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

I. Financial Markets, Institutions & Instruments

 Match savers and 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

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

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.

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

 Involved on Wall Street since  Prominent philanthropist.  Client losses = $65 bill.  “Ponzi” scheme: ◦ Began in ◦ “Model” unreplicated. ◦ Targeted charities. ◦ Client suicides. Client suicides

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

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

Money Market Instruments Outstanding, April 2005

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

 1930s Regs/diversification option?  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.

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

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

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

Dutch  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. $85 ◦ Ended up with a price of $85. ◦ Earned $1.67 billion on sale. Investment underwriters are not biased!  Conclusion: Investment underwriters are not biased! Case - Google IPO

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

II. Derivative Financial Instruments

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

 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%. “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. “Purpose” of a Derivative

 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. Forward vs. Future Contract

 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. “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. “Purpose” of a Derivative

 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!! Derivatives as speculative

 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. Case: Barings Bank to 1995

 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). The Credit Swap Derivative

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

III. Regulating the Banking Industry

 Maintaining depository institution liquidity.  Assuring bank solvency by limiting failures.  Promoting an efficient financial system.  Protecting consumers.

 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.

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

 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.

 Financial Institutions Reform, Recovery & Enforcement Act (FIRREA)  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.

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

Resolution Depository Assets Failure Cost Institution ($ Billions) Date ($ Billions) First Republic Bank (Dallas)$33.5July 1988$3.9 MCorp (Dallas)15.7February Continental Illinois (Chicago)33.6May Texas American (Fort Worth)4.8July First City Bancorp (Houston)4.8April Bank of New England (Boston)21.8January Goldome FSB (Buffalo)8.7May New York Bank for Savings (NYC)3.4March st National Bank of Keystone (WV)1.1September Crossland Savings Bank (Brooklyn)7.3January Superior Bank (Illinois)2.3July

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

 Act removes Glass-Steagall restrictions and permits: ◦ Securities firms and insurance companies to own commercial banks. ◦ Banks to underwrite insurance and securities, including shares of stock.

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

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