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

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

3. 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.

4. Fed Balance Sheet (millions), April 2009
Assets
Liabilities & Capital
Gold & Coin ,107
Loans to depository institutions
Repurchase agreements
US treasury securities ,969
Agency securities ,511
MBS ,590
Term Auction Facility (TAF) ,799
CP Facility ,431
Maiden Lane & related ,163
Other loans ,988
Other ,711
2,198,269
Federal Reserve Notes ,960
Rev Repurchase agreements ,681
Deposits
Depository inst balances ,773
US Treasury ,399
Other ,456
Capital ,000
2,198,269

5. 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

6. 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.

7. 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.

8. 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

9. 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.

10. 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.

11. 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

12. 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.

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

14. Quantitative Easing
We had QE, QE2, QE3 ( ) 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.

15. Open Market Injection of $30 Billion
9/28

16. 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)

17. 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.

18. 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).

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

20. 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 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).

21. 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.