Global Financial Instruments II

Summary

This script delves into the intricacies of the financial market, focusing on overnight loans through repurchase agreements (repos) and reverse repos, which facilitate trillions in daily transactions. It explains the role of brokers' calls in margin buying, where investors purchase stocks on borrowed funds. The script further explores the expansive bond market, detailing the varying risks and returns of bonds issued by entities ranging from governments to corporations. It covers Treasury securities, municipal bonds, and the complexities of mortgage-backed securities, which played a pivotal role in the 2008 financial crisis. The discussion highlights the importance of bond ratings and the evolution of lending standards post-crisis.

Takeaways

• 💼 **Repo and Reverse Repo**: Repos are overnight loans between financial institutions, with the borrower agreeing to repurchase the securities the next day at a slightly higher price.
• 🔄 **Understanding Repos**: East Bridge Capital and Vanguard's transaction exemplifies a repo, where East Bridge temporarily sells and then repurchases Treasury bonds to secure a loan.
• 🌐 **Size of Repo Market**: The repo market is enormous, with trillions of dollars exchanged daily, reflecting the need for short-term liquidity among financial institutions.
• 🏦 **Federal Funds**: Federal funds are overnight loans between banks, which are a fundamental part of the money market operations.
• 📈 **Brokers' Calls**: Brokers' calls refer to loans from commercial banks to brokerage firms, enabling customers to buy stocks on margin.
• 💵 **Money Market Securities**: These securities are short-term investments, including Treasury bills (with maturities up to one year), notes (one to five years), and bonds (up to 35 years).
• 🏦 **Bonds Issued by Various Entities**: Bonds can be issued by a wide range of entities including governments, corporations, and municipalities, making the bond market larger than the stock market.
• 🏗️ **Municipal Bonds**: These are tax-exempt if the investor resides in the same state as the issuing municipality, providing a local investment option with tax benefits.
• 🏢 **Corporate Bonds**: Corporations issue bonds with various features such as sinking funds, secured or unsecured status, and options, which are rated by agencies like S&P, Moody's, or Fitch.
• 🏡 **Mortgage-Backed Securities**: Mortgages are bundled into pools and sold as mortgage-backed securities, which were central to the 2008 financial crisis due to risky lending practices and insufficient oversight.
• 📊 **Market Changes Post-2008**: The market for mortgage-backed securities has seen increased federal oversight and stricter lending standards, making it more difficult for some borrowers to qualify for loans.

Q & A

What is a repo and how does it differ from a reverse repo?

A repo is a sale of securities with an agreement to repurchase them at a higher price, effectively an overnight loan. A reverse repo is the same transaction but from the perspective of the lender, who buys the securities with an agreement to resell them.

How does the federal funds market relate to repos?

The federal funds market involves overnight loans between banks. It's similar to a repo in that it's a short-term loan, but it specifically involves banks lending to each other.

What is a broker's call and how does it connect to margin buying?

A broker's call is a loan from a commercial bank to a brokerage firm to enable its customers to buy securities on margin. Margin buying is when investors borrow money to purchase securities, and broker's calls facilitate this by providing the necessary funds.

Why is the bond market larger than the stock market?

The bond market is larger because a wider variety of entities can issue bonds, including governments, corporations, and municipalities, whereas stocks can only be issued by corporations.

What are the differences between Treasury bills, notes, and bonds?

Treasury bills are short-term investments with maturities up to one year, notes are medium-term with maturities up to five years, and bonds are long-term with maturities usually up to 35 years.

Why are Treasury securities considered safe investments?

Treasury securities are backed by the full taxing authority of the U.S. federal government, which has never defaulted on its loans.

What is federal agency debt and how is it related to the federal government?

Federal agency debt refers to bonds issued by agencies like Fannie Mae and Freddie Mac. Although they are not officially federal agencies, there is an expectation that the federal government would intervene if these agencies defaulted.

What are some risks associated with international bonds?

Risks include the possibility of default by the issuing country and foreign exchange risk, which involves fluctuations in currency values relative to the investor's home currency.

How do municipal bonds provide tax benefits to investors?

Municipal bonds are tax-exempt if the investor lives in the same state as the issuing municipality. This makes them attractive to high tax-bracket individuals.

What features might corporate bonds have that affect their risk and return?

Corporate bonds can have features like sinking funds, secured or unsecured status, call options, and put options, all of which can affect their risk profile and the interest rates they offer.

How does the mortgage-backed securities market work?

Mortgage-backed securities are created by pooling mortgages and selling bonds based on the cash flows from those mortgages. Investors receive payments from the mortgage holders, and the mortgages serve as collateral.

What changes occurred in the mortgage-backed securities market after the 2008 financial crisis?

The market became more regulated with increased federal oversight. Lending standards tightened, and the paperwork for borrowers increased significantly, making it harder for some to obtain loans.

Outlines

00:00

💼 Money Market Securities and Repo Transactions

The paragraph discusses the concept of repurchase agreements (repos) and reverse repos, which are short-term loans between financial institutions facilitated by the sale and repurchase of securities like Treasury bonds. It uses the example of East Bridge Capital borrowing money overnight by selling Treasury bonds to Vanguard, with an agreement to repurchase them the next day at a slightly higher price. The paragraph also touches on the massive size of the repo market, the concept of federal funds as overnight loans between banks, and brokers' calls, which are short-term loans from banks to brokerage firms to finance customers' margin purchases. The speaker mentions that the money market is crucial for financial institutions needing overnight loans.

05:01

🏦 The Bond Market: Size, Components, and Types

This paragraph explains that the bond market is significantly larger than the stock market, with bonds being a long-term debt instrument issued by various entities, including governments and corporations. It outlines the different types of bonds, such as Treasury bills (short-term), Treasury notes (medium-term), and Treasury bonds (long-term), all backed by the U.S. federal government. The paragraph also discusses the concept of federal agency debt, where private companies like Fannie Mae issue bonds that are perceived to have government backing. It mentions the risks associated with international bonds, including default risks and foreign exchange risks, and the variety of bonds issued by different countries.

10:03

🏢 Municipal and Corporate Bonds: Features and Risks

The paragraph delves into municipal bonds, which are issued by local governments to finance infrastructure projects and are often tax-free for investors residing in the same state. It contrasts these with corporate bonds, which are issued by companies like Apple and IBM to raise capital. Corporate bonds come with various features, such as sinking funds, secured or unsecured status, call options, and put options. The paragraph also introduces bond rating agencies like S&P, Moody's, and Fitch, which rate bonds based on their credit quality, influencing the interest rates offered to investors.

15:04

🏠 Mortgages and Mortgage-Backed Securities

This paragraph explains the mortgage market, where individuals take out loans to purchase homes, using the home as collateral. It describes the process of mortgage origination and how lenders often sell these mortgages to other entities, which then package them into mortgage-backed securities. These securities are sold to investors worldwide, providing the original lenders with immediate capital. The paragraph also discusses the 2008 financial crisis, which was partly caused by low-quality borrowers defaulting on their loans within these mortgage-backed securities. It mentions the role of insurance companies, like AIG, which provided insurance on these loans and faced significant financial strain due to the defaults.

20:08

📈 Post-Crisis Changes in the Mortgage Market

The final paragraph discusses the changes in the mortgage market following the 2008-2009 financial crisis. It highlights increased federal oversight, stricter lending standards, and the impact on borrowers, many of whom now find it more difficult to secure loans. The paragraph suggests that these changes have made the market more cautious and regulated, affecting both lenders and potential homebuyers.

Keywords

💡Repo

A repo, short for repurchase agreement, is a financial transaction where one party sells securities to another with the agreement to repurchase them at a later date, typically overnight. This is a form of short-term borrowing for the seller. In the script, East Bridge Capital sells Treasury bonds to Wanggaard Federal Money Market Fund and agrees to repurchase them the next day at a slightly higher price, effectively borrowing money overnight.

💡Reverse Repo

A reverse repo is the opposite of a repo transaction, where the roles of the parties are reversed. It is a transaction where one party buys securities with the agreement to sell them back at a later date. This is essentially a loan from the buyer to the seller. In the context of the script, it is mentioned as a counterparty perspective to a repo, illustrating how financial institutions use these transactions for short-term lending and borrowing.

💡Federal Funds

Federal funds refer to the overnight loans made by one bank to another. These loans are unsecured and are typically used to meet reserve requirements set by the Federal Reserve. The script explains that these are short-term loans and are a part of the money market activities where banks operate to manage their liquidity.

💡Brokers Call

Brokers call is a term used for loans that brokerage firms extend to their customers for buying securities on margin. These are short-term loans provided by commercial banks to brokerage firms, which then lend to their customers. The script uses the example of a brokerage company like Schwab borrowing money from a bank to enable its customers to buy stocks on margin.

💡Bond Market

The bond market is a financial market where debt securities, or bonds, are issued and traded. It is larger than the stock market and includes bonds issued by various entities such as corporations, governments, and municipalities. The script highlights the bond market's size and diversity, explaining that it is a significant part of the financial system where entities raise long-term funds.

💡Treasury Securities

Treasury securities are debt obligations issued by the U.S. Department of the Treasury to finance government spending. They include Treasury bills, notes, and bonds, which have different maturities. The script explains that these are considered safe investments because they are backed by the full taxing authority of the U.S. federal government.

💡Municipal Bonds

Municipal bonds, or munis, are bonds issued by local governments to finance public projects like infrastructure. They are often tax-exempt for investors who live in the same state as the issuing municipality. The script discusses how these bonds can be an attractive investment for some due to their tax advantages, but they may not be as appealing for others due to potential tax implications.

💡Corporate Bonds

Corporate bonds are debt securities issued by corporations to raise capital. They come in various forms with different maturities, coupon rates, and features such as sinking funds, call options, and put options. The script mentions that corporate bonds are a significant part of the bond market and can offer varying levels of risk and return based on the issuer's creditworthiness.

💡Mortgage-Backed Securities

Mortgage-backed securities (MBS) are financial products created when a group of mortgages are bundled together and sold as an investment. These securities allow lenders to receive funds upfront rather than waiting for the loans to be repaid over time. The script discusses the role of MBS in the financial crisis of 2008-2009, where poor underwriting and the failure of insurance companies that provided default protection led to significant losses.

💡Credit Rating Agencies

Credit rating agencies, such as S&P, Moody's, and Fitch, are organizations that assess the creditworthiness of entities issuing bonds. They provide ratings that help investors determine the risk associated with investing in those bonds. The script implies the importance of these ratings in the bond market, especially in the context of the variety and complexity of corporate bonds.

Highlights

Repo and reverse repo are mechanisms for overnight loans between financial institutions.

East Bridge Capital and Vanguard example illustrates how repos function in practice.

The repo market operates with trillions of dollars daily, reflecting the need for short-term liquidity.

Reverse repo is the counterparty perspective of a repo transaction, as explained with Weingartz's perspective.

Federal funds are overnight loans between banks, a concept likely covered in Econ 351.

Brokers calls are short-term loans from commercial banks to brokerage firms for customer margin buying.

Schwab's margin lending is an example of how brokers calls work in practice.

The global bond market is significantly larger than the stock market due to its diversity of issuers.

Bonds can be issued by a wide range of entities, unlike stocks which are limited to corporations.

Treasury bills, notes, and bonds represent short to long-term U.S. federal government debt.

Treasury securities are considered safe due to the backing of the U.S. federal government's taxing authority.

Fannie Mae and Freddie Mac are private companies with an implicit federal guarantee, influencing their bond prices.

International bonds carry varying levels of risk, with some countries having defaulted in the past.

Municipal bonds offer tax-free interest to investors residing in the same state as the issuing municipality.

Corporate bonds come with a variety of features, such as sinking funds, secured status, and embedded options.

Bond rating agencies like S&P, Moody's, and Fitch help investors assess the quality of corporate bonds.

The mortgage market involves home loans secured by the property itself, with default leading to repossession.

Mortgage-backed securities pool multiple mortgages and sell shares to investors, a market significantly impacted by the 2008 financial crisis.

The 2008 financial crisis highlighted the risks of low-quality borrowers and the role of insurance in mortgage-backed securities.

Post-2008, the mortgage market has seen increased federal oversight and stricter lending standards.

Transcripts

that brings me to the last three items

on this slide let's talk about the first

one repose and reverses repose and

reverses are the market for overnight

loans made from one institution to

another let's just understand what a

repo is in the reverse is just like the

reverse of the repo

suppose you have East bridge capital

it's a company that deals in Treasury

securities and they want to borrow money

overnight so what they can do is they

can sell twenty million dollars worth of

Treasury bonds to Wanggaard is federal

money market fund okay this federal

money market fund invests in federal

money market securities and then

simultaneously East bridge and Vanguard

enter into an agreement to repurchase

those bonds for a slightly higher price

the next day so the next net effect of

this is each bridge capital gets twenty

million dollars today and then tomorrow

they repurchase those Treasury bonds for

little more than twenty million dollars

from Vanguard so essentially what

happens is it's loan from Vanguard to

East bridge Capital overnight the market

for repose is gigantic trillions of

dollars on a daily basis

it's just that financial institutions

need loans overnight and they operate in

this market okay a reverse is except

essentially a repo but from the other

parties perspective in this case from

weingartz perspective

okay federal funds are basically all

night loans made by one bank to another

I'm sure you've learned about federal

funds in your econ 351 class so I won't

really expand too much over here

brokers calls okay now most brokerage

companies want their customers to borrow

money and buy stocks on borrowed money

when a investor does that that's called

margin buying next week I'm gonna give

you some specific examples on margin

buying with all the numbers and so on

and so forth okay but how does that

happen

like where does the money come from for

margin buying where essentially

brokerage companies have to have their

commercial banks lend that money to

their customers these loans are called

brokers calls okay so for example we

have a large brokerage company like

Schwab their customers buy stocks on

margin

well Schwab borrows money from its bank

it could be a large bank like

continental bank which doesn't exist

anymore but when it did it was a massive

Bank based in Chicago so continental

bank would provide the credit to enable

Schwab's customers to buy securities on

margin these are all short-term loans

they're investments from the perspective

of continental bank Schwab also adds a

tiny little fee to compensate its

services

and that's why in a way it's a

money-making making activity for Schwab

okay that pretty much covers my coverage

of money market securities let's go on

to the bond market the bond market

worldwide is much much larger than the

stock market the stock market gets more

traction in the media because there's

like a glamor component associated with

investing in stocks and bonds are more

like a run-of-the-mill

investment and that's why they don't get

as much respect in the media but in

terms of volume in terms of size the

bond market is much much larger than the

stock market

remember what a bond is bond is a long

term debt

well more entities can borrow money in

long term then corporations corporations

are the only entity that can issue stock

okay but bonds can be issued by

corporations by the federal government

by state governments by local

governments by foreign governments by

colleges and universities by religious

institutions and so on and so forth and

that's the reason why the bond market is

much much larger than the stock market

let's talk about the different

components of the bond market we start

with the safest Treasury notes and

Treasury bonds what Treasury bills are

to short-term investments Treasury notes

are to medium term investments while

Treasury bills their maturity is ranging

from 90 days to 365 days Treasury notes

have maturities ranging from one year up

to five years

Treasury bonds are also US federal

government obligations but they have

maturities ranging from five usually up

to 35 years okay the longest maturity

Treasury bond that I am aware of is 35

years recently there's some talk of the

federal government issuing bonds with no

maturity date but don't hold your breath

it's not going to happen very soon 35

years is about the longest maturity

you'll find on Treasury bonds but the

main thing is both notes and bonds are

backed by the full taxing authority of

the US federal government the US federal

government has never defaulted on loans

so they're considered to be relatively

safe debt okay retail investors like you

and I can very safely invest in Treasury

notes and bonds it's a safe investment

you will get your money back but then

because it's safe the yield is

relatively low there are some agencies

like Fannie Mae and so on and so forth

they're private companies but there's a

feeling in the market that if these

companies defaulted on their loans the

federal government would step step in

and make good on those divorce okay so

officially these are not federal

agencies Fannie Mae Freddie Mac etc they

were started as federal agencies but no

longer federal agencies but if you

invest in bonds issued by Fannie Mae

Freddie Mac whatever then if if the if

that agency is in financial distress

it's very likely that the federal

government will make good on that

agency's debt so that's called federal

agency debt

just like the US federal government

borrows money by selling bonds so to

other sovereign governments like the

government of Germany sells German bonds

the government of Greece sells Greek

bonds Switzerland borrows money the

country Spain UK Russia Australia New

Zealand all of these countries India

Brazil Argentina you name it all of

these governments that run budget

deficits borrow money by selling bonds

of course some bonds are more risky than

others like if you were to buy born sold

by the Italian federal government you'd

be a little bit more nervous or Greece

you'd be a little bit bit more nervous

or even Russia you know in 1998 Russia

defaulted on their debt and one of the

side effects was hedge fund called

long-term capital management that was

founded by two Nobel prize-winning

economist Merton and Scholes had to file

for bankruptcy because that hedge fund

had invested a ton of money in bonds

issued by Russia Russia defaulted on

those loans and that push long-term

capital management into bankruptcy

proceedings okay so some of these

international bonds are more risky than

others but if you analyze bonds issued

by different countries you may find some

good deals out there deals where the

interest rate is attractive still the

probability of default is not that high

of course you have to be aware of

foreign exchange risk so for example if

you buy bonds issued by the Australian

Government

they are denominated in Australian

dollars

you'd be concerned about what the

exchange rate between your home currency

and Australian dollars would be when the

government finally repays those bonds

okay so that throws in another

complication into the investment

equation just like the federal

government and state governments and

foreign governments issue bonds so do

local governments the City of Harrisburg

sells bonds to finance the building of

bridges or incinerators or whatever okay

the city of Pittsburgh the city of New

York the city of Philadelphia all of

these large cities sell bonds to finance

infrastructure projects many years ago

the US Congress felt that they should

give these localities a shot in the arm

by making these visible bond investments

attractive to investors

so they made municipal bonds essentially

tax-free provided the investor lives in

the same state as the municipality okay

so suppose you live in Harrisburg so you

live in Pennsylvania and you buy bonds

issued by the city of Philadelphia the

interest that you receive on those bonds

is tax-free free from federal local and

state taxes but living in Harrisburg if

you buy bonds issued by New Orleans

Louisiana then because you don't stay in

the same state you would have to pay

federal state and local taxes on the

interest received on those bonds next

week I'll do a short example that

illustrates how exactly municipal bonds

work they are not necessarily attractive

to everybody they're mostly attractive

to people who have high

thanks rate okay and I'll illustrate

that idea by using a specific example in

the classroom that brings me to

corporate bonds when companies borrow

money they sell bonds they might borrow

money from banks but if it's a large

loan that the company needs then they

sell bonds to any member of the general

public so for example Apple corporation

borrows money by selling corporate bonds

so does IBM and so on and so forth okay

there's a large variety of corporate

bonds out there different maturities

different coupon rates mostly the

interest is paid on a semi-annual basis

but corporate bonds also have a variety

of different features okay

so for example some corporate bonds have

a sinking fund feature that requires the

company to set aside money every couple

of years to pay off the bonds they might

be secured or unsecured they they might

have a call option embedded in the bond

that allows the borrower to recall the

bond to pay off the bond before the bond

matures it might have a put option

embedded in it which allows the lender

the investor to put the bond meaning

sell the bond bank to the borrower

before the bond matures okay so there's

a phenomenal variety of corporate bonds

out there and to accommodate all these

different bonds a bunch of bond rating

agencies have naturally arisen so that

investors can tell between the different

qualities of these bonds so you have

agencies like S&P Moody's or Fitch that

rate bonds and depending on the ratings

of these bonds you can decide whether

you want to invest in high quality or

medium quality or low

borns okay and depending on the quality

of the barn the bond will yield a higher

or a lower interest rate okay that

brings me to the market for mortgages

and mortgage-backed securities

okay the market for mortgages is very

easy to understand suppose after

graduating you get a good job you know

where you're going to live and you want

to buy a house you've got some money

saved but not enough to buy the house

that you want to buy so what you do is

you go to the local bank or you go to

some nationwide lender like rocket

mortgage mortgage like I'm sure you've

seen ads for rocket mortgage on TV and

you apply for a home mortgage loan if

you are approved they lend you money

then allows you to buy your home and

your home access security for that loan

so for some reason if you were to

default on that loan the lender would

repossess your house that's simple

enough that's the market for mortgages

okay the actual mortgage process can be

divided into a couple of parts one is

where the lender evaluates your

creditworthiness and actually originates

the loan okay

that's where the lender really makes

money evaluation of your

creditworthiness and origination of the

loan if your loan has a maturity of 30

years the lender could just choose to

sit on that loan for 30 years meaning

hold the law and collect interest and

principal payments for you for the next

30 years but that's that's not sexy okay

that's not like exciting for the lender

the lender would rather receive all

their money back right away and then

originate another loan so that they make

more money okay so a bunch of like

really smart finance people

figured that part out so what they

started doing is they started going to

different mortgage companies and saying

they're going to buy all these mortgages

off of your balance sheet we're going to

buy these mortgages by paying you the

amounts that are due on them and we're

going to package these mortgages into a

pool and we are going to sell

mortgage-backed bonds on these pools of

mortgages okay and we will get investors

from across the world to invest in those

bonds in those mortgage-backed

securities

okay that's how the market for

mortgage-backed securities works this is

the market that really got us into the

mess that occurred in 2008 2009 some of

the borrowers in that pool were low

quality borrowers but somebody hadn't

done sufficient homework to figure out

that these borrowers were low quality so

they started defaulting on their loans

which meant that those investors that

are invested in those mortgage-backed

securities couldn't get their money back

which was not a big deal that happens

often the problem was to convince those

investors to buy these bonds they'd

convinced other companies to sell

insurance so if some borrower defaults

on their mortgage the insurance company

kicks in and makes payments on behalf of

that borrower okay so think let's think

this true a lot of these borrowers were

low quality nobody had done their

homework to figure out that they were

quality but the investors who invested

in these securities had insurance on

these loans okay so as the borrower's

defaulted the insurance companies had to

kick in and start paying these investors

this is where the problem really blew up

as large insurance companies like AIG

came close to bankruptcy because they

had to make good on all the insurance

that the end sold okay so this market

has completely changed in the last 10

years there's a lot more federal

oversight of this market the paperwork

has increased tremendously for borrowers

and many borrowers who could easily get

loans before 2007 can now no longer get

loans because the lending standards have

increased so substantially