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Lesson 4: Issues in Depository Institutions and Hedging. A. Bank Issues of Securities.
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A. Bank Issues of Securities • Federal Funds markets allow banks and other depository institutions to borrow from one another to meet Federal Reserve requirements. Excess reserves of one bank may be loaned to other banks for satisfaction of reserve requirements. The rate at which these loans are extended is referred to as the Federal Funds Rate. • Negotiable Certificates of Deposit (a type of Jumbo C.D.) are tradable depository institution CDs with denominations exceeding $100,000. • Banker's Acceptances are originated when a bank accepts responsibility for paying a client's loan or assuming other financial responsibilities. • Repurchase Agreements (Repos) are issued by financial institutions (usually securities firms) acknowledging the sale of assets and a subsequent agreement to re-purchase at a higher price. • The counterparty transaction is a reverse repo.
B. Eurocurrency Issues • Eurodollars are freely convertible dollar-denominated time deposits outside the United States. • Eurocredits (e.g., Eurodollar Credits) are bank loans denominated in currencies other than that of the country where the loan is extended. Their rates are generally tied to LIBOR (the London Interbank Offered Rate) and U.S. rates. • Eurobonds are generally underwritten, bearer bonds denominated in currencies other than that of the country where the loan is extended. • Euro-Commercial paper is the term given to short-term (usually less than six months) notes issued by large, particularly "credit-worthy" institutions. Most commercial paper is not underwritten. The notes are generally very liquid (much more so than syndicated loans) and most are denominated in dollars. They are usually pure discount instruments. • Euro-Medium Term Notes (EMTN's) are interest-bearing instruments usually issued in installments. Most are not underwritten. Eurobonds are generally underwritten, bearer bonds denominated in currencies other than that of the country where the loan is extended.
C. Banks as Monitors and Fiduciaries • Banks could be ideal corporate monitors. • large financial resources necessary to take large positions • clients provide significant important and relevant information not be available to the public • While effective in some respects, bank monitoring has not proven to be a panacea. • Lending relationships skew incentives from maximizing shareholder wealth. • Banks may use their control to maximize creditor wealth rather than shareholder wealth. • Overlapping directorships and other business relationships that skew monitoring incentives. • Banks may monitor less aggressively in order to support other business relationships with their clients. • Banks are in ideal positions to obtain information from clients in the event of financial distress. • Japanese banks tend to actively support clients facing financial distress • German banks tend to provide much less support to their distressed clients.
Bank Trusts • Bank trusts act as fiduciaries for clients and as principals. • Banks might not be sufficiently motivated to actively monitor on behalf of beneficiary-shareholders. • Usually, trusts are irrevocable such that trust beneficiaries have little recourse if returns are low. • Trust beneficiaries cannot discipline banks to improve investment performance. Compensation to bank and officer trustees is not normally related to investment performance. • Banks vote the shares that they hold in trust. • Most banks derive most of their business from corporations, creating conflicts of interest and reduced incentives to monitor. • Many banks and corporations have overlapping directorships and other business relationships.
D. Structured Lending • Structured finance activities involve the pooling of debts such as loans, bonds and mortgages and subsequent issuance of a prioritized and collateralized structure of claims known as tranches against these pools. • Repackaging and pooling of these original instruments allows redistribution of risks. • During the late 1990s and early part of this century, use of structured lending increased dramatically, bolstered by favorable ratings by credit agencies, leading to overvaluation and a subsequent bubble and crash.
E. Thrift Institutions • The thrift industry (except credit unions) exists primarily to provide low-cost, fixed interest-rate mortgages specifically for housing. • The three types of thrift institutions are: • Savings and Loans Institutions (S&Ls), • Savings Banks • Credit Unions, which tend to emphasize consumer loans. • Many thrift institutions were established as mutual organizations. • More recently, many S&Ls have re-organized under stock charters.
Redlining • Establishment of the FHA encouraged redlining, the denying, or discouraging services such as banking and insurance to residents in usually racially-determined regions and neighborhoods. • The FHA drew maps of most larger and medium-size U.S. cities, which defined minority (particularly African-American, but also Hispanic, Asian and Jewish) neighborhoods, and declaring such neighborhoods as being ineligible to receive financing. • The practice of redlining significantly and simultaneously contributed to the growth of suburbs and the decay of inner cities. • The Fair Housing Act of 1968 was passed to eradicate the practice of redlining and other discriminatory practices.
The S&L Crisis: The Lead-Up • Because long-term mortgages were financed primarily with short-term deposits, interest rate increases in the 1970's and early 1980's caused the thrift industry to experience difficulties. • The response by Congress was to enable thrift institutions to raise and invest funds in manners that were previously prohibited, while increasing deposit insurance ceilings. • Until passage of the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA), thrift institutions were prohibited from making commercial loans and issuing checking accounts. • At the same time, equity capitalization standards were reduced and re-defined, enabling institutions to continue operations when technically insolvent. • Furthermore, the Reagan administration reduced thrift examination staffs as part of its budget-cutting initiatives, enabling thrifts to initiate and continue operations which would have been prevented by regulatory agencies.
The S&L Crisis • These new activities and lack of effective monitoring led to massive failure in the industry by the late 1980s. • Ultimately, between 1986 and 1995, the number of U.S. federally insured savings and loans institutions declined from 3,234 to 1,645. Institutional abuses including fraud and insider transactions were rampant. • Thrift institutions were generally not as impacted by the financial crisis of 2008 as were commercial banks. There were some important exceptions, as Washington Mutual Savings Bank, the largest thrift institution in the U.S. and Indy Mac both failed.
Credit Unions • A credit union is a member-owned, not-for-profit cooperative financial institution established to encourage savings, offer competitive interest rates on deposits and use deposits to make loans at low interest rates to its members. • The World Council of Credit Unions reported that at the end of 2010, there were 52,945 credit unions in 100 countries serving 188 million members and holding $1.5 trillion in assets. • Most credit unions limit membership to specific groups of individuals sharing a common bond, such as employees of a given organization or members of a given association, and are prohibited from serving the general public. • Credit unions are cooperatives or mutually owned organizations, controlled by their members who make deposits or loans.
F. Asset-Liability Hedging • Fixed income instruments provide for fixed interest payments at fixed intervals along with principal repayments. • In the absence of default and liquidity risk, uncertainties in interest rate shifts are the primary source of pricing risk for many fixed income instruments.
Bond Yields and Sources of Risk • A bond maturing in n periods with a face value of F pays interest annually at a rate of c with yield y. • In general, bond risk might be categorized as follows: • Default or credit risk: the bond issuer may not fulfill all of its obligations • Liquidity risk: there may not exist an efficient market for investors to resell their bonds • Interest rate risk: market interest rate fluctuations affect values of existing bonds.
Fixed Income Portfolio Dedication • Assume that a fund needs to make payments of $12,000,000 in one year, $14,000,000 in two years, and $15,000,000 in three years. • 12,000,000 = 40bA + 60bB + 0bC • 14,000,000 = 1040bA + 60bB + 0bC • 15,000,000 = 1060bB + 1100bC • we find from this system that bA = 2,000, bB = 198,666.67 and bC = -195,586.67.
