CHAPTER 1

Overview of Financial
Management and the Financial
Environment

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1
 BUS 349: General Instructions

 Video on
 Presence throughout the class
 HW and Assignments submission through BB. NO EMAILs
 Groups for assignment. 4 students each
 No Recordings….Ravneet
 Quizzes and Final exam (BB or Google
 Text Book cover
 If quiz is through google form use your
ufv email Id.
 All correspondence with ufv id

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Brigham & Ehrhardt

Financial Management:
Theory and Practice 14e

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3
Topics in Chapter

1. Forms of business organization

2. Objective of the firm: Maximize wealth
3. Determinants of fundamental value
4. Capital Allocation Process
5. Cost of Money- Determinants
6. Financial securities, markets and institutions
7. Financial Crisis-2008 & Mortgage securitization

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Why is corporate finance
important to all managers?
 Corporate finance provides the skills managers need to:
 Identify and select the corporate strategies and
individual projects that add value to their firm.

 Forecast the funding requirements of their company,

and devise strategies for acquiring those funds.
 4 main decisions in corporate finance:
 Working Capital Decisions
 Capital Budgeting Decisions
 Financing Decisions
 Dividend Decision
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Topics in Chapter

1. Forms of business organization

2. Objective of the firm: Maximize wealth
3. Determinants of fundamental value
4. Capital Allocation Process
5. Cost of Money- Determinants
6. Financial securities, markets and institutions
7. Financial Crisis-2008 & Mortgage securitization

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Business Organization from Start-
up to a Major Corporation
 Sole proprietorship
 Partnership
 LLP (Limited Liability Partnership)
 Corporation

(More . .)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Starting as a Proprietorship
 Advantages:
 Ease of formation
 Subject to few regulations
 No corporate income taxes
 Disadvantages:
 Limited life
 Unlimited liability
 Difficult to raise capital to support growth

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Starting as or Growing into a
Partnership
 A partnership has roughly the same
advantages and disadvantages as a sole
proprietorship.

 LLP (Limited Liability Partnership)

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 LLP (Limited Liability Partnership)-is a partnership in which some or all partners have limited liabilities. Liability of the partner is limited to his agreed contribution. Further, no partner is liable on account of the independent or un-
authorized acts of other partners, thus allowing individual partners to be shielded from joint liability created by another partner’s wrongful acts or misconduct.

Characteristics:

I. Separate legal entity

II. No requirement of minimum capital

III. Minimum number of members:2; Max- no limit

IV. No requirement of compulsory audit: A limited liability partnership

is required to get the audit done only if:
the contributions of the LLP exceeds ₹ 25 lakhs or
the annual turnover of the LLP exceeds ₹ 40 lakhs
 In LLP risk of lenders, suppliers and customers increases.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
  (LLP) is a hybrid of partnership firm and corporation

Features of a corporate structure:

 Liability of partners is limited.
 One partner is not responsible or liable for another partner's misconduct or
negligence

Features of Partnership

 the partners have the flexibility to manage the business directly unlike the
shareholders of a company .

 Canada has permitted LLPs for lawyers and accountants. In British Columbia, the
Partnership Amendment Act, 2004 (Bill 35) permitted LLPs for lawyers and other
professionals as well as businesses

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Most Common Forms of Business Organizations

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Becoming a Corporation
 A corporation is a legal entity separate
from its owners and managers.
 File papers of incorporation with state.
 Charter
 Bylaws

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Advantages and Disadvantages of
a Corporation
 Advantages:
 Unlimited life
 Easy transfer of ownership
 Limited liability
 Ease of raising capital
 Disadvantages:
 Double taxation
 Cost of set-up and report filing

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Becoming a Public Corporation
and Growing Afterwards
 Initial Public Offering (IPO) of Stock
 Raises cash
 Allows founders and pre-IPO investors to
“harvest” some of their wealth
 Subsequent issues of debt and
equity(FPO)

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Agency Problems and Corporate
Governance
 Agency problem: managers may act in their own
interests and not on behalf of owners (stockholders)

 Corporate governance is the set of rules that control

a company’s behavior towards its directors,
managers, employees, shareholders, creditors,
customers, competitors, and community.Infosys_ Corporate gov
i.pdf

 Corporate governance can help control agency

problems.Yes Bank.pdf

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Topics in Chapter

1. Forms of business organization

2. Objective of the firm: Maximize wealth
3. Determinants of fundamental value
4. Capital Allocation Process
5. Cost of Money- Determinants
6. Financial securities, markets and institutions
7. Financial Crisis-2008 & Mortgage securitization

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 What should be management’s primary
objective?
 The primary objective should be
shareholder wealth maximization, which
translates to maximizing the fundamental
stock price.

 Should firms behave ethically? YES!

 Do firms have any responsibilities to society at
large? YES! Shareholders are also members of
society.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Is maximizing stock price good for society, employees,
and customers? Price based on
fundamental factors of a
firm as opposed to the
market price

 Maximize the Intrinsic Value of its stock

 Most individuals have stake in the stock
market.
 Consumers benefit
 Employees benefit

(Continued)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Topics in Chapter

1. Forms of business organization

2. Objective of the firm: Maximize wealth
3. Determinants of fundamental value
4. Capital Allocation Process
5. Cost of Money- Determinants
6. Financial securities, markets and institutions
7. Financial Crisis-2008 & Mortgage securitization

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 20
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 What determines a firm’s
fundamental, or intrinsic, value?

Intrinsic value is the sum of all the

future expected free cash flows when
converted into today’s dollars:
FCF1 FCF2 FCF∞
Value = + +…+
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

See “big picture” diagram on next slide.

(More . .)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Invest $100 after 1 year FCF =$ 110; r=?
r=10%

Invest = ?; to earn 10% if that project still generates $110

Invest = p=? =$100

Invest= PV of FCF that will come in future

PV is calculated at rate which is your required rate of return

If r =20%; then P or investment = $92

Value of any project or business = the PV of future receivables discounted at your

required rate of return

In a firm the value is found by discounting or dividing FCF by WACC =?

WACC is the rate of return expected/ required by firms investors i.e.

shareholders and debtholders

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Determinants of Intrinsic Value: The Big Picture
Sales revenues

− Operating costs and taxes

− Required investments in operating capital

Free cash flow

=
(FCF)

FCF1 FCF2 ... + FCF∞

Value = + +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted average
cost of capital
(WACC)

Market interest rates Cost of debt Firm’s debt/equity mix

Market risk aversion Cost of equity Firm’s business risk

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Free Cash Flows (FCF)
 Free cash flows are the cash flows that
are available (or free) for distribution to
all investors (stockholders and
creditors).
 FCF = sales revenues - operating costs
- operating taxes - required investments
in operating capital.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
What three aspects of cash flows
affect an investment’s value?
 Amount of expected cash flows (bigger
is better)
 Timing of the cash flow stream (sooner
is better)
Eg which has higher PV:
100, 200 or 200, 100
 Risk of the cash flows (less risk is
better)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
What is the weighted average
cost of capital (WACC)?
 WACC is the average rate of return required
by all of the company’s investors.
 WACC is affected by:
 Capital structure (the firm’s relative use of debt
and equity as sources of financing)
 Interest rates
 Risk of the firm
 Investors’ overall attitude toward risk

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 26
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Topics in Chapter

1. Forms of business organization

2. Objective of the firm: Maximize wealth
3. Determinants of fundamental value
4. Capital Allocation Process
5. Cost of Money- Determinants
6. Financial securities, markets and institutions
7. Financial Crisis-2008 & Mortgage securitization

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Who are the providers (savers)
and users (borrowers) of capital?
 Households: Net savers
 Non-financial corporations: Net users
(borrowers)
 Governments: U.S. governments are
net borrowers, some foreign
governments are net savers
 Financial corporations: Slightly net
borrowers, but almost breakeven

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 The Capital Allocation Process
1. Direct Transfer
Business’s Securities
Business Dollars Savers

2. Through Investment Bank

Business’s Securities Business’s Securities
Investment
Business Savers
Dollars Bank Sharda - IPO.pdf
Dollars

3. Through Financial Intermediary

Intermediary’s
Business’s Securities Securities
Financial
Business Savers
Dollars Intermediary Dollars

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Transfer of Capital from
Savers to Borrowers
 Direct transfer
 Example: A corporation issues commercial paper to an
insurance company.
 Through an investment banking house
 Example: In an IPO, seasoned equity offering, or debt
placement, company sells security to investment banking
house, which then sells security to investor.
 Through a financial intermediary
 Example: An individual deposits money in bank and gets
certificate of deposit, bank makes commercial loan to a
company (bank gets note from company).

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 30
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Topics in Chapter

1. Forms of business organization

2. Objective of the firm: Maximize wealth
3. Determinants of fundamental value
4. Capital Allocation Process
5. Cost of Money- Determinants
6. Financial securities, markets and institutions
7. Financial Crisis-2008 & Mortgage securitization

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 31
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Cost of Money(WACC)
 What do we call the price, or cost, of
debt capital?
 The interest rate
 What do we call the price, or cost, of
equity capital?
 Cost of equity = Required return =
dividend yield + capital gain

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
What four fundamental factors
affect the cost of money?
 Production opportunities
 Time preferences for consumption
 Risk
 Expected inflation

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 34
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
What economic conditions
affect the cost of money?
 Federal Reserve policies-OMO
https://indianexpress.com/article/business/banking-and-finance/bond-yield
-falls-under-6-per-cent-on-rbi-plan-to-buy-additional-g-secs-7303509/

 Budget deficits/surpluses
 Level of business activity (recession or boom)
 International trade deficits/surpluses

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
What international conditions
affect the cost of money?
 Country risk. Depends on the country’s
economic, political, and social environment.
 Exchange rate risk.
 Exchange rates affected by:
 International trade deficits/surpluses
 Relative inflation and interest rates
 Country risk

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
What two factors lead to exchange
rate fluctuations?
 Changes in relative inflation will lead to
changes in exchange rates.
 An increase in country risk will also
cause that country’s currency to fall.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Topics in Chapter

1. Forms of business organization

2. Objective of the firm: Maximize wealth
3. Determinants of fundamental value
4. Capital Allocation Process
5. Cost of Money- Determinants
6. Financial securities, markets and institutions
7. Financial Crisis-2008 & Mortgage securitization

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 38
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Financial Securities

Debt Equity Derivatives

Money •Options
•Futures
Market •T-Bills •Forward
•CPS
•CD’s contract

Capital • Common
Market •T-Bonds stock
•Municipals • Preferred stock
•Corporate bonds

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
A stock option gives an investor the right, but not the obligation, to buy or
sell a stock at an agreed upon price and date. There are two types of
options: puts, which is a bet that a stock will fall, or calls, which is a bet
that a stock will rise. 

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
What are some financial
institutions?
 Commercial banks-LEVERAGE, FDIC/ DICGC
 Investment banks-IPO, UNDERWRITING, CONSULTING, WEALTH/ ASSET MGT, BROKERAGE
Sharda - IPO.pdf

 Savings & Loans, mutual savings banks, and credit

unions
 Life and General Insurance companies
 Mutual funds-ACTIVE, PASSIVE, DEBT, EQUITY
 Exchanged Traded Funds (ETFs)
 Pension funds
 Hedge funds and private equity fundsP E firms.docx

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
What are some types of
markets?
 A market is a method of exchanging
one asset (usually cash) for another
asset.
 Physical assets vs. financial assets
 Spot versus future markets
 Money versus capital markets
 Primary versus secondary markets

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Primary vs. Secondary
Security Sales
 Primary
 New issue (IPO or seasoned)
 Key factor: issuer receives the proceeds
from the sale.
 Secondary
 Existing owner sells to another party.
 Issuing firm doesn’t receive proceeds and
is not directly involved.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
How are secondary markets
organized?
 By “location”
 Physical location exchanges
 Satellite/Computer/telephone networks
 By the way that orders from buyers and
sellers are matched
 Open outcry auction
 Electronic communications networks (ECNs)
 Dealers (i.e., market makers)

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Types of Orders
 Instructions on how a transaction is to
be completed
 Market Order– Transact as quickly as possible at
current price
 Limit Order– Transact only if specific situation
occurs. For example, buy if price drops to $50 or
below during the next two hours.
 Stop loss order

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 46
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 47
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Over the Counter (OTC)
Markets
 In the old days, securities were kept in a safe
behind the counter, and passed “over the
counter” when they were sold.
 Now the OTC market is the equivalent of a
computer bulletin board (e.g., Nasdaq Pink
Sheets), which allows potential buyers and
sellers to post an offer.
 No dealers
 Very poor liquidity

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 48
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Topics in Chapter

1. Forms of business organization

2. Objective of the firm: Maximize wealth
3. Determinants of fundamental value
4. Capital Allocation Process
5. Cost of Money- Determinants
6. Financial securities, markets and institutions
7. Financial Crisis-2008 & Mortgage securitization

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 49
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Financial Crisis 2008: Brief Story

Home Mortgages Before S&Ls

 The problems if an individual investor tried to
lend money to an aspiring homeowner:
 Individual investor might not have enough money
to fund an entire home
 Individual investor might not be in a good position
to evaluate the risk of the potential homeowner
 Individual investor might have difficulty collecting
mortgage payments

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
S&Ls Before Securitization
 Savings and loan associations (S&Ls)
solved the problems faced by individual
investors
 S&Ls pooled deposits from many investors
 S&Ls developed expertise in evaluating the
risk of borrowers
 S&Ls had legal resources to collect
payments from borrowers

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Problems faced by S&Ls
Before Securitization
 S&Ls were limited in the amount of
mortgages they could fund by the amount of
deposits they could raise
 S&Ls were raising money through short-term
floating-rate deposits, but making loans in the
form of long-term fixed-rate mortgages
 When interest rates increased, S&Ls faced
crisis because they had to pay more to
depositors than they collected from
mortgagees
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Taxpayers to the Rescue
 Many S&Ls went bankrupt when
interest rates rose in the 1980s.
 Because deposits are insured, taxpayers
ended up paying hundreds of billions of
dollars.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Securitization
 Some securities are created from packages
of other financial assets, a process called
securitization.
 The misuse of securitized assets is one of
the primary causes of the most recent
global financial crisis, so every manager
needs to understand the process of
securitization.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Structure of Securitization

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Securitization in the Home
Mortgage Industry
 After crisis in 1980s, S&Ls now put their
mortgages into “pools” and sell the
Federal National
Mortgage Association
(Fannie Mae) and
Federal Home Loan
Mortgage
Corporation (
Freddie Mac
pools to other organizations, such as
Fannie Mae.
 After selling a pool, the S&Ls have
funds to make new home loans
 Risk is shifted to Fannie Mae

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Fannie Mae Shifts Risk to Its
Investors
 Risk hasn’t disappeared, it has been shifted to
Fannie Mae.
 But Fannie Mae doesn’t keep the mortgages:
 Puts mortgages in pools, sells shares of these pools to
investors
 Risk is shifted to investors.
 But investors get a rate of return close to the mortgage
rate, which is higher than the rate S&Ls pay their
depositor.
 Investors have more risk, but more return
 This is called securitization, since new securities
have been created based on original securities
(mortgages in this example)

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Collateralized Debt Obligations
(CDOs)
 Fannie Mae and others, such as investment banks,
can also split mortgage pools into “special” securities
 Some securities might pay investors only the mortgage
interest, others might pay only the mortgage principal.
 Some securities might mature quickly, others might mature
later.
 Some securities are “senior” and get paid before other
securities from the pool get paid.
 Risk of basic mortgage is parceled out to those
investors who want that type of risk (and the
potential return that goes with it).

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The Dark Side of Securitization
 Homeowners wanted better homes than they could
afford.
 Mortgage brokers encouraged homeowners to take
mortgages even though they would reset to
payments that the borrowers might not be able to
pay because the brokers got a commission for closing
the deal.
 Appraisers thought the real estate boom would
continue and over-appraised house values, getting
paid at the time of the appraisal.
 Originating institutions (like Countrywide) quickly
sold the mortgages to investment banks and other
institutions.
(More . .)
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The Dark Side (Continued)
 Investment banks created CDOs and got rating
agencies to help design and then rate the new CDOs,
with rating agencies making big profits despite
conflicts of interest.
 Financial engineers used unrealistic inputs to
generate high values for the CDOs.
 Investment banks sold the CDOs to investors and
made big profits.
 Investors bought the CDOs but either didn’t
understand or care about the risk.
 Some investors bought “insurance” via credit default
swaps.

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The Collapse
 When mortgages reset and borrowers defaulted, the
values of CDOs plummeted.
 Many of the credit default swaps failed to provide
insurance because the counterparty failed.
 Many originators and securitizers still owned sub-
prime securities, which led to many bankruptcies,
government takeovers, and fire sales, including:
 New Century, Countrywide, IndyMac, Northern Rock, Fannie
Mae, Freddie Mac, Bear Stearns, Lehman Brothers, and
Merrill Lynch.

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Other Assets Can be
Securitized
 Car loans
 Student loans
 Credit card balances

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 Topics not covered:
 1.10, 1.11a, d, c, d, 1.12

 Questions to be prepared:
 1-1 (all parts)
 1-2, 1-3, 1-4.

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