Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Chapter 13 Nonbank Finance

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Insurance Life insurance –Permanent (whole, universal, and variable) –Term Property and Casualty –Hold more liquid assets than life insurance companies –Reinsurance

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Insurance (cont’d) Competitive threat from the banking industry Credit insurance –Credit default swaps AIG case. –Monoline insurance

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Table 1 Relative Shares of Total Financial Intermediary Assets, 1970–2008 (percent)

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Insurance Management To lower moral hazard and adverse selection –Screening –Risk-based premiums –Restrictive provisions –Prevention of fraud –Cancellation of insurance –Deductibles –Coinsurance –Limits on the amounts of insurance

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Pension Funds Defined-contribution plan Defined-benefit plan –Fully-funded; underfunded Private pension plans –Employee Retirement Income Security Act (ERISA) of 1974 Pension Benefit Guarantee Corporation (PBGC, Penny Benny)

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Pension Funds (cont’d) Public pension plans –Social Security Pay as you go system. Massive underfunding. Possible reforms proposed.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Finance Companies Virtually unregulated compared to commercial banks and thrifts institutions Sales finance companies Consumer finance companies Business finance companies –Factoring –Leasing equipment

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Securities Market Operations Financial facilitators –Investment banks –Securities brokers and dealers –Organized exchanges

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Investment Banking Assist in the sale of securities –Advise the corporation on whether it should issue bonds or stock. –Bonds: advise on maturity and interest payments –Stocks: advice on price Seasoned issues or initial public offering –Underwrites

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Investment Banking (cont’d) Regulated by SEC –Registration statement –Provide potential investors with a prospectus –20 day waiting period

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Securities Brokers and Dealers Securities brokers and dealers conduct trading in secondary markets Brokers –Agents for investors, match buyers and sellers –Paid brokerage commission Dealers –Stand ready to buy and sell –Hold inventories –Paid by the ‘spread’ Brokerage firms –Act as brokers, dealers, and investment bank –Regulated by SEC

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Organized Exchanges NYSE: largest organized exchange in the world. Hybrid of auction market and dealer market. Specialist Regulated by SEC –Authority to impose regulation and to alter the rules set by the exchanges Securities Amendments Act of 1975 Growing internationalization

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Mutual Funds Pool the resources of many small investors by selling shares and using the proceeds to buy securities Sovereign wealth funds –Estimated to hold $3 trillion in assets –Concerns Size (can cause market instability) National security issues Provide very little information about their operations Open-end fund and closed-end fund

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Mutual Funds (cont’d) Load funds and no-load funds Regulated by Securities and Exchange Commission Money market mutual funds –Function as checkable deposits that earn interest.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Hedge Funds Similar to mutual funds but: –Minimum investment typically $1 million –No more than 99 investors –Net worth requirement for investors –Long-term commitment –Speculates on spreads

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Private Equity and Venture Capital Funds Private equity fund –Long-term investments in companies that are not traded in public markets. Two types –Venture capital funds –Capital buyout funds (leveraged buyout) Carried interest

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Government Financial Intermediation Mortgage market –GNMA, Ginnie Mae –FNMA, Fannie Mae (GSE) –FHLMC, Freddie Mac (GSE) Farm Credit System Federal Credit Reform Act of 1990 The creation of GSEs has led to conflict of interest and moral hazard problems.