How Pair Trading Works (a) 75 70 65 9/21

How Pair Trading Works (b) liq,goshort 75 liq,golong liq liq,golong goshort liq,goshort liq,golong 70 liq,goshort liq 65 golong

How Pair Trading Works (c) liq,goshort +500 75 -200 liq,golong liq +800 liq,golong goshort liq,goshort +0 liq,golong +700 70 +500 +500 liq,goshort -300 liq +500 65 +500 golong Plausible rule: Say mean spread 3.0 with a stdev 1.6. Go into action, say, when spread +1.5 or -1.0 stdevs. Funds use math and statistics to figure out best strategy.

Fed Balance Sheet (millions), April 2009 Assets Liabilities & Capital Gold & Coin 15,107 Loans to depository institutions - Repurchase agreements 0 US treasury securities 534,969 Agency securities 64,511 MBS 367,590 Term Auction Facility (TAF) 455,799 CP Facility 242,431 Maiden Lane & related 72,163 Other loans 102,988 Other 342,711 2,198,269 Federal Reserve Notes 862,960 Rev Repurchase agreements 64,681 Deposits Depository inst balances 915,773 US Treasury 295,399 Other 13,456 Capital 46,000 2,198,269

Securitization Securitization is the financial engineering practice of repackaging pools of relatively illiquid assets into much more liquid securities (that are easier to market) 9/24

MBS (Mortgage Backed Securities) MBSs (mortgage backed securities) are created by a securitization process. They are securities whose cash flows are derived from a pool of mortgages. Two types of MBSs: Mortgage Bonds, created from a pool of mortgages CDOs, collateralized debt obligations, created from a pool of mortgage bonds, but we will discuss CDOs later. MBSs can get extremely complicated.

A Securitization Example A bank creates a trust, i.e, special purpose vehicle (SPV). Then lends SPV money to buy many loans of a particular type. Go into a pool. SPV then sells bonds, structured into tranches, to investors to pay back bank with proceeds. Loans in pool pay interest and make principal repayments, which flow through to service the bonds and pay them off. Bank makes money in several ways including: (1) fees for setting up the SPV, (2) annual fees for operating the SPV, (3) by owning bottommost tranche to claim all residual profit after all higher level tranches have been paid off.

Term Auction Facility (TAF) As mortgage default problems arose in late 2007, many banks encountered liquidity problems. Overwhelmed discount window. In Dec 2007, Fed suspended traditional discount window in favor of Term Auction Facility (TAF): rather than just overnight, made 28 and 84-day loans accepted other securities, rather than just Treasuries and agency securities, as collateral. originally for depository institutions, extended to non-bank financial institutions (i.e., investment banks). new TAF loans stopped after March 2010 9/26

CP (Commercial Paper) Facility Unsecured promissory notes that mature before nine months (270 days). Proceeds to be used only for operating purposes (inventories, receivables) and not for fixed assets (land, buildings, machinery). Issued by 600 to 800 corporations. Sold at discount, mature at par. Some sold by direct placement, but most sold through dealers. Dealers charge something like one-eighth of a percent of face value to underwrite an issue for a firm.

Underwrite Formal Definition - If a bank or other organization underwrites an activity, it gives it financial support and takes responsibility for paying any costs if it fails. CP Example – If a dealer agrees to underwrite, dealer buys the whole CP issue. Then intends to sell to customers/investors. If for some reason all can’t be sold, dealer is stuck owning what is left.

CP Backup Lines of Credit Usually not possible for an issuer to sell CP without a backup line of credit. Backup line of credit is agreement by which a bank will lend an issuer, if needed, the money necessary to redeem maturing paper. Makes purchasers feel more secure in the event issuer is not able to “roll over” maturing CP (i.e., sell new CP to pay off old CP). Typical charge is 12.5 basis points of par (on an annual basis) for backup lines of credit, then market interest rate if money is actually borrowed. Average CP maturity is about 30 days In financial crises, difficult to roll over

CP Rated: prime, desirable, satisfactory. P-1, P-2, P-3 (Moody’s) A-1, A-2, A-3 (S&P’s) Virtually impossible to sell unrated commercial paper Advantage of CP: low interest rates About 30 commercial paper dealers. There is a secondary market and issuers sometimes buy back their commercial paper. Transaction costs in range of about one-eighth of one percent. Normal for $1 trillion in CP to be outstanding at any moment.

Fed Balance Sheet, September 20, 2018 Assets Liabilities & Capital Gold & Coin 18,001 Loans to depository institutions 442 Repurchase agreements 0 US Treasury securities 2,313,206 Agency securities 2,409 MBS 1,695,223 Term Auction Facility (TAF) - CP Facility - Maiden Lane & related 7 Other loans - Other 178,771 4,208,059 Federal Reserve Notes 1,637,959 Rev Repurchase agreements 234,836 Deposits Depository inst balances 1,822,718 US Treasury 399,519 Other 73,931 Capital 39,056 4,208,059

Quantitative Easing We had QE, QE2, QE3 (2008-2014) when the Fed purchased securities other than US Treasuries and agency securities to provide stimulus during financial crisis. This greatly expanded balance sheet to a max of $4.5 trillion. Fed now trying to slowly reduce balance sheet. Quantitative easing done by central banks only in emergencies.

Open Market Injection of $30 Billion 9/28

Technical Factors Cash drains – increased cash holdings by public decrease banking system reserves. Example: Suppose system in equilibrium But people take more money out of their checking accounts than anticipated in advance of a big weekend. Reduces vault cash Banks have harder time meeting RRs Makes Fed Funds rate go up Fed does repurchase agreements to increase temporarily depository institution reserves Causes Fed Funds rate to drop US Treasury transactions can cause shifts in reserves. Fed can offset with calibrated open market transactions (typically with repos and reverse repos)

Velocity of Money Velocity is annual money supply turnover rate. Velocity * Money supply = GDP Velocity is difficult to predict. For given change in money supply, the Fed can expect direction of change in economy, but cannot ensure the degree.

Asset Backed Securities ABSs (asset backed securities) are same as MBSs but cash flows are from a pool of home equity loans, auto loans, student loans, credit card receivables, . . . Now $1.5 trillion in student loans (but not all have been securitized, i.e., made into ABSs).

Subprime Lending Although definition varies, subprime lending is to people with a FICO score of less than 640.

Subprime Mortgages teaser rates pick-a-pay interest only no down payment When rates would reset, told can either sell at profit (because housing prices would go up) or refinance to get another low rate. But prices went down starting in 2006. Couldn’t pay mortgage, couldn’t refinance. Mortgage servicers foreclosed. Mortgage bond holders (many of which were financial institutions) suffered huge losses. Mortgage bonds became toxic securities (nobody would buy them).

Asset-Backed Commercial Paper In addition to normal commercial paper, there is asset-backed commercial paper (ABCP). Average ABCP maturities: 90 to 180 days In run up to financial crisis, issued by up to 1,000 SPVs to help buy pools of mortgages, auto loans, student loans, credit card receivables, etc., but mostly mortgages. Going into financial crisis, up to $1 trillion of US ABCP outstanding. Then couldn’t roll over, so Fed stepped in.