Guiding Seminar 2

Question 1

What is a ‘run-prone’ design? (Prone to Fail: The Pre-Crisis Financial System)

Answer 1

In short, bankruptcy stay implies that a lender is obliged to stay with the debtor in the event of the debtor’s default. Most repos and OTCs are exempt from this automatic stay, meaning that the moment a dealer declares bankruptcy, the lender is free to sell the collateral and ‘run’. This is repos vulnerable to “runs”.

Question 2

What are intra-day repos? (Prone to Fail: The Pre-Crisis Financial System)

Answer 2

Each morning in the pre-crisis period, when the dealers’ repos matured (think overnight repos) and they repaid the cash investors, the dealers needed intra-day financing for their securities inventories until new repos could be arranged and settled near the end of the same
day.

Question 3

What’s wrong with intra-day repos? (Prone to Fail: The Pre-Crisis Financial System)

Answer 3

If a dealer defaults, the TPB could discover that the value of the collateral is insufficient to recover the cash lent.
If a dealer defaults, the value of its collateral may drop just because of that default (the ‘wrong way’ risk).
A TPB may doubt the creditworthiness of a dealer and refuse to provide intra-day financing, thus restricting a dealer from a vital source of cash.

Question 4

What do we mean by ‘the cash side of tri-party repos were settled with unsecured commercial bank deposits in the same two tri-party agent banks’? (Prone to Fail: The Pre-Crisis Financial System)

Answer 4

The cash TPBs gave to dealers during intra-day repos was held in the deposit accounts of different investors in TPBs and belonged to those investors, including cash investors in overnight repos. The key risk here is that an investor can withdraw cash from the deposit without
any prior notice to the TPB. If this happens during intra-day repo, the cash that should be in the deposit is actually given out to the dealer, so TPB has to look for cash somewhere else —> balance sheet of a TPB could be destabilized.

Question 5

How everything could go wrong before the crisis? (Prone to Fail: The Pre-Crisis Financial System)

Answer 5

A dealer whose solvency or liquidity comes into question may be unable to find cash lenders that are willing to roll over a sufficient quantity of its repos. The dealer could fail, or its securities might need to be
liquidated in a fire sale, or both.
Fire sales could have spillover effects on other dealers.
Cash investors could become concerned that a clearing bank could be destabilized by intraday exposure to a dealer. A run of these deposits can destabilize the balance sheet of the clearing bank.
Thus the clearing bank might lack funds to provide intraday financing to a dealer.
This creates concerns about losses, thus everyone reduces their lending to even the safest dealers -> creating illiquidity.

Question 6

What are SIVs and what’s their role? (Prone to Fail: The Pre-Crisis Financial System)

Answer 6

Structured investment vehicles —> off-balance-sheet entities set up by banks (including large dealers —> SIVs are a form of short-term off-balance-sheet financing).
The plain idea is to profit from the yield on MBS/CDOs/etc being higher than interest on commercial paper (CP) SIVs should pay.

Question 7

What is the risk of SIVs? (Prone to Fail: The Pre-Crisis Financial System)

Answer 7

Value of ABCP falls —> chance of SIVs default rises —> lenders refuse to roll over CPs —> SIVs default —> banks bail out their SIVs by taking them back into their
own balance sheets.

Question 8

What ultimately caused the 2008 crisis? (Prone to Fail: The Pre-Crisis Financial System)

Answer 8

A combination of a run on prime money market funds
(repos are no longer an option), on other (non-tri-party) sources of repo financing, and on the asset-backed commercial paper market (think SIVs defaults) could have caused a complete meltdown of the securities financing market.

Question 9

Why do not hedge funds disclose their trades? (Hedge Funds: Past, Present, and Future)

Answer 9

Hedge funds do not disclose their trades to (1) protect their strategies as intellectual property and to (2) avoid investors’ excessive concerns as a strategy may not pay off for quite a while before it finally brings profit.

Question 10

What are the costs behind hedge funds not disclosing their trades? (Hedge Funds: Past, Present, and Future)

Answer 10

A hedge fund that does not disclose information can find it more difficult to attract investors.

Question 11

What are the risks for hedge funds to disclose their trades? (Hedge Funds: Past, Present, and Future)

Answer 11

Lack of disclosure makes proper risk and performance evaluation very difficult. E.g. a manager may ‘massage’ returns throughout the years to assure investors of stable profitability while true annual returns may vary widely; the complex instruments used make it hard to assess underlying payoffs, risks, and interconnectedness with different financial institutions.

Question 12

What is “noise trader risk”? (Hedge Funds: Past, Present, and Future)

Answer 12

After taking the position, the valuation disparity widens, causing the net wealth of the arbitrageur to decline —> possible bankruptcy before the prices/spreads converge in the desired direction.

Question 13

What is a corporate spinoff? (Anomalies: The Law of One Price in Financial Markets)

Answer 13

Establishing an independent firm by selling/distributing its newly created shares.

Question 14

What is Moore’s and Murphy’s law? (Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents)

Answer 14

▪ Moore’s law in financial markets: from 1929 to 2009 the total market capitalization of the US stock market has been doubling every decade
▪ Murphy’s law: “whatever can go wrong will go wrong” (faster and with worse consequences when computers are involved)

Question 15

What is algorithmic trading? What are the benefits of AT? (Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents)

Answer 15

Algorithmic trading (AT): the use of mathematical models, computers, and telecommunications networks to automate the buying and selling of financial
securities (benefits: cost savings, operational efficiency, and scalability)
▪ Cheaper, enhances operational efficiency and promotes economies of scale, but
creates tighter interconnections in the financial system
▪ Regulation is outdated and its philosophy is ripe for an overhaul
▪ AT is not bad per se, but it needs to be appropriately monitored to benefit the
society at large

Question 16

What is spoofing? Layering? (Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents)

Answer 16

Spoofing- placing an order in a certain direction (buy/sell) to create a false impression of demand/supply for a particular security and to later trade in the opposite direction of the initial order, profiting from the imbalance.
Layering- the same but or a series of orders at different prices (?)

Question 17

What were the factors leading up to the housing bubble? (Deciphering the Liquidity and Credit Crunch 2007-
2008)

Answer 17

i) A low interest rate environment:
▪ The Fed reluctant to raise interest rates fearful of deflation after the dot-com bubble
▪ Large capital inflows from abroad, especially Asia
ii) A new “originate and distribute” banking model:
▪ Banks pooled, tranched, and resold loans via securitization instead of holding on to them
▪ CDOs became extremely popular.
▪ Banks could lower their capital charges by securitizing
iii) Lax regulation led to a dramatic fell in lending standards
iv) Banks relied on short-term financing and repo financing –> refinancing risk (if liquidity in the market dries up, it will be difficult to roll over short-term loans)

Question 18

What were the reasons for optimistic CDO ratings? (Deciphering the Liquidity and Credit Crunch 2007-
2008)

Answer 18

1) Rating models were based on historically low mortgage default and delinquency rates
2) Past downturns in housing prices were primarily regional phenomena (diversification due to low cross-regional correlation)
3) Rating agencies collected higher fees for structured products (+ an issuer could resort to another rating agency if not satisfied with a product’s rating)
4) “Rating at the edge”: bank made sure that tranches were slides in such a way that they just barely crossed the dividing line to reach a certain rating (AAA, AA,…)

Question 19

What is the Medici vicious cycle? (Towards a Political Theory of the Firm)

Answer 19

The ability to influence political power increase with economic power so does the need to do so (fear of expropriation by politics) “Medici vicious cycle” risk: money is used to gain political power and political power is them used to make more money.

Question 20

What are the reasons behind why the size of the average publicly listed company has tripled in the market capitalization? (Towards a Political Theory of the Firm)

Answer 20

▪ The size and market share of companies has increased reducing competition across conflicting interests in the same sector (more powerful vis-à-vis
consumers)
▪ The complexity of regulation has increased (easier to tilt the playing field)
▪ The demise of the anti-business ideology that prevailed among Democrats took place
▪ The ideal state of affairs is the “goldilocks” balance between the power of the state and power of firms (otherwise, one entity will exploit the other)
▪ Network externalities (an increase in usage leads to a direct increase in the value for others)
▪ The proliferation of information-intensive goods (high fixed and low variable costs with increasing returns to scale) [winner-take-all industries]
▪ Reduced antitrust enforcement.

Question 21

What is the goldilocks balance? (Towards a Political Theory of the Firm)

Answer 21

The ideal state of affairs is the “goldilocks” balance between the power of the state and power of firms (otherwise, one entity will exploit the other).