Part 2 finance class summer 2010 forum nexus

Class #2Tuesday in Spain

Brian David ButlerProfessor of international finance and global entrepreneurship with Forum-Nexus Study Abroad. Guest lecturer with the IQS Business School of the Ramon Llull University in Barcelona, and the Catholic University of Milan. Previously, Brian taught finance, economics and global trade courses at Thunderbird’s Global MBA program in Miami, and worked as a research analyst with the Columbia Business School in New York City. Brian currently lives in Recife, Brazil where he is teaching classes at the university Faculdade Boa Viagem.

A global citizen, Brian was born in Canada, raised in Switzerland (where he attended international British school), educated through university in the U.S., started his career with a Japanese company, moved to New York to work as an analyst, married a Brazilian, and has traveled extensively in Latin America, Asia, Europe and North America.

briandbutler@gmail.com

LinkedIn/briandbutler

Skype: briandbutler

Brian Butler is a specialist in international economic analysis, and is founder of the prestigious “GloboTrends“ (www.globotrends.com) online economics site, which has been featured as syndicated content on Nouriel Roubini’s RGE Monitor, Emerginvest.com, Business Week Exchange, Wikinvest.com, and other leading news outlets.

http://globotrends.pbworks.com/ , http://blog.globotrends.com/

Lecture Schedule*

* Does not include professional visits, *Subject to change, modification without warning

•Tues 22th – boat to Greece

•Mon 26th – Athens

•Tues 27th – Rhodes•Wed 28th – Rhodes•Thurs 29th – Rhodes EXAM

Observations while in Spain…

•For next 3 classes –

•Each student - tell one thing about Spanish economy they noticed so far + class discuss

•Note: observations should come from reading, observations, and 3 professional visits: ▫Barcelona Stock exchange, SEAT (VW), Codorniu

Questions from visits

•Barcelona stock exchange – meeting with director –great opportunity - chance to ask questions about economy (not just about stock exchange) – to work on paper

Team Project • An in-depth analysis will be completed, looking at the

Euro zone countries. Students must include in their report:▫During a crisis: What are the benefits /drawbacks to

countries for being inside / outside of the Euro-zone? (You need to relate this discussion relate to topic of 'fixed vs. flexible exchange rates)

▫Students must highlight the risks of borrowing abroad, and relate this discussion to class lectures on this topic.

▫Make recommendations for how they think the fiscal crisis in Europe should be handled, as well as predictions for the long-term sustainability of the currency union.

Team Project• I. Country Selection• ALL Students are required to include in their analysis:

▫ the UK; ▫ at least one country from the Forum-Nexus trip (Spain,

France, Italy or Greece); ▫ at least one of the 'East-central' European states: Czech

Republic, Hungary, Poland, Slovakia, Slovenia);

Grad Students must also include:▫ AND at least one of the Balkans: (Albania, Bosnia and

Herzegovina, Bulgaria ,Croatia, Macedonia, Montenegro, Romania, Serbia)

▫ AND at least one of the Baltic States: (Estonia, Latvia, Lithuania),

Team Project

•Graduate Students:▫The project report should be between 8

and 11 pages long (Font: Arial, 12; Line Spacing: 1.5).

•Undergrad:▫The project report should be between 6

and 8 pages long (Font: Arial, 12; Line Spacing: 1.5).

How to turn in: either (hand written, neatly!) or computer, email:

Resources:1. Lectures2. Text Book: “An Introduction to Global Financial Markets”

(Valdez), chapter 11, “European Economic and Monetary Union” 2007, (suggested focus: p. 287-305). Pay special attention to “EMU – the benefits” – p 287, and “The counter arguments” – p289

3. Handout article: “Holding Together, A special report on the euro area”, from the Economist, June 13th 2009 (p 1-16)

*Grad Students only:▫ Read handout: “Country Forecast, Economies in

Transition, Eastern Europe”, from EIU, May 2009 (p. 5-10)

Group Project, “The Euro Zone – before, during and after the Global Economic Crisis”

International FinanceIntro…

REVIEW FROM LAST WEEK…

Borrowing $$ abroad in foreign currency = RISKY

Who remembers why?

What are the benefits of “International Finance”?

What are 2-3 benefits?

Benefits of Global Finance1. Serve international companies

▫CitiBank in Sao Paulo▫HSBC everywhere

2. Some countries don’t have DEEP enough capital markets

▫Needs of companies Bigger than Depth of capital markets

3. Efficiency, 4. Best practices (international competition

forces local monopolies to offer better rates)

What are the dangers of “International Finance”?

What are 2-3 dangers?

Currencies

When Argentina’s currency broke the “PEG” from 1:1 with the US dollar, and went to 4:1 … who suffered? Why? Who benefited? How?

New currency hedging problem…

Terms you need to know….

•Appreciation:▫Currency gets STRONGER vs other

•Depreciation:▫Currency gets WEAKER vs other

0 6 mo.

$R100k

Risk - in foreign currency•Example:

▫You are a German company… buying a container of furniture from Brazil (to resell at fixed prices in Germany)

▫You agree to pay 100,000 Reais (Brazilian currency) in 6 months to the Brazilian company

▫Assume the currency exchange rate is currently 2:1 (R$ to Euro)

▫How many Euros will you expect to pay in 6 months? (if FX doesn’t change)

0 6 mo.

$R100k

Risk - in foreign currency•Easy:

▫You expect to owe 100,000 / 2

▫= 50,000 Euros (if FX doesn’t change)

▫But what is the risk???▫(euro appreciates? Or depreciates?)▫(BRL appreciates? Or depreciates?)

Risk - in foreign currency

▫Forget the numbers for a minute…

▫Conceptually…You owe foreign currency in the future… What is your risk?

Risk - in foreign currency

•…if the exchange rate goes from 2:1 to 1:1

▫ You now need 100,000 Euros… (instead of 50,000 Euros…ouch!!!)

▫Question: how could you have avoided that risk?

Avoiding Risk

1. Don’t buy foreign goods (avoid risk)2. Negotiate contract so currency is based

in YOUR currency (transfer risk)3. How else?

Avoiding Risk – tools to use:

You could…1. Convert your money to R$ today…and deposit

that money in a Brazilian bank account (deposit hedge)… and pay the Brazilian supplier in 6 mo.

2. Contract with your bank to buy $R forward (sell Euros forward) in 6 months at a fixed rate (2:1) for a fee (forward contract)

3. Buy Future contracts on exchange (if you can find them) to sell Euros forward

4. Buy Options contracts (most expensive, but with option to tear up, don’t execute trade) to sell Euros forward

•Key lesson of international finance:•Currencies change, so…

1. Danger in owing $$ in foreign currencies

* Solution: be aware, and hedge to protect!

Core of our class:

•International finance = risk •We will outline those risks, and offer:

•Tools to protect•Hedging techniques:

▫Forward, Futures, options, etc…▫tools to PROTECT (and potentially

speculate)

Review from last week … continued…

Commercial Banking (business model)

•Commercial Banking business model:•“Borrow short, lend long”

•Who can explain what this means?

Borrow short – Lend long* time

T=0 10 20 30 years

Your deposits = bank “borrowing” (LIABILITY for bank) = short term (you might take out tomorrow)

Home Mortgages = bank “Lending” (ASSET for bank) = LONG term (30 yrs)

….. Inherently RISKY business model!!

Borrow Short▫Deposits are LIABILITIES for banks▫They are BORROWING money from clients▫But, deposits can be withdrawn at any time▫So… their Liabilities are short term (might

owe money tomorrow)

Lend Long• Banks invest in Long term Assets• Mortgages, for example… 30 years

duration• So, money is borrowed short (term), but

lent out long (term)

Banks Business model = fragileBorrow short, lend long

Note: this is the HEART of the issue for why banks are “fragile” business models .

*** For FINAL exam, you will need to remember this order:1. Fragile business model (borrow short, lend

long)2. Government guarantees (FDIC)3. Moral Hazard (guarantees lead to risky

behavior?)4. Regulation (in exchange for guarantees)

• must understand this…. In order to understand crisis, and to understand international finance.

Review: last week we discussed…

▫#1 First – banks are fragile – subject to “LIQUIDITY” crisis (bank run)

▫#2 Second – governments offer guarantees

▫#3 Third – regulations▫#4 Fourth – innovations

Who can explain this?

Moral Hazard

•Does regulation + bank guarantees… result in making the banking system more, or less risky?

▫Do you think government guarantees encourage risky behavior?

Law of Un-Intended Consequences

And… “Moral Hazard”

NY times article 1999…•Fannie Mae Eases Credit To Aid

Mortgage LendingBy STEVEN A. HOLMESPublished: Thursday, September 30, 1999

•“In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.”

NY Times, “Fannie Mae Eases Credit To Aid Mortgage Lending”, By STEVEN A. HOLMES, September 30, 1999

NY times article 1999…

•“The action…will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans.”

•“Fannie Mae…has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people

•… and felt pressure from stock holders to maintain its phenomenal growth in profits.”

NY times article 1999…• In addition, banks, thrift institutions and

mortgage companies have been pressing Fannie Mae to help them make more loans to so-called subprime borrowers.

• These borrowers whose incomes, credit ratings and savings are not good enough to qualify for conventional loans, can only get loans from finance companies that charge much higher interest rates -- anywhere from three to four percentage points higher than conventional loans.

NY times article 1999…• In moving into this new area of lending, Fannie

Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's.

• ''If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.''

•“By expanding the type of loans that it will buy, Fannie Mae is hoping to spur banks to make more loans to people with less-than-stellar credit ratings.

•Fannie Mae officials …add that the move is intended in part to increase the number of minority and low income home owners who tend to have worse credit ratings ...

Review: Solvency v Liquidity – QUIZ last week•Last week….Only Raymond got the extra

credit – 1 point

•What is the difference between: ▫a “Solvency” problem (for banks)▫a “Liquidity” problem (for banks)

•Who else can answer this NOW?

Solvent: not Solvent•Ok NOT OK

ASSETS-Include home mortgages-subprime

Liabilities (Borrowing, debt)

Equity

Solvency v Liquidity•Solvency problem:

• liabilities > assets (equity = 0)▫Person: I owe more than I’m worth

•Liquidity problem: • Mismatch between: long term asset, short

term liability▫I owe money NOW, but have money tied up

in my house, car, etc…

Solvency v Liquidity

•Last week we discussed how this related to the Global Financial Crisis?

▫Who can summarize? ▫What was the timeline?

Solvency v Liquidity Timeline

•2007 – September 2008▫Problem = Solvency▫Mortgages (assets on Banks

balance sheet) worth less than anticipated… write down

•After – mixed liquidity + solvency▫Liquidity = credit markets

freeze up so even good solvent banks had trouble

Equity

•Question: if a bank is having a SOLVENCY trouble… should the government come to their rescue?

•(clue – remember the discussion on “moral hazard”)

Equity

•Answer: NO! (probably not) *

•* but, gets complicated by worries about systemic risk, and interconnectedness, and “too big to fail” banks

Equity

How about a “Liquidity” crisis?

•Should the government step in to help a bank facing a “liquidity” crisis?

How about a “Liquidity” crisis?

•YES!!•To help banks bridge the gap between short term liabilities and long term assets

•* this is exactly why the FDIC, insurance was offered.

The trouble during the crisis…

•… after September 2008… it was difficult to tell which banks faced “liquidity” crisis (and should be helped), and those that faced “solvency” crisis, and should be allowed to fail (to avoid “moral hazard” from saving them)

International Finance

Pyramid of promises

What “promises”?• Financial assets represents “promises of

future, often contingent, receipts in return for current payments”

• Bonds▫Represent PROMISES of fixed payment (in

time), plus PROMISE of regular payments in between

• Equity (stocks)▫Represent PROMISES a share in future

corporate profits• Pensions

▫Represent PROMISES for a stream of income in retirement

Martin Wolf, “Fixing Global Finance”… based on McKinsey “Mapping Global Capital Markets”, 2005

What “promises”?• Life Insurance Policy

▫Represent PROMISES of payment after some fixed date or death

• Accident / Health Insurance Policy▫Represent PROMISES of payment if something

happens• Mutual Fund

▫Promises to return to investors the proceeds from mutual funds purchase of promises from corporations

• Options▫Is a promise to hand over a claim to a certain

promise under specific conditionsMartin Wolf, “Fixing Global Finance”… based on

McKinsey “Mapping Global Capital Markets”, 2005

Remember 2 dangers of international finance…

1. Currency might devalue2. Foreign governments might default (less

obligation to foreigners, not to voters)

* Promises based on trust

Pyramid of Promises

•“Central feature of the financial system: it is a Pyramid of promises- often promises of long or even indefinite duration. This makes it remarkable that sophisticated finance systems exist”

•Promises may not be kept•Interest of those who make promises NOT

to keep them

Pyramid of “promises”?

•“As the financial system grows more complex… it piles PROMISES on PROMISES”.

Just how big is the MOUNTAIN of promises…?

•Amazing….

data from McKinsey report 2005, "Mapping the global capital market" and http://www.federalreserve.gov/releases/

Size of Finance…

•“What is amazing is that the financial sector ballooned to the size that it has...with a worldwide total of $140 trillion in promises outstanding in 2005”

Size of Finance…

•Of that total, the US was the prime holder of promises (assets).

•The US household sector held about $39 trillion (28% of world total), and with the US as a whole holding nearly $52 trillion (37% of all world financial assets, or promises).

Size of Finance…

“PYRAMID of Promises”

•Modern economies depend on pyramids of promises far more impressive and complex than those of stone constructed almost 5 thousand years ago”

“PYRAMID of Promises”

•But, the system is extremely FRAGILE

•Confidence that sustains them could be misplaced

•People could end up with promises NOT WORTH the paper (they used to be) printed upon

Underneath that “PYRAMID”

•The “Foundation” of all of these PROMISES is = title to real assets▫Housing, land, property, factories,

machines, etc

▫Need to BELIEVE the original owner really ownes what they say they own.

▫So, key = property rights, law, institutions – for trust, and development of financial system

Banking is fragile…

•Why?

Hint: borrow short / lend long…

Series of Crises

This is NOT the first one!!

History of Crises (series)

Series of Crises• Financial liberalization = series of crises?

• Finance is increasingly fragile. Barry Eichengreen of the University of California at Berkeley and Michael Bordo of Rutgers University identify 139 financial crises between 1973 and 1997 (of which 44 took place in high-income countries), compared with a total of only 38 between 1945 and 1971. Crises are twice as common as they were before 1914, the authors conclude.

Martin Wolf book, “Fixing Global Finance”

Series of Crises – 1990’s• Japanese recession - 1990 to 2003, collapse of a real estate bubble

and more fundamental problems halts Japan's once astronomical growth, “lost decade”

• United Kingdom - 1992 - devaluation of currency, "broke the bank of England“, currency speculating against the European currency unit peg

• Mexico crisis 1994 ”tequila crisis” - currency devaluation, debt crisis

• Asian Crisis 1997: SE Asia Crisis - 1997 & 1998 - currency devaluation, debt crisis

• South Korea - 1998 • Russia - 1998 • USA - Long term capital management - hedge fund meltdown - 1998

- causes were SE Asia Crisis of 1997, and Russia crisis of 1998• Brazil - 1999 - currency Real was pegged to US dollar, then forced

to float – currency crisis

http://globotrends.pbworks.com/history-of-economic-crisis-and-currency-devaluations

SpainCrisis, recovery, EU, Euro

Spain review

•Crisis & recovery in Spain --

•Spain can not control monetary policy (lower interest rates). Who can explain? What is the impact on Spain? How was it different before Spain joined the Euro-zone?

Discussion on Spain…• Post crisis -- How can Spain regain competitive edge? Why

doesn’t Spain drop out? What is the risk? competitive devaluations. Productivity, pay cuts. Danger of civil unrest.

• Director of Stock Exchange said… risk is in 1-2 years from now, when inflation picks up, and if the ECB is forced to raise interest rates BEFORE Spain's economy picks up. If Spain’s economy is still slow, and if rates go up, it could choke off recovery (politically raising anger v ECB, euro)

• discuss

Homework:

•Find 1 example of Spain & the economic crisis

•Observation ok•News story ok

•Due – BEGINNING of next class (Wednesday)

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