Quiz 2 Prep.pdf

Bank Regulation Intro • Banks are one of the most-regulated industries in the US • Q: Why do you think this is? • Plan for today: • The problem of bank runs • And factors that mitigate this problem • Lender of last resort • Deposit insurance • Capital requirements Bank runs You're thinking o...

Bank Regulation Intro • Banks are one of the most-regulated industries in the US • Q: Why do you think this is? • Plan for today: • The problem of bank runs • And factors that mitigate this problem • Lender of last resort • Deposit insurance • Capital requirements Bank runs You're thinking of this place all wrong. As if I had the money back in a safe. The money's not here. Your money's in Joe's house...right next to yours. And in the Kennedy house, and Mrs. Macklin's house, and a hundred others. Why, you're lending them the money to build, and then, they're going to pay it back to you as best they can. -George Bailey in It’s a Wonderful Life Bank runs • A bank run occurs when many depositors demand their deposits back at the same time • Why is this a problem? In a fractional reserve system, banks don’t have enough reserves to cover all withdrawals → Only get your money back if you are close at the front of the line! • Example: Five banking panics between 1929 and 1933. FDR declared banking holiday and created FDIC in 1933. Not just ancient history • While bank runs have become less common over time, they still happen • Asian Financial Crisis (Indonesia, South Korea, and Thailand) in 1997 • Northern Rock (UK) in 2008 • Lebanon in 2021 • Similar behaviors for other types of non- bank institutions • E.g., Fed took actions to limit runs on money market mutual funds (MMMFs) in September 2008 and March 2020 • Although ordinary small depositors by and large did not run, we nevertheless experienced the equivalent of runs on the network of nonbank financial institutions that has come to be called the shadow banking system. –Ben Bernanke Economics of bank runs • Diamond and Dybvig (1983) is a seminal paper about the economics of bank runs • In the model, banks play an important role in the economy by providing maturity transformation (i.e., take short-term deposits, make long-term loans) • However, banking system is susceptible to runs. Let’s see why… Theory of bank runs • Suppose we have 3 time periods: 0, 1, 2. • At time 0, depositors give their money to the bank. • Some fraction of these depositors (α) are impatient and will withdraw at t=1. • The rest (1- α) are patient and will get a higher payoff at t=2. • The bank takes these funds and loans them out (say, to a business to purchase a new machine for its factory). • Key idea: The assets finance by the bank are illiquid. They are positive NPV once production takes place at t=2, but it is costly to liquidate early at t=1. Two possible equilibria • Equilibrium 1 (The “good” equilibrium) Note: Formally, this is a Nash equilibrium. Nobody has an incentive to deviate given the behavior of other “players” (i.e., depositors). • Impatient depositors withdraw at t=1. The bank expects this (because it knows α) and has reserves to cover the withdrawals. • Patient depositors don’t withdraw until t=2. By then, loans are paid off and the bank is able to cover the withdrawals. • Equilibrium 2 (The “run” equilibrium) • All depositors withdraw at t=1. • Suppose you are patient (so willing to wait until t=2). If you think other patient-types will withdraw at t=1, then you will want to as well. Why? • Takeaway: Runs are the result of self-fulfilling beliefs. They are not necessarily related to bank fundamentals. Lender of last resort Back to the Fed • Recall from a few lectures ago that the Fed was created to serve as “lender of last resort” • This helps to address one of the main reasons why banks fail: Illiquidity • Going back to Diamond-Dybvig, a key assumption is that banks aren’t able to quickly turn outstanding loans into cash at t=1. However, if the bank is able to borrow against these loans, depositors demanding their money at t=1 can be made whole. • Fed largely fulfills this role via discount window lending, in which banks put up collateral in exchange for loans from the Fed. • But, this doesn’t completely rule out bank runs/failures. Why? The Fed and the Great Depression • As we saw, thousands of banks failed during the Great Depression. • At the time, there were fairly strict restrictions on what types of collateral could be used for discount window lending. • Calomaris (1998): “The Federal Reserve Act restricted the collateral for discount-window loans to high- quality, short-term commercial loans. In relaxing the collateral provisions, first in 1932, and then by subsequent legislation during 1933-35, Congress accepted the argument that…this had worsened the banking collapse and depression.” • Today, Fed accepts a wide range of assets as collateral (corporate bonds, MBS, consumer loans, etc.), but riskier assets are assigned lower collateral value. Deposit insurance • Another way to mitigate the problem of bank runs is by the government insuring deposits. Why? • Federal Deposit Insurance Corporation (FDIC) created in 1933 in response to bank failures during Depression • Part of Banking Act of 1933 (Glass-Steagall), which also separated commercial banking from investment banking (more on this when we walk about investment banks) • Initially insured deposits up to $2,500. Today, deposits insured up to $250k. • Funded by premiums paid by banks What happens when a bank fails? • When a bank fails, the FDIC has two options: • Option 1: Payoff and liquidate • Depositors are paid off up to $250k and bank assets are liquidated • Once assets are liquidated, uninsured deposits receive a partial settlement • Option 2: Purchase and assumption agreement • Rather than liquidating, the FDIC can assist in the purchase of the failed bank • One way this can be done is for the FDIC to retain some of the bank’s assets, creating a “clean” bank that is purchased by another bank • Provides de facto 100% insurance coverage because all deposits typically are assumed by new bank Q: Why might FDIC prefer the second option? Deposit insurance and moral hazard • Moral hazard occurs when an entity has an incentive to increase its exposure to risk because it does not bear the full costs • In Lecture #1 we talked about moral hazard in the context of lending, but the same general ideas apply to a wide range of behaviors • E.g., If you have renter’s insurance, you have weaker incentives to protect against theft because your belongings are covered in the event that they are stolen. In other words, you do not bear the full costs of theft. Q: Why does deposit insurance lead to moral hazard? [Hint: Think about this from the perspective of a depositor] Discussion: Too big to fail (TBTF) What does TBTF mean? Why does TBTF create a moral hazard problem? What are the origins of TBTF? How has the nature of this problem changed over time? What are policy proposals to address TBTF? What are potential drawbacks to these proposals? Discussion: Too big to fail (TBTF) • Example from Bernanke’s article: There are three banks: A, B, and C. Banks A and B both have $1trillion in assets, while C is smaller, with only $400billion in assets. Bank A actually generates significant economies of scale, so that it is socially optimal for it to remain at its current size. Banks B and C, by contrast, have very modest economies of scale, not enough to outweigh the costs that their size and complexity impose on society. From the perspective of an omniscient social planner, it would be better if both B and C were half their current size. If regulators impose a cap of $500b for banks, why is this not optimal? Bank insolvency • Banks can fail even without a run if they become insolvent, meaning that its liabilities become greater than its assets (e.g., if many of its loans default). • Both bank managers and regulators are therefore concerned about banks maintaining adequate amounts of capital →Provides a financial cushion that allows banks to continue operating even if they have some losses • When we refer to bank capital, this means funds available to cover loan losses. Similar idea as shareholder’s equity on the BS. Bank capital requirements • Throughout the 1980s, US bank regulators used leverage ratios to determine minimum bank capital • Amount of capital / Total bank assets • Well capitalized if leverage ratio >5% • Under-capitalized if leverage ratio <3% • This approach is simple, but may be problematic. • Assume two banks with the same amount of total assets. Bank 1 has safe assets (e.g., cash, Treasury securities) Bank 2 has risky assets (e.g., subprime loans, corporate debt) • Since Bank 2 is riskier, it would make sense to require it to hold more capital • However, in terms of their total assets, these two banks are indistinguishable. Basel Accord • Major rules governing bank capital adopted by the Basel Committee on Banking Supervision • Started by central banks of G10 countries • Meetings are at Bank for International Settlements in Basel, Switzerland • Goal is to coordinate bank supervisory policies across different countries • No direct legal authority, but adopted by over 100 countries • Basel Accord (Basel I) implements risk-based capital requirements to address these shortcomings of using leverage ratios • Regulations further refined by Basel II and Basel III Basel I • Requires banks to hold capital equal to 8% of risk-weighted assets • Assets are divided into buckets, each with different weight to reflect degree of credit risk • Securities with little risk of default (e.g., cash, government bonds) have 0% weight • Weights increase with default risk. For example: Loans to other banks = 20% weight Residential mortgages = 50% weight Corporate debt = 100% weight • Example: If a bank is holding $10 million cash, $18 million Treasuries, $10 million in loans to other banks, $50 million residential mortgages, and $70 million corporate loans: 𝑅𝑊𝐴 = 0 × 10𝑀 + 18𝑀 + 0.2 × 10𝑀 + 0.5 × 50𝑀 + 1 × 70𝑀 = $97𝑀 → Bank must have 0.08(97)=$7.8M in capital Basel II and III • Weights for asset classes under Basel I are very broad • For example, all corporate debt has a weight of 100%. But some corporate debt is very risky and some is very safe. • Basel II (2006) made weights more sensitive to risk, and also allowed banks to use an internal estimates to assess credit risk • Greatly increased the complexity of Basel I (26 pages → 500 pages) • Basel III (2010) further enhanced regulatory framework to deal with financial stress, improve risk management, and promote transparency in response to the Financial Crisis. Examples of improved weighting schemes Weights for sovereign debt incorporate a country risk classification (CRC) higher CRC → higher weight Weights for residential mortgages incorporate loan-to-value higher LTV → higher weight Capital ratios • Regulators use capital ratios to assess bank safety • Two most common capital measures: 1. Roughly equal to shareholder equity on BS CET1 (Common equity tier 1) = Common equity + retained earnings + stock surpluses 2. Tier 1 capital = CET1 + other options to absorb losses beyond common equity (e.g., preferred shares) • Under Basel III, banks adequately capitalized if • CET1/Risk-weighted assets = 4.5% • Tier 1/ Risk-weighted assets = 6% Capital ratios since financial crisis Capital ratios and stress tests • As part of Dodd-Frank, the Fed conducts stress tests for large (“systemically important”) banks to see how their capital ratios would respond to a negative economic shock • For example, the “severely adverse” scenario assumes 10% unemployment, 25% drop in house prices, 50% drop in equity prices, etc. • As of Q4 2020, banks remain adequately capitalized in such a scenario Mortgages and Securitization Plan for today 1. Mortgage basics 2. Securitization process Mortgage basics What is a mortgage? • A mortgage is just a loan to buy real estate. • Typically 15 or 30 years. • The loan is secured by the borrower’s property. If the borrower defaults, the lender can seize the property (foreclosure). • Under normal circumstances, a borrower makes a down payment when getting a mortgage. • E.g., If you are buying a house for $300k, you may make a down payment of $60k (20%), and then borrow the remaining $240k. Types of mortgages We’ll consider three different types of mortgages: 1. 2. 3. Federally-insured vs. conventional mortgages Fixed-rate vs. Adjustable-rate mortgages (ARM) Prime vs. subprime mortgages Federally-insured vs. Conventional mortgages • Conventional mortgage • Often when you get a mortgage, lenders require a down payment of 20% • When down payment < 20%, many lenders require that you purchase private mortgage insurance (PMI) • Federally-insured mortgages • Federal Housing Administration (FHA) provides insurance against default risk • Buyers can put as little as 3.5% down • Restrictions on loan amount (“Conforming” limit in DC is currently $1,089,300 (about 32% increase from 2021); anything larger than this is called a “Jumbo” mortgage) • Similar types of programs offered by other government agencies (e.g., Veterans Affairs) Recent policy debate • The Federal Housing Finance Agency implemented new mortgage rules on May 1, 2023 at the direction of President Biden: - increased mortgage payments for homeowners with higher credit scores Is the new rule fair or unfair? • The Free Market Mortgage Act of 2023 (H.R. 2876) - aims to repeal the regulation that would require lower-risk mortgage borrowers (>680) to subsidize lower rates for high-risk borrowers (630-679). Fixed-rate vs. Adjustable-rate mortgages (ARM) • Fixed-rate mortgages lock in the borrower’s interest rate. • Required monthly payments are fixed over the life of the mortgage. • Lenders assume interest rate risk (i.e., changes in value of mortgage due to changes in rates) • Adjustable-rate mortgages (ARMs) tie the borrower’s interest rate to some market interest rate or interest rate index. • Monthly payments can change over the life of the mortgage, although they may initially be fixed for a set time period (e.g., 5/1 ARMs have fixed rates for first 5 years and then changes once a year after that). • Borrowers assume interest rate risk. Prime vs. subprime mortgages • The riskiness of a mortgage (from the lender’s perspective) depends on the creditworthiness of the borrower. • Prime mortgages (“A-paper”): Borrowers are high credit quality. • Subprime mortgages: Borrowers do not qualify for a prime credit rating due to poor credit history. Usually this means credit score <600 or <640 (different lenders use different standards) • Alt-A mortgages (“Alternative A-papers”): Riskier than prime mortgages, but not as risky as subprime mortgages. Delinquencies during the crisis Securitization The mortgage markets in simpler times… • During much of the 20th century, lenders had an “originate-to-hold” business model for mortgages • What does this mean? • Banks make mortgage loans to borrowers • Borrowers pay back bank with mortgages over time • Loan stays on bank’s balance sheet until it is paid off • Why is this business model risky for lenders? How the mortgage market really works • Examples of risks lenders are subject to: • Credit risk: Borrower might default before paying off the mortgage • Prepayment risk: Borrower might refinance when interest rates fall (Q: Why don’t lenders like this?) • Liquidity risk: Loaned funds are tied up for a long time • Over time, many lenders have switched to a “originate-to-distribute” (OTD) model to mitigate these risks • Lenders pool mortgages together and create a security (usually containing hundreds of mortgages) to sell to investors • By pooling mortgages, can eliminate idiosyncratic (i.e., mortgage-specific) risk • Securitization: The rights to the cash flows from the mortgage pool are sold as separate securities (called a mortgage-backed security or, in short, MBS) Q: How does the OTD business model affect the incentives of lenders? The economics of OTD • As we’ve discussed, a key part of banks’ expertise is the ability to mitigate adverse selection and moral hazard problems • However, there may be “frictions” that prevent banks from fully taking advantage of their abilities • E.g., Regulatory capital requirements may prevent banks from lending the amount that they would otherwise want to • OTD helps to mitigate the effects of such frictions! • But, this comes at a cost. Shift from OTH to OTD affects bank incentives. • Banks make lending decisions based on both “hard information” (e.g., credit scores) and “soft information” (e.g., borrower’s educational background) • Soft information is hard to verify except for originating institution → Weaker incentives for loan officers to screen on this type of info! How securitization works • Next, we’ll get into some of the institutional details of securitization • Government plays a key role in this process: • In 1938, the Fannie Mae (Federal National Mortgage Association) was created to develop a secondary market for mortgages • In 1968, Ginnie Mae split off from Fannie Mae. In 1970, Freddie Mac created. • Agency MBSs are the MBSs issued or sponsored by the three mortgage agencies (Ginnie Mae, Fannie Mae, or Freddie Mac) • Let’s go over what exactly these agencies do… Ginnie Mae (GNMA) • Provides timing insurance for pools of government-guaranteed mortgages Default/credit risk is insured by FHA, VA, etc. GNMA makes sure all interest/ principal payments are received when promised if mortgage is in default • GNMA doesn’t originate/purchase any mortgages • Lenders originate loans, acquire a GNMA guarantee on the pool, and sell security interests • Wholly owned by US gov. (part of HUD) • Only MBS explicitly backed by full faith and credit of US gov. • Similar yields as Treasuries with same maturity, but there is still pre-payment risk Fannie Mae (FNMA) • FNMA creates MBS by purchasing packages of loans from lenders • Unlike GNMA, FNMA purchases both FHA/VA loans and conventional loans (subject to some requirements e.g. size, loan-to-value ratio) • FNMA sells MBS to institutions (e.g., insurers, pension funds) and guarantees full and timely payment of interest/principal • FNMA also has its own portfolio (“retained portfolio”), which it finances by issuing bonds • Freddie Mac (FHLMC) performs a similar function as FNMA Fannie structure • Fannie is a Government-Sponsored Entity (GSE) • This means they were created by the gov, but are private corporations • Indeed, they have normal shares just like any publicly-traded corporation • In principle, the MBSs FNMA guarantees do not carry the full faith and credit of the US gov • But most investors believed there was an implicit guarantee that FNMA bonds were guaranteed by US gov • During financial crisis, Treasury made sure Fannie and Freddie would continue to meet obligations, effectively making the implicit guarantee explicit Fannie and Freddie today • Since financial crisis, Fannie and Freddie are in government conservatorship • Conservatorship: Used to manage the assets of the entity in place of stockholders with the expectation that the entity will return to financial health (and the conservatorship ended) • Not clear when GSEs will exit conservatorship; ongoing litigation • Still publicly traded (over-the-counter), but shareholders don’t get dividends or have decision rights Agency MBS • Agency MBSs are the MBSs issued or sponsored by the three mortgage agencies (Ginnie Mae, Fannie Mae, or Freddie Mac). • As we just discussed, credit risk is not a major concern for agency MBS • Two types: 1. Pass through securities • These securities simply “pass-through” promised payments of principal and interest on pools of mortgages. • Each security represents a fractional ownership share in the pool. • All security holders have same prepayment risk. 2. Collateralized mortgage obligations (CMOs) • Adopt a multiclass structure, dividing the pool into multiple tranches • Some tranches face more prepayment risk than others • Allows investors to determine how much prepayment risk they want to face CMO example • Example: Tranches A, B, and C • Tranche A gets interest payments and all principal payments • Tranche B gets interest payments until Tranche A paid off, then gets all principal payments → Tranche B has pre-payment protection as long as A outstanding • Tranche C gets interest payments until Tranche B paid off, then gets all principal payments → Tranche C has pre-payment protection as long as B outstanding Non-agency MBS • Non-agency MBSs are called private-label MBSs. • Underlying collateral generally consists of non-conforming mortgages, which cannot be purchased/insured by agencies (e.g. jumbo mortgages, subprime mortgages, etc.). • Relative to agency MBSs, default risk is potentially a significant factor. • Market for non-agency MBS basically disappeared following financial crisis CDOs • Securitization is not limited to mortgages. • The term “asset-backed securities” is sometimes used as an umbrella term for any type of securities backed by a pool of assets. • CDOs (Collateralized debt obligations) are similar to CMOs, but they include other types of debt instruments • Credit card debt, student loans, Corporate bonds/loans, and even other securitized products (known as CDOs–squared) • Just like with private-label CMOs, CDO investors face default risk • But, once again, we can use “tranches” to allow investors to determine how much risk they want to bear. CDO tranches • In a CDO, the tranches are created based on default priorities. • The highest rated tranches are called the super senior tranche. Then, the next tranches are the senior tranche, mezzanine tranche, and the equity tranche. • Losses from the pool go to the most junior tranche. Once this tranche principal is completely wiped out, the losses go to the next junior tranche. Super senior tranche only has losses if all others are wiped out. CDOs and the financial crisis • Highest-rated traches have (had) AAA ratings, but offered higher returns than a typical AAA security. → Something that investors really like! • High demand for CDOs → incentives to make more loans to create more CDOs • Eventually, this led some lenders to making loans to not so creditworthy borrowers E.g., NINJA loans = no income, no job, no assets • As we’ll see when we discuss the financial crisis, this didn’t end well… The Financial Crisis Plan for today • First, we’ll discuss the case study and the failure of Lehman Brothers • Second, we’ll discuss major events that transpired after the Lehman shock Case study discussion What were the main risk factors for Lehman that ultimately lead to its failure? What were the options to save Lehman Brothers? What are the pros/cons of each option? What are the pro/cons of letting Lehman fail? How do you propose that policymakers should decide which (if any) financial institutions it should be willing to bail out? Would Lehman have been bailed out under this proposal? The Collapse of Lehman Brothers • Risk factor #1: Real estate exposure: • Up to $110bn in 2007 from $52bn in 2006 • Most assets are MBS, which doesn’t work if homeowners fail simultaneously • MBS are risky, not transparent, hard to value, held off balance sheet The Collapse of Lehman Brothers • Risk factor #1: Real estate exposure: • Up to $110bn in 2007 from $52bn in 2006 • Most assets are MBS, which doesn’t work if homeowners fail simultaneously • MBS are risky, not transparent, hard to value, held off balance sheet • Risk factor #2: Leverage • Small change in value of assets can wipe out net worth. • Example: suppose asset value falls by 2%, • If leverage ratio is 10 to 1, then net worth falls by 20% • If leverage ratio is 20 to 1, then net worth falls by 40% • If leverage ratio is 40 to 1, then net worth falls by 80% The Collapse of Lehman Brothers • Risk factor #3: Liquidity mismatch • Funding by short-term debt like repo • Investing in long-term assets (hard to liquidate in short notice) • Creating possibility of a “modern” bank run. The Collapse of Lehman Brothers • Risk factor #3: Liquidity mismatch • Funding by short-term debt like repo • Investing in long-term assets (hard to liquidate in short notice) • Creating possibility of a “modern” bank run. • Risk factor #4: Interconnectedness • Lehman has a wide connection to the rest of financial system • Creates an amplifying feedback loop, rippling through entire financial system Lehman is stressed -> AIG is stressed -> Lehman is more stressed September 10, 2008 (Wed) • Lehman came under mounting pressure after a Korean bank cut off talks about a possible deal. • Its shares tumbled 45%, highlighting investor concerns. September 11, 2008 (Thu) • Lehman said it would shed most of its realestate assets, sell half of its moneymanagement business and slash dividends • Fuld left open possibility of a sale. September 12, 2008 (Fri) • Lehman actively looking to sell itself; BofA and Barclays in preliminary talks September 14, 2008 (Sun) From Too Big to Fail by Andrew Ross Sorkin September 15, 2008 (Mon) • Lehman Brothers files for bankruptcy • Merrill Lynch sold to BofA • AIG needs cash September 16, 2008 (Tue) • AIG down 61%; Will they make it to the end of the week? September 17, 2008 (Wed) • AIG bailout → Fed opens a credit line of $85bn to AIG, Treasury gets 79.9% equity interest • Credit markets frozen • “Forget about retail investors, all the pros are scared,” one broker told WSJ. “People have no idea where to put their money.” September 18, 2008 (Thu) • Reserve Primary Fund breaks the buck • 3-month T-bills go to zero • Banks rush to raise capital; Morgan Stanley next? September 19, 2008 (Fri) • Here come the politicians! • Plans for a system-wide bailout leaked • SEC temporarily bans short selling for bank stocks September 29, 2008 • Congress stuns the world…rejects TARP (Troubled Asset Relief Program) October, 2008 • TARP eventually passes • US government becomes major shareholder in 9 banks TARP MS - biggest incentive to sign ASAP much more than RE Successful policies 3r • Broad goal was to inject capital into the financial sector. Accomplished this in various ways: 1. Capital Purchase Program • • • • US Treasury purchased preferred shares in 9 banks Gov paid a 5% dividend (increase to 9% in 2013) Additional 42 other participants in CPP announced later Total investment = ~$200 bn 2. Additional capital for financial institutions • Treasury purchased an additional $20bn in preferred shares in Bank of America and Citi • Treasury purchased $67.8bn of AIG preferred shares, allowing AIG to retire CDS it had issued and avoid bankruptcy 3. Auto bailout • $79.7 billion in loans and capital injections to automakers (GM + Chrysler) 3 e it ①Earne Fed • TARP included other programs to help prevent foreclosures and purchase TARP l on “toxic” assets. • Limits on executive compensation (e.g., “golden parachutes”) were a condition of participating in TARP. • In the end, TARP was quite profitable: taxpayers recovered $441.7 billion on TARP investments compared to $426.4 billion disbursed, for a profit of a bit over $15 billion. aeasy togive c Did TARP work? The fact it was necessary doesn't mean we should be happy about it. -Prof. Austan Goolsbee If the only choice is between evil and Armageddon, evil might look ok. -Prof. Luigi Zingales The aftermath “I come from Main Street…I’ve never been on Wall Street. And I care about Wall Street for one reason and one reason only – because what happens on Wall Street matters to Main Street. And if we don’t have stabilization in financial markets…then my father couldn’t get a loan to build his new store.” -Ben Bernanke on 60 Minutes in 2009 The aftermath: Stock market Th aftermath: House prices The longer sample period: till June2023 The aftermath: Foreclosures The aftermath: Unemployment Legislative response: Dodd-Frank • In June 2009, President Obama proposed a “sweeping overhaul of the United States financial regulatory system, a transformation on a scale not seen since the reforms that followed the Great Depression.” • Financial Stability Oversight Council (FSOC) • Charged with assessing systemic risk across the financial system and facilitation coordination across regulators • Chaired by Secretary of the Treasury. Members include chairs of Fed, FDIC, SEC, etc. • Bank regulations (especially for banks with > $50bn in assets) • Living wills • Stress tests • Prohibition on proprietary trading (Volker Rule) Legislative response: Dodd-Frank • Investor protection & corporate governance • For example, Say-on-pay mandates (non-binding) shareholder resolutions to approve the compensation package for a company's executives • Securitization Retention Requirements • Issuers of asset-backed-securities must have “skin in the game” and retain an economic interest of at least 5% of ABS • Derivatives • Increased transparency (centralized exchanges rather than OTC) and reporting requirements • Consumer Financial Protection Bureau (CFPB) • Works with bank regulators to protect consumers from abusive lending practices and provide “plain English” disclosures for mortgages 2018 Dodd-Frank revisions • In 2018, threshold for stress tests and living wills increased to $250bn from $50bn. • Goal was to reduce regulatory burdens for mid-size banks. Mutual Funds, ETFs, & Hedge Funds Game plan • We’ll discuss “investment companies” • Open-end mutual funds • Closed-end mutual funds • Exchange traded funds (ETFs) • At the end of the lecture, we’ll also discuss hedge funds Investment companies & NAV MF- cash Intro is liquidity Luffer • Investment company = entity that invests pooled capital in financial securities → Generally, funds issue shares which are purchased by investors in order to make an investment • Net asset value (NAV) is the per share book value (assets – liabilities) of shares sold by investment company: 𝑉𝑎𝑙𝑢𝑒𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑉𝑎𝑙𝑢𝑒𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 𝑁𝐴𝑉 = # 𝑆ℎ𝑎𝑟𝑒𝑠 book value Example: NAV per share 3 A fund has 400 shares outstanding, holds $210 in cash, and has an accrued management fee (a liability) of $40. The fund holds the following 4 stocks: Stock A Stock B Stock C Stock D Shares 100 50 220 30 Price $15 $30 $12 $45 What is the NAV of the fund? Example: NAV • First, calculate the value of the stock portfolio 100 15 + 50 30 + 220 13 + 30 45 = $6,990 • Second, subtract liabilities from total assets $6,990 + $210 − $40 = $7,160 • Divide by number of shares to get NAV 𝑁𝐴𝑉 = $7,160 = $17.90 400 Open-end funds Open-end funds • Typically, just called mutual funds. • Generally they invest in stocks or bonds (or a combination) • Previously we’ve discussed one specific type of open-end funds: money market mutual funds • Our discussion will primarily focus on equity MFs • Investors can buy/redeem shares at NAV • Most MFs hold 4-6% of assets in cash to facilitate redemptions (e.g., so shares don’t have to be ↓ sold to meet redemptions). e sometime Equity MFs • Two types: • Active = try to outperform a stock index; relatively high fees (sometimes > 1%) • Passive (index) = try to match returns of index; relatively low fees (often < 0.10%) • Recent years have seen significant flows out of active funds and into passive funds ~Peterancemarketfees cannot often seat the En yig Benchmark Should Active MF styles be apples to applet 3 • Active mutual funds are often classified according to the Morningstar Style Box • 2 components: • Market capitalization (small, mid, large) • Style (value, blend, growth) • Style classification can be used to help determine appropriate benchmark • E.g., Wouldn’t make sense to use the S&P 500 as a benchmark for a small-growth fund. Better to use something like the Russell 2000 growth index. 3 en performance - Active fund performance • Not much evidence that the average active fund can consistently beat its benchmark (especially after fees). This table shows % of funds that beat their benchmark Passive MFs • Goal is to match returns of an index; also called “index funds” • The “Big 3” fund families dominate passive investment vehicles lob of Voting rights - exect pressure to any firm they invest -h I Esc I Corporate governanc etc . e n - Example: The Big Three common onvership Tesla ownership: Ford ownership: Q: Any problems with cross-ownership? Hint: Think about competition… Mutual fund fees • Competition has led to reduced fees for MFs over past 2 decades • Fess usually quite lower for passive funds • Passive: Often < 0.10% • Active funds: Can be >1% • Some funds also charge “loads” (i.e., a fee to invest in a fund) that goes to a broker/financial adviser Fund fees can add up! • Normally, index fund fees are <0.15%; active fund fees can be 1% or higher • Consider a mutual fund available in my 401k plan 0.73% fee Fund fees can add up! • Alternatively, I can (and do) invest in S&P 500 index funds 0.015% fee magic of compounding How much of an impact does this difference in fees have over time? Fund fees can add up! • Suppose you save $18k per year (401k limit) for 30 years • Market return averages 7% per year • Assume the active manager doesn’t beat the market in the long-run → consistent with the evidence we saw earlier • After fee performance for index fund is 7% - 0.015% = 6.985% • After fee performance for active fund is 7% - 0.73% = 6.27% • With passive fund you will end up with $1.78 million • With active fund you will end up with $1.59 million Investing in passive fund saves you close to $200k! Closed-end funds Closed-end funds unlike ETFA e I deviate from NAV ! • Basic idea is same as open-end funds: Funds pooled together to buy financial assets • But one important difference: Fund manager does not redeem or sell shares. • Why do this? Often closed end funds often use leverage and/or purchase more exotic securities (e.g., derivatives), so liquidating to meet redemption requests may be more costly • If you want to invest in a closed-end fund, you must purchase shares from an existing investor Closed-end fund prices • Prices for shares of closed-end funds are determined by supply and demand; often deviate (significantly) from NAV • Typically trade at a discount to NAV (i.e., price<NAV) • Not necessarily indicative of a market inefficiency. Often happens because the are unrealized taxable gains or because closed-end funds are sometimes not very liquid • But sometimes trade at a premium to NAV (i.e., price>NAV) • May occur because of investment restrictions making it difficult for investors to otherwise buy an asset Example: Grayscale bitcoin trust (GBTC) • GBTC is a closed end fund that invests in bitcoin • Fee = 2% per year • NAV = (value of bitcoin held / # shares) • Prior to 2021 traded at a significant premium to NAV, but then started trading at a significant discount. Q: What are possible explanations for this pattern? ETFs Exchange-traded funds • ETFs are investment companies whose shares trade on a traditional stock exchange (like closed-end funds) • Historically, ETFs have been used to track large stock indexes SPY is the largest ETF by assets. It tracks the S&P 500. Other types of ETFs numel sends can only of be - raded ouch God - • Recently, increase in the number of actively managed ETFs Super convenient • Also, many ETFs that track commodities (either by holding physical assets or futures contracts) • GLD: Tracks price of gold • USO: Tracks price of oil ETF creation/redemption • ETFs have a unique creation/redemption feature to prevent large deviations from NAV • Authorized participants (large institutions, typically) can trade back and forth between the ETF and underlying shares • If ETF trades at a discount, they can exchange the ETF for the underlying assets • If ETF trades at a premium, can exchange the underlying assets for shares of the ETF ETF creation/redemption example • Suppose the BAI ETF only owns shares of PepsiCo. The ETF holds 1,000 witu shares trading at $100 each. The ETF has 500 shares outstanding. • The NAV of a share is $100×1000 500 for for = $200 enation => room arbite opPS • Suppose the market price of the ETF is $205. What would an authorized participant do? synthetic EFF Buy 2 shares of Pepsi ($200), create a share of the ETF and sell if for $205→ Risk-free $5 profit! sell high , ETFs vs. mutual funds • Usually fees for ETFs are comparable to mutual funds • Some advantages of ETFs 1. 2. 3. Tax efficiency: MF managers must constantly re-balance portfolios, creating “taxable events” for investors Trading: MFs can only be traded at the end of the day; ETFs trade whenever market is open Shorting: You can borrow shares of an ETF for short sales Hedge Funds black What is a hedge fund? 20x Pre-GFC • Hedge funds are investment vehicles that pool money together to invest in a variety of assets. ↳t of self-reporting • Several differences with mutual funds: 1. HFs often use more complex (and sometimes risky) strategies than MFs → These include buying assets besides just stocks and bonds 2. HFs subject to few regulations and disclosure requirements → Those with $150m in assets must register with SEC (Dodd-Frank) 3. 4. Only “accredited” investors (i.e., wealthy individuals and institutions) can invest in hedge funds Relatively high fees (2 & 20) emec HF performance • Two reasons why analyzing HF performance is tricky: 1. HFs not required to report performance, so data is self-reported 2. Survivorship bias → We only see returns for HFs that continue to survive; may not see it for those that go bust • Evidence suggests that HFs tend to outperform the market during “bad” times and underperform during “good” times HFs also outperformed during Covid crash in March 2020 HFs outperformed S&P 500 during 01-02 and 08-09 recessions HF performance • To the extent that HFs outperform the market, not clear if this is because investors are exposed to rare, extreme losses • “Fake alpha” • We use alpha to measure outperformance of an investment (CAPM model) • However, we can generate “fake alpha” by betting against extreme risks • Consider a simple investment strategy: • Buy the S&P 500 and sell earthquake insurance in DC • Most years there is not a significant earthquake in DC, so no payouts need to be made (and the strategy outperforms the S&P 500) • If there is an earthquake in DC, the losses may be extreme • In the long run, this strategy will not beat the market (assuming insurance is fairly priced) but it may beat it the short run (assuming no earthquake) HF strategies • Rather than just buying and holding securities, hedge funds use a variety of (potentially risky) strategies. We’ll discuss some of the most common: 1. Activism loustry CS0 , MOA ex ) 2. Global Macro 3. Arbitrage , - Activism • Activism involves a HF pushing firms to change in order to increase firm value • E.g., increase payouts to shareholders, sell the company, fire CEO, change business strategy • Often, this involves using a proxy fight, where the activist nominates new directors to be on the board • To initiate an activism campaign, an activist often needs to file a Schedule 13D with the SEC • Public filing for when an investor acquires a 5% stake in a company and seeks to influence management Activism Academic research shows that activist campaigns lead to higher stock prices (e.g., Brav et al. 2008) Can only Global macro -> OB Setting -> w/ Central the Supply chan - gor't - • Global macro funds speculate on changes in the value of currencies and interest rates in different countries • Example: Soros breaking the Bank of England • In the early 90s, UK agreed to peg the pound to the deutschmark to stabilize exchange rates (GBP/DEM couldn’t go below 2.78) • Starting in Spring 92, exchange rate approached the 2.78 floor • B of E “defended” the currency by buying pounds and increasing rates e - Black Wednesday (9/16/1992) Soros “attacked” the pound by establishing a large short position. B of E wasn’t able to hold the GBP/DEM floor. Eventually, the peg was dropped and Soros profited ~$1bn. Arbitrage • Arbitrage = the simultaneous buying and selling of securities, currency, or commodities in different in order to take advantage of differing prices for the same asset. • Suppose an identical asset trades at different prices in two different markets. To arbitrage this situation, an investor would buy the cheaper security and sell the expensive one. • Note: Pure arbitrage involves no risk. However, the term is often used when there is risk. • E.g., In a merger (risk) arbitrage, an investor buys the stock of a company that will be acquired (in order to exploit the difference between the current price and the acquisition price). If the deal falls through, this will lead to a big loss. Example: LTCM • Example: Long-Term Capital Management (LTCM) • Hedge fund founded in 1994; board included two Nobel Laureates • Main strategy was to make exploit arbitrage opportunities in bond markets • Find 2 (almost) identical bonds; buy the cheap one and sell the expensive one • Magnitudes of mispricing is small, so LTCM used extreme amounts of leverage to make large profits • $4bn of investor capital levered 25x (~$100bn in assets) • “Picking up pennies on the train tracks” Example: LTCM • 1998: Russian financial crisis • The Russian government devalued the ruble, defaulted on domestic debt, and declared a moratorium on payment to foreign creditors. • LTCM’s positions moved opposite as expected (i.e., cheap bonds got cheaper; expensive bonds got more expensive) → Big problem given LTCM’s leverage! • To prevent widespread failures in the financial system, the FRBNY arranged a bailout of LTCM by major creditors (banks).