Investments: Background and issues CHAPTER 1

Investments & Financial Assets Essential nature of investment  Reduced current consumption  Planned later consumption How to invest  Real Assets: Assets used to produce goods and services produce income to economy  Financial Assets Claims on real assets or income generated by them Allocation of income, real assets among investors, individuals in the economy

Balance Sheet – U.S. Households

Financial Assets Financial assets Fixed-income (Bonds) Equity (Stocks) Derivatives Money Market (Short-term) Common Stocks Preferred Stocks Options Futures Bond Market (Long-term)

Role of Financial asset and financial markets in the Economy Consumption Timing Allocation of Risk Separation of Ownership and Management

Consumption Timing Savers (earn more than spend) Borrowers (spend more than earn) Financial assets: stocks, bonds, deposits, etc. How do you transfer money from when you do not need to when you need?

Allocation of risk Example: GM wants to build a new auto plant, it raised money by issuing stocks and bonds GM Stock investors (high risk) Bond investors (low risk) Auto plant High risk and low risk Stock Bond

Separation of ownership and management Example: GE, total asset is $640 bil Cannot be single owner, must have many owners Selling stocks to market Currently, GE has 500,000 owners These owners choose managers Can easily transfer ownership without any impact on management

The Investment Process Asset allocation Security selection Risk-return trade-off Market efficiency Active vs. passive management

Investment process Broad assets Stocks Bonds Real estate Commodity Small stock Big stock corporate bond T-bond, T-bill House Land coffee, tea gold, oil, etc (1) Asset allocation (2) Security analysis

30s70%30% 40s s s4060 Common AgeStocksBonds Example of Asset Allocation

Example of Security Selection Your Stock Portfolio AutoRetailFinancial Wal-Mart Nordstroms Sears Bank of America Berkshire Hathaway Citibank

There is no free lunch!

Market Efficiency Security prices accurately reflect all relevant information. The price in the market is the true price Earn return just enough to compensate for risk, no abnormal return

Active vs. Passive Management Active Management Finding undervalued securities Timing the market Passive Management No attempt to find undervalued securities No attempt to time Holding an efficient portfolio

Players in the Financial Markets Business Firms – net borrowers Households – net savers Governments – can be both borrowers and savers Investment Bankers

Players in the Financial Markets borrowers Savers securities fund borrowers financial intermediaries savers securities lending rate securities borrowing rate borrowersinvestment bank savers securities fund securities fund get commission fees

Recent Trends Globalization Securitization Financial Engineering Computer Networks

Globalization In 1970, US equity market accounted for about 70 percent of equity in the world Currently, only percent How to invest globally  Purchase ADRs  Invest directly into international market  Buy mutual fund shares that invest in international market  derivative securities with payoff depends on prices of foreign market

Securitization Banks pool all loans Mortgage loans auto loans credit card student loans other loans securities loans are securitized Investors Benefits of securitization (1)more funds available to borrowers (2)Transfer risk of loans to corresponding investors in the market High risk loanHigh risk securitiesHigh risk investors Low risk loanlow risk securitieslow risk investors

Figure 1.2 Asset-backed Securities Outstanding

Financial engineering refer to creation of new securities Bundling: combine more than one security into a composite security Unbundling: breaking up and allocating the cash flows from one security to create several new securities

Collateralized Debt Obligation (CDO) A CDO is an asset backed security (ABS) whose underlying collateral is typically a portfolio of bonds (corporate or sovereign) or bank loan A CDO cash flow structure allocates interest income and principal repayments from a collateral pool of different debt instruments to a prioritized collection (tranches) of CDO securities.

Mortgage 1 Mortgage 2 Mortgage 3  Mortgage n Average Yield 12.5% ($100 mil) Tranche 1 (AAA) Yield = 5% ($25mil) Tranche 2 (A) Yield = 10% ($25mil) Tranche 3 (BBB) Yield = 15% ($25mil) Tranche 4 (junk bond) Yield = 20% ($25mil) Cash CDO Structure Illustration An investment bank creates a set of securities (tranches) backed by a mortgage pool (CDO) Investor: banks, pension funds, college saving funds, universiti es, cities, etc.

Collateralized Debt Obligation (CDO) In normal time, mortgage borrowers are able to make the mortgage payments, so the investors will get the interest payments, the values of slices of CDOs increase When housing bubble busts, mortgage borrowers, especially subprime mortgage borrowers are not able to make payments, investors don’t get their money, values of CDOs decrease substantially. The value decrease is write-down and counted as loss in the income statement. For example, investment bank A, equity: $10 mil, borrow $90 mil. Invest all $100 mil in CDOs. When mortgage crisis happens, the market value of these mortgage backed securities drops substantially say to $80 mil, that means the income will go down by $80 mil, and at this point, technically the bank is insolvent.

Subprime Mortgage Crisis: Winners and Losers Big losers:  Bear Stearns: two hedge funds (>$1 billion)  Australia: Basis Capital ($1 billion?); Absolute Capital ($200 million?); IKB Deutsche Industriebank …  May take two more years to completely resolve! Big losers:  Citigroup ($18B+)  Merrill Lynch ($11.5B+)  UBS ($17.8B+)  Morgan Stanley ($9.4B+) …  Bank of China (initial estimate $223 million, now could be $4-5B)

Building a Complex Security

Unbundling – Mortgage Security

2008: Making History 29

2008: The End of Wall Street 30

A New Legend? 31 John Paulson The Wall Street investor who shorted subprime – and made $15bn or 600% return

The Largest Ponzi Scheme 32 Bernard Madoff $50B

Computer network Online trading fee is only $20, compared with brokerage firm $100. Online information: cheap and available automated trade crossing  example: if IBM price falls below $50, sell the stock automatically.

Decision Making 1. Perceive the situation 2. Possible actions 3. Evaluate the outcomes 4. Choose the action with the best outcome 34

Summary Financial assets Risk return tradeoff Next class: Financial Securities