LEARNING OBJECTIVES

2. LEARNING OBJECTIVES After studying this chapter, you should be able to: Explain how investment banks operate. 11.1 Distinguish between mutual funds and hedge funds and describe their roles in the financial system. 11.2 Explain the roles that pension funds and insurance companies play in the financial system. 11.3 Explain the connection between the shadow banking system and systemic risk. 11.4

3. When Is A Bank Not A Bank? When It’s A Shadow Bank! • During the financial crisis of 2007–2009, “nonbank” financial institutions (shadow banking system) acquired funds that had previously been deposited in banks and then used these funds to provide credit. • It became clear that commercial banks no longer played the dominant role in routing funds from savers to borrowers.

4. Key Issue and Question Issue: During the 1990s and 2000s, the flow of funds from lenders to borrowers outside of the banking system increased. Question: Does the shadow banking system pose a threat to the stability of the U.S. financial system?

5. 11.1 Learning Objective Explain how investment banks operate.

6. Investment Banking Investment Banking What Is an Investment Bank? Investment banking is financial activities that involve underwriting new security issues and providing advice on mergers and acquisitions. • Investment bankers are involved in the following activities: • 1. Providing advice on new security issues • 2. Underwriting new security issues • 3. Providing advice and financing for mergers and acquisitions • 4. Financial engineering, including risk management • 5. Research • 6. Proprietary trading

7. Providing Advice on New Security Issues • Firms turn to investment banks for advice on how to raise funds by issuing stock or bonds or by taking out loans. Underwriting New Security Issues Underwriting is an activity in which an investment bank guarantees to the issuing corporation the price of a new security and then resells the security for a profit, or spread. Initial public offering (IPO) is the first time a firm sells stock to the public. • An investment bank typically earns 2% to 4% of the dollar amount raised in a secondary offering (or seasoned offering). • In return for the spread, the investment bank takes on the risk that it cannot profitably resell the securities being underwritten. Investment Banking

8. Syndicate is a group of investment banks that jointly underwrite a security issue. • In a syndicated sale, a lead investment bank keeps part of the spread, and the remainder is divided among the syndicate members. • Once a firm has chosen the investment bank that will underwrite its securities, the bank: • carries out a due diligence process to research the firm’s value; and • prepares a prospectus as required the Securities and Exchange Commission (SEC). • During the financial crisis of 2007–2009, investment banks underwrote mortgage-backed securities that turned out to be very poor investments. Investment Banking

9. Providing Advice and Financing for Mergers and Acquisitions • Investment banks are very active in mergers and acquisitions (M&As) by advising both buyers and sellers. • Investment banks can: • Find an acquiring firm willing to pay more than the market value of the firm. • Provide a fairness opinion about a fair proposed offer. • Advise firms on their capital structure (mix of stocks and bonds) used to raise funds • Advising on M&As is particularly profitable for investment banks because the bank does not have to invest its own capital. Investment Banking

10. Financial Engineering, Including Risk Management • Financial engineering involves developing new financial securities or investment strategies using sophisticated mathematical models. • Derivative securities, used by firms to hedge, are the result of financial engineering. • Investment banks help to raise funds by selling stocks and bonds, and construct risk management strategies for firms. • During the financial crisis, investment bank managers greatly underestimated the risk that the prices of derivatives might fall if housing prices declined and people began to default on their mortgages. Investment Banking

11. Research • Investment banks provide research for advising investors on M&As. • Research analysts also advice investors to “buy,”“sell,” or “hold” particular stocks. Overweight is a term used for a stock they recommend and underweight for a stock they do not. • The opinions of senior analysts at large investment banks can have a significant impact on the market. • They also provide useful information for the investment bank’s trading desks, where traders buy and sell securities. • Analysts also engage in economic research, writing reports on economic trends and providing forecasts of macroeconomic variables. Investment Banking

12. Proprietary Trading • Proprietary trading is buying and selling securities for the bank’s own account rather than for clients. • Beginning in the 1990s, this became a major part of operations and an important source of profits for investment banks. • Proprietary trading exposes banks to both interest-raterisk and credit risk. During the financial crisis, credit risk was the most significant risk that investment banks faced. • The problems of investment banks worsened during the financial crisis as they used large amounts of borrowed funds to finance their proprietary trading, resulting in higher leverage—funding risk. Investment Banking

13. “Repo Financing” and Rising Leverage in Investment Banking • Among the sources of funds for investment banks are the bank’s capital and short-term borrowing. • During the 1990s and 2000s, most large investment banks converted from partnerships to publicly traded corporations. Proprietary trading became a more important source of profits. • Financing investments by borrowing rather than by using capital increases leverage. Investment Banking

14. “Repo Financing” and Rising Leverage in Investment Banking • Federal banking regulations on the size of a commercial bank’s leverage ratio did not apply to investment banking. • Investment banks increasingly relied on borrowed funds to finance their investments and became much more highly leveraged than commercial banks. • The process of reducing leverage is called deleveraging. • Investment banks borrowed primarily by either issuing commercial paper or by using repurchase agreements (short term loans). • If the short-term funds raised are used to invest in mortgage-backed securities or to make long-term loans, investment banks face a maturity mismatch. Investment Banking

15. Solved Problem 11.1 The Perils of Leverage • Suppose that an investment bank is buying $10 million in long-term mortgage-backed securities. Consider three possible ways that the bank might finance its investment: • 1. The bank finances the investment entirely out of its equity. • 2. The bank finances the investment by borrowing $7.5 million and using $2.5 million of its equity. • 3. The bank finances the investment by borrowing $9.5 million and using $0.5 million of its equity. • a. Calculate the bank’s leverage ratio for each of these three ways of financing the investment. • For each of these ways of financing the investment, calculate the return on its equity investment that the bank receives, assuming that: • The value of the mortgage-backed securities increases by 5% during the year after they are purchased. • The value of the mortgage-backed securities decreases by 5% during the year after they are purchased. Investment Banking

16. Solved Problem Solved Problem 11.1 The Perils of Leverage Solving the Problem Step 1Review the chapter material. Step 3 Answer the first part of question (b) by calculating the bank’s return on its equity investment for each of the three ways of financing the investment. Step 2 Answer question (a) by calculating the leverage ratio for each way of financing the investment. Step 4 Answer the second part of question (b) by calculating the return for each of the three ways of financing the investment. Investment Banking

17. Figure 11.1 Leverage in Investment Banks Panel (a) shows that at the start of the financial crisis in 2007, large investment banks were more highly leveraged than were large commercial banks. Panel (b) shows that during 2008 and 2009, Goldman Sachs and Merrill Lynch reduced their leverage ratios. Investment Banking [To Jim: does the last sentence in the notes belong here?]

18. Making the Connection Did Moral Hazard Derail Investment Banks? • By the time of the financial crisis, all the large investment banks had become publicly traded corporations. • A separation of ownership from control in corporations results in a principal–agent problem. • Underwriting complex financial securities is an activity that shareholders and boards of directors do not understand and therefore cannot effectively monitor. • But some commentators argue that since top managers also suffered significant losses during the crisis, the moral hazard problem could not have been so severe. Investment Banking

19. The Investment Banking Industry • After the great stock market crash of October 1929 resulted in heavy losses from underwriting, the Glass-Steagall Act in 1933 separated investment banking from commercial banking. • Economists argued that the act had protected the investment banking industry from competition. • In 1999, the Gramm-Leach-Bliley (or Financial Services Modernization) Act repealed the Glass-Steagall Act. • The Gramm-Leach-Bliley Act allowed securities and insurance firms to own commercial banks, and commercial banks to participate in securities, insurance, and real estate activities. Investment Banking

20. Where Did All the Investment Banks Go? The effect of the financial crisis of 2007-2009 was known as “the end of Wall Street” because the troubled investment banks had been considered important financial firms. Investment Banking

21. Making the Connection In Your Interest So, You Want to Be an Investment Banker? • Over the past 20 years, investment banking has been one of the most richly rewarded professions in the world. • The pay of top executives has been controversial: Some argue that their pay is out of line with their economic contributions, and they have helped bring on the crisis by promoting mortgage-backed securities. • New college graduates are hired as analysts researching industries, helping in the due diligence process, and with M&As. • After two to four years, a bank either promotes an analyst to the position of associate or asks him or her to leave the firm. MBA graduates are sometimes hired directly as associates. Investment Banking

22. 11.2 Learning Objective Distinguish between mutual funds and hedge funds and describe their roles in the financial system.

23. Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies • In addition to investment banks, investment institutions are financial firms that raise funds to invest in loans and securities. • The most important investment institutions are mutual funds, hedge funds, and finance companies. Investment institution is a financial firm (e.g., mutual fund or hedge fund) that raises funds to invest in loans and securities.

24. Mutual Funds Mutual fund is a financial intermediary that raises funds by selling shares to individual savers and invests the funds in a portfolio of stocks, bonds, mortgages, and money market securities. • Mutual funds help to reduce transaction costs, provide risk-sharing benefits, and gather information about different investments. • The industry in the United States dates back to 1924, with the creation of the Massachusetts Investors Trust, State Street Investment Corporation, and Putnam Management Company. Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies

25. Types of Mutual Funds • Closed-end mutual funds: a fixed number of nonredeemable shares is issued, with the share price fluctuating with the market value of the assets. • Open-end mutual fund: investors can redeem shares after the markets close for a price tied to the value of the assets in the fund. • Exchange-traded funds (ETFs): market prices track the prices of the assets. • No-load funds: funds do not charge a commission, or “load.” • Load funds: funds charge buyers a “load” to both buy and sell shares. • Index fund: consists of a fixed-market basket of securities, such as the stocks in the S&P 500 stock index. Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies

26. Money Market Mutual Funds Money market mutual fund is a mutual fund that invests exclusively in short-term assets, such as Treasury bills, negotiable certificates of deposit, and commercial paper. • Most money market mutual funds allow savers to write checks above a specified amount against their accounts. • They are popular with small savers as an alternative to commercial bank checking and savings accounts. • Money market mutual funds brought additional competition for commercial banks. Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies

27. Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies Hedge Funds Hedge fund is a partnership of wealthy investors that make relatively high-risk, speculative investments. • Hedge funds are typically organized as partnerships of 99 investors or fewer, either wealthy individuals or institutional investors. • They are largely unregulated and free to make risky investments. • Modern hedge funds typically are involved in speculation rather than hedging, so their name is no longer an accurate description of their strategies. • In 2012, there were as many as 10,000 operating in the United States, managing more than $2 trillion in assets. Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies

28. Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies Hedge Funds Hedge funds have been controversial: • Hedge fund managers charge not only a management fee but also get a share of fund profits. • Investments in hedge funds are illiquid as investors are often not allowed to withdraw their funds for one to three years. • Some hedge funds have experienced substantial losses that led to potential risk to the financial system, e.g., Long-Term Capital Management in 1998. • Hedge funds’ use of short selling can cause security prices to fall by increasing the volume of securities being sold. Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies

29. Making the Connection In Your Interest Would You Invest in a Hedge Fund if You Could? A comparison between hedge funds and mutual funds: Investment Banking

30. Finance Companies Finance company is a nonbank financial intermediary that raises money through sales of securities and uses the funds to make small loans to households and firms. • A lower degree of regulation allows finance companies to tailor loans closer to the needs of borrowers than do the standard loans. • The three main types of finance companies are consumer finance, business finance, and sales finance firms. • Finance companies have an advantage over commercial banks in monitoring the value of collateral, so they are key lenders for consumer durables and business equipment. Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies

31. 11.3 Learning Objective Explain the roles that pension funds and insurance companies play in the financial system.

32. Contractual Savings Institutions: Pension Funds and Insurance Companies Contractual Savings Institutions: Pension Funds and Insurance Companies Contractual saving institution is a financial intermediary that receives payments from individuals as a result of a contract and uses the funds to make investments. Examples: a pension fund or an insurance company

33. Pension Funds Pension fund is a financial intermediary that invests contributions of workers and firms in stocks, bonds, and mortgages to provide for pension benefit payments during workers’ retirements. • Represent about $10 trillion in assets in the United States in 2012. • Private and state and local government pension funds are the largest institutional participants in capital markets. • To receive pension benefits, an employee must be vested. Vesting is the number of years you must work in order to receive benefits after retirement. Contractual Savings Institutions: Pension Funds and Insurance Companies

34. Figure 11.2 Assets of Pension Funds, 2012 Both private and state and local pension funds concentrate their investments in stocks, bonds, and other capital market securities. Contractual Savings Institutions: Pension Funds and Insurance Companies

35. Employees prefer pension plans to personal savings for three reasons: • (1) pension plans can manage a portfolio more efficiently and at a lower cost; • (2) benefits such as annuities are expensive for individuals to obtain; and • (3) the tax treatment of pension funds benefits the employee. • Defined contribution plan: the firm invests contributions for the employees who own the value of the funds in the plan. These are the most common plans today. • Defined benefit plan: the firm promises employees a particular dollar benefit payment, based on each employee’s earnings and years of service. • 401(k) plan: one particular defined contribution plan in which an employee makes tax-deductible contributions through regular payroll deductions. Contractual Savings Institutions: Pension Funds and Insurance Companies

36. Insurance Companies Insurance company is a financial intermediary that specializes in writing contracts to protect policyholders from the risk of financial loss associated with particular events. • Insurers obtain funds by charging premiums to policyholders and use these funds to make investments and direct loans to firms known as private placements. • Two types of insurance companies: • Life insurance companies: sell policies to protect households against a loss of earnings from the disability, retirement, or death of the insured person. • Property and casualty companies: sell policies to protect households and firms from the risks of illness, theft, fire, accidents, or natural disasters. Contractual Savings Institutions: Pension Funds and Insurance Companies

37. Figure 11.3 Financial Assets of U.S. Insurance Companies Life insurance companies have larger asset portfolios than do property and casualty insurance companies. Property and casualty insurance companies hold more municipal bonds, while life insurance companies hold more corporate bonds. Contractual Savings Institutions: Pension Funds and Insurance Companies

38. Risk Pooling • Insurance companies use the law of large numbers (average occurrences of events for large numbers of people) to make predictions. • By issuing a sufficient number of policies, insurance companies take advantage of risk pooling and diversification. • Statisticians known as actuaries compile probability tables to help predict the risk of an event occurring in the population. Contractual Savings Institutions: Pension Funds and Insurance Companies

39. Reducing Adverse Selection through Screening and Risk-Based Premiums • People most eager to buy insurance are those with the highest probability of requiring an insurance payout. • To reduce adverse selection problems, insurance company managers gather information to screen out poor insurance risks. • Insurance companies also reduce adverse selection by charging risk-based premiums—premiums based on the probability that an individual will file a claim. Contractual Savings Institutions: Pension Funds and Insurance Companies

40. Reducing Moral Hazard with Deductibles, Coinsurance, andRestrictive Covenants • Moral hazard occurs when policyholders change their behavior once they have insurance. • Tools to reduce adverse selection and moral hazard problems align the interests of policyholders with the interests of the insurance companies: • A deductible is used to reduce the likelihood that an insured event takes place. • To further hold down costs, insurance companies may offer coinsurance as an option in exchange for charging a lower premium. • Insurers also sometimes use restrictive covenants, which limit risky activities by the insured if a subsequent claim is to be paid. Contractual Savings Institutions: Pension Funds and Insurance Companies

41. 11.4 Learning Objective Explain the connection between the shadow banking system and systemic risk.

42. Risk, Regulation and the Shadow Banking System Risk, Regulation, and the Shadow Banking System Systemic Risk and the Shadow Banking System • The “shadow banking system” consists of investment banks, hedge funds, and money market mutual funds (i.e., nonbank financial institutions). • On the eve of the financial crisis, the size of the shadow banking system was greater than the size of the commercial banking system. • The FDIC and the SEC were created with the goal to protect depositors from the likelihood that the failure of one bank would lead depositors to withdraw their money from other banks—contagion. • Congress was less concerned with the risk to individual depositors than with systemic risk to the entire financial system. Systemic risk is risk to the entire financial system rather than to individual firms or investors.

43. Deposit insurance succeeded in stabilizing the banking system, but there is no equivalent to deposit insurance in the shadow banking system. • In the shadow banking system, short-term loans consist of repurchase agreements, commercial paper and money market mutual funds rather than deposits. • The government generally does not reimburse investors who suffer losses when they make loans to shadow banks. • During the financial crisis, the shadow banking system was subject to the same type of systemic risk that the commercial banking system experienced in the early 1930s. Risk, Regulation and the Shadow Banking System

44. Regulation and the Shadow Banking System • Rationales for exempting many nonbanks from restrictions on the assets they can hold and the degree of leverage: • Policymakers did not see these firms as being important to the financial system as were commercial banks. • Regulators did not believe that the failure of these firms would damage the financial system. • These firms deal primarily with other financial firms, institutional investors, or wealthy private investors rather than with unsophisticated investors. So policymakers assumed that these investors could look after their own interests without the need for federal regulations. Risk, Regulation and the Shadow Banking System

45. In 1934, Congress gave the SEC broad authority to regulate the stock and bond markets. • In 1974, Congress established the Commodity Futures Trading Commission to regulate futures markets. • Securities that were not traded on exchanges were not subject to regulation. By the time of the financial crisis, trillions of dollars worth of securities were being traded in the shadow banking system. • When derivatives are traded on exchanges, the exchange serves as the counterparty, which reduces the default risk to buyers and sellers. • In 2010, Congress enacted regulatory changes that would push more trading in derivatives onto exchanges. Risk, Regulation and the Shadow Banking System

46. The Fragility of the Shadow Banking System • Many firms in the shadow banking system were borrowing short term and lending long term. • Investors providing funds to investment banks were not protected by deposit insurance, making them more susceptible to runs. • Due in part to lack of regulation, investment banks could invest in risky assets and became highly leveraged. • Many investment banks suffered heavy losses due to investments in mortgage-backed securities. Risk, Regulation and the Shadow Banking System

47. Are Shadow Banks Still Vulnerable to Runs Today? • Following the Financial Crisis of 2007-2009, many economists and policymakers called for extensive regulation of the shadow banking system. • However, the Dodd-Frank Act contained limited regulation of the shadow banking system: • Trading of derivatives needed to be carried out on exchanges. • Large hedge funds needed to be registered with the SEC. • Firms selling mortgage-backed securities were required to hold 5% of the credit risk. • A basic problem was still not addressed: some shadow banks borrow short term to make highly leveraged long-term investments. Risk, Regulation and the Shadow Banking System

48. Answering the Key Question At the beginning of this chapter, we asked the question: “Does the shadow banking system pose a threat to the stability of the U.S. financial system?” The shadow banking system clearly played a key role in the financial crisis of 2007–2009. Many shadow banks were highly leveraged. So, as housing prices fell, these firms suffered heavy losses, and some failed. Shadow banks can continue to operate as much as they did because they are more efficient in filling a role in the financial system than commercial banks. Systemic Risk and the Shadow Banking System