Debt and Exchange Rate Essay

University of Toronto ECO 349 Money, Banking and Financial Markets G. Georgopoulos Student name: Kaiji Lin Student number: 997800535 Assignment 1. Find a recent  (August 2011? present) money and banking related article in the media (the Economist, Globe and Mail, National Post, New York Times, etc. ,), and attempt to explain parts or all of it using the tools we learned in class. Highlight the sentences that you analyze, and hand in the article along with your work. Use written and graphical explanations. (approximately 3 double spaced pages) S&P downgrades top US banks’ credit ratings By EILEEN AJ CONNELLY | AP – Tue, Nov 29, 2011

NEW YORK (AP) — Standard & Poor’s Ratings Services has lowered its credit ratings for many of the world’s largest financial institutions, including the biggest banks in the U. S. Bank of America Corp. and its main subsidiaries are among the institutions whose ratings fell at least one notch Tuesday, along with Citigroup Inc. , Goldman Sachs Group Inc. , JPMorgan Chase & Co. , Morgan Stanley and Wells Fargo & Co. S&P said the changes in 37 financial companies’ ratings reflect the firm’s new criteria for banks, and they incorporate shifts in the industry and the role of governments and central banks worldwide.

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The agency did not release its evaluation of each company but said it plans to discuss the changes during a conference call early Wednesday. Bank of America’s issuer credit rating was cut to “A-” from “A,” as were its Countrywide Financial Corp. and Merrill Lynch & Co. Inc. units, along with a series of related subsidiaries Ratings downgrades are never seen as positive, but this round may be particularly damaging for Bank of America. Concern already was growing Tuesday about whether B of A has enough capital to withstand another downturn in the U. S. conomy or further trouble in Europe, and the bank’s stock fell to a two-year low before the ratings announcement. The Charlotte, N. C. -based bank said in a recent regulatory filing that downgrades from S&P or Fitch Ratings, which also is reevaluating its ratings, “could likely have a material adverse effect on our liquidity” and cut off its access to credit markets. It typically costs companies more to borrow when their credit ratings are cut, the same way a decline in a person’s credit scores drives up the interest rates that banks and credit cards will offer him.

Downgrades could hurt parts of the bank’s businesses where creditworthiness is critical, Bank of America said in a filing Nov. 3 with the Securities and Exchange Commission. A downgrade also could trigger provisions in derivative contracts that require B of A to put up more collateral, and it could terminate the contracts, resulting in losses and hurting the bank’s liquidity. The bank posted a $6. 2 billion profit for the third quarter, mostly the result of accounting gains and the sale of a stake in a Chinese bank, but it was still moving toward a loss for the year as of Sept. 0. Bank of America shares fell 17 cents, or 3. 2 percent, to close Tuesday at $5. 08 and lost another penny after hours. S&P cut its rating on Citigroup Inc. ‘s credit to “A-” from “A”; a series of its subsidiaries also saw changes. Citigroup shares closed up 19 cents, at $25. 24, and lost 14 cents aftermarket. Goldman Sachs also was cut to “A-” from “A,” which triggered some downgrades for subsidiaries. The investment bank’s shares closed regular trading down $1. 62, at $88. 81, and lost another 12 cents in late trading.

JPMorgan Chase’s rating also dropped to “A” from “A+,” and its Chase Bank unit was downgraded to “A+” from “AA-” and other subsidiaries ratings also changed. JPMorgan Chase took the place of Bank of America as the nation’s largest bank in recent months. The bank’s stock lost 6 cents aftermarket after closing the regular session down 60 cents, or 2 percent, at $28. 56. Morgan Stanley’s rating slipped to “A-” from “A” and several of its units also got cut one notch. Shares slipped 9 cents in late trading from their close down 49 cents, or 3. 6 percent, at $13. 1. Wells Fargo fell to “A+” from “AA-” which likewise triggered downgrades for several subsidiaries. Shares closed down 7 cents at $24. 08, then lost 18 cents aftermarket. In addition, Bank of New York Mellon Corp. , the sixth biggest bank in the U. S. , was cut to “A+” from “AA-,” and some units were downgraded. Bank of New York Mellon is a custodian bank, which collects dividends on stocks and holds cash deposits, among other things, on behalf of its customers, which are mainly large pension funds and money market funds. The stock closed down a penny at $18. 8, then lost 8 cents in late trading. Top U. K. downgrades include Barclays PLC, HSBC Holdings PLC, Lloyds Banking Group PLC and The Royal Bank of Scotland. Ratings for several big European banks, including Credit Suisse, Deutsche Bank, ING Groep N. V. and Societe Generale were unchanged, but in some cases they were given a “negative” outlook. Analysis The main idea of this news is to report that Standard & Poors announced its downgrade in the credit ratings of the some biggest banks and financial institutions in world, such as Bank of America, JP Morgan Chase Co. , Citigroup Inc. , etc.

It mentioned the reason of why S&P decided to lower the credit ratings of these large institutions. The major loser of this event is the Bank of America, because it will confront some problems related to their costs of borrowing and revenues. Financial institutions’ creditworthiness is a very important indicator of how they are performing related to the risk. This downgrade apparently will put these financial institutions in a weak situation where they have to face a large amount of problems. The decline in these financial institutions’ stock price is the result of uncertainties after downgrade.

The major country that suffers from this is the United States, but also some global financial institutions will be also facing the same problems, some of them are Barclays PLS, HSBC Holdings, etc. S&P as a rating agency has been improving and changing their methodology of how to revise financial institutions’ performance after the bankruptcy of Lehman Brothers Holdings Inc. and Bear Stearns Cos. After changing their criteria about financial institutions’ credit ratings, they announced the downgrade. S&P is a research company which evaluates stocks and bonds, and it earns revenue from subscribers and financial assets issuers.

S&P’s main objective is to provide reliable creditworthiness research to the investors or subscribers, however issuers also have to pay an amount of money to them for doing research, therefore a conflict of interest might exist. Investors and regulators may worry about this credit-rating agency to bias their report, because they might upgrade the rating to attract more business. In this case the downgrade may also involve conflicts of interest, which made this credit assessment quality to decline and increase the asymmetric problem that affect the financial market.

Financial institutions serve as an intermediary that transmitted the funds from people who have an excess to people who have a shortage. Their existence will benefit the financial market, with condition that they have to have good asset and liquidity management. When they manage these two factors in a healthy way, their credit rating will increase means that they will have lower chance to default. The asset management consists of how to diversify by acquiring different types of financial products to lower the risk. The objective can be understood as get high return while reduce the risk.

This management is revised by the S&P when they are doing the credit rating research. The liquidity management is also an important factor for these institutions, because they have to be prepared when there are large deposit outflow. These institutions have to calculate how much reserve to be put away to face any possible contingent situation. So the reserve of asset with high liquidity will be also considered by the credit-rating agency, because low liquidity may cause the financial institutions to suffer from losses or even worse.

When the downgrade happens, these financial institutions have to put addition billions of dollars as collateral to protect the depositors. That is why a downgrade will never be considered as a positive event. In the news, it is mentioned that the Bank of America may confront liquidity problems, and the additional collateral is one of it. Also, the downgrade might violate some contract covenants, therefore losses will also occur. From here, we can say that the downgrade of credit rating can affect financial institutions’ performance until the market is adjusted.

The credit rating evaluates the credit worthiness of an issuer of specific debt; in this case the issuers are the financial institutions. The downgrade on the rating will make these institutions to have higher cost of borrowing as mentioned in the news. The credit rating which is associated to the default risk will represent if the issuer is still able to pay off the debt. So when the S&P downgrade these financial institutions, means that the default risk of their debts will increase, therefore investors will reduce heir holdings on them which leads to a decrease in demand for the debt (in this case we consider it as bond), then decrease in price and drive up the yield or interest rate. A higher interest rate means that if these financial institutions need to borrow money from the investors, they have to pay larger amount of interest which means their cost of borrowing has increased. To sum up, the downgrade will create liquidity problems and make the borrowing cost higher to these financial institutions.

It will also bring uncertainties to the market; therefore these financial institutions will suffer from losses because of reduced amount of businesses. This downgrade wi ll be a big attack to the world economy because these financial institutions are important to the market. On the other hand, this will also increase the pressure on firms that are already dealing with weak economies and Europe’s debt crisis. Finally, I consider the timing of S&P’s announcement of this downgrade as not appropriate. 2. Outline the major factors that contributed to the financial crises of 2007? 009, relating to factors within the U. S. financial system and outside factors. (approximately 3 double spaced pages). Financial risks can be defined as severe disruption or disorder in financial markets, and the major effects are declines in asset prices and firm failures. Some key factors that lead to the financial risk are the following: asset market effects on balance sheets, deterioration in financial institutions’ balance sheets, banking crises, increases in uncertainty, increases in interest rates and government fiscal imbalances.

The 2007-2009 financial crises are the outcome from the combination of the factors mentioned; the primary ones are asset market effects on balance sheets and deterioration in financial institutions’ balance sheets. Financial liberalization as the driven factor of the crisis is the form that reduces the limitations or restrictions on the financial markets and institutions. This has its advantage as making the lending process more efficient; however it also has shortcoming such that the financial institution that have loosen the qualification to obtain a mortgage will burden excessive risk.

By lowering too much restriction or introducing innovative financial products can attract consumers to borrow more, which leads to an excessive lending or credit boom that will make the information research more difficult for the financial managers. Subprime mortgages are the financial innovation that was introduced after 2000 for people that are not credit-worthy to borrow money for buying houses. The financial institutions will issue this type of mortgage characterized by a higher interest rate and less favourable terms, in order to compensate the higher risk to people who do not have healthy credit ratings.

Further, the financial institutions that issued subprime mortgage started to bundle together the loans and sell it to the investors, this process is called securitization. The two major products of this type of financing are mortgage-backed securities and collateralized debt obligations (CDO). They are somehow similar but the first product is security based only on mortgage loan and the latter can be secured by any bonds and mortgages. The CDO was very popular before the financial crisis, because it can provide different returns and risks to satisfy the investors’ preferences.

Due to the large practice of the securitization, banks started to issue even more subprime mortgage loans. They will put them together and sell it as a security to different investors and get the money to issue mortgages again, and this process went on and there a credit boom existed. The securitization attracted investors from all countries, especially China and India, which made the subprime mortgage market to become a trillion dollar market by 2007. U. S politicians and economist have supported the development of the subprime market, because it is liberalizing the lending process and this can make the U.

S. homeownership rate to increase. This means that people that were not considered credit-worthy before could still request for a residential loan, however, politicians have forgotten the basics of default risk. Along with this, people were starting to get mortgage to buy houses, and the higher demand has driven the house price. Having the higher housing prices will give the subprime borrowers power to refinance their houses with even larger loans, because if default to pay the interest they can just sell the house to pay off the loan.

Therefore, borrowers would request for even more mortgage loans and investors will lend even more money, because they are happy with the higher return from subprime mortgage. So this process of financial liberalization has lead to an increase in the demand for houses and a large growth on housing prices, eventually another driving factor, housing price bubble was formed. Another factor that has eased the growth of the subprime market is the rise of agency problem. The central idea here is that the subprime market is an originate-to-distribute based business odel. This can be explained as the mortgage broker and the investor are two individual parties, so the broker issued the mortgage and sell the security that is backed by the mortgage to the investors. This leaded to a major problem, because the broker who issued the mortgages would not care about the credit risk or the power of repaying the loan that the subprime borrowers had. The only concern that they had was to issue as many mortgages as possible, so they could earn the transaction fee.

This is typical adverse selection problem, because risk lover people can easily acquire the subprime mortgage and earn high profit from increase in housing prices or leave the house when the house price cool down. Investors that did not know about the risk they are facing would just lend the money because they thought the financial institutions have done enough credit evaluation to all the borrowers. More importantly the brokers, in order to gain more transaction fee by underwriting mortgage, will persuade householders to acquire mortgages that they cannot afford.

Therefore due to this agency problem, a larger amount of subprime mortgages was out in the market. This financing process continued till the end of the 2006, when the housing prices started to decline that leaded to the housing price bubble burst. It got even worse, and subprime borrowers found out that the price of their houses has declined below the value of their mortgage. Therefore householders that cannot repay the mortgage would just leave the home to their lenders which means call the mortgage to default.

And this leaded to 1 million mortgages to default and large financial institutions that have largely invested in subprime-related securities suffered huge losses and some of one had to file bankruptcy; and the 2007-2009 started. 3. Predict and explain what would happen to the yield spreads in response to the following macroeconomic events: (i) recession; (ii) high inflation; (iii) stock market increase. (approx. 2 double spaced pages). Yield spread is the difference between quoted rates of two investments that are differed by the maturity, credit ratings, etc. In this case, we will consider the spread of credit ratings.

This indicator can help people to forecast macroeconomic events, such as inflation and business cycle. Usually, the government bond is considered as default-free bond that is the government will always pay off the loan because they increase taxes. The corporate bond normally will have a higher quoted rate than the government bond does and this difference is the yield spread, also known as risk premium which is the compensation for people who are willing to hold on the riskier bond. The liquidity is also a important factor, government bonds are easier to trade and corporate bonds are not.

In a recession, the yield spread will be wider. Recession is defined as a business cycle contraction or a general slowdown in economic activity. During this period, production will decline and increases the unemployment rate. As we know in a recession, people will be fear about the uncertainty, so they replace risky assets by lower-risk assets, therefore generally, the funds will move from the stock markets to the bond markets. In a recession, because of lower production and higher unemployment rate, people will reduce their consumption which leads to higher default for corporations.

The default risk is higher for corporate bonds, so investors will try sell them, therefore the demand for corporate bonds decreases, so prices goes down and interest goes up. On the other hand, people will demand more for government bond which has almost zero default risk, and this drives up the price and the interest rate go down. With corporate bonds rate goes up and government bond rate goes down, the yield spread will be larger. In a high inflation time, the yield spread will be wider. Inflation can be defined as an increase in the level of prices of goods and services in the economy during a period of time.

During this macroeconomic event, each unit of dollar can buy fewer goods or services; this means the money power has decreased. This effect will affect corporation’s profits, because the money they earn or they will earn tomorrow will not have the same power as yesterday; this problem creates more uncertainty. Under this situation, investors will decrease their holdings on corporate bonds; therefore the bond price will go down and the interest goes up. From this we can see that in a high inflation time, the yield spread will be wider. When the stock market increases, the yield spread will be narrower.

When there is an increase in stock market, it means that the economy is booming. When this happens, the aggregate demand will be high, businesses will increase their production and employment rate will also go up. An increase in demand for products and services will drive up their prices, and the businesses will increase their earnings. When this happens consumers will demand more, companies will make more earnings and investors will have more to invest. Generally, when this happens, funds will be moved from the bonds market to stocks market.

On the bond market, since the corporations are doing better, the default risk of their bonds will decrease. Investors will not be afraid of the default risk, so basically the risk of the corporate bond and government will be similar, but corporate usually gives higher interest rate. When this happens, they will demand for more corporate bonds and decrease the demand for government bonds; this will drive down corporate bond rate and drive up government bond rate. Therefore the yield spread will be narrower when stock market increases. 4.

Because diversification is a desirable strategy for avoiding risk, it never makes sense for a financial institution to specialize in making specific types of loans. ” Is this statement true, false, or  uncertain? Explain your answer. (approx. 2 double spaced pages). The statement is false. Financial institution is a business that provides financial services to their clients. More generally, financial institutions served as an allocator of funds in the financial market, means that they perform the process of transferring funds from people who have an excess on it to people who have a shortage.

So the job of the most financial institution is to borrow funds from people who deposited and in turn make loans to others. Acting as financial intermediaries, they reduce the transaction cost as taking advantage of economies of scale, can share risk by performing portfolio diversification and alleviating asymmetric information by hiring expertise to screen and monitor. Some examples of financial financials are banks, insurance companies, pension funds, etc. Diversification means to reduce the amount of risk by investing in a variety of financial assets, so its major objective is to raise the return while lowering the risk.

Financial institutions tend to invest in diversified loans. On the other hand, they also have to make sure that the loans they make can be successfully paid back in full so they can earn profit. To make successful loans, financial institutions have to reduce the credit risk which can be done by eliminating or alleviating asymmetric information. Asymmetric information is referred to when one party does not know enough about the other party to make accurate decisions. Two types of problems will occur when asymmetric information exists and they are adverse selection and moral hazard.

Adverse selection happened before the transaction occurred, in this scenario, it will occur when the loan is not yet made. This problem takes place when the bad risk borrowers are the ones who act more eagerly to obtain the loan and have more chance to be selected. Since adverse selection will make the loan more likely to have bad credit risk, investors will decide not to lend, even though there are credit-worthy borrowers. One way of eliminating this problem is to screen out bad risks by making an effective and reliable information collection from prospective borrowers.

This is what the financial institutions usually do to reduce credit risk, and it is less costly for them because they have the experts and apply the economies of scale. Moral hazard happens after the loan is made. The trouble here is that when a borrower is engaged to an undesirable activity after he/she obtained the loan. The undesirable activity will increase the risk that the borrower cannot pay back the loan. Since this asymmetric information problem might happen, investors will decide not to lend the money, which will disturb the financial market.

The way that the financial institutions do to solve this problem is monitoring. This means that they hire experts to monitor what are the activities that the borrowers are engaged to after acquiring the loan, and along with the contract covenants they can enforce the borrowers do not perform any risky activities. The statement says that financial institutions should not invest in a specific type of loans which is false, because financial institutions can improve their screening and monitoring process when they are only specifying in making a particular type of loans.

After specializing in the lending type, financial investors can better screen out the bad risk businesses that want to acquire loans because they will have more experience and knowledge in the specified area. For example, if the bank only concentrates in making loans to technology companies, they will learn how these companies work and how they make money. Even after making the loans, they can also better monitor if the companies are engaged to some activities that will violate the covenant, because they have got the expertise by specifying in this area.

In this sense, financial institutions specialize in a particular type of loan in order to alleviate the asymmetric information problems and make good credit risk lending so they can earn high profit with low risk. 5. “Given the high value of the Canadian dollar relative to the U. S. dollar, Canada should lower the value of the dollar and keep it at this lower level, that is be on a fixed exchange rate system as opposed to a flexible exchange rate system. ” Comment on this statement, outlining whether you agree or disagree with it and explain why. approx. 2 double spaced pages). Exchange rate system is the way how a country manages its currency related to other currencies and the foreign exchange market. Two commonly used systems are floating exchange rate system (Flexible) and fixed exchange rate system. Countries policymakers, related to this system, will have three basic objectives which are, to stabilize the exchange rate, to enjoy free international capital mobility, and to engage in a monetary policy oriented toward domestics goals.

However since these three objectives are contradictory, only two of them can be mutually consistent, therefore policymakers have to decide which exchange rate system to use depending on the country’s economy. Floating exchange rate system, as its name suggests, the exchange rate values are determined by market without intervention of governments. Therefore, based on the demand and supply for the country currency, the exchange rate of this currency can fluctuate freely, which is considered to be market efficient.

Some of the countries that use this system are Canada, United States, etc. Fixed exchange rate system means that the rates are determined by the government against another largely economy currency, such as U. S dollars and Euro. Since the exchange rate is controlled, when the currency is overvalued, the central bank will purchase domestic currency and sell foreign reserves; and when the currency is undervalued, the central bank will do the opposite.

This system has the power to force the domestic currency to devaluate or revaluate against the selected foreign currency. Each of these exchange systems has its advantages and disadvantages. Flexible exchange rate system’s major advantage as it can automatically adjust based demand and supply, which is useful to solve large balance of payment deficits. When the balance of payment deficit happens, there is an outflow of the currency so it will depreciate and then net exports will increase to eliminate the deficit.

Another advantage will be that the domestic country will be insulated from world economic fluctuations. This system also allows the government to perform monetary policies, such as determining interest rate. On the other hand, this system also has its main disadvantage as there is too much uncertainty because it is not fixed, so investors and traders will have to carry the risk. Fixed exchange rate system’s advantage is that it provides certainty for traders and investors, therefore less speculative activity will be needed.

This system will be beneficial to those countries whose economy is largely based on trade, exporters and importers will not suffer losses due to uncertainty about the currency value. It has another advantage as to control the inflation by linking the inflation to the anchor country (usually US dollar). This system has its shortcoming as the country adopting it cannot implement its independent monetary policy, so they cannot eliminate shocks that happen in this country. And this country will also suffer when shocks happen in the anchor country.

This system may also leave the country open to speculative attacks when people engage to this activity observe some weaknesses on the commitment to system. The statement says that Canada should adopt a fixed exchange rate system; however I am disagreed with it. Since the only reason for an industrialized country as Canada to apply the fixed exchange rate system is when the monetary and political institutions are not well developed in the country. As we know, Canada has well conductive monetary institution, the Bank of Canada that has considerable implementation of monetary policies.

A floating exchange rate system will allow Canada to run its independent monetary policy. In addition, this flexible system allows Canada to have different monetary conditions to the U. S. and that are appropriate the Canada’s economic circumstances. This system also will allow Canada to external and internal economic shocks by implementing monetary policy. So Canada should continue using this shock-absorber system and it can execute independent monetary policies and conditions.

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