In reviewing fixed income, I ran through the Minsky framework (SS14, R53) and thought to myself that this would be a decent curveball for this year’s exam. Just like BOP, it isn’t particularly complicated, but there’s enough to build an item set and either you know it or you don’t. Anyone agree? If not, what’s another reading that you think they could surprise us with?
who cares–just know everything and you will be good to go:) bring on minsky-that would be easy points!
Don’t forget Moody’s approach towards credit analysis. It can be mixed with Porter’s 5 Forces.
Moody’s approach…as in…how many notches to adjust in each scenario “downgrade watch, upgrade watch, negative outlook, stable outlook, positive outlook” ?
do you have any examples to show, eltia?
Moody’s looks at 1. Industry Trends 2. Regulatory Environment 3. Operating and Competitive Positions 4. Financial Position & Liquidity, company structure, parent support agreements, special event risk How about the ratios that S&P uses. funds from operations / total debt funds from operations / capital spending requirements (free oper CF + int) / interest Debt Service Coverage = (free oper CF + int) / (interest + annual prin repmt) Debt Payback period = total debt / discretionary CF For strong issuers focus on funds from operations ratios For weak issuers focus on free operating CF ratios NI + Dep --------- Funds from operation - Change NWC -------------- Operating CF - Capex ------------ Free Operating CF - Cash Dividends ------------- Discretionary CF - Acquisitions + Asset Disposal +/- other sources -------------- Prefinancing CF
Basically when accessing capacity to pay, Moody considers the industrial trends. So this is the part that ties into Porter’s Five Forces. I think it’s an excellent material for exam question. There is also this other guy in FI (same chapter as Moody) who talks about why high yield corproate bonds should be valuated using equity framework. That’s another nice connection with the Equity materials. There are other tiny connection like this all over the place in the curriculum. Many of them make good exam materials. Another example I found is volatility yield (term structure chapter) and how it relates to confident level in Quant.
With respect to Minsky, how is subprime (as an example) is a free at the-money call option? It then becomes out-of-the money as the property’s price drops below the purchase price. It then says that negative equity makes the call option worthless causing the homeowner to stop making mortgage payments. Could someone show this with an example?
Because banks effectively let people borrow money with no interest for two years, while the underlying asset continued to go up in value. So as long as the asset value continues to go up, the borrower has the right to sell the asset at a higher price than the amount that they borrowed and earned a risk free profit. This is like a free call option granted by the bank so that the borrowers can speculate on the asset value without worrying about paying off the interest nor principle for two years. Then when the housing bubble crashed, the call option was out of money. So no one was paying off the mortgages and the MBS/CDO investors suffer due to high defaults on the underlying loan pools.
great stuff… so, 1) The purchase price is the strike price of the call option, i.e., strike price = $300k. 2) When you bought the house, it is at the money because market price = strike price. 3) You didn’t pay any premium for this call option. 3) As the property’s price went up, market price > strike price, so you have in-the-money option. 4) House price tanks, and the option is out of the money. 5) Seeing that and fearing that the house price will not get up above the strike price before expiration of the call option (mortgage period), you stop making payments. Thanks for helping through this.
You stop making payments but good look getting another mortgage in the future
I think this is what is referred to as Ponzi Phase… M.