Characteristics of the Debt Market

The world’s financial system was almost brought down in 2008 by the collapse of Lehman Brothers that was a major international investment bank at that time. The government sponsored these banks’ bailouts that were funded by tax money in order to restore the industry. Before the crisis, banks were lending irresponsible mortgages to subprime borrowers who had poor credit histories. These mortgages were purchased by banks and packaged into low-risk securities known as collateralized debt obligations (CDOs). CDOs were divided into tranches by its default risk. The ratings of those risks were determined by rating agencies such as Moody’s and Standard & Poor’s. However, those agencies were paid by banks and created an environment in which agencies were being generous to ratings since banks were their major clients.

Is that make loans or buy bonds with long maturities are relatively more exposed to credit risk. Foreign exchange risk, is the risk that exchange rate changes can affect the value of an FI’s assets and liabilities denominated in foreign currencies. FIs can reduce risk through domestic-foreign activity. Liquidity risk, is the risk that a sudden and unexpected increase in liability withdrawals may require an FI to liquidate assets in a very short period of time and at low prices. Can be day-to-day withdrawals by liability holders are generally predictable. And are usually large withdrawals by liability holders can create liquidity

The debt in the United States has been growing for decades and has accumulated all the way up to 19.9 trillion dollars. This amounts to 61,036 for each person living in the U.S, 157,735 for each household, 104 % of the U.S gross domestic product, and 546% of annual federal revenues. Tackling debt and deficits is a national security issue that affects our ability to compete in the international system. The proportion of U.S. government debt held by foreign entities has significantly increased.

In 2008 the United States economy faced it most serious economic downturn since the great depression. This crisis began in 2006 when the subprime mortgage market showed an increase in mortgage defaults. This would lead to the decline of the U.S. housing market after a decade of high growth. The problems in the mortgage market where able to spread to other sectors of the economy especially in financial markets because of Collateralized Mortgage Obligations or CMOs. CMOs where mortgage backed securities that where given out by investment banks and where not regulated by the government. These securities fell as did mortgages due to increasing default rates. Because of CMOs companies bought Credit Default swaps or CDSs. These CDSs where nominally

One of the biggest influences of the economic crash was the faulty rating given from various rating agencies such as “Standard and Poor” and “Moody’s.” The point of a credit agency is to give an accurate evaluation of a bond

We are team Baldwin, and we used two main strategies while playing Capsim. We focused on being broad cost leaders, and we were aggressive. During the practice rounds, we did not do well because of our lack of knowledge of the simulation and also did not really take the time to make appropriate decisions. When the real decisions started, we wanted to be broad cost leaders; dominant in all segments of the market, which included: Baker, Bead, Bid, Bold and Buddy. We were profitable, because we were competing against the other teams in all segments of the market. For this reason, we were able to compete against everyone and had captured 25.75% of the market share at the end of decision six. Additionally, we used an aggressive strategy; one of

With the hunger for yields driving down rates across the fixed income market, an increasing number of articles are coming out warning of lower underwriting standards and the danger in covenant-lite (cov-lite) investments. Covenants on high yield bonds and bank loans are loosening; however we are not observing the excesses of a late-cycle boom. It is easy to point to a few statistics and draw startling conclusions about the below investment grade market. While cov-lite loan issuance is increasing, these securities still provide protection to secured lenders. High Yield bond covenants have also been weakening. Issues are coming to market with investment grade style covenant packages that do not provide strong liens and change of control protections. While loan and bond covenants are getting leaner, credit fundamentals still remain robust.

From the view of demand, after 2000, the decreasing interest rate and the availability of

From the data discovered based on the increase of technology, it provided an understanding of the traditional process of being granted or providing loans and mortgages. Banks traditionally grant loans to individuals or businesses that meet specific credit requirements and would receive periodic payments. This process continues until the loan is fully paid off. Due to the increase in technology, banks were able to lower their costs for transactions by securitizing loans electronically. This innovation allowed them to bundle up all small loans into a standard debt security, which then could be bought and sold in the financial market. This led to a structured credit product offering that generated large cash flows from a collection of underlying assets with certain risk management. Investors had the opportunity to pick and choose what they wanted to purchase depending on their likes and

Collateralized debt obligations (CDOs) refers to a kind of innovative derivative securities product which simply bundling mortgage debt, bonds, loans and other assets together and then rearranging these assets into different tranches with different credit ratings, interest rate payments, risks, and priority of repayment to meet the needs of different investors. As borrowers began to default, investors in the inferior tranche of the CDOs took the first hit, so the owner of this tranche of CDOs may be riskier. In order to compensate for the higher risk, the subordinate tranche receives higher rate of return while the superior tranche receives lower rate but still nice return. To make the top even safer, the banks ensured it small fee called the credit default swap (CDS). The banks do all of the works so that creating rating agencies will stamp the top tranche since as a safe, triple A rated

In the new system, an investment banker buys the mortgage from the lender, borrowing millions of dollars to buy thousands of mortgages, and every month he gets payments from homeowners for each of the mortgages. The banker then consolidates all the mortgages and splits the final product into three sections: safe, okay, and risky mortgages, which make up a collateralized debt obligation (CDO). As homeowners pay their mortgages, money flows into each of the sections, with the safe filling first and the risky filling last, contributing to their respective names. Credit agencies stamp the top two safer mortgages with a triple A or triple B rating, which are then be sold to investors who want a safe mortgage, while the risky slice is sold to hedge funds who want a risky investment. The bankers make millions, pay back their loans, and investors also make a worthwhile investment. So pleased are the investors, however, that they want more. Unfortunately, back at the beginning of the cycle, the mortgage broker can no longer find qualified mortgagers

Comparing each bond’s theoretical yield and price to its actual yield and price, we find that both bonds are underpriced. However, this alone is insufficient to conclude that an arbitrage opportunity exists, since our calculated theoretical prices ignore the effects of liquidity premium. As, in this exercise, we are unable to calculate what the true liquidity premium for each bond should be, we consequently do not have a true price for each bond to compare with and ascertain whether each bond is underpriced (ie. both the theoretical and actual prices may not be the true price). Nonetheless, we have calculated the implied liquidity premium for each bond as the difference between the theoretical yield and actual yield (see Table 1 above).

You have been asked to write a training document about the US Bond Market for use in the new employee-training program. In your document, you must make sure to address each of the following:

This distinction between debt securities prices and interest rates – on which more will be said below – is supported by the fact that the actual markets where their joint values are determined are explicitly debt securities markets. Bond markets – primary as well as secondary – and commercial paper markets quote either the prices or discount rates of their debt securities, and leave the corresponding interest rate to be inferred. The “interest rate” is a pricing term generally spoken outside of the larger financial markets by retail borrowers and lenders such as local banks.3 In addition to the great familiarity with interest rates by those who borrow or lend through banks, most economists dependably refer to interest rates instead of debt securities’ prices because it is assumed that economic agents think in terms of interest

Another financial vehicle that could be problematic was CDS (credit default swap). CDS is a financial derivative works like insurance on securities. The underwriter is obligated to pay a pre-determined fee to counterparty if a certain security default. In return, underwriters charge a fee as compensation. CDS can be used to hedge against risks. However there are still some difference between a CDS and an insurance contract.