Urgent Can anyone help me with a finance article?

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"http://www.businessweek.com/magazine/content/10_15/b4173080302669.htm "
If you fail to open the article link, please Google a Businessweek article entitled "Making Debt Holders into Watchdogs "
Hello everybody, I have a few minor questions about this article, which talks about the Dodd financial reform bill and how tail risks are involved in the financial crisis. Hope somebody would help answer my questions, I appreciate your help.
1. What does the author mean by saying " D....argue that perverse risk-taking had nothing to do with incentives" ? Also, what does perverse risk-taking refer to here as I couldn't find any specific meaning of it in the dictionary.
2. "In fact, studies show that CEOs of banks that paid most aggressively took the greatest risks. It paid off during the 1990s........The Fed came to their rescue......"
After reading this paragraph, I assumed the CEOs who are paid the most by banks took the greatest risks. Risk-taking paid off during the 90s but it backfired afterwards. Did I understand it correctly? if not, please let me know what it really meant.
3. "all banks should be required to issue a minimum level of debt(say 10& of assets) that is automatically impaired - either converted to equity or written down - if the bank suffers sufficient losses."
Why does a bank need to issue at least 10% impaired debt when it is already losing money? Wouldn't it make more sense if it were to be required to issue a "maximum" level of 10% debt?
4. For those who have a finance background, I would like to ask you one more question: "They miss the point that anyone who has equity-like claim to all the upside of a firm's profits has an incentive to take on tail risk." Can anyone help me explain this? Thank you very much.

AlpheccaStars · Accepted Answer

1) argue that perverse risk-taking had nothing to do with incentives.

These people say that the large amounts of money paid to the CEOs was not related to the bad risks that these banks took.

perverse - opposite of wise and good.

2)

the CEOs who are paid the most by banks took the greatest risks. - yes.
Risk-taking paid off during the 90s but it backfired afterwards. - No. there were a few problems in the 90's, but the 2008 crash was much much worse.

3. "all banks should be required to issue a minimum level of debt"
The bank will be required to sell bonds to investors in the amount of 10% or more of the bank's assets, so if the bank fails (the assets go bad), the bond investors will lose their money. The government does not back this debt up with taxpayer's money. The risk is transferred from the government to the investors.

4) They miss the point that anyone who has an equity-like claim to all the upside of a firm's profits (and faces a fraction of the leveraged losses) has an incentive to take on tail risk because there are fat premiums for doing so.

Let's suppose you are in a poker game and you have $1 to bet.
You have a rich Uncle Sam who does not want you to fail, and Uncle Sam will give you $0.90 back for every $1 that you lose. (a fraction of your losses).

You can make the following bets:

1. $1 bet where you win $0.05, and not lose anything. You end up with $1.05. (This is the conservative banking business, where banks use the depositor's funds to loan out on cars, houses, credit cards, etc. and make the profit from the difference on interest rates of about 5%)

2. $1 bet where you win $0.50, but have a 10% chance of making nothing. So you will have $1 (if you lose) or $1.50 (if you win) (The bank is making riskier loans, but in the worst case, the income from the successful loans will cover the loses from bad loans. If the bank uses good judgement in picking the loans, they will not have many defaults. )

3. you borrow $99 from your friends (these are the bank's bond investors), and bet the total ($100) on a game that can double your money.
If you win, you get $200. You have to pay your friends back a 10% profit ($109), but the $1 of your money that you risked wins you $91.($109+$91=$200). Borrowing from others to risk in your business ventures is called "leveraging."

This bet has a tail-risk (say a 2% chance that it will fail, and if it fails you lose 90% of your money).
If your bet loses, you have only $10. But Uncle Sam will give you $90, so you have $100- $1 for you and $99 for your friends.
This strategy is called "perverse risk-taking" - It has huge profits, and a small probability that there will be huge losses if it goes wrong. Of course, Uncle Sam will not be very happy with you!

The new law is requiring that your "friends" take some of the losses. So if you are doing risky things, people won't lend you money, or they will demand a higher return than the 10% in the example. When they demand higher returns, your returns will be less, so it won't be as worthwhile to take such perverse risks.

Ntfs200 · Answer

Hello AlpheccaStars:
Thank you so much for your reply, you did a great favor to me.
Regarding your answers, I have a few minor questions for you.
1.How do you define "equity-like" here?
The following definition is what I found in my Cambridge dictionary," the value of a company, which is divided into many equal parts owned by the shareholders, or one of the equal parts into which the value of a company is divided".
Does this definition fit the term in this article? If so, I assume that equity-like means anything that's close to equity.
2.I still don't understand why the article says"It paid off during the 1990s, creating once-heroic CEOs like...", this guy told me there were problems in the 90s, but how was it possible to pay off and create heroic CEOs?

Thanks again for your help!!!
Jerry

AlpheccaStars · Answer

1.How do you define "equity-like" here? Does this definition fit the term in this article? Yes. CEOs get paid in options, which is a claim (usually future) on equity shares in the company.
2) .I still don't understand why the article says"It paid off during the 1990s, creating once-heroic CEOs like..", this guy told me there were problems in the 90s, but how was it possible to pay off and create heroic CEOs?
The losses were minor, compared to the gains. It's like a little kid being punished by a very light tap in the hand for snitching a whole bucket of ice cream.

Ntfs200 · Answer

Hello AlpheccaStarsall, I'd like to ask you if the first definition of http://www.merriam-webster.com/dictionary/upside

fits this sentence - the "upside" of a firm's profits.
If I'm not wrong, then I'd paraphrase it as the portion of a firm's profits with a potential to gain more value.
I was doing a Chinese translation of this article; therefore, I must get every word right, thank you for your help!!
Jerry

AlpheccaStars · Answer

...fits this sentence - the "upside" of a firm's profits.
If I'm not wrong, then I'd paraphrase it as the portion of a firm's profits with a potential to gain more value.

"Upside" would relate to the potential of profits to increase. It is not any portion or division or subset of particular profits, unless indicated in the context: The opposite is "downside."

eg.
Microsoft's revenues from its software products have less upside potential than its revenues from its Internet services.

Ntfs200 · Answer

Hi AlpheccaStars,
Thank you for your reply. Now I understand the points I'd asked you above. Looking back on my translation of
the title of this article and the first paragraph, I've realized I must have misunderstood them in the very beginning.
Please let me rephrase these two parts in my own words and correct me if I am wrong, I appreciate your help.
"Making Debt Holders into Watchdogs"--> Debt holders are those who lend banks money, debt holders are what you called
"banks' friends" in your scenario.

Bank debt holders got off scot-free in the financial crisis. A tweak to the Dodd bill would make them soldiers in the war on foolish risk"--> Based on this lead, I assume bank debt holders shouldn't be like what I had mentioned above, it's "banks as debt holders"(= banks), a revision of the Dodd bill

will pose a tremendous risk to banks because by issuing a minimum of impaired debt, debt holders

will not lend banks money. hmm I'm confused now, can't tell who's who. Would you please explain it to me?
"One was economywide default risk, the risk that a broad portfolio of assets, such as mortgages, would suffer deep losses. The other was liquidity risk, essentially the way they financed the first kind of risk."--> default risk does the most harm
on a wide range of assets, mortgage is one of the kinds. After that, I'm not sure about the rest of the sentence...

AlpheccaStars · Answer

There are many characters in the "big picture"
a) The bank, in business to make money, but can lose a lot of money if it takes risk
b) The people with bank accounts (insured by the by government).
c) The bank's bond holders (people who lend money to the bank.
d) The bank shareholders (people who hold equity shares in the bank)
e) The mortgagees and businesses that the bank lends money to.
f) The government's insurance agency (insuring the bank accounts - ( b))
g) The government (the tax payers)

See this little video.

Kim is the bank. ( a)
Ricky is one of the businesses that the bank lends to ( e)
What the video does not show is where Kim gets her $1000 to lend to RIcky.

This money comes from the depositors ( b), the bond holders ( c) and the shareholders ( c)

If Ricky ( e) does not pay Kim ( a) the $1000, and Kim has no Rolex to sell, then who loses?

1. The bank ( a) will lose and go out of business.
2 The bank's shareholders ( d) lose because the share price will go to $0 in the stock market.
3. The government's insurance agency ( f) will lose money, since it has to pay back the insured depositors ( b). But it has a fund, paid by all the banks as an insurance policy to cover failed banks.
4. This article is about the bank's bond holders ( c) who lent money to the bank at a fixed interest rate. These instruments are called bonds, issued by the bank.

Ntfs200 · Answer

Hello AlpheccaStars,

Thank you so much for your reply. I 've taken a quick look at your explanation and the video.
It's just I couldn't understand why the author give a title and lead like this.
Regarding the title, I assume the implementation of the Dodd bill makes debt holders aware of the losses
they may have to be responsible for, so they would stop banks from expanding risk-taking if banks went too far.
As for the lead, I assume those debt holders(here the bank debt holders are still people who lend banks money
, right?) didn't suffer from losses because the US government bailed them out. But from now on, the Dodd bill
will make them pay for the losses, so debt holders (= soldiers) will bear risk, debt holders must oversee the banks
to protect themselves, right?
Thank you AlpheccaStars, this will all for my question for this article.

Making Debt Holders into Watchdogs

Bank debt holders got off scot-free in the financial crisis. A tweak to the Dodd bill would make them soldiers in the war on foolish risk

AlpheccaStars · Answer

Making Debt Holders into Watchdogs

It is a metaphor. The part of the government that enforces the financial laws cannot watch all the banks all the time for their risky bets.
So they are enlisting the watchful eyes of the investors, who will look at the Bank's liabilities (especially its unsecured loans) before they lend any money to them. If these investors knew that the government would pay them for any losses, then they wouldn't bother to check on the stability of the bank.
The European banks are in particularly dire straits, because the bond holders are the governments (the banks are government institutions.)

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Hello AlpheccaStars,

Making Debt Holders into Watchdogs

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