Summary
Highlights
Andrew Lo begins by reviewing Lehman Brothers' financial highlights from the end of 2007, noting its $19 billion in net revenues and $4 billion in net income, making it a major financial institution. He highlights its $145 billion in long-term capital and $282 billion in assets under management. Lo then introduces the concept of net leverage ratio (16:1 for Lehman) and illustrates its implications using a personal example of a highly leveraged home mortgage (5% down payment resulting in 20:1 leverage). He explains how a small decline in asset value can wipe out equity with high leverage, linking it to Lehman's eventual collapse.
Lo explains that high leverage is only problematic if asset values are volatile. He points out that historically, housing prices were stable and consistently rose, making high leverage seem less risky. However, recent volatility in housing prices has exacerbated problems. He discusses the 'mark to market' concept and how falling home values, combined with rising adjustable mortgage rates, forced many homeowners to default, leading to foreclosures.
The discussion covers the Federal Reserve's potential interest rate cuts to ease market pressure and reduce default rates, and the risks associated with inflation if rates remain too low for too long. Lo addresses questions about the 'reasonableness' of market bubbles and human nature (fear and greed) driving financial markets. He emphasizes that understanding finance provides a disciplined framework to navigate these emotional forces, especially during times of market fear like the current period.
Lo explains what Lehman Brothers' bankruptcy means: its assets are liquidated to pay creditors, with shareholders typically receiving nothing. The stock value plummeted from $62 to zero in nine months, largely due to a loss of brand and business viability, not a decline in employee talent. He likens Lehman's collapse to Bear Stearns, where a loss of counterparty trust led to business failure. He reassures students that while Wall Street will experience short-term chaos, the long-term prospects for those entering the finance industry, particularly MIT students, are good due to the need for expertise in handling market dislocations.
Lo transitions to a core finance concept: inflation. He defines inflation as the change in the purchasing power of money over time, distinct from the time value of money. He uses the example of wealth and a 'basket of goods' to illustrate how nominal returns (dollar value increase) can differ significantly from real returns (purchasing power increase) if inflation is high. He provides an approximation formula: real return is roughly nominal return minus inflation rate. He stresses the importance of matching nominal cash flows with nominal discount rates and real cash flows with real discount rates in NPV calculations.
Lo introduces fixed-income securities as instruments with fixed, known payoffs, contrasting them with uncertain stock payoffs. Examples include treasury securities, federal agency securities (Fannie Mae, Freddie Mac), corporate bonds, municipal bonds, mortgage-backed securities, and complex instruments like CDOs and CDSs. He highlights the massive size of the US bond market, dwarfing the stock market, and its significant growth, especially in mortgage-related and asset-backed securities since the 1980s.
Lo discusses the participants in fixed-income markets: issuers (governments, corporations), investors (pension funds, hedge funds), and intermediaries (dealers, investment banks, credit rating agencies). He explains that the current market turmoil stems largely from issues within the intermediary sector, particularly with firms like Lehman and Merrill Lynch taking on excessive risk. He draws a parallel to the 1987 stock market crash, emphasizing the high-pressure environment for market makers during dislocations. He confirms that the lecture will focus on riskless debt, specifically US government bonds, before addressing risky debt later.
Lo explains the valuation of fixed-income securities, starting with a coupon bond example. He outlines a three-year coupon bond with a $1,000 principal and 5% annual coupon payments. He then introduces pure discount bonds (zero-coupon bonds), which only make one payment at maturity, like US treasury bills. He explains that financial engineers created 'STRIPS' (Separate Trading of Registered Interest and Principal Securities) by separating the coupon and principal payments of government bonds, creating a new market for discount bonds. The price of a discount bond is simply its face value discounted to the present by the appropriate interest rate. He hints that these prices can reveal forecasts of future interest rates, akin to a 'crystal ball' for market participants.