Financial Engineering - Union College

Financial Engineering - Union College

Financial Engineering Structured Investment Vehicles (SIVs), Mortgage Backed Securities (MBSs), Collateralized Debt Obligations (CDOs) and other devices Minsky, Leverage Hyman Minsky Financial Instability Hypothesis Minsky Moment Irving Fisher Debt Deflation

Wolf, Martin, The Shifts and the Shocks: What Weve Learnedand Have Still to LearnFrom the Financial Crisis. Penguin, 2014. Reviewed by Paul Krugman, Why Werent Alarm Bells Ringing? The New York Review of Books, October 23, 2014, pp. 41-42. AAA Corporate Bond Yields versus 10-Year Treasury Yields 1990.01-2019.02 10 9 8 7 6 5 4 3

2 1 90 92 94 96 98 00

02 04 06 08 10 12 14

16 18 Risk Premium AAA Corporate Bond Yields - 10-Year US Treasury Yields 1990.01-2019.02 (Average for the period = 1.41 percentage points) 2.8 2.4 2.0 1.6 1.2 0.8

0.4 90 92 94 96 98 00 02

04 06 08 10 12 14 16

18 Leverage Bank One Assets 100 Liabilities 80 20 NW Capital Ratio: 20/100 = 20% Leverage Ratio: 100/20 = 5

Ones return on Bank Two Assets 100 Liabilities 95 5 NW Capital Ratio: 5/100 = 5% Leverage Ratio: 100/5 = 20 Twos return on

Introductory Concepts Probability Two independent events, A and B Pr( A B) Pr( A) Pr( B) Two non-independent events Pr( A B) Pr( A) Pr( B | A) Expected value E[ X ] Pr( x1 ) x1 Pr( x2 ) x2 The Simple Case

Asset characteristics Price Probability of default = 10% $900 IOU $1,000 Rate of Return 11.11%

Key assumption: statistical independence of assets A Portfolio of Assets Possible outcomes Probability of default for each asset = 10% IOU $1,000 IOU $1,000

Outcome Probability $2,000 81% $1,000 18% $0

1% Create two new assets (e.g., MBSs) based on the portfolio Senior tranche IOU $1,000 Probability of default Price

Rate of return 1% $990 1.01% 19% $810 23.46%

Junior tranche IOU $1,000 Rating Systems (simplified) Moodys Aaa, Aa, A, Baa investment grade Ba, B, Caa, Ca, C Standard & Poors AAA, AA, A, BBB, BBB- investment grade

BB+, BB, B, CCC, CC, C, D Now, assume perfect correlation between the two original IOUs Senior tranche Had a pr. of default = 1%, now 10% Was worth $990, now its worth $900 Junior tranche Had a pr. of default of 19%, now 10% Was worth $810, now its worth $900 Thus, risk pricing completely backwards Prudent investors lost, hedge funds gained

Those who warned about the coming crisis Raghuram Rajan, Professor, University of Chicago, Booth School of Business Nouriel Roubini, Professor, NYU Stern School of Business Paul Krugman, Professor, Princeton University

Dean Baker, Center for Economic Policy and Research Med Jones, President, International Institute of Management Peter Schiff, CEO, Euro Pacific Capital, Inc. Bob Shiller, Professor, Yale University Byron Dorgan ( ) Human Behavior Market Fundamentalism

Markets are self-correcting The best government is a small government The financial crisis was an accident Add a few courses on ethics What to do? Analogies FDA NTSB Sports Hurricanes and other natural disasters Are markets self regulating?

Information asymmetry Moral hazard Regulation Government size Is small good? Glass-Steagall Costs and Benefits of the Financial System [Benjamin Friedman] In both instances [the crash and the housing bubble burst], the cost was not just financial losses but wasted real resources. Moreover, to ask just how efficient a financial system is

in allocating capital leads naturally to the question of the price that is paid for such efficiency. The share of the finance sector in total corporate profits rose from 10 percent on average from the 1950s through the 1980s, to 22 percent in the 1990s, and an astonishing 34 percent in the first half of this decade. Friedman [continued] Those profits accruing to the financial sector are part of what the economy pays for the mechanism that allocates its investment capital (as well as providing other services, like checking accounts and savings deposits). The finance industrys share of US wages and salaries has likewise been rising, from 3 percent in the early 1950s to 7

percent in the current decade. An important question is what fraction of the economys total returns to productively invested capital is absorbed up front by the financial industry as the costs of allocating that capital. Friedman [continued] the Financial Accounting Standards Board recently changed its rules to allow banks more latitude to claim that assets on their balance sheets are worth more than what anyone is willing to pay for them. The Robo-Signing Issue

The robo-signing largely involved assignments of mortgage notes to mortgage servicers or trusts representing the investors who put up the loan money. Assignment was necessary to give the trusts legal title to the loans. But assignment was delayed until it was necessary to foreclose on the homes, when it had to be done through the forgery and fraud of robo-signing. Why had it been delayed? Why did the banks not assign the mortgages to the trusts when and as required by law? Robo-Signing A working hypothesis, suggested by Martin Andelman: securitized mortgages are the pawns used in the pawn

shop known as the repo market. Repos are overnight sales and repurchases of collateral. Yale economist Gary Gorton explains that repos are the deposit insurance for the shadow banking system, which is now larger than the conventional banking system and is necessary for the conventional system to operate. The problem is that repos require sales, which means the mortgage notes have to remain free to be bought and sold. The mortgages are left unendorsed so they can be used in this repo market. SPVs and MERS The shadow banking system evolved in response to the need for large institutional investors to park their money securely and

earn some interest. The special purpose vehicle (SPV), which acts as the shadow bank, evolved in response to this need. MERS The housing shell game was made possible because it was all concealed behind an electronic smokescreen called MERS (an acronym for Mortgage Electronic Registration Systems, Inc.). MERS allowed houses to be shuffled around among multiple, rapidly changing owners while circumventing local recording laws. Title would be recorded in the name of MERS as a place holder for the investors, and MERS would foreclose on behalf

of the investors. Robo-signing (references) Martin Andelman Ellen Brown (primary) Gary Gorton (more general) Six Films on the Financial Crisis

Margin Call (2011) Too Big To Fail (2011) Inside Job (2010) Frontline: The Warning (2009) The Flaw (2010) Enron: The Smartest Guys in the Room (2005) Fed Funds Rate (1)

FEDFUNDS 20 16 12 8 4 0 55

60 65 70 75 80 85 90

95 00 05 10 Fed Funds Rate (2) FEDFUNDS 9 8 7 6

5 4 3 2 1 0 90 92 94 96

98 00 02 04 06 08 10

12 14 Legislation DoddFrank Wall Street Reform and Consumer Protection Act (Effective: July 21, 2010) They should have known Not everyone regards a house as an investment. We do not make this statement about Cars [NTSB]

Medicines [FDA] Appliances [Consumer Union] Food [Dept. of Agriculture] Just about anything They should have known Externalities Neighborhood level Macroeconomic level Global level They should have known Top financial firms do not believe in this Too big to fail

Too big to jail To what purpose? People demand much higher standards of evidence for unpopular or unexpected findings than for comfortably familiar findings. George Stigler, Nobel Laureate, Economics Memoirs of an Unregulated Economist (Chicago, 2003)

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