AEM1200_0919 - AEM1200, Introduction to Business...

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Unformatted text preview: AEM1200, Introduction to Business Management. AEM1200, Wednesday 9/17 An Overview of the Current Financial Crisis Principles of financial markets The causes: increase in liquidity, securitization The and derivatives and Consequences The Basic Financial System The Holders of Funds have capital that they are Holders willing to lend (for a price) to people, firms, or financial institutions; financial Financial institutions (consumer banks, Financial commercial banks, and private equity institutions) agglomerate capital from holders of funds and look for reasonably risky and profitable opportunities to invest these funds; profitable Users of funds are people or firms looking to make long-term investments and willing to pay a price (iinterest) for the capital they borrow. price nterest) for Financial Intermediaries Financial Financial institutions that facilitate the process of Financial funneling capital from holders of funds to primary financial institutions to users of funds; financial Investment banks Mortgage originators Insurers Originate financial instruments (bonds, publicly traded Originate equity, derivatives); equity, Assume and manage risk Financial intermediaries The Theory of Efficient Markets The The efficient-market hypothesis (EMH) asserts that The efficient-market financial markets are "informationally efficient", or that prices on traded assets, e.g., stocks, bonds, or property, already reflect all known information. The efficientalready market hypothesis states that it is impossible to market consistently outperform the market by using any information that the market already knows, except through luck. Information or news in the EMH is defined as anything that may affect prices that is unknowable in the present and thus appears randomly in the future. the Wikipedia (?) A Random Walk through Wall Street Central banks have subscribed to one economic philosophy in an expanding economy and quite another when the economy is contracting. When things are going well, central banks leave the markets alone. But at the merest hint of crisis, central bankers have responded by cutting interest rates to stimulate their economies and prevent asset prices from falling. prevent The Economist review of “The Origin of Financial Crises: Central Banks, Credit Bubbles and the Efficient Market Fallacy”. Author George Cooper, Published by Harriman House. 2008 Harriman The goal of liquidity was indeed achieved, but the changes also triggered a race to the bottom in the auditing profession, destroyed the economics of investment analysis, and discouraged professional investors from relying on their own rational judgment. relying Healy and Palepu, 2003 The consequences The Mechanical accounting rules The end of independent investment analysis Many investment managers resort to an strategy Many called “passive indexing,” rather than put time and effort into independent analysis and Not bothering makes the market less efficient An interpretation of the current crises An Financial institutions of the “Street” set to Financial arbitrage the “efficiency gaps” left by the increasing mechanization of financial management and trading; management They did so through massive leverage Goldman – 1.1 trillion in assets against 40 billion in Goldman equity equity Changes in underlying value can wipe out the Changes institution! institution! The use of derivatives can result in large losses due to the use of leverage. Derivatives allow investors to earn large returns from small movements in the underlying asset's price. However, investors could lose large amounts if the price of the underlying moves against them significantly. There have been several instances of massive losses in derivative markets, including: derivative The Nick Leeson affair in 1994. The The bankruptcy of Orange County, CA in 1994. The The county lost about $1.6 billion through derivatives trading. The bankruptcy of Long-Term Capital Management in The 2000. The loss of $6.4 billion in the failed fund Amaranth The Advisors, which was long natural gas in September 2006 when the price plummeted. The loss of $7.2 Billion by Société Générale in January The 2008 through mis-use of futures contracts. Events Events 2000-2001 – End of the dot-com bubble. Increase 2000-2001 in liquidity. End of US budget surpluses. in September 2001 – Additional increase in liquidity September as a result of 9/11 as March 2003 – Start of the Iraq war. Additional March public debt incurred to finance the war public 2002 – 2006 – Real estate bubble. Growth of the 2002 subprime mortgage segment and related consumer debt. consumer Financial Causes of the Crisis Financial Securitisation—the packaging of bank loans into Securitisation—the tradable bonds—grew too complex. The incentives of those involved, especially loan originators, were warped. Lending standards plummeted as a result, not only in mortgages but in credit cards and corporate lending too. Investors over-reached for yield as interest rates fell. Everyone focused on credit ratings rather than the underlying credits. The Current Climate The Decline in real estate and other assets value Non-performing mortgages and loans Attempts to shore up capital in response to nonperforming and deteriorating assets Credit crunch Consolidation has led to uncertainty and “toxic bonds” U.K, Spain and Japan particularly affected. Lack of confidence in financial instruments General weakness of world economy This (Business) American Life This Bear Stearns (J.P. Morgan, March 2008) Freddie Mac (Treasury, September 2008) Fannie Mae (Treasury, September 2008) Merrill Lynch (Bank of America, September Merrill 2008) 2008) Lehman Brothers (Chapter 11) American Insurance Group (next in line?) American (next The problem is fear: private-sector finance has dried up because investors, burned by their losses on securities that were supposed to be safe, are now reluctant to buy anything that isn’t guaranteed by the U.S. government. And the proliferation of special rescue packages — the TAF [Term Auction Facility], the TSLF [Term Securities Lending Facility], the Bear Stearns deal, the FannieSecurities Freddie thing — may have staved off blind panic, but has fallen far Freddie short of restoring confidence… overextended, undercapitalized financial institutions have to rein in their lending, and it’s not realistic to expect the public sector to pick up all the slack — especially when quasipublic institutions like Fannie and Freddie are also in trouble. are Paul Krugman, “A SlowMo Meltdown”, Paul NYT August 4, 2008 NYT ...
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