Lecture_8_2010

Lecture_8_2010 - E4729 Financial Institutions, Markets, and...

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E4729 Financial Institutions, Markets, and Risk Lecture 8 Financial Darwinism July 30, 2010 Leo M. Tilman L.M.Tilman & Co. & Columbia University
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2 E4729 Financial Institutions, Markets, and Risk The Challenge Macroeconomic Forces Low Return Environment Bretton Woods II Imbalances US Housing & Deficits Monetary Policies Financial Instruments Derivatives CDOs ABCP & SIVs Subprime MBS Financial Institutions Investment Banks Commercial Banks Hedge Funds SWFs & Pension Plans Intellectual Paradigm Accounting Earnings Financial Disclosures Credit Ratings Equity Market Valuations Complexity + Deficient Lens = Value Destruction RISK
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3 E4729 Financial Institutions, Markets, and Risk Role of Risk in Value Creation and Destruction BoA/Merrill Lynch “This was almost a perfect fit, and we thought it was close enough to the bottom that we could make the deal work and be very good for our shareholders.” Ken Lewis, CEO, Bank of America Wachovia/Golden West “Growing deposits is perhaps the most profitable thing that a retail and small business bank can do.” Ken Thompson, Former CEO, Wachovia Investment banks, GSEs, Money managers, Proprietary trading Issues: Origination risk management vs portfolio risk management Strategic vision and staying power
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4 E4729 Financial Institutions, Markets, and Risk Static Business Models (and the old, blinding ways of thinking) If a business person has to ask his accounting department if he is making a profit, he will not be in business very long. Alan C. “Ace” Greenberg, Memos from the Chairman
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5 E4729 Financial Institutions, Markets, and Risk The mechanism of economic value creation (and destruction) in finance is a key to understanding modern financial institutions and capital markets Economic Performance = return on assets – cost of liabilities + fees – expenses – cost of capital Institution Fees Depositories & Investment REITs Loss-adjusted asset/liability spread (buy-and-hold, all fixed income) Deposit account service charges, loan origination, servicing, and ATM fees, etc. Insurers Loss-adjusted asset/liability spread (buy-and-hold, mostly fixed income) Surrender charges, management and other misc fees Investment Banks Loss-adjusted asset/liability spread (funding activities) Bid/ask spreads, commissions, underwriting and securitization fees GSEs Option-adjusted A/L spread (given typical hedging & debt strategies) Securitization and credit guarantee fees DB Pensions Realized differential returns: equities vs. bonds (equity risk premium) L A R R Economic Performance as a Conceptual Anchor
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6 E4729 Financial Institutions, Markets, and Risk MV Asset Classes ($millions) Residential Mortgages 35,000 Government Bonds 7,000 LIBOR Floaters 20,000 Asset-Backed Securities 8,000 Commercial Mortgages 9,000 Corporate Bonds 20,000 Municipal Bonds 1,000 Total Assets 100,000 Certificates of Deposit 5,000 Retail Deposits 46,000 Wholesale Debt 37,000 Total Liabilities 88,000 Shareholder Equity 12,000 Total Balance Sheet 100,000 Liabilities Assets Current Year 1 Year 2 Year 3 Year 4 Net Interest Margin Recession (-100) 3.05 2.83 2.74 2.72 2.65 Base Case 3.19 3.14 3.10 3.11 3.10 Recovery (+100) 3.09 3.34
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This note was uploaded on 10/16/2010 for the course IEOR 4729 taught by Professor Leotilman during the Summer '10 term at Columbia.

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Lecture_8_2010 - E4729 Financial Institutions, Markets, and...

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