Fin3244 Exam 2 notes Chapter 5 investment banks mutual funds and hedge funds and the shadow banking system The great depression Bank failure a mismatch in the maturity of deposits o Banks mainly invest money into mortgages especially 30 yr mortgages o When these banks have a mismatch in short term loans vs long term loans then it creates bank failure o Mismatches occur when the an individual wants to take all the money out in his account but the bank has invested too much in a long term loan such as a mortgage o This creates a liquidity crisis when the bank cannot pay out DJIA longest average to this date Roaring 20s Dow Jones hit high of 381pts Black Monday and Black Tuesday severe drops in the market in a course of a couple of months It rose for a secondary peak and then fell again to get a 89 2 drop over a 3 year time period Took 25 years for the market to climb to 381 again Ben Bernanke the chair of the Federal Reserve during the time of the great recession Great depression was caused by the tightening of monetary policy Tightening removing money from the economy and highering interest rate To fix inflation higher interest rate was declared that causes people to stop borrowing money which results in lower spending and a drop in prices The problem with the depression was the interest rates increasing and causing unbalance in the financial market If interest rates stay to high for too long then people and companies stopped borrowing as much and caused slowing in the economy Commercial banking Take in deposits and make loans Adverse selection process for depositors o Depositors withdrawal their money at a quick rate and the banks care less about the borrowers creditworthiness Grt depression solution o FDIC if bank did not have enough money for your withdrawal then the gov would supply funds so there wouldn t be a problem Must be balancing in the restrictions and government regulations in US banks Fannie may was created following the depression to give banks federal money in order to finance mortgages so the home market is more accessible Investment banking Provide advice on o New security issues o How to raise new funds o When to Borrow and issue new stock or bonds o Deciding on debt and bonds or ipos and price of stocks When Underwriting new issue o Investment bank receives 6 8 of initial ipo Mergers and acquisitions o Merger two companies join o Acquisition company buys another Financial engineering and innovation this when they create new products and strategies CDO collateral debt obligation o First company to use these Drexel Burnam Lambert o A CDO is an Asset backing debt obligation o Most common CDOs CDOs backed by mortgaged back securities MBS which in turn are backed by individuals homes o Video Crisis of credit individuals are connected to investors through mortgages CDO has three levels of risk Safe rated AAA Okay rated BBB And risky which has no rating The higher the safety level the lower the return o Problems occurred when lenders started sub prime mortgages instead of sticking with safe prime mortgages o Homeowners then had to default and banks mortgage turns into house in the banks CDO o Banks CDO continues to produce more defaults and CDO is eventually filled with houses instead of mortgages Now there are many houses for sale on the market and houses prices are declining o Now people are paying mortgages on a house that was 300k but is only worth 90k so now people walk away from their house o Now the investor banks and lenders are all not wanting to purchase anything from each other Investment bank does a lot of research as well o Visiting firms buy sell recommendations for stock prices in the firm and investment bank employees are usually the talking heads of big financial analyst shows Proprietary trading trading with banks own money not the clients o This money comes from profits made in the past by the company itself Unintended consequences o 07 09 1st time in US history that a major financial crisis hadn t started in the commercial banking system o It actually occurred in non bank financial institutions since they played a larger role in moving funds between borrowers and savers o New types of securities became more complex and also Lacked transparency making it harder to tell its worth And ratings of mortgage backed securities were ranked inaccurately o Adverse selection o Moral hazard Securitizations of mortgages Partnerships to publicly traded firms Short term gains increase o Government regulations No FDIC Leverage limits or minimum asset requirements Bank Changes and Leverage Many things changed in the financial system throughout the years Specifically in investment banking o Technology increased speed of transactions o Financial innovation and engineering o Proprietary trading o Structure of investment banks Privately owned to publicly owned meaning they sold off some of their own company in stock Commercial banks use to hold mortgages on the books Investment banks became willing to buy mortgages and package them into Mortgage backed securities Then gov made fanny may and Freddie mac to create marketplace for these securities and then firms became less interested in the riskiness If someone failed to pay then bank then they didn t care because the weight was on someone else This creates adverse selection Leverage Borrowing money to invest using less equity Leverage magnifies returns and magnify losses ROE Return on equity value of assets capital o Investment value value of equity Investment banks Primary money sources Commercial paper and repurchase agreements repos which are short term loans Commercial paper is a short term unsecured loan and is fairly risky so companies must be high quality companies to issue them It has a maturity of 270 days or less around 6 months A repo agreement o Loans made overnight aka very quickly o Bank borrows from another with collateral then bank agrees to pay other bank to repurchase the collateral Collateral package of securities o So what can go wrong Bear sterns ex they used MBS as collateral but MBS were plummeting so banks didn t lend Aka the investment bank started to fail and would have to default and bankrupt since they could not repo in money for their expenses Investments during the housing bubble MBS and CDOs which are long term debts on avg of 30 years Therefore there was mismatch and allowed for possible bank runs liquidity problem The problem was that commercial banks have FDIC insurance but investment
View Full Document
Unlocking...