The Financial System Sherif Khalifa Sherif Khalifa () The Financial System 1 / 52
Financial System Definition The financial system consists of those institutions in the economy that matches saving with investment. The financial system channels funds from those who save to those with investment projects. These investment projects make the economy more productive. These projects provide new jobs for workers and produce new goods for consumers. By increasing an economy s productivity, the financial system helps the economy to grow and the living standards to increase. The financial system is comprised of the financial market and the financial intermediaries. Sherif Khalifa () The Financial System 2 / 52
Financial System Definition Financial Markets are the institutions through which savers can directly provide funds to borrowers. Financial markets are markets in which people and entities buy and sell securities such as stocks and bonds. Definition A security is a claim on some future flow of income. The most familiar securities are stocks and bonds. Definition Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. Sherif Khalifa () The Financial System 3 / 52
Financial System Definition A bond is a security issued by a corporation or a government that promises to pay the buyer predetermined amounts of money at certain times in the future. Corporations issue bonds to finance investment projects. Governments issue bonds to cover budget deficits. The bond issuer is borrowing money from those who buy the bonds. The bond issuer receives funds immediately and pays the buyers back in the future. Because bond issuers owe money to bond purchasers, bonds are called debt securities. Sherif Khalifa () The Financial System 4 / 52
Financial System Bonds A bond issuer defaults if it fails to make coupon payments or pay the face value at maturity. A corporation defaults if it declares bankruptcy, and a government defaults if it does not have enough revenues. The risk is smaller for bonds issued by the government or by well established successful corporations. The risk is larger for new corporations with unknown prospects or those that may go bankrupt. The greater the risk of default, the higher the interest rate that a bond must pay to attract buyers. Sherif Khalifa () The Financial System 5 / 52
Financial System Definition A stock is an ownership share in a corporation. Corporations issue stocks to finance investment projects. The earnings from a company s stock are a share of profits which are unpredictable. Buying stocks is riskier than buying bonds. People buy stocks despite the risk because stocks produce higher returns. Stockholders also have ultimate control over a corporation. Sherif Khalifa () The Financial System 6 / 52
Financial System Matching Savers and Investors A system of markets and institutions help channel funds from savers to investors. At any time, some people consume less than they earn and save the remainder. Other people know how to use these savings for investments that earn profits, increase production and employment. Financial markets transfer funds from an economy s savers to its investors. Sherif Khalifa () The Financial System 7 / 52
Financial System Risk Sharing If a person s wealth is tied to one company, the person loses a lot if the company is not successful. If the person buys the securities of many companies, the person diversifies. Diversification is the distribution of wealth among many assets. Diversification lets savers earn healthy returns from securities while minimizing the risk. Sherif Khalifa () The Financial System 8 / 52
Financial System Definition Asymmetric information is a situation in which one participant in an economic transaction has more information than other participant. In financial markets, asymmetric information occurs because the sellers of securities have more information than the buyers. Two types of asymmetric information exist in financial markets: adverse selection and moral hazard. Sherif Khalifa () The Financial System 9 / 52
Financial System Definition Adverse selection means that people or firms that are most eager to make a transaction are the least desirable to parties on the other side of the transaction. In securities markets, a firm is most eager to issue stocks and bonds if the values of these securities are low. This is the case if the firm s prospects are poor as earnings on its stocks are likely to be low and default risk on its bonds is high. Adverse selection is a problem for buyers of securities because they have less information than issuers about the securities value. Sherif Khalifa () The Financial System 10 / 52
Financial System Definition Moral hazard is the risk that one party to a transaction will act in a way that harms the other party. In securities markets, issuers of securities may take actions that lowers the value of the securities. This leads to harming the buyers of the securities. The buyers can not prevent this because they lack information on the issuer s behavior. Sherif Khalifa () The Financial System 11 / 52
Financial System Asymmetric Information Adverse Selection Moral Hazard Prior to a transaction, savers lack Information about investors characteristics After a transaction, savers do not observe investors behavior Investors with worst projects are most eager to sell securities Investors have incentives to misuse savers funds Savers won t buy securities Financial markets cannot channel funds from Savers to investors Sherif Khalifa () The Financial System 12 / 52
Financial System Definition A bank is a financial institution that raises funds by accepting deposits, and uses these funds to make loans to companies and individuals. Channeling funds through banks is called indirect finance. Channeling funds through financial markets is called direct finance. Banks reduce adverse selection by screening potential borrowers. To combat moral hazard, banks include covenants about how the bank expects the borrower to behave. Sherif Khalifa () The Financial System 13 / 52
Financial System Asset Prices As the prices of stocks and bonds fluctuate, the owners of these assets see their wealth increase and decrease. As prices increase, asset owners increase consumption spending contributing to an expansion. As prices decrease, asset owners decrease consumption spending contributing to a contraction. Sherif Khalifa () The Financial System 14 / 52
Financial System Asset Prices Definition The future value of a dollar is how many dollars it can produce in some future year. Definition The present value of a future dollar is how much a future dollar is worth today. $ (1 + i) n in n years = $1 Today $ (1 + i) n $1 (1 + i) n in n years = (1 + i) n Today Present Value of $1 in n years = $1 (1 + i) n Today Sherif Khalifa () The Financial System 15 / 52
Financial System Asset Prices X Present Value = $X (1 + i) n Present Value = i = 4% n = 3 $1 (1 + 0.04) 3 = $0.889 Sherif Khalifa () The Financial System 16 / 52
Financial System Asset Prices X 1 X 2 X 3 X T Present Value = $X 1 (1 + i) + $X 2 (1 + i) 2 +... + $X T (1 + i) T i = 4% n = 7 $X 1 = $X 2 =... = $X 7 = $23 Present Value = $23 (1.04) + $23 $23 +... + 2 (1.04) (1.04) 7 = $138 Sherif Khalifa () The Financial System 17 / 52
Financial System Asset Prices X X X Present Value = $X (1 + i) + $X (1 + i) 2 +... = $X i i = 4% $X = 100 Present Value = $100 0.04 = $2500 Sherif Khalifa () The Financial System 18 / 52
Financial System Asset Prices X X(1+g) X(1+g) 2 X(1+g) 3 Present Value = $X $X (1 + g) $X (1 + g)2 + (1 + i) (1 + i) 2 + (1 + i) 3 +... = $X i g Present Value = i = 4% $X = 100 g = 2% $100 0.04 0.02 = $5000 Sherif Khalifa () The Financial System 19 / 52
Financial System Asset Prices Asset Price = Present Value of Expected Asset Income People purchase an asset because it yields a future stream of income. The present value tells us how much the income stream is expected to be worth and thus how much we should be willing to pay for the asset. If an asset s price is below the present value of its expected income stream, buyers pay less than the asset is worth. Lots of savers will purchase the asset, and high demand will push the price up. If an asset s price exceeds the present value of expected income, then sellers receive more than the asset is worth. The asset s owners will rush to sell it, and the increase in supply will push down the price. Sherif Khalifa () The Financial System 20 / 52
Financial System Asset Prices If a bond has a face value F, an annual coupon payment C, and a maturity T. Bond Price = F = $100, C = $5, T = 4 years, i = 4% C (1 + i) + C (1 + i) 2 +... + C + F (1 + i) T Bond Price = 5 (1 + 0.04) + 5 (1 + 0.04) 2 + 5 (1 + 0.04) 3 + 105 (1 + 0.04) 4 = $103.63 Sherif Khalifa () The Financial System 21 / 52
Financial System Asset Prices If a stock pays dividends D 1 after one year, D 2 after two years, and so on. Stock Price = D 1 (1 + i) + D 2 (1 + i) 2 +... Sherif Khalifa () The Financial System 22 / 52
Financial System Asset Prices An asset price is the present value of expected income from the asset. The present value changes if expected income changes or if interest rates change. Stock prices change frequently because of changes in expected income from the stock. These changes occur when there are news about a company s prospects or about economic conditions. Higher expected earnings mean larger expected dividends for stockholders, so the stock price increases. Lower expected earnings mean lower expected dividends for stockholders, so the stock price decreases. Changes in interest rates affect stocks and bonds prices. Sherif Khalifa () The Financial System 23 / 52
Financial System Asset Prices In a bubble, asset prices increase even though there is no change in interest rates or expected income to justify it. When a bubble occurs, an asset price increases simply because people expect it to increase. At some point during the bubble, people start worrying that it will end. They would like to hold assets as long as prices increase but sell before the bubble bursts. A few asset holders get nervous and decide to start selling. Others notice this and fear that the bubble may be ending, and they sell hoping to dump their assets before prices fall too much. As prices fall, panic sets in and many asset holders try to sell at the same time and prices plummet. Pessimism about prices is self fulfilling, just as optimism was self fulfilling during the bubble. Sherif Khalifa () The Financial System 24 / 52
Financial System Yield to Maturity If a bond has a face value F, an annual coupon payment C, and a maturity T. Bond Price = C (1 + i) + C (1 + i) 2 +... + C + F (1 + i) T F = $100, C = $5, T = 4 years, Bond price= $95 $95 = 5 (1 + i) + 5 (1 + i) 2 + 5 (1 + i) 3 + 105 (1 + i) 4 i = 0.065 Sherif Khalifa () The Financial System 25 / 52
Financial System Rate of Return P 0 : initial price of the security. P 1 : the price of a security after you hold it for a year. X : direct payment. P 0 = $80, C = $4, P 1 = $82 Rate of Return = (P 1 P 0 ) P 0 + X P 0 Rate of Return = (82 80) 80 + 4 80 = 0.075 Sherif Khalifa () The Financial System 26 / 52
Financial System Yield Curve Definition The yield curve shows interest rates on bonds of various maturities at a given point in time. The yield curve s shape tells us about the expected path of interest rates. A steep curve means that the short term interest rates are expected to increase. An inverted curve means the short term interest rates are expected to decrease. Sherif Khalifa () The Financial System 27 / 52
Financial Crisis Definition Subprime lending refers to making loans to people who may have diffi culty maintaining the repayment schedule.these loans are characterized by higher interest rates, poor quality collateral, and less favorable terms in order to compensate for higher credit risk. Sherif Khalifa () The Financial System 28 / 52
Financial Crisis Regulators encourage banks to be conservative in lending, and not to take risks that could lead to large losses. Banks deny credit to people with high default risk including those with low income or poor credit histories. People who cannot borrow from banks often turn to subprime lenders, or finance companies that specialize in high risk loans. Government regulates finance companies less heavily, as they do not accept deposits. So the government does not owe insurance payments if a finance company fails. Sherif Khalifa () The Financial System 29 / 52
Financial Crisis Light regulation allows finance companies to make loans that regulators deem risky. Eager to increase business, finance companies made loans to people who were likely to have trouble paying them back. Subprime lenders grew increasingly confident that credit scores were accurate measures of default risk. By knowing a borrower s default risk, finance companies could offset expected losses from defaults by charging high interest rates. The reliance on credit scores led lenders to neglect traditional safeguards against defaults like down payments. Sherif Khalifa () The Financial System 30 / 52
Financial Crisis There was a house price bubble, where housing prices increased by more than 70% from 2002 to 2006. People believed that prices would continue to increase indefinitely. The housing price bubble was a key factor behind the subprime boom. Increasing house prices made it easier for homeowners to cope with high mortgage rate payments. Someone short on cash can take out a second mortgage because the higher value of the house gave more collateral. Someone can sell the home for more than he paid for it, pay off his mortgage, and earn a capital gain. Sherif Khalifa () The Financial System 31 / 52
Financial Crisis Definition Securitization is the process of taking an asset, or group of assets, and through financial engineering, transforming them into a security. Definition Securitization is the practice of pooling various types of contractual debt such as mortgages, auto loans or credit card debt obligations and selling their related cash flows to investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations (CDOs). Investors are repaid from the principal and interest cash flows collected from the underlying debt. Definition Securities backed by mortgage receivables are called mortgage-backed securities, while those backed by other types of receivables are asset-backed securities. Sherif Khalifa () The Financial System 32 / 52
Financial Crisis Banks sell many of the loans they make rather than holding them as assets. Banks sell loans because the possibility of default makes it risky to hold them. Banks and finance companies make loans and sell them to a large financial institution, the securitizer. By selling loans, the bank shifts default risk to the ultimate holders of the loan. The institution buying the loan pays the bank for reducing asymmetric information problems. The bank earns a profit from the sale and avoids the default risk it would face if it held onto the loan. Sherif Khalifa () The Financial System 33 / 52
Financial Crisis The securitizer gathers a pool of loans with similar characteristics. The securitizer issues securities that entitle an owner to a share of the payments on the loan pool. Securitization occurs because banks want to sell loans and because securities backed by bank loans are attractive. Securitization provided more funds for subprime loans. In turn, more subprime lending increased the demand for housing fueling the increase in the house prices. Sherif Khalifa () The Financial System 34 / 52
Financial Crisis In the early 2000s, the investment banks started to issue mortgage backed securities. They purchased home mortgage loans from the original lenders and bundled them together. The buyers of the securities became entitled to shares of the interest and principal payments that borrowers made on mortgages. The securities issued by investment banks had mortgages that were subprime. Sherif Khalifa () The Financial System 35 / 52
Financial Crisis Subprime borrowers must pay higher interest rates than traditional mortgage borrowers. Securities backed by subprime mortgages promised high returns to their owners. The decline in house prices caused defaults on subprime mortgages, because borrowers could not make payments. As defaults increase, participants in financial markets realized that securities backed by subprime mortgages would produce less than expected. Lower expected income reduced the prices of the securities, causing large losses to investment banks. Sherif Khalifa () The Financial System 36 / 52
Financial Crisis Definition Securities firms hold securities, trade them, or help others trade them. Sherif Khalifa () The Financial System 37 / 52
Financial Crisis Definition Mutual funds is a financial institution that holds a diversified set of securities and sell shares to savers. Each shareholder owns a small part of all the securities in a fund. The shareholder of the mutual fund accepts all the risk and return associated with the portfolio. If the value of the portfolio increases shareholders benefit, and if the value decreases the shareholders suffer a loss. Allow people with small amounts of money to diversify their investments and face less risk. Give ordinary people access to the skills of professional fund managers. To protect small savers, the government limits the risks that mutual funds can take with shareholders money. Sherif Khalifa () The Financial System 38 / 52
Financial Crisis Definition Hedge funds raise pools of money to purchase securities. They cater mainly to wealthy people and institutions. Hedge funds are largely unregulated because the government assumes that the fund s wealthy customers can look out for themselves. Light regulation means that hedge funds can make risky bets on asset prices. These bets sometimes produce large earnings and sometimes large losses. Sherif Khalifa () The Financial System 39 / 52
Financial Crisis Investment banks has a traditional function which is underwriting. As an underwriter, an investment bank helps companies issue new stocks and bonds. A firm becomes public by making a first sale of stock, which is called an initial public offering. Investment banks advise companies, and markets the securities to potential buyers. Potential buyers are concerned because they know less about the firm s business than the firm does. Investment banks reduce this concern by researching the firm and trying to ensure that it is sound and its securities are priced reasonably. Investment banks also practice financial engineering, or the development and marketing of new types of securities. Sherif Khalifa () The Financial System 40 / 52
Financial Crisis A more recently developed asset is called a derivative. The payoffs from this security are tied to the prices of other assets. That is the value of the security is derived from other assets. Common types of derivatives are credit default swaps. A credit default swap buyer pays premiums. Payments on credit default swaps are triggered by defaults on the original securities. We can interpret credit default swaps as an insurance policy. Sherif Khalifa () The Financial System 41 / 52
Financial Crisis Many credit default swaps issued in the 2000s were tied to subprime mortgage backed securities. The sellers of CDS on mortgage backed securities promised to pay CDS buyers if the market prices of the underlying securities fell. That is even if the securities had not yet defaulted. When the prices of mortgage backed securities fell, it triggered payments on CDS. Other firms used credit default swaps to speculate as they foresaw trouble in the housing market. They bet against mortgage backed securities by purchasing CDS on securities they did not own. AIG, a conglomerate of insurance companies, was selling the CDS and received a steady flow of fees by selling CDSs. As the mortgage crisis unfolded, AIG had to make larger payments to holders of its CDS. Sherif Khalifa () The Financial System 42 / 52
Financial Crisis Definition A financial crisis is a major disruption of the financial system, and involves sharp falls in asset prices and failures of financial institutions. Sherif Khalifa () The Financial System 43 / 52
Financial Crisis Bubble Burst A crisis may be triggered by large decreases in the prices of stocks, real estate or other assets. Economists interpret these decreases as the end of asset price bubbles. A bubble occurs when asset prices increase far above the present value of the expected income from the assets. As sentiment shifts, people begin to worry that asset prices are too high and start selling the assets pushing prices down. Falling prices shake confidence further, leading to more selling. Sherif Khalifa () The Financial System 44 / 52
Financial Crisis Insolvencies An institution may fail because it becomes insolvent. That is its assets fall below its liabilities and its net worth becomes negative. Insolvencies can spread from one institution to another because financial institutions have debts to one another. If one institution fails, its depositors and lenders suffer losses, and they in turn may become insolvent. Sherif Khalifa () The Financial System 45 / 52
Financial Crisis Liquidity Crises A financial institution can fail because it does not have enough liquid assets to make payments it has promised. Depositors lose confidence in the bank, try to withdraw large amounts from their accounts, and exhausts the bank s reserves and liquid securities. The bank must sell its illiquid assets at low prices, and losses on these transactions can push it into insolvency. If a bank experience a run, depositors at other banks start worrying about the safety of their own funds. They start making withdrawals triggering an economy wide bank panic. Sherif Khalifa () The Financial System 46 / 52
Financial Crisis The direct costs of financial crises include losses to asset holders when asset prices fall. They also include losses from financial institution failures. Owners of a failed institution lose their equity, and the institution s creditors lose funds they have lent. The indirect cost is that a crisis can set off a chain of events that plunges the whole economy into a recession. A fall in asset prices can cause a sharp fall in aggregate demand, because as asset holders suffer a loss of wealth they decrease their consumption. Falling asset prices also shake the confidence of firms and consumers, who may interpret them as signs that the overall economy is in trouble. Sherif Khalifa () The Financial System 47 / 52
Financial Crisis Uncertain of the future, they put off major decisions about spending until things settle down, and investment and consumption fall. A fall in asset prices makes it harder for individuals and firms to borrow. Lower prices decreases the value of borrowers collateral. The outcome is a credit crunch, or a sharp decrease in bank lending. Failures of financial institutions also cause a credit crunch, as when commercial banks fail they stop lending. Surviving banks may fear failure and become more conservative in approving loans. This also means less spending by firms and individuals who rely on credit. Sherif Khalifa () The Financial System 48 / 52
Financial Crisis This decrease in consumption and investment decreases aggregate demand. A fall in aggregate demand reduces output, and a crisis can cause a deep recession. The recession can exacerbate the crisis, as asset prices are likely to fall further. A financial crisis can trigger a vicious circle, and once a crisis starts it can sustain itself for a long time. Sherif Khalifa () The Financial System 49 / 52
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Financial Crisis The real estate price increases were an unsustainable asset price bubble. The bubble burst, and prices fell by 33% from 2006 to 2009. When house prices started falling, homeowners found themselves with mortgage payments they could not afford. They could not borrow more and they could not sell their houses for enough to pay their mortgages. As housing prices fell and defaults on subprime mortgages increase, institutions that made subprime loans suffered large losses. Other financial companies that held securities backed by subprime mortgages lost billions of dollars. Lenders suddenly became scarce because banks questioned whether borrowers would be able to repay their loans. Sherif Khalifa () The Financial System 51 / 52
Financial Crisis Sherif Khalifa () The Financial System 52 / 52