Econ545 - Economics Final Paper

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Business Economics:

Investment Banking – Credit Default Swaps – Mortgage Backed Securities –

Keller Graduate School of Management
GM545 – Business Economics

The world of investment banking has changed since the recession of 2007-2008. The global impact of unregulated credit lending procedures, the Credit Default Swaps market, and mortgage-backed securities have crippled the economy and have called for regulations to bring economic stability back to the markets. Prior to the recession, investment banking was an idealized industry where bonuses equaled individual salaries, yet oversight was practically non-existent. This freedom allowed greed to lead carelessness, packaged with poor credit lending procedures, leading to the recession of 2007-2008 and the reformation of investment banking as we once knew it.

Investment banking is a term assigned to the marketplace of buying and selling securities, underwriting, mergers and acquisitions, market making, foreign exchange, and buy-side and sell-side transactions. Investment banks are a financial institution that assists individuals, corporations, and governments in raising capital using various techniques on the buy and sell-side of the market. As of Oct. 11, 2008, towards the end of the recession, banking revenues within the United States make up 15% of the nation’s overall GDP. The total revenues of the ten largest investment banks total $495.371 billion. It should also be noted that the investment banking sector accounts for an almost 30% share of all profits made by US corporations.

As we have drawn a relative picture to establish the size of the investment banking sector, let’s move onto understanding what role investment banks play in the credit lending system and assess how some of their strategies maybe to blame for the credit crunch we face today. One of the most popular terms in investment banking is “leveraging”. We hear the term used when referring to “leveraged accounts” or “leveraged positions” sometimes even being regarded as “over leveraged” and/or “under leveraged”. Leveraging can be both a risky and rewarding investment technique but in 2008, it played a major role in leading up to the credit crisis and the recession.

Leverage is defined as “the use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment”. Leverage in the investment banking sector was mostly in form of borrowed capital or loans. A firm would typically borrow money to invest in a particular investment given the anticipation that it would leverage itself enough that the spread between the loan and the potential interest rate was high enough to warrant the debt. However, one key thing about a leverage position, the risk is mostly on the side of the creditor, i.e. – the bank lending the money.

Most financial institutions who utilize leveraged portfolios calculate their anticipated equity returns in a similar fashion to the following example. Given the following details – i. 5% projected return on investment

ii. 4% cost of debt (interest rate on loan)
iii. 8:1 Leverage of Debt:Equity
Short-Form Calculation –
i. First we take the interest rate differential between the guaranteed the loan interest rate and the potential return on investment for which the loan is being used (hence, 5-4 = 1) ii. We then calculate the debt to equity multiple (which in this case is given to use as the ration of 8:1, hence 8) iii. Multiple the IRD (interest rate differential = 1) by the DEM (debt to equity multiple = 8). In our example, 8 * 1 = 8. iv. Add your projected return on investment of 5%, therefore 8 + 5 = 13%. In this short form calculation you have found that your leverage opportunity here can bring you a total return of 13% for a cost of debt of 4%, providing you a 9% spread. This type of analysis is what was used by investment banking firms to justify borrowing various credit forms and even at time...
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