FINS1612 Lecture 13: Textbook Notes (all) V

In October 2009, Greece elected George Papandreou, who had promised to increase public spending and clean up corruption. At an EU summit during December of that year, to regain the confidence of his EU colleagues, Mr. Papandreou delivered a short, blunt speech that stunned the 26 bloc members: ‘‘Corruption, cronyism and a lack of transparency have undermined the state and have to be eliminated,’’ and added basically that his country was corrupt from A to Z. While it had been suspected for some time, he said that the magnitude of Greece’s budget deficit was not the 3.7% of GDP reported in April 2009, nor the feared 6%, but nearly 13%! After numerous upward revisions, it turned out to be 15.8%! Greece understated its deficits in previous years as well. From 1995–2010, Greek deficits averaged nearly 6%, and exceeded the Maastricht limit of 3% in every year. The cumulative effect of these deficits was a government debt/GDP ratio by the end of 2010 of 143%, the highest in the Eurozone. Further, in early January 2010, a European Commission report found that the Greek government had persistently and deliberately misreported the country’s public finances from before Greece joined EMU in 2001—a step that would never have been allowed if what is known now was known then. Entry to EMU contributed to the eventual crisis as it enabled Greece to issue huge amounts of debt at low interest rates, the implicit assumption being that the Eurozone would not allow one of its members to default. The ability to borrow at low rates enabled Greece to live well beyond its means for a decade. At the end of the decade, the bill came due.

In December 2009, the credit rating agencies began cutting Greece’s debt rating, triggering large-scale sales by many private investors and pushing up yields (see Exhibit 3.24). Despite ambitious deficit-cutting plans, the credit rating agencies were still not convinced and continued to downgrade Greek debt and interest rates continued to rise. Opposition to the bailout in Germany meant that market confidence had all but vanished by April 27, 2010, when S&P cut its rating of Greek government bonds to BB+, just below investment grade. S&P estimated that the likely ‘‘recovery rate’’ for bondholders if Greece were to restructure its debt or to default, was only 30−50% of their principal. That prompted panic in bond markets. The yield on Greece’s 10-year bonds leapt above 12% and the yield on two-year

bonds soared over 16% at one point on April 29, 2010. Borrowing rates for Portugal, Ireland, and Spain jumped, too.

By April 2010, a €110 billion ($150 billion) European bailout was announced that would save Greece for several years. One motive for this intervention was to avoid banks taking losses on loans to Greece. However, many believed it offered only a temporary respite as Greece was basically insolvent. Austerity measures imply the government needed to convert a 13% budget deficit into a surplus of 5% over the next several years to pay off interest payments as well as improve competitiveness. Analysts and the rating agencies viewed these cutbacks as unlikely in a politically charged environment coupled with poor growth and high unemployment rates. Civil servants voiced strong opposition to 12% cutbacks and took to the streets with strikes and demonstrations. Protestors also laid siege to Greece’s parliament, and extremist provocateurs torched a bank that killed three employees. The alternative to the degree of austerity required to service Greece’s debts is debt restructuring—a polite term for default. The market’s expectation of default is reflected in the high yields on Greek bonds.

Despite representing only 2% of the Eurozone’s GDP, the Greek financial crisis sent shockwaves throughout the Eurozone as investors speculated which country would be the next to suffer. Portugal, for instance, in 2010 saw its debt rating lowered two notches since its debt/GDP ratio approached 90%. The government was forced to adopt a series of increasingly harsh austerity measures to bring its public finances under control after a budget deficit of 9.6% the prior year. During the crisis, the euro fell 20%, from above $1.50 in December 2009 to below $1.20 in June 2010. During the same six-month period, the Greek stock market declined 46%, and also precipitated contagion effects in other markets, including the Spanish stock market, which fell a third, and the Portuguese market, which declined more than 25%. The Economist reported (December 4, 2010) that ‘‘The euro is proving costly for some . . . as one botched rescue follows another.’’ The periphery economic crisis has sorely tested the Eurozone.

By early 2012, after the public sector unions and pensioners living off the state and the multitudes enjoying lavish welfare benefits violently resisted every serious reform, Greece faced a stark choice: Take another bailout and adopt austerity or abandon the euro and accept the consequences. Despite defaulting on its privately held debt in March 2012, the ultimate end to the crisis would not come until the Greeks understood that they could not consume more than they produced and adopted pro-growth policies that would allow them to produce more.

Questions

What event initially precipitated the Greek crisis?

Why was Greece in so much trouble?

What problems in Greece highlighted wider problems in the Eurozone?

How did the Greek crisis affec tthe euro?

What pro-growth policies could the Greeks adopt that would allow them to produce more and how would adopting them help resolve their crisis?

Multiple Choice Quiz
PLS EXPLAIN ALL YOUR ANSWERS
1
If a bond's rating improves:
A) It should cause the bond's price and yield to increase, allother factors constant.
B) It should cause the bond's price and yield to decrease, allother factors constant.
C) It should cause the bond's price to increase and its yield todecrease, all other factors constant.
D) None of the above.



2
An investor earning 6% from a tax-exempt bond, who is in a 25% taxbracket, holding risk constant:
A) Would be indifferent to a taxable bond with a 7.5% yield.
B) Would be indifferent to a taxable bond with a 8.0% yield.
C) Would be indifferent to a taxable bond with a 4.5% yield.
D) None of the above.



3
When the yield curve is downward sloping:
A) People are expecting an economic slowdown.
B) Short term yields are lower than long term yields.
C) This is impossible, since the yield curve always slopesupward.
D) People could be expecting a loosening in monetary policy.



4
Assume the Expectation Hypothesis regarding the term structure ofinterest rates. If the current one-year interest rate is 4% and thecurrent two-year interest rate is 6%, then:
A) Investors are expecting the future one-year rate to be 4%.
B) Investors are expecting the future one-year rate to be 8%.
C) Investors are expecting the future one-year rate to be 6%.
D) None of the above.



5
Which of the following statements is(are) true?
A) Conforming mortgages are mortgages for which the borrowers donot meet standards of creditworthiness.
B) Subprime mortgages are often made to individuals with low creditscores or income levels that are relatively low when compared tothe price of the home.
C) Subprime mortgages are never used in mortgage backed securitiesbecause of their riskiness.
D) All of the above.



6
Assume an investor has a choice of 3 consecutive one-year bonds orone 3-year bond. Assuming the Expectations Hypothesis of the termstructure of interest rates:
A) The average interest rate of the three consecutive one-yearbonds should be less than the 3-year bond to reflect the riskpremium.
B) The interest rate of the 3-year bond should equal the averageinterest rate of the 3 one-year bonds.
C) The three consecutive one-year bonds must have the same interestrate.
D) The current one-year interest rate must equal the current 3-yearinterest rate.



7
We would expect the risk spread between Baa bonds and U.S. Treasurysecurities of the same maturities to:
A) Widen during periods of economic recession.
B) To remain relatively constant over the business cycle.
C) To decrease during economic slowdowns.
D) To increase during economic growth periods.



8
Increased borrowing by the U.S. Treasury to finance growing budgetdeficits will:
A) Result in U.S. Treasury yields being higher than high gradecorporate bonds.
B) Result in the price of U.S. Treasury bonds rising.
C) Cause the yield on U.S. Treasury bonds to increase, but still belower than corporate bonds.
D) Result in lower yields on corporate bonds.



9
Imagine a scandal that finds the officers of bond rating agencieshave been taking bribes to inflate the rating of specific bonds.This should:
A) Have no impact on the bond market since bond markets are highlyefficient.
B) Decrease the demand for all bonds.
C) Increase the demand for U.S. Treasury securities and decreasethe demand for corporate bonds.
D) Decrease the risk spread.



10
A proposed increase in the federal income tax rates may actually beviewed favorably by many mayors of cities because:
A) It will allow them to also raise their tax rates.
B) It will cause the demand for Municipal bonds to increase andtheir yields to increase.
C) People will pay less attention to local taxes.
D) It will cause the price of municipal bonds to increase and theiryields to decrease.



11
Bonds rated as "highly speculative":
A) Are rated so because they guarantee high returns for thebuyer.
B) Are commonly referred to as junk bonds.
C) Are ranked just below investment grade by Standard &Poor's.
D) Are rated so because they do not have any default risk.



12
Ratings problems contributed to the financial crisis of 2007-2009because:
A) Ratings agencies sharply downgraded the ratings of MBS ashousing prices declined, reinforcing the decline in the prices ofMBS.
B) MBS issuers consulted ratings agencies to structure MBS to getthe highest ratings, causing a conflict of interest.
C) Ratings agencies were compensated by the issuers of the MBS,causing the incentive for favorable ratings.
D) All of the above.



13
An investor in a 30% marginal tax bracket, earning $10 in interestannually for a $100 U.S. Treasury bond:
A) Earns a 10% after-tax return because interest on U.S. Treasurybonds is tax exempt at the federal level.
B) Earns a 3% return after-tax.
C) Would be indifferent between this bond and a municipal bondoffering $7 annually per $100 of face value, assuming the samedefault risk.
D) Earns a 1% return after-tax.



14
Commercial paper refers to:
A) The financial publications read by the CEO's of publiccorporations.
B) Any debt security with a maturity exceeding one year.
C) Short-term collateralized securities issued only bycorporations.
D) Unsecured short-term debt issued by corporations andgovernments.



15
The addition of the Liquidity Premium Theory to the ExpectationsHypothesis allows us to explain why:
A) Yield curves usually slope upward.
B) Interest rates on bonds of different maturities movetogether.
C) Long-term interest rates are less volatile than short terminterest rates.
D) Yield curves are flat.

Bob, Chad and Dylan had been dreaming of this day for the past six years; ever since they first met in an introductory economics course in college. For several years they had been pooling their money and buying Arizona Lottery tickets dreaming that one day they would win big. They realized that the lottery was considered by many to be a voluntary tax on the statistically challenged. But miraculously they now sat at their favorite local “watering hole” holding the winning ticket that meant they would split “The Pick” jackpot of $6 million. What a great feeling! Now they just needed to decide if they wanted to take their winnings as a lump sum now or to be paid over the next twenty in installments. Bob had been a political science major in college but things hadn’t worked out as he anticipated when he was a student. He had entered the job market at what looked now to be the bottom of the economic downturn following the housing crisis in the U.S. Bob believes he did not start his job search soon enough and found suitable openings virtually nonexistent. He was currently working part-time at an organic farm and still living at home which cramped his style consider-ably. He has $150,000 in college related loans (7% interest rate) which he cannot service based on his annual taxable income of $15,000. His share of the jackpot would allow him to be debt free and change his life for the better without doubt. Chad had been more fortunate than Bob. He had applied himself in college and earned a master of accounting degree with an emphasis in taxation. After graduation he immediately went to work for one of the international accounting firms and was now earning a taxable income of $100,000 in spite of the economic issues facing his friend Bob and the country as a whole. He too had debt but not from student loans. Chad had purchased a very nice home in Anthem, Arizona for approximately 50% of what it had sold for three years earlier when built. He had a $250,000 mortgage on the home, at a 4% interest rate, which he saw little reason to pay off since he anticipated significant inflation in the near future. Of the three friends Dylan was by far the most successful. Dylan had majored in finance and had excelled. When he graduated, although he had several attractive offers in the financial services industry, he decided to go into the family business. The company which his father and uncle had started nearly 50 years ago had done amazingly well in the downturn and since he was the only child/nephew they were rewarding him handsomely. He had been reluctant to tell Bob but he was on track to receive to- tal compensation (including bonuses) that yielded a taxable income of $300,000 this year. Unlike his friend Bob, Dylan was frugal and had taken on zero debt. He was pleased with the trio’s good fortune but he didn’t think the windfall would change his life all that much. A few days later when the euphoria of winning was subsiding the three friends met again at the same establishment. All four were obviously in good spirits and were looking forward to presenting their winning ticket to Arizona Lottery officials. Chad started the conversation by telling Bob and Dylan that he had taken the initiative of doing some basic research on how “The Pick” worked and what the payout options were. Bob, proud of his forethought, produced an article he had saved years earlier from the Arizona Daily Star with the headline “Lump-sum Lotto Payout is Best, Experts Say.” Bob excitedly told his buddies that the experts were local CPAs and that clearly the lump-sum payout was “the way to go.” Dylan said he wanted to hear what Chad had found out since he had gone to the effort of looking into the specifics. Chad (being a tax accountant) had prepared a summary of his research which follows: “A percentage of the proceeds from the sale of Lotto tickets are allocated to a prize pool. The size of the Jackpot that is prominently advertised, six million dollars in this instance, is actually only an estimate. The advertised amount is the sum of the estimated annuity1 payments, without consideration of the time value of money, which Lotto officials believe can be purchased from the prize pool. If the winner chooses the annuity payout multiple insurance companies submit bids. Officials award the bid to the insurance company that offers the largest annual payments in return for the prize pool amount. The insurance company with the best bid typically offers a rate that is near the long term U.S. Treasury Bonds rate (currently 3%). If the winner chooses the Lump Sum payout they simply receive the prize pool amount; the amount that would have been used to buy the annuity.” 1.The term annuity is actually a misnomer. Since the payments are made by the insurance company at the beginning of each of twenty periods it is an annuity due. After reading the summary Bob said he didn’t see how this related to the decision that had to be made since he didn’t see anything that changed the preferred option being that the lump-sum payout is best. Chad acknowledged that Bob was probably correct but he still wanted to “run the numbers” and suggested that Bob and Dylan should do the same. Chad reminded them that they needed to consider the tax consequences of the payout schema and then provided the following schedule of federal income tax rates and reminded them that the state tax rate was an additional 5%.Bob rolled his eyes but said he would get right on it. Dylan thanked Chad for the information and they agreed to meet again tomorrow to decide on the best course of action.

Questions 1. Prepare a personal analysis of the payout options for Bob, Chad and Dylan including their net income after taxes. Designate the preferred option for each individual and explain why.