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.