3210AFE

Advanced Corporate Finance

Jason West
Semester 1 2011
Course Description

This course examines advanced aspects of the financial management of corporate issues with
an emphasis on issues in financial planning and strategy. Topics include firm governance and
the role of shareholders and stakeholders, the management of corporate debt and equity,
mergers and ecquisitions, financial distress and restructuring, and financial achitecture and
strategies. Special attention given to the increasing complexity of the business environment
and departure from the assumptions of an ideal capital market.

Prerequisites: 2201AFE , 2204AFE, 2206AFE, 2306AFE (Corporate Finance, Financial

Institutions Management, Investment Analysis & Management, Quantitative Methods for
Business Finance & Economics).

Hillier, D. Grinblatt, M. and Titman, S. (2009)

Financial Markets and Corporate
Strategy, European Ed. McGraw-Hill

Course Staff

Primary Convenor: Dr Jason West

Students: Please sign in to the Griffith Portal to view your list of
enrolled courses and click the relevant Profile link to
access all course contributor details held in this profile
Learning Objectives
After successfully completing this course you should be able to:

1  better understand the theory underlying corporate financial decision making;

2  undertake applications of portfolio, capital asset pricing and arbitrage theory;
3  appreciate efficient capital markets and their impact on financial decision-
making;
4  undertake corporate asset decisions and strategy;
5  understand firm funding decision-making abilities;
6  engage in the management and promotion of firm performance;
7  develop internal and external investment strategies;
8  appreciate risk management and the interface with corporate strategy.
Learning Activities

Week Commencing Activity Learning Objectives

Introduction to corporate finance and strategy (Lecture):
28 Feb 11 1
Readings/Ref: Hillier et al. (Chapter 1, 2 & 3);
Portfolio theory and evidence (Lecture):
7 Mar 11 1, 2
Readings/Ref: Hillier et al. (Chapter 4);
Capital asset pricing theory and evidence (Lecture):
14 Mar 11 1, 2
Readings/Ref: Hillier et al. (Chapter 5);
Factor models & arbitrage pricing theory &evidence (Lecture):
21 Mar 11 1, 2
Readings/Ref: Hillier et al. (Chapter 6);
Investing in risk-free projects (Lecture):
28 Mar 11 1, 4
Readings/Ref: Hillier et al. (Chapter 9 & 10);
Investing in risky projects (Lecture):
4 Apr 11 3, 4
Readings/Ref: Hillier et al. (Chapter 11);
Capital allocation and corporate strategy (Lecture):
11 Apr 11 3, 4
Readings/Ref: Hillier et al. (Chapter 12 & 13);
Taxation and financial decisions (Lecture):
2 May 11 4, 5
Readings/Ref: Hillier et al. (Chapter 14 & 15);
Capital structure decisions (Lecture):
9 May 11 3, 5
Readings/Ref: Hillier et al. (Chapter 16 & 17);
Managerial incentives, information and financial d (Lecture):
16 May 11 6
Readings/Ref: Hillier et al. (Chapter 18 & 19);
External investment decisions (Lecture):
23 May 11 7
Readings/Ref: Hillier et al. (Chapter 20);
Corporate risk management decisions (Lecture):
30 May 11 8
Readings/Ref: Hillier et al. (Chapter 21 & 22);
 Weightin Learning
Assessment Task Due Date
g Objectives
Mid Semester Exam
Outside Scheduled
Week 7 20% 1, 2, 3
Class
Mid-Semester Exam*
Report
1, 2, 3, 4, 5, 6,
Financial Assessment 20 May 11 17:00 50%
7, 8
Report
Exam during Exam
Period (Central) Examination Period 30% 4, 5, 6, 7, 8
Final Exam
 3210AFE
Advanced Corporate Finance
Week 1. Introduction to corporate finance and
strategy
Self-study objectives
Chapters 1-3 of the text (HGT) provides a review of basic terminology, definitions and
concepts encountered in the prerequisite courses.

After reading these chapters, students should be able to:

 Describe the ways in which firms can raise funds for new investment.
 Describe the main sources of debt financing; bank loans, leases, commercial paper and
debt securities.
 Describe the various characteristics of debt securities that a firm can issue.
 Describe the global environment in which firms issue debt securities.
 Discuss the operation of secondary markets for debt securities.
 Describe the types of equity securities a firm can issue.
 Provide an overview of the operation of secondary markets for equity.
 Describe the role of institutions in secondary equity markets and in corporate
governance.

This material is assessable.

Lecture objectives
 Our main objective today is to study the consumption and investment
decisions by individuals and firms and the role of interest rates in these
decisions.
 The theory presented underlies corporate finance decision-making
encountered thus far.
 The model, though simple, helps us to understand corporate finance
decision-making.
 It also explains the benefits of financial markets to individuals and
firms and how they promote economic welfare.
 This forms the benchmark of behaviour in our study of corporate
finance.
 However, we conclude the lecture by pointing out the basic omissions
from this model.

In this course, we aim to reconcile the theory of corporate finance

with changing real world behaviour.
The investment/consumption decision
An individual’s perspective…
 For most of your working life, you will be (should be?) earning and
spending money.
 Rarely, though, will your money income at a point in time exactly balance
with your consumption desires.
 Sometime you may have more money than you want to spend (surplus
spending unit or lender-saver); at other times you may want to purchase
more than you can afford (deficit spending unit or borrower-spender).
 These imbalances will lead you either to borrow or to save to maximise the
benefits from your income.
 We are essentially asking ourselves the question "How much of my wealth
or income should I consume now and how much should I save for later?“

So how about firms…?

 A very similar thing applies for firms: in fact, regardless of the governance
structure, firms are merely extensions of individuals.
 This is the basis of our study of corporate finance.
 C1
Slope = MRT
C0C1

D Z

A simple investment-consumption model

Consume next year

Consume now Invest

0 C A C0

 Simple two-period model: now (Year 0) and the future (Year 1)

Some assumptions:
 Assume a firm has finite resources (capital); this can be invested now or
paid as dividends in the current period (Year 0).
 Shareholders (individuals as owners of the firm) can use their dividends
for consumption.
 If invested, the firm earns a return which is paid out as dividends in the
next period (Year 1).
 The size and timing of outflows and inflows is known with certainty →
no risk.
 Only physical investment opportunities are available. Our initial
assumption is there is no capital market where money may be borrowed
or lent (autarky).
 Fractions of projects may be undertaken. Cash flows are independent.
Investment-consumption model cont…
 We naturally assume rational utility maximisation by owners.
 Production possibilities frontier - all bundles of the produced good possible in
year 0 and 1 given the level of allocated resources.
 If the company invests nothing, the dividend available in year 0 is 0A and 0 in
year 2.
 If the firm selects point Z then CA is invested with a total return (dividend) of
0D in year 1.
 We can see that the return on investment (slope = marginal rate of
transformation of C0 for C1) falls as we move upwards along the PPF.
 We have to give up larger amounts of current resources to gain resources in the
next period.
 This is because we have ranked all investments in terms of return.
 Firms are generally faced with thousands of alternative investment projects of
varying sizes with more and less attractive ROI.

Given the infinite array of combinations of current consumption

and investment for future consumption, how does the firm
decide how much to invest?
The answer lies in the preferences of its shareholders.
C1 Slope = y/x = y1-y2/x1-x2
= -1/10 = -0.1 = 10%

Slope = MRT
C0C1
Slope = 1/1 = 100%

D Z
Consume next year
Slope = -5/1 = 500%

Consume now Invest

0 C A C0
 Indifference Curves
 Indifference curves - all possible
combinations of current and future
consumption which yield the same level C1 Slope = MRS
C0 C 1
of utility (happiness or satisfaction).
 Represents the rate at which I am willing
to trade off current for future
consumption - it is a subjective measure. Increasing utility
 All other things being equal, as I get
more and more of either current or future
consumption, I am willing to give up a U2
lot of it just to get a little of the U1
alternative. U0
 This is called diminishing marginal
utility. C0
 These curves are infinitely dense and
uniformly mapped (do not cross).
 As we move out from the origin, the
level of utility (satisfaction increases).
Production-consumption without a capital
market

 When we combine the firm’s production

possibilities, with the owners’ U0
preferences for consumption we
establish a point of tangency (slopes are C1
equal) at Z.
 This tangency between the marginal rate
of return on investment (MRT) and the MRS=MRT
marginal rate of substitution (MRS)
between current and future consumption D Z
determines the point of production and
consumption.
 The implication is that the owner is on
the highest level of utility possible given
the production opportunities available.
 We can’t go to a higher utility curve C A C0
because of the finite production
resources of the firm.
Why is this position best?
 If MRS > MRT (to left of Z) then the return on
investment is less then the rate at which the owner is
willing to trade current for future consumption - utility
will fall. U0
 For example, the ROI may be 10% but my subjective C1
consumption trade-off preference is 12%.
 If MRS < MRT (to right of Z) then the return on MRS=MRT

investment exceeds the rate at which the owner is willing D Z

to trade current for future consumption.
 Increasing investment would then increase the level of
utility. C A C
0
 For example, my required return may be 12% and the
ROI may be 15%.
 In the absence of a capital market the firm’s production
bundle and the owner’s consumption bundle will be
identical.
 Could the owner be unambiguously better off if this is
not the case?
 C1
Production-consumption Slope = -(1+r)

with a capital market D

Capital market assumptions: F

 No transaction costs
 Costless information available to all C0
 Perfect competition - many price-taking borrowers and lenders.
 Single market clearing rate of interest.
 This determines the rate the market is able to trade off current for future
cash flows or vice versa.
 For example, let us assume the market rate is 10% and I have an equal
income allocation each year (0 and 1). Let us assume I would rather
have more income in year 0 (now).
 In this case I would borrow at 10% and repay the principal and interest
from my income in year 1.
 Alternatively, I may like to have more income in the year 1.
 Here I would invest (lend) my excess funds and receive it and the
interest return in year 1.
C1
Slope = -(1+r)

E
F

C0
Capital market decisions
 Because we have a capital market the decision process of the firm now
contains two separate and distinct steps:
 First, choose the optimal production decision by taking on projects until the
marginal rate of return on investment equals the objective market rate, and
 Second, choose the optimal consumption pattern by borrowing or lending
along the capital market line to equate the owners subjective time preference
with the objective market rate of return.
 We call this Fisher separation.
 Given a perfect and complete capital market the production/investment
decision is governed solely by an objective criterion (represented by
maximising attained wealth) without regard to an individual’s subjective
preferences that enter into their consumption decisions.
Person X
C1
CX MRS = MRT = -(1+r)

CY
Person Y
PXYZ
CZ
Person Z

Lending Borrowing
C0
 Person X
C1
CX MRS = MRT = -(1+r)

CY
Person Y
PXYZ

CZ
Person Z

Lending Borrowing
C0
Implications of the separation theorem
 The investment or production decisions of the firm are undertaken
separately from the consumption decisions of the firm’s shareholders.
 Dividend policy does not matter.
 Individuals will use the same time value of money in making
production/investment decisions.
 So long as firms undertake objective investment decisions they will
maximise firm value and in turn shareholders wealth.
 Now have two decision-making criteria for investments:
 Investments will be undertaken up to the point where:
 the net present value of the marginal investment is zero (NPV), or
 where the marginal rate of return on investment is greater than the market
interest rate (IRR).
 While the models presented are an obvious abstraction from reality, i.e. no
taxation, lack of perfect capital market, transactions cost, agency problems,
etc. they are remarkably robust so long as most assumptions hold.
 Capital markets are an important instrument of resource allocation.
What can this model tell us about
corporate finance?
 How much to invest.
 The decision criteria used to select investments.
 How much dividend to pay.
 How much debt we should borrow in the capital market.
 That management (agents) address shareholders’ (principals) preferences.
 The objective of the firm is shareholder wealth maximisation.
 That free and comprehensive capital markets make shareholders (and the
economy) unambiguously better off.
But what is missing?
 Principal-agent and other conflicts: management do not always act in the best
interests of owners and there are conflicts of interest between management and
shareholders, management and debt holders, and shareholders and debt
holders.
 Information asymmetry: Not all parties involved have the same level of
information and addressing this may compromise other aspects of corporate
behaviour.
 Fisher separation does not strictly hold: the firm’s financing and investment
decisions are interrelated.
 Markets are not perfect and frictionless: taxes, transactions costs, government
policy and others impact upon the decisions we make.
 Shareholder wealth maximisation does not always hold: firms often choose to
depart from these principals to meet the needs of shareholders.
 Stakeholders, including workers, society, government, customers, suppliers, as
well shareholders are affected by the actions of the firm.
 Risk (variation in future outcomes) affects all of the firm’s decision-making.
The world of corporate finance is always changing, and often very quickly.
 Theory in Practice…

Week 1. Introduction to corporate finance and

strategy
 The Global Financial Crisis
• What was the source of the crisis?
• Why did we not pick it before the collapse?
• Why were the models wrong?
• Where to now?
 Origination and Securitisation
Process
Mortgage
Broker

$
Lender/
Borrower
Conduit

Mortgage

Step 1: Borrower obtains a loan from a

Lender. May be done with help from a
Mortgage Broker. In many cases the
Lender and Broker have no further
interaction with the borrower after the
loan is made.
Home buyers go shopping
• The home is viewed as the key to financial security in the US.
• Government policy encourages home ownership by providing federal
income tax deductions on mortgage interest and requiring that lenders
issue mortgages in poor neighbourhoods.
• Renters are eager to buy and many homeowners trade up several times
during their lifetime.
+ INTEREST RATES FALL
• Interest rates fall to rarely seen lows allowing the same monthly
payment to support a larger loan.
• This makes homes affordable for people who previously had rented and
it allows homeowners to move up to properties that are more expensive.
+ HOUSE PRICES RISE
• By allowing people to borrow more low interest rates allow them to
offer more when they bid on homes, driving home prices up.
US House Prices – Shiller Index
Adjustable-rate loans
• Home buyers finding prices getting out of reach resort to sub-prime
and other adjustable-rate loans that start with low ‘teaser’ rates
allowing a person with a given income to qualify for a larger loan.
• After one, two or three years, rates reset by tracking an index of
prevailing rates, causing monthly payments to rise.
• Example: The 2/28 ARM
 US$500k loan at Libor + 500bp for 30 years
 Fixed for the first 2 years
 After 2nd year, rate jumps from 4% to 9%
 Payments go from US$2,480pm to US$4,080pm.
• 25% of all US borrowers are classified as sub-prime.
 Appraisers add to the pain
• Before issuing a mortgage a lender requires that a property be appraised to
assure that it is valuable enough to serve as collateral on the loan.
• Appraisers come under pressure from lenders and real estate agents to support
the rapidly increasing home values, despite a growing belief that home prices
are in a bubble.
misrepresenting loan application
data
 Origination and Securitisation
Process cont…
Mortgage Warehouse
Broker Lender

$
Mortgage
Collateral
$

Borrower
Lender/ Step 2: Lender obtains funds from
Conduit the wholesale markets and the
Mortgage Borrower begins making monthly
payments to the Lender.
 Lenders relax standards
• As home prices grow faster than incomes it gets harder for borrowers to
qualify for loans under traditional standards.
• To keep the volume of lending up lenders gradually reduce down payment
requirements from the traditional 10% of sales price to zero.
• They also stop requiring that borrowers prove they have enough income to
make their loan payments.
 Investors seek yield
• With interest rates are unusually low levels institutional investors – such as
hedge funds, pension funds, endowments and insurers – hunt around for higher
yields with investment-grade ratings.
• They are eager to buy securities backed by mortgages since these pay more
than US Treasuries.
• Securities backed by subprime loans pay even more since subprime borrowers
are charged extra-high interest rates.
Securities firms oblige
• Banks and other securities firms such as Bear Stearns feed the yield-
hungry investors by re-packaging mortgages into mortgage-backed
securities offering generous yields.
• Through this process of securitisation the mortgage lenders’ risk is
passed on to investors around the world.

Mortgage Backed Securities (mortgage passthroughs)

Types (guaranteed by these agencies):

• Government National Mortgage Association (Ginnie Mae)
• Federal Home Loan Mortgage Corporation (Freddie Mac)
• Federal National Mortgage Association (Fannie Mae)
Origination and Securitisation Process

Mortgage Warehouse Trustee

Broker Lender
$
P&I
Mortgage
$
Collateral
$ $
Lender/ Trust Individual
Borrower
Conduit (SPE) Investors

Mortgage Mortgages

$ $
P&I P&I
Step 3: Lender sells the loans to
Servicer the Issuer (SPE) and the Borrower
then makes payments to the
Servicer.
The Issuer sells securities to
Appraisers Settlement
Investors.
Agents
Origination and Step 4: Underwriter assists in the
sale. Requires the use of Ratings
Securitisation Process agencies and Bond Insurers.
CDO
Managers,
Hedge
Warehouse Funds,
Mortgage Trustee Conduits,
Broker Lender $ SIVs
P&I
Mortgage
$ Collateral
$ $
$ $
Lender/ Trust Bond Individual
Borrower
Conduit (SPE) Underwriter Investors
Mortgage RMBS RMBS
Mortgages

$ $
P&I P&I
Bond Rating Institutional
Servicer Investors
Insurers Agencies

Step 5: Appraisers
The Servicer collects monthly payments
Settlemen Due from theAccounti
Borrower and remits
payments to the Issuer (SPE). The Servicer
t Agents and Trustee manage
Diligence delinquent loans
ng Firms
Firms Agreement.
according to terms in the Pooling and Servicing
 What is a MBS?
• Holders of mortgages form a collection (pool) of mortgages and sell
shares/participation certificates in the pool.
• An MBS may consist of a few or thousands of mortgages.
• Loans with similar characteristics are bundled together.
• Assumptions are made concerning:
 Interest rate change effects
 Prepayment rate (contraction and extension risk)
 Default rate
• A tranched MBS = Collateralised Mortgage Obligation
 CMOs seek to separate out the risks of prepayment and default by forming
tranches within the bond.

Page 37
CMO Example 1
FJF-01 4 Tranche Sequential Pay Structure
Tranche Par Amount ($) Coupon Rate (%)
A 194,500,000 7.5
B 36,000,000 7.5
C 96,500,000 7.5
D 73,000,000 7.5
Total 400,000,000

Relatively simple structure.

Principal on Tranche A is paid first, followed by B, C and D.
Interest rate and default exposure is highest for Tranche D - BUT yields should
compensate…
CMO Example 2
FJF-03 5 Tranche Sequential Pay Structure with Floater,
Inverse Floater and Accrual Bond Tranches
Tranche Par Amount ($) Coupon Rate (%)
A 194,500,000 7.5
B 36,000,000 7.5
FL 72,375,000 1-month LIBOR + 50bp
IFL 24,125,000 28.50 – 3 x (1-month LIBOR)
Z (Accural) 73,000,000 7.5
Total 400,000,000
More complex structure (but basically the same with extra bells and
whistles).
Interest rate and default exposure is highest for Tranche Z - BUT yields
should compensate…
A Generalised Securitisation Process
– Backyard Pool
Buys a Pools Galore:
swimming Loans for pools requires a large
credit department to check credit
pool quality of each customer.
Treasurer wishes to remove loans
Pools from its balance sheet, as well as
Customer Galore raise funds for a new pool factory.
Ltd Instead of issuing bonds set up a
SPV (legal entity) to issue
securities.
Makes a
loan Sells Pays cash
customer for loans
loans
Sell
securities
Quality
Investor Pools SPV
Trust

Cash $

Page 40
 Why do banks wish to remove
loans from its BS?
• Securitisation allows banks to transfer credit, interest rate and prepayment risk
in portfolio from its BS to investors.
• This removed potentially long-maturity assets from the BS and frees up capital
to be invested elsewhere.
• Lowers leverage and enhances borrowing capacity.
• Improves ROE and ROA.
Capital effect of loans on the BS?
Capital
Depositor BBB-rated Investment Requirement
bank
Capital = Assets –
Liabilities
Min = 8% of firm
Value
Deposits $92m Invests in assets
@ 5% interest worth $100m After 1 Year:
rate Expected return = Asset = 100 x
6.9% 1.069 x 0.85 =
Default prob. = 15% $90.9m
Liabilities = 92 x
1.05 = $96.6m

BUT, what if? Long-term MBS

Wholesale invested in Expected return = -30% Capital shortfall =
funds Asset default rate = 50% $5.7m
Medium-term Recovery rate = 30%
leveraged callable
bonds
To avoid insolvency the
minimum capital held =
approx $13.5m
Short step to
insolvency
How does Basel II impact on capital
adequacy?
Depositor + AA-rated Capital
BBB-rated MBS
Shareholders Requirement
bank
Capital = Assets –
Liabilities
Min = 8% of firm
Value
Deposits $92m Invests in MBS worth $100m
@ 5% interest After 1 Year:
Expected return = 6.9%
rate Asset = 100 x
+ Prob. of default = 15%
1.069 x 0.85 =
Equity $8m $90.9m
Liabilities = 92 x
1.05 = $96.6m
Capital Adequacy - Capital Adequacy - Therefore:
Loans MBS The BBB-rated
bank can deploy
= $8m/$100m = $8m/$50m $50m in capital
=8% =16% for other
purposes

Risk weighted Risk weighted

capital for loans capital for MBS Leverage
= 100% = 50%
 CDO Family Tree
CDO

Synthetic
Cash CDO CDO

Arbitrage BS Arbitrage BS
Driven Driven Driven Driven

Cash Flow Market

Cash Flow
CDO Value
CDO
CDO
Rating agencies help
• Ratings agencies work with mortgage issuers such as banks and other lenders
and loan packagers to find innovative ways to give investment-grade ratings to
risky mortgage-backed securities.
• While ratings involve an assessment of the chance that borrowers will default,
there is little track record for gauging this risk with the new types of securities,
so ratings agencies and other participants rely on theoretical computer models.
+ INTEREST RATES RISE
• As rates go up resets cause monthly payments on adjustable-rate mortgages to
soar reaching levels homeowners cannot afford.
 Credit Crisis: Fed Interest Rate Cuts
Failed to Reduce Mortgage Rates
January 2000 - August 2008
Fed slashes interest rates by 325 basis points Interest rate on conventional
(from 5.25% to 2.00 from July 2007 to mid- mortgages remained high despite
9.0 2008) Fed rate cuts
8.0
7.0
6.0
5.0
4.0 Mortgage FF spread
increased to 4.5% from about
3.0 1% pre-crisis
2.0
1.0
0.0

Jan-06

Jan-07

Jan-08
Jan-00

Jan-01

Jan-02

Jan-03

Jan-04

Jan-05

Aug-08
Source: US Bureau of Labor Statistics; Insurance Information Institute.
Home prices fall
• Higher interest rates mean a borrower with a given income must settle for a
smaller mortgage.
• As fewer people qualify for big loans home prices drop…so do bank lending
practices cause house prices to change?

• Rising interest rates push up monthly payments on adjustable-rate mortgages

and growing numbers of homeowners fall behind in payments.

• The growing number of mortgage delinquency rate exceeds expectations in the

computer models causing prices of MBS to plummet.
• Financial institutions that invested in them suffer enormous losses.
US Home Price Indices

19%
Fall in prices over 2
years
Size of US Housing Market –
US$20 Trillion

Aggregate value of all US equity markets = Approx US$16 Trillion

Source: Freddie Mac

Size of US Housing Market –
US$20 Trillion

Total Mortgages Approx US$11 Trillion

Around US$7 trillion packaged as bonds / asset backed securities

Subprime bonds Approx US$1.5 trillion Downpayments as little as
Alt-A bonds Approx US$0.8 trillion 5% of house value
Jumbo bonds Approx US$1.1 trillion

Source: Freddie Mac

Credit markets freeze
• Financial market participants worry that institutions losing money on
mortgage securities – the list includes investment houses and large
institutional investors – may be forced to sell securities based on other
types of debt such as bonds to raise money.
• That would cause a flood of supply that would depress prices.
• Investors thus become wary of all types of debt securities causing
prices to drop and making some nearly impossible to trade.

• As it becomes harder for individuals and companies to borrow

economic activity slows. Recession impending.
 Homeowner feels the impact
• Growing numbers of homeowners find they cannot afford their higher
mortgage payments and many discover their homes are no longer worth what
they owe on their mortgages.
• As the economy weakens unemployment rises.
• More and more homeowners fall behind in mortgage payments and enter the
foreclosure process.
• Loss of homes and jobs.
Prime Lending Rates - Cleveland, Ohio
Black Majority Areas - Cleveland, Ohio
Mortgage Foreclosures - Cleveland, Ohio
Deutsche Bank Mortgage Trust Exposures -
Cleveland, Ohio
Mortgage Delinquency

Page 57
 Unemployment Rate:
On the Rise
January 2000 - August 2008
6.5 Previous Peak: 6.3% in August 2008 unemployment
June 2003 jumped to 6.1%, its highest
6.0 level since Sept. 2003
5.5

5.0

4.5 Trough: 4.4% in March

2007
4.0 Unemployment will likely continue to
approach 6% during this cycle, impacting
3.5 Average unemployment
rate since 2000 is 5.0% payroll sensitive p/c and non-life exposures
3.0
Jan-00

Jan-01

Jan-02

Jan-03

Jan-04

Jan-05

Jan-06

Jan-08

Aug-08
Jan-07
Source: US Bureau of Labor Statistics; Insurance Information Institute.
 AIG Rescue Package by the Fed
• AIG suffered a liquidity crisis due to large positions, mostly associated with Credit
Default Swaps, related to mortgage debt through its AIG Financial Products division
• The losses at AIGFP brought AIG’s holding company to the brink of bankruptcy by
Sept. 16 (AIG has 245 divisions, 71 are US domiciled insurer)
 Efforts to create large credit pool via private banks failed
• AIG’s separately regulated insurance subsidiaries were solvent at all times and met
local capital requirements in all jurisdictions*
• Federal Reserve Agreed to Lend AIG $85 billion to prevent bankruptcy, of which
about $30B has been borrowed (as of 9/22)
 2-year term @ 850 bps over LIBOR (about 11 to 11.5%); 8% unborrowed
 Fed gets 79.9% stake in AIG (temporary nationalization)
 CEO Robert Willumstad replaced by former Allstate CEO Edward Liddy
• Proceeds from sale of non-core assets will be used to repay loan
• New CEO says most insurance divisions are “core”

Source: AIG press releases and regulator statements.

 Rational for Federal Reserve’s
Rescue Package of AIG
• “Too Big to Fail” Doctrine applied to insurance for first time
• AIG is the largest insurer in the US and one of the Top 5 globally:
• It would be internationally disruptive
 Disorderly unwinding of CDS positions (which guarantee large amounts of
debt) would have had large negative consequences on already fragile
credit markets
• Fear was that generally healthy insurance operations affecting millions of
people and businesses would have to be sold at fire sale prices
• Loan allowed time for an orderly sale of assets and a minimal disruption on
credit markets while also protecting policyholders

Source: Insurance Information Institute research.

 Leverage Ratios for Investment
Banks and Traditional Banks*
Merrill Lynch 44.0
Morgan Stanley 33.0
Goldman Sachs 24.3
Lehman Brothers 23.3
Fannie Mae 21.5
Investment bank leverage ratios were
Citibank 15.4 extremely high.
Lehman filed for bankruptcy 9/15
JP Morgan Chase 13.3 Merrill merged with JP Morgan Chase
Goldman and Morgan converted to bank
Wells Fargo 12.4 holding companies

Wachovia 10.8
Bank of America 10.5

0 10 20 30 40 50
*Based on data for last quarter reported (May or June 2008).
Source: “The Perils of Leverage,” North Coast Investment Research, Sept. 15, 2008
 Top 10 Largest Bank Failures

Resurgent bank Sept. 25 failure of

$350 Washington
failures are Mutual was by far $307.0
$300 symptomatic of the largest in US
history. Sold to JP
$250 weakness in the Morgan Chase by
financial system govt. for $1.9B
$ Billions

$200 plus WaMu’s loans

Failure of IndyMac and deposits
$150 was the 4th largest in
history
$100

$50 $30.2 $32.0 $32.5 $40.0

$12.2 $13.0 $15.1 $18.5 $21.7
$0
England (1991,
Bancorporation

First Republic
Savings & Loan
(1988, Houston)

IndyMac (2008,

Mutual (2008,
Mcorp (1989,
Homefed Bank

Savings (1989,

Illinois (1984,
(1988, Dallas)
Stockton, CA)

Continental

Washington
Bank of New
Simi Valley)

Chicago)
(1992, San

Gibraltar

Pasadena)
American
First City

Dallas)

Boston)

Seattle)
Diego)

(1988,

Source: FDIC; Insurance Information Institute research.

Bank Values
 Treasury’s Fannie/Freddie Rescue Package Should Help
Residential Property Insurers 2008/09
THE SOLUTION: A 4-POINT PLAN
1. Government seizes Fannie Mae/ Freddie Mac and places them in
“conservatorship” under their regulator the Federal Housing Finance
Agency (FHFA)
 Current CEOs ousted. Fannie will be run by Herb Allison (CEO
TIAA-CREF) and Freddie by David Moffet (CEO US Bancorp)
2. Treasury purchases senior preferred stock; Govt. gains 79.9%
ownership. Could buy up to $100 billion per firm.
3. Treasury will buy mortgage backed securities (MBS) in the open
market issued by Fan/Fred in attempt to lower borrowing costs ($
unspecified)
4. Treasury establishing new lending facilities for Fan/Fred
Total federal involvement could amount to $200 billion

Source: Federal Housing Finance Agency; Wall Street Journal Online, 9/7/08; Insurance Information Institute.
 Notes
• Subprime mortgages represent 14% of the stock of US mortgages
• July 2007 Ben Bernanke estimated credit losses US$50-100bn
• One study states that a US$200bn credit loss = 125bp decline in GDP
growth

The fallout
• Growth in defaults
• Evaporating liquidity
• Magnitude of loans
• Contagion
• Litigation and regulatory risk
Questions
For next week
 Read Chs. 1, 2 and 3 in HGT and Chapter 1 in
Copeland, T., Weston, J. and Shastri, K. (CW&S)
(2004) Financial Theory and Corporate Policy:
International Edition, 4/e, Pearson, ISBN 0321223535
(available under Course Resources on L@G) and take
appropriate notes.
 Complete Problems 1.4, 1.6, 1.7, 2.1, 2.3, 3.2 and 3.6
in HGT and 1.1, 1.2, 1.5 and 1.6 in CW&S. These will
be discussed when tutorials commence in Week 3.
Appendix
Fisher Separation Theorem
 The decisions of production and consumption involve 2 distinct steps.
1st step: Choosing production point by moving along POS and produce at the point where MRT = (1+
r), this means return on the marginal investment is just equal to market interest rate.
2nd step: Choosing consumption point by moving along the capital market line and consume at the
point where MRS = (1 + r), this means subjective rate of time preference is equal to market
interest rate.
 We call this the “FISHER SEPARATION THEOREM”. The important point is the
production point is governed solely by objective criteria, namely, the set of opportunities
available and the market interest rate. This is independent of individual’s subjective rate
of time preferences.
C1

P*1
(C*0, C*1)

U3
Y1 U1
U0
P*0 Y0 W*0 C0
 Fisher Separation Theorem
Implication 1:
 As the graph below shows, with two different individuals that differs only in their
subjective preferences, given the same opportunity set, both of them would choose the
exact same point of production regardless of the difference of their preferences.

C1

Individual 2
P*1

Individual 1
Y1

P*0 Y0 W*0 C0
 Fisher Separation Theorem
Implication 2:
 The role of capital market: the market channel funds from the lenders to the borrowers.
Setting demand = supply, we have a market-determined r. Given the individual’s exposure
to his own production opportunities, he may decide whether to lend or borrow money. By
allowing lending and borrowing, those who need money can get financed, while those
have excess fund will be able to lend out and earn interest. Everyone is made better off.
 In short, as shown below, capital market is important because everyone can be happier
with it.

C1

Individual 2
P*1

Individual 1
Y1

P*0 Y0 W*0 C0
 Fisher Separation Theorem
Implication 3:
 Consider the following two investors investing all their money on the stocks of a single firm.
Their well-being is thus tied to the well-being of the firm. Consider the firm is making
decision of what to produce.
 Fisher Separation Theorem implies even the two investors differ in their subjective
perception of how to consume between now and future, they both has one unified objective,
i.e, to maximize their current wealth.
 Doing so means the firm can maximize its value. This is the same as investing until the
return on the marginal investment is just equal to the cost of capital, i.e, the market interest
rate.
C1

Individual 2
P*1

Individual 1
Y1

P*0 Y0 W*0 C0
 Fisher Separation Theorem
Implication 3:
 MRT = (1 + r) is the point where both of the two individuals would agree for the firm to
produce.
 This is exactly the famous project selection rule, the “positive Net Present Value rule”.
The firm value is maximized by taking all projects that have positive NPV.
 NPV = -initial investment + present value of future payout discounted by cost of capital.
 Cost of capital = r

C1

Individual 2
P*1

Individual 1
Y1

P*0 Y0 W*0 C0
How to maximise shareholder’s wealth?
 We employ the Fisher Separation Theorem
 Given perfect and complete capital markets, the owners of the firm
(shareholders) will unanimously support the acceptance of all projects until
the least favourable project has return the same as the cost of capital.
 In the presence of capital markets, the cost of capital is the market interest
rate.
 The project selection rule, i.e., equate
marginal rate of return of investment = cost of capital (market interest rate)
 Is exactly the same as the positive net present value rule:
Net Present Value Rule
 Calculate the NPV for all available (independent) projects. Those with
positive NPV are taken.
At the optimum:
NPV of the least favourable project ~= zero
 This is a rule of selecting projects of a firm that no matter how individual
investors of that firm differ in their own opinion (preferences), such rule is
still what they are willing to direct the manager to follow.
 Again and again,
Fisher Separation Theorem
• The separation principle implies that the maximization of the
shareholder’s wealth is identical to maximizing the present value of
lifetime consumption
• Since borrowing and lending take place at the same rate of interest,
then the individual’s production optimum is independent of his
resources and tastes
• If asked to vote on their preferred production decisions at a
shareholder’s meeting, different shareholders will be unanimous in
their decision
 unanimity principle
• Managers of the firm, as agents for shareholders, need not worry
about making decisions that reconcile differences in opinion among
shareholders i.e. there is unanimity
• The rule is therefore
– take projects until the marginal rate of return equals the
market interest rate = taking all projects with +ve NPV