1. PowerPoint Presentation by Charlie Cook Copyright © 2004 South-Western. All rights reserved. Chapter 10 Nondepository Financial Institutions

2. Copyright © 2004 South-Western. All rights reserved.10–2 Fundamental Issues 1.What do securities market institutions do, and how does the government regulate these institutions? 2.What do insurance companies do, and who regulates their activities? 3.How are pension funds structured, and why have they grown? 4.What is the special role of finance companies? 5.How do mutual funds and hedge funds differ?

3. Copyright © 2004 South-Western. All rights reserved.10–3 Investment Banks Investment banks as intermediaries:  Securities underwriting  Firm commitment underwriting  Standby commitment underwriting  Best efforts deal

4. Copyright © 2004 South-Western. All rights reserved.10–4 Investment Banks as Intermediaries Securities underwriting:  A guarantee by an investment bank that a firm that issues new stocks or bonds will receive a specified minimum price per share of stock or per bond. Firm commitment underwriting:  An arrangement in which the investment bank purchases and distributes to dealers and other purchasers all securities offered by a business.

5. Copyright © 2004 South-Western. All rights reserved.10–5 Investment Banks… (cont’d) Standby commitment underwriting:  An arrangement in which the investment bank earns commissions for helping the issuing firm sell its securities under the guarantee that the investment bank will purchase for resale any initially unsold securities. Best efforts deal:  An arrangement in which the investment bank has an option to buy a portion of the issuing firm’s securities but is not required to do so.

6. Copyright © 2004 South-Western. All rights reserved.10–6 Types Of Brokers Full-service broker:  An agent who offers a range of financial services, including consultations about what financial instruments to buy or sell and other financial planning advice, in addition to making securities trades for clients. Discount broker:  An agent whose services are limited to making securities trades for clients.

7. Copyright © 2004 South-Western. All rights reserved.10–7 Types Of Brokers (cont’d) Share broker:  A discount broker which bases its commission charges on the volume of shares that it trades on a customer’s behalf. Value broker:  A discount broker which charges commissions that are a percentage of the dollar value each transaction.

8. Copyright © 2004 South-Western. All rights reserved.10–8 Securities Brokers and Dealers Over-the-counter (OTC) broker-dealer:  A broker-dealer that trades shares of stock that are not listed on organized stock exchanges. Specialists:  Stock exchange members that are charged with trading on their own accounts to prevent dramatic movements in stock prices. Limit orders:  Instructions from other stock exchange members to specialists to execute stock trades at specific prices.

9. Copyright © 2004 South-Western. All rights reserved.10–9 Regulation of Securities Market Institutions Securities and Exchange Commission (SEC):  Created in the Securities Exchange Act of 1934 to regulate all securities market institutions.  The SEC is composed of five presidentially appointed commissioners whose mandate is to enforce rules governing securities trading. Prospectus:  A formal written offer to sell securities.

10. Copyright © 2004 South-Western. All rights reserved.10–10 Dealing with Asymmetric-Information Problems in Insurance Limiting adverse selection  Restricting the availability and quantity of insurance. Limiting moral hazard in insurance  Deductible: A fixed amount of an insured loss that a policyholder must pay before the insurer is obliged to make payments.  Coinsurance: A policy feature that requires a policyholder to pay a fixed percentage of a loss above a deductible.

11. Copyright © 2004 South-Western. All rights reserved.10–11 Determining Policy Premiums Actuary:  An individual who specializes in using mathematical and statistical principles to calculate insurance premiums and to estimate an insurance company’s net worth.

12. Copyright © 2004 South-Western. All rights reserved.10–12 Life Insurance Whole life policy:  A policy whose benefits are payable to a beneficiary whenever the insured person’s death occurs and that accumulates a cash value that the policyholder may acquire prior to his or her death. Level premium policy:  A whole life insurance policy under which an insurance company charges fixed premium payments throughout the life of the insured individual.

13. Copyright © 2004 South-Western. All rights reserved.10–13 Life Insurance (cont’d) Limited payment policy:  A whole life insurance policy under which an insured individual pays premiums only for a fixed number of years and is insured during and after the payment period. Term life policy:  A policy under which an individual is insured only during a limited period that the policy is in effect.

14. Copyright © 2004 South-Western. All rights reserved.10–14 The Distribution of Life Insurance Policies Figure 10–1 SOURCE: A.M.Best,2002.

15. Copyright © 2004 South-Western. All rights reserved.10–15 The Distribution of Property-Casualty Premiums by Line of Business Figure 10–2 SOURCE: Insurance Information Institute, 2002. Percentages are rounded to the nearest whole percent.

16. Copyright © 2004 South-Western. All rights reserved.10–16 Annuities Fixed annuity:  A financial instrument, typically issued by an insurance company, that pays regular, constant installments to the owner beginning at a specific future date. Variable annuity:  A financial instrument, typically issued by an insurance company, that beginning on a specific future date pays the owner a stream of returns that depends on the value of an underlying portfolio of assets.

17. Copyright © 2004 South-Western. All rights reserved.10–17 Types of Pensions Contributory pensions:  Pensions funded by both employer and employee contributions. Noncontributory pensions:  Pensions funded solely by employers. Defined-contribution plan:  Pension benefits (undefined) are based on total pension contributions during working years. Defined-benefits plan:  Pension benefits are set in advance—key issue is certainty of funding of benefits at retirement.

18. Copyright © 2004 South-Western. All rights reserved.10–18 Pension Funds’ Share of Financial Institution Assets Figure 10–3 SOURCE: Flow-of-Funds Accounts, Board of Governors of the Federal Reserve System, various issues.

19. Copyright © 2004 South-Western. All rights reserved.10–19 Alternative Pension Funding Arrangements Terminally funded pensions:  Pensions that must be fully funded by the date that an employee retires. Pay-as-you-go pensions:  Pensions not fully funded when employees retire. Vesting:  Occurs when a worker covered by a pension will receive retirement benefits from that employer even if the worker leaves the employer prior to the retirement date.

20. Copyright © 2004 South-Western. All rights reserved.10–20 Transferability Of Pension Funds Single-employer pensions:  Pensions that are established by an employer only for its own employees and are nontransferable to other employers. Multi-employer pensions:  Pensions whose accumulations and benefit rights may be transferred from one employer to another.

21. Copyright © 2004 South-Western. All rights reserved.10–21 Pension Fund Insurance and Regulation Employment Retirement Income Security Act (ERISA) of 1974:  Established Federal rules for disclosure of pension information, funding arrangements, and vesting provisions.  Also created the Pension Benefit Guaranty Corporation (PBGC), which provides federal insurance guaranteeing solvency for all pensions with tax-deferred benefits.

22. Copyright © 2004 South-Western. All rights reserved.10–22 Government Credit Agencies The Pension Benefit Guaranty Corporation General National Mortgage Association (“Ginnie Mae”) Federal National Mortgage Association (“Fannie Mae”) Federal Home Loan Mortgage Corporation (“Freddie Mac”) The Federal Housing Administration (FHA) Department of Housing and Urban Development (HUD) Veterans Administration (VA) Farm Credit System of the Farmer’s Home Administration Student Loan Marketing Association (Department of Education) Federal Home Loan Banks (Federal Housing Finance Board)

23. Copyright © 2004 South-Western. All rights reserved.10–23 Finance Companies Business finance companies:  Typically specialize in making loans to small businesses. Consumer finance companies:  Specialize in making loans to individuals for the purchase of durable goods or for home improvements. Sales finance companies:  Specialize in making loans to individuals for the purchase of items from specific retailers or manufacturers.

24. Copyright © 2004 South-Western. All rights reserved.10–24 Types of Mutual Funds Load funds:  Mutual funds marketed by brokers who receive commissions based on the returns of the funds. No-load funds:  Mutual funds that investment companies market directly to the public and that charge management fees instead of brokerage commissions.

25. Copyright © 2004 South-Western. All rights reserved.10–25 Mutual Fund Growth Figure 10–4 SOURCE: Flow-of-Funds Accounts, Board of Governors of the Federal Reserve System, various issues.

26. Copyright © 2004 South-Western. All rights reserved.10–26 Shares of Stock Assets Held via Stock Mutual Funds Figure 10–5 SOURCE: John Duca, “The Democratization of America’s Capital Markets,” Federal Reserve Bank of Dallas Economic and Financial Review, Second Quarter 2001, pp.10–19; authors’ estimates.

27. Copyright © 2004 South-Western. All rights reserved.10–27 Total Mortgage Assets of the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation Figure 10–6 SOURCE: John Duca, “The Democratization of America’s Capital Markets,” Federal Reserve Bank of Dallas Economic and Financial Review, Second Quarter 2001, pp.10–19; authors’ estimates.

28. Copyright © 2004 South-Western. All rights reserved.10–28 Types of Mutual Funds (cont’d) Closed-end funds:  Mutual funds that sell nonredeemable shares whose market values vary with the market values of the underlying mix of financial instruments held by the mutual funds. Open-end funds:  Mutual funds whose shares are redeemable at any time at prices based on the market values of the mix of financial instruments held by such funds.

29. Copyright © 2004 South-Western. All rights reserved.10–29 Hedge Funds Hedge funds:  Limited partnerships that, like mutual funds, manage portfolios of assets on behalf of savers, but with very limited governmental oversight as compared with mutual funds.

30. Copyright © 2004 South-Western. All rights reserved.10–30 The Top Ten Debt Issues of the 1990s and Early 2000s. Table 10–1 Fannie Mae and Freddie Mac accounted for five of the top ten debt issues. Issuer$ Billions Fannie Mae$11.5 Fannie Mae10.0 Deutsche Telekom9.5 Ford8.6 Fannie Mae8.0 AT&T8.0 RJR Holdings Capital6.1 WorldCom6.1 Freddie Mac6.0 SOURCE: Office of Federal Housing Enterprise Oversight.