CMFAS Module 10 Key Notes
1. How are most of the risks in the banking sector transferred to the insurance sector?
The risks in the banking sector are transferred to the insurance sector through the following ways, which includes derivatives contracts, insurance of loans and leases, insurance of performance or projects, insurance of assets, loan trading, portfolio securitization, special securities such as catastrophe bonds and currency-linked bonds, reinsurance of captive insurance subsidiaries of banks, insurance securitization, and purchase of debt and preferred stock of banks.
2. How do banks differ from insurance companies?
Banks differ from insurance companies in various ways and the following distinguishing factors can facilitate or hamper risk regulation:
- Funding and balance-sheet structure, types of investments and assets, sources of funding, duration of assets and liabilities.
- Type of ownership and shareholders.
- Liquidity risk.
- Risk ownership and transparency.
- Interconnectedness with other financial institutions.
- Ability to participate directly or indirectly in reinsurance (some may argue that loan trading is a form of reinsurance).
- Volatility of business operations.
- The nature of the entity’s asset-liability management and investment management.
- Macroeconomic role.
- Risk exposure at the institutional level.
- Systemic risk exposure.
Most Mechanism Design Theory is based on equilibrium as a relevant state and as an objective; and the concept of equilibrium is static. True equilibrium does not exist, and cannot be achieved in mechanisms due to:
(a) continuous changes in agents’ preferences, information processing capabilities, time constraints, wealth, access to information, and so on;
(b) transaction costs and opportunity costs;
(c) mental states of agents;
(d) government regulations and/or industry standards/practices;
(e) agents’ varying reactions to incentives over time.
While it is true that MDT is based on the inaccurate assumption that all agents truthfully disclose their preferences. It also presumes that all agents disclose their preferences at the same rate and at the same time.
It is also based on the incorrect assumption that each mechanism is monolithic and static in time, space, and expense, and it does not account for differences in agents’ information-processing capabilities.
Actually, the MDT inaccurately implies that the mechanism’s main role is either allocation or coordination. In reality, many mechanisms serve other economic and non-economic purposes (some of which are unintended) such as:
(a) psychological re-assurance (e.g., voting, auctions, etc.),
(b) information dissemination,
(c) comparison—which increases social welfare by reducing overall agents’ search costs, and
(d) entertainment.
While it is true that the global primary mortgage markets consist of financial institutions and nonfinancial institutions that are lenders & borrowers. They are not the only ones involved as the market also includes:
- attorneys;
- real estate brokers;
- mortgage brokers;
- lawyers;
- title companies;
- appraisal companies;
- servicing companies;
- purchasers of mortgages;
- mortgage insurance and property insurance companies;
- loan servicing companies;
- government agencies; and
- securitization sponsors.
While there are a many sectors that are the same as the primary mortgage markets, the global secondary mortgage markets also consist of:
- financial institutions and nonfinancial institutions that are either securitization sponsors or sellers of mortgages or purchasers of commercialmortgage-backed securities (CMBS)/residential mortgage-backed securities (RMBS);
- other sellers of mortgages and guarantees;
- securities brokers
- accounting/auditing companies;
The main products in the secondary mortgage markets are whole loans, CMBS, RMBS, and mortgage derivatives
Economic and demographic factors predicted debt category well, supporting previous results. Lea, Webley, and Walker found that:
(1) further variance between groups was accounted for by people’s money management skills and facilities, by measures of their time horizons, and by aspects of their consumer behavior;
(2) non-debtors had more money management facilities (e.g., bank accounts) than debtors, and rated their
abilities at money management more highly;
(3) debtors had shorter time horizons than non-debtors;
(4) debtors were more likely to buy cigarettes and Christmas presents for children than nondebtors;
(5) no group differences were found for attitudes to debt or locus of control; and
(6) there were significant group differences for measures of economic socialization, social comparisons, use of credit, and other aspects of consumer behavior, but these differences were not independently significant on multivariate analysis.
Not true, as real estate developers who obtain tax credits for renovation or new development are sometimes more likely to seek more tax credits; enter into development projects that are not truly beneficial, solely to obtain tax credits; and falsify records and applications in order to obtain tax credits.
Yes, not only can the government intervention effect account for thethe growth of the regular residential mortgage and subprime mortgage markets in the United States; it can also account for trends and behaviors such as strategic defaults, the behavior of developers who seek or obtain government benefits, and the quality of housing units provided wholly or partially with government benefits.
Not only does foreclosure causes credit contagion—wherein lenders tend to reduce lending to geographic areas that are deemed to be prone to foreclosures. It can also cause:
(a) information contagion—wherein news of foreclosure affects the volume of sales of real property and general consumption.
(b) inertia contagion—wherein residents of neighborhoods that have known high foreclosure rates (information that is often publicly disclosed) tend to lose faith in their ability to overcome foreclosure and “underwater mortgages” (where the mortgage value exceeds the value of the underlying property), reallocate their resources to other expenses, and do not make extra efforts to prepare for or solve foreclosures.
12. What are the contagion effects of foreclosure?
The following are the contagion effects of foreclosure: (a) compel prospective entrepreneurs to wait and delay their plans; (b) compel households that face foreclosure to shirk and consider strategic default; and (c) compel banks to reduce lending. For families facing foreclosure, information contagion and/or high income-to-mortgage ratios (i.e., high costs of ownership), new tax credits, and reduction of income tax rates are almost meaningless, and cannot stimulate the economy.
13. What are the standard tests for Takings cases?
The standard tests for Takings cases include:
- the “reduction-of-value” test (ability to profit before and after Takings) is evaluated and there must be impairment;
- the “cause-of-harm” test (show that one person’s use causes harm to another’s property,and there is state action);
- the Government Invasion Theory (show that government takes possession of property); and
- the “noxious-use” test.
14. What are the reasons in which Luo would support the anti-preemption position?
There are essentially four main reasons Luo (2008) supports the anti-preemption position (i.e., supports the decisions of state courts to bar preemption and apply state debtor/creditor statutes):
(1) there can be no conflict when no bankruptcy petition has been filed;
(2) the weight of authority, including Supreme Court precedent and subsequent state and federal decisions, favors upholding the state law;
(3) California’s ABC statute does not interfere with the operation of the federal bankruptcy code but furthers the goals of insolvency legislation; and
(4) statutes, such as Section 1800, make good policy.
A transfer is deemed to be constructively fraudulent under Section 548(a)(1)(B) of the Code and may be set aside if all of the following five conditions exist:
1. The transfer was made within one year prior to the filing of the bankruptcy petition.
2. In the transfer, the creditor received “less than reasonably equivalent value” in a transaction.
3. The transferor was insolvent at the time of the transfer or was rendered insolvent as the result of the transfer (insolvency test).
4. The transfer or was under capitalized at the time of the transfer or became undercapitalized as the result of the transfer (capitalization test).
5. The transferor was unable or rendered unable by the transfer to pay its debts as they became due (cash-flow test).
The U.S. Bankruptcy Code preempts U.S. state foreclosure laws and state debtor-creditor statutes in at least four ways, which are summarized as:
1. Section 362(a) of the U.S. Bankruptcy Code creates an “automatic stay,” which precludes the creditor from seeking to obtain property of the estate or from assessing or collecting on a prepetition claim against the debtor.
2. The U.S. Bankruptcy Code’s (11 U.S.C. §§ 548, 544 & 547) fraudulent conveyance statutes can be used to invalidate completed or ongoing state-law real property foreclosure proceedings in civil courts.
3. The doctrine of equitable subordination can be applied in the U.S. Bankruptcy Court to preempt ongoing and completed state-law foreclosure proceedings.
4. The DePrizio Controversy—The Section 550 fraudulent conveyance statutes in the U.S. Bankruptcy Code can also be used to invalidate completed or ongoing state-law real property foreclosure proceedings.
A state lien and state-law foreclosure process has different transaction cost effects compared to a federally created lien and foreclosure process:
(a) a state-created lien and foreclosure process is more likely to disrupt local/regional property price patterns (a federal system expands markets and increased comparability can reduce price volatility), will reduce information diffusion, and will create inefficient “local/regional” markets;
(b) a federally created foreclosure process will require a national database that will have to be updated in real time to be effective, create more transparency, increase competition among service providers, and enhance comparability across regional markets;
(c) a federally created lien and foreclosure system is more likely to increase standardization, and thus, reduce transaction costs, due diligence costs and compliance costs; and
(d) a state-created lien and foreclosure process for real property is more likely to create agency problems between the real estate broker and the owner, whereas federal foreclosure processes will provide more incentives for real estate brokers to make interstate transactions and expand the potential markets for foreclosed properties and distressed properties
18. How are Stay Takings characterized?
Stay Takings are characterized as follows:
– The Takings arise solely because of (state or federal) preemption or a judicially ordered stay of acts or proceedings.
– The property interests in the stayed or precluded acts/proceedings have economic value to the parties (i.e., lender and borrower). The stayed proceedings are special proceedings.
– There is asymmetrical commitment by the parties to the property interest (e.g., right-to-foreclosure processes) or to the subject asset (the collateral property); that is, the lender is more interested in foreclosure than the borrower who typically wants to negotiate extensions or short sales.
– There is substantial information asymmetry among the parties (e.g., lender, borrower, court).
– The transaction costs that may be incurred by the parties (i.e., lenders, borrower, and court) in the stayed/precluded proceedings/lawsuit (Ts) may or may not be greater than the transaction costs inherent in the alternate prevailing proceedings, if any (Ta). The magnitude of the Takings increases as the difference between Ts and Ta increases.
When the central bank reduces benchmark interest rates, there is less impact on mortgage-heavy banks (compared to the average bank) for the following reasons:
(a) the effect depends on the extent to which the rate change affects long-term interest rates;
(b) any increase in the value of the mortgages can be offset by the sum of the bank’s derivatives/swaps positions;
(c) the mortgage-heavy bank is likely to have fulfilled its quota of mortgages (asset allocation effect);
(d) in most cases, the mortgage-heavy bank’s incentives to provide business loans and consumer loans will decline due to lower loan margins, and because such banks can make more profits from originating and selling mortgages; and
(e) mortgage-lending processes are highly automated and incur fewer transaction costs than the average business loan, and thus, mortgage-heavy banks will be much less likely to allocate capital and resources to business lending.
When money supply is increased, banks that own above-average holdings of mortgages (mortgage-heavy banks) will experience fewer shocks than ordinary banks because:
(a) they typically can sell the mortgages in secondary markets and the liquidity of whole-loan mortgage markets in many countries has been relatively independent from monetary policies partly due to securitization;
(b) many mortgages have mortgage insurance and have shorter payment frequencies than regular business loans, and so mortgage-heavy banks are less likely to provide more business loans; and
(c) the resulting lower interest rates provide disincentives for mortgage heavy banks to grant business loans and/or consumer loans.
REITs can achieve growth either internally (organic) or via development and/or acquisitions to achieve growth by the following ways:
• Core portfolio growth by raising rents and occupancy while controlling operating expenses;
• Acquisitions of individual properties or portfolios;
• New development of properties;
• Refurbishment of existing properties; and
• Participation in joint venture programs to earn fee income including asset management, acquisition, and financing fees.
22. Can REITs only achieve internal growth through hiking their rental rates?
While hiking their rental rates is the main way for REITs to achieve internal growth, they are not limited to only that as minimizing their operating expenses will also lead to an improvement in the profit margin of REITs and enhance their attractiveness to investors.
23. What does the US Commodity Futures Trading Commission (CFTC) working definition encompass?
The US Commodity Futures Trading Commission (CFTC) working definition encompasses the use of extraordinarily high-speed order submission/cancelation/modification systems with speeds in excess of five milliseconds or generally very close to minimal latency of a trade.
Also the use of computer programs or algorithms for automated decision making where order initiation, generating, routing, and execution are determined by the system without human direction for each individual trade or order. As well as many others such as:
• The use of co-location services, direct market access, or individual data feeds offered by exchanges and others to minimize network and other types of latencies.
• Very short time-frames for establishing and liquidating positions.
• High daily portfolio turnover and/or a high order-to-trade ratio intraday.
• The submission of numerous orders that are canceled immediately or within milliseconds after submission.
• Ending the trading day in as close to a flat position as possible (not carrying significant, unhedged positions overnight).
24. Does the HFT liquidity providers hold any overnight inventory with their orders?
Contemporary HFT is characterized by algorithmic trading at high velocity with high order-to-trade ratios and is employed by both the “buy side” for the purpose of executing hedging or investment strategies, as well as the “sell side” for the purpose of executing client orders.
HFT liquidity providers inevitably generate high volumes of small-sized orders throughout the trading day, while holding little or no overnight inventory and thereby incurring limited credit and clearing risk.
25. What are some of the high-frequency information according to HFT?
High-frequency information include the following:
(a) Order book dynamics, the supply, and demand of an asset shown by those who want to buy and sell it.
(b) Trade dynamics, containing information about short-term direction of stock prices.
(c) Past asset returns, whose evolution contains information on future direction.
(d) Correlations between assets and asset classes.
(e) Information delays between trading venues.
(f ) Illegal sources, which may come from front-running, quote-stuffing, and layering.
26. What is considered as a legitimate HFT profitability?
Legitimate HFT profitability includes, but is not limited to, the following:
(a) Market-making.
(b) Collecting liquidity rebates.
(c) Detecting statistical patterns which can be monetized.
(d) Upholding the law of one price—that is, an actual hard arbitrage.
27. What is the procedure for a standard PIP identification?
The procedure of the PIP identification is first, to divide the target financial time series based on rotation windows. Secondly, In each window, the first and last PIPs will be the prices at the beginning point and the last point. The third PIP will be the point in price with MD to the first two PIPs. The fourth PIP will then be the point in price with MD to its two adjacent PIPs. The above PIP location process continues until we find all the PIPs in each pattern
The key principles and objectives for the development of mortgage alternatives markets for the CIS/CEE countries and China are:
– Transparency and adequate disclosure.
– Accountability and effective penalty systems.
– Stimulating liquidity—for example, through taxation, incentives, creation of liquidity centers, penalty systems.
– Efficient price discovery.
– Statutory efficiency refers to minimal regulations; minimization of conflicts of laws among agencies and across jurisdictions; maximization of social welfare; and achievement of the objectives and legislative intent of statutes.
– Minimization of regulatory friction.
– Minimization of transaction costs and low monitoring costs.
– Absence of Enforcement Premia, that is, a “state” where procedural rules and evidentiary rules ensure that investigation costs and enforcement costs are always lower than the sum of both awarded and realized penalties/fines.
– Facilitation of innovation and rapid adoption of best practices.
– Adequate consumer protection and efficient enforcement of consumer protection statutes.
– Maximization of social welfare.
– Counter-cyclical liquidity.
– Risk reduction.
– Stability of markets.
– Affordability of housing (both rental and purchase).
Yes, there should be a system of penalties for banks and nonbank lenders and their employees and agents in order to provide substantial incentives for the rapid development of the mortgage-alternatives market. The main principles are:
– Deterrence effect is more important than punitive effects.
– Penalty system should target top and mid-level employees. Penalties for individuals should focus on both total wealth and incarceration.
– Penalties for corporate entities should also focus on total wealth.
– Penalties should cover government investigators’ monitoring costs, prosecutors’ enforcement costs, and government administration costs.
Changes in reserve requirements often have adverse systemic effects on banks and the banking industry:
(1) banks typically have to change the prices of their services;
(2) changes in reserve requirements can affect many banks in very different ways, and thus it is not accurate monetary policy;
(3) the changes in reserve requirements affect the perceived credit quality of banks—thus an increase in reserve requirements can reduce aggregate investment where bank credit quality is considered a major economic
indicator;
(4) changes in reserve requirements can create suboptimal incentives for banks—for banks to increase lending to less desirable industries/purposes, and simultaneously reduce lending to more desirable industries/ purposes;
(5) increasing reserve requirements can cause immediate liquidity problems for banks that have low reserves;
(6) the typical reserve requirement applies to checking accounts and transaction accounts and not to savings accounts, CDs, and deposits by foreign entities, which are sometimes subject to much lower reserve requirements—but increasingly, savings accounts are used for transactions