ECON 252: Financial Markets with Robert Shiller (Spring 2008)

notes by Peter Pesti




http://oyc.yale.edu/economics/financial-markets/                      ECON 252: Financial Markets (Robert Shiller at Yale), Spring 2008
https://classesv2.yale.edu/access/content/group/econ252_s08/index.htm class pages
http://www.econ.yale.edu/~shiller/                                    Shiller at Yale
http://www.ritholtz.com/blog/2009/01/authorsgoogle-robert-shiller/    Shiller @ Google (10/2008)
http://financialdemocracy.org/                                        Financial Democracy (by Shiller)
  1. ECON 252: Financial Markets with Robert Shiller (Spring 2008)
    1. Lecture 1 - Finance and Insurance as Powerful Forces in Our Economy and Society
    2. Lecture 2 - The Universal Principle of Risk Management: Pooling and the Hedging of Risks
    3. Lecture 3 - Technology and Invention in Finance
    4. Lecture 4 - Portfolio Diversification and Supporting Financial Institutions (CAPM Model)
    5. Lecture 5 - Insurance: The Archetypal Risk Management Institution
    6. Lecture 6 - Efficient Markets vs. Excess Volatility
    7. Lecture 7 - Behavioral Finance: The Role of Psychology
    8. Lecture 8 - Human Foibles, Fraud, Manipulation, and Regulation
    9. Lecture 9 - Guest Lecture by David Swensen
    10. Lecture 10 - Debt Markets: Term Structure
    11. Lecture 11 - Stocks
    12. Lecture 12 - Real Estate Finance and Its Vulnerability to Crisis
    13. Lecture 13 - Banking: Successes and Failures
    14. Lecture 14 - Guest Lecture by Andrew Redleaf
    15. Lecture 15 - Guest Lecture by Carl Icahn
    16. Lecture 16 - The Evolution and Perfection of Monetary Policy
    17. Lecture 17 - Investment Banking and Secondary Markets
    18. Lecture 18 - Professional Money Managers and Their Influence
    19. Lecture 19 - Brokerage, ECNs, etc.
    20. Lecture 20 - Guest Lecture by Stephen Schwarzman
    21. Lecture 21 - Forwards and Futures
    22. Lecture 22 - Stock Index, Oil and Other Futures Markets
    23. Lecture 23 - Options Markets
    24. Lecture 24 - Making It Work for Real People: The Democratization of Finance
    25. Lecture 25 - Okun Lecture: Learning from and Responding to Financial Crisis, Part I (Guest Lecture by Lawrence Summers)
    26. Lecture 26 - Okun Lecture: Learning from and Responding to Financial Crisis, Part II (Guest Lecture by Lawrence Summers)

Lecture 1 - Finance and Insurance as Powerful Forces in Our Economy and Society

-finance is a technology and an engineering discipline


Lecture 2 - The Universal Principle of Risk Management: Pooling and the Hedging of Risks

-Schiller says variance is risk; this is directly in conflict with the Buffett-view of the world
-probabilities, distributions, variance, covariance, correlation, regression line, beta, alpha; probability distribution function, bell curves, Gaussian curve
-present value, discounting; perpetuity/consol, coupon, PV = c/r; growing consol, PV = c/(r-g); annuity (pays c dollars for n years), eg. mortgage, PV = c*(1-(1/(1+r))^n)/r
-utility function, diminishing marginal utility


Lecture 3 - Technology and Invention in Finance

1. long-term risks
  -moral hazard
2. (psychological) framing
  -Kahneman & Tversky
3. invention

1. risk management, risk sharing
-Backus, Kehoe & Kydland: correlation of consumption around the world
-socialism, Robert Owen (1771-1851), New Harmony colony failure (issue of moral hazard)
-kibbutzim, Ito-En, yamaguchir-kai,a hutterites
-Karl Marx, Louis Blanc, communism as theory of risk management (but with moral hazard problem)
-John Harsanyi
-John Rawls: Theory of Justice
-public finance, tax & welfare system

2. framing
-framing & taxes
  -Edward McCaffery, progressive taxing during world wars
  -income tax (1861, during civil war)
-Kahneman & Tversky
 -eg.: losing tickets
 -eg.: insurance
-money frame vs. real frame (indexed for inflation)

3. invention
-eg.: insurance policy as an invention; appraisal of value to avoid moral hazard; collecting of statistics
-invention of the wheel; original wheeled suitcase (1972), new wheeled suitcase (1991)
-patents
-information technology
  -19th century: paper prices down --> record keeping; carbon paper; typewriter; standardized forms; bureaucracy (management science, civil service); filing cabinet; postal service
  -19th century Germany (1889, under Otto von Bismarck): social security (employee payment + employer matching contribution), with post office/stamps/carbon copy technology


Lecture 4 - Portfolio Diversification and Supporting Financial Institutions (CAPM Model)

-he thinks variance is risk...
-equally weighted portfolio:
 -n _independent_ assets in portfolio, each has a 'sigma' standard deviation, r: expected return of assets
 -square root rule: stdev_portfolio = sigma / sqrt(n)
 -r_portfolio = r
 -by increasing number of assets (n) as much as possible, you can reduce the variance, while the return remains the same
-two asset case:
  -n=2, but not independent assets
  -Asset1: r_1 = E(return on Asset1), sigma_1 = stdev(return on Asset1)
  -Asset2: similarly
  -cov(r1, r2) = sigma_12
  -x1 in Asset1, x2=1-x1 in Asset2, x1+x2=1; (x1 could be negative, ie. shorting)
  -portfolio expected return: r= sum[r=1..n] x_i * r_i = x1*r1 + x2*r2 = x1*r1 + (1-x1)*r2
  -portfolio expected variance: sigma^2 = x1^2 * sigma1^2 + x2^2 * sigma2^2 + 2*x1*x2*sigma12 = x1^2 * sigma1^2 + (1-x1)^2 * sigma2^2 + 2*x1*(1-x1)*sigma12
  -x1 = (r-r2)/(r1-r2)
  -frontier for portfolio
-three asset case: r1, r2, r3; sigma1, sigma2, sigma3; sigma12, sigma13, sigma23 --> these are estimates!
-riskless asset (sigma=0): government 1-year fixed-return treasuries
-tangency portfolio -> mutual fund theorem (everyone should hold a single portfolio of assets balanced in the above way)
  -his calculations: 9% oil, 27% stocks, 64% bonds
-Capital Asset Pricing Model (CAPM); Tobin, William Sharpe, Lintner, Markowitz
 -assumes everyone is rational, and holds the Tangency Portfolio + certain amount of the riskless asset
 -Tangency Portfolio = actual market portfolio
 -r_i = r_f + beta_i * (r_m - r_f)
   -r_i: return on i-th asset
   -r_f: riskless asset return
   -beta_i: regression coefficient
   -r_m: expected return on the Market Portfolio (anything that's available as an asset in the whole world put together)
-Jeremy Siegel's book finds a 4.0% premium on stocks over bonds
 http://www.ritholtz.com/blog/2009/07/jeremy-siegel-is-not-having-a-good-year/    1802-1870 data iffy in Stocks for the Long Run, 07/11/2009
-I say: this is great, if you have no knowledge about the assets, except their historic returns/performance. However, if you are not a know-nothing investor, and financial performance is not the only thing available (eg. you know what a business does, the quality of its management, how it utilizes the fallibilities of the intelligence of the human animal to create a moat, etc.), then it is crazy to rely on this theory for making investments. This theory is more like a "financial middleware", or something to fall back on, _only_ when no other information is available. This, however, is probably never the case. Eg. in the case of sub-prime mortgages, the reliance on such risk-management theory, when knowledge about the real quality of mortgages would have been accessible, is the reason why everybody is looking foolish and incompetent.


Lecture 5 - Insurance: The Archetypal Risk Management Institution

-in connection with the last lecture:
 -equity premium puzzle (Prescott & Mehra), 4%/year for US since 1802 according to Jeremy Siegel's book
   -if we study US only --> selection bias
   -Dimson, Maursh & Staunton looked at several countries around the world -> all have positive equity premium for 20th century (highest: Sweden, then Australia)
    -does not exclude eg. Russia, China (-> communist nationalization)
 -stock markets are essentially politicized
   -corporate profits tax (in US: almost 60% after WWII, today: about 30%)
   -personal income tax (dividend tax in US: 0% before 1913, over 90% in WWII, today: 15%)
 -mutual fund theory calls for diversified portfolio service by mutual fund, when in reality they try to beat the market by stock picking
 -Khorana, Survaes & Tufano: survey on which countries have strong mutual fund industry growth
  -strong property laws, higher level of education & wealth, institutional structures encouraging investing (eg. pension plans)

-insurance: provides risk pooling
 -have to deal with moral hazard (ie. setting fire on house with fire insurance)
 -selection bias: you attract people who have higher risk
-risk pooling:
 -independent risks: x: number of accidents, n: number of policies written, p: probability of accident
  --> binomial distribution gives having x accidents: f(x)= p^x * (1-p)^(1-x) *n/(x! * (n-x!))
  mean(x/n)= p, stdev(x/n)= sqrt(p*(1-p)/n)
 -normal approximation of binomial
 -as you write more policies, the stdev of the bell-curve decreases
-my note: insurance services are one type of "financial middleware", that allow mitigation of risks (eg. which were not available in Roman times)
-insurance as an invention:
  -contract design (risks covered; exclusions designed to manage moral hazard & selection bias)
  -mathematical model
  -form of the company (eg. for/non-profit corporation, mutual insurance company owned by the insured)
  -government regulation (reserve requirements)
-multiline (insures many different kinds of things), monoline (eg. fire insurance only; more risky, eg. subprime-specialized insurers)
-monolines [with 2007 assets]:
 -property & casualty (P&C): insuring homeowners (fire, hurricanes), automobiles (collisions) [$1.4T]
   -automobile insurance is a bigger business (since there are more accidents)
 -health
 -life insurance (insures a beneficiary against death of insured) [$4.9T]
-growth of insurance: (a succession of inventions)
 -began in 1600s (invention of statistics, life tables, actuarial science)
 -Morris Robinson, head of Mutual Life New York (1840s) realized how hard it is to sell life insurance to people --> highly paid insurance salesmen
 -Henry Hyde, Equitable Life (late 1800s) --> insurance policy that had a cash value on it
 -sociologist Vivane Zelizer's book found that life insurance opposed by 19th century women: perception of insurance as betting on husband's death --> changing sales pitch from explaining probability theory, to acting as missionaries of insurance
-government regulation of insurance:
 -largest concern: capital adequacy (specifying reserves to be held)
 -in US: regulated at the state-level (not federal)
 -statutory surplus
 -National Association of Insurance Commissioners (NAIC) -> creates policy recommendations to state regulators (has no authority, but acts like a congress)
 -Gramm-Leach-Blilley financial modernization act of 1999: allows banks to merge with insurance companies
-life insurance:
 -term insurance: pay each year, for insurance in that year (doesn't build cash value)
 -whole life insurance: builds cash value according to schedule; participating or non-participating
 -variable life: policy-holder can make decisions about investment of policy cash value
 -universal life: flexibility of amount paid in
 -survivorship policies: pays out eg. when both people die
-monoline problems:
 -subprime crisis
 -systemic effects: failure of underlying assumptions can cause this in many cases
 -municipal bond insurers (private insurance companies)
  -local govermnents can go bankrupt
  -big ones: MBIA, AMBAC, FGIC
  -they invested reserves in subprime mortgages
 -January 18, 2008: Fitch lowered AMBAC from AAA to AA rating


Lecture 6 - Efficient Markets vs. Excess Volatility

-catastrophe bond: the issuers doesn't have to pay it off, if there is a catastrophy (it's like an insurance, but operates thru the securities markets)
-eg. Mexico earthquake catastrophe bond (cat bond)

-efficient markets hypothesis: prices are perfect indicator of value; the markets efficiently incorporate all information; "trust markets"
-1889, George Gibson's book: first mention of the concept
-Mr. Reuter's carrier pigeons for fast dissemination of information
-it says you can only beat the market by getting information faster than others: competition of utilizing received information
-1967 Harry Roberts
 -weak form: info of past prices is already incorporated in the price (ie. you can't predict based on past prices)
 -semi-strong form: all public info is incorporated (ie. don't bother to trade on news) <-- this is what we usually refer to
 -strong form: all information, whether public or not, is incorporated (ie. all information gets out into price)
-efficient markets, simplest version: price = expected present value of future dividends paid on stock
 -present discounted value: dividend= D0*e^(y*t), present discount value (pdv) = D/(r-g)  , where (g<r)
 -price = D/(r-g)
 -p_t = sum( E_t(D_{t+k}) / ((1+r)^k)  ) [k=1..inf]
-First Fed Financial's P/E= 8.5 in Dec 2006
  -small mortgage lender with 80% of mortgages no-doc, and many option-ARMs (adjustable rate + option of delaying payment)
  -price drop from $70 to $40 from 2007 to 2008
-he thinks that a company which never will pay a dividend is essentially worthless, based on the above
-he thinks that a share is just a piece of paper that's only useful because of the dividend (he doesn't consider that it is ownership of a portion of the company)
-he thinks EMH is not exactly right, but mostly right ("sympathetic" to it)
-I say: EMH says that information we didn't know before causes prices to change (this is a finance theory-based view); Graham says: changing interpretation of existing information also causes prices to change, and this can be substantial (this is a business-based view)
-EMT became popular in 1970s
-random walk theory: under efficient markets, stock market prices are random walks (Karl Pearson, 1905 Nature article)
 -drunk-at-the-lamppost: try to predict where the person will be
 -X_t = X_{t-1} + epsilon_t
 -the market is unforecastable
-AR-1 (First Order Autoregressive model)
 -elastic cord tying the drunk to the lamppost
 -(x_t - x') = x' + rho * (x_{t-1} - x') + E_t,  where -1 < rho < 1
 -this gives a little predictability
 -random walk is actually an AR-1 with rho=1
-y = alpha + beta * x + u


Lecture 7 - Behavioral Finance: The Role of Psychology

-relatively recent (20 yrs) concept, since early 90s
-Shiller's graph of PV of all actual dividends -> a very smooth line
-overconfidence
-Rakesh Khurana: the search for charismatic CEOs
-Fadi Kanaan & Dirk Jenter: failing businesses fire CEOs due to high expectations (even if the whole industry goes down)
-Nassim Taleb: Fooled by Randomness
-Irving Fisher - an example of overconfidence before 1929
-Danny Kahneman & Ames Tversky: Prospect Theory (1979; famous paper on human behavior; most important economics article in last 30 years)
 -how people make choices
 -replaces expected utility; replaces utlity function with a value function; replaces probabilities with weights
 -Paul Samuelson's story (1963 article): $200/100 bet
 -expected utliity theory says: I want wealth; I get a concave utiliity curve based on wealth (diminishing marginal utility)
 -Kahneman & Tversky says: the value function has a kink (a discontinuity of slope) around the current time -> people don't like bets with a possibility for loss, even if the odds are in their favor (people are very concerned with small losses)
 -weighting function: people distort probabilities in their thinking
  -Maurice Allais; Allais-paradox:
   choice of a) 25% chance to win $3000, or b) 20% chance to win $4000 (crowd choice: b)
   choice of a) 100% chance to win $3000, or b) 80% chance to win $4000 (crowd choice: a)
 -x: probability, y: weight: increasing, except jumps down around 0, and jumps up around 1
 -expected utility: max Sum prob_i * utility_i; prospect theory: max Sum weight_i * value_i
 -regret theory: people go to great lengths to avoid the pain of regret
 -mental compartments: eg. gamblings in casino are "different" from non-casino gambles (or investors' "play-portfolio")


Lecture 8 - Human Foibles, Fraud, Manipulation, and Regulation

1. wishful thinking: the error of believing what you want to believe (exploited by people selling securities)
2. attention anomalies: many errors are errors of inattention (too much attention on certain parts, while too little attention on other parts)
  -social basis: people tend to pay attention to what others pay attention to
3. anchoring: making quantitative judgments to justify some arbitrary idea
  -Kahneman & Tversky: wheel of fortune experiment -> people tended to give an answer close to the random number
  -eg. over-influance in stock market by some arbitrary number
4. representativeness heuristic: judging events on the basis of similarity to other events in our mind (without regard to the occurence of those event)
  -K. & T.; sculptress example (we exaggerate some rare event in our mind)
5. gambling behavior
  -some game of chance present in all human cultures
  -1.1% men, 0.5% women pathological gamblers
6. magical thinking: assuming that something we did was the cause of events (when it might have been pure luck)
 -B. F. Skinner's pigeon experiment: one piece of food every 15 seconds; reinforcement learning
7. quasi-magical thinking: people get the impression that they can control randomness thru willpower
 -Shafir & Tversky
 -Ellen Langer: people willing to bet more when coin hasn't been tossed yet
 -gives rise to overconfidence
 -voting: I have to vote to prove that good people vote (when I know that I will not be the one deciding the election)

-temptations of the market: tendency to...
 1. oversell (promise to everyone that it will do well)
   -eg. National Association of Relators ad of homepricing doubling; gold coin ads
 2. hide information: avoid telling people what might discourage them
 3. loyalty to friends: channgel good investments to friends, while dump the crap on "others"
 4. churning (for commission)

-origins of securities regulation:
 -Louis Brandeis: Other People's Money (1914) book --> disclosure of information very important ("sunshine is the best disinfectant")
 -state-by-state "blue sky laws" regulating how securities are sold
 -1920s: telephone widely spread -> "boiler rooms" (businesses called around to sell securities, often bogus stuff)
 -1934: Securities and Exchange Commission (SEC) --> ensuring proper disclosure & convenient access to information
 -William O. Douglas SEC chairman: Democracy and Finance (1940) book --> financial markets have to be made to work for real people
  -legal realism school: recognized human failings & behavior in laws
-public securities: SEC accepted as suitable for the general public (-> Edgar); vs. private securities
-hedge fund: a private investment company
 -a public investment company: have to file quarterly report on activities -> they prefer to be private
 -not allowed to advertise (you're not for the public) --> very low profile
 -limited in the kind of investors they can take
 -3C1 hedge fund: limited to 99 investors (they must be accredited investors: $1M in investable assets, make at least $200k (or $300k if married) per year)
   -SEC wanted to raise minimum to $2.5M --> never happened
 -3C7 hedge fund: can take 500 investors; limted to qualified purchasers ($5M assets for natural persons, or $25M for institutions)
-insider vs. outsider
 -regulation FD (in 2000): full disclosure; whenever a company announces news, they hold a web event (instantaneous disclosure to all)
-market surveillance: making sure that insider information is not being mishandled
-SROs (self-regulatory organizations) are industry organizations --> try to discover insider trading
 -1995: secretary at IBM copying proposed takover of Lotus; told husband; who told 2 friends; who bought shares
 -late 90s, Emulex: Mark Jacob shorted the company and put out a fake press release
-accounting regulation: Financial Accounting Standards Board (FASB; organized by SEC in 1973, but not a government organization) --> GAAP
 -GAAP: net income (profits after expenses/"bottom line"), operating income
 -other non-GAAP standards: Corr earnings, pro forma earnings, EBITDA, adjusted earnings
-off-balance sheet accounting: trying to hide liabilities
 -assets (owned) & liabilities (owed) columns
 -Enron Corp had a number of partnerships off the balance sheet
 -SIV (Structured Investment Vehicle): used by banks to cover up risky sub-prime mortgage investments made with commercial paper market borrowings
-SIPC (Securities Investor Protection Corporation, 1970): securities analog of FDIC (Federal Deposit Insurance Corporation, 1934)
 -motivated by Goodbody & Co. brokerage failure in 1970
 -you can lose your money in the cash account (up to $100k insured) and securities account (up to $500k insured)


Lecture 9 - Guest Lecture by David Swensen

(see also: http://boards.fool.com/Message.asp?mid=10485033 Charlie Munger's endowment address, 1998)
-3 tools: asset allocation, market timing, security selection
  -the latter two include career risk --> Yale model is all asset allocation
-I say: the notion that when stock prices drop the money has to go somewhere else (eg. into bonds) is false, since: the same number of stocks, bonds, cash and any other asset class are owned before & after, just the price levels of stocks & bonds are different (if somebody says my assets are worth 2x than previously, it doesn't mean that I spent 2x on it). Every stock sold by somebody is a stock bought by somebody. This is why a $1T loss in aggregate market cap is possible, and the wealth has just "disappeared" (it actually never existed). The only thing that can change in fact is the aggregate quotational wealth: eg. by building a house I create a qutational wealth of $200k out of thin air; a bank with an equity basis of $1B can create a quotational wealth of say $10B out of thin air. The amount of cash does not change; however, the amount of non-cash ie. quotational wealth does change, and therefore no "conservation of wealth" law exists (which would say that when quotational wealth of one asset class decreases by X, the quotational wealth of another asset class will increase by X).
-survivorship bias: we only have data for good-performing funds (taking out bad records)
-backfill bias: appearance of new managers (adding new good records)
-Burton Malkiel adds these two up to 11+%/yr, Roger Ibitson to 7-8%/yr
-no direct measure of market efficiency
-what market might be efficiently priced? --> where there are no big bets made, eg. government bonds (other end of the spectrum: venture capital) --> should spend time & energy in most inefficiently priced asset classes
-I say: the better you are, the more you should focus on inefficiently priced asset classes (eg. equities or venture capital), where a strategy of smart concentration should be followed). You can't have your cake and eat it too: if Yale (Swensen) thinks they are smart, they should do Berkshire-style equity selection, or even venture capital; if they are not smart, they should do ETF-based total diversification (and expect to perform as average). The idea that they are smart enough to do manager-selection only, is a half-assed solution, but incurs fees: if you're smart enough to select managers, you are smart enough to do stock-selection.
-Swensen's attitude seems to be somewhat Munger/Buffett-like (eg. looking for integrity), but his academic finance inclination pushes him toward diversification (impairing his potential)
-"worry top down, invest bottom up" (macro circumstances vs. individual opportunities)


Lecture 10 - Debt Markets: Term Structure

-Shiller: despite what he says, Swensen does more than just diversify
-discount bonds (bill): no interest, but sold at discount to principal/par
 -Treasury Bills (http://www.treasurydirect.gov/RI/OFBills) -> for serious investors (ie. large denominations); <=1 year
 -Savings Bonds --> for small investors
 -CUSIP is a unique security identifier
 -discount = discount_rate * term_in_days / 360  (not divided by 365)
 -investment rate: percentage return on an annual basis
  investment rate = (1/(1-discount) - 1) * 365/term_in_days
 -you would normally buy from a dealer (who bought from Treasury on some past auction day)
  bid: what they'll pay you; ask: what you'll pay them; the bid-ask spread is tighter/smaller in more liquid securities
 -Wall Street Journal is most influential financial publication
-coupon-carrying bonds
 -Notes (1-10 years), Bonds (>10 years)
 -coupon; principal; pays C/2 every 6 months
 -price = PDV(coupons & principal, at rate R)
  C/2. C/2, ..., C/2, 100+C/2
  P = C/2 * ( 1/(R/2) - 1/(1+R/2)^2T * 1/(R/2) )  +  100/(1+R/2)^2T
-inflation-indexed bonds: coupons are indexed to inflation
 -8% of total US national debt (ie. minority)

-term structure: plot of yield-to-maturity against time-to-maturity
 -shows price of time
 -theory of interest (as per Irving Fisher) --> today vs. next period/year diagram
  -budget constraint -> straight line
  y_today + y_next/(1+r); y_today*(1+r) + y_next
 -production possibility frontier
 -forward rates
  -comes from Sir John R. Hicks: Value and Capital (1939) book
  -implicit in the term structure is the 1-year rate one year in the future
  -lock in the investment return of a future year
  -in 1925: buy this many two-period bonds: (1+r2^2)/(1+r1); short 1 one-period bond
   p2=1/(1+r2)^2
   no cash flow in 1925; pay $100 in 1926 (for the short); get the maturity of the long bonds in 1927: $100 * (1+r2^2)/(1+r1);
  -forward rate = (1+r2^2)/(1+r1)
  -expectation theory of the term structure: what the rates are implicitly expected to be in future years, based on the term structure
  -liquidity premium theory: a tendency for upward sloping term-structure (even if rate expectations are flat)
-inflation rate: pi
 -1 + real interest rate = (1 + r_nominal)/pi
 -real interest rate ~= r_nominal - pi


Lecture 11 - Stocks

-shares
-corporation - corpus (lat. body); also see distinction between legal person & natural person
-publicani (lat. company); stock market in Roman Forum
-by-laws (like a constitution of the corporation) + state laws
-typically one share - one vote; annual meeting, where shareholders vote, among on board of directors; board hires CEO & other managers (who are employees)
-for-profit vs. non-profit corporation (no shareholders: not owned by anyone; also has board of directors)
-number of shares outstanding; splits (aiming for $20-40 range typically, but no good reason); dilution (issuing to management as compensation; issuing new shares is not necessary delutionary, since there is income from the issuance)
-dividend: all shareholders treated equally; price should decline by dividend amount (ex-dividend date price drop; brokers might try to "sell the dividend")
-stock dividend: eg. 5% of shares held is given out (meaningless, like splits; companies might do this alongside some good news, hoping the price does not adjust down to reflect the stock dividend)
-the board is in a fiduciary role to protect the shareholders' interests
-earnings is an accounting concept (ie. defined by the accounting rules and adjustments), unlike dividends (which is cash money)
-typical P/E=15
-payout ratio: dividends/earnings (div/E)
-normally, you would buy a company for its dividend, not its price appreciation (eg. in early part of 20th century)
-other ways to get money out of a company:
  -stock repurchase
  -liquidation
-Franco Modigliani and Merton Miller: "Dividend policy is irrelevant" (Modigliani-Miller proposition)
  -it could matter for tax reasons, though: eg. if dividends taxed higher than capital gains, you should avoid them
  -I say: this is not true, eg. if doing share repurchase at higher-than-intrinsic values, it is a bad investment decision, that decreases the value of the company
  -"neutral mutation"
-corporate debt:
  -debt: owed to bond-holders, banks, commercial paper holders, etc.
  -leverage = debt/equity
  -more debt -> more risk
  -Modigliani-Miller theorem: debt irrelevance
    -to own all rights to the company, you'd have to buy all the shares and all the debt (so the lenders can't have any claims on your assets)
    -but: tax reasons (debt is tax-deductible, dividends are not) --> M&M would say: borrow a lot
    -but: bankruptcy costs, when more leveraged
-Lintner model of dividends
 -boards are worried about share prices and investor psychology
 -tau - target payout ratio; rho - adjustment (0..1)
 -Div_t - Div_(t-1) = rho * (earnings_t - Div_(t-1))


Lecture 12 - Real Estate Finance and Its Vulnerability to Crisis

-biggest asset class: $20T held by households
  -stock market total: $6T
-commercial real estate (held by businesses)
 -DPP (Direct Participation Program) -- traditionally the most important form of holding
  -unlike corporations, not taxed on profit
  -holds real-estate on the behalf of owners
  -Limited Partnership (LP)
   -corporations have limited liability, but in normal partnerships the partners are liable for more than they put in
   -general partner: takes on full liability; limited partners: do not share the liability
  -the general rule has been that only accredited investors should participate (Regulation D -- accredited investor: $1M wealth or $200k/yr income); can't advertise
  -late 1950s: complaint that this is regressive taxation (since wealthy people can get around the corporate profits tax)
  -1960: Real Estate Investment Trust (REIT)
   -subtle distinction from corporations:
     -75% of assets must be real estate (eg. Wal-Mart can't be a REIT)
     -75% of income must be from real estate
     -95% of earnings must be paid out (it's a pass-thru vehicle)
     -<30% of income from sale of properties can be from real estate held <4 years (ie. can't be flippers)
  -1st REIT boom in 1960s: disintermediation (switching from bank deposits with limited to REITs)
  -2nd REIT boom: Tax Reform Act of 1986 made DPPs less attractive (DPPs were a tax loss device before)
  -3rd REIT boom in 1990s: enthusiasm for REITs, became more diverse asset class
-mortgages -- debt secured by property as collateral (if you fail to pay on the loan, the property is taken by the lender)
 -loan-to-value ratio (LTV) should be below 1 for the lender to avoid much risk
 -maturity: the date when the mortage is paid off
 -1920s: LTV: 60%, maturity: 5 years (ie. short)
   -balloon payment: interest, interest, ..., large final payment at the end
 -1930s: biggest housing crisis in US historyt (after 1929 unemployment rose to 25%, so many couldn't refinance their mortgages and lose their house)
 -1933: Home Owners Loan Corporation (HOLC) -- Roosevelt
  -financed by US Congress; refinancing these homeowners indirectly via banks, goverment guarantee of mortgages
  -15 year maturity, no balloon payment (self-amortizing mortgages: pay interest + principal every month)
 -1934: Federal Housing Administration (FHA) -- guaranteeing homes for low-income people
  -20 year maturity, self-amortizing mortgages
 -since early 1950s to today: 30 year mortgages
 -since 1990s: a proliferation of new mortgages
  -Adjustable Rate Mortgages (ARM) -- interest rate is not fixed
   -2 year teaser rate, then interest goes up for the next 20 years (re-set)
   -sold to low income people
 -standard/conventional fixed-rate 30-year mortgage:
   -Canada: mortgages tend to be shorter term
   -rate r: r/12 paid monthly
   -mortgage balance = mortgage payment  *  1/(r/12) * (1 - 1/(1+r/12)^12T)    <-- this is the annuity formula (T: years to go)
   -median price in US: a little over $200,000
   -mortgage payment first mostly goes to interest, later mostly principal (mortage balance declines slowly at first, then declines rapidly)
 -Fannie Mae (1938 -- Federal National Mortgage Corporation)
  -buying up mortgages from originators (originator: a company that lends money to households; servicer: deals with the people & payments)
 -Freddie Mac (1970)
  -government-created competitor to Fannie, privatized
  -GSE: goverment sponsored enterprise; they are technically private, but the goverment regulates them, so people lend to these organizations at low rates, since there is an implicit (though not explicit) government guarantee
-real estate boom
 -boom in housing after WWII (returning soldiers starting families; construction shut down during the war)
 -biggest cost in housing construction is labor (construction price falling since 1980s)
 -Case-Shiller index study in 1988: "hottest market" L.A.; "deadest market" Milwaukee
   -80% L.A. people said they would be left out if they do not buy now
 -1880s L.A. housing bubble
 -"what is the best investment?" question: 'stock market' grew until 1999; 'real estate' grew until 2003 in L.A, still growing in Milwaukee
 -LTV is up close to 100%; mortage-to-total debt ratio is also up


Lecture 13 - Banking: Successes and Failures

-options compensation -> strange price-jumps after issuances
 -timing of good news after issuing out-of-the-money options (which brings them to in-the-money, but without the tax liability)
 -options backdating (Eric Lie)
 -Andrew Redleaf went out and figured out who will be impacted by this, and shorted their stock --> this is an example of market inefficiency
-Redleaf bought GM bonds at a discount because of fears of default, and then made a plea to cut the dividend -> bond prices went up
-goldsmith bankers with a safe for gold --> fractional reserves
 -notes written ("promise to give so many gold coins")
 -bearer notes ("I will pay to the bearer so much gold") -> the bearer could be anyone -> paper money
-commercial bank: accepts deposits, makes loans -> profit: the difference in interest on deposits & loans
 -traditionally dealing with wealthy people/businesses
-thrifts:
 -savings banks (early 19th century philantropic movement to set up small-deposit safety banks in UK)
 -Saving & Loan Association (from UK Building Society movement: set up for small savers to be able to afford a house; ie. pool the money and loan it for mortgages)
 -credit unions (a club of people: deposits/loans to/from members; ie. not open to the whole public)
-investment bank: underwriter for securities (no deposits/loans)
-US assets: (2003Q3)
 -commercial banks: $10.8T of which 20% foreign; $7.987T domestic banks' assets
 -savings banks + savings & loan: $1.868T
 -credit unions: $748B
-number of companies: (1998)
 -credit unions: 11000
 -commercial banks: 9000
 -savings banks + savings & loan: 1500
-fundamental reasons for the existence of banks: (problems solved)
 -adverse selection: if you don't watch out and don't know who's trustworthy, you'll end up with the bad loans -> relationship banking: an ongoing relationship with the business community (bankers play golf a lot, to connect with local businessmen; you should be generally available)
 -moral hazard in lending: lenders have an obligation in fixed dollars -> incentive to do a big gamble type venture (since the creditors will end up bearing the losses if something goes bad)
 -liquidity: banks lend long, and borrow short term (using fractional reserves, ie. depositors will not come on the same day)
-banking is bigger in less developed countries, since they have less developed securities customs & regulations, so it is central to funding businesses
-rating agencies:
 -John Moody (1909): first rating agency in the world -> Moody's gave letter-grades to securities (AAA, AA, A, BA, ...)
 -Henry Poor (1916) --> Poor's rating agency (later merged with Standard Statistics -> Standard & Poor's)
 -Fitch (smaller)
 -scandal of AAA ratings on subprime securities
  -after Moody's death in the 1950s, the agencies started accepting fees
-fractional reserves:
 -bank failures occur when there is not enough gold to give out
 -Basel accord (1988): recommended risk-based capital requirements to regulators around the world (panic can create a run on the banks) -> US adopted in 1989
  -tier 1 capital: stock holders equity + preferred stock
  -tier 2 capital
  -4 credit risk categories -> a formula requiring how much tier 1/2 capital to hold in each category
 -Basel II: tries to deal better with the complexity -> comes full in force in US in 2009, but subprime crisis already showing its inadequacy
-S&L crisis (1980s US; Reagan): savings & loan associations making bad loans
 -Depositary Institution Deregulation and Monetary Control Act (1980): eliminated ceiliings on interest rates (high-yield deposits possible)
 -Federal Savings & Loan Insurance Corporation (FSLIC; like FDIC; now defunct because of this crisis): didn't reign in the irresponsibly lending banks
 -$150B federal cost
-Mexican crisis (1994)
 -President Salinas privatized banks, who went on a lending spree: loans grew from 10% (1988) of GDP to 40% (1994)
 -government deregulating, but not watching
 -almost all foreign banks now taken over by foreign banks
-Asian crisis (1997-98)
-Argentine crisis (2000-02)
-subprime crisis
 -shadow banking system (act like banks, but not techincally banks, so escape regulation eg. Basel II.)
   -instead of loans, they issue ABS (asset-backed securities), particularly CP (commercial paper; short term obligations)
   -invest long term in sub-prime loans
   -SIV (Structured Investment Vehicle): companies without employees, invests in assets and issues asset-backed commercial paper; sponsored by a bank (appears on its balance sheet, but not subject to regulation; but the bank promises to bail out the SIV in case of trouble)
   -run on asset-backed commercial paper
 -Northern Rock (building society in UK) -> bank run in September 2007 (first bank run in UK since 1866)
  -the US Fed system was a copy of the UK Central Bank, which was successful in bailing out failing banks to prevent bank runs
  -UK limit of 3000 GBP for deposit insurance, and 90% up to 75000 GBP
  -February 2008: British government nationalized Northern Rock
-IKB Deutche Industriebank AG (July 2007)
 -invested heavily in US subprime paper (thru Rhineland Investment Vehicle SIV) --> value collapsed --> bank insolvent
 -German goverment bailout
 -Sachsen LB also failed in Germany --> together 26B EUR bailout
-BNP Paribas (France) problems
-Bear Stearns
 -High Grade Structured Credit fund; Enhanced Leverage Fund collapsed


Lecture 14 - Guest Lecture by Andrew Redleaf

-market inefficiencies:
 -Shell shares in Netherlands & UK
 -discrepancy between closed-end funds' underlying assets' value & quote value
 -stubs: eg. 3Com owed Palm, and Palm's value exceeded 3Com's
 -bubbles: internet, housing, subprime lending
-challenges in beating the market:
 -individuals: limited access to information, limited expertise
 -institutions spend lot of money in information; have infrastructure
 -universal psychological challenges, biases
-unknown mix of randomness & skill -> hard to deal with it
 -really good poker players are not bothered to lose
 -attributing causality (A happened, then B happened, so it must be that A caused B)
 -anchoring (eg. giving distance of 2 unknown cities -> another 2 unknown cities will be estimated to be similarly distant)
 -outside motivations interfere with best-practices for making money in the market
-3 principles:
 -coupon-clippers (interested in cash flow; Redleaf, Buffett) vs. security resellers (interested in reselling at higher price; eg. venture capital, Cramer-style riding a craze)
 -risk is the worst thing that can happen (vs. typical Wall Street: what is the range of moderately probable outcomes?, value-at-risk/VaR; done because statisticians are good at this -> man-with-a-hammer syndrome)
 -you don't get paid for taking risk, but you get paid for eliminating risk (eg. tight-rope walker; pharma drug-development; insurance company; casino)
-coupon-clipping & risk mitigation, eg:
 -long a high-yield (15-16%) bond, short the equity
-current situation:
 -big American banks "not open for business", Japanese zombie banks
-invest (ie. not in cash) only when there is a compelling reason (eg. stocks look cheap based on P/10E, P/B)
 -the long-term good performance of equities is the United States' survivor bias (ie. it went from an agricultural to highly industrialized)
-fixed-income inherently more analyzable (specified coupon & maturity)
-bond indenture (bond agreement, eg. what counts as a default event)
 -they identified companies that probably backdated their stock options, because this causes delays in financial filings, which triggers the default clause of their bond, so the holder is entitled to par


Lecture 15 - Guest Lecture by Carl Icahn

-options expertise
-merger arbitrage (short stocks, long bonds)
-"management arbitrage": buy stock for cheap, then beef up poor management with active shareholder action
-anti-Darwinian management in corporate America
 -fraternity president guy, gets along with people, not too intelligent/no great ideas, likeable/politically astute, does not shake things up, non-threatening, progresses well in the corporate ladder, CEO chooses him as substitute as he is a little dumber than him, eventually becomes CEO
 -corporate managements getting more and more moronic
-America giving too many IOUs, dollar devaluating
-http://www.kipling.org.uk/poems_if.htm     Kipling: If
-keeping grounded: if you're winning, it's not just you, but also luck (same if you're losing)
-Graham & Dodd philosophy; best if everybody else is wrong about the company (but hard psychologically)
-poor managements use "shark repellants" to repel activist investors (eg. they can sue them using company resources)
-Motorola: current activism


Lecture 16 - The Evolution and Perfection of Monetary Policy

-monetary policy is about setting interest rates
-goldsmith bankers issuing notes
-old notion of essence of banks: they print local paper money
-gold standard
 -first adopter was UK (1717); US adopted in 1900
 -now completely gone
 -shilling (silver based); guinea (=12 shillings; gold based) --> but the silver-gold ratio shifted --> government then set the exchange rate at 12; eventually they abandoned the shilling completely
 -Bank of England (1694): world's first central bank; started out as just a powerful bank, without monopoly on note issuance
  -over time, demanded that smaller banks keep a deposit with the BoE (or otherwise BoE would buy up the local notes and induce a run on it)
  -became banker's bank & regulator of them & loaner to them -> BoE was source of stability
  -private banks issuing notes -> potential for failure with fractional reserves -> BoE demanding adequate reserves
-US Federal Reserve System (1913)
 -series of US banking crises: 1797, 1819, 1837, 1857, 1873, 1893, 1907
 -Suffolk Bank (in Massachussetts) created the Suffolk System (1819-1860) --> Suffolk Bank was the BoE for MA
 -lots of banks' paper moneys; no cash register, but cash box & bank note reporter magazine (to compute a discount on another state's risky money)
 -First Bank of United States (1791; 20 year charter); Second Bank of United States (1816; 20 year charter)
 -National Banking System (1863): a list of banks instead of a single central bank, who would help bail out failing banks
 -federal distribution of power: 12 regional federal reserve banks
  -privately owned by "member banks" in the region, who get dividends, choose directors, etc.
  -member banks keep reserves and can borrow from their regional banks
 -much more independent than central banks in other countries
 -supposed to maintain the convertibility to gold --> price of gold constant while on gold standard
  -1931: UK dropped convertibility of pound sterling to gold (US: 1933)
  -to keep currency convertible, they had to keep interest rates high -> bad for the economy during the depression
-new role of central banks: managing money stock to stabilize the economy
 -Fed System still holds $11B of gold
 -Fed banks now managing inflation (on gold standard: 0 inflation with regard to gold)
-Bank of Japan (1882, imitating BoE)
-European Central Bank (1998, issues Euro): replaced central banks of member countries (they still exist, but they don't manage a currency)
-central banks guard the money stock
 -goverment needs resources, especially during war, so they would raid the central bank (ie. demanding that they print new money and lend it to them)
 -independence of US Fed system --> central bank can refuse to print money
 -independence a tendency: BoJ and BoE (independent since 1997); lengthy terms of office for central bank leaders
-Federal Reserve Board: board members have 14 year terms
 -centralized money issuance: Federal Reserve notes (1913)
-FOMC (Federal Open Market Committe): makes monetary policy
 -meets every 6 weeks, setting interest rates & reserve requirements
 -smaller banks have lower requirements (ie. progressive) -> for large banks: 10% on demand deposits
 -Federal Funds Rate (overnight lending rate between banks) -> primary policy tool
  -announces it publicly since 1994
  -Fed targets this rate, and attempts to hit by buying & selling Treasuries/goverment bonds
   -eg. Fed buys short term government bonds -> pushes up the price -> pushes yield down -> funds rate down
 -discount rate: rate that Fed charges on loans to member banks (when they are in trouble)
  -since Jan 2003:
    -primary (funds rate + 1%) & secondary rates; (before: typically 0.5% below the Fed funds rate; new rates higher to avoid stigma of borrowing from Fed, which was an admission that the bank is in trouble)
-inflation preferred around 2%
-stagflation (1970s term): high inflation + high unemployment
-Term Auction Facility (TAF; Dec 12, 2007, Ben Bernanke)
 -in cooperation with Bank of Canada, Bank of England, European Central Bank (ECB), Swiss Central Bank
 -new monetary policy tool to help troubled financial institutions
 -certain amount of money auctioned as loans to banks, for which collateral (eg. mortgage-backed securities) must be supplied by banks
-Term Securities Loan Facility (TSLF; March 11, 2008): auctions of loans of Treasury securities with mortgage-backed securities collateral
 -also joint effort with the same international banks
-Primary Dealers Credit Facilty (PDCF; March 16, 2008)
 -extension of discount window beyond member banks
 -broker dealers: when the Treasury sells Treasury bills/notes/bonds, it deals only with these companies
-biggest recession since the Great Depression: 1980 & 1981-82 worldwide recession
 -1960s & 70s: central banks around the world were inflating the currency (eg. currency in UK inflated by 20%)
 -central banks around the world raised interest rates to kill inflation (Paul Volcker in US)
 -view that the inflation was caused by lax monetary policy, and then new tough policy killed inflation, but created a recession
-1990-91 recession:
 -oil spice spike (war against Hussein)
 -Fed came in late to cut interest rates
-2001 recession:
 -caused by end of stock market boom
 -Fed cut interest rates again in 2001
-2008 recession:
 -consumer confidence index (Conference Board); housing price collapse


Lecture 17 - Investment Banking and Secondary Markets

-current Treasury-proposal (Henry Paulson & David Nason; Treasury Blueprint)
 -objectives-based regulation: 3 parts
  -market-stability regulator: the Fed
  -prudential financial regulator: protect US interests in institutions guaranteed by the government
  -business conduct regulator: aimed at consumer protection
 -archaic, incidental institutions:
  -Office of the Comptroller of the Currency (OCC; 1863; founded to supervise national banks only)
  -Office of Thrift Supervision (OTS; regulates savings banks)
 -OCC + OTS merger
 -SEC (Securities and Exchange Commission) + CFTC (Commodity Futures Trading Commission) merger
 -central bank: a banks' bank --> they want to make the Fed a bank for the whole financial institution (eg. TSLF, PDCF already going in this direction; lending to non-banks was not done since the Great Depression)
-$52T CDS outstanding

-Shiller's MacroMarkets company is an investment bank
-investment banking: the underwriting of securities (arranging for the issuance of stocks and bonds by other companies)
 -not a depository institution
 -not a broker-dealer (not dealing in securities)
 -their customers are companies
 -eg. if Ford wants to issue new shares or bonds
-Glass-Steagall Act (1933): investment banks cannot be combined with insurance or depository institution (can only be one or the other)
 -eg. JP Morgan became a commercial bank, and stopped their investment banking business --> that became Morgan Stanley (an investment bank)
 -outside the US there was no such restriction
 -repealed in Gram-Leach-Blilley Act of 1999
  -Travelers Insurance & Citigroup merger (1998)
  -JP Morgan & Chace merger (2000)
  -UBS & Paine Webber merger (2000)
  -Credit Suisse & Donaldson, Lufkin & Jenrette merger (2000)
-Bear Stearns (1923-2008): investment banking, private equity, private banking
 -June 2007: two subprime funds collapsed -> $3.2B loss
 -rumors started that they are in trouble -> they couldn't pay their bills, couldn't sell their assets
 -Fed bailout: line of credit to JP Morgan to buy Bear Stearns
  -the Fed took troubled securities as collateral for a $29B loan to JPM
  -$2/share (=$200M market cap)
-Lehman Brothers is also rumored to be in trouble (-> they now raised capital)
-UBS (Union Bank of Switzerland: created in a merger around 1900, between 2 banks)
-underwriting:
 -it is the reputations of the underwriters that enables issuers to issue new securities
 -in commercial banking: moral hazard (the company takes the loan and runs) & asymetric information (you know less than insiders) problems --> banker who plays golf with all the business people in the community and tries to find out what's really happening with the businesses
 -here also: moral hazard & asymetric information --> i-banks are matchmakers between security issuers and the public
 -image of sober responsibility and good citizenship (they thrive on their reputation) --> well-dressed, patrician in manners, go to the Symphony on saturday night, sponsors for cultural events, etc.
   -vs. traders: vulgar accents, shout on the phone, roll up their sleeve, dribble food on their shirt, etc. :)
-deals:
 -bought deal: the i-bank buys the shares for a price, takes the risk, and then sells to the public
 -best efforts deal: the i-bank doesn't buy the shares
-underwriting process formalized & regulated by the SEC
 -register the securities with the SEC: pre-filing period (no talk to the public about the shares)
  -i-bank forms a syndicate of underwriters (since 1 i-bank is not big enough to handle an issue, and you need a broad network of distribution of the new securities) --> lead underwriter is the original i-bank that the company approached
 -cooling-off period: preliminary prospectus ("red herring") filed with the SEC --> it goes up on SEC website + circulation with potential buyers (but they can't have a separate brochure, which would be a sales job)
  -tombstone: announcement of the securities in a newspaper (regulated wording)
 -SEC approval --> becomes effective
 -eg. IPO: company is not known --> underwriters try to make interest in it
-i-banks similar to impressario (manager of eg. a singer): concern with reputation, sold-out performance
 -price movement of an IPO very volatile --> peculiar practices
  -eg. underpriced IPOs --> they are over-subscribed --> reputation of the underwriter grows
 -i-banking is a reputation business


Lecture 18 - Professional Money Managers and Their Influence

-Where are the Customer's Yachts? (1940s) book
-financial advisors: gives advice about investment for a fee
 -excludes: lawyers, bankers, insurance salesman, reporters, professors, broker-dealers
 -includes: analysts
 -National Securities Market Improvement Act of 1996
 -<25M under management: must register with state regulator; >30M: must register with SEC; in-between: choose
 -FINRA (Financial Institutions Regulatory Authority); formerly: NASD (National Association of Securities Dealers)
  -is an SRO (Self-Regulatory Organization)
  -Series 65 or 66 exam
  -churning can get your license revoked
-financial planners
 -Financial Planning Association (FPA)
  -certifies CFP (Certified Financial Planner)
  -become financial advisor first
  -more than a broker; plans for your life
 -National Association of Personal Financial Advisors (NAPFA)
 -don't make money from commissions, only an hourly fee
-institutional investors
 -fiduciaries; they pool money for people
 -(3 types of ownership: people & non-profits own themselves; businesses are owned by people; government)
 -balance sheet for households & non-profits (2007Q4): (B.100 in Flow of Funds Accounts: http://www.federalreserve.gov/releases/Z1/Current/accessible/b100.htm)
  Assets: real estate: $22.483T, pension funds: $12.779T, equity in non-corporate business (eg. barber, family store): $7.892T, corporate equities (stock): $5.447T, mutual funds (stocks & bonds via institutional investors): $5.082T, consumer durables (car, furniture): $4.035T, bonds: $2.730T, life insurance: $1.205T
 => total: $72.093T
  Liabilities: home mortgages: $10.509T, consumer credit (credit cards): $2.551T, loans & other: $1.315
 => total: $14.315T
  Net worth: $57.718T (~$192k/person, but unequally held)
 -mutual funds: a structure of an investment company for the general public
  -owned by the investors in it; everyone benefits in an equal way
  -first mutual fund: MIT (Massachusetts Investors Trust, 1920s)
   -1920s mutual funds: classes of shareholders (some treated better than other); fund run for the benefit of founders, not for the people who put money in
   -MIT stood out as an "honest" fund: published portfolio, only 1 class of investors
  -Investment Company Act of 1940: defines structures used by mutual funds
  -if you withdraw money, they would calculate your worth at 4PM
  -ICI (Investment Company Institute) --> their own SRO
-mutual fund scandals:
 -late trading: abusive trading after 4PM
 -market timing: some people trading at 4PM prices after it
-exchange traded fund (ETF)
 -American Stock Exchange (AMEX), 1993
 -likely <$1T total
 -unlike mutual funds, traded on stock exchange (ie. no fund manager to call when you want your money)
 -first one: SPDR, Standard & Poors Depositary Receipt (=S&P 500; "spiders")
 -creation units: institutional investors can create & redeem them (eg. "I want to create $1M new SPDRs" --> they exchange gives them X new creation units, in exchange for the underlying stocks)
 -price tracks underlying stocks ("tracks well")
 -in contrast: closed-end funds (has some premium/discount to NAV, "tracks poorly")
-trust
 -often a department of a bank, managing money on behalf of an individual or family
 -eg. spendthrift trust: pays an income for life & beyond (prevents you from squandering the money, betting in the casino); you can't get the money out, your divorce can't take it away
 -manager is a fiduciary, who is supposed to be managing the fund on your behalf
 -trustee has well-defined rights (eg. if trustee goes bankrupt, they can't take the money away)
-pension funds ($12T, but doesn't include Social Security): invest on behalf of people for their retirement
 -Social Security (1935 by Congress, to care for old & orphaned)
  -there is a Social Security Trust Fund, which is a government-managed pension fund (~$1T)
 -first US: American Express employees' corporate pension fund (1875) --> had to work there 20 yrs, be over 60 yrs old & disabled -> you get 50% of average pay for last 10 yrs worked --> designed for benefit of company (ie. retain employees)
 -first big company fund: Carnegie Steel pension plan (1901); but no actual money set aside (ie. they would pay from profits)
 -union pension fund for members: granite cutters & cigar makers (1905); locomotive engineers (1912) --> failures in 1929
 -company pension fund: what if company goes bankrupt? -> employee loses
 -General Motors pension fund (GM Pension, 1950; GM chairman Charles Wilson)
  -funded plan: investing on behalf of the pensioners, not in their own (GM) stock
 -Studebaker automaker's default (1963) --> they claimed to have funded a pension plan, but it was underfunded
  -United Autoworkers (UAW) union was asleep
  -ERISA (Employment Retirement Income Security Act, 1974) --> required adequate funding
   -prudent person rule (prudent man rule)
  -Pension Benefits Guaranty Corporation (PBGC) --> a GSE (like FDIC), that guarantees the pension plan (receives dues from pension plans)
   -companies in late 90s were putting their pension plans in risky stocks, but the PBGC didn't step in
 -O'Bar & Conley, anthropological techniques in observing pension fund managers --> pension fund managers living in a strange world of ERISA, where they have to behave as others would: always thinking of a lawsuit and shifting blame, not about supposed economic goals
  -creation myth ("where did it all start?")
 -defined benefit pension plan: the pension will pay you a certain amount (benefit is defined)
 -defined contribution pension plan: no promise of retirement income, you put in the money and hold a portfolio
  -1981: 401(k) plans (Section 401(k) is a paragraph in the IRS's internal revenue code) --> money held in trust for others not taxable; no tax deduction on contribution, just on withdrawal
  -unions (who preferred defined benefit) were declining, public liked it
  -people can choose the general categories of investment (from a selected list of mutual funds) --> more of an investment society


Lecture 19 - Brokerage, ECNs, etc.

-open markets do efficient price discovery
-2 types of people who trade securities:
 -broker: brokers act on behalf of others as a agents, for which they earn a commission (goes between two people who want to trade, and gets a fee)
 -dealer: dealers act for themselves as a principal, for a markup (buys & sells for himself, and has an inventory of securities; you sell/buy to/from him)
-you can't be a broker & dealer in the same transaction
-broker-dealer (BD): a firm that employs brokers & dealers
 -must register with the SEC; responsible for the employees, who have to be licensed
 -they manage employee's exams thru FINRA --> recognition of tendency for bad behavior (like churning)
-other examples: broker: real-estate agent; dealer: antique shop
-exchanges
 -rapid change because of information- & financial technology
 -no law says you must buy/sell on an exchange
 -4 markets (in US):
  -first market: NYSE (1792, New York Stock Exchange; founded under a buttonwood tree on the street)
  -second market: NASDAQ (1971, National Association of Securities Dealers Automatic Quotation System; 1st electronic) national market
  -third market: NASDAQ small cap
  -fourth market: large institutions trading among themselves
 -history: ancient Roman stock exchange; Antwerp; Amsterdam; London
 -New York Securities Law (1811) --> a model for securities law, 2 principles:
  -anybody can set up a corporation and have it traded on a stock exchange (ie. no act of Parliament/King's permission required)
  -limited liability set as standard (ie. investor can't be sued for misdoings of the company)
 -importance of information technology
  -around 1800: only a handful of stocks on the London exchange; feather-pen; paper was expensive (newspaper a single sheet; made out of cloth by hand)
  -19th century: cheap paper; carbon paper; typewriter (late 19th); printed forms (from 1700s in Holland); filing cabinets (1890s; before: tie documents with ribbons & store them on a bookshelf); telegraph (Samuel Morse, 1837); ticker machine (Thomas Edison's first invention, 1867; -> ticker tape parade)
 -Securities Act of 1975: National Market System --> to avoid people not getting the same price in different exchanges (a challenge to the monopoly of the NYSE)
  -ITS (Intermarket Trading System): allows a broker to look over all exchanges to find the best price
  -2006: all major exchanges proposed to replace ITS with "NMS Linkage" (ITS is a slow system for today)
 -ECNs (Electronic Communications Networks)
  -Instinet: one of the first ones; electronic bulletin board (popular among institutional traders)
  -"Island": order book public on the web
 -"Archipellago" --> NYSE ArcaEx after merger
  -late 1990s/early 2000s: merging with exchanges
  -ECNs have been merged & acquired
 -NYSE: largest stock exchange in US
  -still has a trading floor (most exchanges don't have one anymore)
  -each stock has a specialist at his post, and traders roam around to various posts
   -specialist is a dealer (with an inventory), but traders can just buy from each other --> a crowd develops at each post
   -specialist has a responsibility to preserve a good market (eg. buy when nobody else wants to)
   -specialist's book: records bid & ask prices in a big book, showing the list of orders outstanding
  -used to be: buy-sell crowd; loan crowd (a place on the floor where stocks are lent, not sold; they argued about the loan cost)
   -J. Edgar Hoover (head of FBI) didn't like shorting after 1929 --> New York Times didn't publish loan costs anymore & loan crowd disappeared
  -kinds of orders: market order (buy/sell X shares), limit order (buy/sell X shares at most/at least P price), stop loss order (buy/sell X shares when price goes above/below P price)
   -you would do a "buy stop" if you shorted the stock
   -these would be on the book of the broker
   -inside spread: the price difference on the orders at the top of the book on the buy & sell side
-what it means to operate as a dealer on an exchange:
 -dealer: trades every day; has an inventory of stocks --> chance of being ruined continuously
 -gamblers ruin problem:
  -market microstructure: (get $1 if win, lose $1 if lose)
   P(winning on a transaction)= p
   if S=0, you're ruined (S: the amount you have)
   chance of ruin: 100%; P(ruin from S) = ((1-p)/p)^S, if p>0.5
 -set bid-ask spread wide enough to counter the probability of ruin


Lecture 20 - Guest Lecture by Stephen Schwarzman

 http://en.wikipedia.org/wiki/Stephen_A._Schwarzman
-Blackstone Group (20% return on investors' equity)
 -private equity, real estate
-Yale undergrad, Harvard Business School
-Donaldson, Lufkin & Jenrette (DLJ)
 http://en.wikipedia.org/wiki/Donaldson,_Lufkin_&_Jenrette
-tried hands in public equity, but didn't like that you can't ask all the questions
-usual leverage: 25%
-20% of profits go to general partner (--> 31% return for the company)
-US Steel saved from Icahn takeover by Blackrock buying their railroad & barge assets, so that USX could do share-buybacks (1988-89; $600M deal, with only $20M put up --> 24x return in 12 years)
-1997-98: 2nd largest cell phone company in Argentina (currency indexed to dollar) bought for 8x cash-flow; they borrowed for long term in USD --> currency unpegged from dollar --> earnings in devalued Argentinean currency, but had to paid debt in USD...
-Celanese (2003) chemical company (HQ'ed in Germany, but most activities in US) --> moved HQ to the US, and leveraged up --> 6x return in 2 years
-hierarchy: managing director, vice president, associate, analyst (models & statistical work)
 -finance is an apprentice-business (like medieval guilds) --> you learn your business by apprenticing with somebody who's already done it


Lecture 21 - Forwards and Futures

-bothering concept of "smart money" who sets prices in EMH
-importance of personality traits, down-to-earth persistence in wanting to know why
-he thinks Swensen and Schwartzman are wrong when they are predicting that the turmoil will be over in 1 year

-futures has origins in agriculture; Chicago was 2nd largest city
-Chicago Mercantile Exchange + Chicago Board of Trade joined --> CME Group
-fundamental problem: agricultural commodities are harvested eg. once a year, but people need it the whole year --> need to store it
-futures started in Japan on the island of Dojima in Osaka prefecture in 1673
 -rice merchants selling in Dojima; storage warehouses
 -spot contract: buy & sell right now (eg. load rice into my wagons)
 -forward contract: arrange loading into my trucks which arrive in 1 month (contract to exchange between two parties at a certain time in the future, at a price that is set now)
 -central marketplace for forward contracts --> no need to visit warehouses to figure out a good price
  -noisy central exchange floor --> hand signals
  -standardized rice for delivery (normally there would be different types of rice, some with vermins, etc.; standard is the most common type of that rice, coffee, etc.) --> you can't deliver sub-par quality, and you wouldn't want to deliver above-quality
  -standardized delivery dates & standardized locations
  -trading hours --> burning fuse lit before the end of trading (now: closing bell)
  -the standardization sets up a liquid market
  -CME & CBOT still have trading floors & use hand signals, but it's getting increasingly electronic
-futures: you don't know the counterparty, since you're dealing with the exchange; vs. forward contract: you know the counterparty, and have to deal with them, trust that they will honor the contract, etc. (you have counterparty risk)
-futures markets by their natures are standardized/retail markets, they are liquid
-forward contracts: they can be anything you want, they are not liquid, you can't get out of it
-foreign exchange forward market --> forward contract for exchange of currencies (eg. exchange X amount of yen to dollar at a certain forward exchange rate on a future date)
 -forward interest parity: relation between forward exchange rate & spot exchange rate (if it doesn't hold, there is an arbitrage situation to make riskless money: you would invest your money where the interest rate is higher, and hedge exchange rate risk with a futures contract)
-forward rate agreements: promises interest rate on future loan
 -LIBOR (London Interbank Offer Rate)
-most people don't complete the futures contract & don't need to deliver to eg. Chicago (goal is just to hedge against eg. a drop in prices) --> buy it back before expiry
 -it is the threat of having to deliver that makes the futures price converge on the spot price
 -cross hedging: maybe you're not even raising the right kind of corn
 -purely financial transaction
-winter wheat: plant in winter, harvest in May
-fair value in futures contract:
 -losing interest on money invested and storage cost
 -if futures price is below spot price, I should just sell it all now
 -future price above spot price: contango
 -future price below spot price: backwardation
 -price of grain is normally a sawtooth pattern: depends on whether its in harvest or in storage (ie. harvest -> 100% in storage & price collapses -> depletion to 0%, price increases -> cycle repeats)
  -if there is no grain in storage, the futures price can be below fair value, since there is no arbitrage for lack of available grain
  -convenience yield: a negative storage cost --> if somebody really needs it, they won't sell it even if they have any
-basis: futures price minus spot price (spot premium: -basis)
 -people in the warehouse business compare the 'basis' vs. their costs all the time, to figure out if they should keep storing or sell
 -basis shrinks to 0 as you approach the expiration date of the contract


Lecture 22 - Stock Index, Oil and Other Futures Markets

-ticker tape machine (1867, Edison) --> electronic communication established liquid markets
-name "futures" misleading, because the price is today; most important is the standardization of terms
 -change in price is not because of change in terms of what is being delivered
 -sometimes spot price is further in the future than the futures price (because each contract has delivery, etc. terms)
 -price of oil
-margin requirement for each futures contract, to eliminate counterparty risk
 -exchange assumes the counterparty risk (stands between buyer & seller), but protects itself by the margin requirement (settled daily: they adjust it every day)
 -"buy wheat futures": you put up eg. 5% margin, and stand ready for your account to be credited or debited the change in the futures price every day
 -buyers & sellers both have to put up margin
 -what if price drops a lot?: buyer's margin account is wiped out --> margin call: he has to post more margin, or close out the trade
 -last day of the contract: delivery in commodities (deliver / take delivery of goods); settlement if in financial futures
-before 1970s: no financial futures
-~1980: stock index futures prices (Standard & Poor 500 Index futures traded at Chicago Mercantile Exchange)
 -S&P 500: value weighted index
 -it's like placing a bet on the stock market --> buy 1 contract: you get (or lose) the final stock index minus the original futures price * 250
 -fair value: F= (price index) + (price index)*(interest between now & expiration - dividend between now & expiration)  => essentially the same formula as for wheat, but the storage cost is negative (since you get the dividends by storing)
 -it would be very unusual to see backwardation (eg. if dividend yield > interest rate); at that moment they are about the same
 -bid-ask spread is the profit of the dealer (eg. antique dealer or stock market specialist) --> there is large volume in futures, faster than the S&P500 index or the stocks in the index; less fear of being ripped off by some very knowledgeable counterparty; low bid-ask spread
-http://www.cmegroup.com/trading/equity-index/us-index/sandp-500.html    S&P 500 Index futures
-oil futures (since early 1980s)
 -http://www.nymex.com/lsco_fut_cso.aspx    New York Mercantile Exchange (NYMEX), light sweet crude oil futures
 -sweet oil is better than sour oil (sweet crude = West Texas Intermediate)
 -physical delivery of 1000 barrels of oil in Cushing, OK
 -in backwardation at that time
 -the NYMEX price is what people quote as "current price"
 -where is the oil?
  -in the ground --> not considered, because it's not ready-to-go
  -US Government's strategic petroleum reserves --> not on the market
  -heating oil reserve (New York & New Haven, created by Clinton in 2000) --> not big (2M barrels)
  -there isn't much storage compared to flow-thru
  -taken out of ground --> tankers --> temporary storage at harbors --> oil trucks --> gas stations
  -price of oil refects temporary scarcities of oil --> futures prices often in backwardation
  -futures term structure
 -in 1990, futures only went out 18 months (not as developed)
 -first oil crisis (1973-74)
  -OPEC (Organization of Petroleum Exporting Countries, 1960)
 -second oil crisis (1979-80)
 -ownership of oil: used to be privately owned --> subsequent nationalization (1938, left-leaning government of Mexico)
  -1951: Iran nationalized
  -now supply is dwindling --> Mexico wants to privatize
-gold: very steady, simple contango market (it's always in storage, and there's no practical use of it)
-copper: industrial commodity that gets used up (like oil, can fall into backwardation)
-Federal funds rate futures (cash-settled, since you can't store the rate; can go into contango/backwardation easily): interpret as 100-x
-home price futures:
 -value of US single-family homes about 30% more than US stock market
 -1988 Case-Shiller working paper: they realized that there is not only no market, but no index for home prices
 -S&P 500: stocks don't go untraded for more than a few minutes/hours at a time; home prices have a large non-trading problem
 -they set up a company to make the indexes, but couldn't get exchanges to list them
 -goal: hedge risk (not speculation) --> sell your wheat (short position) in the futures market
 -May 2006: Chicago Mercantile Exchange, futures market for single-family homes
  -in backwardation since the first day


Lecture 23 - Options Markets

-option: owner of option contract has right to buy/sell something (stock) at a specified price & date
 -exercise price (strike)
 -exercise date
 -styles:
  -American style: exercise until (& including) a date
  -European style: only on the exercise date
 -rights:
  -put: right to sell 100 shares
  -call: right to buy 100 shares
 -parties:
  -buyer (the usual perspective): pays a price up-front to buy the option (!=exercise price)
  -writer: writes the option in hopes that it will not be exercised (just collects the price)
-The Great Mirror of Folly (1720) book (http://icf.som.yale.edu/GREAT_MIRROR/)
 -crash of 1720 (Paris, London, Amsterdam)
 -they had printed form option contract
-options exchange
 -traditional problem with options: it's a contract between two parties --> counterparty risk
 -1973, Chicago Board Options Exchange (first options exchange; spinoff of CBOT) --> central marketplace for standardized options
  -writer of a naked call has to put up margin (naked = you don't actually own the shares) --> margin requirement (to eliminate counterparty risk)
-options on futures (CME Group, which is a futures exchange)
-intrinsic value of option:
 -out-of-the-money (stock price < exercise price)
 -at-the-money (stock price = exercise price)
 -in-the-money (stock price > exercise price)
-you would never want to exercise an American call option early
-an at-the-money option is still worth something, because the stock price might move until expiration --> price
-an option can never be priced more than the stock price itself
-put-call parity relation
 -buy a call and short (write) a put == stock price, minus the exercise price
 -implication: we need just a theory for calls, and the put pricing you can calculate from that
-option price "shrinks onto" the intrinsic value line, as the exercise date approaches
-binomial option pricing (arbitrage theory for call option pricing):
 -assume a European option (there is 1 period to exercise date)
 -assume only 2 possible prices (up or down) in next period: S*u, or S*d
 -we want to form a riskless portfolio composed of the stock and call options on it
 S = current stock price
 u = 1+fraction of change in stock price if price goes up
 d = 1+fraction of change in stock price if price goes down
 r = risk-free interest rate
 C = current price of call option
 C_u= value of call next period if price is up
 C_d= value of call next period if price is down
 E = strike price of option
 H = hedge ratio, number of shares purchased per call sold
 -investor writes one call and buys H shares of underlying stock
 -if price goes up, will be worth u*H*S - C_u
 -if price goes down, worth d*H*S - C_d
 -for what H are these two the same?: H = (C_u - C_d) / ((u-d)*S)
 -Black-Scholes option pricing follows the same logic
-critical problem with Black-Scholes: what is the sigma (stock price variance) value?
 -strike price (S), price (P), time to expiration (T), interest rate (r) --> all known
 -the more variable the price, the more valuable the option
 -if the variance were 0, than an out-of-the-money option would just be worthless (since no chance to get in-the-money)
 -the variance is not constant thru time
-implied volatility: turn around, and calculate sigma from the actual option price in the market --> VIX

-options on home price futures (puts & calls for 10 US cities)
 -eg. 500k in a house (100k own capital, 400k mortgage) --> buy puts for a total of 450k in your own city --> if house prices fall, you will always have 50k equity at worst
-fire insurance ~= put options exercisable when house burns
-derivative:
 -financial contract that derives value from another
 -eg. options
 -derivatives are similar risk-management instruments as insurance


Lecture 24 - Making It Work for Real People: The Democratization of Finance

-corporations exist for the benefit of people
-democratization of finance: bringing it to the people (demos)
 -centuries-long trend
 -1780: President of Harvard's salary indexed to inflation
 -New Financial Order book
 -Subprime Solution book
-economic inequality
 -life insurance: helps alleviate inequality (for families who lost one parent)
 -health insurance: sickness would result in economic ruin for the person
 -disability insurance
-behavioral finance: people don't make optimal use of financial instruments (like insurance)
 -human factors (financial) engineering
-social insurance: government programs insuring people against risk
 -David Moss (Yale PhD): When All Else Fails book -> on history of risk management
  -much of what modern governments do is risk management
  -progressive income tax (AKA graduated income tax, Adam Smith: The Wealth of Nations, 1776)
   -first income tax: UK & Holland (end of 18th century)
   -US: 1860s experiment with income tax, but abandoned
   -1913: US income tax
    -above 90% in the top bracket after WWII
    -finances universal education, social services, public goods
   -Milton Friedman: Capitalism and Freedom (1963) --> idea of negative income tax on low income people -->"earned income tax credit" (EITC) exists today
   -concern of moral hazard will all government-based risk management schemes
   -welfare: a gift to someone who has no income --> encourages unemployment --> EITC avoids this, since the more income you have, the more you get it
   -EITC: US was the first; now copied
 -Social Security
  -original in Germany (Otto von Bismarck, 1883): Krankenversicherung --> mandatory government health insurance
  -1884: Unfallversicherung (mandatory workplace accident insurance, bought by employers)
  -1889: Altersversicherung (old age insurance)
  -Lloyd George (UK Prime Minister) traveled to Germany around the turn of the century; now copied everywhere
  -Gustav Schmoller, German economist
   -charity is whimsical & uneven --> these insurance solutions are a significant advance
  -US: Social Security (1935; copy of Altersversicherung)
   -copy of Krankenversicherung still doesn't exist
   -6.2% FICA taken out of paycheck + 6.2% paid by employer => 12.4% (with ~95k cutoff)
   -OASDI: Old Age, Survivors, Disability Insurance
    -Survivors (effectively life insurance) added in 1939
    -gives: pension (62/65+ old); support on parent's death; support if disabled
   -Aid to Families with Dependent Children (1935): welfare system, eg. for single mother getting aid for self & children
    -abolished in 1996 because of moral hazard: Welfare Reform Act
    -some welfare still exists, with life-time 5-year limit
    -no welfare to non-citizen immigrants
    -effectively replaced by EITC
 -bankruptcy & bailouts
  -temporarcy bankruptcy laws before 1898, during repeated financial crises
   -normally people would be sent to debtor's prison
   -1841: "Fresh Start" after bankruptcy
  -1898: landmark permanent bankruptcy law
  -1978: easier to declare bakruptcy --> bankruptcy a commonly used large-risk management tool
   -1M+ personal bankruptcies/year (more than divorces)
  -2005: reverses some of 1978 bill
  -3 main types of bankruptcies:
   -Chapter 7: liquidation form --> all assets divided to creditors, then get a fresh start
    -1978 bill: you can do this every 6 years; 2005 bill: every 8 years
    -2005 law: you can only do personal bakruptcy on Chapter 7, if personal income below median of your state
   -Chapter 11: reorganization form (for companies)
    -idea is to keep the company in business, and temporarily hold off the creditors, to avoid a disorderly dissolution of the business
   -Chapter 13: individual bakruptcy --> bakruptcy court makes adjustments and a plan to pay off debts
    -now: court can't adjust mortgage
  -informal bankruptcy: people in debt just stop answering the phone
   -bakruptcy is for people with foresight: stop paying the bills, save $1000 and use the money to hire a lawyer & declare Chapter 13 bakruptcy
   -creditors can appeal to state court to garnish your salary, and the employer is given a state order to take money out of the paycheck to pay off debts
  -current Chris Dodd-Barney Frank bailout bill to help people who can't pay their mortgages (without declaring bankruptcy)
   -enable Federal Housing Administration (FHA) to do a workout of the mortgage, and then give FHA guarantee to loans
   -a one-time workout
  -continuous workout mortgage (from Subprime Solution): payments automatically adjust for changes in home prices & incomes
-thought about finance
 -you take a job to do some task that someone needs done --> how does it fit in the big picture?
 -Peter Unger: Living High and Letting Die (1996)
  -first page has www.unicef.org (United Nations Children's Fund): who will put down the book to send a donation?
  -dismisses casual justifications: eg. futility (it doesn't help anyway), difficulty of being a truly moral person
 -Bill Gates' foundation ($38.7B)
 -Muhammad Yunus (Vanderbilt PhD in Economics, 1969; Asst. Prof. at Middle Tennessee State U): Grameen Bank (1976) in Bangladesh
  -microfinance: small loans (eg. to buy a food-cart)
  -Nobel Peace Prize

Lecture 25 - Okun Lecture: Learning from and Responding to Financial Crisis, Part I (Guest Lecture by Lawrence Summers)

-Summers quote:
 -"You might as well work on big problems, because it takes just as much time to write a paper on a little problem, as on a big problem."
http://fraser.stlouisfed.org/publications/BusConD/    Business Conditions (Cycles) Digest
http://www.brookings.edu/press/journals.aspx    Brookings Institution publications
http://en.wikipedia.org/wiki/Brookings_Institution
http://en.wikipedia.org/wiki/Arthur_Melvin_Okun
http://en.wikipedia.org/wiki/Okun%27s_law
http://en.wikipedia.org/wiki/James_Tobin
-Okun gaps exist and are large, and more important relative to microeconomics
 -underemployment and output gap
 -inflation and output
-what you gain in the booms, you lose in the recessions (if output gaps or unexpected inflations average to 0)
 -cyclical fluctuations in macroeconomics
-Keynesian discussion on Phillips-curve: skeptical of economic policy to have positive effect
-Okun: how can inflation be brought down w/o a large output gap?
-prevalent view: downturns caused by monetary policy (byproduct of disinflation) (3 Eisenhower recessions, 1966-67, 1969-70, 1974-75, 1980-82) vs. financial crash related recessions (1907, 1929, 1990-92, 2001, 2008)
-global financial crisis experiences: Japan (crisis followed by '90s depression), Nordic countries (early 1990s)
-US related financial cirses: 1987 (stock market crash), 1990 (savings & loans/real estate), 1995 (Mexico), 1997 (Asian financial crisis), 1998 (LTCM/Russia), 2001 (tech bubble bursting, Nasdaq/Enron/high yield sector problems), 2007 (mortgages/credit)
-previously: rare financial crises, business cycles cause by Fed's concerns of inflation; new era: the opposite
-the achievement of disinflation (the success of the previous era of Volcker) leads to unchecked expansion, terminating in a financial crisis and economic downturn
 -a byproduct of achieving low inflation
 -the response to financial crises needs more attention, than traditionally
 -better management or prevention of financial crises could lead to a smoother running economy, and thus a higher average output over time
-each crisis has different details in how the story played out, but there is a common structure
 -bank takes deposits that it lends to higher-rate-of-return, long-term, illiquid (no market for half-finished) projects -> subject to multiple Nash-equilibria:
  -everyone remains the bank will remain healthy --> depositors paid back, projects are completed, bank shareholders happy
  -everyone taking their money out --> you are advised to take the money out too
  http://en.wikipedia.org/wiki/Diamond-Dybvig_model    bank run model
  -bank can stay solvent or become insolvent, depending on expectations, and expectations of others' expectations (~newspaper beauty contest)
   -building with most solidly built facade in a town: a bank (particulary before existence deposit insurance) -> projecting credibility and permanence
  -possibilities exist, some of which are clearly better for everyone -> role for government (coordinator, guarantor)
 -why won't some profit-maximizing actor come in to buy half-finished projects (and making depositors whole)? -> a possibility of a solvency problem is needed for a liquidity problem
 -bailouts/support programs: coordinating around the more desirable equilibrium
 -some crises don't seem to involve bank runs (eg. 1987) --> but they do
  -good times: bank deposit of $1 worth $1
  -bad times: worth of claim on bank falls --> you will be eager to sell the claims back to the bank (ie. withdraw money)
  -Econ 101: supply & demand, markets as negative feedback cycle (eg. price falls -> supply decreases; price increases -> shortage)
   -if falling price leads to less demand or more supply --> normal intutions don't work if the demand curve is unusual --> similar to bank run
-if you have to call it "science" (eg. social sc.), it is not a science (Harary's law, http://en.wikipedia.org/wiki/Frank_Harary)
-summer of 1987: stock prices were high by any denominator measures --> two interpretations:
 -conventional: high demand for stock buying, which pushed  prices up; returns going forward will be lower (stock returns low b/c prices high) -> this seemed to be case, and ppl were expecting even higher returns than before
 -alternative: people who used to demand 8% returns, now are happy wiht 6% (so future returns were discounted at a lower level) (stock prices high b/c demanded returns low)
 -this was a first example of mechanisms that can cause positive feedback behaviors
  -eg. a weaker dollar is only possible by a falling dollar
  -eg. a rising stock price leads to a higher stock price
 -sources of positive feedback effects:
  -naive learning from recent experience
  -social contagion (bubble psychology)
  -agency and risk management (recently non-successful trades/activities/departments are eliminated, so there is a survivorship bias and overlearning)
  -margin calls, capital requirements, leverage (falling price -> more selling & liquidation; financial institutions with capital requirements)
  -Bayesian updating of priors (model uncertainty)
   -eg. buy option on yen, or yen itself? --> option: you increase your exposure as the price rises (positive feedback loop)
  -seeking to front-run trend followers
-positive serial correlation in the short run, mean-reversion in the long run --> suggest pervasiveneness of positive feedback behavior --> financial markets subject to substantial instability (updrafts/downdrafts) --> strong case for government action to contain financial crises
-macroeconomics of next generation will be more about finance
-social gains from preventing crises are significant; reducing average output gap --> producing more total output
-market efficiency is a bad basis for policy and a bad basis for realistic theory of financial crises
-bank run-like behavior by speculators in financial markets, who react perversely to price signals (from a traditional economist's viewpoint)
-these thoughts similar to Soros's reflexivity thoughts
-moral hazard: expectational effects of government action
 -moral hazard fundamentalism: since expectational effects of government action exist, government action cannot help --> he says this is not a valid reason for no govt action
 -moral hazard is not a reason not to have insurance
 -eg. placing of guardrails beside highways --> people drive faster  => should we not have guardrails?: welfare gain from guardrails is larger than the loss
 -if govt is loaning at a higer interest rate than its cost (ie. making a profit), then the cost of a bailout is reduced
  -eg. 1995 US loan to Mexico, +2% over Treasury's borrowing cost (market price would have been: +10%) --> is this a subsidy?: a) we profit 2%, b) we lose 8% compared to market loan rate, c) our result is between +2% and -8%, because the US govt is better at collecting from Mexico than eg. Citigroup --> difficult to evaluate
 -just because government intervention affects public sector behavior, is not a cause in itself that such action must be avoided
-investors generally overstate default risk -> buy riskier bonds and sell safer bonds, is a profitable strategy
 -the optimal number of accidents is not 0 (there are tradeoffs with the cost paid)

Lecture 26 - Okun Lecture: Learning from and Responding to Financial Crisis, Part II (Guest Lecture by Lawrence Summers)

[06/27/2009]
-disinflation recession: Fed tightening money, leftward movement of LM-curve
 -interest rates up -> output down
-financial system breakdown recessions
 -output goes down, Tobin's q down, short-term interest rates down -> looks like IS-shock
 -alternative formulation: on ISLM diagram; focus on output & required return on capital (or output & q) -> shock to price of capital at any interest rate
 -output down -> interest rates reduced
-IS curve vs. LM curve
-policy response:
 -disinflation recession: Fed steps on brake -> disinflation -> Fed allows short-term interest rates to decline -> economy expands
 -financial overextension recessions; two types:
  -recessions that didn't or barely happened (eg. 1987, 1998, 2001): decline in financial sector is of not much consequence, as a small part of the large economy
  -large losses in output (1929, 1990s Japan, emerging markets)
 -why two types?: financial intermediation capital is a substantial contibutor to the production process -> when suddenly destroyed, a shock to both aggregate supply & demand (-> Ben Bernanke's work)
 -eg. "telephone shock": for the next 6 months it will not be possible to make a phone call -> lost output without disinflation benefit (no glut of supply)
  -poor method to estimate damage: by market cap of phone companies, then value loss of these companies, then marginal propensity to consume
  -instead: production capability is impaired because of the loss of communication
-avoiding financial breakdown recessions has much social value (it's not true that what you gain here, you lose elsewhere, as thought relating to cyclical fluctuations)
-destruction of financial intermediation capital: reducing output capacity (Bernanke) -> making people poorer, reducing demand
 -when this can occur -> crisis relevant outside Manhattan, and policy action required
-managing & containing 3 vicious cycle mechanisms: (challenges for economic policy)
 -liquidation cycle (tendency for MBS to go into decline in value -> selling pressure -> further decline self-reinforcement)
 -credit accelerator cycle: deteriorating financial economy -> less lending -> deteriorating real economy -> less capability to pay back debt -> more financial damage -> ...
 -Keynesian mechanism: reduced spending -> reduced income -> reduced spending -> ...
-some numbers:
 -equity capital of leveraged US financial institutions: 2T --> supporting 20T asset holding (levered 10:1; Fannie Mae, Freddie Mac 30:1; bank with 8% capital requirement 12:1)
 -est. losses & projected losses: 1T (half are outside of the intermediation system, held by levered holders like pension funds) --> losses of capital to intermediation sector: 300B
 -offset: 150B capital raised (eg. Citigroup from Abu Dhabi)
 --> 150B capital at 10:1 leverage: 1.5T lost intermediation capacity (7.5% of 20T asset-holding)
 -if leverage reduced by 10% --> another 2T loss of lending capacity (on 20T asset-holding)
 -total 3.5T loss (15% of previous intermediation capacity)
-policy:
 -seek to maintain aggregate demand; monetary stimulus should not be the only tool in such a non-normal situation -> also provide timely (no lags) & spending-targeted (tax breaks for low-income ppl) fiscal stimulus
  -eg. capital-constrained lender (1B capital -> can lend 10B): if rates go down, lending capability does not change (a low interest will allow it to build up its capital over time); multiplier from monetary policy likely less than usual
  -Fed funds rate & LIBOR spread has risen; LIBOR rate reflects credit risk of counterparty in bank-to-bank lending; right indicator for policy is LIBOR -> there has actually been less easing than the Fed intended
  -side-effects of low interest rates: impact on dollar & commodity prices -> may contribute to inflation; setting the stage for future bubbles
-policy tools for maintaining financial stability:
 -new Fed facilities & ad-hoc actions --> signaling readiness to provide liquidity to financial institutions
  -he assigns 50+% risk to a cascading failures effect if Bear Stearns had not been contained (a major systemic risk)
 -infusion of new capital into financial institutions
  -externality: soundness judged on capital ratio
  -reducing leverage: shrinking balance sheet, or raising capital (dilutes shareholders, but debt-holders become more secure -> no private incentive) --> prudent regulators should secretly pressure financial institutions to raise more capital
 -capital situation of 30:1 levered GSEs: reduction in their capital requirement, to incentivize further mortgage lending
 -more direct intervention in markets:
  -Japanese experience: price-level keeping efforts of government just delay the inevitable
  -some MBS price a 50% foreclosure rate
  -support for MBS markets: actions of GSEs (+180B mortgage-purchasing power), support for Federal Home Loan banks
 -strategic intervention in foreclosure situations (writing down mortgages instead of foreclosure, which can cost 50% of value of home)
-global dynamic & policy coordination:
 -US & foreign aggregate demand falling
 -should stimulate aggregate demand
 -dollar depreciation vs. Euro, but not others (should be more balanced)
 -large liquidity managed by governments (pools of patient capital) could be put to good use
-regulatory changes:
 -causative forces are the same that are needed to get out (now: too much fear & too little greed)
 -stronger regulation
 -government should be paid for providing the safety net
 -regulating to avoid pro-cyclicality (shrinking the balance sheet is individually prudent, but collectively catastrophic in bad times)
 -slow, careful, deliberative regulation: forces to get out are opposite of what is needed in the long run to avoid such crises
-competitive regulation of banks ("dual banking system"): assures reasonable regulators, or rather a prescription for limited regulation
 -if you believe eg. in consumer regulation, they need their own regulator
 -central bank should have a major role in regulation of financial institutions
 -elimination of competitive regulation; separation of consumer protection; regulation of major financial institutions by a single entity (central bank)
-focus on leverage vs. focus on lending (more capital -> more lending w/o more leverage); capital ratio-setting doesn't distinguish
 -security that converts from debt to equity in bad times
 -punitive capital requirement (more than needed, for cushion) -> strong incentive to avoid it
-Japan: arbitrary accounting to mark up securities to "confidence-inducing" levels totally counterproductive