Finance Companies, Mutual Funds & Insurance Companies

1. Class 3, Chapters 3, 5 & 6 Finance Companies, Mutual Funds & Insurance Companies

2. Lecture Outline • Finance Companies • Functions • Types • Investment and financing activity (balance sheet) • Mutual Funds • Types, specialization and organization • Prices and returns • Fees • Regulationand scandals • Hedge Funds • Brief introduction • Insurance Companies • Life Insurance • Property Causality

3. Finance Companies

4. What Are Finance Companies?

5. Function of Finance Companies • Provide similar services as depository institutions • consumer lending • business lending • mortgage financing • Finance Companies vs. Depository Institutions: • Financing: Instead of deposits, they borrow by issuing securities: • Commercial paper (unsecured note with maturity from 1 to 270 days) • Long-term debt • Regulation: They are not subject to the same regulation as depository institutions • Non-deposit financing = no reserve requirements or FDIC insurance • lend to riskier borrowers than commercial banks (e.g. subprime lender)

6. How Did They Start? • First major finance company: General Electric Capital Corp. • Founded during the Great Depression • The first finance companies were established to provide credit to customers so they could buy goods from the parent company.

7. Types of Finance Companies • Sales Finance: Specialize in providing secured credit for the purchase of goods usually from the parent company. • Often subsidiaries of manufacturing companies • GE Capital Corp. • Ford Motor Credit Corp. • General Motors Acceptance Corp. • Can quickly and easily provide financing for these products – have an advantage over commercial banks • Personal Finance: Specialize in making installment and other loans to consumers (e.g. Household International Group and AIG American General) • They provide risky loans to customers with low income and bad credit history; accept collateral that banks would find unacceptable. • They get to charge higher interest rates than banks!!! An Installment loan is paid back in fixed installments with some principal and interest covered by each payment. Think: traditional mortgage

8. Finance Companies (Continued) • Business Credit Institutions specialize in providing financing to corporations, especially through factoring • CIT Group • Fleet Boston Financial Factoring: Finance companies purchase accounts receivables from other corporations at a discount in exchange for assuming the risk of collecting.

9. Balance Sheet of a Finance Company Financing Companies A L Accounts Receivable … 77.5% Consumer……........ 31.5% Business………..… 24.5% Real Estate …….... 21.5% Other assets …………... 27.5% Reserves ……………… (4.7%) Bank Loans ………………….. 8.3% Commercial Paper …………... 3.1% Debt Due to Parent ………….. 14.4% Debt not elsewhere classified… 44.1% Other liabilities ………………. 17.8% Capital Surpluses …………….. 12.3% Mostly financing from parent and long/short-term debt Mainly invested in consumer loans Aggregate assets and liabilities for finance companies 2009 – Federal Reserve Board

10. Funding Activity Advantages: • Higher Rates: • Finance companies can issue higher risk loans (because they are not funded by deposits) and charge higher rates • More flexible terms • Debt financing obtained from the parent tends to carry more flexible terms. It is in the best interest of the parent to have a viable subsidiary • Regulation: • Since they do not use deposits they are not subject to the same regulation.

11. Funding Activity Disadvantages • Funding investment activity with debt and commercial paper is more expensive than funding with deposits • Financing through capital markets exposes them to roll-over risk, and liquidity risk through exposure to external markets

12. Mutual Funds

13. Mutual Funds

14. Mutual Funds - Definition • Financial Intermediaries - pool funds and invest in diversified portfolios of securities Mutual fund shares Portfolio: shares of individual securities Individual investors

15. Types of Mutual Funds Types of Funds • Open-endmutual funds • Closed-end mutual funds Differences: • Open-end funds • Have an unlimited supply of shares. If you want to purchase shares, the fund will create new shares and sell them to you at the Net Asset Value (NAV) • Number of shares outstanding can change every day • Shares can be purchased or redeemed at any time through the fund • most funds are open-ended • Closed-end funds • Have limited number of shares (there may only be 10,000 shares outstanding, like a company) • Shares can be purchased from dealers, brokers or directly from other owners Main difference is in the way their shares are issued and traded

16. Areas of Specialization • Short term funds: • Money market mutual funds (MMMF): invest in liquid, short-term debt (e.g. Treasury bills). • Alternative to the money market deposit accounts at banks. • Some are taxable and some are tax-free • MMMFs broke the buck in 2009. This led to large runs, the US treasury had to step in with guarantees • Long-term funds: • Stock Funds; Bond Funds; Hybrid (some of each) • Stock: Index fund, Growth fund, etc. • Bond: U.S. Government, Corporate Bond, Junk Bond, MBS, etc. • Specialty funds: Commodities, Internet stocks, Int’l.

17. Structure of Mutual Funds • Investment advisor: Runs the fund. Responsible for selecting the mutual fund’s portfolio of assets. • An investment advisor’s annual compensation is usually equal to a fixed proportion of the mutual fund’s total assets, for example, 0.5 % of the fund’s assets. • Board of directors: with oversight responsibility for the fund’s management. • Until June 2004, the fund’s investment advisor (Ex: Fidelity, Putnam) usually controlled the board. • New SEC rules now require 75% of the directors and the chairman to be independent. • WSJ: June 9 2012 “Mutual-fund boards typically don't hold annual shareholder meetings. It's almost unheard-of for a fund's investors to remove a director or change a management fee. When an advisory firm opens a new fund, it handpicks the fund's directors—who, in theory, can vote themselves onto the board for life. “

18. Mutual Fund Prices • Closed-end mutual fund trade shares at the market price • Open-end mutual fund redeems shares or issues new shares at its Net Asset Value (NAV) once per day, usually at 4:00 p.m. ET after major U.S. markets close. • The NAV is calculated as • NAVs of stock funds are more reliable than NAVs of corporate bond funds because stock prices are easily obtained and have a low bid-ask spread. Market Value of Mutual Fund’s Securities NAV = # of Mutual Fund Shares Outstanding

19. Example: A mutual fund holds IBM Ford and Home Depot in its portfolio. The number of shares is given below. Calculate the NAV if there are currently 7,300 mutual fund shares outstanding Step #1 calculate the market value of the funds assets Step #2 Calculate the NAV

20. In the above example, suppose that the fund sells 2000 more shares at the NAV. It uses the proceeds from this sale to buy 800 shares of IBM, 1200 shares of Ford, and 700 shares of Home Depot. It holds the remainder in cash as reserves. The NAV is currently $77.66 • Calculate the New NAV of the fund. • Did the purchase dilute existing shareholder value?

21. Mutual Fund Returns • Dividends • earned on the asset portfolio. • Capital gains • when assets are sold by mutual funds at prices higher than the purchase price. • Capital appreciation • The value of the underlying portfolio changes on a daily basis. • Assets are marked-to-market daily by calculating the NAV.

22. Stylized Facts • First mutual fund was founded in Boston in 1924. • Both retail and institutional investors are mutual fund shareholders. • As of 2008 year-end, the U.S. has over 8,800 open-end funds holding total assets of over $9.6 trillion, making them the second largest type of financial intermediary. • Total net assets fell by 20% in 2008 due to the sharp drop in equity prices. • There are about 650 closed-end funds holding total assets about $188 billion • Increasingly, mutual funds are part of large management companies who create and sponsor them. • A family of mutual funds managed by the same company is called a fundcomplex (e.g. Fidelity and T. Rowe Price).

23. Mutual Fund Fee Structure Types of mutual fund fees • Front-end load • Back-end load • No-load • 12b-1 fee Load funds • Funds sold through broker-dealers or financial planners who charge investors a sales load. • front-end load: Charged at the time of purchase this is the most common type of load • Back-end load: The sales fee is charged at the time the investor leaves the fund or fund complex No-Load fund • These funds are usually sold directly to investors through a management company. Because they are not sold through a sales agent they do not have sales (load) fees 12b-1 fees • Fee paid to the broker to cover sales, marketing and distribution costs • Usually combine with front or back end loads • The various ways of charging sales fees led to offering different classes (A,B, and C) of shares for the same mutual fund. • Example: Class A shares have high front-end loads but low 12b-1 fees.

24. Share Classes and fees • Share Classes and Fees: Mutual funds have setup different share classes to accommodate the different fee options • Funds are also sold through 401k or 403b retirement plans

25. Mutual Fund Supermarkets • Broker service: • Allows investors to buy and sell mutual fund shares of several funds and sometimes several sponsors through a single broker. • Non-load based trades: investors are no charged a upfront or backend load to trade. • Broker is paid by the mutual fund.

26. Regulation of Mutual Funds • Main regulator is the SEC. • They may not borrow (issue debt). • They are limited in their ability to engage in short sales, buy or sell real estate or commodities, or make loans. • While each fund is organized as a corporation with investors being its shareholders, they are exempt from corporate taxes. • Must invest in what they said they would in their prospectus available to potential investors. • New regulations in 2004.

27. Mutual Fund Scandals • 2000’s saw several mutual fund scandals that fell in to four categories • Market Timing • Late Trading • Directed Brokerage • Improper assignment of fees

28. Market Timing - Time Zone Arbitrage Example: PIMCO International StocksPLUS Total Return Strategy A • Has 5 Million Shares outstanding • Has a total asset value of 50 Million USD • Holds100,000 shares of Fox Marble Holdings plc. Listed on the LSE

29. Market Timing - Time Zone Arbitrage Day 1 At 2:00pm EST the US Gov announces that Fox Marble has just won a government contract – the price of Fox jumps to $25 in after market trading on the LSE The LSE closes at 5:00pm (12 pm EST) the closing price of Fox Marble is $15 Is the fund over or under valued? NYSE closes and NAV for mutual funds holding is calculated using the $15 closing price from the LSE A market timer can step in an buy undervalued Pimco Shares and wait for them to adjust

30. Market Timing - Time Zone Arbitrage Day 2 The LSE opens at 8:00am (3 am EST) the price of Fox Marble will adjust to $25 4:00 PM: NYSE closes and NAV for mutual funds holding is calculated using the $25 closing price from the LSE The Market timer receives some return

31. Market Timing - Time Zone Arbitrage Why is this bad how does it affect the existing share holders or fund? – lets look at 2 scenarios • Without market timer: • With market timer: Day 2 Calculate NAV using the adjusted $25 price Day 1 Calculate NAV using the stale $15 price Day 2 Calculate NAV using the adjusted $25 price Day 1 Calculate NAV using the stale $15 price

32. Market Timing - Time Zone Arbitrage Capital gain from announcement Return without market timer • Calculated NAV Day 1 (after US markets close): • Calculated NAV Day 2– no market timing Return

33. Market Timing - Time Zone Arbitrage Return with market timer The market timer jumps in and buys 1 million shares at $10/share ($10 mill added to the fund) • Calculated NAV Day 1 (after US markets close): • Calculated NAV Day 2– with market timer Capital gain from announcement Additional 10M invested by market timer Return Additional 1M shares sold to market timer

34. Who are the market timers? • Why would mutual funds allow this to happen? • Market timers are usually large institutional investors i.e. hedge funds • This is basically a service mutual funds were providing to preferred customers • It did not hurt the mutual fund because they are basically transferring wealth from existing shareholders to the market timer – they do not incur any losses • News Clip

35. Against Market Timing… • Some mutual funds refuse orders from traders known to be market timers. • Alternatively, a fund could use fair-value pricing. The fund uses a fair-value estimate of stock prices rather than stale closing prices to calculate its NAV.

36. More on Conflicts of Interest • Market Timing: Investors my try to buy-in or sell-out of different sectors as they heat up and cool down. The violation was mainly in the frequency of trading. Preferred clients were allowed trade more frequently than what was outlined in the prospectus. • Late Trading: It occurs when a mutual fund accepts an order submitted after 4:00 ET. In this case, a late trader can profit from news events after 4:00.

37. More on Conflicts of Interest • Directed Brokerage: It involves agreements where a mutual fund agrees to place trades with a broker in return for the mutual fund being heavily promoted to the broker’s clients. • Improper Assessment of Fees to the Investors: 12b-1 fees allowed some brokers to trick investors into believing that they were buying no-load funds.

38. Hedge Funds

39. Hedge Funds • Funds that pool investments from wealthy investors • Commercial banks • Pension funds • University Endowments • State Funds • Avoid mutual fund regulation • Have less than 100 investors OR • Have all “accredited investors” (net worth of over 1,000,000 or annual salary of 200,000 300,000 if married) • No restrictions on asset classes they can hold • No restrictions on leverage or short selling • Despite their name, hedge funds do not always “hedge” their investments to protect the fund.

40. Hedge Funds (Continued) • For example, LTCM detected a price discrepancy between U.S. Treasuries and other bonds • They shorted U.S. Treasuries and took long positions in the other bonds. • Profit if Treasury prices drop and bond prices increase • But in 1998, large drops in foreign markets •  Money flew to U.S. Treasuries •  Treasury prices went up while prices of other bonds dropped due to a drop in funds flowing into these bonds •  LTCM experienced huge mark-to-market losses! • As a result of trading abuses in 2003, SEC began scrutinizing the hedge fund industry more closely. • Recommended that large hedge funds register as investment advisors, subjecting them to periodic audits. • But hedge funds still heavily use leverage and short-selling

41. Insurance Companies

42. Insurance Companies Types: • Property Causality Insurance • Life Insurance Why do people buy insurance? • Risk aversion implies that an individual is willing to pay a premium that is at least equal to his/her expected loss.

43. Life Insurance Companies • The insurance company collects premiums in exchange for a promise to reimburse policy holders (or their beneficiaries) should they die or suffer serious bodily harm. • Mortality risk – is the risk that more claims are filed than would be expected. • Increasing the number of policies in the pool, decreases the chances of seeing unexpected outcomes Law of Large Numbers • They decrease mortality risk by increasing the number of policies in the pool. This allows them to accurately predict and manage policy claims • Actuarial tables are used to forecast life expectancies for certain types of individuals (e.g., 25 year-old, female non-smoker).

44. Life Insurance Companies (Continued) • However, a factor that could invalidate this statistical model is adverse selection. Insurers must always be conscious that applicants for policies may not be representative of the entire population of individuals. • Individuals that know they have poor health (and lower life expectancy) have a greater incentive to apply for life insurance.

45. Preventing Adverse Selection… • Hence, insurers will put conditions in place to prevent adverse selection. • Individuals applying for life insurance will be required to submit a medical exam. • Group life insurance paid for by an employer and covering all employees avoids adverse selection because of its mandatory coverage. Medical exams are unnecessary if the employees are representative of an overall population.

46. Examples of Life Insurance Policies • Term Life Insurance: In return for periodic premium payments over a fixed term of coverage, the policyholder receives a (tax-exempt) payment contingent on death (if death occurs during the term of the policy). • Whole Life Insurance: Combines mortality insurance and a savings plan. It covers the policyholder from the beginning of the policy throughout his entire life. • Policy holder makes periodic premium payments. The value of these payments is above (below) the fair term premium in early (late) years. • The accumulated overpayments accrue interest at a fixed rate and equal the policy’s “cash value.” Cash value in excess of premiums paid is taxable.

47. Other Life Insurance Activities • Annuities: In return for the annuity holder making an investment, the insurance company promises a series of payments starting immediately (immediate annuity) or at some future date (deferred annuity). • The motivation for offering these products is mainly that the earnings on these investments are not taxed until the payments are received. • Fixed annuity: Fixed interest is paid on the annuity’s principal. • Variable annuity: Return on principal varies with a mutual fund return (therefore they have been called “mutual funds in a tax deferred wrapper”). • Private Pension Funds: Because of their expertise in managing long-maturity liabilities (e.g., life insurance policies), they manage some employers’ pension plans. • Accident and Health Insurance

48. Composition of Life Insurer’s Assets, 2008 (Total year-end assets equal $4,648 billion) Source: Life Insurers Factbook

49. Liabilities are mostly reserves… Source: Life Insurers Factbook, 2009

50. Property-Causality Insurance • Property insurance protects individuals and firms from loss of real and personal property. • Fire insurance • Automotive • Causality (liability) insurance provides protection against liability for harm that the insured causes to others. This can be the result of product failure, accidents, or mal-practice. • Unlike life insurance, property- causality (P-C) insurance involves short-term contracts, usually of a year or less. • Claims for losses are more difficult to predict – natural disasters hurricanes can result in simultaneous claims on several policies