Financial Markets, Institutions & Instruments; Derivatives and Bank Regulation

1. Financial Markets, Institutions & Instruments; Derivatives and Bank Regulation ECO 473 – Money & Banking – Dr. D. Foster

2. I. Financial Markets, Institutions & Instruments

3. Economic Functions of Financial Markets • Match saversand investors • Savers want to  wealth • Investors want to create wealth • Spread/share risk. • Successful strategy - diversification • Savers seek out mutual funds • Savers seek out financial intermediaries • Investors seek OPM

4. Financial Markets - Why & Who • banks • credit unions • S&Ls • thrifts • savings banks • Why - Intermediation • Who . . . • pension funds • Insurance companies • mutual funds • mortgage brokers • investment bankers • finance companies

5. Banks A financial intermediary • Banks raise funds by accepting deposits. • Banks use the funds to make loans. • Banks as a solution to “asymmetric info.” • How does this occur for “direct” finance? • S&L, Thrifts, Credit Unions also. • Not “Investment” banks.

6. Asymmetric Information When one party to a transaction knows more than the other party. • Adverse selection- parties to a transaction have different information sets. • Borrowers as inherently risky. • Moral hazard- after the transaction, behavioral changes adversely affect one party. • How is the $ used? • Bernard Madoff.

7. Case: Bernard Madoff • Involved on Wall Street since 1960. • Prominent philanthropist. • Client losses = $65 bill. • “Ponzi” scheme: • Began in 1991. • “Model” unreplicated. • Targeted charities. • Client suicides.

8. Financial Markets - New & Used • New - Primary Markets • stocks (IPO), bonds, mortgages, other. • Used - Secondary Markets • exchange of ownership. • Where: NYSE,NASDAQ,OTC . . .

9. Financial Markets - Short & Long • Short - Money Markets • A financial instrument that matures w/in one year. • Used to facilitate liquidity demands. • Need funds soon. • Have excess cash. • Fed’l funds • Repurchase agreements • Bankers’ acceptances • Euro$ funds • 3 mo. & 6 mo. T-Bills • Commercial paper • Bank CDs

10. Money Market Instruments Outstanding, April 2005

11. Financial Markets - Short & Long • Long - Capital Markets • Maturities of more than one year. • Used for capital purchases (investment). • Less liquid & more risk than MM. • Other U.S. & Munis • Mortgages • Comm./Con. loans • Corporate stock • Corporate bonds • U.S. Treasury bonds

12. Capital Market Instruments Outstanding, April 2005

13. Case: The End of Investment Banks? • 1930s Regs/diversification option? • 2008 - collapse of MBSs. • Bear Stearns - couldn’t roll over debt. • Lehman Brothers - $639 bill. in assets. • Merrill Lynch - sold to BoA • Goldman Sachs & Morgan Stanley- converted to commercial banks.

14. Federal Financing Bank Banks for Cooperatives Federal Intermediate Credit Banks Federal Land Banks Federal National Mortgage Association (FNMA, or “Fannie Mae”) Government Players • General National Mortgage Association • (GNMA, or “Ginnie Mae”) • Federal Home Loan Banks (FHLBs) • Federal Home Loan Mortgage Corporation • (FHLMC, or “Freddie Mac”)

15. Sell diversification to individual savers. Government regulations limit risks. 8,000 mutual funds in the United States. Mutual Funds Hedge Funds • Raise money from wealthy people/institutions • Largely unregulated • Use leverage which magnifies gains/losses. • Trade in derivative instruments.

16. A brokerbuys and sells securities for others May be “full service” or “discount.” Adealerbuys and sells for itself, making a market in these securities. Brokers and Dealers Investment Banks • Underwrites and advises companies on mergers and acquisitions. • Investment banks buy and sell securities and derivatives.

17. Case - Google IPO • Google structured IPO as a “Dutch” auction. • Google saved on investment bank services. • Presumption is Google earned more $$. • Had touted a price of $135 earlier. • Ended up with a price of $85. • Earned $1.67 billion on sale. • Conclusion: Investment underwriters are not biased!

18. Case - Google IPO After After After After 8/2012 trading Aug. 20, trading Aug. 20, trading IPO, IPO, IPO, IPO, At peak, traded at At peak, traded at At peak, traded at At peak, traded at at about $460 at about $542 at about $460 traded traded traded traded almost $715 almost $715 almost $715 almost $715 at $106 at $106 at $106 at $106

19. II. Derivative Financial Instruments

20. Derivative Financial Instruments • Forward contracts • Future contracts • Options • Swaps Derivatives in . . . • Interest rates • Currency • Stock • Commodities • Weather

21. “Purpose” of a Derivative • Hedging/Insuring against adverse changes … You have $10 million in U.S. Treasuries with a nominal yield of 5% which matures 5 years from now. But, you only want to hold these bonds for 3 more years. Risk – If interest rates rise, the price will fall. Hedge – execute a forward contract, promising to sell bonds in 3 years at a price yielding 5.1%.

22. “Purpose” of a Derivative • Hedging/Insuring against adverse changes … You need to buy €5 million in 6 months,the current exchange rate is $1.33/ €. But, you think the dollar will depreciate by then. Risk – If the dollar falls, it costs more to buy €. Hedge – go “long” and agree to buy €, through a futures contract, at $1.36 each.

23. Forward vs. Future Contract • Forward: • Variable in content. • Settled at maturity date. • Matching participants. • Future: • Standardized amounts and terms. • Ongoing settlement cash flows. • Active, liquid market. • Default can’t hurt other party.

24. “Purpose” of a Derivative • Hedging/Insuring against adverse changes … You need to buy €5 million in 6 months,the current exchange rate is $1.33/ €.But, you think the dollar will depreciate by then. Risk – If the dollar falls, it costs more to buy €. Alternative Hedge – buy a call option to purchase Euros at $1.40 each; exercise only if the rate moves higher than that.

25. “Purpose” of a Derivative • Hedging/Insuring against adverse changes … You pay a variable return on $25 million worth of outstanding bonds. Risk – If interest rates rise, so do your costs. Hedge – execute an interest rate swap, to gain a fixed payment schedule, and reducing your exposure to interest rate changes.

26. Derivatives as speculative • Bank agrees to buy bonds in one year at a price that earns 5% . . . thinking rates will fall. • Buy/sell currency futures if you expect rates to move contrary to market. • Buy options to leverage your investment. Actions raise market liquidity for non-speculators!!

27. Case: Barings Bank - 1762 to 1995 • 1992 – Nick Leeson becomes a trading manager at Baring Securities in Singapore. • Charged with executing client option orders and arbitraging price differences between SIMEX and Osaka exchanges. • Took “speculative positions” in futures linked to Nikkei 225 and Japanese gov’t. bonds. • Hid losses in an unused error account:$400 m. – 1994 and $1.4 b. – 1995 • Fled Singapore; arrested in Germany.

28. The Credit Swap Derivative • Hedging against adverse changes.. You own $25 million worth of outstanding bonds. Risk – If the firm goes bankrupt . . . Hedge – buy a credit default swap, and make a fixed payment (insurance). If firm goes bust, the seller owes you for the bond (difference).

29. The Credit Swap Derivative • First one in 1995 (J.P. Morgan) • By 2008, $45 trillion in value. • As speculation – buy & sell to manage risk. • You don’t need to own bond! • Done OTC. • Party-to-party transaction. • Settlement/liquidity issues. • Build a virtual bond portfolio. • Insider trading issue . . .

30. III. Regulating theBanking Industry

31. Rationales for Government Regulation • Maintaining depository institution liquidity. • Assuring bank solvency bylimiting failures. • Promoting an efficient financial system. • Protecting consumers.

32. Federal Regulation: 1933–1970 • The Banking Act of 1933 (Glass-Steagall Act): • Created the Federal Deposit Insurance Corporation (FDIC). • Placed interest rate ceilings on checking deposits of commercial banks. • Separated commercial and investment banking. • Branching restrictions.

33. Partial Deregulation: 1971–1989 • Disintermediation in the 1970s. • 1980 - Depository Institutions Deregulation and Monetary Control Act (DIDMCA): • Six-year phaseout of interest rate ceilings. • Permitted NOW accounts. • Increased FDIC coverage to $100,000.

34. Partial Deregulation: 1971–1989 • The Garn–St. Germain Act of 1982: • Authorized money market deposit accounts. • Increase the DIDMCA limit on consumer loans and commercial paper. • Authorized savings institutions to make commercial real estate loans. • Gave these institutions the power to purchase “unsecured loans,” including low-rated, “junk” bonds. • Gave the FDIC power to permit troubled financial institutions to merge with healthier partners.

35. Partial Deregulation: 1971–1989 • 1989 - Financial Institutions Reform, Recovery & Enforcement Act (FIRREA): • Authorized taxpayer funds to cover cost of liquidating failed thrifts.--Insurance wasn’t enough! • Abolished current thrift regulatory structure.--Created Office of Thrift Supervision.--Created the Resolution Trust Corp. to liquidate thrifts. • Moved thrift insurance (FSLIC) into FDIC. • Required insurance fund = 1.25% of insured deposits.

36. Deposit Insurance Complications • The moral-hazard problem of deposit insurance: • S&L crisis. • Too-big-to-fail policy: • Continental Illinois. • The FDIC Improvement Act Of 1991-- Allowed for earlier intervention by the FDIC.-- Let FDIC set/change premiums to boost fund.-- Mandated risk-based premium structure.

37. FDIC’s Most Costly Failure Resolutions since 1980 ResolutionDepository Assets Failure Cost Institution ($ Billions) Date ($ Billions) First Republic Bank (Dallas) $33.5 July 1988 $3.9 MCorp (Dallas) 15.7 February 1989 2.8 Continental Illinois (Chicago) 33.6 May 1984 1.1 Texas American (Fort Worth) 4.8 July 1989 1.1 First City Bancorp (Houston) 4.8 April 1988 1.1 Bank of New England (Boston) 21.8 January 1991 0.9 Goldome FSB (Buffalo) 8.7 May 1988 0.8 New York Bank for Savings (NYC) 3.4 March 1982 0.8 1st National Bank of Keystone (WV) 1.1 September 1999 0.8 Crossland Savings Bank (Brooklyn) 7.3 January 1992 0.7 Superior Bank (Illinois) 2.3 July 2001 0.6

38. Capital Requirements • Capital requirements: • Minimum equity capital standards. • Risk-based capital requirements: • Risk factors that distinguish different depository institutions. [Degree of capitalization.] • Risk-adjusted assets: • A weighted average of bank assets to account for risk differences across types of assets. [Type of capitalization.]

39. The Financial Services Modernization Act of 1999 (Gramm-Leach-Bliley Act) • Act removes Glass-Steagall restrictionsand permits: • Securities firms and insurance companies to own commercial banks. • Banks to underwrite insurance andsecurities, including shares of stock.

40. Regulatory Issues Off-balance-sheet banking: Loan commitment; credit default swaps. Asset valuation: Historical cost vs. market value Derivatives: Replacement cost exposure. Credit/market/operating risks. New wave of regulation: SOX; Dodd-Frank

41. Financial Markets, Institutions & Instruments; Derivatives and Bank Regulation ECO 473 – Money & Banking – Dr. D. Foster