Transcript Document

Recent Changes in The United
States Financial Services Industry
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Introduction
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Thank you for inviting me to visit your
university
Tom Root
PhD Economics University of Kansas
[email protected]
Drake University
Des Moines, Iowa
Approximately 4,000 students
Background
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Recent changes in U. S. Financial Markets
Overview of the role of the Financial Services
Industry in an Economy
Regulatory Changes, Recent Trends, and
Current Events
Financial Services Modernization Act
Securitization and Role of Government
Sponsored Enterprises.
Recent Scandals
Mutual Funds
Corporate Governance
Risk Management
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The changes have increased the need for
managing risks in the financial marketplace.
This includes both measuring risk and
developing products designed to eliminate
risk.
Outline of Classes
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After the introduction we will cover:
Securitization:
How the process of securitization should decrease
credit risk for individual institutions. However did is
also change systematic risk?
Value at Risk
measuring risk in the market place
Derivatives
How options and other derivative products are used to
decrease risks faced by institutions.
Background
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Financial Institutions (FI) – Channel funds
from individuals and institutions with a
surplus of funds to (suppliers) to those with a
shortage or funds (users of capital).
Depository Institutions Banks, Savings and
Loans, Credit Unions
Non Depository Institutions Insurance
Companies, Mutual Funds, Pension Funds
Total assets 2000 in US = $14.75 trillion
Similar Risks and Rewards
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All Financial Institutions:
Hold Assets that are subject to default (or
credit) risk
Are exposed to interest rate risk
Change in value of assets
Matching maturity assets and liabilities
Exposed to liquidity (withdraw) risks
Face operational costs and risks
Bringing Together
Borrowers and Lenders
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Direct Financings vs. Indirect Financing
Funds are either exchanged between the
borrower and lender directly (Direct Financing)
or via a financial institution (indirect
financing).
Direct Financing
Surplus Funds
Households
Business
Government
Direct
Claims
Dollars
Indirect
Claims
Dollars
Private
Placement
Brokers &
Dealers
Investment
Bankers
Indirect Financing
(intermediaries)
Banks & Thrifts
Finance Companies
Insurance Firms
Pension Funds
Mutual Funds
Deficit Funds
Direct
Claims
Dollars
Households
Business
Government
Direct
Claims
Dollars
Examples
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Commercial Bank: Accept Deposits (short
term) and use the cash to make loans to
other participants (both households and
businesses – Long Term)
Mutual Fund Firm: Pooling Funds of
individuals and uses them to buy a portfolio
of securities
The Roles of Financial
Intermediation
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Maturity and Denomination Intermediation
The intermediary can produce assets of varying
maturities. It transforms demand deposits
into long term commercial loans for example.
Similarly the intermediaries can produce a wide
variety of denominations in the new assets via
pooling and separating of funds
The Roles of Intermediation
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Diversification
The firm is able to change the risk characteristics
of the claims.
For example a mutual fund which takes a
relatively small sum of money form an individual
investor but invests in a portfolio of assets.
(Decreases Credit Risk).
The size of the firm allows it to be more cost
effective at producing this risk reduction . An
individual doing this alone, faces high costs.
(there is an economy of scale in the intermediaries
operations)
The Roles of Intermediation
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Information Cost Reduction
Specialization allows the intermediary to focus on
investment analysis. This is a costly process for the
individual. It also allows a reduction in loan
contracting costs.
Providing a payment mechanism
The firms provide a means of noncash payment
(checks, debit card etc…). The intermediaries also
provide many claims that are highly liquid, allowing
individuals to invest in less liquid assets indirectly.
Roles played by FI’s
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Brokerage Function
Research and information provider (reduces information
costs such as agency costs)
Economies of Scale (decreases transaction costs and
information costs)
Asset – Transformation Function
Purchase primary claims and issue secondary claims
backed by the primary claims (reducing contracting
costs)
Allows for risk sharing via diversification (reduces price
and liquidity risk)
Special Roles played by FI’s
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Economy - Wide Services
Information, Liquidity, Price risk reduction, Transaction
cost and Maturity intermediation services
Institution Specific Services
Monetary policy transmission (depository Institutions),
Credit allocation (thrifts, farm banks),
Intergenerational Transfers (Insurance and pensions,
payments services (depository institutions) and
Denomination intermediation
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Special Roles played by FI’s
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Transmission of Monetary Policy
The liquid nature of depository institutions make them
the main way monetary policy is transmitted to the
public
Credit Allocation
Primary suppliers of capital to special sectors of the
economy (Residential lending for example)
Intergenerational Transfer of Wealth
Insurance and pension funds allow transfer across
generations
Trends in the Market
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Market Broadening Instruments
Increase liquidity of the market attracts new
investors and provides opportunities for
borrowers. Securitization
Risk Management Instruments
Reallocate financial risks to those willing and
able to accept them.
Arbitraging Instruments
Allow investors and borrowers to take advantage
of differences between markets
Regulation
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Given the important roles played by the
Financial Services Industry in the economy, it
is highly regulated.
Justification of Regulation of FI’s
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Safety and Soundness Regulation
Monetary Policy Regulation
Promotion of “Fair” Competition
Credit Allocation Regulation
Consumer Protection Regulation
Investor Protection Regulation
Entry Regulation
Regulatory Overview
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1933 Glass-Steagall Act:
Separates securities and banking activities
Prohibited commercial banks from most
underwriting of securities. Fear of conflict of
interest
Established Federal Deposit Insurance
Corporation
National banks allowed to branch state wide if
state chartered banks were allowed to do so.
1999 Financial Services
Modernization Act
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Allowed banks, insurance companies, and
securities firms to enter each others’ business
areas
Streamlined regulation of Bank Holding
Companies
Prohibited FDIC assistance to affiliates and
subsidiaries of banks and savings institutions
Provided for national treatment of foreign banks
Federal Crime to steal account information
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Trends in the US
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% Share of Total Assets for US Financial Institutions
Commercail Banks
Thrift Institutions
Insurance Companies
investment co's
Pension Funds
Finance Co's
Securities Brokers
Mortgage Co's
Real Estate Ivest. Trusts
Total
Total Trillion dollars
1860
1880
1900
1922
1939
71.4%
17.8%
10.7%
60.6%
22.8%
13.9%
62.9%
18.2%
13.8%
0.0%
0.0%
2.7%
0.0%
0.0%
3.8%
1.3%
63.3%
13.9%
16.7%
0.0%
0.0%
0.0%
5.3%
0.8%
51.2%
13.6%
27.2%
1.9%
2.1%
2.0%
1.5%
0.3%
0.0%
0.0%
99.9%
0.00
100.0% 100.0% 100.0% 99.8%
0.01
0.02
0.08
0.13
1960
1980
38.2% 34.8%
19.7% 21.4%
23.8% 16.1%
2.9%
3.6%
9.7%
17.4%
4.6%
5.1%
1.1%
1.1%
0.0%
0.4%
0.0%
0.1%
100.0% 100.0%
0.60
4.03
2000
35.6%
10.0%
16.8%
17.0%
10.7%
7.9%
1.5%
0.3%
0.2%
100.0%
14.75
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Competition among FI’s
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Products Sold by US
Payment
Savings
Fiduciary
Financial Institutions
Services
Products
Services
Bus
Cons
X
X
X
X
X
Depository Institutions
Insurance Companies
1950
2000
X
Lending
x
X
Pension Funds
X
Mutual Funds
X
Equity
Debt
x
Finance Companies
Securities Firms
Underwriting
Insurance
Risk Mgmt
X
X
X
X
X
Depository Institutions
X
X
X
X
X
X
X
X
Insurance Companies
X
X
X
X
X
X
X
X
Finance Companies
X
X
X
X
X
x
x
X
Securities Firms
X
X
X
X
X
X
X
X
X
X
X
X
X
Pension Funds
Mutual Funds
X
X
X
Impact on US Market
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Increased merger and acquisition activity in
financial services industry.
Demutualization of insurance firms and
savings and loans
Asset Securitization
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Securitization is the pooling and repackaging
of loans so they have the characteristics of
security instruments which enable them to be
more easily resold.
Creates both Maturity Intermediation and
Denomination Intermediation while spreading
credit risk
Should broaden the market and decrease risk
Use of Securitization in the
Mortgage Market
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The market that has been impacted the most
by increased securitization is the secondary
market for mortgages.
The largest participants in this market are
government sponsored enterprises (GSE).
Government Sponsored
Enterprises
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Privately owned, government sponsored
entities.
Created to lower the cost of capital for a
specific sector
Generally issue two types of notes and debt
Special Treatment of GSE’s
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Debt and mortgage backed securities are exempt
from SEC registration
Agencies are exempt from state and local taxes
Treasury can purchase up to $2.2 B of FNMA and
$4B of FHLB debt via line of credit
Banks can make unlimited investment in debt
issued by GSE’s
GSE securities are eligible as collateral for public
deposits and for loans from the Federal Reserve
GSE’s and Mission
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Federal National Mortgage Association (Fannie
Mae) & Federal Home Loan Mortgage
Association (Freddie Mac) promote secondary
market for mortgages
Government National Mortgage Association
(Ginnie Mae) – promote secondary market for
government sponsored mortgages
Federal Home Loan Bank – Liquidity in
banking system
GSE’s and Mission
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Student Loan Marketing Association (Sallie
Mae) – promote a secondary market for
student loans
Federal Farm Credit Bank – promote a
secondary market for lending in agricultural
industry
Mortgage Pass Through
Securities
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GSE Purchases a pool of mortgages from originators
GSE issues a new pass through security. Interest
and Principle are collected on the mortgage pool by
the GSE who then transfers (passes through) the
payments to the owners of new securities backed by
the mortgages.
Neither the amount or timing of the cash flows
actually matches the cash flows on the pool of
mortgages.
When a mortgage is included in a pool it is said to be
securitized.
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Possible Benefits of Securitization
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Benefits to Issuers
Diversification – Broadens funding source
Ability to manage capital requirements
Provides Fee Income
Manage interest rate volatility
Benefits to investors
Increased Liquidity
Reduced Credit Risk
Benefits to Borrowers
Reduced spreads
Composition of US Debt Market Sept
2003 (Total value $22.6 Trillion)
Asset
Money Backed
Market, $1.68T
$2.526T
Federal
Agency
$2.636T
Corporate
$4.347T
Muni
1.883T
Treasury
$3.446T
Mortgage
Related
$5.129T
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% of Outstanding Debt Market
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100%
7.8%
23.6%
8.1%
80%
60%
40%
20%
0%
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Municipal
Treasury
Corporate*
FedAgencies
MoneyMarket
Mortgage-Related
Bond Market Association 2003 is as of Sept 30,2003
Asset-Backed
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Average Daily Trading Volume
($Billions)
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438.60
450.00
400.00
366.40
350.00
1995
1996
MBS
1997
1999
2000
Treasuries
Bond Market Association 2003 as of Sept 30,2003
2001
154.49
2002
2003
Treasuries
1994
MBS
1993
219.23
297.90
69.47
1992
206.60
67.12
1998
12.83 17.03 22.11 30.41 29.39 38.15 47.08
1991
186.50
70.93
0.00
226.60
212.10
193.20
191.30
50.00
111.96
100.00
173.60
150.00
152.10
200.00
203.70
250.00
127.50
$ Billions
300.00
Issuance by GSE’s ($ Billions)
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1800
1600
1400
$ Billions
1200
1000
800
600
400
200
0
1980
1982
1984
1986
1988
GNMA
1990
FNMA
1992
1994
1996
FHLMC
Bond Market Associattion 2003 as of Sept 30, 2003
1998
2000
2002
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Outstanding Mortgage and Asset
Backed Securities in US
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5802.3
6000
5077.9
5000
4006.9
3536.2
4000
Billioins $
4330.4
3146.8
2840.4
2595.7
3000
2000
1000
0
1995
1996
MBS
Manufactured Housing
1997
Credit Card
Student Loans
1998
1999
2000
Auto
Equipment Leases
Securitization Davidson et al Wiley Pub. 2003
2001
2002
Home Equity Loans
Current Questions in the Market
Place relating to GSE’s
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Are the GSE’s, especially Fannie Mae and
Freddie Mac growing too fast?
Do they pose a systematic risk for the US
economy?
Should the special treatment they receive be
changed?
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Recent Study by Federal Reserve
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Wayne Passmore, an economist at the Federal
Reserve Bank has recently completed a study
on the impact of GSE’s
The GSE’s have a funding advantage
Slightly lower mortgage rtes for a few
borrowers
Implicit subsidy from government relationship
Implicit subsidy responsible for much of GSE
Market Value
MBS have not increased homebuilding
Risk Management
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The increased competition among financial
institutions and the expansion into new
business lines has placed increased
importance on Consolidated Risk
Management.
This includes methods of measuring risk and
methods of reducing risk.
Value at Risk
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Value at Risk measures the market value of
assets that may be lost given a change in
the market place (for example, a change in
interest rates) that may occur with a
corresponding probability
We are going to apply this to look at market
risk.
A simple example
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Assume you own a 10% coupon bond that
makes semi annual payments with 5 years until
maturity with a YTM of 9%.
The current value of the bond is then 1039.56
Assume that you believe that the most the yield
will increase in the next day is .2%. The new
value of the bond is 1031.50
The difference would represent the value at
risk.
Value at Risk
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Methods based upon Value at Risk have
become a common component of risk
management.
For example the Basel II standards use value
at risk methodology in some portions of risk
measurement.
How effective is it? What are the limitations
of the methodology?
Limiting Risk Exposure
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In addition to measuring the amount of risk
financial managers are interested in products
that can be used to limit exposure to risk.
Options provide an excellent vehicle for this.
We will cover the basic option pricing
methodology and discuss combining options
to create products designed to limit risk
exposure.
Option Pricing and Asset Value
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Additionally many financial products include
options embedded in the product for example
a call option on a corporate bond. These
options increase the risk of holding the
product.
We will use a second option pricing model to
value call options and put options in fixed
income securities.
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Other Risk Management Techniques
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Swaps – exchanging one cash flow stream for
another in an attempt to change the asset or
liability structure of the firm.
Time permitting, we will describe a basic
swap and discuss the use of swaps in
managing risk.