2/28/2013

2/28 Banking notes

Suppose the Fed wants tot buy 100 mortgage backed securities
Assets                                    Liability
MBS 100                              Reserve 100
suppose MBS down by 85, what Fed does is to sell the entire securities, on liability side, 85 is taken out by other banks, and Fed creates assets worth 15 on the balance sheet.

Regulation Q prohibited banks from being able to pay interest on deposits within checking accounts. This is strange:
(1) A deposit is an input for the output of an event. Deposit is the input of the bank's production function. Labor, similarly, is the input of firm's production function. We actually want to pay labor as little as we can in order to squeeze them.
(2) The reason why investment and commercial banks are forced to tear apart is that we think commercial banks are safe and we don't want commercial banks do anything that is risky as investment banks. But regulation Q implies that commercial banks are not safe.
(3) loanable funds market, demand and supply of loanable funds and a required low interest rate. Analysis of demand and supply function. The effect is small when curves are elastic or spread isn't big. When there is inflation, deposit flee happens.

Two types of depositors:
(1) retail customers: went to MMMFs,
(2) corporation

If the corporation is worried about its investment, it can (1) ask money back from investment bank (2) ask for collateral (3) ask bank to make more collateral
Shadow banking


The commercial paper
Commercial paper issuance is an important alternative to bank loans as a means of short-term financing. Some paper is sold unsecured (that is,without specific collateral), while other paper is
secured by bank-issued letters of credit or pools of assets, including a firm’s receivables.

Aside: letter of credit is A letter from a bank guaranteeing that a buyer's payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase.

The rise of MMMFs (money market mutual fund) during the 1970s boosted the growth of CP by (indirectly) allowing small investors access to CP investments. During the 1980s, the CP market began to develop into its current form, particularly with the creation of the asset-backed commercial paper (ABCP) conduit.

 In its traditional form, CP is an unsecured promissory note issued by a business (either financial or nonfinancial) for a specific dollar amount and with maturity on a specific date. (It is exempt from SEC registration)

Similar to Treasury bills, CP is typically issued at a discount, meaning that the buyer pays less
than face value and receives face value at maturity: The “interest” is equal to the face value minus the purchase price.

Although CP is issued at short maturities to minimize interest expense, many issuers roll over CP by selling new paper to pay off maturing paper. Because of modest credit risk, yields on CP are slightly higher than on Treasury bills of similar maturity. Large denominations and short maturities typically limit the CP market to large institutional investors, such as MMMFs.

CP generally is classified in three broad (but overlapping) categories: nonfinancial, financial, and asset-backed. Further, CP may be classified as being sold with the assistance of a CP dealer (dealer placed) or without (directly placed).

Traditional nonfinancial and financial paper, respectively, are unsecured short-term debt issued by highly rated corporations. The simplest description of ABCP is as a form of securitization: it is CP with specific assets attached.

Why is the yield of ABCP higher than unsecured CP?
(1) the lack of transparency

Why did bank market share fall in 1970s?
(1) technology
(2) regulation

Interest rate and bond pricing
If I know an interest rate, I can convert PV to FV and vice versa. interest rate and discount rate
The interest rate moves in the same direction as the future value does.

Buy a bond at par value of 10000$, with maturity of 1 year and interest rate as 10%, PV=10000/1.1

Interest rate and asset price move in opposite directions. 
Multiperiod compounding
 

2/26/2013

2/26 Banking notes

Financial institutions
What sorts of things can or cannot be insured? The difference between insurance and gamble
Insurance is a method of displacing unavoidable risks. Gambling is a method of inviting risks. With or without insurance, you have the same risks - the same is not true of gambling. Insurance companies use law of large number to pool the known risks. For gambling, it bets on one specific incidence.

IT is not true that insurance is about letting rich people pay poor people.
Deposit insurance:
Adverse selection and moral hazard
Central banks charge every bank premiums and provide protection. Risky banks will consider FDIC premium requirement a good deal
Possible ways to reduce adverse selection: Screening.
Charge different premiums towards people with different backgrounds, may exclude certain kinds of people.

Moral hazards: In financial market, when lenders are protected by deposit insurance, they put less monitor work on bank behavior and induce bank to make more risky investments.
Possible ways to reduce the moral hazard:
let lenders pay deductible, supervision or threat of cancellation
Credit default swap: what's the nature? Gamble or insurance?

Federal Credit agency: Freddie Mac (Federal Home Loan Mortgage Corporation), Fannie Mae (Federal National Mortgage Association), Sallie Mae (Student Loan Marketing Association), Ginnie Mae (Government National Mortgage Association), Farmer Mac
Lending institutions set up or sponsored by the U.S. federal government, such as Small Business Administration (SBA), Federal Housing Administration (FHA), Rural Housing Service, and Veteran Affairs' Loan Program. These agencies borrow from the U.S. Treasury (through the Federal Financing Bank) in order to offer below market rate loans to individuals, businesses, and other types of organizations. These loans are offered as a means of developmental support to those who do not have ready access to the financial markets.

The reason to set up Freddie and Fannie was to make housing more affordable, but today the reason why we keep them is that we want to the houses price up.

The brief history of Fannie Mae and Freddie Mac
http://www.time.com/time/business/article/0,8599,1822766,00.html

1970 California shortage of loanable funds reasons
(1) a high demand of loanable funds pushed up the interest rate

Ginne Mae http://www.investopedia.com/terms/g/ginniemae.asp#axzz2M33qLKEh

Balance sheet of Freddie Mac
A                                                                              L
Cash 50                                                                  Mortgage backed security 1250
Mortgage 1450                                                       Asset debt 200
                                                                              Ownership equity 50
Suppose I have a 10 bad loan, then Freddie will take 10 cash out of its account and pay the investors, and they will write down the mortgage security value by 10, then MBS will be down by 10 and equity will be down by 10. Freddie is over leveraged.

China eats asset debts.

Two types of pension plans
(1) Defined benefit plan

the employer guarantees that the employee will receive a definite amount of benefit upon retirement, regardless of the performance of the underlying investment pool



(2) Contribution plan

the employer makes predefined contributions for the employee, but the final amount of benefit received by the employee depends on the investment's performance.



Social security system is not a pension plan, it is just a pay-as-you-go plan. Social securities itself is not a financial intermediary

2/21/2013

Banking notes 2/21

Solvency and liquidity shocks
Piggy bank
Assets                           Liability
reserve 1000                 Deposit 10000
ST assets 2000              LT loans 5000
LT assets 7000              Equity 3000
Bus assets 8000
Total 18000                  18000

The reason why banking regulation is hard is because it is hard to know whether the shock derives from assets side or liability side.

Solvency shocks: long term assets decrease value by 4000. The reasons may be (1) the investment turns out to be bad (2) the perception of the investment turns negative even though the underlying value may be good. The result is that the equity decreases by 4000, coming to an end of -1000.
This bank is insolvent because it has an total asset of 14000, but it owes 15000. (bankruptcy)

Mark-to-market accounting: accounting for the "fair value" of an asset or liability based on the current market price, or for similar assets and liabilities, or based on another objectively assessed "fair" value.
The reason to introduce mark-to-market accounting: sometimes investors decide to pull out the money even though the underlying condition of the asset is good. Firms have to liquidate the healthy assets at a discount to pay the money. This process is not good. (For assets that are not liquid, the loss is higher)

Another element of systematic risk due to the existence of financial intermediaries:
(1) If the company has crappy investment decision and is insolvent, we should let it fail. Suppose the public owned company faces bankruptcy, it will influence other companies in the market.
For example, if other firms owns equity of this firm, their value of equity turns of to be zero, their assets value go down and influence their balance sheet. Such risk is more of a concern when firms in the market are highly leveraged. 
(2) If in bankruptcy the firm fire sales its assets, price of assets goes down and companies in real economy are negatively affected.
(3) If a company faces bankruptcy, some of its long term creditors will not gain anything back.
Spillover effect, and this is the justification of financial regulation.


Liquidity shocks: 4000 dollars are withdrawn, reserve and short term assets are cashed out, but there is still another 1000. The firm has to liquidate the long term assets or bus assets, or they can borrow money. The problem of liquidating assets is that sensitive people may think the asset is worthless, and people may lose faith in this particular asset. So it is possible that liquidity shock, which has nothing to do with the viability of the firm, may put the firm into bankruptcy.

When the fed does emergency lending to firms, it is supposed to be of only liquidity reasons. 
The major regulatory tools to protect us from insolvency and liquidity shock:
(1) For prevention of liquidity problem: reserve requirement
(2) For prevention of insolvency problem: capital requirement (make sure the number of equity is big)
In addition, government and agents decide what can be considered as reserve and capital.

A few types of intermediaries
When we talk about different types of intermediaries, we are basically distinguishing them as a general function of different liability they issue, and general types of assets they are purchasing.

(1)Some intermediaries only issue liability claim, not issue equity claim: for example, a COMMERCIAL bank. Most of the assets they own are debt (mortgage), most of the liability they owe is debt (saving account).

(2) Stock mutual fund: only issue equity claims but doesn't issue liability. On the assets side, it consists of a bunch of equities.

(3) Investment bank: like the commercial bank, most of the money investment bank is through debt markets. And most of the thing that it invests in is debt.
Difference: investment banks take risks by trading by their own accounts.
1. issue stock
2. issue bonds
3. mergers and acquisitions
A major thing investment bank does is underwriting, pricing and evaluating the firms. Trade, researches. Merchant banking.

Investment banks take the risk away from people who want to raise money to themselves. 
For investment banks, they don't invest mortgage loan; instead, they invest in stock and bonds; besides, less than 25% of the liability is deposits. 
Investment banks are not supposed to be part of the federal reserve system.

The implication of Glass-Steagall Act
The reason of the existence of the banking regulation is that people want investment to have better rate return than mere interest, but they don't want too much risk and illiquidity.
So the Act shows that sectors that handle payment should be separated from sectors that do not.

commercial banks have stricter reserve and capital requirements than investment banks.

Investment banks actually have a safer balance sheet because stock and bonds are transparent and liquid, and a portfolio can diversify the risks.

Insurance company:
assets: debt claim, because insurance companies want to make sure the stream of money is continuous
liability: stocks, bonds, issue contingent debt claims
How does interest rate impact insurance:
When interest is low, insurance premium is high.

Adverse selection and moral hazard

2/19/2013

Banking note 2/19

The basic accounting identity:
Things of value = Claims on those things (this is a stock measure)

Balance Sheets:
All resources are owned by someone. Things of value are called assets and claims on those things are called liability.

assets = liability
Subcategories of liability:
1. claims held by outsiders (liability) outsiders' claims are paid first (fixed claim)
(a) long term: paid after long term (junior claims)
(b) short term: paid before long terms. (senior claims) For example, you can withdraw money from checking account whenever u want.
2. claims held by insiders (owners of equity) (residual claim)

Assets
(1) long term assets
(2) short term

Balance sheet of a typical commercial bank
Assets                                            Liabilities
reserves 4%                                   deposits 18% (checking account)
loans 68%                                    time deposits 48% (saving account)
securities 23%                              other liabilities 26%
other assets 5%                             equity 8%

Reserves are what a bank uses to execute payments on its customers' behalf (move money from one account to another)

Reserve ratio= reserves/deposits =4%/18%=22%
Capital ratio= equity/total assets = 8%/100%=8%
What's the point of the bank? To make equity bigger
(1) increase liability
(2) issue stocks

How balance sheet changes
 Scenario 1: A person deposits 10 $
Liability: deposit + 10 $
Assets: reserve + 10 $

Scenario 2: A person withdraw 15$ of cash from the ATM machine
Liability:  deposits - 15$
Assets: reserves - 15$

Scenario 3: A person writes a check of $15 to another one
Liability: deposits - 15$
Assets: reserves - 15$

Scenario 4: The bank makes a new loan of 30$ to its depositor at the same bank
Assets: loan + 30$
Liability: deposits + 30$
Suppose the bank invests the money in a banana factory:
Assets: reserves - 30$
Liability: deposits - 30$
Suppose it turns out that the bank's investment is worth only 5$
Assets: loan - 25$
Liability:  equity - 25%
When the loans go bad, equity holders are worse off
Suppose a customer wants to pay the 75$ for the 30$ loan
Assets: reserves + 75$, loan - 30$
Liability:equity + 45%
Suppose the bank buys 40$ of the subprime mortgage
Assets: reserves - 40$, securities + 40$

Scenario 5: Suppose bank doesn't have money around, they can turn to federal funds market.
Liability: federal funds loan
Assets: reserves

Scenario 6: bank issues new equity by 55$
Assets: reserves + 55$
Liability: equity + 55$
If the value of the equity falls by 20$
Assets: reserves - 20$
Liability: equity - 20$

Three ways to structure the balance sheets:
least leveraged, moderately leveraged, highly leveraged
(1) 100% capitalized firm
Assets                                  Liability
Investment 100$                Liability 0
                                            Equity $100
Appreciation 5%, Investment now becomes 105$, and equity becomes 105$.
A 5% increase of value in securities translates into a 5% return of investment
A 5% decrease of value results in 5% loss of investment
It is unlikely bank will run bankrupt

(2) 50 % capitalized firm
Assets                                  Liability
Investment 100                   Liability 50
                                            Equity 50
Capital ratio = 50%
Leverage= 1:1 , leverage: of all the stuff you owe people what shares are owed to outsiders as compared to insiders.  
Appreciation 5%. Investment 105$, equity 55$
equity increases by 10%
5% loss in market results in 10% loss in firm
A loss of 50% in the value of investment results in firm's bankruptcy

(3) Highly leveraged firm
Assets                                       Liability
investment 100                       liability 97
                                                equity 3
capital ratio= 3%
leverage 97:3

Plain-vanilla housing finance:
Assets                                      Liability
cash reserve 100                          deposit   1000
mortgage 1900                             long term loans   600
                                                     equity             400
capital ratio: 20%
leverage: 4:1
This bank is healthy

When shit happens on asset side or liability side:
Problem on the asset side: solvency shocks
Problem on the liability side: liquidity shocks
Solvency shocks: banks are making bad investments
Liquidity shocks: withdraw rates are high
It is easy that a solvency shock turns into a liquidity shock:
When banks make bad investments, customers may freak out and withdraw the money, causing a liquidity shock.
A healthy system may also be toppled down because of animal spirit.
Suffering from liquidity shock, banks may have to sell healthy assets, driving down the value of the assets. (supply increases and price decreases)

Piggy bank (solvency shock)                                         Piggy bank (liquidity shock)
Assets                      Liability                                         Assets                               Liability
Reserve 1000               Deposit 10000                        Reserve 10000                deposit 10000
Short term asset 2000   Long term loans 5000         Short term 2000                 Long term loans 5000
Long term asset 7000    equity   3000                      Long term 7000                  equity    3000
Bus asset   8000                                                      Bus asset 8000
18000                            18000                                         18000                           18000

Suppose long term asset goes bad, at a loss of 4000$. Equity loses 4000$, at value -1000$, more obligation to pay

2/14/2013

2/14 Banking note

Two categories of contracts in financial markets for interactions between lenders and borrowers:

(1) Debt contracts: fixed contract
they specify the future payment from borrowers to lenders.
Lenders also are referred to as savers, creditors, investors. These people purchase the financial products.
Borrowers also are called debtors, sellers and issuers of financial products.
Debt contracts are not contingent at all about anything the business is doing. Lower uncertainty.
Great for debtors when extra gains are very generous. Great for lenders when gains are poor because they are promised something.

Types of debt contracts: bank loans, mortgage, treasury notes, bills, bonds, checking accounts, saving accounts, commodity paper, corporate bond, agency papers, etc

(2) Equity contracts: residual contract
borrowers buy purchasing powers, Uncertainty is higher, 
Types: stocks

When contracts are traded, they are called securities.

Maturity: (mostly for bonds), bond with no maturity is perpetuity bond
Liquidity: how easily they can be converted into contract
(1) how difficult to liquidate the contract
(2) can be liquidated only by great discount
Some securities are structured to be illiquid: hedge funds,
Risk

Direct intermediary
Brokers match up buyers and sellers
Dealer buy securities out of their own accounts and sell it to the buyers
Full service provide research services

Indirect intermediation
middlemen. They participate in market transactions and put the contract on their balance sheets. When you need to invest money, what you end up doing is not investing in a particular firm, but rather buying a claim on the investment bank like JP Morgan investment bank.
(You lend JP Morgan money)

Two different economies at work:
Non-financial sector (Real economy) &  Financial sector
--Households, entrepreneurs                    --banks
  (save)            (borrow)                              (match up)
Non-financial sector
Households are net savers, they care more about what happens on the assets sheets while net borrowers entrepreneurs pay more attention to liability sheets

Entrepreneurs issue securities that are risky and long term. Entrepreneurs want some stability in terms of borrowing because they don't want to be in short of fund in the process of doing the business.

But the households are risk-averse, that is they want to buy risk-free and short-term assets. So the problems are  1)risk-aversion asymmetry and 2)different timing preferences.

But financial sector can step in to accommodate that by issuing short-term riskless liability to households (checking account) and buying up long term risky assets (accommodate entrepreneurs). This is the importance of financial sector.

IN terms of non-financial sectors, households want to keep risk-free, short term assets. They wouldn't be very willing to buy those risky bonds. But entrepreneurs do need long term capital to investment their business. Also households tend to hoard money. Beyond that, entrepreneurs may be subject to animal spirits. So without financial intermediaries, entrepreneurs have to progressively persuade households to lend them money for a long time, which may turn out to be unsuccessful. Households won't do it unless they can get a very high return. As a result, there won't be many long term business.

Now suppose a banker steps in and opens a piggy bank. He issue short-term financial products like checking account to households for money and invest the money to the promising entrepreneurs. Based on law of large numbers, the banker doesn't have to hold all the cash. He only has to hold a fraction of it, what he has to do is make sure to households that the bank is safe to save money. Households put more money in the bank, and bank invests more in other companies.

Actually the households' money is more put in the entrepreneurs' business.

Why is this model possible? The law of large number
(1) diversification: if individual risks on something is not perfectly correlated, then as scales increases, the actual risk falls.
Two major risks in market: systematic and idiosyncratic (unsystematic) risk.
The reason why mutual fund is popular: it collects funds from many households and invest a large amount, decreasing the risk of the investment and benefiting every shareholders of the mutual fund.
Law of large number decreases the risk of entrepreneurs.
The supply of loanable funds shifts right because of the advent of the financial intermediaries

(2) underwriting/ customer selection
On the asset side of the balance sheet, we say underwriting; on the liability side, we say customer selection.
--Banks, before making the loan, will investigate whether the borrowers are able to repay. This is the underwriting process. (banks can pick out investment of better quality)
-- Banks want to know the types of households that loan the bank the money. Banks don't want people who withdraw from checking account frequently. Some banks offer interest rate in checking account to attract patient people to put money in the checking account. (Liability side)

(3) behavior modification
Bank can modify people's behavior on both sides of the balance sheet
On asset side: change entrepreneurs' decisions
On liability side: change households' decisions

Why would you put money in a bank which penalizes you from taking money out?
You are imposing negative externalities upon others. When you take money out for whatever reasons, it lowers the possibility that other people will get their money.

2/05/2013

Banking notes 2/5

Why do we use different money in different time periods:
(1) cheaper to use new money
(2) more profitable for producers to produce new money

use vs exchange value
certain commodity becomes more attractive when it is used as money
The value of commodity in exchange would exchange the value in use when this commodity has some other uses.

Questions:
(1) When will other commodities come up to be a kind of exchange?
(2) What will the old commodity's value change in the competition?

Technology will shift supply curve of money out and drive down the value of money

What are the justifications of  government to step in the production of money:
(1) Natural monopoly: huge fixed cost of making money
 Second thought: It doesn't seem to stand. It is cheap to starting printing money, but no one would accept that. Huge fixed cost lies in gaining people's trust to use it as a means of exchange, not in producing money itself.

(2) Externalities problem: some people may free ride one producer's high quality money; if we have different kinds of money, how could anybody know the standard of unit?
Second thought: government should possibly be the ruler rather than be the producer. Standardization do incur benefit to people, but this could be internalized by the market, for example the first guy who invents the stuff.

(3) Information problem: some people say that if there are many kinds of money floating around, then people are confused.
Second thought: we can produce brocheure showing the denomination of currencies.

(4) The reason why government steps in money production: seiniorage and debasement
It is mysterious why few textbooks refer to seiniorage and debasement