Seminar in Finance Part One

• Economic Analysis

Position: Portfolio Manager, CFA

Firm: Trailblazer Investment Advisors (TIA)

Client: Sam and Amy Kratchman

Date: 10/01/2016

Situation: A potential new client has just been left $1,100,000 (on an after-tax basis) from a wealthy grandparent and is deciding between your firm and Blackrock Investment in terms of who will manage their new found wealth. As part of the process, the client would like you to put together a mock portfolio, detailing all potential assets to be included in the portfolio, as well as your forecast of the economy, markets, etc. and why TIA will provide a higher risk adjusted rate of return than other managers.

Client: Your clients are Sam and Amy Kratchman both 39 years old (as of 10/16). They have two children, ages 7 and 3 and two dogs, Scooby and Shaggy. Sam and Amy need your help to plan for their retirement at age 65 and college tuition for both of their children. In addition, they would like to buy a beach house with their new found inheritance. They have been saving for many years but do not have a clear, diversified investment strategy to meet their future goals.

Overall Outline of Written Work for Part One (Table of Contents):

• Purpose / Objective

Introduction of portfolio manager and client?s overall objectives (due with economic analysis)

Risk and return of the portfolio (completed in part one b)

Assess current holdings including a calculation of the total return and risk as measured by standard deviation earned on each position. Should they hold onto these positions? (completed part one b)

• Economic Assessment of 2014 ? Q3 2016 (See details below)
  • Year 2014 (From 12/31/2013 ? 12/31/2014)
  • Year 2015
  • First three quarters 2016 (won?t have GDP data yet for Q3 but will have employment, retails sales, personal income, financial market info, Federal Reserve data, etc.)

• Asset Allocation (completed in part one b)

Graph your allocation and analyze why you chose this particular distribution

Explain how it makes sense given your client?s objectives and constraints including discussion about correlation and fundamental reasoning for your decisions

Include your portfolio risk adjusted return versus the overall market

Complete Bibliography (complete for entire paper)

Data sources

Research sources

Details for Economic Analysis

The economic and market analysis part of the paper focuses on the period of economic recovery and recent questions of a possible ending of the growth period. Much of what we have experienced over the last several years of ?recovery? is not typical in the US. You should not analyze the cause and effect of the 2008-09 recession or any prior periods, but can include those issues that are still impacting the economy today. You should NOT write this paper as a quarter by quarter breakdown of what occurred but rather an overall trend analysis for the year. For example, in 2011, the first and second quarters were weak and then the economy picked up during the rest of the year. What caused the slowdown? Where has some renewed strength come from?

• Year 2014: Analyze economic growth and financial market performance.
  • Include a detailed discussion of the components that affected overall GDP growth inter-relating cause and effect analysis. This assessment should focus on consumption, investment, government spending and net trade (with the largest sections on C+I)
  • C+I section should include a detailed analysis of the overall trend during the 2014 calendar year (leading in from year end 2013), including significant global events that may have impacted each in terms of its effect on GDP. For example, how have Europe and China impacted US growth? How does employment impact consumption and investment? Has inflation impacted spending in this time period? Analyze specific macroeconomic variables that reflect C and I.
  • Net X section should focus on overall trends in terms of what is helping the US have a positive versus negative contribution to GDP
  • The government piece should include some discussion on regulatory changes that have impacted both government spending as well as consumer/ business investment (Fiscal not monetary policy)
  • Monetary policy: Discuss reasons why the Fed acted or didn?t act, including the Fed?s two mandates, inflation (show trend of core versus nominal) and unemployment. State specific policy changes enacted during this time period.

Include a discussion on the performance of the financial markets. For this section, analyze a large cap benchmark such as the S&P 500 and a UST benchmark such as the BofA ML Treasury (or you can assess some of these changes by looking at the YTM of the 10-year UST ? keeping in mind total return vs YTM), to reflect the market?s perspective on the economy during this time. State the annual % total return of each index. Look at the trend throughout the year giving strong versus weak performing industries.

Analysis should include numerical data (tables or graphs work well) over this time paper as well as a written analysis discussing trend, important events, cause and effect

Year 2015 Same analysis

Year 2016 Same analysis ? Although we do not have the actual Q3 GDP report yet, we do have data regarding consumer spending, inflation, unemployment, monetary policy, etc. for the quarter. By the time you hand in your final paper, you will add in the actual GDP number for the quarter.

All written work must be double spaced, with footnotes not endnotes and a complete bibliography. Reading other economists perspective is great, but DO NOT copy word for word someone else?s description of the economy/ market. Specific forecasting is not part of this first section.

Sourcing Requirements

• You cannot use sources such as Wikopedia, Investopedia, blogs etc.
• You must use at least five sources for your written work and cannot have more than 20% of your written work from any one source (for example, any part of www.bea.gov counts as one source)
• Example of footnote http://www.wsj.com/articles/oil-prices-slip-as-u-s-iran-nuclear-talks-continue-past-deadline-1427878448?
• Example of Bibliography for same source:
• If you do not source all the appropriate data and information, you will either receive a ?0? or fail depending on the extent of the plagiarism
• In total,less than 20% of your overall work should be direct quotes from your sources. This implies putting your research into your OWN words not simply changing one word or two in a sentence.Consequence: Fail the class!

ECONOMIC ANALYSIS There was a great deal of contributing factors to the financial crisis including sub-prime lending practices, deregulation, over-leveraging, financial innovations, commodity booms and failed credit rating agencies. However, of this list of factors contributing to the crisis, two in particular really were at the heart of the crisis and contributed most towards the venerability of the Unites States financial system. Financial innovation in securitization was the primary reason financial innovation was responsible for putting the financial system at risk. Both mortgage backed securities (MBS) and collateralized mortgage obligations (CMO) product were often bundling different types of mortgages into a single product that could then be sold to investors. This practice of bundling mortgages with varying degree of risk combined with the failure of credit rating agencies to accurately assess the total risk of the collection of the underlying assets, was responsible for a large part of the financial crisis in 2008. Although MBSs and CMOs existed well before the financial crisis, the volume of their issuance was extremely low in 2004 compared to the 2007 levels. As shown in figure 1, the volume of CDO issuance went from 25 billion in the first quarter 2004 to about 180 billion in the fourth quarter 2006, a remarkable 614 percent increase in less than three years. This sudden increase was due to institutional investors demand for AAA rated securities, something that these pooled mortgage creations were often rated. CDO Issuance 200 180 160 140 120 100 80 60 40 20 0 Figure 11 These securitized mortgage products are essentially a pooling of assets, in this case subprime mortgages combined with various other types of mortgages, together into a single security, which can then be sold to investors ranging from individuals to institutional investors. In addition to vanilla MBSs as just described, there are CDOs which are similar to MBSs except the pools of mortgages are split up into several tranches, each of which is then sold off to investors. Once the assets are pooled and the tranches are created, credit rating agencies assign a rating to each tranche. A rating is a \"forward-looking opinion that speaks to the relative probability that principle and interest will be repaid in a timely manner\"2. Each tranche is created for a different risk level, where the more senior tranches would receive their interest and 1 Global cdo market issuance data. (2007). Proceedings of the Securities industry and financial markets association (pp. 1). Thomson Financial. 2 Fagen, M, & Frankel, T. (2008). Mbs, abs, spv, cds, arm, bbb+: understanding the alphabet soup of securitization. Unpublished raw data, Harvard University, Cambridge, Massachusetts. Retrieved from http://www.hks.harvard.edu/m-rcbg/Events/fagan_frankel_securitization_october08.pdf principle before the junior tranches and thus have less risk. The rating agencies would then assign each of tranches a rating based on their probability to default, which is the chance of loss to an investor arising from the underlying borrower's failure to make their promised interest or principle payments when due.3 Investment banks who created most of the CDOs would then sell the products to investors making substantial profits from doing so between 2004 and 2007. Initially these mortgage derivative products started to appear as government sponsored entities (GSE)'s such as Fannie Mae and Freddie Mac began to sell securities being backed by mortgage assets the GSE's owned. Once investment banks saw that there was a large demand for different mortgage based products not owned by the GSEs they began to securitize4. While it seems like MBSs and CDOs are useful tools to allow millions of families in the United States to own homes because of the increases amount of capital being lent to borrowers who are seeking mortgages as a result of these financial innovations, there are drawbacks. The drawbacks in this particular segment of mortgages are numerous. There are serious transparency issues that arise, which when coupled with questionable rating agency practices spell disaster such as the case in 2008 with the crisis. CDO tranches deemed senior and carrying very high credit ratings of AAA, meaning a low credit risk, turned out to be a lot more risky than expected. Without much oversight by the U.S. Government, the credit agencies were able to assign false ratings at will with little consequences. The average recovery rate of high quality CDOs, a CDO 3 Glossary of Finance and Economic Terms (A-F).Freddie mac. Retrieved October 17, 2010, from http://www.freddiemac.com/smm/a_f.htm 4 Cox, J., Faucette, J., & Lickstein, C. V. (n.d.). Why Did the Credit Crisis Spread to Global Markets?. The University of Iowa. Retrieved December 7, 2010, from http://www.uiowa.edu/ifdebook/ebook2/contents/part5II.shtml with a credit rating of AAA, was 32 cents on the dollar5, which shows an obvious mispricing of risk on an enormous scale. These credit ratings were given by agencies primarily earning their income from the banks who issued the securities being rated so there is an inherent conflict of interest. This system is partially to blame for the financial crisis because it allowed millions of investors to purchase securities paying out a good return with supposedly low risk, when in actuality carried significantly higher default risks. This mispricing was all too apparent when the mortgages started to default quickly and many investors investments began to disappear. Funds that were supposed to maintain low risk investments had billions of dollars invested in CDOs, when in reality only 32 percent of those investments was returned overall. The complexity and lack of transparency of MBSs and CDOs in addition to a failing rating process contributed to much of the financial crisis in late 2007 through 2008. Coming out of 2008 the state of the United States economy was never so fragile since the 1930s. The Federal Reserve began to enact quantitative easing policies with a November 25th 2008 announcement to purchase up to $100 billion of government sponsored enterprises and $500 billion MBSs. Entering 2009 the economy was coming off a staggering negative 6.8 percent gross domestic product (GDP) annual real growth rate from the fourth quarter 2008. With the United Economy in a deep recession the Federal Reserve took unprecedented actions in 2009 in an effort to foil deflation and keep the economy afloat. In the United States 2009 was a pivotal year due to the official end of the worst recession in eighty years occurring at the end of the second quarter, for the first time in over a year there was positive overall GDP growth and overall inflation began to turn positive once again. However the year started off with a still large negative 4.9 percent annualized GDP growth, 5 Insight: time to expose those cdos. (2009, February 26). Financial Times, which while a bit higher than in 2008 was still at a dismal level. The largest component of the low first quarter GDP number was the rapid decrease in private investment spending, which is depicted in figure 2 on the right axis as decreasing 42.2 percent in the first quarter 2009. The lack of corporate investment was the main reason behind the large decrease in the end of 2008 because they had no confidence in a recovery at that point. Despite a better personal consumption amount, which went from negative 3.3 percent to negative 0.5 percent, the large drop in private investment was able to hold the overall GDP rate into still very negative territory. 8.0% 40.0% 6.0% 30.0% 20.0% 4.0% 10.0% 2.0% 0.0% 0.0% Overall GDP Personal Consumption Government Spending Private Investment -2.0% -10.0% -20.0% -4.0% -30.0% -6.0% -40.0% -8.0% -50.0% Figure 26 From the second quarter through the end of 2009, GDP growth was much improved as apparent in figure 2. The largest component of this increase can be attributed to the increase in 6 Bureau of Economic Analysis, National Economic Accounts. (2010). Gross domestic product. Washington, DC: Retrieved from http://www.bea.govational/index.htm#gdp private investment, which was due to the restored confidence in the economy evident by very bullish domestic equity markets. Within private investment, most of the positive growth can be attributed to equipment and software, which by the second quarter was already growing by a positive 0.2 percent. Also, the government increased spending in the second quarter to enable growth to pick up, with much of this government infusion coming in the form of the Troubled Asset Relief Program (TARP). At the time the sharp increase in investment and government spending appeared to have jumpstarted the economy being led by the massive government stimulus, spurring a climb all the way up to an annualized 5 percent overall real GDP growth in the fourth quarter. It is important to note that by far consumer spending contributed the least to the apparent recovery as unemployment remained high as can be seen in the unemployment graph in figure 3. Without jobs consumers were uncertain about their financial future so they saved or paid off outstanding debts instead of consuming, leading to a lower increase in personal consumption as compared to the overall GDP amount. While the increase up to 5 percent growth along with a bull equity market setting seemed to be signs of a rapid recovery and transition towards a new boom, it wasn't quite as it seemed. While this improvement in overall growth was taking place in the last three quarters of 2009, unemployment continued to climb from 7.7 percent to 10 percent by the end of the year. This job loss was accompanied with the government stimulus money and an extensive Federal Reserve quantitative easing policy making the rapid increase in the United States equity markets more of a response to policy events rather than overall increasing economic conditions. However there were significant effects in international markets with the implementation of a massive QE effort in the US mainly due to a weaker dollar. The sharply lower dollar left many countries both in developing and developed markets with appreciated currencies and a tough exportation market. While the policy decisions in the U.S. did not really alleviate the domestic economy it had arguably more of an effect on international economies cutting off much of their exportation revenue, a worry especially for several Asian countries who rely on that production for a majority of their GDP output. Unemployment Rate 12.0 10.0 8.0 Unemployment Rate 6.0 4.0 2.0 0.0 39661 39722 39783 39845 39904 40026 40087 40148 39630 39692 39753 39814 39873 39934 40057 40118 Figure 37 What started in late 2008 with monetary policy at a rate of 0.25 percent as quantitative easing in the form of MBS and GSE purchases quickly became an extensive treasury, agency and mortgaged back securities purchase program on a unprecedented scale. In March 2009, the Federal Reserve announced their intention to expand the MBS purchase program to $1.25 trillion and buy up $300 billion of longer-term Treasury securities.8 These purchases continued up through the beginning of 2010 and did several things the United States economy. Quantitative 7 Bureau of Labor Statistics, (2010). Unemployment Rate. Washington, DC: Retrieved from http://www.bls.gov/cps/data.htm 8 M- Removed by professor easing was enacted to increase the liquidity of money markets during a time when banks were reluctant to lend due risk concerns, thus drying up the nation's liquidity before the easing occurred. However, the other purpose of quantitative easing was to push down interest rates, which is accomplished when a massive purchases of treasuries causes the prices to rise, thus lowering interest rates across the yield curve. This lowering of rates was an effort to make saving less attractive in an attempt to get consumers and corporations alike to spend again, bolstering demand in the economy. The period of quantitative easing in 2009 was the Federal Reserve acting swiftly to address the United States fragile economy, evident by the high unemployment and low inflation levels. Throughout 2010 there have been several divergent economic indicators, which following positive data of late 2009 including a 5 percent annualized GDP growth rate in the fourth quarter shown in figure 4, indicates serious concerns over the state of the recovery. Although the fourth quarter GDP breakdown has not been released, the first three quarters of the year in contrast with the fourth quarter of 2009 reveal a lot of the shortcomings of the United States economy. Overall GDP growth dropped from 5 percent in the fourth quarter of 2009 down to just 1.7 percent in the second quarter of 2009. While most of the components remained unchanged, consumer spending showed some promise in jumping from 0.7 percent in 2009 to 1.3 percent in the first quarter of 2010. To counteract that improvement in consumer sentiment, the net exports growth rate fell from almost positive 2 percent down to negative 3.5 percent, indicating a large reduction in overall exports due mainly to a large increase in imports, a worrying sign for an economy trying hard to climb out of a recession. A recent study from the International Monetary Fund (IMF) revealed a trend for exports to recover at a swifter pace than imports in developed countries emerging from recessions due to the tendency for the corresponding currency to be weak.9 Because the United States' trade gap is increasing instead of what the IMF has observed over the course of recent history, it raises a major cause for concern over the state of a recovery, especially because exports comprises 13 percent of the U.S. economy10. However, in the third quarter of 2010 net exports were improved significantly to -1.8 percent, a sign that perhaps the concern of a double dip recession earlier in the year was premature. Combined with a better 2.5 percent overall GDP growth and improved personal consumption as can be seen in figure 4 below, the economy has appeared to improve in the third quarter of 2010. It is important to note that a single quarter of data is not telling of the state of the economy's direction, until future quarters occur the direction will be difficult to identify. GDP Breakdown Q4 2009 - Q3 2010 Q4 2009 Q1 2010 Q2 2010 Q3 2010 GDP Overall 5.0% 3.7% 1.7% 2.5% Personal Consumption 0.7% 1.3% 1.5% 2.0% Private Investment 2.7% 3.0% 2.9% 1.5% Government Spending -0.3% -0.3% 0.8% 0.8% 1.9% -0.3% -3.5% -1.8% Net Exports Figure 411 9 http://www.imf.org - remainder removed by Professor 10 Dadush, U., & Ali, S. (2010, February 17). Can the United States Double Exports in Five Years? Carnegie Endowment for International Peace. Carnegie Endowment for International Peace. Retrieved December 7, 2010, from http://www.carnegieendowment.org/publications/index.cfm? fa=view&id=30998 11Bureau of Economic Analysis, National Economic Accounts. (2010). Gross domestic product. Washington, DC: Retrieved from http://www.bea.govational/index.htm#gdp This major decline in the bottom line number of economy growth in the United States is worrying enough and when combined with a steadily declining inflation rate is extremely distressing. As shown in figure 5, the nominal inflation rate has fallen almost consistently from month to month over the course of 2010. Due to the high commodity prices, especially energy and food based products, the earlier inflation numbers are artificially higher in 2010, this just adds to the worry of low inflation. The Federal Reserve had been quite vocal about their concern with the current inflation rate, which was below the unofficial mandate of around 2 percent for a healthy growing economy. The events of May 2010 changed the Federal Reserve's sentiment from a hopeful one to a dovish one, favoring another round of quantitative easing in the near future. Until May, there was at least some positive housing data including an increase in housing starts seen in figure 6, however overall there was little actual improvement in the housing markets. Since the equity markets and housing markets started to head south in the second quarter, the Federal Reserve took a stance early in the third quarter 2010 in favor of further easing if the conditions worsened, and worsened they have. Throughout the third quarter 2010 there has been no significant positive employment or housing numbers released, the hope for a strong GDP number seems unlikely given the increasing trade deficit along with a slowdown in consumer demand due mainly to the prolonged period of high unemployment. This negative tone of the third quarter has caused counter intuitively both the equity market and the government bond market to rally considerably in anticipation of a likely second round of easing, which becomes more likely every time a negative data report is released. The economic recovery is unusually uncertain and most of the markets believe that a second round of easing is imminent in an effort to bolster raise inflation rates to a healthier level, fighting off the threat of deflation. 2010 Inflation 3.0% 2.6% 2.5% 2.1% 2.3% 2.2% 2.0% 2.0% Inflation 1.5% 1.1% 1.0% 1.2% 1.2% 1.1% August September 0.5% 0.0% January February March April May June July Figure 512 Housing Starts 800 700 600 500 400 Housing Starts 300 200 100 0 Figu re 613 12 B u r e a u o f L a b o r S t a t i s t i c s , ( 2 0 1 0 ) . I n f l a t i o n R a t e . Wa s h i n g t o n , D C : R e t r i e v e d f r o m http://www.bls.gov/cps/data.htm 13 U S t o t a l n e w p r i v a t e l y o w n e d h o u s i n g u n i t s s t a r t e d ; t h o u s a n d s ; s a a r . ( n . d . ) . R e t r i e v e d f r o m h t t p : / / w w w. e c o n o m a g i c . c o m / e m cgi/data.exe/cenc25/startssa01