1. Using Flow of Funds to Explain the Financial Market Crisis David Nawrocki Villanova University November 2009 Philly Chapter of FPA

2. National Flow of Funds Economies are dependent on the flow of funds from lenders to borrowers. If I produce $1000 worth of goods then I have $1000 in income and I have the right to trade my goods for other goods ($1000 worth). Every economic unit has a decision to choose between future consumption and present consumption. Economic Units are Households, Businesses, Government

3. Household A Household B $1000 Income (Y) $1000 800 Consumption 1200 $200 Savings -$200 Flow of Funds Y = C + S Y = C – S Lender Borrower

4. Household A Household B $1000 Income (Y) $1000 800 Consumption 1000 200 Savings 0

5. Household A Household B $800 Income (Y) $1000 1000 Consumption 1000 0 Savings 0 Production of Goods and Services has dropped from $2000 to $1800. All because the flow of funds has been blocked.

6. The National Flow of Funds System Monetary Institutions Checkable Deposits Coins and Paper Money Deficit Debt Markets as Surplus Units Broker-Dealer Units Y = C – S Equity Networks Y = C + S Non-monetary Indirect Institutions Securities Claims to Goods and Services

7. Operations of Monetary Institutions Assets Institutions Issue Liabilities Taxing Power U.S. Treasury Token coins US Notes Treasury Debt Federal Reserve Federal Reserve Notes Consumer Loans, Commercial Banks Checkable Commercial Loans, Savings and Loans Deposits Mortgages, Call Loans, Mutual Savings Banks Credit Cards Credit Unions Short Term Money Market Mutual Mutual Fund Shares Securities Funds Checkable Deposits Operations of Broker/Dealers Assets Institutions Issue Liabilities Securities Broker/Dealers Call Loans

8. Operations of Nonmonetary Institutions Assets Institutions Issue Indirect Securities Securities Mutual Funds Mutual Fund Shares Real Estate R.E.I.T.s Mutual Fund Shares Securities Life Insurance Co. Cash Deposits Mortgages Insurance Reserves Annuities Securities Property Insurance Co. Insurance Reserves Securities Pension Funds Cash Deposits Annuities Securities, Real Assets Trust Departments Trust Accounts Mortgages FNMA FNMA Bonds Securities GNMA Insurance Reserves Mortgages GNMA Mutual Fund Insured GNMA Bonds Securities, Loans Non-Bank Finance Finance Paper, CMO Mortgages, Credit Cards CDO, CLO, RMBS, CMBS,CDS

9. Private Borrowing 09Q1 -2112.4 09Q2 -2471.5

10. Explosive Loans

11. Role of the Federal Reserve 1.Lender of the Last Resort 2.Influencing the Money Supply Fed Interventions in the Flow of Funds 1.1970 Penn Central Bankruptcy 2.1987 Stock Market Crash 3.1999 Y2K 4.2008 Bear Stearns, AIG, Money Market Funds

12. Failure of Deregulation Programs Fed did not control the broad money supply through the shadow banking system.

13. SEC allowed Investment Banks to get away with extreme leverage deregulating them in 2004. Debt/Equity ratios for the five investment banks 2003 2008 Today Bear Stearns <15:1 33:1 N/A Lehman <15:1 30:1 N/A Merrill Lynch <15:1 40:1 N/A Goldman 30:1 <15:1 Morgan Stanley 30:1 <15:1

14. Implications for Financial Planners 1.Distributions are Nonstationary 2.Monte Carlo Simulation Needs to be Modified for Nonnormal-Nonstationary Distributions. 3.Asset Allocation Hoax 4.Post-Modern Portfolio Theory – Downside Risk Measures 5.Strategies for a Nonstationary World

15. Nonstationary Means and Variances Figure 4 – Whitelaw JF (1994) Replication for Means and Variances for the period 1971-2008 Conditional on Quality Spreads (BBB-AAA and CP-Tbill), Treasury Yields, and S&P 500 Dividend Yields.

16. In a Crisis, Most Correlations Go Towards One Correlation between Russell 3000 and other assets 2005-2007:6 2007:6-2008:12 MSCI EAFE Index 0.6368 0.9181 Emerging Markets 0.6654 0.8936 C&S Real Estate 0.5299 0.8528 1-3 Year Treasuries -0.0939 -0.5269 20+ Year Treasuries -0.1423 -0.0934 Investment Grade Corp 0.0616 0.3245 Gold 0.1378 0.2315 Russell 1000 Large Cap 0.9961 0.9960 All Asset Classes are iShares ETFs.

17. In a Crisis, Most Returns Go Down the Drain Annualized Returns for Various Asset Classes 2005:2 to 2007:7 to 2007:7to 2007:6 2008:12 2009 YTD* 2009:12* Russell 3000 11.25% -29.06% 21.13% -27.63% MSCI EAFE 19.61 -32.43 28.57 -28.59 Emerging Markets 32.31 -31.33 58.60 -9.75 C&S Real Estate 16.92 -37.98 14.60 -44.03 1-3 Yr Treasury -0.63 3.71 0.55 6.20 20 Yr Treasury -3.01 25.22 -15.08 18.99 Corporate Bonds -3.12 -1.88 11.65 8.52 Gold 19.04 21.87 13.74 53.02 Russell 1000 10.95 -28.98 21.03 -27.56 All Asset Classes are iShares ETFs. * Cumulative Returns not Annualized Returns

18. Strategies for a Nonstationary World With Nonstationary Means and Variances, Equally Important Performance Factors Include: Security Selection. Hedging against macroeconomic conditions (Market Timing). Tax Management. Spending Policy – Withdrawal Rates in Retirement Accounts and Endowments – Liquidity Management. Asset Allocation (It is not 93% of Anything Which is the Hoax.)

19. Strategies for a Nonstationary World The appropriate response to a nonstationary world is to be adaptive through gradual adjustments to beliefs or expectations. It is a combination of adapting to events after they occur and anticipating future events.

20. Strategies for a Nonstationary World Our quantitative toolbox (optimizers, downside risk measures, MCS) can only be used for shorter time periods, i.e. one to two years. There can be short-term stability in a long-term unstable environment. You cannot forecast 20-30 years into the future but you can steer a path through the future with small-to-major adaptations for 20-30 years.

21. Managing a Retirement Portfolio in a Nonstationary World A disbursement account is harmed whenever there is a down market in the early years of the investment horizon. It is very difficult to recover from losses when you are making annuity payments at the same time. A portfolio needs to be built assuming that a three year period of negative returns can occur at any time. Behavioral Finance provides us with the concept of mental accounts.

22. Managing a Retirement Portfolio in a Nonstationary World Build three mental accounts based on time horizon and revise every 12-24 months. Bucket A – Money Market Securities – Highly Risk Averse – 3 year horizon. Bucket B – Mixture of Fixed Income and Income Stocks – 4-9 year horizon – Risk Averse Bucket C – Equity – 10-30 year horizon - Risk Neutral. (It’s a little like a target date fund but those are not set up for disbursement accounts only accumulation accounts.)

23. Thank you! Flow of Funds are important. No recovery until private sector credit flows are restored. Market Deregulation Fever was at the heart of the Crisis. We will see Re-regulation of Financial Markets. Goal of High Home Ownership will not be going away any time soon. Markets are Nonstationary. Investment Managers have to be Adaptive in the Short-Run (12-24 months).