EDT Summary Nöth Finance-Household&Debt PDF

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EDT: Summary Finance – Household & Debt

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Finance – Debt Investments & Finance   

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Corporate finance. Investments & financing Household finance (incl. retirement savings) Debt o Households: credit cards, cars, real estate, student loans o Companies Capital markets Banks & other institutional investors Insurance

Debt: main topics 

Why? o Intertemporal consumption smoothing For example, MBA @ HBS: 2 yr program, tuition ~ 125k (!no earnings!), room & board ~ 300k

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Skizze:

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 Entering students: ∅ income 50k/yr Leaving students: ∅ income 125k/yr o Investments (that pay off later) Main parameter o Interest rate (% p.a.) o fixed/variable  fixed interest is defined before the loan and stays the same; variable interest goes up/down with the market (Leitzins)

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maturity (time of loan/mortgage) secured/unsecured (secured means you back a loan with an asset, for example your car. If you can’t pay back the loan, the borrower can take your car as compensation. Advantages: easier to get than an unsecured loan, lower interest) o currency Other aspects o Ratings Businesses  starts at “0” (hard to get first loans) credit score Germany: Schufa  start w/ “perfect” credit score “100”  handed out (Your credit score determines if banks trust you enough to give you money. The better your score, the more money you can borrow and the lower the interest rates) US: have to take loan and pay back on schedule to get credit score in the first place “0”  have to get it o Covenants (= Kreditvereinbarungsklausel): Rules that the lender puts on the borrower. For example: if I borrow you 5 million for your company, you are not allowed to borrow more money from other lenders o Tradeable o prepayment rules: Rules that apply if you want to pay off a loan before it’s maturity date. Usually, a prepayment rule states that you have to pay a fee if you pay off the loan early (this is because when you pay the loan early, the bank misses out on interest) o other embedded options o o

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Student debt    

7/10 students; $1 trillion in US  tripled in past decade, bigger than debt from credit cards & loans; subsidized by government (limit on interest rate)  good intention; Problems later in renting/buying appartement/house b/c of credit score Non-dischargeable in bankruptcy; tax refund claimed when behind loan-plan In last years: reduce funds, rise tuition Education important – but important to pay for?

For-profit colleges (German examples: FOM, Frecenius, Cologne Business School): Small class sizes of 20-25 students; high tuition €500-€1500 per month  not worth what you’re paying for; good grade BUT not the same education  admission tests (TM-WiSo)  actually worse than from non-profit schools  end up w/ higher debts and worse education + higher dropout-rates (!US! graduates don’t necessarily find a job/only small amount graduate in the first place) Non-profit colleges Neat-blind admission (for ex. at Stanford) 2

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 Big difference between for-profit and non-profit colleges!  Difference university education Germany vs US: Germany Personal bankruptcy:  3-year period where you give up all earnings to creditors (live on Hartz-4)  Then: fresh sheet

US  

Low tuition ~€7,000 program More students in class

for

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High tuition ~€70,000 for the SAME program

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Same bankruptcy rules BUT student loans stay (!)

 Debt is very dangerous; Does it pay up in the future?  Opportunity costs! Bonds Bonds represent the debts of issuers, such as companies or governments. These debts are sliced up and sold to investors in smaller units. For example, a $1 million debt issue may be allocated to one-thousand $1,000 bonds. In general, bonds are considered to be more conservative investments than stocks and are more senior to stocks if an issuer declares bankruptcy. Bonds also typically pay regular interest payments to investors, and return the full principal loaned when the bond matures. As a result, bond prices vary inversely with interest rates, falling when rates go up and vice-versa. The bond markets are a very liquid and active but can take second seat to stocks for many retail or part-time investors. The bond markets are often reserved for professional investors, pension and hedge funds, and financial advisors, but that doesn't mean that part-time investors should steer clear of bonds. In fact, bonds play an increasingly important part in your portfolio as you age and, because of that, learning about them now makes good financial sense. In fact, having a diversified portfolio of stocks and bonds is advisable for investors of all ages and risk tolerance. 

Bonds are debt securities issued by corporations, governments, or other organizations and sold to investors

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Backing for bonds is typically the payment ability of the issuer to generate revenue, although physical assets may also be used as collateral

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Because corporate bonds are typically seen as riskier than government bonds, they usually have higher interest rates

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Bonds have different features than stocks and their prices tend to be less correlated, making bonds a good diversifier for investment portfolios

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Bonds also tend to pay regular and stable interest, making them well-suited for those on a fixed income

What Is a Bond? When you purchase a stock, you're buying a microscopic stake in the company. It's yours and you get to share in the growth and also in the loss. On the other hand, a bond is a type of loan. When a company needs funds for any number of reasons, they may issue a bond to finance that loan. Much like a home mortgage, they ask for a certain amount of money for a fixed period of time. When that time is up, the company repays the bond in full. During that time, the company pays the investor a set amount of interest, called the coupon, on set dates (often quarterly). 3

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There are many types of bonds, including government, corporate, municipal and mortgage bonds. Government bonds are generally the safest, while some corporate bonds are considered the riskiest of the commonly known bond types. For investors, the biggest risks are credit risk and interest rate risk. Since bonds are debts, if the issuer fails to pay back their debt, the bond can default. As a result, the riskier the issuer, the higher the interest rate will be demanded on the bond (and the greater the cost to the borrower). Also, since bonds vary in price opposite interest rates if rates rise bond values fall. Credit Ratings: Bonds are rated by popular agencies like Standard and Poor's, and Moody's. Each agency has slightly different ratings scales, but the highest rating is AAA, and the lowest rating is C or D, depending on the agency. The top four ratings are considered safe or investment grade, while anything below BBB for S&P and Baa3 for Moody's is considered "high yield" or "junk" bonds.1 Although larger institutions are often permitted to purchase only investment grade bonds, high yield or junk bonds have a place in an investor's portfolio as well but may require more sophisticated guidance. Generally, governments have higher credit ratings than companies, and so government debts are less risky and carry lower interest rates. Pricing Bonds: Bonds are generally priced at a face value (also called par) of $1,000 per bond, but once the bond hits the open market, the asking price can be priced lower than the face value, called a discount, or higher than the face value, called premium. If a bond is priced at a premium, the investor will receive a lower coupon yield, because they paid more for the bond. If it's priced at a discount, the investor will receive a higher coupon yield, because they paid less than the face value. Bond prices tend to be less volatile than stocks and they often responds more to interest rate changes than other market conditions. This is why investors looking for safety and income often prefer bonds over stocks as they get closer to retirement. A bond's duration is its price sensitivity to changes in interest rates—as interest rates rise bond prices fall, and vice-versa. Duration can be calculated on a single bond or for an entire portfolio of bonds. Bonds and Taxes: Because bonds pay a steady interest stream, called the coupon, owners of bonds have to pay regular income taxes on the funds received. For this reason, bonds are best kept in a tax-sheltered account, like an IRA, to gain tax advantages not present in a standard brokerage account. If you purchased a bond at a discount, you'll be required to pay capital gains tax on the difference between the price you paid and the bond's par value, normally $1,000 per bond, but not until the bond matures and you receive the face value of the bond.3 Issuers of bonds, on the other hand, such as corporations, often receive favorable tax treatment on interest, which they can deduct from their taxes owed. Local governments and municipalities may issue debt too, known as municipal bonds. These bonds are attractive to some investors as the interest payments to investors can be tax-free at the local, state, and/or federal level. Issuers of Bonds: There are four primary categories of bond issuers in the markets. However, you may also see foreign bonds issued by corporations and governments on some platforms. 4

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Corporate bonds are issued by companies. Companies issue bonds—rather than seek bank loans for debt financing in many cases—because bond markets offer more favorable terms and lower interest rates. Municipal bonds are issued by states and municipalities. Some municipal bonds offer tax-free coupon income for investors. Government (sovereign) bonds such as those issued by the U.S. Treasury. Bonds (T-bonds) issued by the Treasury with a year or less to maturity are called “Bills”; bonds issued with 1 to 10 years to maturity are called “notes”; and bonds issued with more than 10 years to maturity are called “bonds”. The entire category of bonds issued by a government treasury is often collectively referred to as "treasuries." Government bonds issued by national governments may be referred to as sovereign debt. Governments may also offer inflation-protected bonds (e.g., TIPS) as well as small denomination savings bonds for ordinary investors, Agency bonds are those issued by government-affiliated organizations such as Fannie Mae or Freddie Mac.

How to Buy Bonds: Most bonds are still traded over the counter (OTC) through electronic markets. For individual investors, many brokers charge larger commissions for bonds, since the market isn't as liquid and still requires calling bond desks in many buy and sell scenarios. Other times, a broker-dealer may have certain bonds in their inventory and may sell to their investors directly from their inventory. You can often purchase bonds through your broker's website or call with the bond's unique ID number, called the CUSIP number, to get a quote and place a "buy" or "sell" order. Alternatives to Buying Bonds Directly: If you want the income earning power of a bond, but you don't have the funds or don't want to own individual bonds, consider a bond ETF or bond mutual funds. These are well diversified funds that give you exposure to many different bonds and pay a monthly or quarterly dividend. Because some bonds have a minimum purchase amount, smaller investors may find these products more appropriate for their smaller amount of capital, while remaining properly diversified. The Bottom Line: Most investors, regardless of age, should have at least a small amount of their portfolio allocated to fixed income products such as bonds. Bonds add safety and consistency to a portfolio. Although there is a risk that a company may default and cause a large loss, investment grade bonds rarely default. However, along with this safety comes a lower rate of return. Coupon bonds = a bond that is essentially anonymous, with no name on the bond or sale record. The bond represents semi-annual interest payments; they are increasingly rare since the advent of electronic payments; Although coupon bonds—which are sometimes called bearer bonds—are rare, they offer a simple way for an investor to collect on earned interest Zero-coupon bonds (Zinseszinsvertrag) = a debt security instrument that does not pay interest; Zero-coupon bonds trade at deep discounts, offering full face value (par) profits at maturity; the difference between the purchase price of a zero-coupon bond and the par value, indicates the investor's return -70 5

0% nominal rate, 10yrs

+100

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Example: coupon bond, maturity: 10yrs, (fixed) interest rate: 3% Market price Maturity (t)

-100 T=0

+3 T=1

+3 T=2

… …

+3 T=9

+3 +100 T = 10

New contact @t = 5: maturity 5yrs, 5% - 100 +5 +3 +2 Old bond: p < -90

+5 +3 +2

Newest bond: -100 +1 +1

+1

+5 +3 +2 +1

+5 +3 +2

+5 +100 +3 +100 +2

+1 +100

When interest rates go up the market price goes down and vice versa Repayment/Prepayment:  

Pay interest until maturity, then repayment Annuity contracts: pay a fixed amount incl. repayment over time o E.g., loan of 100@3% Annuity repayment of 13 p.a. 100

t=1: -13 (3% interest/10 repayment, balance = 90)

Debt: Process 1. Origination a. Loan application b. Credit analysis c. Contract & pricing 2. Funding (offer to customer) 3. Servicing (collection of payments, bookkeeping) 4. Risk processing a. Monitoring default risk 6

t=2: -13 (2.7/10.3)

…

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b. Diversification of credit exposure c. Interest rate risk 5. Credit culture (organizational design, reporting, communication, incentive schemes for credit officers)

Debt: risk 

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Asymmetric information  identify and quantify risk  price the risk correctly (i.e., interest rate should at least match risk so you don’t lose money)  pricing of risk But: market impact of big players  competition of supply side (lenders have competition, so they can’t charge too much)  Secondary demand of debt (MBS and ECB)

Financial crisis 2008 Subprime mortgages: Mortgages that are given even to borrowers with low credit score, because the lender thinks that the economy is doing so well that the risk of the borrowers defaulting is low Collateralized Debt Obligations: 

CDOs are a type of ABS

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Finance product that is backed by a pool of loans (i.e., the CDO represents a pool of loans).

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This means: when the loans lose value because the borrowers default or are likely to default, the CDO loses value too.

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CDOs are structured in tranches with each having a different risk profile. Example:

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If Investors want a low-risk, low-return investment, they invest into the Senior tranche with an AAA rating and 5.27% interest. If they want more return (and more risk), they can go further down and invest into one of the other tranches (Junior has the highest risk and highest interest)

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If too many of the loans get defaulted on, the senior (low risk) investors get their return first, and it trickles down through the other branches until there is no more money left over (as explained above)

Collateralized Mortgage obligations: Also a type of ABS. Difference to CDOs: CMOs only have mortgages, CDOs can also have other types of debt. A CMO can be securitized by a CDO. 7

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Frozen credit markets: banks become afraid of lending out money because they think the risk of people defaulting on loans is too high —> economy freezes, many companies can no longer afford to pay their employees etc. Credit Default Swap (CDS): An „insurance“ against loan defaulting that the lender can buy from other investors. If a borrower defaults on a loan, the investor who sold the CDS has to reimburse the lender for his loss. How did the credit crisis happen? Low interest rates  US banks borrow lot of money; investors don’t buy T-bonds anymore (low ROI)  CHEAP CREDITS 

Leverages: is borrowing money to amplify the outcome of a deal (leverage turns good into great deals  how banks make money) o Leverage refers to the use of debt (borrowed funds) to amplify returns from an investment or project o Investors use leverage to multiply their buying power in the market o Companies use leverage to finance their assets—instead of issuing stock to raise capital, companies can use debt to invest in business operations in an attempt to increase shareholder value Wall Street grows tremendously rich & pays back leverages Investors want part of it  mortgages (connecting investors w/ homeowners)

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Mortgages: o Mortgages are also known as "liens against property" or "claims on property" o With a fixed-rate mortgage, the borrower pays the same interest rate for the life of the loan o A burgeoning share of the lender market includes non-banks Family wants a house & saves for a down payment  contact mortgage broker  he connects the family to a mortgage lender who gives them a mortgage (broker makes commission); Prime Mortgages  family buys house & become homeowners (good b/c housing prices always increase) Lender sells mortgage to investment banker for a fee  investment banker borrows millions of dollars and buys thousands of mortgages  cuts package into pieces: CDO (Collateralizes Debt Obligation  safe/okay/risky) to compensate the risk: safe 4% (AAA), okay 7% (BBB), risky 10% (unrated); “safe” part is insured w/ Credit Default Swap investment banker sells slices: AAAsafe investors, BBBbankers, riskyhedge funds, risktakers he then repays his loans investment bankers want more CDOs  lender wants more mortgages  broker can’t find anyone Idea! Mortgages w/: no down payment, no proof of income  lending Sub-Prime Mortgages

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Turning Point Same path as before  playing hot potato w/ CDOs  investment banker is stuck w/ houses as ppl don’t pay  more supply in housing  prices plumb  value of all houses goes down  mortgage payers stop paying (walk away from houses)  investment banker owns multiple worthless houses  can’t sell his CDOs anymore, can’t pay back loans  all have the same problem 

Financial Market is frozen  all go bankrupt  all goes in a cycle

In short: Low federal reserve interest rate (1%)  abundance of cheap credit, investors have lots of money 

Lots of people buy houses with mortgages, Investors invest in CMOs and CDOs (better investment than federal reserve loans)

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Lenders start giving risky mortgages, investors don’t rate the CMOs and CDOs properly  high-risk tranches are rated as low risk

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Risky mortgages get defaulted  abundance of houses on market  house prices fall, more people default on mortgages

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CMOs and CDOs rapidly lose value, nobody wants to lend money  frozen credit market, economy crashes

Debt & Mortgages – Basics Asset Backed Securities (ABS): Security (security = Wertpapier) that derives its value from other assets, for example loans. „Securitization“ = turning a...