A brief introduction to the security market 

There are two basic instruments in the security market, equity and debt. We own a house. The ownership is called equity. Most of the time, we also borrow from a bank to finance our purchase. The borrowing is called debt. In the security market, the equity part is called stock market. The debt part is called bond market.

We heard a lot more about the stock market than the bond market. But we really need to know that the bond market is a lot larger than the stock market. When we buy a house, most people would borrow money from a bank. But few would share the ownership of the house with others. Similarly, many companies would borrow from banks or directly from the security market. But relatively few companies would issue stocks. Knowing the tremendous size of the bond market, we can understand why most market activities and innovations are concentrated in the bond market.

Why financial innovations occur? We will give some examples. In the old time, mortgage debts stay with the banks. When banks accumulate many mortgages, they cannot issue new ones. Otherwise, too many debts will be risky to a bank. Later, banks securitize mortgages. In other words, they sell the mortgages to other institutions, such as retirement funds. In this way, the banks reduces their debt holdings and can continue to issue new debts. You can imagine the appetite of banks for new mortgages. They encourage more houses and bigger houses. Remember the slogan of one bank (Scotia Bank), you are richer than you think. With the encouragement from the financial institutions, people are buying more houses, bigger houses, fancier houses. As a result, people are less affordable to raise kids. This is an example how financial institutions affect our real life. 

Another major innovation is to sell bonds in tranches. There is a thirty year bond. We can slice it into three (or more) tranches. The first tranches contains all the coupon payment of first ten years and the last tranches contains all the cash flows for the third ten years. Then the banks package these three tranches and sell them separately.

What is the purpose of this packaging? Suppose I retire after twenty years. If I buy a regular bond, I will receive coupon payment every year. I have to pay tax every year on these coupons before I reinvest these coupons. But if I only buy the third tranches, I don’t have to pay tax for the coupons for the next twenty years. Tax consideration is the main drive for many financial innovations.

We often consider Warren Buffet the greatest investor. His real edge is tax avoidance. His main method is very simple. He would buy a company in whole if possible. This reduces future financial transactions and tax liabilities. When one holds part of a company, you get dividends from that company and you pay taxes on your dividends. When one holds the whole company, you can reinvest the profit, which lowers or eliminates taxes.

Financial instruments, being traded actively and widely, are generally very simple. But they are often given sophisticated names to command respect and to evade regulations. CDS (credit default swap) is such an example. CDS is simply an insurance policy. Insurance industry is heavily regulated. One cannot buy insurance for his neighbor’s house. A heart surgeon cannot buy insurance on his patient’s life. But one can buy CDS on anything. Just before financial crisis, Goldman Sachs sold many mortgage bonds to their clients. At the same time, it bought a lot of CDS on mortgage bonds. Usually they don’t have to disclose their transactions. But this time, AIG got a lot of government bailout money. It had to disclose where the money went. More than ten billion dollars went to Goldman Sachs.