1 Investment banks Mutual and hedge funs And the shadow banking system The Great depression Bank Failure o Commercial banks Get most of their money from on demand deposits can take out money whenever not reliable long term Invests in mortgage loans 30 years in most common Mismatch in maturity of money short term deposits funding for long term loans This is problem because if people want there money back all at once the money will not be there because the money is invested o This makes a Liquidity problem Great depression solution FDIC Too big to fail government wont let them fail so banks take more risks Moral hazard problems mitigated by monitoring means government will regulate banks o Too restricted If we get too restricted we cannot compete with overseas banking markets Not too risky not to safe have to be balanced Dust bowl o Did not rotate crops no agriculture rules o Drought in Midwest o Part of the reason why it took 25 years to recover The great depression was caused by a tightening of money policy o Raise interest rate too high people stop borrowing people don t buy prices go down inflation is reduced Spring of 1928 began to increase interest rates hoping to deflate inflation rates kept raising interest rates during a recession and that is what made the market crash Gold standard selling gold for dollars Fed Raised interest rates on dollars 2 The Crisis of Credit Who is affected Everyone How it happens credit crisis brings 2 groups of people together houses o Home owners represent their mortgages represents o Investors represent their there money represents pension funds insurance companies sovereign funds mutual funds These groups are brought together by the financial system Banks and brokers Wall Street o Leverage Borrowing money to amplify the outcome of a deal How banks make their money Investment Banks Provide advice on new security issues o How to raise new funds Borrow issue new stock or timing Commercial paper Repurchases agreements repos Underwriting new issues o Primary mkt IPO initial public offerings around 6 8 or seasoned issues 2 4 Mergers two companies join together and Acquisitions one company boys another don t invest own funds identify clients 3 Create new products strategies Financial engineering innovation o Products investment banks come with Mortgage back securities collateralized debt obligation o Investment banks do a lot of research Analyst look into viability of different industries check in on different firms buy or sell recommendations Talking heads on tv o Proprietary trading Trading with banks own money not the clients Banks can raise money by borrowing Selling pieces of themselves stock or equity Unintended consequences o 2007 2009 crisis 1st time in US history that a major financial crisis hadn t started in the commercial banking system Non bank financial institutions played larger role in moving funds between borrowers savers than commercial banks People have more money in pensions mutual funds invest more in bonds and New types of securities complex more complex the less transparent harder to tell what is really stock worth Introduction to the financial crisis adverse selection Times have changed 4 New technology Faster speeds world has gotten smaller New products online stores online purchases Finance is global Money and products Changes to commercial investment banks What they are permitted to do regulations How they do it Investment banks o Activities of reduced importance to earnings Advise on new security issues Underwriting new issues Research Mergers and acquisitions o Technology increases speed of transactions Financial innovation and engineering major source of profit o Proprietary trading trading with banks own money not clients Structure of investment bank Privately owned Publicly owned Multiple Events o The past mortgages on books of commercial banks Banks concerned with borrowers creditworthiness o Changing times Securitization Financial innovation teams with government policy Government creates market place for mortgage backed securities Investment banks package and sell mortgages Financial engineering created CDO COLLATERALIZED DEBT OBLIGATION Adverse selection 5 Banks care less about borrows creditworthiness they already sold the MBS Global Finance US MBS held internationally Investment Banks 2 o Financial securities are global US MBS spread internationally o Proprietary trading own money to buy or sell Structure of investment banks Privately owned publicly owned sold stock o Separation of ownership share holders and management Moral hazard principal agent problem Leverage o Use less of their own equity ownership stock or percentage of Borrow money to invest what you own o Magnifies returns o Magnifies losses Return on equity ROE Values of assets Capital Investment value value of equity 6 Commercial paper Repos and the Crisis of Credit Primary money sources o Commercial paper o Repos repurchase agreements Both short term loans Investments during housing bubble o MBS Mortgage back securities o CDO collateralized debt obligations Long term debt Mismatch maturities o Potential liquidity problems possible bank runs o Commercial banks have FDIC insurance o Investment banks do not have FDIC insurance Commercial paper o Short term loan Unsecured Sale of issues means of borrow demands o Firm with reputation as high quality only companies that can issue commercial paper Maturity of 270 days or less common for 6 months or less SEC registration Not required Reduces transaction costs Repurchase agreement repo One bank sells another bank treasury bills low risk o Short term sale of high quality securities o Terms of sale include Repurchase of price of securities 7 Time to repurchase often over night Repurchase price is higher than sale price o Essentially a short term loan o Went from selling mainly 3 month treasury bills to selling repos The credit crisis Money marker mutual funds o Pensions retirement plans MBS spread through US economy o Finance is global o MBS held worldwide financial institutions Firms they provided high rates of return Everyone had to invest in them Housing bubble burst o MBS fall in value to essentially zero Firms cant use them to get short term loans Firms with MBS as assets cant sell their commercial paper No longer acceptable in repurchase agreements Repo market o REPO repurchase Borrow investment Bank that needs money Lender commercial bank To borrow you need to hand over a treasury security Recently 8
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