Week 3

Question 1

How do you create safe debt?

Answer 1

You would have a depositor, could just be a retail investor, it could be a small business. And the depositor would give dollars to the bank. That’s step A. And that’s the dollars that are flowing down from the depositor to the bank. The bank then takes those dollars and loans them out to a borrower. Let’s say somebody who needs the money for a mortgage for a house. The bank takes, onto their balance sheet, the arrow that coming up, which is a loan, which is an obligation of the borrower and an asset to the bank. What the bank gives back to the depositor is a savings account or a checking account which is insured. Which means in this case in the United States as of 2007, $100,000 by the depositor could be put into the bank and would be insured by the federal government.

Question 2

Can the depositor take out money any time?

Answer 2

Yes, he can

Question 3

Does the borrower have to give the money back to the bank ay time the bank wants?

Answer 3

No.

Question 4

So, who has the long term debt and who has the short term debt?

Answer 4

The bank has a short term debt to the depositor and the borrower has a long term debt to the bank

Question 5

Is it a safe thing for the depositor?

Answer 5

Yes, it is fairly safe since the government has said that it will pay no matter what.

Question 6

Why can we not have insurance for everybody?

Answer 6

Because insurance is limited, in the case of the united states to 100 000

Question 7

Why can we not make it unlimited?

Answer 7

Because then you would ensure the entire banking system by government. No matter how ich you are and how much risk the bank takes.

Question 8

So what do you do with the rest of the money if you only can insure 100 000?

Answer 8

that is where shadow banking comes in

Question 9

What are people called who give money to the institutional investors?

Answer 9

retail investors

Question 10

What is an example of an institutional client that does not take any money from others?

Answer 10

sovereign wealth fund or a large corporation

Question 11

Can the institutional investor give money directly to the bank?

Answer 11

No they cannot. They need some ways to make sure they get their money back

Question 12

What is the difference for banks now?

Answer 12

Some of the money is not going to be insured. So the shadow banking systems there to insure that the money is insured somehow.

Question 13

What is the first way of making sure the money is safe?

Answer 13

Instead of taking the mortgages on its balance sheet and saying this keeps us sat, they say let us put the money and put it into this box.

Question 14

What is this box called?

Answer 14

Securization. So instead of putting money into a bank we put it into a box that we call securization.

Question 15

So instead of the investor putting his or her money into a bank, what does he do?

Answer 15

He buys a slice of the securization directly. So now you do not need to worry a lot about what the bank is doing but rather about what your asset is doing.

Question 16

So describe in a nutshell the first way to make things safe.

Answer 16

The bank takes the first slice of risk out of the assets and you ge the least risky part of it. So instead of giving the bank your money, you are just getting a bit of what used to be the banks portfolio. You take that slice and it becomes your collateral.

Question 17

What is the second way to make your money safe?

Answer 17

A second way to do this is a little more indirect. Instead of going and just buying the securities by yourself, as the institutional investor. You say to the bank, I will give you my $1 million or $10 million deposit. But since you can only insure $100,000 of it, I would like you to give me some additional collateral that I can hold to make sure that I am safe.

Question 18

what is collateral?

Answer 18

Collateral is a property or other assets that a borrower offers a lender to secure a loan. If the borrower stops making the promised loan payments, the lender can seize the collateral to recoup its losses. Because collateral offers some security to the lender in case the borrower fails to pay back the loan, loans that are secured by collateral typically have lower interest rates than unsecured loans. Read more: Collateral Definition | Investopedia http://www.investopedia.com/terms/c/collateral.asp#ixzz4BGlglGfn Follow us: Investopedia on Facebook

Question 19

How does the collateral make the investor feel?

Answer 19

The collateral makes the investor feel extra safe.

Question 20

Why is collateral useful?

Answer 20

Collateral is useful, because in normal times you can quickly sell it in the market and get all of the money back. It’s the best form of insurance that you can have, because of its speed.

Question 21

What is the problem of collateral in times of panic?

Answer 21

You would not be able t sell collateral quickly

Question 22

What is the process called by which the collateral insures an investor is called what?

Answer 22

The process by which the collateral insures an investor. And the money goes from the investor to the bank, or to whatever financial intermediary we have, is something called a Repurchase Agreement.

Question 23

What are safe assets?

Answer 23

Something that an investor can put his or her money into and not have to worry about it

Question 24

What is information insensitivity?

Answer 24

What it refers to is that when I enter into a transaction with you, I am not at all worried that you have an incentive to produce information to try to figure out whether the transaction that we’re entered into is going to be beneficial to you or me.

Question 25

What is risk free?

Answer 25

Risk free which means under all circumstances this thing, the thing that we are exchanging will be worth exactly what we want it to be worth in buying goods and services.

Question 26

Are government bonds risk free?

Answer 26

They're not risk free. There's some chance that in the future, interest rates will go up and the value of your bond will fall.

Question 27

What is a coupon?

Answer 27

The annual interest rate paid on a bond, expressed as a percentage of the face value.

Question 28

What is at at par?

Answer 28

At par is a term that refers to a bond, preferred stock or other debt obligation that is trading at its face value. The term "at par" is most commonly used with bonds.

Question 29

Do financial instruments often trade at par?

Answer 29

Due to changing interest rates they almost never do

Question 30

When interest rates go up the value of a bond...

Answer 30

falls.

Question 31

What si the cleanest definiotn of a safe asset?

Answer 31

What's important about long-term governments bonds is that right now, you kinda think these things are priced correctly. And that the person that you're talking to and exchanging that bond with does not have any huge advantage, nor would they really have any way to come up with a huge advantage in figuring out what the bond is worth. That is going to be the cleanest definition that we have of a safe asset. One that is insensitive to information.

Question 32

Why do we sometimes think of it as adverse selection?

Answer 32

Sometimes we also think of this as having no adverse selection. That's a term in economics that has existed for a long time. Adverse selection just means two parties to a transaction. And at the time that those two parties are signing the deal, they have the same information as each other about the item that they're transacting over.

Question 33

What is an example of information sensitive to not information sensitive?

Answer 33

If the next day, you wake up and you hear some news that makes you think it's not safe, it has suddenly gone from being information insensitive, where yesterday, you didn't worry about it at all.

Question 34

What is an example of not information sensitive?

Answer 34

First would be stocks. So, the stock market, it's not that the stock market is rigged or unfair. It's just that it's quite clear that there's a real benefit to going and studying and figuring out what a company is worth. And if I am an uninformed investor, and someone comes to me and wants to offer me equity in a company, I might be a little worried that that person knew more than I did about what the company was worth.

Question 35

Are debt of third parties information sensitive?

Answer 35

The private debt of third parties would be another bad example. So the debt of a country? Stable, information insensitive if it's a stable country. The debt of my friend John, if I gave you that debt and I said, look, John gave me this IOU. I don't have any money in my pocket right now. Let me give you the IOU that John gave me, and now, you'll have that instead of money. You would say, whoa, I don't know John and even if I knew John, I'd have to spend a lot of time figuring out whether he was actually going to pay me back.

Question 36

Did the demand for safe assets change over the years preceding the financial crisis?

Answer 36

Yes, it changed dramatically.

Question 37

What happened to short term interest rates as opposed to long term interest rates?

Answer 37

between 2003 and 2007, short-term interest rates in the United States increased by four percentage points. But longer term tenure interest rates hardly moved.

Question 38

What is the federal funds rate?

Answer 38

A short interest rate rate, it is controlled by the federal reserve.

Question 39

What about the ten year treasury rate?

Answer 39

Does not really have large moves.

Question 40

Are the federal funds rate and the ten year treasury viewed as safe?

Answer 40

Yes, as very safe.

Question 41

Who borrows with the federal funds rate?

Answer 41

borrowing between banks.

Question 42

What is the gap between these two terms?

Answer 42

The gap between these two rates is a term spread. It's the amount that you would need to pay extra, to borrow over ten years instead of federal funds, which would be borrowing a very short term. Perhaps overnight.

Question 43

At the beginning og the 21st century these rates were...

Answer 43

quite similar

Question 44

Is it unusual that the federal funds rate and the 10 year treasury are that similar ?

Answer 44

Yes that is very unusual.

Question 45

How can the rates be very similar?

Answer 45

When we expect them to fall

Question 46

What did the FED do in th beginning of the 21st century?

Answer 46

It lowered interest rates, becuase teconomic groth was relatively mild

Question 47

When did interest rates fall to a minimum?

Answer 47

In 2003

Question 48

Did the long-term interest rate move during this time?

Answer 48

didn't move very much in part because these changes down were largely expected at some point to be reversed. But they weren't expected to be reversed immediately, and they weren't expected to be reversed nearly as sharply.

Question 49

What did the FED expect when it raised interest rates in 2003?

Answer 49

that this would move the long term rates back up near the levels they were at the beginning of the 21st century.

Question 50

Did the long term rates rise after the FED had increaed interest rates.

Answer 50

So, if you look in 2000, that rate is close to six percent. By 2003, the long term rate is down near 3%. Despite increasing the short term rates, the Federal funds target rate over the subsequent four years, long term rates only moved up about 1.5%. Not sufficient, to bring them all the way back near the levels they were, before the Federal Reserve started dropping rates. This was a bit of a puzzle, so let's have that kind of in mind which is that, long term rates did not move as much as we might have expected from raising the short term rate.

Question 51

What does happen when long rates do not move up?

Answer 51

Interest rates stay low

Question 52

What happens when morgage rates stay low?

Answer 52

There is a boom in the housing market

Question 53

What si rthe global savings glut?

Answer 53

From emerging countries and commodity rich countries with large current accout surplus. They really liked buying safe government assets. The damand of those assets was very high.

Question 54

What was the reaction of the US by all thse assets pumped into the market?

Answer 54

They tried to push liquidity into the markets in order to later raise interest rates and discourage credit conditions from overheating, there was still very high demand. According to Ben Bernanke, it was this global saving glut that was keeping the strong link between long term and short term interest rates.

Question 55

WHAT WERE the cumulative investments of China in the US?

Answer 55

A little bit under a trillion.

Question 56

What is the bottom line?

Answer 56

China was putting its money in the United States. Global saving glut countries wanted very safe investments

Question 57

What did European countries do at the time?

Answer 57

They demanded government debt and other substitutes

Question 58

What is agency debt?

Answer 58

Fannie and Freddy Mac

Question 59

What were global savings glut countries buying between 1998 and 2002?

Answer 59

Mostly agency debt

Question 60

Did the United States create surpluses?

Answer 60

Yes, it did. One of the common questions of the time was what the United States would do once they have retired all of their long term debt.

Question 61

What did European countires do between 2003 and 2007 in terms of inflows into US AAA-rated securities?

Answer 61

They greatly increased their demand

Question 62

What is the difference in amount that has been purchased from abroad?

Answer 62

2.5 trillion

Question 63

How much government debt did the United States produce dubetween 2003 and 2007?

Answer 63

1 trillion of new government debt

Question 64

What happened to the new debt that was produced?

Answer 64

it was effectively soaked up by foreign buyers.

Question 65

What was the result that we had so many foreign buyers?

Answer 65

it left no capacity for investors in the united States. They bought other AAA stuff - residential morgage backed securities

Question 66

What type of investor was growing quite significantly in the years leading up to the crisis?

Answer 66

We also have institutional cash pools, large institutional investors, that are growing significantly over this time period.

Question 68

What did institutional cash pools deman?

Answer 68

Short term government securities

Question 69

Where would you look for safe assets?

Answer 69

precious metals and debt and currencies of stable countries

Question 70

Was there a lot of supply?

Answer 70

Not really. There was not much supply out there

Question 71

Where is the problem for short term securities coming from?

Answer 71

not from the saving glut countries but from insituttional cash pools.

Question 72

What was the estimated deficit of short term treasury securities?

Answer 72

There was an estimated deficit of 1 trillion.

Question 73

Why caused the fall in deficit of safe liquid shiort term products in the later years of the risis?

Answer 73

The US government started to issue more in the way of treasury securites

Question 74

What does the financial system do if there is more demand than supply for a certain thing?

Answer 74

- gold - debt and currency of stable countries - insured deposits You can expect the financial system to try to manufacture it.

Question 75

How can you manufacture a safe asset?

Answer 75

The key principle is that you take an asset and you use only part of it as collateral. So for example, my house would not count as a safe asset under any definition. Nobody would be willing to accept from me, or from any financial intermediary that helped me do it, a even fractional share of my house as the payment for something. If someone came to you and said, here's 1% of my house. Here's a certificate that's worth 1% of my house. I'm going to use that as currency. The estimated value of my house is $300,000. So, here's $3,000 of something that you'll use as currency. You would never do that. You would think, how can I possibly accept 1% of your house as payment? I would have to go and figure out what your house is worth. Plus, I don't even know if I could even sell your house if I needed to sell it. There's certainly risk that's involved in that. So instead, what ultimately can happen is, I say all right, you're not gonna have just 1% of my house, how about this? You have the first $3,000 of the value of my house. The other 99% of my house, that's my problem. But you would get the last, that's your collateral. Your collateral is, if this loan doesn't get paid back, you get the very first $3,000. The most senior part of the loan.

Question 76

Securization: the trust receives the assets by whom?

Answer 76

The originating firm. This is most likely the bank. The originating firm places these assets into a trust.

Question 78

What happens to the bank after it sold the assets to the trust?

Answer 78

It is out of the transaction

Question 79

What is pooling?

Answer 79

That the originating firm sells the assets to the trust

Question 80

Can the entity (the pool) go bankrupt?

Answer 80

No.And the rules are it may at some point have obligations, and if it's unable to meet those obligations, instead of declaring bankruptcy, the way a corporation would, it follows the rules that are written down in its founding documents to liquidate itself and to distribute the proceeds out to the claimants.

Question 81

Where does the pool get the money from to buy the assets from the bank?

Answer 81

Well, it gets its money by issuing bonds, and the bonds that it's issued are the asset-backed securities, the ABS that we talk about throughout this entire course.

Question 82

What does it mean that the assets come in tranches?

Answer 82

And what this means is we're going to slice up the assets of the trust, all of these mortgages, so that there is a senior layer, then there's a layer just below it, a layer just below it, and then finally a layer all the way at the bottom.

Question 83

Can different layers of the morgage be paid at different times?

Answer 83

Each layer will have to then wait until the more senior layer has been paid before they get paid. And all the way at the bottom would be called the equity tranche. And the equity tranche would be the very very last piece that would be paid off and would be risky.

Question 84

What are the buyers of the tranches called?

Answer 84

These buyers are, what we label all the way over on the right, securitization investors.

Question 85

What are most buyers out there looking for?

Answer 85

AAA securities

Question 86

What does the senior part represent of the asset?

Answer 86

75%

Question 87

What are morgage backed securities?

Answer 87

bonds issued by trusts, build through these securizations, with morgages as the assets underlying everything

Question 88

Morgage backed securoities were issued by whom ?

Answer 88

They were dominated by the agencies, the government sponsored enterprises of Fannie Mae and Freddie Mac until about 2003.

Question 89

What is the most important thing about this picture?

Answer 89

The most important thing about this picture is to notice the gap between the dotted line and solid line that emerges after 2003. That gap is what you will hear called private label mortgage backed securities. So, not coming out through Fannie Mae and Freddie Mac, but rather through some other entity and not having any kind of government guarantee.

Question 90

What arer RMBS?

Answer 90

Residential morgage backed securities. Residential mortgage backed securities are, as you might expect, backed by residential mortgages. These are going to be mortgages that do not qualify for the government sponsored enterprise guarantees.

Question 91

What are CMBS?

Answer 91

And the dotted line is CMBS or commercial mortgage backed securities.

Question 92

Who issues commercial morgage backed securities?

Answer 92

These are loans to businesses. And again, there is no government program that would enable us to guarantee these in the form that we have here. These are going to be banks taking things off of their balance sheet, putting them into a trust, and then selling securities, and the cash flows come from that trust.

Question 93

Did non-morgage backed securities increase as well?

Answer 93

Yes, they did.

Question 94

To what to asset backed securities refer?

Answer 94

To all securities that do not have morgages in them.

Question 95

What is the difference between corporate bond and an asset backed security?

Answer 95

If instead, IBM, after making sales of computers and financing those sales to its customers, bundled all of the loans for those computer sales and put them into a trust, they could create their own vehicle, which effectively be an asset-backed security.

Question 96

What happened to corporate debt and Asset backed securities?

Answer 96

Look what happens during the global savings glut period. So beginning in 2003, the red line sharply increases. And by the time we reach 2007, we've actually even had a year where the amount of asset-backed debt was just as much as the amount of debt issued by all corporations in the United States, public debt by all corporations in the United States. Furthermore, very little of the blue is going to turn out to be AAA debt. Very hard for a company to issue too much debt, which truly in the end, seems super safe to people.

Question 97

What is the advantage if you issue Asset backed securities as opposed to corporate bonds?

Answer 97

you get way more AAA ratings