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ECON 330
John Shea

Patrick Dooley 9/27/13 Economics Money and Banking Asymmetric Information (AI) in Financial Contracts • Basic Problem: Borrowers know more about ability to repay than lenders. o Creates problems of adverse selection (AS) and moral hazard (MH) • Debt Contract o Adverse Selection (AS): people/business with bad creditworthiness more likely to want to borrow o Adverse Selection: Borrowers with riskier projects are more likely to find debt appealing than safer borrowers because they are more likely to benefit from option to default, and just walk away(ex-ante) o MH: Once you borrow and behave badly o MH: Once you have borrowed incentive to change your business plan to make it riskier (ex post) • Equity Contract o The issuer or borrower promises a share of future profits in exchange for upfront funds (funds today) o Adverse Selection: Businesses have prior and private information (ex-ante) about their prospects o Optimistic Businesses who have anticipate high future profits will be less willing to give up a share of future profits than more pessimistic businesses who anticipate lower future profits o Moral Hazard (MH): Once a business sells share of future profits to outside shareholders insiders (executives0 have less incentive to work hard to make profits (Principal – agent problem) Shareholder= principal Managers =Agent How can financial Markets (securities markets: bonds, stocks etc...) overcomeAI? 1. Mandatory Information Disclosure (Government force companies to give information) a. In U.S. securities exchange commission (SEC) requires all companies issuing securities to report accounting data on income, balance sheet variables o Limitations:  Accounting data understate profit potential of new business, especially in emerging technologies  Accounting data can be manipulated (ENRON- made their profits to look a lot better than they actually were)  Many outside investors lack the time or expertise to digest and interpret accounting data • Another example of economies at scale that favor mutual funds over individual investors It is Cheaper (in terms of time) for a mutual fund to pay a couple of analyst to digest information than for thousands of individual investors to do that on their own. 2. Third Party Certification • Companies like (Moody’s, S+P) send investment newsletters, has advisors: o Specialize in gathering, interpreting publicly available data on companies o Issue ratings, give advice— they make money by selling their advice • Outside individuals investors who lack time or expertise to judge companies can pay for advice before investing o Limitations: o Third parties are unlikely to rate small companies because the potential market for such ratings is too small (meaning not many people(investors) are going to be interested in small companies to invest in, so they will not waste time to research those companies) o Free rider problem: Third parties will only produce information if they are paid for it  Once one person pays for information, others (the free riders) might be able to get that information that was paid for, for free • Moody’s, S+P used to charge investors (banks, individuals) for bond ratings o Free riding made this business model infeasible o So they change the business model, to where the rating agencies now charge companies’fees to rate their securities. • Problem: o Conflict of Interest: third parties reluctant to issue candid assessments of companies they want to do business with in future  Acompany is paying them to rate them so sometimes the raters will lighten their ratings, so it makes the companies look better than they actually are just because they would like to do business with that company again in the future - Bottom Line: Information disclosure, third party certifications do support functioning of securities markets. The work much better for large, established companies, such companies are only ones who can rely on issuing securities (stocks, bonds) to finance themselves - Smaller and newer companies generally can’t raise funds by issuing securities and must rely on indirect finance coming from financial intermediaries (banks, for bank loans) for financing. How do financial intermediaries (banks, venture capitalist, etc…) overcomeAsymmetric Information? 1. Screening: (ex-ante) basic tool for overcomingAI problems a. Banks finance companies and venture capitalist, etc… specialize in gathering and interpreting information on small businesses and households, to determine their creditworthiness 2. Monitoring: (ex-post) basic tool for overcoming Moral Hazard(MH) a. Put covenants in loan or equity investment contract restricting behavior and then you have to follow up to ensure compliance with these covenants. i. Examples of covenants- must use funds to buy specific equipment (nothing else but that equipment)—then follow up by checking receipts or the business to see they bought the right things ii. Cannot go into a different line of business or acquire another business - Examples of Monitoring strategies: o Surprise visits to business o Venture capitalist sit on board of directors of the business o Banks require borrowers to keep business checking account at certain bank 3. Collateral and/ or internal Net Worth a. Collateral: Assets pledged by borrower that can be seized by lender in case of default (like house, car, business equipment) b. Internet Net worth: banks insist on partial self- funding down payment on house, Business putting up 20% upfront costs - Benefit: o 1. Directly reduces downside risk to the bank and gives the bank something in the event of a default o 2. Indirectly forcing borrowers to put more skin in the game and reduces adverse selection and moral hazard problems by increasing cost of default of the borrower 4. Private Financing a. Banks issue loans, rather than buying bonds in small businesses b. Venture capitalist make private equity investments and prohibit public offerings c. This limits FREE Riding 5. Repeat business a. Banks provide lower interest rates to existing borrowers in good standing i. Insurance companies will lower your premiums if you have made no claims in a while - This Economizes on Screening costs - Combats Moral Hazard by rewarding good behavior 6. Group Participation a. Insurance mandates can reduce adverse selection by forcing low risk types into pool b. Grameen Bank-(provide credit to vary poor households in undeveloped countries) Group lending - Small scale loans - Out to make money or break even THE FINANCIAL CRISIS OF 2008 Underlying Problem: Speculative bubble in U.S. housing market, that burst • Mean by bubble: Most of the time the prices of assets (houses, stocks) are determined by fundamental value for stocks, present value of stream of expected future dividend. o For house- (benefits) present value of rent saved, taxed saved, over lifetime of house, plus non- pecuniary benefits o But sometimes assets prices will rise very quickly to level unjustified by fundamentals: bubble • Tell-tale signs of a BUBBLE: 1. Ratio of price to current flow benefit spikes up to high level bu historical standards o Stock bubbles: price/ dividends --- and price/earnings ratios will be extremely high (e.g. 1929 great depression) o Housing: price/rental ratio spikes up 2. People willing to buy asset at inflated price only because they expect to resell it at an even price later on: speculative/ motive for buying (flipping the house) 3. People Believe ThatAsset price will keep rising rapidly in the future because it’s been rising quickly in recent past ---- bubble psychology EXAMPLES of bubbles: th • Tulipmania in 17 century Holland • Beanie Babies (U.S. 1990s) • U.S. stock market (late 1920’s stock market, late 1990s .com bubble) -Bubbles are similar to pyramid/ Ponzi schemes where they are sustained by only by steady inflow of new buyers (suckers) -Once new buyers dry up, then the bubble plateaus, and then BURST -Burst of a bubble is when a panic-driven sales happen, people try to sell their stocks before the price starts to drop U.S. House Prices (Case- Shiller) • 1987-2000: annual average % growth in house was prices was = 4.5% (benchark/fundamental) • 2001-2006: house prices went up 11% (bubble) • March 2006 to March 2007: house price dropped 2% (start of the burst the bubble) • March 2007 to March 2008: house prices dropped 14%(burst) • March 2008 to March 2009: house prices dropped 19% Why did burst of housing bubble cause global financial/ economic crisis? • Not inevitable that bursting bubble will cause a crisis: o Dot-com crash in U.S. stocks in early 2000s caused at MOST a mild recession but definitely not a major crisis • For a bubble burst to trigger a crisis it needs to be financed by borrow money (people defaulting on loans) 1920 2000 Bubble fueled by borrowed money and banks Bubbled fueled by pension funds, individual loans money to stock speculators investors but When market crashed loans defaulted and Crash wiped out individuals savings but did bank solvency threatened not trigger people to default on loans 1929 to 1933- wave of bank failures Patrick Dooley 10/4/13 NOTES ON FINANCIAL CRISIS OF 2008 Basic Problem: Housing Bubble inflates 2001-2006 and then BURSTS People default on mortgage loans and puts financial institutions at risk Aggravating Factors: Relaxed lending standards and securitization (2 developments in the financial system that made the problem worse- in mortgage markets) Lending Standards on Mortgage loans Traditionally – (normal tools used by Financial Intermediaries to overcome adverse selection and moral hazard. Screening (bank checked your personal finances), internal net worth) A. required down payment 5-20% B. Verifiable, stable income C. Good Credit history D. Affordability “Ratios”- (28/33 percent ratio rule- your monthly payment had to affordable due to your income) Bubble Period- could get loans with 0 down payments A. ALT-Aloans: no income verification B. Subprime loans: loaned to people with sketchy credit history C. Affordability “ratios” not concern: teaser rates/ no payment loans (were used to lower monthly payments upfront) Problems: 1) Increased probability of Default (went up): marginal borrowers a. Borrowers had less skin in the game to deter to default because of low/ no down payments 2) Low down payments: increased losses to lender when defaults occurred (banks lose more money if someone defaults on their loans) 3) Relaxed lending standards helped to inflate bubble: increased housing demand WHY DID THE BANKSAND FINANCIAL INSTITUTIONS LEND THESE LOANS??? 1. Bubble psychology: lenders believed that house prices would keep rising • As long as house prices are rising, mortgage lending is almost risk free, since in the event of default you can foreclose, re-sell house at good price (prices are going up so if someone defaults banks thought once they take the house away, they can sell the house for more money than they lend the money for house) 2. Securitization: mortgage originators bore less/ no risk Securitization: Traditional: A. Bank would make a loan, it would hold the loan in portfolio and it would service the loan Securitization model: A. Mortgage originator would make a bunch of loans to borrowers and a mortgage originator would sell the loans to mortgage backed security i. Mortgage backed security- a bond whose promised payments are backed by repayments on a pool of underlying mortgages ii. Financial Intermediary creates MBS: buys loans from originator and then bundles loans into a pool; so then the borrower repays to the MBS that the loans were sold toAND then creator of MBS sells MBS to outside investors: other FI’s (pension funds, foreign banks, wealthy individuals) b. Creator hires a third party services for loan (people calling to remind you, to tell you that you need to or are late on payments) Model started in 1079s’s: Fannie Mae, Freddie MAC (quasi- government entities) • They would buy “conforming“ loans (that would satisfy traditional lending standards), they would bundle the conforming loans into mortgage back security, and then guaranteed payments (insurance) to make MBS more attractive to outside investors Benefits of securitizations: 1. Made loans more liquid: improved liquidity of bank’s balance sheets 2. Increased flow of resources into mortgage lending outside investors could indirectly make mortgage loans 3. MBS were attractive to outside investors: a. Liquid: MBS could be resold b. Safe: Fannie/Freddie insurance i. Diversification: bundles of many mortgages less invulnerable to idiosyncratic (household-level risk) ii. NOTE: MBS not inherently diversified against overall in house prices Bubble Period: Securitization change in 2 important ways 1. Private investment banks (like Lehman brothers, Goldman Sac, etc..) began securitizing non- conforming loans (like subprime, alt- a loans ) o Private label MBS didn’t have Fannie/ Freddie insurance 2. Rise of “Collateralized debt obligations” (CDO’s) which were complicated repackaging’s of underlying mortgage loans a. CDO is like a MBS on steroids Problems with securitization: 1. Adverse selection- happens because the creators of mortgage back securities know more about the underlying loan quality ( ex- ante) and the rules of the mortgage back security/ CDO than outside investors a. The creators originate underlying loans in many cases b. In other cases they buy loans form originators but still have information that outside investors do not have about the loans i. Creators have incentive to keep the best loans for themselves and bundle the worst loans into a mortgage back security that will then be sold to outside investors ii. Also have incentive to design complicated rules that benefit themselves at expense of outsiders 2. Moral Hazard/ Principal agent problems: a) Creators of MBS (principal) VS. Mortgage originators(agent) b) Creator hires originator to make loans, Creator wants originator to practice due diligence in screening borrowers But originator may cut corners (ex-post) c) Creator VS services (ex- post) : creator hire servicer to handle problem borrowers(people who call and harass borrowers for payments) a. The contracts gave the servicers sometimes more incentive for people to foreclose on their house than the servicers work with people to make payment plans The Creator doesn’t necessarily want servicer to foreclose (especially after bubble burst) but in some cases servicers got higher fees for foreclosure than for working out alternative payment plan (conflict of
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