Nivine Richie, Ph.D., CFA is an Associate Professor of Finance at the University of North Carolina Wilmington. She teaches courses in corporate financial management, derivatives, fixed income, and commercial bank management. Her research interests include cost of capital, banking, and derivatives. She has published studies in the Journal of Economics and Finance, Journal of Futures Markets, Review of Futures Markets, and Journal of Trading, among others.
Several years ago, I heard a radio program where the reporter described an anti-capitalism protest. She went on to report that anti-capitalism protestors were selling T-shirts for $15.
Capitalism is alive and well, and needs fuel to operate. That fuel is the capital markets.
Click here for an interactive guide to capital markets by Goldman Sachs which describes capital markets, how they work, and the key players.
What is the role of capital markets in economic development?
photo of Credit Suisse Madison Ave, NY courtesy of Credit Suisse
The Bank for International Settlements (BIS) defines operational risk as, "The risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or external events." That is the risk that Credit Suisse faced recently when it accidentally wired $1.5 million to a hedge fund. You would hope that a large error would be caught after the first transaction, but in this case, the error wasn't discovered for two weeks and three transactions later. The bank is suing Galbraith Capital Investment Management, but Mr. Galbraith and the money are nowhere to be found.
According to CNBC (Goldstein, 30 Oct 2014):
The litigation offers a rare glimpse into the kind of money transfer mistakes that sometimes take place between hedge funds and their banks. Servicing money transfers for hedge funds is part of a lucrative business for Wall Street, known as prime brokerage, which also involves lending money to funds and processing trades. Disputes between banks and hedge funds tend to be resolved amicably and are seldom aired in public.
A number of people who work for other hedge funds said that while wiring errors do occur, the amount of money at issue in the case of Mr. Galbraith is larger than normal. Some of those people also expressed surprise that Credit Suisse had made three separate wire transactions that were all in error.
Perhaps more surprising is how long it took Credit Suisse to realize it made a mistake when it wired the money to an account at the Toronto branch of the Royal Bank of Canada for a hedge fund based in Florida. It transferred the money on Jan. 13, and not until Jan. 27 did it begin contacting Mr. Galbraith and his employees to seek the return of the $1.5 million, according to court papers.
What are the other risks faced by banks? How can banks hedge these risks?
Cash is still king. Especially for the unbanked or underbanked segment of our population.
According to CNBC (Holland, 30 Oct 2014):
Some 9.6 million American households, or about 25 million Americans, were unbanked in 2013, according to new data from the FDIC. And a TD Bank study found 71 percent of the unbanked use cash for daily purchases, compared with 30 percent of the overall population. That simple approach automatically limits how much a consumer can spend to what they actually have on hand.
From the FDIC press release:
Also unchanged from 2011, is the finding that one-quarter of households have used at least one alternative financial service (AFS), such as non-bank check cashing or payday loans in the past year. In all, 12 percent of households used an AFS in the past 30 days, including four in 10 unbanked and underbanked households.
The Survey report drew three implications from the findings that could point the way toward better meeting consumers' needs:
What does it mean to be unbanked or underbanked?
Why might some families choose to remain unbanked?
This video from The Economist argues that the benefits of doing away with cash should convince the public to give it up. But is it that simple?
What are the arguments in favor of giving up cash?
What are the arguments against giving up cash?
Which do you think are more convincing?
Many 401k plans offer target date funds as one of the choices of investments. But do you know what these funds are?
According to the U.S. Department of Labor:
With the growth of 401(k) and other individual account retirement plans, many more participants are responsible for investing their retirement savings. Target date retirement funds, or TDFs, can be attractive investment options for employees who do not want to actively manage their retirement savings. TDFs automatically rebalance to become more conservative as an employee gets closer to retirement. The “target date” refers to a target retirement date, and often is part of the name of the fund. For example, you might see TDFs with names like “Portfolio 2030,” “Retirement Fund 2030,” or “Target 2030” that are designed for individuals who intend to retire during or near the year 2030.
For which investors are target date funds appropriate? What are the pros and cons of investing in these instruments?
Photo by Urban available by creative commons at Wikimedia Commons
This CNBC article lists "10 Insane Things Wall Street Really Believes."
Here they are:
1. Falling gas and home heating prices are a bad thing.
2. Layoffs are great news, the more the better.
3. Billionaires from Greenwich, Connecticut, can understand the customers of JC Penney, Olive Garden, Kmart and Sears.
4. A company is plagued by the fact that it holds over $100 billion in cash.
5. Some companies have to earn a specific profit—to the penny—every quarter but others shouldn't dare even think about profits.
6. Wars, weather, fashion trends and elections can be reliably predicted.
7. It's reasonable for the value of a business to fluctuate by 5 to 10 percent within every eight-hour period.
8. It's possible to guess the amount of people who will get or lose a job each month in a nation of 300 million.
9. The person who leads a company is worth 400 times more than the average person who works there.
10. A company selling 10 million cars a year is worth $50 billion, but another company selling 40,000 cars a year is worth $30 billion because it's growing faster.
Can you identify which theory of finance or economics corresponds to each of these "myths?"
European banks have been under stress and the results of the stress tests will be revealed October 26th. This video from Bloomberg explains just what is being scrutinized.
The analysis involves scenario analysis of banks' balance sheets to determine whether the banks can withstand shocks to the system. The analysis will also include an examination of the quality of bank assets. Hopefully, the results bring good news to the banking industry in Europe.
Why do market participants need to see some banks fail the stress tests?
It got so bad that Tiffany & Co., the New York-based jeweler, bought an advertisement in the New York Times that said, “We think it is unconscionable for anyone to hoard several billion, yes billion, dollars worth of silver and thus drive the price up so high that others must pay artificially high prices for articles made of silver from baby spoons to tea sets, as well as photographic film and other products.”
This quote from a recent Bloomberg article (Ivry, 23 Oct 2014) gives a glimpse into the life of the late Nelson Hunt and the silver market of the 1970s.
Nelson Bunker Hunt feared inflation and political uncertainty, so investing in a commodity he could get his hands on--like silver--was his investment of choice. But after buying and accumulating and buying some more, the Hunt brothers dominated the silver market and drove the price of silver from $2/ounce to more than $45.
Then the rules changed.
In an attempt to control the buying of silver, the exchange imposed stricter margin requirements. The prices started to fall, margin calls kicked in, and the Hunts were eventually forced to liquidate and lose everything.
From the article:
On March 27, 1980 -- what came to be known as “silver Thursday” -- Comex asked Bache Group, the Hunts’ broker, for $134 million. The three Hunt brothers had $4.5 billion in silver holdings, $3.5 billion of it pure profit, Knight said. But they didn’t have $134 million.
[read the rest of the article here]
Today markets are different. No one party can control the market. In fact, exchanges are now considered to be the safer place to trade.
Cliff Asness, the successful and U of Chicago-trained analyst and founder of AQR Capital Management believes that the market can be beat. In spite of having studied under Eugene Fama, the famed creator of the Efficient Market Hypothesis, Asness uses some of the same strategies followed by Warren Buffett. According to Bloomberg BusinessWeek (Coy, 16 Oct 2014):
Buffett’s edge can be chalked up to two other techniques that AQR calls BAB and QMJ . BAB is short for betting against beta, which means picking stocks whose ups and downs aren’t correlated with those of the overall market. And QMJ means quality minus junk: Buy stocks that are safe, profitable, growing, well-managed, and have high dividend payout ratios. Those are strategies that AQR itself practices.
What is the efficient market hypothesis (EMH)?
What is a value investor? What is a growth investor? Which type of investor typically outperforms the market over the long-term?
The statistics are staggering. 46% of Americans have less than $10,000 saved for retirement and 31% have no money saved at all.
This CNN Money video points to some resources to help you figure out just how much you may need for retirement.
How much do you need for retirement?
If you're behind on your savings, what can you do now?
Source: DJIA chart from yahoo.finance.com
Markets go up. Markets go down. But before we get too excited about market volatility, we should agree on what "market" we're talking about.
According to this MarketWatch blog (Jaffe, 17 Oct 2017), the Dow Jones Industrial Average (DJIA) is the wrong measure of market movements. From the article:
The Dow has served its purpose, but it has devolved into the equivalent of a rotary phone in a world filled with smartphones. It’s the wrong tool for the modern era; while Luddites may not want to adopt new technology, most of them adapt pretty quickly and are better served once they do.
Thus, investors need to hang up on the Dow.
Just as the stock market experts use the Standard & Poor’s 500 or the Wilshire Total Stock Market Index as their representative version of “the market,” so should individual investors migrate to better measures. (In fact, with the S&P at around 1,900, an investor could again go back to where 100-point days are much more rare and, thus, much more meaningful.)
What is the difference between a "price-weighted" index and a "market-weighted" index? Which one is the DJIA? Which one is the S&P 500?
Why might one type of weighting be a better indication of the general market than the other?
Graph of 10year US Treasury yield over last month
Bond dealers have been short US Treasury notes and their bet against the US government is the largest short position since last year. But it isn't working out so well.
According to Bloomberg (Abramowicz, 10 Oct 2014):
Primary dealers had the biggest short position on benchmark government notes at the beginning of the month since last year’s taper tantrum. It was the wrong bet: The debt has gained 1.5 percent in October as 10-year Treasury yields plunged to the lowest since June 2013.
The surprise rally has even the most experienced bond traders struggling to figure out how to maneuver in this market. On one hand, the Federal Reserve is slowing its unprecedented stimulus, suggesting that yields are poised to rise. On the other, central banks elsewhere across the globe are accelerating their easy-money policies to suppress borrowing costs and avoid deflation.
One of the forces working against bond traders is the pessimism of the general market. In times of trouble or uncertainty, investors seek safety and their flight to quality leads them to invest in US Treasury notes. So demand by retail investors is trumping the bearish outlook by the professional investors.
What is "shorting" and why are bond traders shorting US Treasury notes
In commodity markets like the market for oil, many factors drive prices--factors like supply and demand of the underlying asset. This Bloomberg video shows that the oil market has done nothing but decline in recent months, mostly driven by weak demand.
What are the supply and demand-related factors that are contributing to the fall in oil prices?
A moral hazard exists when the party taking on risk is not responsible for the consequences associated with that risk. A moral hazard can exist anywhere, but it comes up regularly in finance and about financial institutions.
Recently, the International Monetary Fund (IMF) pointed to Wall Street and its culture of big bonuses as a possible contributor to the reckless investing culture that exists. This NY Times (Cohan, 9 Oct 2014) article explains:
“Pay incentives may go too far and encourage the bank staff to engage in too much risk taking from the shareholders’ point of view.”
“For example,” the I.M.F. report observes, “by taking on loans that appear to be profitable in the short term but come with hidden, long-term risks, bankers can increase their immediate performance-based pay and move on before the risks materialize.”
A little history: Once upon a time, when Wall Street was made up of a series of undercapitalized private partnerships, partners actually contributed their own capital and had their entire net worth at risk every day. If a trader or a banker made a wrong bet and the partnership went bankrupt, creditors could seize the fortunes of individual partners to try to get their money back. Needless to say, with their own personal capital at risk, bankers and traders were reluctant to do anything too foolish.
This sounds like a classic case of moral hazard to me. By their large short-term compensation plans, young investment bankers are encouraged to take risk, but bailout is always right around the corner.
What are some other everyday examples of a moral hazard?
How can the moral hazard problem be solved?
[Watch the video here]
In finance, we deal with big data all the time. When traders and researchers have to manage large numbers of stock price and quote observations, they're managing big data.
This Harvard Business Review (HBR) video explains the difference between "big data" and "analytics." According to the video, big data refers to the "vast volumes and types of information that companies can now collect and process using increasingly high tech systems." Analytics, on the other hand "are the use of math and statistics to derive meaning from data in order to make better business decisions."
What are the sources of big data?
In what ways are data structured? In what ways are data unstructured?
What are the 3 types of analytics?
What are some other examples of big data and analytics in finance?
This interview with Blockchain president, Peter Smith, explains the Bitcoin market. Blockchain is the software company that provides the computer programming needed for investors to use their Bitcoin. The company is not an exchange, as he points out, but rather it is strictly a software company providing the computer services needed for this market to operate.
Unlike a bank, Blockchain doesn't hold your money for you. And unlike an exchange, Blockchain does not provide a trading venue. As Mr. Smith stresses, his firm is strictly a software provider.
What are the risks associated with investing in Bitcoin?
How is Bitcoin different from other payment services like PayPal?
In what ways can Bitcoin allow financial crime to thrive? In what ways would financial crimes be difficult using Bitcoin?
Borrowers and lenders of subprime auto loans are discovering that the dangers of this loan market, especially when it involves the dealership falsifying documents to issue the loan in the first place.
This NY Times article describes the loan fraud that is currently being investigated in the car loan industry. From the article (Silver-Greenberg and Corkery, 1 Oct 2014):
Federal and state authorities, a group that includes prosecutors in New York, Alabama and Texas, are zeroing in on the most powerful, and arguably the least regulated, rung of the subprime auto loan chain, used-car dealerships, according to people briefed on the investigations. Already, they have found hundreds of fraudulent loans that together total millions of dollars.
At their center, the people said, the investigations are examining whether dealerships are inflating borrowers’ income or falsifying employment information on loan applications to ensure that anyone, no matter what their credit quality, can buy a car.
Some of the same dynamics — the seemingly insatiable demand for loans as the market heats up and the dwindling pool of qualified borrowers — that helped precipitate the 2008 mortgage crisis are now playing out, albeit on a smaller scale, in the auto loan market. Under pressure to generate more and more loans, salesman at some used-car dealers are suspected of getting inventive.
Who is responsible for too much consumer debt and fraudulent loans in the car market?
photo: N. Richie
Secret recordings of the NY Fed’s dealings with Goldman Sachs reveal that Segarra’s claim that she was fired for being too hard on the investment bank may not be unfounded.
Carmen Segarra is the lawyer that was hired by the NY Fed to examine too-big-to-fail institutions. However, seven months later, she was fired. When she sued her former employer, a judge “threw out the case this year without ruling on its merits saying that the facts didn’t fit the statute under which she sued” (Bernstein, ProPublica 26 Sep 2014).
Segarra was hired in response to a report by Columbia professor David Beim, where he outlined the issues faced by the New York Fed. From the ProPublica article:
After interviews with dozens of New York Fed employees, Beim learned something that surprised even him. The most daunting obstacle the New York Fed faced in overseeing the nation's biggest financial institutions was its own culture. The New York Fed had become too risk-averse and deferential to the banks it supervised. Its examiners feared contradicting bosses, who too often forced their findings into an institutional consensus that watered down much of what they did.
The NY Times (Popper and Eavis, 2 Oct 2014) reported this week:
Lawmakers are scrutinizing allegations that the Federal Reserve Bank of New York went easy on one of the most prominent banks under its watch, Goldman Sachs, despite concerns voiced by those inside the Fed that a deal Goldman was pursuing was “legal, but shady.”
Now committees in the Senate and House of Representatives are looking at whether to hold hearings or conduct more extensive investigations into the Fed’s oversight of Goldman and other banks.
How is the Federal Reserve organized? In what ways could this structure be perceived as an inherent conflict of interest?
In finance, we’re introduced to the regular annuity as a stream of payments with a future value at the end of the term. For example, if I save $5,000 every year for the next 20 years at 4% annual interest rate, how much will I have in the account at the end of the 20th year? This is the typical financial question faced by most people, and the variations on that question can go something like this:
How much must I save each year at 4% annual interest rate to be able to retire in 40 years with $1 million in the bank?
What interest rate must I earn on my annual investments if I put away $15,000 each year for the next 30 years and I want to have $2 million at the end of the 30th year?
Elderly homeowners face a related annuity problem when they choose a reverse mortgage, but the cash flows are in the opposite direction.
According to the Consumer Financial Protection Bureau (CFPB), “A reverse mortgage is a special type of home loan that allows older homeowners to access the equity they have built up in their homes now, and defer payment of the loan until they pass away, sell, or move out of the home.” Unfortunately, this type of lending has been associated with shady practices that hurt elderly homeowners.
More recently from Bloomberg (Steverman, 9 Sep 2014)
New regulations are supposed to improve the unsavory reputation of reverse mortgages, which are loans against a home that don't need to be repaid until the borrower moves. "It used to be the Wild West out there, without much regulation and enormous fees," says financial planner Warren Ward.
While stronger oversight is helping to end past abuses, the number of people taking out reverse mortgages is shrinking. The pace is down 24 percent from last year, government data show, and less than half its peak in 2009. One reason: Many advisers say the loans remain a last resort and can handcuff homeowners who have better options.
Under what circumstances would you recommend a reverse mortgage to a homeowner?
photo copyright N. Richie
When electronic banking entered the marketplace, many thought that the end of brick and mortar banks was imminent. And yet here we are, years later, and banks still dominate the financial landscape.
This video describes the roles that banks play in financial markets. Among those roles is delegated monitoring where savers can put their money to work and trust that experts (aka bankers) will monitor the safety and investment of their funds.
What do you see for the future of banking? What factors suggest that banks will continue in their present form? What factors suggest that they may become extinct?
The first case against high-frequency traders engaging in "spoofing" has been filed. According to the NY Times (Alden, 2 Oct 2014):
A high-frequency trader has been charged with manipulating the prices of futures contracts, in what the government said was the first criminal case to be brought under new rules against abusive trading.
A federal grand jury charged Michael J. Coscia, the founder of Panther Energy Trading, with six counts of commodities fraud and and six counts of “spoofing,” the illegal trading practice of quickly placing and then canceling orders to send a false impression to the market, federal prosecutors said on Thursday. He made nearly $1.6 million in profit through the trades, according to the indictment, which was filed in Federal District Court in Chicago.
Spoofing is defined in this CFTC guidance as:
Spoofing" includes, but is not limited to: (i) submitting or cancelling bids or offers to overload the quotation system of a registered entity, (ii) submitting or cancelling bids or offers to delay another person’s execution of trades, (iii) submitting or cancelling multiple bids or offers to create an appearance of false market depth, and (iv) submitting or canceling bids or offers with intent to create artificial price movements upwards or downwards.
Is spoofing unethical? Should it be regulated?