Q1 Property ownership & the bubble - a perfect obsession

In the UK, rocketing property prices were partly driven not only by the wide availability of lending, but by the buy-to-let market. Originally the preserve of professional developers, small scale investors with access to funds or loans were fuelled by stories of the great wealth to be derived from the simple buying and selling of property or buying and letting at high rental rates. However, the bubble was predicated on the easy availability of finance, and when that began to dry up and confidence in the property market began to evaporate, prices began to slide and many investors found themselves with housing assets worth less than the loans they had taken to purchase them.

The Subprime-lending crisis

The main problem occurred because of the lack of regulation and discipline which led to massive lending to the sub-prime mortgage market, e.g. granting mortgage loans to people with little ability to pay and poor credit records - NINJAS (“No income, no job, no assets”) Lenders, including subsidiaries of large financial institutions, developed various credit products (e.g. car loans, credit card facilities and mortgages) but at comparatively high rates of interest - frequently 60% higher than their average lending rate. These mortgages were typically offered at “teaser rates” to attract customers, but when the rates increased a substantial number of mortgagees could not afford the payments. Tens of thousands of mortgage holders began to default on their payments. The collapse of the sub-prime market led to the failure of a number of sub-prime lenders which in turn created immense pressures on the institutions which provided finance for those lenders.

Credit derivatives

The creation and growth of credit derivatives was largely unregulated there is often lack of transparency, specifically with respect to the underlying assets in credit derivatives. Many of the underlying assets were not fully understood, not properly valued-and have subsequently described as “toxic”

The crash in the housing market meant that the underlying assets, houses, were worth much less than the size of the loans. This led to a collapse in the values of toxic CDOs (Collateralized Debt Obligations). It is a type of derivative as it is derived from debt obligations. Debts are repackaged and traded on the secondary market. For example, a large financial institution may have made loans to several corporations. It then combines these loans packages, CDOs, and sells them to other investing institutions. The money received enables the bank to make further loans, repackage these, and sell them to raise more cash to make more loans, and so on. If any of the loans default then the bank is protected because the debt is now held by somebody else. As the bank does not lose out if any of the loans default, and because the market is not regulated, it becomes less disciplined in making further loans, and it can repackage them in CDOs and sell them on. When markets are buoyant, and the content of CDOs increasingly complex and unclear, it is difficult to give correct credit ratings to CDOs. Rating agencies were giving As instead of Bs, and Bs instead of Cs.

The packaging of sub-prime mortgages and credit card debts into bonds, (i.e. asset backed securities) were then traded on the global capital markets. Investors acquired these bonds, to a certain extent on the basis of the creditworthiness of the securitiser as well as on an evaluation of the reliability of the income flows of the underlying assets (credits cards, mortgages etc). However, part of the problem was that the valuation of risk was in part made by the international rating agencies who in the prevailing market conditions prior to 2007-2008 appeared to have no realistic concept of the effect of the collapse of confidence in major banking institutions. In effect, many of these securitised assets were overvalued, and by September 2008 had reached junk bond status.

As well as selling CDOs banks were also buying CDOs when they had excess liquidity. The whole financial system became interlinked and reliant on the credibility of CDOs, which were now so complex that hardly anyone understood how they could be valued. In fact, the values of underlying assets were becoming increasingly doubtful and many were later described as “toxic”. Banks then had to write down their assets, and rebuild their collateral (liquid assets). In order to preserve liquidity banks became unwilling to lend in the inter-bank market and this led to the “credit crunch”. Institutions that were overly dependent on the inter-bank market for their liquidity could not survive without state support, e.g. the Northern Rock in the UK was rescued by the Bank of England and taxpayers' money.

The Anglo-Saxon obsession with property ownership and trading in property results in the property bubble. The massive lending to the sub-prime mortgage market (to NINJAS) and excess liquidity triggered the later large number of defaults on loans, collapse of housing price and collapse of derivatives with houses as underlying assets. The collapse of the sub-prime market led to the failure of a number of sub-prime lenders which in turn created immense pressures on the institutions which provided finance for those lenders. Risky derivatives and other highly leveraged securities are one of the main reasons for the worldwide financial crisis. While exposures of financial institutions to over-priced and risky housing assets in the UK and USA is one of the roots of the problems in the international banking system in 2008-2009.

Q2

Q3

Q4

It is false, to protect asset and limit exposure to potential loss we should be purchasing an asset and subsequently buy a put option on that asset instead of selling a put option.

If we purchase an asset and sell a put option on the asset, when asset price decreases, the put option will further increase the loss of the investor in addition to the loss on the original asset.

Using options to hedge risks include hedging with protective puts

Protective put = long stock + long put

A protective put protects an investment by restricting the possible losses. That is, when asset prices decrease below the exercise price, the put option will be exercised. The loss on the asset will be offset by the gain on the put option and therefore limit the amount of possible loss to a certain amount. While when the share price is above the exercise price the protective put will gain a bit lower than buying shares alone by the amount of put option premium. This is the price for having limited loss when share price drops. Graphically

Q5

Financial market is an organizational framework within which financial instruments can be bought and sold. It exists to provide facilities for the purchase and sale of financial instruments.

Financial markets include long-term capital market, short-term money market, foreign exchange market, international capital market and derivatives market. In all these markets, participants include arbitrageur—who buys a security in one market and selling in another to take advantage of price differentials

Hedger—who purchases a financial instrument which will provide protection against fluctuation in interest or exchange rates (or in the price of securities)

Speculator—who takes an open position on a transaction. Although speculators drive volatility in markets, they also provide liquidity

It is worth noting that speculators are at work in all those markets while their exact roles are controversial. Speculators are agents that hope to make a profit by accepting risk. They hope to make money by taking an ‘open' position which means their assets are often not matched by a corresponding liability. It needs to be stressed that Speculators hope to make money because they think they have the expertise and wisdom to estimate the trend of the market and they think their estimation are right. If the markets develop in a way against them, speculators will incur substantial losses. This is especially the case in derivatives market. Speculating on interest rate using futures contract can involve large amount of gain or loss compared with the initial outlay. They enter the market in the first place with the aim of seeking higher return by accepting higher risk being aware (or not) that there might be substantial loss.

On the one hand, speculators can restore prices to equilibrium in market place; on the other hand, they increase volatility in the market place. One example of this is the roles speculators play in foreign exchange market. Private speculation can be stabilizing in that it is in the interests of speculators to move the exchange rate to its fundamental economic value. Speculators will attempt to buy the currency at a low value and sell it at a high value and in so doing reduce the gap between the low and high values. Since destabilizing speculation involves losses, there is every reason to suppose that private speculators will move the exchange rate towards its fundamental equilibrium value.

The ways speculation can be destabilizing which produce the ‘wrong' exchange rate include both ‘irrational' speculation and uncertainty. One example of ‘irrational' speculation is that foreign exchange market can be too risk-averse. There might be unjustified reluctance to move out of a strong currency and to hold a weak currency. Excessive risk-aversion unjustified by the fundamentals implies inefficiency of market and implies that part of the risk premium required is unjustified by the fundamentals. Another case of irrational speculation is the ‘bandwagon effect'. There is too much self-generated speculation detached from the fundamentals, ‘speculation feeding upon speculation' rather than the fundamentals.

The above two scenario presuppose speculators do not use all the information efficiently. In fact, even rational speculators can produce the ‘wrong' exchange rate. These explanations are all based upon the concept of exchange rate uncertainty. Speculators might not know the correct exchange rate model, and as such using a seriously defective model. There is also the ‘Peso problem'. Even if the speculators' model of the underlying fundamentals is correct, their perceptions about the future can prove to be seriously wrong. Another reason for rational speculation producing the wrong rate is known as ‘rational bubble'. It exists when holders of a currency realize that it is overvalued but they are nevertheless willing to hold it since they believe the appreciation will continue for a while longer and that there is only limited risk of a serious depreciation during a given holding period. Such speculation both prolongs an exchange overvaluation and aggravates the macroeconomic costs associated with it.

Speculator, arbitrageur and hedger participate in the market place; together they help ensure market efficiency to a certain degree through restoring equilibrium price levels. Hedgers enter the market to hedge risk while arbitrageurs seek to make riskless profits through zero investment. Speculators enter the market seeking profit by accepting risk. It can be said that speculators are a necessary and vital component of the financial marketplace, but at the same time we need to recognize that speculators also increase volatility in the market place which is discussed above.

Q6 the nature of financial intermediation

Traditionally the role of the intermediary is to act as a connecting point between investors and enterprises or borrowers and savers. In part this is due to the fact that the decision to invest is frequently taken separately form the decision to save. Intermediaries exist to:

i) Mediate between the different requirements of investors/savers and enterprises/borrowers - investors/savers tend to seek a short maturity/low risk/high return environment; enterprises/borrowers are seeking a long maturity/low cost environment. The intermediary facilitates the matching and smoothing process and the same applies to a general extent in the derivatives markets - whether exchange or OTC based.

ii) Meet transaction costs, which are a strong component in the pricing of futures, options and related products. The four basic types of transaction cost-search costs (finding a counter-party); verification costs (checking the accuracy of statements made by providers); monitoring costs (monitoring the progress of an instrument); enforcement costs (seeking recovery or part recovery of an investment in the event of default) are also generally applicable in derivative markets

iii) Deal with problems arising from asymmetric information. Asymmetric information relates to the situation where one party in a financial transaction holds more information than the other party. Often, the enterprise will have access to more information about the potential return and risks of an investment than an investor. This may result in adverse selection or moral hazard may occur. The role of the intermediary and of the market itself is to reduce the problems of asymmetric information by improving the level of information to all parties.

The process of intermediation will tend to result in:

Transformation of instruments - intermediaries can gain access to research and analytical data which allow them to improve the range of instruments offered to an investor

Reduction of transaction costs - economies of scale and expertise enable intermediaries to reduce the normal transaction costs, it therefore helps achieve market efficiency in the form of operational efficiency.

How recent crisis in the developed financial market affect banks' financial intermediation

Global markets and the globalised banking and financial service system have been seriously affected by the events of the last three years. So is financial intermediation by banks. Between January 2007 and January 2008 23 of the world's largest banks saw at least 90% of their market capitalization wiped out and major players such as RBS and Fortis were required to accept effective nationalization of their equity base to avoid financial collapse.

The classic model of banking intermediation, in which banks derived income from the depositor-lending interest rate spread, has changed significantly. Previously the classic concept of a bank had been a utility-type institution that assisted depositors in safeguarding their cash assets and deriving a degree of income from those assets. At the same time banks would employ depositors' assets in order to extend credit facilities to consumers and enterprises. During the 1980's and 1990's, driven by the pursuit of higher profitability, institutions seek to maximize shareholder and senior managers' interests. Data produced by the OECD showed a strong trend in those Western developed countries for non-interest income (as a share of all income) to rise overall from 25% in 1984 to 41% in 2003. In the UK, the figure rose from 36% to 46% in that period.

Increasing Complexity of financial instruments

Financial community focuses on complex financial products which by their very nature were not only inherently risky, but were little understood by those retailing them. These products ultimately failed to provide a return and at the same time the financial collapse which they triggered also destroyed the confidence of consumers in the system in general.

Leveraging on a massive scale

The investment and merchant banking operations of the large retail banks began a huge degree of leveraging, not only for clients but also on their own behalf. It was this exposure to leveraging (part financed by deposits) which could be seen as having a significant responsibility for the collapse of a number of major institutions during 2007-2008. These institutions appear to have shifted their role from such traditional areas as advisory services and underwriting classic securities issues into the operation of complex and highly technically intensive financial instruments.

The inherent, embedded conflict of interest

In general, many institutions became subject to a number of conflicting forces - the utility needs of depositors/borrowers, the profit motivation of shareholders and the bonus culture driving senior executives. Shareholder value not only drove banks into increasingly risky and non-prudential situations, but it also created a culture of assuming that risk/return was valued above servicing the needs and aspirations of bank depositors.

All in all, in the pursuit of ever larger profit and bonuses, the merging of traditional utility function and more profitable risky function, the use of ever more complex product to boost profit, the leveraging to a massive scale, the lack of prudence and risk-seeking, result in the recent financial crisis which saw the near collapse and nationalization of large banks by government using tax-payer's money.

It saw the loss of confidence in consumers in the banking system as a whole and run on banks (Northern Rock). Government needs to provide deposit insurance in order to restore consumer confidence.

It saw the ‘credit crunch' where liquidity dried up. Banks become reluctant to lend to each other or lend to businesses (especially small ones). Even if they do they require high interest rate which is a blow to many businesses which are already in distress in the current economic downturn. This is partly due to stricter regulation and capital adequacy requirements on banks and partly due to banks wishing to take on less risk as business might not be able to repay the loan or simply go bust which is more likely in the current economic climate. The less liquidity banks provide, the more difficult it is for business to survive and the more reluctant banks wish to lend, therefore economy enters into a vicious circle.

In a word, it saw a significant curb in the intermediation function by banks.

Q7

a) Net proceeds from the loan: $800m * (1-0.0175) = $786m

Coupon on the loan is six-month LIBOR plus 1.2%, LIBOR for the next six month is 4.7% therefore annual interest rate for the next six month is 1.2% plus 4.7% which is 5.9% (LIBOR + Margin)

Interest cost for the next six month will be $800m * (5.9%/2) = $23.6m

With coupon being reset on a six monthly basis, which will always be 1.2% above LIBOR, interest cost for each of the following six month period will be different if LIBOR changes.

The public utility will need to pay 2*7 =12 six-monthly coupon payments and at the end of year seven pay the principle of $800 million.

b) Proceeds the company can anticipate

Discount rate= 7.6% (annual on 360 day basis)

Discount rate 7.6%* (90/360) = 1.9% (90 days)

Price per $100 nominal = 100 * (1-0.019) = 98.1

Value of $120m (nominal) = $117.72m (proceeds of issue)

Effective rate of borrowing

(i) Convention based yield: relate the discount specific on an annual basis to the discounted value of the paper

d/(1-d*(N/360))= 0.076/(1-0.076*(90/360)) = 0.07747 = 7.747%

(ii) Bond equivalence

0 = -98.1+ 100/ (1+i) 90/360

I = (100/98.1) 360/90-1

= 0.07975 = 7.975%

Source: Essay UK - http://turkiyegoz.com/free-essays/finance/subprime-crisises-in-uk.php


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