Man v. Markets by Hirsch

Ref: Hirsch (2012). Man v. Markets: Economics Explained (Plain and Simple). Harper Publishing.

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Summary­

  • A beginners guide to advanced stock market terms; securities, swaps, leverages, futures, and more.  

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Credit Rating

  • Three official Rating Agencies: Fitch Ratings, Moody's Investor Service, and Standard & Poors (S&P).

  • Rating Arbitrage: Companies that shop between the three agencies looking for the most favorable rating.

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---Trade Types---

 

Futures/Options

  • The futures and options market allow bankers and investors to profit from movements in the markets of commodities without actually having to own the product. Example:

a.     Clara: I want you to sell me a turkey future.

b.     Me: But I don't have a turkey, Clara!

c.      Clara: You don’t need one. All you need is a blank check.

d.     Me: I'm not giving you a blank check!

e.     Clara: No, silly. You're going to keep it- for now. Just make it out to me and sign it, then leave the dollar amount blank. Then put the check in an envelope, write "Turkey" on the front, and slip it in your desk drawer.

f.      Me: Okay, what's next?

g.     Clara: Next you write me a claim. Something like "This claim gives the bearer the right to receive the value of one 26lb turkey in return for the amount of $50, delivery and payment to be made at 8am on Thanksgiving Day.

h.     Me: Okay, but I still don't get it.

i.       Clara: Here's the thing. At 8am on Thanksgiving Day, I'm going to give you a 50 dollar bill, and you're gonna give me a turkey.

j.       Me: But I don't have a turkey.

k.      Clara: I know, silly. So you're going to give me the cash equivalent. You're going to open the envelope, call the store, and ask how much a 26lb turkey costs. Whatever number they clerk gives you, you write down on the check. Then you give the check to me.

l.       Me: Aha, now I get it.

Leveraging

  • Leveraging: a technique that magnifies an investment's return with borrowed money and options. Both gains and losses are magnified.

1.     Invest Money into an asset.

2.     Get the original investment money back.

3.     Keep control of the original asset.

4.     Move the money into a new asset.

5.     Get the investment money back.

6.     Repeat.

  • Leveraged Buyout (LBO): The purchase of a company using debt, or leverage.

  • Private Equity funds: Groups of investors pool cash (equity); then they go to the bank and borrow several times that initial amount (leverage); and then they acquire a target company (leveraged buyout-LBO). They then tweak the company with the aim of making it more profitable, so that they can sell it off in a few years for a profit. Pay back the loan and split the profits.

Swaps

  • Swap: Exchanging something unknown- whether it be an uncertain interest rate each month or a surprise dessert for lunch- for something defined, such as a fixed payment each month.

    • There is often someone who's prepared to take on risk- for a fee. The biggest players in the risk game have traditionally been the insurance companies. In effect, then, the insurance policies are swaps: a truck crash swap; a sunken boat swap; a destroyed house swap.

    • If I don't insure the truck, and I take the risk that'll have to pay $50,000 for a new vehicle if it's totaled. So I paid the insurance companies $100 per month to take that risk for me. That's my truck crash swap, where I swap the risk of the crash for a monthly payment.

1.     Bank CEO: You mean they might default?

2.     Loan Officer: Yes, Mr. Houston.

3.     Bank CEO: What can we do about it?

4.     Loan Officer: Well, we could do a credit default swap with F&S.

5.     Bank CEO: Really? I hate those guys.

6.     Loan Officer: Yes Sir, but they might be willing to take on the Loan risk in return for a monthly fee.

7.     Bank CEO: Spell it out for me, Jones. You know I don't understand that stuff.

8.     Loan Officer: We pay them $500 a month for the duration of the loan. If the company fails to make a payment and defaults on their loan, then F&S pays us the full amount, $500,000, and takes the loan off our hands.

9.     Bank CEO: What happens if the company doesn't default and pays back the loan to us?

10.  Loan Officer: Nothing. But either way, F&S keeps the fee money.

11.  Bank CEO: What? That's, like, $30k over 5 years!

12.  Loan Officer: Yes Sir, but $30k in insurance is better than $500k if the company defaults.

13.  In a CDS, when the borrower fails to pay interest, the seller of protection writes a check.

Securities

  • Securitization: Pooling of various debts such as mortgages, car loans, credit cards, and selling their cash flows (interest, mortgage, and loan payments) to investors as securities (aka mortgage-backed securities- MBS, pass through securities, collaterized debt obligations- CDOs).

1.     Bank Provides Money for Loan.

2.     Bank groups the debt (interest, mortgage, loan payments ) due in various loans and sells them as securities.

3.     Investors purchase securities in order to diversify.

4.     Banks make it easier to give out loans to continue selling securities.

  • In the past, banks were very cautious about who they would lend money. Securitization changed that allowing banks to offload every loan they made in the form of securities. The banks collected a fee for making the loan, and in some cases, another fee for arranging to collect the loan and loan interest payments. Securitization freed up billions of dollars that they could lend out without worry of default. 

  • Lenders realized that anything that generated cash flow or a steady stream of money each month could be securitized. Whether it was a mortgage, an aircraft lease, a student loan, or a book royalty payment, if it had cash flow, it was called an asset, which meant it could be turned into a so-called asset backed security (ABS).

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Banks

  • Banks make money by investing the money their customer’s deposit. They are required by law to keep  They needed to keep a certain amount of money on hand, but can lend the rest out for a steady rate of interest.

  • Most banks borrow money from depositors at one interest rate (the very low rate you receive on your checking and savings accounts), and lend the money out at a higher interest rate, pocketing the difference.

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Loans & Borrowing

  • Loan Definitions: Principal, the Term, maturity date, interest rate, and payment schedule.

  • Syndicated Loans: money comes not from one lender, but from a syndicate.

  • Covenants: Rules that require borrowers to hit certain averages.

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Real Estate

  • When you receive your home loan, it is guaranteed by the FHA. Home loans are generally sold to Fannie Mae on the secondary market (banks lose the interest payments but keep the loan processing fees).

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2008 Housing Market Collapse

  • 2008: USG Bailouts; As Ben Bernanke and Hank Paulson saw it, mortgages were at the root of the problem. Mortgages that irresponsible, avaricious lenders had made to unwitting or greedy people all over America; mortgages that were now worth nothing, because those borrowers couldn't make their interest payments; mortgages that had been bundled into CDOs, whose bonds were now worth next to nothing because so many of the mortgages in the bundles were worth nothing at all. Bad mortgages and their toxic CDO offspring were like a virus that was raging through the country, infecting every financial institution from the biggest banks in the nation to the smallest municipal pension funds. To Paulson and Bernanke, the only way to stop the infection was to cut it out immediately, and to make as many mortgages and CDOs off the banks balance sheet as possible. The bailout was proof that a number of banks had become so big that the government could not let them fail without threatening the entire financial system.

    • In the five years following the 2007 Financial Crisis. The Fed pumped $2.7 trillion of new money into the economy in two - rounds of quantitative easing, called QE1 and QE2.

  • 2007-2008: The Subprime Mortgage Market collapses forcing millions of foreclosures and the subsequent collapse of the securitization market as millions of Americans were unable to pay back loans, leading to Bank Failures.

    • Oct, 2008: The Troubled Asset Relief Program (TARP) is formed by the USG to buy toxic debt from banks in order to get them lending to companies and consumers again.

  • Early 2000’s: An unprecedented amount of debt was being lent to subprime borrowers, who opened credit card accounts, bought cars, boats, and, of course, houses in subprime mortgages.

  • 1990s: Banks doled out mortgages, car loans, and credit cards to unqualified people.

  • 1980s: Securitization allowed banks to offload every loan they made in the form of securities. The banks collected a fee for making the loan, and in some cases, another fee for arranging to collect the loan and loan interest payments. Securitization freed up billions of dollars that they could lend out without worry of default. 

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Misc

  • Bubble: Occurs simply when the price of something rises far higher than what the thing is really worth.

  • Gouging: Occurs when there is scarcity of goods, with lots of demand, and the seller takes advantage of the scarcity to jack up prices.

  • Subprime Borrowers: Borrowers who are least likely to stay current on their debts.

  • Subprime Mortgages: Mortgages without any form of collateral or proof of earnings.

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Chronology

  • 2008: The US Housing Market Collapse.

    • 14-15 Sep, 2008: Collapse of Lehman Brothers; fearing a moral hazard from other failing banks, Bernabke and Paulson decided against bailouts. Lehman filed for bankruptcy on 15 Sep, 2008.-Man v. Markets by Hirsch.

    • 14 Mar, 2008: Collapse of Bear Stearns who is subsequently purchased by JP Morgan Chase with $30B in bailout money loaned in collaboration between the Federal Reserve Chair Bernanke and Treasury Secretary Paulson.-Man v. Markets by Hirsch.

  • 1985: Marine Midland Bank creates the first securitization of car loans. A year later in 1986, Bank One creates the first securitization of credit card receivables. Soon after, banks were filling securitization vehicles with various forms of debt including loans made as part of LBOs, all of which allowed investors immediate diversification creating demand for securitization, pressuring the banks to make more loans, making it easier to get a loan.-Man v. Markets by Hirsch.

  • 1983: Collateralized Mortgage Obligations are created by Investment banks, Salomon Brothers and First Boston, as a new securitization scheme for Freddie Mac that offered a range of bonds based on a pool of private mortgages. Each class of bond had a different tenor and a different interest rate.-Man v. Markets by Hirsch.

  • 1970: The first mortgage-backed security is created, known as a pass-through, the interest and principal on all the loans in the pool were simply passed straight through to the bondholders (after the people running the trust were paid a fee, of course).-Man v. Markets by Hirsch.

  • 1933: The FDIC is formed in the USA to insure bank accounts, up to a certain amount.-Man v. Markets by Hirsch.

  • 1200's: Rise of Banks; The Knights Templar establish outposts all over Europe supporting the Crusades, granting crusaders and travelers certified papers in exchange for deposits; similar to a debit card.-Man v. Markets by Hirsch.

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