Chapter 1

The Investment Environment

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Real Assets Versus Financial Assets

Real Assets
Determine the productive capacity and
net income of the economy
Examples: Land, buildings, machines,
knowledge used to produce goods and
services
Financial Assets
Claims on real assets
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Real vs. Financial Assets 1

The material wealth of a society is
ultimately determined by the productive
capacity of its economy, that is, the goods
and services its members can create.
This capacity is a function of the real
assets of the economy: the land, buildings,
machines, and knowledge that can be
used to produce goods and services.
Text, page 2.
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Real vs Financial Assets 2

[F]inancial assetsare no more than
sheets of paper or, more likely, computer
entries, and they do not contribute directly
to the productive capacity of the
economy. Text page 2.
While real assets generate net income to
the economy, financial assets simply
define the allocation of income or wealth
among investors. Text, page 2.
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Real & Financial Assets: Household

Balance Sheets in USA
Real Assets: $24.8 trillion
Real estate $20.0 trillion
Financial Assets: $42.4 trillion
Deposits $7.8 trillion
Pension Reserves $10.7 trillion
Equity in noncorporate business $7.0 trillion
Equity in corporate business $6.3 trillion
Total Assets: $67.2 trillion
Liabilities: $14.1 trillion
Mortgages $10.7 trillion
Consumer credit $2.5 trillion
Net Worth: $53.1 trillion
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Real & Financial Assets: Domestic Net

Worth in USA

Nonresidential Real Estate:

Residential Real Estate:
Equipment and Software:
Inventories:
Consumer Durables:
TOTAL:

Prior table showed real HH assets as $24.8 trillion. This table shows
domestic total real assets as $39.1 trillion. This is in large part because real
assets held by firms (nonresidential real investment, equipment and
software, inventories) are included as financial assets in the HH balance
sheet, through the value of corporate equity and other stock market
investments (e.g. pensions).

$ 8.3 trillion
$20.0 trillion
$ 4.5 trillion
$ 1.7 trillion
$ 4.6 trillion
$39.1 trillion

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Financial Assets
Three types:
1. Fixed income or debt
2. Common stock or equity
3. Derivative securities

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Fixed Income
Payments fixed or determined by a
formula
Money market debt: short term, highly
marketable, usually low credit risk
Capital market debt: long term bonds,
can be safe or risky
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Common Stock and Derivatives

Common Stock is equity or ownership
in a corporation.
Payments to stockholders are not fixed,
but depend on the success of the firm

Derivatives
Value derives from prices of other
securities, such as stocks and bonds
Used to transfer risk

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Financial Markets and the Economy

Information Role: Capital flows to
companies with best prospects
Consumption Timing: Use securities
to store wealth and transfer
consumption to the future

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Financial Markets and the

Economy (Ctd.)
Allocation of Risk: Investors can select
securities consistent with their tastes
for risk
Separation of Ownership and
Management: With stability comes
agency problems
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Financial Markets and the

Economy (Ctd.)
Corporate Governance and Corporate Ethics
Accounting Scandals
Examples Enron, Rite Aid, HealthSouth
Auditors watchdogs of the firms
Analyst Scandals
Arthur Andersen
Sarbanes-Oxley Act
Tighten the rules of corporate
governance
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The Investment Process

Asset allocation
Choice among broad asset classes
Security selection
Choice of which securities to hold within
asset class
Security analysis to value securities and
determine investment attractiveness

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Markets are Competitive

Risk-Return Trade-Off
Efficient Markets
Active Management
Finding mispriced securities
Timing the market

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Markets are Competitive (Ctd.)

Passive Management
No attempt to find undervalued
securities
No attempt to time the market
Holding a highly diversified portfolio

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The Players
Business Firms net borrowers
Households net savers
Governments can be both borrowers
and savers

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The Players (Ctd.)

Financial Intermediaries: Pool and invest
funds
Investment Companies
Banks
Insurance companies
Credit unions

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Universal Bank Activities

Investment Banking

Underwrite new stock

and bond issues
Sell newly issued
securities to public in
the primary market
Investors trade
previously issued
securities among
themselves in the
secondary markets

Commercial Banking

Take deposits and

make loans

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Financial Crisis of 2008

Antecedents of the Crisis:
The Great Moderation: a time in which the
U.S. had a stable economy with low interest
rates and a tame business cycle with only
mild recessions
Historic boom in housing market

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Figure 1.3 The Case-Shiller Index of U.S.

Housing Prices

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Changes in Housing Finance

Old Way

New Way

Local thrift institution

made mortgage loans to
homeowners
Thrifts major asset: a
portfolio of long-term
mortgage loans
Thrifts main liability:
deposits
Originate to hold

Securitization: Fannie
Mae and Freddie Mac
bought mortgage loans
and bundled them into
large pools
Mortgage-backed
securities are tradable
claims against the
underlying mortgage pool
Originate to distribute
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Figure 1.4 Cash Flows in a Mortgage

Pass-Through Security

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Changes in Housing Finance

(Ctd.)
At first, Fannie Mae and Freddie Mac
securitized conforming mortgages, which
were lower risk and properly documented.
Later, private firms began securitizing
nonconforming subprime loans with
higher default risk.
Little due diligence
Placed higher default risk on investors
Greater use of ARMs and piggyback loans
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Mortgage Derivatives
Collateralized debt obligations (CDOs)
Mortgage pool divided into slices or tranches
to concentrate default risk
Senior tranches: Lower risk, highest rating
Junior tranches: High risk, low or junk rating

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Mortgage Derivatives
Problem: Ratings were wrong! Risk was
much higher than anticipated, even for the
senior tranches

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Why was Credit Risk

Underestimated?
No one expected the entire housing
market to collapse all at once
Geographic diversification did not
reduce risk as much as anticipated
Agency problems with rating agencies
Credit Default Swaps (CDS) did not
reduce risk as anticipated
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Credit Default Swap (CDS)

A CDS is an insurance contract against
the default of the borrower
Investors bought sub-prime loans and
used CDS to insure their safety

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Credit Default Swap (CDS)

Some big swap issuers did not have
enough capital to back their CDS when the
market collapsed.
Consequence: CDO insurance failed

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Rise of Systemic Risk

Systemic Risk: a potential breakdown of the
financial system in which problems in one
market spill over and disrupt others.
One default may set off a chain of further
defaults
Waves of selling may occur in a downward
spiral as asset prices drop
Potential contagion from institution to
institution, and from market to market
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Rise of Systemic Risk (Ctd.)

Banks had a mismatch between the
maturity and liquidity of their assets and
liabilities.
Liabilities were short and liquid
Assets were long and illiquid
Constant need to refinance the asset portfolio

Banks were very highly levered, giving

them almost no margin of safety.
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Rise of Systemic Risk (Ctd.)

Investors relied too much on credit
enhancement through structured
products like CDS
CDS traded mostly over the counter,
so less transparent, no posted margin
requirements
Opaque linkages between financial
instruments and institutions
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The Shoe Drops

2000-2006: Sharp increase in housing
prices caused many investors to believe
that continually rising home prices would
bail out poorly performing loans
2004: Interest rates began rising
2006: Home prices peaked
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The Shoe Drops

2007: Housing defaults and losses on
mortgage-backed securities surged
2007: Bear Stearns announces trouble at
its subprime mortgagerelated hedge
funds

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The Shoe Drops

2008: Troubled firms include Bear
Stearns, Fannie Mae, Freddie Mac, Merrill
Lynch, Lehman Brothers, and AIG
Money market breaks down
Credit markets freeze up
Federal bailout to stabilize financial system

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Systemic Risk and the Real Economy

Add liquidity to reduce insolvency risk and
break a vicious circle of valuation
risk/counterparty risk/liquidity risk
Increase transparency of structured
products like CDS contracts
Change incentives to discourage
excessive risk-taking and to reduce
agency problems at rating agencies
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