Fin 495 Fixed Income and Their Derivatives Fall 2012 Dr. Clay M. Moffett Cameron 220 – O moffettc@uncw.edu

1. Fin 495Fixed Income and Their Derivatives Fall 2012 Dr. Clay M. Moffett Cameron 220 – O moffettc@uncw.edu

2. Stuff • Intro, • Syllabus: • Grading • Attendance • Homework • Bonus Points • Contacting moi…. • Overview of Markets

3. A Perspective on Global Debt Marketsand Overview of FI MarketsFin 495 2012

4. Global imbalance in savings, and its ramifications for debt markets. Countries on the right tend to borrow from countries on the left. This motivates how debt markets arise in a global context.

5. Global imbalance in savings, and its ramifications. 90% of Japanese debt is financed domestically. About 50% of US Government debt and about 75% of overall US debt is financed domestically. High roll over needs in 2011 for countries to the right.

6. Some questions for players in debt markets • Borrowers: • Debt is held internationally – issuers may need intermediaries to place their debt. • Globally interconnected markets imply actions of a few foreign institutions • may influence the cost of borrowing. • Currency of issuance may be a matter of importance: US companies may want to issue foreign currency denominated debt if there is a greater appetite elsewhere. • 4. Foreign governments may issue foreign currency denominated debt: Mexico issued a 100-year US dollar denominated bond in October 2010. The issue size was $1 billion, and the at-issue yield was 6.1%.

7. Some questions for players in debt markets • Investors: • Currency hedging may be an important consideration. • Actions of central banks and governments may have a consequence on portfolio • value: • Prolonged central bank decisions to keep interest rates low – • currency implications? • Should government agency debt be allowed to default? • Will financial sector debt become sovereign debt in a crisis? • Bank debt versus public debt: bail out policies.

8. Activities and Economic news releases for the month of September 2011 • Total borrowings: $252 billion. • Eleven auctions. • In addition there are 15 T-bill • auctions. Approximately $20 • billion per auction -> $300 billion. • Total: 26 auctions to raise over • half a trillion dollars in one month! • FOMC meetings. • 6. Policy speeches. • 7. Economic numbers: • Employment. • Purchasing power index. • Budget. • Housing. • Trade. • Consumer Confidence.

9. Architecture of Debt Markets – primary and secondary markets • Borrowers: • Minimize uncertainty about their funding needs: • Regular auctions: discriminatory or Dutch? • Should there be a when-issued market? • Real or nominal? • Benchmarks – 4 weeks, 3-months, 6-months, 1-year, etc. Short-term or long-term? • Primary dealer system. • Inter-dealer brokers. • Transparency: • Pre-trade transparency. • Post-trade transparency. TRACE in corporate debt markets and some initiatives in Muni markets.

10. Architecture of Debt Markets – primary and secondary markets • Investors: • Ability to buy or sell in a liquid market. • Liquid secondary markets: • Depth: ability to trade large amounts without an adverse price reaction. • Resilience: Speed with which the price impact of a trade disappears. • Tightness: narrow bid-offer spreads.

11. US Treasury – Yield Curve (benchmarks) Curve has become flatter over last 3 weeks Different benchmarks can react differently to the same information.

12. Central Banks & Governments – big players in debt markets

13. Central Banks & Governments – big players in debt markets

14. Central Banks & Governments – big players in debt markets

15. Central Banks & Governments – big players in debt markets European Crisis • Fiscal prudence: EU’s stability and growth pact of 1997 and • other agreements/treaties sought the following: • Budget deficit ceiling of 3% of GDP. • External debt ceiling of 60% of GDP. • (20 out of 27 members violated this one time or another.) • 3. Greater coordination of policies from members of the EU. • 4. No bailouts. (Violated implicitly by ECB and other programs in EU). • Downside of a common currency: Common currency precludes • an economically weak member state from benefiting from • potential decline in its own currency.

16. Central Banks & Governments – big players in debt markets European Crisis Source: IMF, World Economic Outlook, October 2009.

17. Issues: Did central bank’s institutions work well? • Did the institution of “Discount window” whereby the central bank acts as a lender of last resort work well? • Can the discount window’s design be changed? • With disintermediation of credit, and markets supplanting banks, are central banks well equipped to deal with future crises? How should “shadow banking” sector be tackled?

18. Issues: Did central bank’s institutions work well? • 4. Should European Central Bank accept debt of European peripheral countries in extending liquidity, irrespective of their credit reputation and at common “haircuts?” • Should ECB be buying debt of peripheral countries just before they auction their debt? • When should central banks acknowledge that the crisis is about solvency and not liquidity?

19. Architecture of Debt Markets – Funding and Securities lending • How can the financial intermediaries distribute half a trillion dollars worth of Treasury securities in September 2011 alone? • The dealers must acquire securities from the government and then distribute them to ultimate investors. • Dealer’s capital is limited: they are usually heavily levered. • Inventory positions can subject the dealers to huge price losses – risk in market-making.

20. Housing price bubble

21. Housing price bubble Remove tax incentives to housing? Should loans be non-recourse? Should a minimum down payment of 30% mandated?

22. Housing price bubble burst and Fed’s actions Source: Diana Hancok and Wayne Passmore, “Did the Federal Reserve’s MBS Purchase Program Lower Mortgage Rates?, Board of Governors, Washington, D.C.

23. Housing price bubble burst and Fed’s actions Source: Diana Hancok and Wayne Passmore, “Did the Federal Reserve’s MBS Purchase Program Lower Mortgage Rates?, Board of Governors, Washington, D.C.

24. Housing price bubble burst and Fed’s actions Source: Diana Hancok and Wayne Passmore, “Did the Federal Reserve’s MBS Purchase Program Lower Mortgage Rates?, Board of Governors, Washington, D.C.

25. Pension funding: Some considerations • What is the optimal allocation across asset classes? • Equity. • Fixed income. • Commodities. • Currencies. • Two polar views: • Mean-variance efficient portfolios: buy and hold diversified portfolios – indexation based on market values. • LDI: Liability Driven Investing: manage pension assets so that the liabilities are always met.

26. Looking ahead: Hard Structural Adjustments • Both US and Euro zone countries require strong structural • adjustments along many fronts: • Asset price bubbles: Spain has a real estate sector • well beyond the country’s ability to sustain it. • Overhang of housing, and migration of workers from this • industry remain a challenge. This is true in varying degrees • for other economies. • Banks are still exposed to toxic assets, government and • private sector debt. De-leveraging process is not completed • yet. Capital infusions may be necessary. More equity? • Households are de-leveraging as well. In light of housing • price and equity price adjustments, they tend to consume • less and save more. These factors dampen economic growth • and employment.

27. Looking ahead: Hard Structural Adjustments • Government fiscal adjustments: Fiscal deficit has reached • a point where most developed countries must finds ways • to cut expenses. This requires some very tough re-contracting: • Pension reforms: • Extending retirement age. • Reducing pension benefits (especially state and city • DB plans (California, New York, Illinois, etc.). • Cost of living adjustments/Overtime in public sector • plans. • Privatization of Public sector undertakings: • Selling public sector firms. • Auctioning public services to private sector. • Labor reforms:

28. Mobility of Capital and Labor cost differences • Demographics work to the disadvantage of most developed • countries. • This implies that a smaller fraction of the population must • work to meet the entitlements (healthcare, pensions, • social security, etc.) of the much larger fraction of the population. • Low cost capital is mobile and finds its economic destinations • where skilled and unskilled labor are relatively cheap. • Skilled labor is also relatively mobile and can be sourced from • many locations across the globe.

29. Mobility of Capital and Labor cost differences • These factors coupled with relatively younger population • in developing countries such as China and India have led • to migration of capital (investment) and jobs away from • developing countries. • Debt instruments become the lynchpin in this linkage: • developed countries issue debt, and developing countries • and other exporting countries invest in them. • Banks lend to countries with deficit, with the result that they • become exposed to private sector defaults.

30. Potential Tail Events - I • Sovereign default in Europe: failure to roll over debt, failure of major auctions, bank failures, etc. • Collapse of asset prices in China:property prices in China may collapse and one of the major drivers of global economy may falter. Potential for social unrest. • Global recession: one or more major economies slipping into protracted slow down, leading to a recessionary spiral. Fall in oil prices.

31. Potential Tail Events - II • Break up of the Euro Zone: (Scenario 1) some peripheral countries leave the Euro zone, declare default, and regain competitive edge through devaluation of their currency. • Break up of the Euro Zone: (Scenario 2) a major country (say, Germany) decides to leave the union due to domestic pressure from voters and politicians. • Either of the above scenarios would constitute a failure of Euro experiment, and will cause a major depreciation of Euro.

32. Historical perspective on interest rate & fiscal policies of USA • Accommodating (or Loose?) monetary policy following • the dot-com bubble crash of 2000. Rates at prolonged low levels. • About a 40% depreciation in dollar between 2000 to 2008. • Appreciation in commodity prices. • Unprecedented monetary policy following the credit crisis of 2008. • Target rates close to zero until 2013! • Toxic assets in the balance sheet of central bank. • 3. Surplus in 2000 to deficit for the U.S.

33. Issue: Levels of interest rates and spreads – implications for participants

34. Implied volatility based on options on stock market index

35. LIBOR OIS Spreads – their historical pattern

36. Conclusions • We may expect central banks to continue to be accommodating and delay “exit”, until credible signs of sustainable growth and/or inflationary risks manifest themselves. Tightening may not begin before 2013. • The reforms packages may lead to “downsizing” of banks and divesting banks of major OTC derivatives, hedge funds, private equity, etc. • Banks may face levies, and taxes on financial transactions. They may be subject to higher capital standards, penalizing size – to mitigate “too big to fail”

37. Conclusions • Prolonged periods of slow growth or minor contractions in developed world. • Periods of renegotiations about pension benefits, social security, and healthcare entitlements. Potential for significant re-contracting. • Developing world coping with inflationary risk, and potential social unrest. • Major slowdown or contraction in developed economies may cause a “spill over” effect on developing economies.