2009 Vol. 1

Pansy Yang, Ph.D. (Bio)
Executive Director of the Fink Center for Finance & Investments

Collateralized debt obligations (CDOs), like many arcane derivatives on Wall Street, occupy a vast share of the markets and yet did not become a household name until recent months. Involvement with these securities has taken down major U.S. financial institutions, and has had rippling effects, wrecking international markets as well.

Take Jupiter High-Grade CDO V, "one bad bond" (Time, March 9, 2009), as an example of a CDO that seems to capture the root of the crisis. Jupiter is composed of the riskiest portions of other bonds, and although virtually impossible to value, 93% of Jupiter's bonds were rated AAA when issued in March 2007. Now some top bond traders estimate it's possibly worth as low as five cents on the dollar. Can you say toxic? While many factors are involved, insufficient transparency in the CDO market, significant changes in underlying assets, and the failure of credit rating agencies to accurately assess market risk all played a role in the rapid devaluation of CDOs.

Stuart Gabriel, Arden Realty Chair and Professor of Finance at UCLA Anderson and Director of the Ziman Center for Real Estate, brings with him more than 20 years of research and knowledge on macroeconomics and mortgage pricing. His article is based on his recent research exploring the relationship between CDO issuance and the spread between Treasuries and subprime mortgage-backed securities.

William Petak, former Managing Director and National Head of Origination of the Mortgage Lending and Real Estate Department of AIG Global Investment Corporation , provides the industry perspective this issue. His ruminations include a historical look at the development of CDOs, the impact of mark-to-market pricing in these market conditions, and some thoughts on reform.

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Stuart Gabriel, Arden Realty Chair, Professor in Finance

Recent years have witnessed a boom-bust cycle of explosive growth and then stunning collapse of the global market for collateralized debt obligations (CDOs). Introduced in late 1980s, CDO issuance took off at the beginning of the current decade, reaching roughly $552 billion in 2006. In the wake of the implosion and wholesale repricing of credit risk in the capital markets that began in 2007, CDO issuance plummeted to about $11 billion in 2008.

Because CDO issuance played an important role in the market for subprime mortgage-backed securities (MBS), this striking rise and fall provides an excellent laboratory for studying the interest rate spreads on the underlying subprime MBS collateral. In particular, the surge in issuance of CDOs backed by supbrime MBS coincided with a marked narrowing in subprime MBS-Treasury spreads, while the implosion of the CDO market in 2007 coincided with a marked widening in those spreads. This suggests some measurable effect of CDOs on the balance between the supply of and demand for, and, therefore, the pricing of, subprime MBS. This Brief reports on recent research on this issue by Deng, Gabriel, and Sanders [2008].


William Petak, Managing Director, Mortgage Lending and Real Estate, AIG Investments

As we look into the rearview mirror, it is possible to identify many culprits that helped perpetrate the abuse of a system that has led to our current financial woes. In conjunction with avarice, the crisis in the capital markets has its roots in misplaced ideas and errors in policy, accounting, finance, banking, and in business in general, as well as in the poor financial decisions of many Americans. All of these factors have conspired to cause an unprecedented "meltdown" of the financial system in the United States and around the world. Sadly, the current situation is not just a subprime mortgage issue, but also the result of well-intentioned efforts by regulatory, accounting and business leaders and authorities to create and/or improve capital market function. Despite good intentions, the outcome is a destabilized global financial system characterized by low levels of investor confidence and market liquidity. In the midst of all this, however, stands the poster child and what has been considered the initial contagion factor associated with the widespread economic turmoil: the proverbial "subprime" mortgage.

Subprime mortgages were originated to borrowers with limited financial capacity and poor credit histories who borrowed up to 100% of the value of a house. Historically, the lenders who originated those loans did not worry much about default risk because the subprime mortgages were contributed to trusts that issued bonds called mortgage-backed securities ("RMBS or MBS") which were subsequently sold in the global capital markets. For the most part, subprime lenders unloaded their risk position within a few weeks, such that the credit risk associated with those loans belonged to other investors.


Robert D. Beyer, Chief Executive Officer, TCW

Adapted from keynote speech delivered January 13, 2009 to the first MFE Class of 2009 at UCLA Anderson.

When I graduated from The Anderson School nearly 26 years ago, I accepted a job on Wall Street at an investment bank called Bear Stearns. I remember vividly arriving the same day as the brand new "microcomputers" as they were called. There were two of them and they sat in their cardboard boxes on the floor of the financial analysts' bullpen area for a good two weeks before anyone dared to unpack them. They were made by Victor Electronics, and it was pretty exciting to watch our head analyst, a wild-eyed mathematician who literally wore a green eyeshade, as he booted them up, with their dim amber displays and MS-DOS software. The program that he installed with the included six-inch floppy disk was called "Super Calc", and we all knew the greatest attribute of Super Calc would be the fact that if you discovered you had deducted goodwill expenses from taxable income in error during year two of a 10-year LBO cash flow model, you would not have to manually erase eight years of pencil lead entries to correct the analysis. This was big. We had computers at Anderson (then called "GSM",) but you had to sign up for them in advance, carry punch cards with you to save your work (which mostly demonstrated your programming ability and not your analysis) and there was limited time since there was always somebody waiting.

You can't find any remnants of Victor Electronics any more. The company that made Super Calc and the more ubiquitous VisiCalc is no longer in existence. You can't go to work for Bear Stearns any more. And 10-year LBO models? They switched to five many years back after the buyout firms realized they could deliver greater internal rates of return if they compressed the holding periods for their investments. Everybody's got a "microcomputer" or PC, most probably two or three. In our industry, change is the constant.


Developments in M&A Activity

Fred Weston, Professor of Finance, Emeritus Recalled

The Mergerstat monthly FLASHWIRE January 2009, (p. 2) reported that the number of M&A deals declined by 30 percent during the 12 months ending 11/30/08. For the largest mergers with deal size of $500 million and larger, the percent decline was slightly over 50 percent. The dollar value involved declined by 40 percent.

During roughly the same period producers' durable equipment outlays fell about 10% each quarter of 2008. M&As and outlays for business fixed investments are highly correlated. Both are methods used by firms to make investments. The December 2008 UCLA Forecast is for producers' durable equipment outlays to decline in 2009 by 20% in Q1, a negative 11.1% in Q2, and a negative 4.7% in Q3, with subsequent increases in 2010. If these forecasts are accurate, we could expect M&As activities to continue to decline in 2009 and then begin to be positive in 2010. These fundamental forces will continue to dominate the shotgun weddings between individual companies such as Bank of America with Merrill Lynch in 2008.

Master for Financial Engineering Summer Internship Program

Please consider supporting the Anderson School of Management new Master of Financial Engineering Program by hiring a graduate summer intern. Most of these students already have advanced degrees in mathematics, computer science, engineering and business. These students will make a different to your bottom line by bring new ideas to your work place, develop financial models, assist with financial projections, identify trends in the marketplace, work on investment strategy and investigate new analytics for your company. This is an opportunity to train the next generation of financial leaders. If you have a place in your company for one or two of these bright students, please contact Sandra A. Buchan, Director of Career Services on 310-206-5042 or email sbuchan@anderson.ucla.edu

LA Finance Ph.D. Program Ranked #1 in the World

A recently published article, using sophisticated statistical methods, ranked the UCLA Finance Ph.D. Program #1 in the world. The article looks at the joint contribution of the university granting the Ph.D. degree and the institution one is placed at as an assistant professor. The 2009 article from The Financial Review, published by Kam Chan, Carl Chen, and Hung Fung, is entitled, "Pedigree or Placement? An Analysis of Research Productivity in Finance." The research study ranks the UCLA Finance Ph.D. Program as #1 at enhancing the publication record of its students in the top three finance journals. The study also notes the top five universities for an assistant professorship in finance (which includes UCLA). Approximately ten percent of UCLA finance Ph.D. graduates have ended up at these top five universities and an even greater percentage received offers from them.

UCLA Finance Researchers Prevalent In Forthcoming Research

Approximately 20% of the authors in the upcoming April 2009 Journal of Finance, the research journal of the American Finance Association, are either UCLA Anderson Ph.D. graduates or UCLA Anderson faculty. The authors are Felipe L. Aguerrevere (UCLA Anderson Ph.D. 2000), Tobias Moskowitz (UCLA Anderson Ph.D. 1998), Mark Grinblatt (UCLA Ph.D. Dean and Professor), Mark Garmaise (UCLA Finance Area Ph.D. supervisor and Associate Professor), and Bruce Carlin (UCLA Finance Assistant Professor).

Cesare Fracassi is a PhD student studying Finance at UCLA Anderson. He recently accepted a tenure-track position as Assistant Professor at the McCombs School of Business at the University of Texas, Austin. His research interests are in the area of corporate finance, more specifically, the role of social networks in corporate policy decisions. Other areas of interest include corporate governance, mergers and acquisitions and executive compensation.

Before starting his PhD, he worked as a strategic management consultant at Booz Allen and Hamilton and Roland Berger in Italy, and as summer research intern at the United Nations in New York. Cesare holds a bachelor's degree in Electrical Engineering from Politecnico di Milano, Italy, and an MBA from UCLA Anderson.

Albert Sheen is a doctoral student in Finance at UCLA Anderson. He recently accepted a tenure-track position at Harvard Business School and will be joining their faculty this Fall. Before starting his PhD, he was a management consultant with McKinsey & Company, an analyst at Beecher Investors, and a research associate with Sanford C. Bernstein. Albert received a bachelor's degree in Economics from the University of Chicago. His research interests are in the area of corporate finance, particularly public and private firms, internal capital markets, and product market strategy.

The Fink Center for Finance & Investments
UCLA Anderson School of Management
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