Chapter 15 - Notes

15.1 - Banks

How Banks Make Money

• Banks are middlemen — they borrow money from you (your deposits) at a low interest rate, and lend it out to others at a higher interest rate
• The difference is their profit
  • e.g., bank pays you 2% on deposits, charges borrowers 6% → bank makes 4% on every $100
• When you deposit money, you are the lender and the bank is the borrower — your deposit is NOT being stored, it's being lent out

Five Functions of Banks

1. Pool savings from many savers

• Combines small deposits from thousands of people into large loans for borrowers
• Valuable for both sides — you can earn interest on even $100, and borrowers don't have to ask dozens of individuals for money

2. Spread risk across many borrowers

• Your money doesn't all go to one borrower — it's lent across thousands of different loans
• Diversification makes lending much less risky for you

3. Solve information problems

• Banks check credit history, assets, debts before lending
• They have access to customers' financial histories → better at identifying who will actually repay

4. Provide payment services

• Direct deposit, online bill pay, bank transfers, credit cards — all more convenient and safer than cash

5. Create long-term loans from short-term deposits (Maturity Transformation)

• Maturity transformation: using short-term deposits (you can withdraw any day) to fund long-term loans (e.g., 25-year mortgages)
• This is valuable because it lets investors fund long-term projects even though no individual saver wants to lock up their money for 25 years
• BUT this creates a fundamental vulnerability — the bank has promised savers they can withdraw anytime, but the money is tied up in long-term loans

Bank Runs

• Bank run: when many customers try to withdraw their savings at the same time
• Banks don't keep all your money on hand — they've lent most of it out, only keeping enough for a typical day's withdrawals
• If everyone shows up at once, the bank runs out of cash and can collapse

Why bank runs happen — the interdependence principle:

• If you believe others will panic and withdraw → your best move is to withdraw first before the money runs out
• This is true even if the bank is financially healthy and even if the rumour triggering the panic is false
• It's a self-fulfilling prophecy: people panic because they think others will panic
• Bank runs are contagious — if one bank fails, depositors at other banks get nervous and start withdrawing too

Deposit insurance solves this:

• Government guarantees deposits up to $100,000 per account in Canada (introduced 1967)
• Breaks the interdependence — you don't need to rush to withdraw because your money is guaranteed regardless of what others do
• Has been extremely effective — bank failures became very rare after deposit insurance was introduced

Shadow Banks

• Shadow banks: financial firms that do bank-like things (take deposits, make long-term loans) but aren't regulated as banks
• No deposit insurance → vulnerable to bank runs
• This is essentially what caused the 2008 financial crisis in the US
  • Shadow banks like Bear Stearns faced runs when depositors lost confidence
• Fire sales: a shadow bank facing a run has to sell assets fast → floods the market → pushes asset prices down → hurts other shadow banks holding similar assets → contagion
• Shadow banks are opaque — hard to know which ones hold bad loans, so when problems emerge, people stop lending to ALL of them, not just the bad ones
  • Like contaminated meat analogy: if you don't know which supply is infected, you stop eating all meat
• In Canada, asset-backed commercial paper suffered a crisis of confidence in 2007 (~$35 billion tied up)

15.2 - The Bond Market

Key Definition

• Bond: an IOU "I Owe You" — the borrower gets cash now and promises to repay it later with interest
• Key terms on a bond:
  • Issuer: the borrower (e.g., Nike, the government)
  • Principal: the amount to be repaid at the end (e.g., $1 billion)
  • Maturity date: when the loan must be repaid
  • Coupons: the interest payments made along the way

Four Functions of the Bond Market

1. Channels funds from savers to borrowers

• Alternative to banks for companies that need to borrow large sums
• Bonds are actually a much bigger source of corporate financing than stocks — in 2021, US companies raised ~5x more through bonds than stocks

2. Funds government debt

• Governments borrow by issuing bonds — whenever you hear "government debt," that's bonds
• Canadian federal government has ~$1.2 trillion in outstanding bond debt
• Provincial governments and public entities also issue bonds

3. Spreads risk

• Instead of one person lending $1 billion, thousands of investors each buy smaller bonds (as small as $1,000)
• Lenders should diversify — don't put all your eggs in one basket

4. Creates liquidity

• Liquidity: the ability to quickly and easily convert investments into cash with little or no loss in value
• You can sell your bond to another investor before the maturity date if you need cash
• This is another form of maturity transformation — like banks, the bond market turns short-term investments into long-term loans, but through reselling instead of deposits

Three Risks of Bonds

1. Default Risk

• The risk that the borrower won't repay the loan (e.g., company goes bust)
• Credit rating agencies (Fitch, Standard & Poor's, Moody's) assign ratings to assess this
  • AAA = highest/safest, ratings go down from there
• Higher default risk → higher interest rate demanded by lenders to compensate for the extra risk

2. Term Risk

• The risk from uncertainty about what future interest rates will be
• If you lock in at 2.375% for 10 years and rates rise to 4%, you're stuck earning less than you could elsewhere
• Longer term = more term risk because more time for interest rates to change
• That's why longer-term bonds pay higher interest rates than shorter-term ones

3. Liquidity Risk

• The risk that you can't find a buyer quickly if you need to sell your bond
• Government bonds = very low liquidity risk (billions traded daily)
• Small company bonds = higher liquidity risk (harder to find buyers)

Government Bonds Are the Safest

• Governments like Canada/US can always repay by printing more money → very low default risk
• Government bonds are heavily traded → very low liquidity risk
• Short-term government bonds also have almost no term risk → called the risk-free interest rate
• Tradeoff: lower risk = lower return, so government bonds pay the lowest interest rates
• Exception: if investors doubt a government will repay (e.g., Greece in 2012 → rates hit 25%)

15.3 - The Stock Market

Key Definition

• Stock (or share): partial ownership in a firm — you own a tiny piece of the company
• Owning stock = you make money when the company makes money, lose money when it loses money

Two Ways You Profit from Stocks

1. Dividends: the company pays out a portion of its profits to shareholders (usually quarterly)
   • Profits NOT paid as dividends are called retained earnings — reinvested back into the company
2. Stock price appreciation: if the company's future looks more profitable, the stock price rises and your shares are worth more

Three Functions of Stocks

1. Channel funds from savers to investors

• Companies issue stock to raise money for investment
• Sold to the public through an initial public offering (IPO)
• IPOs are handled by investment banks, usually sold to big institutional investors first

2. Spread risk

• Business risk is shared across many shareholders
• Good year → shareholders benefit; bad year → shareholders take the hit
• No one person bears all the risk

3. Reallocate control

• Shareholders get to vote on how the company is run (one share = one vote)
• Vote on board of directors, mergers, executive pay, etc.
• Corporate raiders can use this to force changes

The Stock Market vs IPOs — Important Distinction

• The stock market is a market for secondhand stock — buying and selling existing shares between investors
• When you buy stock on the stock market, your money goes to the previous shareholder, NOT to the company
• The company only gets money when it first issues stock (the IPO)
• The stock market's main role is creating liquidity — you can easily sell your shares if you need cash, which makes people more willing to buy stock in the first place

Bonds vs Stocks Comparison

Key Stock Market Terms

• Stock price: what one share is currently worth
• Market capitalization: total value of the company = number of shares × stock price
• Price-earnings ratio (P/E ratio): covered in next section
• Retained earnings: profits kept by the company instead of paid as dividends

15.4 - What Drives Financial Price?

Valuing Stocks — Two Approaches

1. Fundamental Analysis

• Fundamental value of a stock = the present value of all future profits the company will earn
• Four-step process:
  1. Forecast future profits (revenues minus costs) for the next 5-10 years, then assume a constant growth rate beyond that
  2. Discount each year's profits to present value (use a higher discount rate for riskier stocks)
  3. Add up all the discounted future profits = the company's fundamental value
  4. Divide by the total number of shares = fundamental value per share
• If the stock price < fundamental value → buy it (cost-benefit principle)
• Big caveat: this only works if YOUR estimate is more accurate than the market's — if not, you might think you're buying underpriced stock when it's actually overpriced

2. Relative Valuation

• Assess value by comparing to similar companies using financial ratios that adjust for size differences
• Price-to-book ratio = stock price / book value per share (book value = assets minus liabilities)
• Price-to-earnings ratio (P/E ratio) = stock price / earnings per share
• Logic: if two companies are similar, they should have similar ratios → use one company's ratio to estimate the other's stock price
• Key: must compare truly similar companies (similar risk, growth prospects, funding needs)
• Can also apply to houses: price-to-size ratio ($/square metre) for comparable properties in similar neighbourhoods

The Efficient Markets Hypothesis

• At any point in time, financial prices reflect all publicly available information
• Stock prices represent the market's collective judgment about fundamental value
• You can't predict whether a stock is over- or underpriced using public information

Key implications:

• It's extremely hard to beat the market
  • Thousands of analysts are constantly digging for information → anything you discover is likely already reflected in the price
  • Trading on inside information (insider trading) is illegal
• Stock prices follow a random walk — changes are unpredictable
  • If a price change were predictable, traders would act on it immediately until the prediction is already baked into the price
  • Good/bad news affects stock prices, but the price adjusts as soon as traders learn the news, not when the event actually happens
• Technical analysis (finding patterns in past price charts) doesn't really work — you can't predict the unpredictable
• Past performance doesn't predict future performance
  • Of the top-quarter performing mutual funds in one period, only ~20% were in the top quarter in the next period — basically random chance
• Index funds beat actively managed funds
  • S&P 500 index fund averaged 7.77% annual return vs 6.28% for actively managed funds (2003-2018)
  • The difference is mostly fees — expert stock pickers don't pick better stocks, they just charge more
  • Economists invest in low-cost index funds and focus on minimizing fees, not past performance
• Stock prices are a macroeconomic indicator — rising stock prices signal expected good times, falling prices signal expected bad times (but very volatile, not every blip matters)

Financial Bubbles

• Speculative bubble: when the price of an asset rises above what appears to be its fundamental value
• Eventually all bubbles burst and prices crash

Why bubbles happen — the "Puppy Beauty Contest" / Greater Fool Theory:

• You buy a stock not because of its fundamental value, but because you think someone else will pay even more for it later
• Everyone buys because they expect others to keep buying → prices keep rising → disconnected from reality
• Works until you can't find a "greater fool" willing to overpay → bubble bursts

Why bubbles persist (three reasons):

1. Hard to spot — in the excitement, you might convince yourself it's real (e.g., "maybe the internet really will change everything")
2. Hard to bet against — even if you think something is overpriced, there may be no easy way to profit from that belief
3. You don't know when it will burst — a bubble can outlast your savings or your job (Tony Dye example: he was right about the dot-com bubble but got fired before it burst)

Examples of bubbles: dot-com stocks (2000), Dutch tulips (1600s), alpacas (1990s-2000s), possibly Canadian housing during COVID, AI (2022ish-Present)

15.5 - Personal Finance

Six Lessons for Managing Your Money

1. Harness the power of compound interest

• Small differences in return rates make a HUGE difference over time due to compounding
• $1,000 invested for 50 years:
  • Treasury bills (1.6% real return) → $2,211
  • Long-term bonds (3.0%) → $4,384
  • Canadian stocks (5.4%) → $13,869
  • US stocks / S&P 500 (7.4%) → $35,499
• Start saving early and reinvest your gains — the longer money compounds, the more dramatic the growth
• Stocks have historically had much higher returns than bonds or treasury bills

2. Don't pick individual stocks

• The efficient markets hypothesis makes it extremely hard to beat the market
• Research shows most investors are overconfident — they think they can beat the market but can't
• Remember: a cat named Orlando beat professional stock pickers

3. Diversify your portfolio to reduce risk

• Don't put all your money in a few big investments — spread it across many different ones
• Diversification reduces how much your wealth swings up and down each year
• Easiest way to diversify: buy index funds (automatically buys a basket of many stocks for you)

4. Past performance is no guarantee of future performance

• Don't pick stock pickers based on their track record — past and future performance are almost unrelated
• No reason to believe professional fund managers who promise to beat the market

5. Minimize paying fees

• Fees are the most predictable part of investment returns — high fees = lower returns, guaranteed
• Don't trade stocks frequently (brokerage fees add up)
• Avoid actively managed mutual funds with high fees
• Shop around for the lowest-fee index funds

6. Follow all five rules with low-cost index funds

• Index funds automatically do everything: compound your money, avoid stock picking, diversify across hundreds of companies, ignore past performance, and charge minimal fees
• This is what most economists do with their own money