Part 1 forum nexus finance class summer 2010

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  • Book – assign reading
  • Conversation with peter – “expensive in Brazil” … vs 3.5 a few years ago
  • Part 1 forum nexus finance class summer 2010

    1. 1. Class #1 Welcome to Spain
    2. 2. Homework (part1) … while in Spain… <ul><li>For next 3 classes – </li></ul><ul><li>Each student – introduce self + tell one thing about Spanish economy they noticed so far + class discuss </li></ul>
    3. 3. Questions: <ul><li>Finance: </li></ul><ul><li>How many econ / finance majors? </li></ul><ul><li>Taken “international finance” before? </li></ul><ul><li>Studied FX, foreign currencies? </li></ul><ul><li>Global Crisis: </li></ul><ul><li>How many “understand” more or less what happened so far? (ask volunteer) </li></ul><ul><li>In US? (ask volunteer) </li></ul><ul><li>In Europe? </li></ul><ul><li>Predictions of what will happen in 6 months? </li></ul>
    4. 4. Brian David Butler Professor of international finance and global entrepreneurship with Forum-Nexus Study Abroad. Guest lecturer with the IQS Business School of the Ramon Llull University in Barcelona, and the Catholic University of Milan . Previously, Brian taught finance, economics and global trade courses at Thunderbird’s Global MBA program in Miami, and worked as a research analyst with the Columbia Business School in New York City. Brian currently lives in Recife, Brazil where he is teaching classes on “Global Entrepreneurship” at the university FBV. A global citizen, Brian was born in Canada, raised in Switzerland (where he attended international British school), educated through university in the U.S., started his career with a Japanese company, moved to New York to work as an analyst, married a Brazilian, and has traveled extensively in Latin America, Asia, Europe and North America. [email_address] LinkedIn/briandbutler Skype: briandbutler
    5. 5. Brian Butler is a specialist in international economic analysis, and is founder of the prestigious “GloboTrends“ ( www.globotrends.com ) online economics site, which has been featured as syndicated content on Nouriel Roubini’s RGE Monitor, Emerginvest.com, Business Week Exchange, Wikinvest.com, and other leading news outlets. http:// globotrends.pbworks.com / , http:// blog.globotrends.com /
    6. 6. Online
    7. 7. Online http://www.roubini.com/author/brian_butler
    8. 8. Lecture Schedule* * Does not include professional visits, *Subject to change, modification without warning <ul><li>Friday 2 nd - Barcelona </li></ul><ul><li>Tuesday 6 th – Barcelona </li></ul><ul><li>Wednesday 7 th – Barcelona </li></ul><ul><li>Thursday 8 th – Barcelona </li></ul><ul><li>Monday 12 th – Paris </li></ul><ul><li>Tuesday 13 th – Paris </li></ul><ul><li>Saturday 17 th – Interlaken </li></ul><ul><li>Tuesday 20 th – Milan </li></ul><ul><li>Wed 21 st – Milan. EXAM </li></ul><ul><li>Tues 22 th – boat to Greece </li></ul><ul><li>Mon 26 th – Athens </li></ul><ul><li>Tues 27 th – Rhodes </li></ul><ul><li>Wed 28 th – Rhodes </li></ul><ul><li>Thurs 29 th – Rhodes EXAM </li></ul>
    9. 9. Course Objectives <ul><li>Upon successful completion of this course students will be able to: </li></ul><ul><ul><li>Be familiar with the functioning of financial markets, both domestic and international. </li></ul></ul><ul><ul><li>Understand the role of key financial institutions, both domestic and international. </li></ul></ul><ul><ul><li>Examine the evolution of financial markets in the last decade and the excesses and abuses that placed the foundation for the global crisis. </li></ul></ul><ul><ul><li>Understand the role and responsibility of financial institutions, central banks and government agencies in contributing to the crisis as well as taking steps towards stabilization and recovery. </li></ul></ul>
    10. 10. Course Objectives <ul><ul><li>Examine the domino effect that resulted in the expansion of the crisis to Europe, Asia, Latin America and the rest of the world. </li></ul></ul><ul><ul><li>Examine the role of multilateral organizations as part of the global financial system. </li></ul></ul><ul><ul><li>Evaluate the key drivers of financial change (financial integration) in a global context. </li></ul></ul><ul><ul><li>Analyze impediments to the globalization of financial markets. </li></ul></ul><ul><ul><li>Evaluate the growth and development of specific international financial markets. </li></ul></ul><ul><ul><li>Analyze the impact of globalization via financial integration on the cost of capital. </li></ul></ul><ul><ul><li>Understand the specific challenges posed by the global crisis on European economies and European financial markets </li></ul></ul>
    11. 11. Required books <ul><li>Required Textbook </li></ul><ul><ul><li>'An Introduction to Global Financial Markets', by Stephen Valdez, Palgrave Macmillan, 5th Edition, 2006 </li></ul></ul><ul><ul><li>'Fixing Global Finance', by Martin Wolf Yale University Press, 2009 </li></ul></ul>
    12. 12. Book : Martin Wolf, “Fixing Global Finance” Martin Wolf is chief economics commentator at the Financial Times (online FT.com)
    13. 13. Assigned Readings <ul><li>Martin Wolf book </li></ul><ul><ul><li>First three Chapters </li></ul></ul><ul><ul><li>Plus…other mini readings to be assigned later </li></ul></ul><ul><li>Finance book </li></ul><ul><ul><li>Chapter 9 – foreign exchange </li></ul></ul><ul><ul><li>Chapter 11 - European Economic and Monetary Union </li></ul></ul><ul><ul><li>Switzerland – p 288 </li></ul></ul><ul><ul><li>Euro – p 289, p304 </li></ul></ul><ul><li>Optional additional reading </li></ul><ul><ul><li>Chapter 2 – banking background p30-38 </li></ul></ul><ul><ul><li>Chapter 6 – the money and bond markets </li></ul></ul><ul><ul><li>Chapter 12 – traded options </li></ul></ul><ul><ul><li>Chapter 13 - Futures </li></ul></ul>
    14. 14. Expectations: <ul><ul><li>Attend classes – exams will be from lectures </li></ul></ul><ul><ul><li>Turn in assignments before class </li></ul></ul><ul><ul><li>Be prepared for class discussions – lots of small group assignments during class </li></ul></ul><ul><ul><li>Contribute to group assignment (team grading / peer review) </li></ul></ul><ul><ul><li>No sleeping, no laptops (sorry)  </li></ul></ul>
    15. 15. Grading <ul><li>See syllabus: http://forum-nexus.com/courses/syllabus_FIN388-02.asp </li></ul><ul><li>Components of Final Grade </li></ul><ul><ul><li>Midterm exam 20% </li></ul></ul><ul><ul><li>Final exam 30% </li></ul></ul><ul><ul><li>Team project 25% </li></ul></ul><ul><ul><li>Assignments (incl. Case study) 15% </li></ul></ul><ul><ul><li>Class participation 10% </li></ul></ul>
    16. 16. Themes – 3 dangers <ul><li>Danger in borrowing abroad in foreign currencies </li></ul><ul><li>Danger in relying on short term finance – especially when foreign capital involved </li></ul><ul><li>Danger in changing rules of finance </li></ul><ul><li>* Solution: be aware, and hedge to protect! </li></ul>
    17. 17. Borrowing $$ abroad in foreign currency = RISKY
    18. 18. Topics to cover - macro <ul><li>$ flow poor-rich </li></ul><ul><li>Foreign reserves – IOUs </li></ul><ul><li>Current / capital account </li></ul><ul><li>IMF </li></ul><ul><li>Self insurance </li></ul><ul><li>Local currency bond – key </li></ul><ul><li>Savings glut = response to past crises </li></ul><ul><li>Series of crises </li></ul><ul><li>Export oriented growth </li></ul><ul><li>US accept capital – stabile, but now… expect crisis in emerging… </li></ul><ul><li>Borrower last resort </li></ul><ul><li>Smoke but don’t inhale, send it back </li></ul><ul><li>Fast money, commercial banks, east Europe, unicredit </li></ul><ul><li>Danger Europe – foreign bank deposits not guaranteed? </li></ul><ul><li>Lack of crisis 2000-09 = result of US policy </li></ul><ul><li>Inflation – impact – no long term investing </li></ul><ul><li>Inflation – good for borrowers, inflate away debts, bad for banks </li></ul><ul><li>Creation of $ , fiat, gold </li></ul><ul><li>Fiscal/ Monetary policy </li></ul><ul><li>Why ever raise interest%? </li></ul><ul><li>Mundell Trilemma </li></ul><ul><li>Euro, fixed currencies </li></ul><ul><li>Liquidity / Solvency </li></ul><ul><li>2 phases of crisis 2008 </li></ul><ul><li>Regulations, deleveraging </li></ul><ul><li>US unique position – borrow own currency, more solvent </li></ul><ul><li>Euro vs. Dollar – 2 weaknesses </li></ul>
    19. 19. Topics to cover - trading <ul><li>Effect of devaluation on investment choices </li></ul><ul><li>Forward, future, options </li></ul><ul><li>How forward rates set? </li></ul><ul><li>Interest rate arbitrage </li></ul><ul><li>How currency FX rates set – money flows </li></ul><ul><li>Eurobond, Eurodollar- facebook case </li></ul><ul><li>Size of FX markets </li></ul><ul><li>More… </li></ul>
    20. 20. Topics to cover - Countries <ul><li>Finance / Economical environment in : </li></ul><ul><li>The European Union + Eurozone (must identify map) </li></ul><ul><li>With special focus on: Countries we visit: </li></ul><ul><ul><li>Spain </li></ul></ul><ul><ul><li>France </li></ul></ul><ul><ul><li>Switzerland </li></ul></ul><ul><ul><li>Italy </li></ul></ul><ul><ul><li>Greece </li></ul></ul><ul><li>Other regions we will discuss </li></ul><ul><li>USA + China – unique relationship </li></ul><ul><li>BRIC’s – big emerging markets </li></ul><ul><li>SE Asia – Thailand, Malaysia, Indonesia </li></ul>
    21. 21. Team Project <ul><li>This team project is designed to provide students with the opportunity to review the benefits and drawbacks for countries in the Euro zone, and to evaluate the threats and challenges facing the Euro in the near future as a result of the global economic crisis / fiscal debt crisis now facing the European Union. Teams will be made up of 3-4 students each. </li></ul><ul><li>Due date: last class before Final Exam </li></ul><ul><ul><li>3 week – Tues July 20 th </li></ul></ul><ul><ul><li>4 week – Wed July 28 th </li></ul></ul>
    22. 22. Team Project <ul><li>I. Country Selection </li></ul><ul><li>ALL Students are required to include in their analysis: </li></ul><ul><ul><li>the UK; </li></ul></ul><ul><ul><li>at least one country from the Forum-Nexus trip (Spain, France, Italy or Greece); </li></ul></ul><ul><ul><li>at least one of the 'East-central' European states: Czech Republic, Hungary, Poland, Slovakia, Slovenia); </li></ul></ul><ul><li>Grad Students must also include: </li></ul><ul><ul><li>AND at least one of the Balkans: (Albania, Bosnia and Herzegovina, Bulgaria ,Croatia, Macedonia, Montenegro, Romania, Serbia) </li></ul></ul><ul><ul><li>AND at least one of the Baltic States: (Estonia, Latvia, Lithuania), </li></ul></ul>
    23. 23. Team Project - II. Analysis <ul><li>An in-depth analysis will be completed, looking at the Euro zone countries. Students must include in their report: </li></ul><ul><ul><li>During a crisis: What are the benefits /drawbacks to countries for being inside / outside of the Euro-zone? (You need to relate this discussion relate to our class lectures on 'fixed vs. flexible exchange rates) </li></ul></ul><ul><ul><li>Students must highlight the risks of borrowing abroad, and relate this discussion to class lectures on this topic. </li></ul></ul><ul><ul><li>Make recommendations for how they think the fiscal crisis in Europe should be handled, as well as predictions for the long-term sustainability of the currency union. </li></ul></ul><ul><ul><li>For extra credit, students will be asked to Compare and contrast the experience of 'Ireland vs. Iceland' during the global economic crisis (with relation to 'fixed, flexible exchange rates', and to 'borrowing in foreign currencies' </li></ul></ul>
    24. 24. Team Project - III. Recommendations & Predictions for future <ul><li>Graduate Students: </li></ul><ul><ul><li>The project report should be between 8 and 11 pages long (Font: Arial, 12; Line Spacing: 1.5). </li></ul></ul><ul><li>Undergrad: </li></ul><ul><ul><li>The project report should be between 6 and 8 pages long (Font: Arial, 12; Line Spacing: 1.5). </li></ul></ul>
    25. 25. <ul><li>How to turn in: </li></ul><ul><li>- either (hand written, neatly!) or computer, email: </li></ul><ul><li>Resources: </li></ul><ul><ul><li>Lectures </li></ul></ul><ul><ul><li>Text Book: “An Introduction to Global Financial Markets” (Valdez), chapter 11, “European Economic and Monetary Union” 2007, (suggested focus: p. 287-305). Pay special attention to “EMU – the benefits” – p 287, and “The counter arguments” – p289 </li></ul></ul><ul><ul><li>Handout article: “Holding Together, A special report on the euro area”, from the Economist, June 13 th 2009 (p 1-16) </li></ul></ul><ul><ul><li>* Grad Students only: </li></ul></ul><ul><ul><li>Read handout: “Country Forecast, Economies in Transition, Eastern Europe”, from EIU, May 2009 (p. 5-10) </li></ul></ul>Group Project, “The Euro Zone – before, during and after the Global Economic Crisis”
    26. 26. <ul><li>Grading: </li></ul><ul><li>30% of final grade for course </li></ul><ul><li>comparative (one team compared to others) </li></ul><ul><li>there is no “right answer”, but grading will be based upon: </li></ul><ul><ul><li>Cover all required topics </li></ul></ul><ul><ul><li>Answer the questions asked </li></ul></ul><ul><ul><li>Additional insights </li></ul></ul><ul><ul><li>Strength of arguments (pro / con) </li></ul></ul><ul><ul><li>Depth of analysis </li></ul></ul><ul><ul><li>Be concise! </li></ul></ul><ul><ul><li>Ability to capture “heart” of issue </li></ul></ul>Group Project, “The Euro Zone – before, during and after the Global Economic Crisis”
    27. 27. International Finance Intro…
    28. 28. Dr. Kishore Dash, January 20, 2007
    29. 29. International Finance <ul><li>Group: Discuss differences between: </li></ul><ul><ul><li>Portfolio investing </li></ul></ul><ul><ul><li>FDI </li></ul></ul><ul><ul><li>Which is “better”? </li></ul></ul>
    30. 30. International Financial Markets 1. 2. 3. Foreign Exchange Market Domestic Financial Markets in Other Countries— Short-Term Domestic Financial Markets in Other Countries— Long-Term Deposits, Cash, Forwards, Futures T-Bills, Deposits, Commercial Paper, Money Market Funds Bonds, Stocks, ADRs, Deposits, CMOs Banks, Companies, Brokers Banks, Companies, Brokers Banks, Companies, Brokers MARKET INSTRUMENTS PARTICIPANTS
    31. 31. International Financial Markets (cont.) 4. 5. 6. 7. Euro-Currency Market Euro-Bond Market International Monetary System (IMF) The Real Sector Deposits, Euro CP Euroloans Eurobonds, Floating Rate Notes, Euro-Equities SDRs, $US, [Gold], Position in the Fund Banks, Clients Investment Banks Companies, Brokers Central Banks, The Fund Goods & Services Consumers & Firms MARKET INSTRUMENTS PARTICIPANTS
    32. 32. Why Study “International Finance”?
    33. 33. Why? <ul><li>Why not just study “Finance”? </li></ul><ul><ul><li>NPV, cash flows, bonds </li></ul></ul><ul><ul><li>If you understand domestic finance, isnt International finance the same thing? </li></ul></ul><ul><li>Currencies </li></ul><ul><li>Gov’t default foreign investors </li></ul><ul><li>Understand macro-themes </li></ul>
    34. 34. Why Finance matters: <ul><li>Long term planning: </li></ul><ul><li>“ If financing is not stable, then investment in social infrastructure does not go as you expect.” </li></ul><ul><ul><li>Hiraoki Nakanishi, president of Japan’s Hitachi </li></ul></ul>
    35. 35. Core of our class: <ul><li>Tools to protect </li></ul><ul><li>Hedging techniques: </li></ul><ul><ul><li>Forward, Futures, options, etc… </li></ul></ul><ul><ul><li>tools to PROTECT (and potentially speculate) </li></ul></ul>
    36. 36. What are the benefits of “International Finance”?
    37. 37. Benefits of Global Finance <ul><li>Serve international companies </li></ul><ul><ul><li>Citi bank in Sao Paulo </li></ul></ul><ul><ul><li>HSBC everwhere </li></ul></ul><ul><li>Some countries don’t have DEEP enough capital markets </li></ul><ul><ul><li>Needs of companies Bigger than Depth of capital markets </li></ul></ul><ul><li>Efficiency, </li></ul><ul><li>Best practices (international competition forces local monopolies to offer better rates) </li></ul>
    38. 38. Benefits of Global Finance <ul><li>“ remember the remarkable prosperity of the past 25 years. Finance deserves some of the credit for that.” </li></ul>source: http://www.economist.com/printedition/displayStory.cfm?Story_ID=12957709
    39. 39. What are the dangers of “International Finance”?
    40. 40. Dangers <ul><li>Fast money in, fast money OUT </li></ul><ul><li>Borrowing in foreign currencies </li></ul><ul><ul><li>Discuss, WHY? </li></ul></ul>
    41. 41. Independent thinkers needed The importance of thinking independently – don’t follow the “herd”
    42. 42. Be careful of “expert” predictions http://bucks.blogs.nytimes.com/tag/asset-allocation/
    43. 43. Challenge to students… <ul><li>While we are in Europe together… </li></ul><ul><li>Think critically </li></ul><ul><li>Challenge* accepted assumptions </li></ul><ul><li>Look for trends (not facts & figures) </li></ul><ul><li>Educational journey… </li></ul><ul><li>*politely, with challenging thoughts, not just words </li></ul>
    44. 44. Failure of “economic forecasting” profession <ul><li>Why didn’t predict worst crisis since Great Depression? </li></ul><ul><li>Some exceptions (Nouriel Roubini, others..) </li></ul><ul><li>But, in general, a few lone voices does not equal a profession (dismissed as quack, “Dr. Doom”, etc…) </li></ul>
    45. 45. Resource: http://www.roubini.com/
    46. 46. Mis-diagnosis of the problem <ul><li>Globally, during much of 2008, economic growth appeared to be holding up </li></ul><ul><li>IMF Projection </li></ul><ul><ul><li>In April 2008, eight months into the global crisis if we date its start as August 2007, the IMF was forecasting only a mild slowdown in global growth in 2008 to 3.7, from the 4.9 percent that then was estimated for 2007. </li></ul></ul><ul><ul><li>ECB </li></ul></ul><ul><ul><li>Recall that the European Central Bank (ECB) raised the target for its key refinancing rate on July 3, 2008, and the ECB was not alone in its inflation concerns at that time. </li></ul></ul>
    47. 47. As late as 2008, the IMF forecasted growth in 2009
    48. 48. Failure of “economic forecasting” profession <ul><li>Conclusion: highest trained, most respected, most influential did not predict collapse </li></ul>
    49. 49. Repeat challenge to students: <ul><li>Think critically, don’t accept “expert” forecasts, challenge accepted assumptions. </li></ul><ul><li>With critical analysis, any one can learn to spot macro trends </li></ul><ul><li>GET AHEAD OF THE TRENDS!!! </li></ul><ul><ul><li>Tools for investors </li></ul></ul><ul><ul><li>Business leaders – position for threats / opportunities </li></ul></ul>
    50. 50. Impossible to Predict <ul><li>Currencies, when flexible, are impossible to predict </li></ul><ul><ul><li>Don’t believe anyone that tells you otherwise </li></ul></ul><ul><ul><li>Tools: PPP, IFE </li></ul></ul><ul><ul><li>Difference in interest rates between 2 countries to set forward rate, estimate future spot rate </li></ul></ul>
    51. 51. Forum-Nexus currencies
    52. 52. Currency
    53. 53. Currencies: <ul><li>Question: </li></ul><ul><ul><li>“ Why is it “expensive” to come to Europe and travel (shop, stay, enjoy)? </li></ul></ul><ul><ul><li>Compared to US, Mexico, Brazil, etc… </li></ul></ul><ul><ul><li>Why does it “seem” expensive here? </li></ul></ul><ul><ul><li>Is it less “expensive” now (compared to 1 year ago?)?? </li></ul></ul>
    54. 54. Global travel… <ul><li>How about if you went to Argentina? </li></ul><ul><li>at about 4-1 USD…. Everything SEEMS cheap….hotels, restaurants, clothes shopping. </li></ul><ul><li>Or Iceland? Idea for (cheap) Global Travel… follow the crises </li></ul><ul><li>Watch from China = $10 </li></ul><ul><li>is that “cheap”? </li></ul><ul><li>how about if you lived in China? Is it still cheap? </li></ul>
    55. 55. Group assignment <ul><li>Assume you are going to Europe in 6 months, and that you expect to spend 1000 Euros. </li></ul><ul><li>What is your risk? </li></ul><ul><li>How could you avoid / limit that risk? </li></ul>
    56. 56. Group assignment <ul><li>Assume you are going to Europe in 6 months, and that you expect to spend 1000 Euros. </li></ul><ul><li>What is your risk? How could you avoid / limit that risk? </li></ul><ul><li>Deposit $ in European bank now… grow to be 1000 euros in 6 months </li></ul><ul><li>Forward contract with Bank </li></ul><ul><li>Futures / Options </li></ul>
    57. 57. Currency basics: <ul><li>Do you want a “strong” currency? Not necessarily…. </li></ul><ul><li>Producers – </li></ul><ul><ul><li>prefer weak currency – produce for exports </li></ul></ul><ul><li>Consumers – </li></ul><ul><ul><li>prefer strong currency – to purchase cheap imports, and afford foreign travel </li></ul></ul><ul><li>Government- </li></ul><ul><ul><li>it depends, but for full employment from exports, often prefer weak currency </li></ul></ul>
    58. 58. Themes to cover: <ul><li>Banking Business Model –today </li></ul><ul><li>Pyramid of Promises - next class </li></ul>
    59. 59. Commercial Banking (business model) <ul><li>Commercial Banking business model: </li></ul><ul><ul><ul><li>“ Borrow short, lend long” </li></ul></ul></ul><ul><li>Who can explain what this means? </li></ul>
    60. 60. Borrow Short <ul><li>Deposits are LIABILITIES for banks </li></ul><ul><li>They are BORROWING money from clients </li></ul><ul><li>But, deposits can be withdrawn at any time </li></ul><ul><li>So… their Liabilities are short term (might owe money tomorrow) </li></ul>
    61. 61. Lend Long <ul><li>Banks invest in Long term Assets </li></ul><ul><li>Mortgages, for example… 30 years duration </li></ul><ul><li>So, money is borrowed short (term), but lent out long (term) </li></ul><ul><li>What is the risk? </li></ul>
    62. 62. Lend Long <ul><li>Risk= profitable bank may not have money on hand to meet short term liabilities (withdrawals) </li></ul><ul><li>This is called “Liquidity” crisis </li></ul>
    63. 63. Bank Run http://michaelcorey.ntirety.com/Blog
    64. 64. Overcoming Banking Weakness of Liquidity <ul><li>Federal Insurance </li></ul><ul><li>As a result of this inherent weakness, banks are offered federal insurance for the deposits.  The government is forced to federally protect (guarantee) depositors that their money will be there if they want it.  Or else, people would not trust the banks, and would not deposit their money.  FDIC </li></ul><ul><li>  </li></ul><ul><li>Regulation </li></ul><ul><li>In exchange for this federal guarantee (that they receive), the banks (give up) are subject to stiff regulation.  One of the main requirements for deposit-taking banks is that they have to maintain a certain level of money on reserve at the (Federal Reserve).  In the US, this reserve requirement is 10%.  </li></ul>http://globotrends.pbworks.com/Commercial-Banking
    65. 65. Getting around Regulations…. <ul><li>Innovation </li></ul><ul><li>Wherever you see regulation, you will see innovation (to get around the regulation).  Banks are some of the most creative organizations when it comes to developing products to get around regulation.  For example, there has been massive Innovation in the financial sector when it comes to the securitization of mortgages (which partly is to blame for the subprime lending crisis). </li></ul>http://globotrends.pbworks.com/Commercial-Banking
    66. 66. Group Question <ul><li>Does regulation + bank guarantees… result in making the banking system more, or less risky? </li></ul><ul><ul><li>Ie. Do you think government guarantees encourage risky behavior? </li></ul></ul>
    67. 67. Moral Hazard <ul><li>Law of unintended consequences </li></ul><ul><li>Moral Hazard </li></ul><ul><ul><li>Ex: fire insurance… less likely to smoke? </li></ul></ul><ul><ul><ul><li>Health insurance…. Less likely to be safe? </li></ul></ul></ul><ul><li>“ Moral hazard: One of two main sorts of MARKET FAILURE often associated with the provision of INSURANCE. The other is ADVERSE SELECTION. Moral hazard means that people with insurance may take greater risks than they would do without it because they know they are protected, so the insurer may get more claims than it bargained for. </li></ul>The Economist.com
    68. 68. Solvency v Liquidity – QUIZ (extra credit) <ul><li>Extra credit – 1 point in final grade </li></ul><ul><li>In 20 words or less – what is a “Solvency” problem (for banks) </li></ul><ul><li>In 20 words or less – what is a “Liquidity” problem (for banks) </li></ul><ul><li>* think of the business model </li></ul>
    69. 69. Solvent : not Solvent <ul><li>Ok NOT OK </li></ul><ul><li>ASSETS </li></ul><ul><li>Include home mortgages </li></ul><ul><li>subprime </li></ul>Liabilities (Borrowing, debt) Equity <ul><li>ASSETS </li></ul><ul><li>Include home mortgages </li></ul><ul><li>subprime </li></ul>Liabilities (Borrowing, debt) Equity
    70. 70. Solvency v Liquidity <ul><li>Insolvent: liabilities > assets (equity = 0) </li></ul><ul><ul><li>Person: I owe more than Im worth </li></ul></ul><ul><ul><li>Bank: assets loose value (subprime mortgages) </li></ul></ul><ul><ul><li>Country: cant pay debts…default </li></ul></ul><ul><li>Illiquidity: long term asset, short term liability </li></ul><ul><ul><li>I owe money NOW, but have money tied up in my house, car, etc… </li></ul></ul><ul><ul><li>Bank: lend long term, borrow short term </li></ul></ul><ul><ul><li>Country: cant access credit markets to pay imports </li></ul></ul>
    71. 71. Solvency v Liquidity <ul><li>How does this relate to the Global Financial Crisis? </li></ul><ul><ul><li>Anyone? </li></ul></ul>
    72. 72. Solvency v Liquidity Timeline <ul><li>2007 – September 2008 </li></ul><ul><ul><li>Problem = Solvency </li></ul></ul><ul><ul><li>Mortgages (assets on Banks balance sheet) worth less than anticipated… write down </li></ul></ul><ul><ul><li>Results: Hedge funds Funds go under (Bear Stearns) </li></ul></ul><ul><ul><li>Bankruptcy threat </li></ul></ul><ul><li>ASSETS </li></ul><ul><li>Include home mortgages </li></ul><ul><li>subprime </li></ul>Liabilities (Borrowing, debt) Equity
    73. 73. Credit bubble led to housing bubble, led to bust… http://www.abc.net.au/reslib/200802/r220644_867185.jpg
    74. 74. Credit Crisis timeline – key dates in September <ul><li>September 7, 2008 : Federal takeover of Fannie Mae and Freddie Mac [25] [26] </li></ul><ul><li>September 14, 2008 : Merrill Lynch sold to Bank of America amidst fears of a liquidity crisis and Lehman Brothers collapse [27] </li></ul><ul><li>September 15, 2008 : Lehman Brothers files for bankruptcy protection [28] </li></ul><ul><li>September 16, 2008 : Moody's and Standard and Poor's downgrade ratings on AIG 's credit on concerns over continuing losses to mortgage-backed securities, sending the company into fears of insolvency . [29] [30] </li></ul><ul><li>September 17, 2008 : The US Federal Reserve loans $85 billion to American International Group (AIG) to avoid bankruptcy. </li></ul><ul><li>September 19, 2008 : Paulson financial rescue plan unveiled after a volatile week in stock and debt markets. </li></ul><ul><li>September 25, 2008 : Washington Mutual was seized by the Federal Deposit Insurance Corporation , and it's banking assets were sold to JP MorganChase for $1.9bn. </li></ul>
    75. 75. Solvency v Liquidity Timeline <ul><li>September 2008 - now </li></ul><ul><ul><li>Crisis CHANGED </li></ul></ul><ul><ul><li>No longer just a SOLVENCY CRISIS </li></ul></ul><ul><ul><li>Became a MIXED crisis of BOTH solvency and liquidity </li></ul></ul><ul><ul><li>How? Why? What does that mean? </li></ul></ul><ul><ul><li>Someone tell me again…what is “liquidity”? </li></ul></ul>
    76. 76. Solvency v Liquidity Timeline <ul><li>Question: if a bank is having a SOLVENCY trouble… should the government come to their rescue? </li></ul><ul><li>(clue – remember the discussion on “moral hazard”) </li></ul><ul><li>ASSETS </li></ul><ul><li>Include home mortgages </li></ul><ul><li>subprime </li></ul>Liabilities (Borrowing, debt) Equity
    77. 77. Solvency v Liquidity Timeline <ul><li>Answer: NO! (probably not) * </li></ul><ul><li>* but, gets complicated by worries about systemic risk, and interconnectedness, and “too big to fail” banks </li></ul><ul><li>ASSETS </li></ul><ul><li>Include home mortgages </li></ul><ul><li>subprime </li></ul>Liabilities (Borrowing, debt) Equity
    78. 78. How about a “Liquidity” crisis? <ul><li>Should the government step in to help a bank facing a “liquidity” crisis? </li></ul>
    79. 79. How about a “Liquidity” crisis? <ul><li>YES!! </li></ul><ul><li>To help banks bridge the gap between short term liabilities and long term assets </li></ul><ul><li>* this is exactly why the FDIC, insurance was offered. </li></ul>
    80. 80. The trouble during the crisis… <ul><li>… after September 2008… it was difficult to tell which banks faced “liquidity” crisis (and should be helped), and those that faced “solvency” crisis, and should be allowed to fail (to avoid “moral hazard” from saving them) </li></ul>

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