Chapter 13 Nonbank Finance

1. Chapter 13Nonbank Finance

2. Preview • This chapter examines how institutions which engaged in nonbank finance operate and how they are regulated.

3. Learning Objectives • Summarize the different types of insurance products and the ways in which insurance companies can reduce asymmetric information problems. • Summarize the distinctions between defined-benefit and defined-contribution pensions and the key features of private and public pension plans. • List and describe the different types of finance companies.

4. Learning Objectives • Summarize the roles of investment banks, securities brokers and dealers, and organized exchanges. • Describe the role and activities of mutual funds in financial intermediation. • Summarize the key distinctions between hedge funds and mutual funds. • Define private equity and venture capital, and summarize their advantages as investment funds. • Describe the two types of government financial intermediation.

5. Insurance • Life insurance • Permanent (whole, universal, and variable) • Term • Property and Casualty • Hold more liquid assets than life insurance companies • Reinsurance

6. Insurance • Competitive threat from the banking industry • Credit insurance • Credit default swaps • AIG blowup • Monoline insurance

7. Table 1 Relative Shares of Total Financial Intermediary Assets, 1970–2013 (percent)

8. Application: 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

9. 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)

10. Pension Funds • Public pension plans • Social Security • Pay as you go system • Massive underfunding • Possible reforms proposed

11. FYI: Should Social Security Be Privatized? • Privatization proposals take three basic forms: • Government investment of trust fund assets in corporate securities • Shift of trust fund assets to individual accounts that can be invested in private assets • Individual accounts in addition to those in the trust fund

12. Finance Companies • Virtually unregulated compared to commercial banks and thrifts institutions • Sales finance companies • Consumer finance companies • Business finance companies • Factoring • Leasing equipment

13. Securities Market Operations • Financial facilitators • Investment banks • Securities brokers and dealers • Organized exchanges

14. 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

15. Investment Banking • Regulated by SEC • Registration statement • Provide potential investors with a prospectus • 20 day waiting period

16. 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

17. 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

18. 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

19. Mutual Funds • Load funds and no-load funds • Regulated by Securities and Exchange Commission • Money market mutual funds • Function as checkable deposits that earn interest.

20. 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

21. 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

22. 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.

23. FYI: The Global Financial Crisis and the Bailout of Fannie Mae and Freddie Mac • Legislation passed in 1992 assigned Fannie and Freddie a federal regulator and supervisor, the Office of Federal Housing Enterprise Oversight (OFHEO), but this regulator was quite weak. • With weak regulation and strong incentives to take on risk, Fannie and Freddie grew wildly, and by 2008 these firms had purchased or were guaranteeing over $5 trillion of mortgages and mortgage-backed securities.

24. FYI: The Global Financial Crisis and the Bailout of Fannie Mae and Freddie Mac • Amidst the losses that came with the subprime mortgage default, the federal government was ultimately forced to takeover both institutions.