The current shape of the yield curve suggests that interest rates are expected to increase in the future. This increases the demand for long-term funds by borrowers like Java and creates a downward pressure on the supply of long-term funds by investors or banks. Investors will increase the supply of short-term funds or a downward pressure on the demand for these short-term funds. The 3-month treasury has already dropped from 4 percent to 3.85 percent. The current spread between the 3-month and 6-month treasury is about 15 bps or less than 25 bps difference between notes and a revolver. The trade deficits and weak dollar will continue to pressure interest rates, due to the demand for compensation for the currency risk. The age of dollar dominance is about to end (as evident by the dollar weakening against all currencies), which will lead to higher interest rates within the USA. This also creates further upward pressure on inflation. Current treasury rates are unattractive to foreign investors and will be attracted to the higher rates abroad. As foreigners either shy away from treasuries or start selling off their current treasuries and do not purchase more, then higher rates will have to be offered to attract investors. The other risk is carry trade and a crowding out effect by foreign traders. Borrowing short-term funds from the USA and lending long-term funds outside of the USA will place upward pressures on interest rates. Higher taxes are expected due to Bush’s tax cut expiring and the Democrats winning both houses and the Presidency in 2008, which also increase the upward pressure on interest rates. Additionally, protectionism and increased government regulations will further weaken the dollar and spur inflation upwards. The context of the current macroeconomics equity is just too risky at this time. Any disappointments by the Federal Reserve will drive the equity markets down.
Read the article via this link about the weak dollar and reasons why.
http://articles.moneycentral.msn.com/Investing/JubaksJournal/WhyTheDollarKeepsDropping.aspx
Monday, October 15, 2007
Thursday, October 11, 2007
MBA 821 - Reflections on Module 3 - Behavior of Stock Market??
Your responses should demonstrate reflective thought:
These reflections are about the equity markets being efficient or not and the three types of efficiency, Weak-form, Semi-Strong form, or Strong-form. This of course, based on comments from Robert Prechter, assumes that these equity markets follow the same logic and rational as economics or the theory of supply and demand. Prechter argues that movements in the equity markets are socionomic and not economic in nature and do not follow the supply and demand theory. If the market followed the supply and demand markets, then investors would sell stock at the top of the market instead of investing more money and buy at the bottom instead selling the stock. Investors follow the socionomic aspect of following the herd or crowd type psychology. Additionally, the supply of a stock is higher at low prices when compared to higher prices which is opposite of the supply and demand curves.
What form do you think is represented on the NYSE?
I would say if one had to chose one it would be weak-form efficiency. This is due to the fact that there is still insider information (i.e. managers knowing more than the market) and other information financial institutions know about the company that causes a stock to rise or fall. This is also due to the creativity that resides in the valuation of a stock. Certain measurements are deemed more valuable at certain time frames and less valuable in others. But assuming more transparency in financial statements, fundamental analysis of a company is a way to sift through and find value stocks or growth stocks that are still growing at acceptable rates. The investor must also be aware of the future economic condition predictions and the socionomic aspects of these predictions. The last thing is which industry the company resides in and if it is stable economic industry, a lagging or leading economic industry.
Do you think stock exchanges in emerging markets have a different level of efficiency?
NO not really. There is enough to argue that all of the market movements have nothing to do with efficiency and everything to do with how society views and assesses risk in the market. The mood of society dictates equity market movements. Emerging markets have a higher degree of risk associated with them due to more insider information and corruption within foreign countries and companies. Less regulation and different accounting regulation cause investors to assign risk.
Does this impact your view in regard to investing in common stocks? Explain.
A little. Shows that the long-term view is the best and has been touted by wealthy investors is right on the mark. Do not get caught up in the herd or crowd movements of speculation of equity markets. Fundamental analysis and holding a stock for a long-term is the best way to invest. If the investor truly believes in the stock and it is undervalued, then they should buy the stock on the downturns to strengthen their position and lower their cost per share and set a long-term price of the stock in which to sell. The socionomic aspect of the market is just riding the waves and chasing after the latest fade or trend.
These reflections are about the equity markets being efficient or not and the three types of efficiency, Weak-form, Semi-Strong form, or Strong-form. This of course, based on comments from Robert Prechter, assumes that these equity markets follow the same logic and rational as economics or the theory of supply and demand. Prechter argues that movements in the equity markets are socionomic and not economic in nature and do not follow the supply and demand theory. If the market followed the supply and demand markets, then investors would sell stock at the top of the market instead of investing more money and buy at the bottom instead selling the stock. Investors follow the socionomic aspect of following the herd or crowd type psychology. Additionally, the supply of a stock is higher at low prices when compared to higher prices which is opposite of the supply and demand curves.
What form do you think is represented on the NYSE?
I would say if one had to chose one it would be weak-form efficiency. This is due to the fact that there is still insider information (i.e. managers knowing more than the market) and other information financial institutions know about the company that causes a stock to rise or fall. This is also due to the creativity that resides in the valuation of a stock. Certain measurements are deemed more valuable at certain time frames and less valuable in others. But assuming more transparency in financial statements, fundamental analysis of a company is a way to sift through and find value stocks or growth stocks that are still growing at acceptable rates. The investor must also be aware of the future economic condition predictions and the socionomic aspects of these predictions. The last thing is which industry the company resides in and if it is stable economic industry, a lagging or leading economic industry.
Do you think stock exchanges in emerging markets have a different level of efficiency?
NO not really. There is enough to argue that all of the market movements have nothing to do with efficiency and everything to do with how society views and assesses risk in the market. The mood of society dictates equity market movements. Emerging markets have a higher degree of risk associated with them due to more insider information and corruption within foreign countries and companies. Less regulation and different accounting regulation cause investors to assign risk.
Does this impact your view in regard to investing in common stocks? Explain.
A little. Shows that the long-term view is the best and has been touted by wealthy investors is right on the mark. Do not get caught up in the herd or crowd movements of speculation of equity markets. Fundamental analysis and holding a stock for a long-term is the best way to invest. If the investor truly believes in the stock and it is undervalued, then they should buy the stock on the downturns to strengthen their position and lower their cost per share and set a long-term price of the stock in which to sell. The socionomic aspect of the market is just riding the waves and chasing after the latest fade or trend.
Saturday, September 29, 2007
MBA 821 - Reflections on Module 2
What is your view of one of the more popular tools associated with relative ratio analysis, the price to earnings ratio?
The P/E valuation tools is a great way to screen stocks. It is not perfect, but is easy to understand and apply. The investor will have to knowledge of the current market's P/E ratio and that of the sector that the stock in question resides in. No one tool for valuation is full proof, but the P/E tool is extremely easy to apply and can be done in ones head - which is valuable for quick analysis and potential decision making. Just like any tool, it is to used by the investor to aid in getting the job done and not as holy grail.
Do you think the measure of P/E is a valuable tool for stock analysis? Explain and justify your response.
As stated above, it is valuable tool for the investor. Quick and easy to apply is the power of this tool. The danger is solely relying on this tool as a catch all and the holy grail. The intent of tools is not to be this, but to aid the investor in finding their way through a maze - which direction should they go.
Are the current markets under, fairly, or over priced?
http://home.businesswire.com/portal/site/google/index.jsp?ndmViewId=news_view&newsId=20070927005589&newsLang=en
This article suggests the market may be under to fairly priced, but there are several discussions in this article that suggest otherwise. It appears that maybe only a few select sectors fit this criteria and not the market as a whole.
The current market, in my opinion, is probably fairly to over-priced – depending on the sector and specific stock. P/Es are creeping up again and this is potentially dangerous sign. Many P/Es are greater than 15 and mainly close to 20. As the market valuation gets back to more basic fundamentals, the market is probably generally over-priced and will correct itself. Companies with high P/Es will have to justify this valuation through strong operational cash flow, strong and effective R&D budgets, low debt, and not be over leveraged.
Responses to the posted article about current “bullishness” in the market and also stated are other questions about the future markets. There are several statements that suggest that the present market is undervalued or fairly valued, but the prices projected in the future may not be so bullish. The financial engineering or the creation of innovative products has lead to discovery of their flaws, which has lead to the current crunch. As stated in the article, “the summer brought several troubling financial issues to the forefront” suggest that scionomics may be playing a part in the bullish attitude. The weak dollar is also helping the market coupled with the continued “bad news” about Chinese companies. The technology sector is currently bullish and the financial sector is bearish right now. The weak dollar is making our exports cheaper abroad and any imports more expensive. Companies with strong manufacturing presence in the USA are seeing an increase, so why are consumer discretionary and services sectors and materials and processing sectors bearish? Is this because of the outsourcing of the past couple of decades is a concern? The advantages of outsourcing manufacturing are no longer being realized due to the weak dollar?
The statements in the article “…call equity markets either fairly valued or undervalued, managers participating… there may be new reasons to begin considering fixed income investments..” does not sound like a bullish statement or that the present value of stocks are really under or fairly valued by these managers. The article goes on to say how “bullishness for corporate bonds more than doubled … US Treasuries recorded one of their highest bullish scores … Are these managers just playing a scionomic game and making sure investor/society confidence remains optimistic? There appears to be a “flight to safety and that managers fundamentally believe that the bigger opportunity still lies in the equity markets … it is true that risk is being repriced ..” by the market. This statement in the article suggests to me that the market may be overpriced, but no one knows until risk is revalued – no one knows what the risk premium on equity should be over treasuries. This suggests that stocks can not be adequately valued, so how can these managers comment on the market being under or fairly valued – when they do not even understand how to value the current market? Review the current yield curve, the 1 month rate was 3.40 % and the 6 month rate was 4.20% or a pretty steep upward sloping curve. Couple this with rising fears of a recession and oil reaching $100 per barrel – is the market overpriced? The article suggests that many managers are bracing themselves for inflationary pressures and looking for safe havens for periods of recession and inflation. The strong increases in gold and silver suggest inflation is looming.
The article finally tells us where the managers see under or fairly priced stocks and it is in large cap growth and not the market as a whole. The title is thus a little misleading and meant to draw the reader in. These companies are a safe haven probably due to low debt, great cash flow, and strong brand recognition. These companies have great credit and not a default risk. These companies also will remain very liquid, due to these reasons. They can continue to offer commercial paper and issue bonds without concerns from investors. These companies also need short-term debt instruments, where small cap etc may be after long-term debt instruments. Review of the yield curve reveals that the investors are not very interested in long-term bonds. They are having strong expectations of higher interest rates to come (based on the pure expectations theory).
One last note here, the links provided are about the Feds power and ability to control the overall market and economy. It suggests that the tools the Feds has are out dated and not effective anymore. The deregulation of the industry has dampened their power. Their tools are really for depository institutions and the market is not controlled by just depository institutions. This sub-prime mess was caused by non-depository institutions, so do we need to reevaluate how the Fed operates to correct the current issues at hand?
http://www.financialweek.com/apps/pbcs.dll/article?AID=/20070924/REG/70921012/1016/ECONOMY
http://www.financialweek.com/apps/pbcs.dll/article?AID=/20070924/REG/70921011/1016/ECONOMY
The P/E valuation tools is a great way to screen stocks. It is not perfect, but is easy to understand and apply. The investor will have to knowledge of the current market's P/E ratio and that of the sector that the stock in question resides in. No one tool for valuation is full proof, but the P/E tool is extremely easy to apply and can be done in ones head - which is valuable for quick analysis and potential decision making. Just like any tool, it is to used by the investor to aid in getting the job done and not as holy grail.
Do you think the measure of P/E is a valuable tool for stock analysis? Explain and justify your response.
As stated above, it is valuable tool for the investor. Quick and easy to apply is the power of this tool. The danger is solely relying on this tool as a catch all and the holy grail. The intent of tools is not to be this, but to aid the investor in finding their way through a maze - which direction should they go.
Are the current markets under, fairly, or over priced?
http://home.businesswire.com/portal/site/google/index.jsp?ndmViewId=news_view&newsId=20070927005589&newsLang=en
This article suggests the market may be under to fairly priced, but there are several discussions in this article that suggest otherwise. It appears that maybe only a few select sectors fit this criteria and not the market as a whole.
The current market, in my opinion, is probably fairly to over-priced – depending on the sector and specific stock. P/Es are creeping up again and this is potentially dangerous sign. Many P/Es are greater than 15 and mainly close to 20. As the market valuation gets back to more basic fundamentals, the market is probably generally over-priced and will correct itself. Companies with high P/Es will have to justify this valuation through strong operational cash flow, strong and effective R&D budgets, low debt, and not be over leveraged.
Responses to the posted article about current “bullishness” in the market and also stated are other questions about the future markets. There are several statements that suggest that the present market is undervalued or fairly valued, but the prices projected in the future may not be so bullish. The financial engineering or the creation of innovative products has lead to discovery of their flaws, which has lead to the current crunch. As stated in the article, “the summer brought several troubling financial issues to the forefront” suggest that scionomics may be playing a part in the bullish attitude. The weak dollar is also helping the market coupled with the continued “bad news” about Chinese companies. The technology sector is currently bullish and the financial sector is bearish right now. The weak dollar is making our exports cheaper abroad and any imports more expensive. Companies with strong manufacturing presence in the USA are seeing an increase, so why are consumer discretionary and services sectors and materials and processing sectors bearish? Is this because of the outsourcing of the past couple of decades is a concern? The advantages of outsourcing manufacturing are no longer being realized due to the weak dollar?
The statements in the article “…call equity markets either fairly valued or undervalued, managers participating… there may be new reasons to begin considering fixed income investments..” does not sound like a bullish statement or that the present value of stocks are really under or fairly valued by these managers. The article goes on to say how “bullishness for corporate bonds more than doubled … US Treasuries recorded one of their highest bullish scores … Are these managers just playing a scionomic game and making sure investor/society confidence remains optimistic? There appears to be a “flight to safety and that managers fundamentally believe that the bigger opportunity still lies in the equity markets … it is true that risk is being repriced ..” by the market. This statement in the article suggests to me that the market may be overpriced, but no one knows until risk is revalued – no one knows what the risk premium on equity should be over treasuries. This suggests that stocks can not be adequately valued, so how can these managers comment on the market being under or fairly valued – when they do not even understand how to value the current market? Review the current yield curve, the 1 month rate was 3.40 % and the 6 month rate was 4.20% or a pretty steep upward sloping curve. Couple this with rising fears of a recession and oil reaching $100 per barrel – is the market overpriced? The article suggests that many managers are bracing themselves for inflationary pressures and looking for safe havens for periods of recession and inflation. The strong increases in gold and silver suggest inflation is looming.
The article finally tells us where the managers see under or fairly priced stocks and it is in large cap growth and not the market as a whole. The title is thus a little misleading and meant to draw the reader in. These companies are a safe haven probably due to low debt, great cash flow, and strong brand recognition. These companies have great credit and not a default risk. These companies also will remain very liquid, due to these reasons. They can continue to offer commercial paper and issue bonds without concerns from investors. These companies also need short-term debt instruments, where small cap etc may be after long-term debt instruments. Review of the yield curve reveals that the investors are not very interested in long-term bonds. They are having strong expectations of higher interest rates to come (based on the pure expectations theory).
One last note here, the links provided are about the Feds power and ability to control the overall market and economy. It suggests that the tools the Feds has are out dated and not effective anymore. The deregulation of the industry has dampened their power. Their tools are really for depository institutions and the market is not controlled by just depository institutions. This sub-prime mess was caused by non-depository institutions, so do we need to reevaluate how the Fed operates to correct the current issues at hand?
http://www.financialweek.com/apps/pbcs.dll/article?AID=/20070924/REG/70921012/1016/ECONOMY
http://www.financialweek.com/apps/pbcs.dll/article?AID=/20070924/REG/70921011/1016/ECONOMY
Wednesday, September 26, 2007
Further Reflections on Module 1 - Sub-Prime Shakeout
Financial innovation and the Global Liquidity Factory
Lets just raise the following: 1) When it is stated that derivative structures are “…virtual and not real” what does this suggest about the value of financial innovation, broadly defined as “…the act of creating and then popularizing new financial instruments as well as new financial technologies, institutions and markets” (Peter Tufano, Financial Innovation 2002 at http://www.people.hbs.edu/ptufano/fininnov_tufano_june2002.pdf).
2) Following up on the article (“Are we headed for an epic bear market?” at http://articles.moneycentral.msn.com/Investing/SuperModels/AreWeHeadedForAnEpicBearMarket.aspx?page=1) that states While you might think that the U.S. Federal Reserve can help prevent disaster by lowering interest rates dramatically, as they did Wednesday, the evidence is not at all clear. The problem, after all, is not the amount of money in the system but the fact that buyers are in the process of rejecting the entire new risk-transfer model and its associated leverage and counterparty risks.
Two questions on the claims about a global liquidity factory:
I. What does the class think of this article’s claims?
A) Completely right
B) Somewhat right
C) Too pessimistic
D) Don’t know and II.
Based on your answer to the above, how should you allocate your assets?
Articles
Peter Tufano link . Below is another link to his paper + another one on the subject.
http://www.people.hbs.edu/ptufano/fininnov_tufano_june2002.pdf
http://www.hbs.edu/research/pdf/07-082.pdf
http://www.nyabe.org/fergusonspeech.pdf
http://hbswk.hbs.edu/item/5745.html
Comments and Reflections
Interesting comments and articles, so knowing what I know now – where would I place my assets? I think Mark hit it pretty close. Precious metals (gold) are not really one place where I would put any money. This is based on history. Even though the price of gold is high right now, it really just getting back to the 1980 price after a decline for many years. But commodities are probably a great place. Now we all know that past performance does not predict future performance, but wheat has more than doubled, oil continues to increase – as well as corn and sugar. But I also know these markets are better left to the experts and I am not an expert on the commodity markets. So that being said, I would keep my liquid assets in short-term Treasuries and long-term investment in large to mid-cap value companies like GE, PEP, MMM, GLW, MSFT, and stocks like this have low betas, low to zero debt and lots of cash. Currencies would have been a good investment, but the chances that there would collaboration among global banks are probably pretty good. Also cooperation and collaboration among government, the Federal Reserve, regulatory agencies, and financial institutions will have to work together to sift through this mess and minimize the global damage. I still think the stock market is solid for the most part, but growth stocks are in potential trouble – due to the credit crunch. Problems will probably loom for 10 years. The S&P Case-Schiller Home Prices Indexes predict falling house prices in certain markets for the next five years and these devaluations are 15 to 20% - not 1 to 5%.
All of these financial innovations or derivatives started in 1986. Numerous new derivatives products were placed in the market. This is probably why many people did not understand them exactly. Derivative had been around a long time and people understood them. My guess is that they all assumed that the new derivatives were just improvements on the older ones – more efficient, etc. The financial engineers knew that the sum of the pieces were greater than the value of the whole in tact. This was proven by the corporate raiders, etc. These financial innovators just had to figure a way around the laws and regulations in order to create this value. Getting around taxes and regulations has been the single greatest motivator for these financial innovations. Turning short-term gains into long-term gains to avoid paying higher taxes or basically greed was involved to increase their profitability and cash flows. Greenspan’s dropping the federal fund rate lead to a large amount of liquidity injected into the market. These financial innovations just applied a multiplier to this existing liquidity, which allowed to easy money. Everyone seemed to forget that derivatives were created to transfer credit risk – diversify the risk – and not to create virtual money and earn high interest rates. Mortgage rates where at the lowest rate in like 30 years. Loan originators were all making in excess of $100,000/year and brokers were probably in excess of $500,000/year. All of these people work basically on commission – no loans no paycheck. If the employees were making this kind of cash (you may have 10 to 15 LOs in one office) how much do you think the financial institutions were making? Also we can all see the motivation was not to be ethical or to work on the fine line of legal and ethical boundaries in order to close the most loans. A high risk – low credit score – so what just charge them 50 to 100 bps more, the interest is still low. Also this greed lead to the ARMS, etc. mortgage product innovations, which further aggravated this entire sub prime issue. This all lead to an explosion in the M3 money supply.
M3 – includes all of the time deposits, money fund balances, Eurodollars, and repos. All basically due to the “financial innovations” of derivatives by the financial engineers. Then the Fed decided to stop tracking and monitoring the M3 money supply in March of 2006. This seems to have left the system unchecked by anyone. Why did the Fed decide to stop monitoring M3? If they stopped tracking it because they could not get their arms around it, then they just decided to stick their heads in the sand and hope for the best.
Financial institutions could use the advances in technology to improve process and system efficiencies or use technology for product innovations and marketing schemes. It is obvious that is was easier to create money through product innovations and clever marketing and packaging schemes than it was to change their operations. The short-term immediate gain without any regard to consequences was chosen instead of a more long-term approach of improving processes and systems to control and eliminate risks.
Lets just raise the following: 1) When it is stated that derivative structures are “…virtual and not real” what does this suggest about the value of financial innovation, broadly defined as “…the act of creating and then popularizing new financial instruments as well as new financial technologies, institutions and markets” (Peter Tufano, Financial Innovation 2002 at http://www.people.hbs.edu/ptufano/fininnov_tufano_june2002.pdf).
2) Following up on the article (“Are we headed for an epic bear market?” at http://articles.moneycentral.msn.com/Investing/SuperModels/AreWeHeadedForAnEpicBearMarket.aspx?page=1) that states While you might think that the U.S. Federal Reserve can help prevent disaster by lowering interest rates dramatically, as they did Wednesday, the evidence is not at all clear. The problem, after all, is not the amount of money in the system but the fact that buyers are in the process of rejecting the entire new risk-transfer model and its associated leverage and counterparty risks.
Two questions on the claims about a global liquidity factory:
I. What does the class think of this article’s claims?
A) Completely right
B) Somewhat right
C) Too pessimistic
D) Don’t know and II.
Based on your answer to the above, how should you allocate your assets?
Articles
Peter Tufano link . Below is another link to his paper + another one on the subject.
http://www.people.hbs.edu/ptufano/fininnov_tufano_june2002.pdf
http://www.hbs.edu/research/pdf/07-082.pdf
http://www.nyabe.org/fergusonspeech.pdf
http://hbswk.hbs.edu/item/5745.html
Comments and Reflections
Interesting comments and articles, so knowing what I know now – where would I place my assets? I think Mark hit it pretty close. Precious metals (gold) are not really one place where I would put any money. This is based on history. Even though the price of gold is high right now, it really just getting back to the 1980 price after a decline for many years. But commodities are probably a great place. Now we all know that past performance does not predict future performance, but wheat has more than doubled, oil continues to increase – as well as corn and sugar. But I also know these markets are better left to the experts and I am not an expert on the commodity markets. So that being said, I would keep my liquid assets in short-term Treasuries and long-term investment in large to mid-cap value companies like GE, PEP, MMM, GLW, MSFT, and stocks like this have low betas, low to zero debt and lots of cash. Currencies would have been a good investment, but the chances that there would collaboration among global banks are probably pretty good. Also cooperation and collaboration among government, the Federal Reserve, regulatory agencies, and financial institutions will have to work together to sift through this mess and minimize the global damage. I still think the stock market is solid for the most part, but growth stocks are in potential trouble – due to the credit crunch. Problems will probably loom for 10 years. The S&P Case-Schiller Home Prices Indexes predict falling house prices in certain markets for the next five years and these devaluations are 15 to 20% - not 1 to 5%.
All of these financial innovations or derivatives started in 1986. Numerous new derivatives products were placed in the market. This is probably why many people did not understand them exactly. Derivative had been around a long time and people understood them. My guess is that they all assumed that the new derivatives were just improvements on the older ones – more efficient, etc. The financial engineers knew that the sum of the pieces were greater than the value of the whole in tact. This was proven by the corporate raiders, etc. These financial innovators just had to figure a way around the laws and regulations in order to create this value. Getting around taxes and regulations has been the single greatest motivator for these financial innovations. Turning short-term gains into long-term gains to avoid paying higher taxes or basically greed was involved to increase their profitability and cash flows. Greenspan’s dropping the federal fund rate lead to a large amount of liquidity injected into the market. These financial innovations just applied a multiplier to this existing liquidity, which allowed to easy money. Everyone seemed to forget that derivatives were created to transfer credit risk – diversify the risk – and not to create virtual money and earn high interest rates. Mortgage rates where at the lowest rate in like 30 years. Loan originators were all making in excess of $100,000/year and brokers were probably in excess of $500,000/year. All of these people work basically on commission – no loans no paycheck. If the employees were making this kind of cash (you may have 10 to 15 LOs in one office) how much do you think the financial institutions were making? Also we can all see the motivation was not to be ethical or to work on the fine line of legal and ethical boundaries in order to close the most loans. A high risk – low credit score – so what just charge them 50 to 100 bps more, the interest is still low. Also this greed lead to the ARMS, etc. mortgage product innovations, which further aggravated this entire sub prime issue. This all lead to an explosion in the M3 money supply.
M3 – includes all of the time deposits, money fund balances, Eurodollars, and repos. All basically due to the “financial innovations” of derivatives by the financial engineers. Then the Fed decided to stop tracking and monitoring the M3 money supply in March of 2006. This seems to have left the system unchecked by anyone. Why did the Fed decide to stop monitoring M3? If they stopped tracking it because they could not get their arms around it, then they just decided to stick their heads in the sand and hope for the best.
Financial institutions could use the advances in technology to improve process and system efficiencies or use technology for product innovations and marketing schemes. It is obvious that is was easier to create money through product innovations and clever marketing and packaging schemes than it was to change their operations. The short-term immediate gain without any regard to consequences was chosen instead of a more long-term approach of improving processes and systems to control and eliminate risks.
Friday, September 21, 2007
MBA 821 Module 1 Reflections
Reflect on your exposure to bonds and bond pricing. Whether you have invested personally in corporate, government, or municipal bonds, certain key characteristics impact their value. One of the important factors is the risk associated with the issuing entity. Many people have purchased or received a U.S. government savings bond.
When would you consider investing in government bonds?
The answer is yet to come - we will have to sift through the comments below. What should we do is not academic anymore - so we will attempt to theoretically discuss the liquidity issue at hand created by the virtual and magical world of the financial institutions - what is real and what is virtual - problem as discussed is that
WE DON'T KNOW - do you agree with my statements and concerns??
The only time to invest in bonds may be just around the corner. You would purchase bonds if the stock market becomes bearish and the economy goes into a recession. This sub prime mess is being blamed on the wrong groups and the root cause must be acknowledged by the government, the regulators, the banks themselves, etc. This mess was created by the incredible greed of people - trying to turn debt into real money. Many people stood by and allowed all of this happen, which includes the regulators and the credit rating services. The analysis is as such:
Probably not a great time to invest in treasuries right now. This statement is due to the fed dropping the Fed Rate to 4.75%, a weak economy, and an even weaker dollar. Treasuries are becoming a bad investment, short-term, for foreign investors. The interest rates are dropping and the their currency is strengthening as the Fed drops the rate even further, all things staying even. Also think about foreign investor borrowing funds from the US, due to lower rates than their own countries. They could borrow at very low rates (would be willing to borrow at higher rates than Americans - due to currency exchange rates) and invest in their own countries bonds etc at much higher rates. This in turn could cause a global crowding out effect. This creates a liquidity issue potentially for the US Government - if no one wants to purchase treasuries. The fed could demand the banks to purchase them, but would tighten the money supply, etc. Round and round, but we get the picture.
The only time to buy in this market is of the foreign investors needed short-term money right now and could not get the money through borrowing. This would cause them to dump the treasuries on the open market, causing the prices of the these treasuries to drop or sold at a large discount - this in turn would cause the yields of these sharply discounted bonds to rapidly increase. Again an issue with global liquidity could cause dramatic events to take place.
Read a number of articles. A few dealt with Satyajit Das, an expert on the derivatives market and the entire CDO, CMO, and CLO magical financial instruments.
This whole mess is due to the allowance of financial engineers creating a "liquidity factory" built on underlying assets of mortgages, etc. They created instruments that over leveraged the "loop holes" and increased the money supply in a way not intended by anyone. They further increased the "money supply" or the multiplier of any monies injected into the economies. The regulators allowed it, all of investors (hedge funds, etc) did not understand them - just the high yields, and banks enjoyed all of this liquidity with their "off-balance sheet" transactions. They were lending out more money and basically getting around their reserve ratio requirements.
The yield curve was flat, which sharply reduced the spread and encouraged lenders to search for cash flow, etc. These lenders needed higher cash flows, due to lower spreads in order to fuel or meet their aggressive and greedy need for growth and acquisitions to fuel this growth. Since in acquisitions, the acquiring company basically pays a 20 to 40 % premium - this premium had to come from some place. So instead of Banks being traditional and underwriting as well as fund the loans - they just acted as originators of these loans. These loans were wrapped up into CMOs, CDOs, CLO, etc. This allowed the banks to take these "loans" off their balance sheets and then "magically" have more money to make further loans. They used debt - CDOs - as collateral to fund more loans.
Foreign investors, mutual and hedge funds, etc leveraged their investments by buying CDOs, etc. with their borrowed money. Basically had debt purchasing further debt on so on and so on - How deep does this rabbit hole really go? No one really knows!!
The credit rating services also either did not understand or chose not to dig deeper and understand, which placed everyone at great risk. No one wanted to be the whistle blower and end the gravy train that all the greedy were eating off of - at our expense. The credit rating services stuck by their out dated or irrelevant mathematical models and believed this output without full knowledge or understanding of the inputs. They chose not to challenge the flawed mathematical models of the financial engineers that created this magical instruments of wealth - these money creating machines! This all allowed the debt to move from heavily regulated institutions into less regulated instruments and institutions - and all with AAA ratings! This was further fueled by bankers "stripping" all apparent assets out of these instruments - further increasing the loan to value ratio in a sense. It is being said that a single dollar of capital or the true/real underlying asset was turned into $20 to $30 of debt or a highly leveraged scenario. Compare this to the reverse ratio requirement of being dropped to only 5 % or even 3.5% from the current 10 %!! This translates into a huge injection in the money supply, except it is all smoke a mirrors! No real money was actually there. Seems to be very similar to the margin calls of 10% during the 1920s that lead to the crash of 1929. Currently banks are fighting to ensure that these derivatives are not being sold at a discount because these being sold at a discount amplifies these discounts of the true underlying assets even further. This was also fueled by the stock market valuations through MBOs, LBOs, stock repurchases, takeovers, acquisitions, etc that have inflated the market somewhat - all that money came from these highly leveraged CDOs, etc instruments.
It is also apparent that blame is going around like wild fire and who is the one who created the fantasy - but the Financial Accounting Standards Board (FASB) and their "level 3, under statement 157". This level 3 is a way for fair value to be measured using "unobservable inputs". What companies claim they can not see and these unseen items are assumed to change their fair values of their assets and liabilities - they are allowed to use their own subjective assumptions (make it up as they go in order to inflate their assets and liabilities). This level 3 treatment magically transforms subjective assumptions of make-believe into reality with a stoke of their own assumptions. Should not the FASB be pushing for conservative approaches and advocating against these off-balance sheet transactions? Also where are the regulators validating "these level 3 subjective assumptions?"
The world of structured credit is living in the make-to-model fantasy world and is being embraced by Financial Institutions and FASB. If you are over leveraged - so what, just use the level 3 magic wand and mark the debt as anything they wish through subjective (and self servicing) assumptions. They all now think they should be allowed to declare - Predict the future gains, based on past gains (even though every single mutual funds, broker etc states a declaimer that past results do not predict future results) and then amortize them into income. This makes the financial statements of financial institutions worthless and unbelievable. You have worthless financial income statements of these financial institutions - many running virtual S&Ls through a fantasy/virtual off-balance sheet entities.
Is this a video game or an excursion of the website second life? No it is and has happened. We have been warned numerous times about blurring reality and real life with the made-up, fantasy of the virtual world.
Why did no one see the mess coming? Off-balance sheet entities and their transactions are just that virtual. You can not see them - so how can you understand or any issues/problems of something you can not see??
Commercial paper - currently in an illiquid environment. Banks are holding over $300 billion of LBOs, etc that they have committed to finance. Assets based CPs - many of them need to be refinanced and no one right wants to touch the refinancing of these CPs. A big problem. Everyone is scared and watching out for the lesser rated tranches of commercial mortgage backed paper.
Now enter the world of Structured Investment Vehicles (SIV) and Special Purpose Investment Vehicles (SPIV). All of these are "Off-Balance" sheets and they operate in the virtual world with NO rules to govern their actions, etc and there is NO ONE to regulate what they are doing. The financial institutions are utilizing more leverage than legally allowed, but they are getting away with it. No one understands what they are doing and it seems that the regulators and FASB do not wish to dig deep and truly understand what they are doing.
When would you consider investing in government bonds?
The answer is yet to come - we will have to sift through the comments below. What should we do is not academic anymore - so we will attempt to theoretically discuss the liquidity issue at hand created by the virtual and magical world of the financial institutions - what is real and what is virtual - problem as discussed is that
WE DON'T KNOW - do you agree with my statements and concerns??
The only time to invest in bonds may be just around the corner. You would purchase bonds if the stock market becomes bearish and the economy goes into a recession. This sub prime mess is being blamed on the wrong groups and the root cause must be acknowledged by the government, the regulators, the banks themselves, etc. This mess was created by the incredible greed of people - trying to turn debt into real money. Many people stood by and allowed all of this happen, which includes the regulators and the credit rating services. The analysis is as such:
Probably not a great time to invest in treasuries right now. This statement is due to the fed dropping the Fed Rate to 4.75%, a weak economy, and an even weaker dollar. Treasuries are becoming a bad investment, short-term, for foreign investors. The interest rates are dropping and the their currency is strengthening as the Fed drops the rate even further, all things staying even. Also think about foreign investor borrowing funds from the US, due to lower rates than their own countries. They could borrow at very low rates (would be willing to borrow at higher rates than Americans - due to currency exchange rates) and invest in their own countries bonds etc at much higher rates. This in turn could cause a global crowding out effect. This creates a liquidity issue potentially for the US Government - if no one wants to purchase treasuries. The fed could demand the banks to purchase them, but would tighten the money supply, etc. Round and round, but we get the picture.
The only time to buy in this market is of the foreign investors needed short-term money right now and could not get the money through borrowing. This would cause them to dump the treasuries on the open market, causing the prices of the these treasuries to drop or sold at a large discount - this in turn would cause the yields of these sharply discounted bonds to rapidly increase. Again an issue with global liquidity could cause dramatic events to take place.
Read a number of articles. A few dealt with Satyajit Das, an expert on the derivatives market and the entire CDO, CMO, and CLO magical financial instruments.
This whole mess is due to the allowance of financial engineers creating a "liquidity factory" built on underlying assets of mortgages, etc. They created instruments that over leveraged the "loop holes" and increased the money supply in a way not intended by anyone. They further increased the "money supply" or the multiplier of any monies injected into the economies. The regulators allowed it, all of investors (hedge funds, etc) did not understand them - just the high yields, and banks enjoyed all of this liquidity with their "off-balance sheet" transactions. They were lending out more money and basically getting around their reserve ratio requirements.
The yield curve was flat, which sharply reduced the spread and encouraged lenders to search for cash flow, etc. These lenders needed higher cash flows, due to lower spreads in order to fuel or meet their aggressive and greedy need for growth and acquisitions to fuel this growth. Since in acquisitions, the acquiring company basically pays a 20 to 40 % premium - this premium had to come from some place. So instead of Banks being traditional and underwriting as well as fund the loans - they just acted as originators of these loans. These loans were wrapped up into CMOs, CDOs, CLO, etc. This allowed the banks to take these "loans" off their balance sheets and then "magically" have more money to make further loans. They used debt - CDOs - as collateral to fund more loans.
Foreign investors, mutual and hedge funds, etc leveraged their investments by buying CDOs, etc. with their borrowed money. Basically had debt purchasing further debt on so on and so on - How deep does this rabbit hole really go? No one really knows!!
The credit rating services also either did not understand or chose not to dig deeper and understand, which placed everyone at great risk. No one wanted to be the whistle blower and end the gravy train that all the greedy were eating off of - at our expense. The credit rating services stuck by their out dated or irrelevant mathematical models and believed this output without full knowledge or understanding of the inputs. They chose not to challenge the flawed mathematical models of the financial engineers that created this magical instruments of wealth - these money creating machines! This all allowed the debt to move from heavily regulated institutions into less regulated instruments and institutions - and all with AAA ratings! This was further fueled by bankers "stripping" all apparent assets out of these instruments - further increasing the loan to value ratio in a sense. It is being said that a single dollar of capital or the true/real underlying asset was turned into $20 to $30 of debt or a highly leveraged scenario. Compare this to the reverse ratio requirement of being dropped to only 5 % or even 3.5% from the current 10 %!! This translates into a huge injection in the money supply, except it is all smoke a mirrors! No real money was actually there. Seems to be very similar to the margin calls of 10% during the 1920s that lead to the crash of 1929. Currently banks are fighting to ensure that these derivatives are not being sold at a discount because these being sold at a discount amplifies these discounts of the true underlying assets even further. This was also fueled by the stock market valuations through MBOs, LBOs, stock repurchases, takeovers, acquisitions, etc that have inflated the market somewhat - all that money came from these highly leveraged CDOs, etc instruments.
It is also apparent that blame is going around like wild fire and who is the one who created the fantasy - but the Financial Accounting Standards Board (FASB) and their "level 3, under statement 157". This level 3 is a way for fair value to be measured using "unobservable inputs". What companies claim they can not see and these unseen items are assumed to change their fair values of their assets and liabilities - they are allowed to use their own subjective assumptions (make it up as they go in order to inflate their assets and liabilities). This level 3 treatment magically transforms subjective assumptions of make-believe into reality with a stoke of their own assumptions. Should not the FASB be pushing for conservative approaches and advocating against these off-balance sheet transactions? Also where are the regulators validating "these level 3 subjective assumptions?"
The world of structured credit is living in the make-to-model fantasy world and is being embraced by Financial Institutions and FASB. If you are over leveraged - so what, just use the level 3 magic wand and mark the debt as anything they wish through subjective (and self servicing) assumptions. They all now think they should be allowed to declare - Predict the future gains, based on past gains (even though every single mutual funds, broker etc states a declaimer that past results do not predict future results) and then amortize them into income. This makes the financial statements of financial institutions worthless and unbelievable. You have worthless financial income statements of these financial institutions - many running virtual S&Ls through a fantasy/virtual off-balance sheet entities.
Is this a video game or an excursion of the website second life? No it is and has happened. We have been warned numerous times about blurring reality and real life with the made-up, fantasy of the virtual world.
Why did no one see the mess coming? Off-balance sheet entities and their transactions are just that virtual. You can not see them - so how can you understand or any issues/problems of something you can not see??
Commercial paper - currently in an illiquid environment. Banks are holding over $300 billion of LBOs, etc that they have committed to finance. Assets based CPs - many of them need to be refinanced and no one right wants to touch the refinancing of these CPs. A big problem. Everyone is scared and watching out for the lesser rated tranches of commercial mortgage backed paper.
Now enter the world of Structured Investment Vehicles (SIV) and Special Purpose Investment Vehicles (SPIV). All of these are "Off-Balance" sheets and they operate in the virtual world with NO rules to govern their actions, etc and there is NO ONE to regulate what they are doing. The financial institutions are utilizing more leverage than legally allowed, but they are getting away with it. No one understands what they are doing and it seems that the regulators and FASB do not wish to dig deep and truly understand what they are doing.
Friday, September 14, 2007
MBA 820 Reflections on Module 6
What caused Congress and the President to ratify the Financial Services Modernization Act? Why?
The power of Citigroup pressured government to repeal the Glass-Steagall act and allow them to operate in all realms of financing. This also allowed the banks themselves to further diversify themselves and obtain more economies of scale and scope. This allows US Banks or financial institutions to compete in the global market. This ACT only occurred in 1999 - so a long time after the 1933 ACT.
Close to 10,000 U.S. banks failed following the restrictive federal legislation in the early 1930s. In contrast to the United States, Canadian banks (often referred to as "mega banks") were not limited by Glass-Steagall. Why did only one of the Canadian banks fail during the Great Depression?
The power of Citigroup pressured government to repeal the Glass-Steagall act and allow them to operate in all realms of financing. This also allowed the banks themselves to further diversify themselves and obtain more economies of scale and scope. This allows US Banks or financial institutions to compete in the global market. This ACT only occurred in 1999 - so a long time after the 1933 ACT.
Close to 10,000 U.S. banks failed following the restrictive federal legislation in the early 1930s. In contrast to the United States, Canadian banks (often referred to as "mega banks") were not limited by Glass-Steagall. Why did only one of the Canadian banks fail during the Great Depression?
The posted article explains why Canadian banks faired better than US banks during that time frame. Mainly due to the size and diversity of the banks. Also was the help the Canadian goverment played in ensuring there wer no runs on the banks and plenty of money to loan them. Government played a more active role in banking.
Financial Institutions: Failures, Insolvency, and Moral Hazard
Cliometric Sessions at 1990 ASSA Meeting--December 29, 8:00 AM
MARKET VALUE ACCOUNTING AND THE SOLVENCY OF THE CANADIAN BANKING SYSTEM, 1922-1940 Lawrence Kryzanowski*Professor of FinanceConcordia University
and
Gordon S. Roberts* Bank of Montreal Professor of Finance Dalhousie University
1. MARKET VALUE ACCOUNTING AND THE SOLVENCY OF THE CANADIAN BANKING SYSTEM, 1922 - 19401
Current research on the interaction between the monetary and real sectors discusses extensively the experience of the Great Depression. Although, economists have advanced different explanations for its severity, widespread banking failures play a key role in competing theories.2
To elicit evidence from the Great Depression, numerous researchers have focussed on an important contrast between the United States and Canada: the two economies faced similar declines in output, but, in contrast with the U.S., there were no bank runs and no banks failed in Canada. The common explanation, which has evolved into a "stylized fact", links Canada's more positive experience to its branching system which promoted the growth of a few large banks which (due to diversification) remained solvent throughout the Depression.
Based on a reexamination of this stylized fact, the present paper argues that the diversification benefits arising from national branching were not primarily responsible for the absence of bank failures in Canada in the 1930's. We use market-value accounting to restate Canadian bank balance sheets for the period 1922 - 1940. Our analysis reveals that nine of ten Canadian banks were technically insolvent during the Depression.
The superior performance of Canadian banks in avoiding explicit failure should be attributed to the Canadian government's policy of monitoring performance, standing ready to lend to banks and most importantly, forcing failing banks into mergers with healthy banks. This policy provided an implicit guarantee that, after a major bank failure in 1923, no other bank would be allowed to fail.3 The role of national branching was to make such a policy feasible by reducing the number of banks, and lessening the degree of competition.
The paper begins with a review of prior analysis of branching and failures. We next discuss key features of Canadian banking in the 1920s and 1930s and develop the argument that an implicit guarantee of all deposits was in place.4
The third part of the paper employs market value accounting to estimate the year-end market values of assets and liabilities for each of the ten Canadian banks in existence during the Depression. Our estimates take account of credit risk and interest rate risk by asset categories.5
Rejecting the "stylized fact", this research finds that Canadian banks were actually insolvent and remained in business only due to the forbearance of regulators coupled with an implicit guarantee of all deposits--much like the recent situation in the U.S. savings and loan industry.6
2. TRACING THE STYLIZED FACTIn a key passage which has made the Canadian experience during the Depression well known as an example in research, Friedman and Schwartz [(1963): 352-3] state that bank failures "...were the mechanism through which a drastic decline was produced in the stock of money." They argue that there was a larger increase in the currency ratio in the U.S. because "...the bank failures made deposits a much less satisfactory form in which to hold assets than they had been before in the United States or than they remained in Canada."
Friedman and Schwartz (1963) examine three reasons for the 1930 bank failures in the United States: the decline in asset values, inaction by the Federal Reserve, and runs which forced liquidation at firesale prices.
While they are silent on why no runs occurred in Canada, Friedman and Schwartz [(1963):ʳ52] began a tradition of linking the survival of Canadian banks (and implicitly, the absence of runs) with the branching system implying that diversification through national branching protected asset values as follows:
Canada had no bank failures at all during the depression; its ten banks with 3,000-odd branches throughout the country did not even experience any runs, although, presumably as a preventative measure, an eleventh chartered bank with a small number of branches was merged with a larger bank in May 1931.7
Later writers, who extend or dispute the conclusions of Friedman and Schwartz, continue the tradition of attributing the lack of runs to the branching system. In a chapter on export-driven economies, Kindleberger (1973), for example, cites Friedman and Schwartz as if the link were a well-known fact needing little elaboration.
The Canadian experience is also important to the advocates of privatizing deposit insurance.8 Ely (1988) discusses the experience of the 1920's as a backdrop to the 1930's. He argues that Canadian banks did better in both decades due to the advantages of unrestricted branching; namely, geographical diversification and greater operating efficiency. Specifically, Ely observes that:
The Canadian experience [in the 1930's], in which some banks operated hundreds of branches nationwide, demonstrates that widespread branching is especially safe and desirable during an era of severe price deflation.
The Canadian experience is also used by O'Driscoll [(1988):ʱ77] to support the argument for private deposit insurance: As the Canadian experience in the 1930's illustrates, a nationally branched banking system with diversified assets can withstand even severe shocks, both real and monetary.
Bernanke (1983) argues that the 1930's banking crisis caused U.S. bankers' fear of runs to be translated into a shift into safer loans which disrupted the intermediation process, and thus worsened the Depression. He subscribes to the theory that the system of a few large banks prevented runs in Canada and goes on to develop a detailed example showing that Canada had a debt crisis but not a banking crisis.9 The example is used to support his theory on the breakdown of intermediation.10
Haubrich (1989) extends Bernanke's conclusions to Canada. He finds that although Canadian banks closed branches in the Depression, closures are not a proxy for bank failures and that bank stocks did better than equities of other industries in this period. He concludes that ...Canada's superior organization of banking prevented a financial crisis...Other sectors did benefit from that superior structure...[ Haubrich (1989)]
Examining a series of financial crises in six different countries, Bordo (1988) shows that the accompanying monetary contractions were generally most severe in the United States. He identifies as a key factor branch banking which "represents a method of pooling risks which proved quite effective in guarding against the type of "`house of cards' effects common to the U.S....banking system" [(1988):ʲ30]. The second factor is that, unlike the other countries, the United States lacked an effective lender of last resort. Although Canada did not have a central bank before 1936, Bordo [(1988):ʲ30-1] argues that:
...the chartered banks had, by 1890, with the compliance of the Government, established an effective self-policing agency, the Canadian Bankers Association, which acting in loco parentis successfully helped insulate the Canadian banks from the deleterious effects of U.S. banking panics in 1893 and 1907. The existence of such a mechanism, whether provided by the Government or by the private market, once it proved effective would educate and instil a sense of confidence in the public sufficient to prevent incipient crises.
Bordo [(1988):ʲ30, fn. 28] notes that the activities of the Canadian Bankers Association included:
...quickly arranging mergers between sound and failing banks, by encouraging cooperation between strong and weaker banks in times of stringency.
Bordo's work is the closest antecedent to our own because he emphasizes the role of the Canadian Bankers Association and the government as factors separate from the advantages of a branch system in explaining the absence of banking failures in Canada during the 1930's. In the following section, an implicit government guarantee of bank solvency is identified, and it is shown that this guarantee stood behind the policy of forbearance which allowed insolvent banks to continue to operate without runs in the 1930's.
3. THE IMPLICIT GUARANTEEBetween Confederation in 1867 and 1940, twenty-seven banks failed in Canada and some depositors incurred losses. Of the thirty-six amalgamations, many involved troubled banks [Beckhart (1964)]. Neufeld [(1972):81] comments that "[t]he large number of failures is rather surprising in view of the Canadian banking system's reputation for solvency." This reputation is largely based on the timing of Canadian bank failures: none occurred between 1923 and 1985.
In 1923, a major failure occurred--- the Home Bank of Canada which had 70 (mainly urban) branches. Its directors were later charged with falsifying the accounting of the bank to cover up losses from bad loans. As a result of civil actions, the directors were required to pay damages for "misconduct, malfeasance and negligence..." [Jamieson (1953):ʶ0-61]. During 1923, several other banks announced losses and reduced dividends or were forced to seek mergers.
The provision of government funds to avert a bank failure appears to have been initiated by the Government of Quebec. The Quebec Government financially assisted the merger of the Bank Nationale with the Banque d'Hochelaga in 1923 as follows [Globe (1924): 6]: ... The arrangement between the Quebec Provincial Government and the Banque d'Hochelaga is a unique one. Whether the Quebec Government felt that it had a moral obligation to advance aid, or whether its motives were purely philanthropic is a most interesting question. So far as Ontario is concerned, it opens up the possibility that Home Bank creditors may press for similar consideration. Although the two cases are admittedly not parallel ones, the fact that a Provincial Government has come to the rescue in one case may suggest a line of action for interested parties in the other.
Partly based on this precedent, the depositors in the Home Bank petitioned the Canadian Government for compensation and received payment up to 35% of the value of their deposits.
After 1923, the Canadian government provided an implicit guarantee to the public that no chartered bank would be allowed to fail and cause depositor losses. This guarantee was implicit because it was never formally embodied in law, and it was equivalent to one hundred percent deposit insurance.11 Beckhart (1964) documents that government policy was to arrange forced mergers for insolvent banks. He argues that the impetus for mergers came primarily from smaller banks near failure and from government.
Evidence exists that bank mergers were designed to avoid firesale insolvency for the merger of the Bank Nationale with the Banque d'Hochelaga in 1923 (discussed earlier) and the takeover of the Weyburn Bank by the Imperial Bank in 1931.
While the impetus for mergers may not have come primarily from larger banks seeking to expand, they were willing participants and there was considerable "behind-the-scenes" manoeuvering by the larger banks to absorb each new target bank. "I think it a pity," said another banker, "that the opportunity [Merchants Bank] was not offered to the other banks to participate in the business of the Merchants, and thus distribute the assets and the load, whatever its nature may be." [Globe (1921a):ʱ].
With regard to the role of regulators, primary evidence for the existence of an implicit guarantee comes from parliamentary documents and the popular press during the 1920's. A report in the Globe [(1921c):ʱ] described the rationale for the Federal Government's approval of the merger of the Merchants Bank with the Bank of Montreal: "The merger is the only way out." That is the considered opinion of Sir Henry Drayton, Minister of Finance, when asked if some other method could not have been found of meeting the crisis brought about by the troubles in the Merchants Bank .... Sir Henry Drayton said that a merger was only justified when the rest of a bank had been wiped out, its capital impaired and the affairs of the bank in such a position that the interests of the depositors themselves required to be guaranteed. It is assumed here that that must be the position of the Merchants Bank.
"What would happen if you had not given the preliminary consent to such a merger?" Sir Henry was asked.
"The only alternative is insolvency, with a consequent loss to depositors," was the reply. "That is my answer to criticisms of the Government's action in permitting the merger."
Although a proposal in 1914 to merge the Bank of Hamilton with the Royal was not approved by the then Minister of Finance, Sir Thomas White, a proposal to merge the then ailing Bank of Hamilton with the Bank of Commerce in 1923 was readily approved. [The Financial Post (1923a): 1, 16]
Similar sentiments were expressed during 1923 and 1924 when the failure of the Home Bank was scrutinized. A former Minister of Finance, Sir Thomas White, stated Government policy in favor of forced mergers to bank failures as follows:
Under no circumstances would I have allowed a bank to fail during the period in questionʮ..ʉf it had appeared to me that the bank was not able to meet its public obligations, I should have taken steps to have it taken over by some other bank or banks, or failing that, would have given it necessary assistance under the Finance Act, 1914. [McKeown Commission (Aprilʲ4, 1924, Vol.ʵ): 324].
If I had believed that the Home Bank at that time was in danger of failing, closing its doors, was insolvent, I should have gone to The Bankers' Association and told them to take over that bank. Either to one bank or more banks .... I would have made them do it. When I say that I had no legal power, but nevertheless I feel confident that I could have got them to do it..." [McKeown Commission (Aprilʲ5, 1924, Vol.ʶ): 359].
The Federal Government's support for the merger of the Sterling Bank with the Standard Bank in 1924 was described in the press [FP (1924):ʹ] as follows:
... The government is determined that there shall be no more bank failures, if reasonable action on its part will obviate them. Accordingly, once it was demonstrated to the acting minister of finance that the proposed merger would strengthen the banks interested, there was no doubt about permission being granted.
Thus, the "forced" mergers of several small with large banks and the Home Bank failure led to a federal government policy placing a safety net under chartered banks. This view of government policy from the early 1920's forward is reflected in newspaper articles on the need to guarantee bank deposits. One editorial writer even assured the public that such a guarantee was in place in statutory form. [The Financial Post (Commons Debates, Aprilʹ, 1924):ʱ195]
This opinion was also reflected in the Home Bank depositors' petition as follows:
(10) Yon Petitioners therefore submit that whether rightly or wrongly the depositors of the Home Bank of Canada were largely of the opinion that the Finance Department of the Government of Canada exercised such supervision over chartered Banks that it was impossible for a depositor to lose their savings entrusted to such a Bank, the charter of which had been renewed from time to time by Parliament and it is further submitted that the confidence of the people as a whole would be greatly restored if adequate relief were granted to these depositors. [Commons Sessional Papers 100B (Thursday, Marchʲ4, 1924)].
In summary, historical evidence shows that beginning in 1923, an implicit guarantee from the Canadian government (amounting to 100% implicit insurance) stood behind all domestic bank deposits. The government actively promoted mergers to avoid firesale insolvency and successfuly created public confidence that no banks would be allowed to fail.12
Further historical evidence of the implicit guarantee of deposits is obtained by applying market-value accounting techniques to bank balance sheets of 1922-1940. Our analysis uses information available at the time to show that all major banks were insolvent at market values from 1930- 1935 at a minimum. Despite such widespread insolvency, no bank runs occurred providing strong support for the existence of an implicit guarantee of deposits.
4. MARKET VALUE MODELThe present analysis adjusts loans; made up of current loans and call and short-term loans, to market values.13 The analysis uses a set of bond indices and a stock index to value collateral securities held for short/call loans, and an activity index and a bad loan account to value current loans. Other assets and securities, along with all liabilities and capital are assumed at par. Banking practice called for valuing securities at the lower of book or market value yet the reported figures are likely optimistic for this period.14
There are two major categories of loans. Call and short term loans represent short-term lending (up to 30 days) to investment dealers secured by inventories of securities. Stated banking practice in the late 1930's was to lend up to 80% of the market value of securities (20% margin) and to update margins with shifts in market conditions [Patterson (1947:45)]. In earlier years, even more generous margins prevailed. In addition, some securities were illiquid and market prices were sometimes outdated due to thin trading. Further, some underwriters experienced difficulties [Neufeld (1972:509)]. Accordingly, the analysis that follows sets margins at 10%.
To obtain the market value of call and short term loans, we develop a securities index to adjust the collateral to market value.15 The bond indices are based on price quotes and new issue prices paid for Dominion, provincial, municipal, and industrial bonds on the Montreal Stock Exchange drawn from The Monetary Times. Close quotes are used if given, else High/Low or Bid/Ask are averaged. In general fifteen issues, if available, are used to arrive at an average price.
The result for each class of bond is an average year-end price. This price divided by the base year price yields the index for that class.16
The common stock index is drawn from Total Common Stock Price (series J494) in [Urquhart and Buckley (1983)] - an aggregate of Bank, Industrial, and Utility common stock indices.
Market value of call and short-term loans is the lesser of book value or the market value of the collateral. To obtain the market value of the collateral, the index is adjusted to reflect a 10% margin and this margin- adjusted index is multiplied by the book value of call and short-term loans to produce their market value.17
Current loans to be market valued are made up of "other current loans and discounts in Canada, other current loans and discounts elsewhere than in Canada after making full provision for bad and doubtful debts, loans to provincial governments, and loans to cities, towns, municipalities and school districts." Cashflows and market values of these loans varied with economic conditions.18 Loans to the federal government are assumed default free.
With the exception of unreserved bad loans, all loans are assumed to mature after one year.19 The interest rate on bank loans is assumed to equal the yield on Canadian corporate bonds at the beginning of the year. The yields are taken from [Neufeld (1972: 565)] and range from 4% to just under 10%.20
It is assumed that the probability of default on current loans is driven by the change in economic activity as measured by relative changes in a broadly based activity index.21 The model treats banks as not providing adequate reserves for "bad" or "doubtful" loans. A new account is created to cumulate this shortfall---"unreserved bad loans".
With a deterioration in economic activity, the unreserved bad loans account increases with new bad loans while an improvement in the economy triggers a decrease in cumulative bad loans as recoveries occur.
The activity index is a weighted average of indices of national manufacturing production, national retail sales, and national wheat gross value.22 The weights used in the activity index are based on an average aggregate breakdown of total banking loans in Canada from 1934 to 1940 in [Bank of Canada (1946:18-19)].
To implement the model, we first find the new current loans at the beginning of the year and outstanding at the end of the year by eliminating the cumulative bad loans outstanding from the book value of current loans. The next step is to find cumulative bad loans at the end of the year. If this year's activity index declined, some new loans default and bad loans increase. If activity increased, some bad loans are recovered. New current loans, unlike bad loans, pay principal and interest at year end. If economic activity decreased, payment is scaled down by the percentage change in the activity index. With an improvement in economic activity, the full promised payment is received.
We discount the market value of the payment to the beginning of the year to give the market value of new loans at the end of the prior year. By employing the corporate bond yield at the end of the year as the discount rate, interest-rate risk is incorporated into the model.
The market value of current loans is the market value of the new current loans plus the book value of loans to the federal government. The market value of the complete loan portfolio is the market value of current loans plus the market value of call and short loans minus the loan loss provision on the bank's books.
To measure solvency, the market value of the total loan portfolio is subtracted from the corresponding book value and the bank's capital reduced by any positive difference.
The four components of capital are dividends declared and unpaid, rest and reserve fund, capital paid up and the profit and loss surplus. These four items are totaled and reduced by the amount written down on loans. If the writedown is more than 100% of the value of the capital then the bank is insolvent. Another component of capital is inner or hidden reserves which did not apppear on the balance sheet. Although they cannot be quantified systematically, inner reserves were of insignificant magnitude compared to bad loans.23 5. RESULTS AND SENSITIVITY ANALYSIS
Nine of ten Canadian chartered banks experienced asset writedowns in excess of their shareholder's capital (insolvency) at least from 1930 to 1935, and frequently for longer periods.24
Sensitivity analysis recasts critical assumptions employed in the valuation of call and short term and current loans. To test the robustness of our major finding, we vary selected assumptions in the direction which mitigates insolvency. In no case, is our major conclusion altered - nine of ten banks remain insolvent from 1930 through 1935.
6. CONCLUSIONSContrary to the "stylized fact", diversification benefits arising from national branching were not primarily responsible for the absence of bank runs and failures in Canada during the 1930's when no legal deposit insurance system was in place. Restating loan portfolios using market value accounting shows that nine of ten Canadian banks were insolvent at market values for each year from 1930 - 1935 inclusive. Sensitivity analysis demonstrates the robustness of these results.
The better failure performance of banks in Canada as compared to the United States should be attributed to the Canadian government policy of forcing failing banks into mergers with healthy banks. As documented above, this policy provided an implicit guarantee that, after a major bank failure in 1923 and several "forced" mergers of "failing" banks in 1921- 1923, no other bank would be allowed to fail. National branching made such a policy feasible by reducing the number of banks.
Our analysis suggests caution in extrapolating Canadian experience during the Great Depression to the current U.S. banking scene. In particular, it is an oversimplification of Canadian experience to argue that larger, more diversified banks are less likely to fail without recognizing the critical role of regulators in arranging mergers, closing troubled banks before they become insolvent as well as in providing an implicit guarantee of bank solvency.
Our reinterpretation of the Canadian experience reinforces the lesson of the savings and loan disaster --- it is dangerous for regulators to think that larger, faster growing financial institutions are necessarily more solvent [Kane (1989)]. Our results are evidence in favor of proposals by Benston (1986) and Benston and Kaufman (1986), among other for risk- adjusted capital and early closure of troubled institutions.
* We thank George Kaufman for enunciating our major hypothesis. Financial support for this research was provided by Fonds pour la formation de chercheurs et l'aide " la recherche (FCAR), the Social Sciences and Humanities Research Council of Canada (SSHRC), and the Center for International Business Studies, Dalhousie University. The authors acknowledge the capable efforts of Jonathan Dean along with those of Ken Bowen, Twila Mae Logan, Andrew Munn and Michael O'Grady in providing research assistance. They benefitted from comments by Michael Bordo and Kevin Huebner and from suggestions on earlier versions from audiences at the Bank Structure Conference, Federal Reserve Bank of Chicago and the Northern Finance Association, 1989 Meeting. Comments are welcomed.
1 This paper is based on a longer, more detailed version available on request from the authors.
2 Friedman and Schwartz (1963) argue that banking failures caused important contractions in liquidity and the money supply. Bernanke (1983) holds that banking failures forced a contraction in financial intermediation services which caused real contraction. Also see Gertler (1988).
3 Thus Canadian policy provided an early precendent for the "too large to fail" approach prevalent in the U.S. (and Canada) today according to Kaufman (1989).
4 Sections 2, 3 and 4 draw on Kryzanowski and Roberts (1989a and 1989b).
5 Our treatment of market value accounting for financial institutions draws on Bennett, Lundstrom and Simonson (1986), Kane (1985) and Kane and Foster (1986) and Benston et al (1986) among others.
6 In the framework of Kane, Unal and Demirguc-Kunt (1990), the implicit, off-balance sheet guarantee constituted a major asset of Canadian banks in the Depression.
7 Schwartz (1987) restates this comparison between the U.S. and Canada.
8 Government deposit insurance was not introduced in Canada until 1967.
9 Specifically, [Bernanke (1983: 259)] notes that: "The U.S. system, made up as it was primarily of small, independent, banks, had always been particularly vulnerable. Countries with only a few large banks, such as Britain, France and Canada, never had banking difficulties on the American scale.
10 Consistent with Bernanke's argument, [Safarian (1959:163, fn.180] states: "There appears to have been some pressure by the banks to reduce credit in the downswing."
11 This is similar to the current day implicit guarantee of FSLIC as discussed in Kane [(1987): 83-84].
12 Our interpretation of the historical evidence is also supported by Neufield[(1972): 98].
13 Logit estimates for Canadian banks were calculated on book values using the coefficients obtained by White (1984). The model was able to identify all except one of the weak banks that underwent mergers in the period 1922-1940. All the banks showed lower values hovering near the insolvency point for the early 1930s.
14 On Spetember 21, 1931, financial markets were unstable after Britain went off the gold standard, Canadian banks and stock exchanges set floor prices for equities in place through mid 1932. The next month, an Order in Council authorized banks to value securities, stock and bonds, at the lower of book value or market price on Aug. 31, 1931 effectively setting a floor under market values. [Joseph Schull and J. Douglas Givson, The Scotia Bank Story, A History of the Bank of Nova Scotia, 1823-1982, MacMillian of Canada, 1982:152] Sensitivity analysis sets securities to market values. 15 The mix of collateral securities is assumed to be equally distributed over Dominion, provincial, municipal and industrial bonds and common stock.
16 Since the bond indices were constructed from quotes available in each year they reflect a survivorship bias. While it is possible to construct more refined indices, this was not done as the survivorship bias works against our hypothesis of insolvency.
17 An upper bound of unity is placed on the margin adjusted index.
18 Default risk on provincial and municipal loans was significant. "From 1936 to 1945, Alberta defaulted on the principal of its maturing issues and paid interest at only one-half the coupon rate...Saskatchewan's credit rating also suffered in te 1930s" [Neufeld (1972: 5670] Municipal defaults were also common [Jamieson (1953: 78)].
19 Loans by the banks are consistently described as short term. Trade bills, a mojor component, averaged six weeks in maturity [Patterson (1947: 46)]. Commercial loans and loans in general are consistently described as short term and farm loans in 1933 were made for 3 to 4 month but were usually not repaid for 6 to 12 months [Royal Commission on Banking Currency (1933: 72)].
20 While bank loans likely had greater default risk than corporate bonds, they were shorter term. According to the Royal Commission (1933: 32-33)] the rate on good commercial loans was 6% ranging up to 10% for small loans and in small branches. Higher effective rates resulted from discounting and compounding cnventions. Agricultural loan rates ranged from 6% in the East to 7% in the West.
21 Haubrich (1989) provides a strong precedent for linking the strength of Canadian banks with economic indicators. The probability of default is take as the same for principal and interest.
22 The indices are, respectively, series Q8, series T53, and series M251 all from [Urquhart and Buckley (1983)].
23 In 1937 chartered banks were requested by the Government to bolster their inner reserves. The Royal Bank transferred $15 million from the published reserve account and reversed the transaction in 1946. [Ince (1969: 48)]. According to our analysis, cumulative bad loans for the Royal Bank were over $115 million in 1937.
24 The exception, Barclay's, was formed in 1929 under the control of the British parent institution [Jamieson (1953; 70)].
How are interest rates determined? What impact do interest rates have on your personal life? Your business organization?
Interest rates are controlled by the supply and demand of funds in the global markets, which is influenced by the monetary policies of the various governments. The Federal Reverse mainly controls the interests rates through manipulation of the money supply. Also through the setting of the Federal funds rate and discount rate.
Saturday, September 8, 2007
MBA 820 - Refelctions on Module 5
What experiences have you had with commercial banks? Describe.
My experiences with banks are through personal and business checking, mortgages for personal and business, as well as loans for cars and personal lines of credit. They provide a service that is adequate for most issues, etc. The on-line banking has come a long way and makes it much easier to access and obtain information quickly. They also issue credit cards, which allow personal and business to acquire noncollateralized debt, which is helpful in many transactions. Floating debt helps a small business equalize cash flow, etc and allows large purchases to be spread out over time.
What have you observed about a merger/acquisition in the commercial bank sector in your geographic region?
The most recent one was Hunnington Bank acquiring Skybank. But there has been numerous mergers over time. First USA is now part of Chase, which is part of JP Morgan-Chase. MBA has been snapped up by Bank of America. You are also seeing Fifth Third and National City spreading into Florida and other states. Also these banks, due to the deregulation, offer financial services and retirement planning services. Their services offer the purchase of stocks, bonds, mutual funds, etc. They do not offer direct insurance plans, but offer life insurance etc through independent quotes etc on the open market. All of this allow the consumer to have all of their accounts in one place, which helps when transferring money from one account/place to another. Accounts/monies in different institutions cause lags in your availability to your money.
My experiences with banks are through personal and business checking, mortgages for personal and business, as well as loans for cars and personal lines of credit. They provide a service that is adequate for most issues, etc. The on-line banking has come a long way and makes it much easier to access and obtain information quickly. They also issue credit cards, which allow personal and business to acquire noncollateralized debt, which is helpful in many transactions. Floating debt helps a small business equalize cash flow, etc and allows large purchases to be spread out over time.
What have you observed about a merger/acquisition in the commercial bank sector in your geographic region?
The most recent one was Hunnington Bank acquiring Skybank. But there has been numerous mergers over time. First USA is now part of Chase, which is part of JP Morgan-Chase. MBA has been snapped up by Bank of America. You are also seeing Fifth Third and National City spreading into Florida and other states. Also these banks, due to the deregulation, offer financial services and retirement planning services. Their services offer the purchase of stocks, bonds, mutual funds, etc. They do not offer direct insurance plans, but offer life insurance etc through independent quotes etc on the open market. All of this allow the consumer to have all of their accounts in one place, which helps when transferring money from one account/place to another. Accounts/monies in different institutions cause lags in your availability to your money.
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