today)

Maturity

The number of years or periods until the bond matures and the holder is paid the face amount

Coupon (interest) rate

Stated annual interest rate on the bond – usually fixed for the life of the bond

Current Yield

Annual coupon payment divided by the current market price of the bond

Yield to Maturity

Yield an investor will earn if the bond is purchased at the current market price and held until maturity, synonymous with market rate

Stock

Represents ownership position • is firm's entire equity position, 1 share is proportional ownership

What are the two ways to earn a return for stocks?

1. Capital Gains (stock price rises over time) 2. Dividends (shareholder payout)

What are the two types of stock?

1) Common stock: comes with the right to vote and may receive dividends 2) Preferred Stock: usually does not vote, receives fixed dividend

Stock Order Types:

1. Market Order: 2. Limit Order: Buy or sell stock at specific price or better 3. Stop Order: Buy or sell stock once it reaches a specific price

Market Order

Buy or sell stock at current market price • Buy Order: buy stock starting with lowest ask price and then up • Sell Order: sell stock starting with highest bid price and then down

Limit Order

Buy or sell stock at specific price or better • Buy Limit Order at $40: buy stock at $40 or lower • Sell Limit Order at $40: sell stock at $40 or higher

Stop Order

Buy or sell stock once it reaches specific price • Buy Stop Order at $40: buy stock once it rises to $40 • Sell Stop Order at $40: sell stock once it falls to $40 (a.k.a. stop-loss order)

What are the Stock Exchanges?

1. New York Stock Exchange (NYSE) 2. National Association of Securities Dealers Automatic Quotation System (NASDEQ) 3. Over-The-Counter (OTC) Markets

What is the NYSE?

• Largest stock market in the world (2,300 companies valued at $30 trillion) • Auction market coordinated by Brokers and Designated Market Makers • Investor orders are matched using "parity/priority" model • Physical location in Manhattan as well as complex electronic network

What is the NASDEQ?

• Second largest market (over 7,000 companies valued around $20 trillion) • Dealer market coordinated by Market Makers • MMs maintain inventory of stock, post bid and ask prices • No physical location, all trading done via complex electronic network

What are OTC Markets?

• Old meaning: any decentralized stock market without a physical location (including NASDAQ) • New meaning: OTC Markets Group operates markets for extremely small, illiquid companies (very risky!)

What are the Stock Market Indices?

1. Dow Jones Industrial Average 2. S&P 500 3. NASDEQ Composite

What is the Dow Jones?

• 30 prominent companies that include some of largest US corporations • Price-weighted: Stock A price is $70, Stock B price is $30  70% of index reflects A, only 30% reflects B • Narrow view of economy (only "blue-chip" stocks), issues with weighting scheme

What is the S&P 500?

• 500 of largest US corporations, represents around 80% of total US market capitalization • Value-weighted: Firm A value is $70, Firm B Value is $30  70% of index reflects A, only 30% reflects B • Generally considered best indicator for health of stock markets

What is the NASDEQ Composite?

• Includes almost all stocks listed on NASDAQ • Value-weighted like the S&P 500 • Dominated by large tech companies

Exchange Traded Funds (ETFs)

- Relatively recent innovation, offers diversification without high transaction costs - Represents a basket of financial securities - Trades on major exchanges throughout the day, just like stock - Indexed to a specific portfolio (e.g., S&P 500) so management fees are low

How to value stocks?

Same concept as valuing bonds: 1. Determine expected future cash flows 2. Determine appropriate discount rate 3. Value of Stock = Present Value of all Future Cash Flows

Three common methods to value stocks:

1. Dividend Discount Models 2. Relative Valuation Models 3. Free Cash Flow Models

Relative Valuation Models

Value stock based on comparing firm's financial ratio to industry's average financial ratio (typically use the Price-to-Earnings Ratio)

Problem with Relative Valuation Models

Circular Referencing: to calculate industry's average PE ratio, need all stock prices in industry

Free Cash Flow Models

Problem with Dividend Discount Models? Many companies don't pay dividends! FCF Method: Determine entire value of firm, then derive stock price

FCF model -> Value of Firm = ?

Value of Operations + Non-Operating Assets

FCF model -> Value of Equity =

Value of Firm – Value of Debt

FCF model -> Stock Price = ?

Value of Equity / Shares Outstanding

How does the growth rate affect the stock price?

Higher growth rate leads to higher stock prices

How does the discount rate affect the stock price?

- A higher discount rate (r) increases the denominator → lower stock price. - A lower discount rate (r) reduces the denominator → higher stock price.

What is the riskiest capital market security?

Common Stock