The economics of Money, Banking and Financial Markets Part 6 potx

See Table 1, which shows the relative shares of financialintermediary assets for each of the financial intermediaries discussed in this chapter.Beginning in the mid-1970s, life insurance

PREVIEW Banking is not the only type of financial intermediation you are likely to experience.

You might decide to purchase insurance, take out an installment loan from a financecompany, or buy a share of stock In each of these transactions you will be engaged

in nonbank finance and will deal with nonbank financial institutions In our economy,nonbank finance also plays an important role in channeling funds from lender-savers

to borrower-spenders Furthermore, the process of financial innovation we discussed

in Chapter 10 has increased the importance of nonbank finance and is blurring thedistinction between different financial institutons This chapter examines in moredetail how institutions engaged in nonbank finance operate, how they are regulated,and recent trends in nonbank finance

a result of accidents, fire, or theft

The first life insurance company in the United States (Presbyterian Ministers’ Fund inPhiladelphia) was established in 1759 and is still in existence There are currentlyabout 1,400 life insurance companies, which are organized in two forms: as stockcompanies or as mutuals Stock companies are owned by stockholders; mutuals aretechnically owned by the policyholders Although over 90% of life insurance compa-nies are organized as stock companies, some of the largest ones are organized asmutuals

Unlike commercial banks and other depository institutions, life insurance panies have never experienced widespread failures, so the federal government has notseen the need to regulate the industry Instead, regulation is left to the states in which

com-a compcom-any opercom-ates Stcom-ate regulcom-ation is directed com-at scom-ales prcom-actices, the provision of

The Insurance Information

Institute publishes facts and

statistics about the

insurance industry

adequate liquid assets to cover losses, and restrictions on the amount of risky assets(such as common stock) that the companies can hold The regulatory authority is typ-ically a state insurance commissioner.

Because death rates for the population as a whole are predictable with a highdegree of certainty, life insurance companies can accurately predict what their payouts

to policyholders will be in the future Consequently, they hold long-term assets thatare not particularly liquid—corporate bonds and commercial mortgages as well assome corporate stock

There are two principal forms of life insurance policies: permanent life insurance(such as whole, universal, and variable life) and temporary insurance (such as term).Permanent life insurance policies have a constant premium throughout the life of thepolicy In the early years of the policy, the size of this premium exceeds the amountneeded to insure against death because the probability of death is low Thus the pol-icy builds up a cash value in its early years, but in later years the cash value declinesbecause the constant premium falls below the amount needed to insure against death,the probability of which is now higher The policyholder can borrow against the cashvalue of the permanent life policy or can claim it by canceling the policy

Term insurance, by contrast, has a premium that is matched every year to theamount needed to insure against death during the period of the term (such as oneyear or five years) As a result, term policies have premiums that rise over time as theprobability of death rises (or level premiums with a decline in the amount of deathbenefits) Term policies have no cash value and thus, in contrast to permanent lifepolicies, provide insurance only, with no savings aspect

Weak investment returns on permanent life insurance in the 1960s and 1970s led

to slow growth of demand for life insurance products The result was a shrinkage inthe size of the life insurance industry relative to other financial intermediaries, withtheir share of total financial intermediary assets falling from 19.6% at the end of 1960

to 11.5% at the end of 1980 (See Table 1, which shows the relative shares of financialintermediary assets for each of the financial intermediaries discussed in this chapter.)Beginning in the mid-1970s, life insurance companies began to restructure theirbusiness to become managers of assets for pension funds An important factor behindthis restructuring was 1974 legislation that encouraged pension funds to turn fundmanagement over to life insurance companies Now more than half of the assets man-aged by life insurance companies are for pension funds and not for life insurance.Insurance companies have also begun to sell investment vehicles for retirement such

as annuities, arrangements whereby the customer pays an annual premium in

exchange for a future stream of annual payments beginning at a set age, say 65, andcontinuing until death The result of this new business has been that the market share

of life insurance companies as a percentage of total financial intermediary assets hasheld steady since 1980

There are on the order of 3,000 property and casualty insurance companies in theUnited States, the two largest of which are State Farm and Allstate Property and casu-alty companies are organized as both stock and mutual companies and are regulated

by the states in which they operate

Although property and casualty insurance companies had a slight increase intheir share of total financial intermediary assets from 1960 to 1990 (see Table 1), inrecent years they have not fared well, and insurance premiums have skyrocketed.With the high interest rates in the 1970s and 1980s, insurance companies had high

The Flow of Funds Accounts of

the United States reports details

about the current state of the

insurance industry Scroll down

through the table of contents to

find the location of data on

insurance companies

investment income that enabled them to keep insurance rates low Since then, ever, investment income has fallen with the decline in interest rates, while the growth

how-in lawsuits how-involvhow-ing property and casualty how-insurance and the explosion how-in amountsawarded in such cases have produced substantial losses for companies

To return to profitability, insurance companies have raised their rates cally—sometimes doubling or even tripling premiums—and have refused to providecoverage for some people They have also campaigned actively for limits on insurancepayouts, particularly for medical malpractice In the search for profits, insurance com-panies are also branching out into uncharted territory by insuring the payment ofinterest on municipal and corporate bonds and on mortgage-backed securities Oneworry is that the insurance companies may be taking on excessive risk in order toboost their profits One result of the concern about the health of the property andcasualty insurance industry is that insurance regulators have proposed new rules thatwould impose risk-based capital requirements on these companies based on the risk-iness of their assets and operations

dramati-The investment policies of these companies are affected by two basic facts First,because they are subject to federal income taxes, the largest share of their assets is held

in tax-exempt municipal bonds Second, because property losses are more uncertainthan the death rate in a population, these insurers are less able to predict how muchthey will have to pay policyholders than life insurance companies are Natural or

Source: Federal Reserve Flow of Funds Accounts.

unnatural disasters such as the Los Angeles earthquake in 1994 and Hurricane Floyd

in 1999, which devastated parts of the East Coast, and the September 11, 2001destruction of the World Trade Center, exposed the property and casualty insurancecompanies to billions of dollars of losses Therefore, property and casualty insurancecompanies hold more liquid assets than life insurance companies; municipal bondsand U.S government securities amount to over half their assets, and most of theremainder is held in corporate bonds and corporate stock

Property and casualty insurance companies will insure against losses from almostany type of event, including fire, theft, negligence, malpractice, earthquakes, andautomobile accidents If a possible loss being insured is too large for any one firm,several firms may join together to write a policy in order to share the risk Insurance

companies may also reduce their risk exposure by obtaining reinsurance Reinsurance

allocates a portion of the risk to another company in exchange for a portion of thepremium and is particularly important for small insurance companies You can think

of reinsurance as insurance for the insurance company The most famous risk-sharingoperation is Lloyd’s of London, an association in which different insurance companiescan underwrite a fraction of an insurance policy Lloyd’s of London has claimed that

it will insure against any contingency—for a price

Until recently, banks have been restricted in their ability to sell life insurance ucts This has been changing rapidly, however Over two-thirds of the states allowbanks to sell life insurance in one form or another In recent years, the bank regula-tory authorities, particularly the Office of the Comptroller of the Currency (OCC),have also encouraged banks to enter the insurance field because getting into insur-ance would help diversify banks’ business, thereby improving their economic healthand making bank failures less likely For example, in 1990, the OCC ruled that sell-ing annuities was a form of investment that was incidental to the banking businessand so was a permissible banking activity As a result, the banks’ share of the annu-ities market has surpassed 20% Currently, more than 40% of banks sell insuranceproducts, and the number is expected to grow in the future

prod-Insurance companies and their agents reacted to this competitive threat with bothlawsuits and lobbying actions to block banks from entering the insurance business.Their efforts were set back by several Supreme Court rulings that favored the banks.Particularly important was a ruling in favor of Barnett Bank in March 1996, which heldthat state laws to prevent banks from selling insurance can be superseded by federalrulings from banking regulators that allow banks to sell insurance The decision gavebanks a green light to further their insurance activities, and with the passage of theGramm-Leach-Bliley Act of 1999, banking institutions will further engage in the insur-ance business, thus blurring the distinction between insurance companies and banks

trans-bonds, stocks, and loans into insurance policies that provide a set of ices (for example, claim adjustments, savings plans, friendly insuranceagents) If the insurer’s production process of asset transformation efficientlyprovides its customers with adequate insurance services at low cost and if itcan earn high returns on its investments, it will make profits; if not, it willsuffer losses.

serv-In Chapter 9 the economic concepts of adverse selection and moral ard allowed us to understand principles of bank management related to man-aging credit risk; many of these same principles also apply to the lendingactivities of insurers Here again we apply the adverse selection and moral haz-ard concepts to explain many management practices specific to insurance

haz-In the case of an insurance policy, moral hazard arises when the existence

of insurance encourages the insured party to take risks that increase the lihood of an insurance payoff For example, a person covered by burglaryinsurance might not take as many precautions to prevent a burglary becausethe insurance company will reimburse most of the losses if a theft occurs

like-Adverse selection holds that the people most likely to receive large insurancepayoffs are the ones who will want to purchase insurance the most Forexample, a person suffering from a terminal disease would want to take outthe biggest life and medical insurance policies possible, thereby exposing theinsurance company to potentially large losses Both adverse selection andmoral hazard can result in large losses to insurance companies, because theylead to higher payouts on insurance claims Lowering adverse selection andmoral hazard to reduce these payouts is therefore an extremely importantgoal for insurance companies, and this goal explains the insurance practices

we will discuss here

To reduce adverse selection, insurance providers try to screen out good ance risks from poor ones Effective information collection procedures aretherefore an important principle of insurance management

insur-When you apply for auto insurance, the first thing your insurance agentdoes is ask you questions about your driving record (number of speedingtickets and accidents), the type of car you are insuring, and certain personalmatters (age, marital status) If you are applying for life insurance, you gothrough a similar grilling, but you are asked even more personal questionsabout such things as your health, smoking habits, and drug and alcohol use

The life insurer even orders a medical evaluation (usually done by an pendent company) that involves taking blood and urine samples Just as abank calculates a credit score to evaluate a potential borrower, the insurersuse the information you provide to allocate you to a risk class—a statisticalestimate of how likely you are to have an insurance claim Based on thisinformation, the insurer can decide whether to accept you for the insurance

inde-or to turn you down because you pose too high a risk and thus would be anunprofitable customer

Charging insurance premiums on the basis of how much risk a policyholderposes for the insurance provider is a time-honored principle of insurancemanagement Adverse selection explains why this principle is so important

to insurance company profitability

Risk-Based

Premiums

Screening

To understand why an insurance provider finds it necessary to have based premiums, let’s examine an example of risk-based insurance premiumsthat at first glance seems unfair Harry and Sally, both college students with noaccidents or speeding tickets, apply for auto insurance Normally, Harry will

risk-be charged a much higher premium than Sally Insurance providers do thisbecause young males have a much higher accident rate than young females.Suppose, though, that one insurer did not base its premiums on a risk classi-fication but rather just charged a premium based on the average combinedrisk for males and females Then Sally would be charged too much and Harrytoo little Sally could go to another insurer and get a lower rate, while Harrywould sign up for the insurance Because Harry’s premium isn’t high enough

to cover the accidents he is likely to have, on average the insurer would losemoney on Harry Only with a premium based on a risk classification, so thatHarry is charged more, can the insurance provider make a profit.1

Restrictive provisions in policies are an insurance management tool forreducing moral hazard Such provisions discourage policyholders fromengaging in risky activities that make an insurance claim more likely Forexample, life insurers have provisions in their policies that eliminate deathbenefits if the insured person commits suicide within the first two years thatthe policy is in effect Restrictive provisions may also require certain behav-ior on the part of the insured A company renting motor scooters may berequired to provide helmets for renters in order to be covered for any liabil-ity associated with the rental The role of restrictive provisions is not unlikethat of restrictive covenants on debt contracts described in Chapter 8: Bothserve to reduce moral hazard by ruling out undesirable behavior

Insurance providers also face moral hazard because an insured person has anincentive to lie to the insurer and seek a claim even if the claim is not valid.For example, a person who has not complied with the restrictive provisions

of an insurance contract may still submit a claim Even worse, a person mayfile claims for events that did not actually occur Thus an important manage-ment principle for insurance providers is conducting investigations to pre-vent fraud so that only policyholders with valid claims receive compensation

Being prepared to cancel policies is another insurance management tool.Insurers can discourage moral hazard by threatening to cancel a policy whenthe insured person engages in activities that make a claim more likely If yourauto insurance company makes it clear that coverage will be canceled if adriver gets too many speeding tickets, you will be less likely to speed

The deductible is the fixed amount by which the insured’s loss is reduced

when a claim is paid off A $250 deductible on an auto policy, for example,

means that if you suffer a loss of $1,000 because of an accident, the insurerwill pay you only $750 Deductibles are an additional management tool thathelps insurance providers reduce moral hazard With a deductible, you expe-rience a loss along with the insurer when you make a claim Because you alsostand to lose when you have an accident, you have an incentive to drive morecarefully A deductible thus makes a policyholder act more in line with what

is profitable for the insurer; moral hazard has been reduced And becausemoral hazard has been reduced, the insurance provider can lower the pre-mium by more than enough to compensate the policyholder for the existence

of the deductible Another function of the deductible is to eliminate theadministrative costs of handling small claims by forcing the insured to bearthese losses

When a policyholder shares a percentage of the losses along with the insurer,

their arrangement is called coinsurance For example, some medical

insur-ance plans provide coverage for 80% of medical bills, and the insured personpays 20% after a certain deductible has been met Coinsurance works toreduce moral hazard in exactly the same way that a deductible does A policy-holder who suffers a loss along with the insurer has less incentive to takeactions, such as going to the doctor unnecessarily, that involve higher claims

Coinsurance is thus another useful management tool for insurance providers

Another important principle of insurance management is that there should

be limits on the amount of insurance provided, even though a customer iswilling to pay for more coverage The higher the insurance coverage, themore the insured person can gain from risky activities that make an insur-ance payoff more likely and hence the greater the moral hazard For exam-ple, if Zelda’s car were insured for more than its true value, she might nottake proper precautions to prevent its theft, such as making sure that thekey is always removed or putting in an alarm system If it were stolen, shecomes out ahead because the excessive insurance payment would allow her

to buy an even better car By contrast, when the insurance payments arelower than the value of her car, she will suffer a loss if it is stolen and willthus take precautions to prevent this from happening Insurance providersmust always make sure that their coverage is not so high that moral hazardleads to large losses

Effective insurance management requires several practices: information lection and screening of potential policyholders, risk-based premiums, restric-tive provisions, prevention of fraud, cancellation of insurance, deductibles,coinsurance, and limits on the amount of insurance All of these practicesreduce moral hazard and adverse selection by making it harder for policy-holders to benefit from engaging in activities that increase the amount andlikelihood of claims With smaller benefits available, the poor insurance risks(those who are more likely to engage in the activities in the first place) seeless benefit from the insurance and are thus less likely to seek it out

Pension Funds

In performing the financial intermediation function of asset transformation, pensionfunds provide the public with another kind of protection: income payments onretirement Employers, unions, or private individuals can set up pension plans,which acquire funds through contributions paid in by the plan’s participants As wecan see in Table 1, pension plans both public and private have grown in importance,with their share of total financial intermediary assets rising from 10% at the end of

1960 to 22.6% at the end of 2002 Federal tax policy has been a major factor behindthe rapid growth of pension funds because employer contributions to employee pen-sion plans are tax-deductible Furthermore, tax policy has also encouraged employeecontributions to pension funds by making them tax-deductible as well and enablingself-employed individuals to open up their own tax-sheltered pension plans, Keoghplans, and individual retirement accounts (IRAs)

Because the benefits paid out of the pension fund each year are highly dictable, pension funds invest in long-term securities, with the bulk of their assetholdings in bonds, stocks, and long-term mortgages The key management issues forpension funds revolve around asset management: Pension fund managers try to holdassets with high expected returns and lower risk through diversification They alsouse techniques we discussed in Chapter 9 to manage credit and interest-rate risk.The investment strategies of pension plans have changed radically over time In theaftermath of World War II, most pension fund assets were held in governmentbonds, with less than 1% held in stock However, the strong performance of stocks

pre-in the 1950s and 1960s afforded pension plans higher returns, causpre-ing them to shifttheir portfolios into stocks, currently on the order of two-thirds of their assets As aresult, pension plans now have a much stronger presence in the stock market: In theearly 1950s, they held on the order of 1% of corporate stock outstanding; currentlythey hold on the order of 25% Pension funds are now the dominant players in thestock market

Although the purpose of all pension plans is the same, they can differ in a ber of attributes First is the method by which payments are made: If the benefits aredetermined by the contributions into the plan and their earnings, the pension is a

num-defined-contribution plan; if future income payments (benefits) are set in advance, the pension is a defined-benefit plan In the case of a defined-benefit plan, a further attribute is related to how the plan is funded A defined-benefit plan is fully funded

if the contributions into the plan and their earnings over the years are sufficient to payout the defined benefits when they come due If the contributions and earnings are

not sufficient, the plan is underfunded For example, if Jane Brown contributes $100

per year into her pension plan and the interest rate is 10%, after ten years the tributions and their earnings would be worth $1,753.2If the defined benefit on her

con-2 The $100 contributed in year 1 would become worth $100  (1  0.10) 10  $259.37 at the end of ten years; the $100 contributed in year 2 would become worth $100  (1  0.10) 9  $235.79; and so on until the $100 contributed in year 10 would become worth $100  (1  0.10)  $110 Adding these together, we get the total value of these contributions and their earnings at the end of ten years:

$259.37  $235.79  $214.36  $194.87  $177.16

 $161.05  $146.41  $133.10  $121.00  $110.00  $1,753.11

pension plan pays her $1,753 or less after ten years, the plan is fully funded becauseher contributions and earnings will fully pay for this payment But if the definedbenefit is $2,000, the plan is underfunded, because her contributions and earnings

do not cover this amount

A second characteristic of pension plans is their vesting, the length of time that a

person must be enrolled in the pension plan (by being a member of a union or anemployee of a company) before being entitled to receive benefits Typically, firms requirethat an employee work five years for the company before being vested and qualifying toreceive pension benefits; if the employee leaves the firm before the five years are up,either by quitting or being fired, all rights to benefits are lost

Private pension plans are administered by a bank, a life insurance company, or a sion fund manager In employer-sponsored pension plans, contributions are usuallyshared between employer and employee Many companies’ pension plans are under-funded because they plan to meet their pension obligations out of current earningswhen the benefits come due As long as companies have sufficient earnings, under-funding creates no problems, but if not, they may not be able to meet their pensionobligations Because of potential problems caused by corporate underfunding, mis-management, fraudulent practices, and other abuses of private pension funds(Teamsters pension funds are notorious in this regard), Congress enacted the EmployeeRetirement Income Security Act (ERISA) in 1974 This act established minimum stan-dards for the reporting and disclosure of information, set rules for vesting and thedegree of underfunding, placed restrictions on investment practices, and assigned theresponsibility of regulatory oversight to the Department of Labor

pen-ERISA also created the Pension Benefit Guarantee Corporation (called “PennyBenny”), which performs a role similar to that of the FDIC It insures pension bene-fits up to a limit (currently over $40,000 per year per person) if a company with anunderfunded pension plan goes bankrupt or is unable to meet its pension obligationsfor other reasons Penny Benny charges pension plans premiums to pay for this insur-ance, and it can also borrow funds up to $100 million from the U.S Treasury.Unfortunately, the problem of pension plan underfunding has been growing worse inrecent years In 1993, the secretary of labor indicated that underfunding had reachedlevels in excess of $45 billion, with one company’s pension plan alone, that of GeneralMotors, underfunded to the tune of $11.8 billion As a result, Penny Benny, whichinsures the pensions of one of every three workers, may have to foot the bill if com-panies with large underfunded pensions go broke

The most important public pension plan is Social Security (Old Age and Survivors’Insurance Fund), which covers virtually all individuals employed in the private sector.Funds are obtained from workers through Federal Insurance Contribution Act (FICA)deductions from their paychecks and from employers through payroll taxes SocialSecurity benefits include retirement income, Medicare payments, and aid to the disabled.When Social Security was established in 1935, the federal government intended tooperate it like a private pension fund However, unlike a private pension plan, bene-fits are typically paid out from current contributions, not tied closely to a participant’spast contributions This “pay as you go” system at one point led to a massive under-funding, estimated at over $1 trillion

The problems of the Social Security system could become worse in the futurebecause of the growth in the number of retired people relative to the working

contains information on your

benefits available from social

security.

www.pbgc.gov/

The web site for the Pension

Benefit Guarantee Corporation

contains information about

pensions and the insurance that

it provides.

population Congress has been grappling with the problems of the Social Security tem for years, but the prospect of a huge bulge in new retirees when the 77 billionbaby boomers born between 1946 and 1964 start to retire in 2011 has resulted incalls for radical surgery on Social Security (see Box 1).

sys-State and local governments and the federal government, like private employers,have also set up pension plans for their employees These plans are almost identical inoperation to private pension plans and hold similar assets Underfunding of the plans isalso prevalent, and some investors in municipal bonds worry that it may lead to futuredifficulties in the ability of state and local governments to meet their debt obligations

Finance Companies

Finance companies acquire funds by issuing commercial paper or stocks and bonds

or borrowing from banks, and they use the proceeds to make loans (often for smallamounts) that are particularly well suited to consumer and business needs The finan-

Box 1

Should Social Security Be Privatized?

In recent years, public confidence in the Social

Security system has reached a new low Some surveys

suggest that young people have more confidence in

the existence of flying saucers than they do in the

gov-ernment’s promise to pay them their Social Security

benefits Without some overhaul of the system, Social

Security will not be able to meet its future obligations

The government has set up advisory commissions and

has been holding hearings to address this problem

Currently, the assets of the Social Security system,

which reside in a trust fund, are all invested in U.S

Treasury securities Because stocks and corporate

bonds have higher returns than Treasury securities,

many proposals to save the Social Security system

suggest investing part of the trust fund in corporate

securities and thus partially privatizing the system

Suggestions for privatization take three basic forms:

1 Government investment of trust fund assets in

cor-porate securities This plan has the advantage of

pos-sibly improving the trust fund’s overall return, while

minimizing transactions costs because it exploits the

economies of scale of the trust fund Critics warn

that government ownership of private assets could

lead to increased government intervention in the

pri-vate sector

2 Shift of trust fund assets to individual accounts that

can be invested in private assets This option has the

advantage of possibly increasing the return on ments and does not involve the government in theownership of private assets However, critics warnthat it might expose individuals to greater risk and totransaction costs on individual accounts that might

invest-be very high invest-because of the small size of many ofthese accounts

3 Individual accounts in addition to those in the trust

fund This option has advantages and disadvantages

similar to those of option 2 and may provide morefunds to individuals at retirement However, someincrease in taxes would be required to fund theseaccounts

Whether some privatization of the Social Securitysystem occurs is an open question In the shortterm, Social Security reform is likely to involve anincrease in taxes, a reduction in benefits, or both.For example, the age at which benefits begin isalready scheduled to increase from 65 to 67, andmight be increased further to 70 It is also likely thatthe cap on wages subject to the Social Security taxwill be raised further, thereby increasing taxes paidinto the system

cial intermediation process of finance companies can be described by saying that theyborrow in large amounts but often lend in small amounts—a process quite differentfrom that of banking institutions, which collect deposits in small amounts and thenoften make large loans.

A key feature of finance companies is that although they lend to many of the samecustomers that borrow from banks, they are virtually unregulated compared to com-mercial banks and thrift institutions States regulate the maximum amount they canloan to individual consumers and the terms of the debt contract, but there are norestrictions on branching, the assets they hold, or how they raise their funds The lack

of restrictions enables finance companies to tailor their loans to customer needs ter than banking institutions can

bet-There are three types of finance companies: sales, consumer, and business

1 Sales finance companies are owned by a particular retailing or manufacturing

company and make loans to consumers to purchase items from that company Sears,Roebuck Acceptance Corporation, for example, finances consumer purchases of allgoods and services at Sears stores, and General Motors Acceptance Corporationfinances purchases of GM cars Sales finance companies compete directly with banksfor consumer loans and are used by consumers because loans can frequently beobtained faster and more conveniently at the location where an item is purchased

2 Consumer finance companies make loans to consumers to buy particular items

such as furniture or home appliances, to make home improvements, or to help nance small debts Consumer finance companies are separate corporations (likeHousehold Finance Corporation) or are owned by banks (Citigroup owns Person-to-Person Finance Company, which operates offices nationwide) Typically, these com-panies make loans to consumers who cannot obtain credit from other sources andcharge higher interest rates

refi-3 Business finance companies provide specialized forms of credit to businesses by

making loans and purchasing accounts receivable (bills owed to the firm) at a

dis-count; this provision of credit is called factoring For example, a dressmaking firm

might have outstanding bills (accounts receivable) of $100,000 owed by the retailstores that have bought its dresses If this firm needs cash to buy 100 new sewingmachines, it can sell its accounts receivable for, say, $90,000 to a finance company,which is now entitled to collect the $100,000 owed to the firm Besides factoring,business finance companies also specialize in leasing equipment (such as railroadcars, jet planes, and computers), which they purchase and then lease to businesses for

a set number of years

Mutual Funds

Mutual funds are financial intermediaries that pool the resources of many small

investors by selling them shares and using the proceeds to buy securities Through theasset transformation process of issuing shares in small denominations and buying largeblocks of securities, mutual funds can take advantage of volume discounts on broker-age commissions and purchase diversified holdings (portfolios) of securities Mutualfunds allow the small investor to obtain the benefits of lower transaction costs in pur-chasing securities and to take advantage of the reduction of risk by diversifying theportfolio of securities held Many mutual funds are run by brokerage firms, but othersare run by banks or independent investment advisers such as Fidelity or Vanguard

www.federalreserve.gov

/Releases/G20/current

/default.htm

Federal reserve information

about financial companies.

www.ici.org/facts_figures

/factbook_toc.html

The Mutual Fund Fact Book

published by Investment

Company Institute includes

information about the mutual

funds industry’s history,

regulation, taxation, and

shareholders.

Mutual funds have seen a large increase in their market share since 1980 (seeTable 1), due primarily to the then-booming stock market Another source of growthhas been mutual funds that specialize in debt instruments, which first appeared in the1970s Before 1970, mutual funds invested almost solely in common stocks Fundsthat purchase common stocks may specialize even further and invest solely in foreignsecurities or in specialized industries, such as energy or high technology Funds thatpurchase debt instruments may specialize further in corporate, U.S government, ortax-exempt municipal bonds or in long-term or short-term securities.

Mutual funds are primarily held by households (around 80%) with the rest held

by other financial institutions and nonfinancial businesses Mutual funds havebecome increasingly important in household savings In 1980, only 6% of householdsheld mutual fund shares; this number has risen to around 50% in recent years Theage group with the greatest participation in mutual fund ownership includes individ-uals between 50 and 70, which makes sense because they are the most interested insaving for retirement Interestingly, Generation X (18–30) is the second most activeage group in mutual fund ownership, suggesting that they have a greater tolerance forinvestment risk than those who are somewhat older Generation X is also leading theway in Internet access to mutual funds (see Box 2)

The growing importance of investors in mutual funds and pension funds,

so-called institutional investors, has resulted in their controlling over 50% of the

out-standing stock in the United States Thus, institutional investors are the predominantplayers in the stock markets, with over 70% of the total daily volume in the stockmarket due to their trading Increased ownership of stocks has also meant that insti-tutional investors have more clout with corporate boards, often forcing changes inleadership or in corporate policies

Mutual funds are structured in two ways The more common structure is an

open-end fund, from which shares can be redeemed at any time at a price that is tied

Mutual Funds and the Internet

The Investment Company Institute estimates that as

of 2000, 68% of households owning mutual funds

use the Internet, and nearly half of those online

shareholders visit fund-related web sites The

Internet increases the attractiveness of mutual funds

because it enables shareholders to review

perform-ance information and share prices and personal

account information

Of all U.S households that conducted mutual

funds transactions between April 1999 and March

2000, 18% bought or sold fund shares online The

median number of funds transactions conducted over

the Internet during the 12-month period was four,

while the average number was eight, indicating that a

high volume of online transactions were conducted

by a small number of shareholders

Online shareholders were typically younger, hadgreater household income, and were better educatedthan those not using the Internet The median onlineshareholder was 42 years old, had a householdincome of $100,900, and was college-educated Themedian shareholder not using the Internet was 51years old, had a household income of $41,000, anddid not have a college degree

The use of the Internet to track and trade mutualfunds is rapidly increasing The number of share-holders who visited web sites offering fund sharesnearly doubled between April 1999 and March 2000

Box 2: E-Finance

to the asset value of the fund Mutual funds also can be structured as a closed-end fund, in which a fixed number of nonredeemable shares are sold at an initial offering

and are then traded like a common stock The market price of these shares fluctuateswith the value of the assets held by the fund In contrast to the open-end fund, how-ever, the price of the shares may be above or below the value of the assets held by thefund, depending on factors such as the liquidity of the shares or the quality of themanagement The greater popularity of the open-end funds is explained by the greaterliquidity of their redeemable shares relative to the nonredeemable shares of closed-end funds

Originally, shares of most open-end mutual funds were sold by salespeople ally brokers) who were paid a commission Since this commission is paid at the time

(usu-of purchase and is immediately subtracted from the redemption value (usu-of the shares,

these funds are called load funds Most mutual funds are currently no-load funds;

they are sold directly to the public with no sales commissions In both types of funds,the managers earn their living from management fees paid by the shareholders Thesefees amount to approximately 0.5% of the asset value of the fund per year

Mutual funds are regulated by the Securities and Exchange Commission, whichwas given the ability to exercise almost complete control over investment companies

in the Investment Company Act of 1940 Regulations require periodic disclosure ofinformation on these funds to the public and restrictions on the methods of solicitingbusiness

An important addition to the family of mutual funds resulting from the financial

inno-vation process described in earlier chapters is the money market mutual fund Recall

that this type of mutual fund invests in short-term debt (money market) instruments

of very high quality, such as Treasury bills, commercial paper, and bank certificates ofdeposit There is some fluctuation in the market value of these securities, but becausetheir maturity is typically less than six months, the change in the market value is smallenough that these funds allow their shares to be redeemed at a fixed value (Changes

in the market value of the securities are figured into the interest paid out by the fund.)Because these shares can be redeemed at a fixed value, the funds allow shareholders

to redeem shares by writing checks on the fund’s account at a commercial bank Inthis way, shares in money market mutual funds effectively function as checkabledeposits that earn market interest rates on short-term debt securities

In 1977, the assets in money market mutual funds were less than $4 billion; by

1980, they had climbed to over $50 billion and now stand at $2.1 trillion, with ashare of financial intermediary assets that has grown to nearly 9% (see Table 1).Currently, money market mutual funds account for around one-quarter of the assetvalue of all mutual funds

Hedge funds are a special type of mutual fund, with estimated assets of more than

$500 billion Hedge funds have received considerable attention recently due to theshock to the financial system resulting from the near collapse of Long-Term CapitalManagement, once one of the most important hedge funds (Box 3) Well-knownhedge funds include Moore Capital Management and the Quantum group of fundsassociated with George Soros Like mutual funds, hedge funds accumulate moneyfrom many people and invest on their behalf, but several features distinguish themfrom traditional mutual funds Hedge funds have a minimum investment requirement

Hedge Funds

Money Market

Mutual Funds

between $100,000 and $20 million, with the typical minimum investment being $1million Long-Term Capital Management required a $10 million minimum invest-ment Federal law limits hedge funds to have no more than 99 investors (limited part-ners) who must have steady annual incomes of $200,000 or more or a net worth of

$1 million, excluding their homes These restrictions are aimed at allowing hedgefunds to be largely unregulated, on the theory that the rich can look out for them-selves Many of the 4,000 hedge funds are located offshore to escape regulatoryrestrictions

Hedge funds also differ from traditional mutual funds in that they usually requirethat investors commit their money for long periods of time, often several years Thepurpose of this requirement is to give managers breathing room to pursue long-run

Box 3

The Long-Term Capital Management Debacle

Long-Term Capital Management was a hedge fund

with a star cast of managers, including 25 PhDs, two

Nobel Prize winners in economics (Myron Scholes

and Robert Merton), a former vice-chairman of the

Federal Reserve System (David Mullins), and one of

Wall Street’s most successful bond traders (John

Meriwether) It made headlines in September 1998

because its near collapse roiled markets and required

a private rescue plan organized by the Federal

Reserve Bank of New York

The experience of Long-Term Capital

demon-strates that hedge funds are far from risk-free,

despite their use of market-neutral strategies

Long-Term Capital got into difficulties when it thought

that the spread between prices on long-term

Treasury bonds and long-term corporate bonds was

too high, and bet that this “anomaly” would

disap-pear and the spread would narrow In the wake of

the collapse of the Russian financial system in

August 1998, investors increased their assessment of

the riskiness of corporate securities and as we saw in

Chapter 6, the spread between corporates and

Treasuries rose rather than narrowed as Long-Term

Capital had predicted The result was that

Long-Term Capital took big losses on its positions, eating

up much of its equity position

By mid-September, Long-Term Capital was unable

to raise sufficient funds to meet the demands of its

creditors With Long-Term Capital facing the

poten-tial need to liquidate its portfolio of $80 billion insecurities and more than $1 trillion of notional value

in derivatives (discussed in Chapter 13), the FederalReserve Bank of New York stepped in on September

23 and organized a rescue plan with its creditors TheFed’s rationale for stepping in was that a sudden liq-uidation of Long-Term Capital’s portfolio would cre-ate unacceptable systemic risk Tens of billions ofdollars of illiquid securities would be dumped on analready jittery market, causing potentially huge losses

to numerous lenders and other institutions The cue plan required creditors, banks and investmentbanks, to supply an additional $3.6 billion of funds

res-to Long-Term Capital in exchange for much tightermanagement control of funds and a 90% reduction inthe managers’ equity stake In the middle of 1999,John Meriwether began to wind down the fundsoperations

Even though no public funds were expended, theFed’s involvement in organizing the rescue of Long-Term Capital was highly controversial Some criticsargue that the Fed intervention increased moral haz-ard by weakening discipline imposed by the market

on fund managers because future Fed interventions ofthis type would be expected Others think that theFed’s action was necessary to prevent a major shock tothe financial system that could have provoked a finan-cial crisis The debate on whether the Fed should haveintervened is likely to go on for some time

strategies Hedge funds also typically charge large fees to investors The typical fundcharges a 1% annual fee on the assets it manages plus 20% of profits, and some chargesignificantly more Long-Term Capital, for example, charged investors a 2% assetmanagement fee and took 25% of the profits.

The term hedge fund is highly misleading, because the word “hedge” typically

indicates strategies to avoid risk As the near failure of Long-Term Capital illustrates,despite their name, these funds can and do take big risks Many hedge funds engage

in what are called “market-neutral” strategies where they buy a security, such as abond, that seems cheap and sell an equivalent amount of a similar security thatappears to be overvalued If interest rates as a whole go up or down, the fund ishedged, because the decline in value of one security is matched by the rise in value

of the other However, the fund is speculating on whether the spread between theprice on the two securities moves in the direction predicted by the fund managers Ifthe fund bets wrong, it can lose a lot of money, particularly if it has leveraged up itspositions; that is, has borrowed heavily against these positions so that its equity stake

is small relative to the size of its portfolio When Long-Term Capital was rescued, ithad a leverage ratio of 50 to 1; that is, its assets were fifty times larger than its equity,and even before it got into trouble, it was leveraged 20 to 1

In the wake of the near collapse of Long-Term Capital, many U.S politicians havecalled for regulation of these funds However, because many of these funds operateoffshore in places like the Cayman Islands and are outside of U.S jurisdiction, theywould be extremely hard to regulate What U.S regulators can do is ensure that U.S.banks and investment banks have clear guidelines on the amount of lending they canprovide to hedge funds and require that these institutions get the appropriate amount

of disclosure from hedge funds as to the riskiness of their positions

Government Financial Intermediation

The government has become involved in financial intermediation in two basic ways:first, by setting up federal credit agencies that directly engage in financial intermedi-ation and, second, by supplying government guarantees for private loans

To promote residential housing, the government has created three government cies that provide funds to the mortgage market by selling bonds and using the pro-ceeds to buy mortgages: the Government National Mortgage Association (GNMA, or

agen-“Ginnie Mae”), the Federal National Mortgage Association (FNMA, or “Fannie Mae”),and the Federal Home Loan Mortgage Corporation (FHLMC, or “Freddie Mac”).Except for Ginnie Mae, which is a federal agency and is thus an entity of the U.S gov-ernment, the other agencies are federally sponsored agencies (FSEs) that function asprivate corporations with close ties to the government As a result, the debt of spon-sored agencies is not explicitly backed by the U.S government, as is the case forTreasury bonds As a practical matter, however, it is unlikely that the federal govern-ment would allow a default on the debt of these sponsored agencies

Agriculture is another area in which financial intermediation by governmentagencies plays an important role The Farm Credit System (composed of Banks forCooperatives, Farm Credit banks, and various farm credit associations) issues securi-ties and then uses the proceeds to make loans to farmers

Federal Credit

Agencies

In recent years, government financial intermediaries experienced financial culties The Farm Credit System is one example The rising tide of farm bankrupt-cies meant losses in the billions of dollars for the Farm Credit System, and as a result

diffi-it required a bailout from the federal government in 1987 The agency was ized to borrow up to $4 billion to be repaid over a 15-year period and received over

author-$1 billion in assistance There is growing concern in Washington about the health ofthe federal credit agencies To head off government bailouts like that for the FarmCredit System, the Federal Credit Reform Act of 1990 set new rules that require suchagencies to increase their capital to provide a greater cushion to offset any potentiallosses However, there have been growing concerns about Fannie Mae and FreddieMac (Box 4)

Securities Market Operations

The smooth functioning of securities markets, in which bonds and stocks are traded,involves several financial institutions, including securities brokers and dealers, invest-ment banks, and organized exchanges None of these institutions were included in ourlist of financial intermediaries in Chapter 2, because they do not perform the interme-diation function of acquiring funds by issuing liabilities and then using the funds toacquire financial assets Nonetheless, they are important in the process of channelingfunds from savers to spenders and can be thought of as “financial facilitators.”First, however, we must recall the distinction between primary and secondarysecurities markets discussed in Chapter 2 In a primary market, new issues of a secu-rity are sold to buyers by the corporation or government agency borrowing the funds

A secondary market then trades the securities that have been sold in the primary

mar-Box 4

Are Fannie Mae and Freddie Mac Getting Too Big for Their Britches?

With the growth of Fannie Mae and Freddie Mac to

immense proportions, there are rising concerns that

these federally sponsored agencies could threaten the

health of the financial system Fannie Mae and

Freddie Mac either own or insure the risk on close to

half of U.S residential mortgages (amounting to $2

trillion) In fact, their publicly issued debt is well over

half that issued by the federal government A failure

of either of these institutions would therefore pose a

grave shock to the financial system Although the

fed-eral government would be unlikely to stand by and

let them fail, in such a case, the taxpayer would face

substantial costs, as in the S&L crisis

Concerns about the safety and soundness of these

institutions arise because they have much smaller

capital-to-asset ratios than banks Critics also chargethat Fannie Mae and Freddie Mac have become solarge that they wield too much political influence Inaddition, these federally sponsored agencies haveconflicts of interest, because they have to serve twomasters: as publicly traded corporations, they aresupposed to maximize profits for the shareholders,but as government agencies, they are supposed towork in the interests of the public These concernshave led to calls for reform of these agencies, withmany advocating full privatization as was done vol-untarily by the Student Loan Market Association(“Sallie Mae”) in the mid-1990s

ket (and so are secondhand) Investment banks assist in the initial sale of securities in the primary market; securities brokers and dealers assist in the trading of securities in

the secondary markets, some of which are organized into exchanges

When a corporation wishes to borrow (raise) funds, it normally hires the services of aninvestment banker to help sell its securities (Despite its name, an investment banker

is not a banker in the ordinary sense; that is, it is not engaged in financial tion that takes in deposits and then lends them out.) Some of the well-known U.S.investment banking firms are Merrill Lynch, Salomon Smith Barney, Morgan StanleyDean Witter, Goldman Sachs, Lehman Brothers, and Credit Suisse First Boston, whichhave been very successful not only in the United States but outside it as well

intermedia-Investment bankers assist in the sale of securities as follows First, they advise thecorporation on whether it should issue bonds or stock If they suggest that the cor-poration issue bonds, investment bankers give advice on what the maturity and inter-est payments on the bonds should be If they suggest that the corporation should sellstock, they give advice on what the price should be This is fairly easy to do if the firm

has prior issues currently selling in the market, called seasoned issues However, when a firm issues stock for the first time in what is called an initial public offering (IPO), it is more difficult to determine what the correct price should be All the skills

and expertise of the investment banking firm then need to be brought to bear to mine the most appropriate price IPOs have become very important in the U.S econ-omy, because they are a major source of financing for Internet companies, whichbecame all the rage on Wall Street in the late 1990s Not only have IPOs helped thesecompanies to acquire capital to substantially expand their operations, but they havealso made the original owners of these firms very rich Many a nerdy 20- to 30-year-old became an instant millionaire when his stake in his Internet company was given

deter-a high vdeter-aludeter-ation deter-after the initideter-al public offering of shdeter-ares in the compdeter-any However,with the bursting of the tech bubble in 2000, many of them lost much of their wealthwhen the value of their shares came down to earth

When the corporation decides which kind of financial instrument it will issue, it

offers them to underwriters—investment bankers that guarantee the corporation a

price on the securities and then sell them to the public If the issue is small, only oneinvestment banking firm underwrites it (usually the original investment banking firmhired to provide advice on the issue) If the issue is large, several investment bankingfirms form a syndicate to underwrite the issue jointly, thus limiting the risk that anyone investment bank must take The underwriters sell the securities to the generalpublic by contacting potential buyers, such as banks and insurance companies,

directly and by placing advertisements in newspapers like the Wall Street Journal (see

the “Following the Financial News” box)

The activities of investment bankers and the operation of primary markets areheavily regulated by the Securities and Exchange Commission (SEC), which was cre-ated by the Securities and Exchange Acts of 1933 and 1934 to ensure that adequateinformation reaches prospective investors Issuers of new securities to the generalpublic (for amounts greater than $1.5 million in a year with a maturity longer than

270 days) must file a registration statement with the SEC and must provide to tial investors a prospectus containing all relevant information on the securities Theissuer must then wait 20 days after the registration statement is filed with the SECbefore it can sell any of the securities If the SEC does not object during the 20-daywaiting period, the securities can be sold

poten-Investment

Banking

www.ipo.com

The site reports initial

public offering news and

information and includes

advanced search tools for IPO

offerings, venture capital

research reports, and so on.

Securities brokers and dealers conduct trading in secondary markets Brokers act asagents for investors in the purchase or sale of securities Their function is to matchbuyers with sellers, a function for which they are paid brokerage commissions Incontrast to brokers, dealers link buyers and sellers by standing ready to buy and sellsecurities at given prices Therefore, dealers hold inventories of securities and maketheir living by selling these securities for a slightly higher price than they paid forthem—that is, on the “spread” between the asked price and the bid price This can be

a high-risk business because dealers hold securities that can rise or fall in price; inrecent years, several firms specializing in bonds have collapsed Brokers, by contrast,are not as exposed to risk because they do not own the securities involved in theirbusiness dealings

Brokerage firms engage in all three securities market activities, acting as brokers,

dealers, and investment bankers The largest in the United States is Merrill Lynch;other well-known ones are PaineWebber, Morgan Stanley Dean Witter, and SalomonSmith Barney The SEC not only regulates the investment banking operation of thefirms but also restricts brokers and dealers from misrepresenting securities and from

Securities

Brokers and

Dealers

Following the Financial News

Information about new securities being issued is

pre-sented in distinctive advertisements published in the

Wall Street Journal and other newspapers These

advertisements, called “tombstones” because of their

appearance, are typically found in the “Money and

Investing” section of the Wall Street Journal.

The tombstone indicates the number of shares of

stock being issued (5.7 million shares for Cinergy)

and the investment bank involved in selling them

Source: Wall Street Journal, Wednesday, February 12, 2003, p C5.

New Securities Issues

www.sec.gov

The Securities and Exchange

Commission web site contains

regulatory actions, concept

releases, interpretive releases,

Price $31.10 Per Share

Copies of the Prospectus Supplement and the Prospectus to which it relates may be undersigned or other dealers or brokers as may lawfully offer these securities in such State or jurisdiction.

Merrill Lynch & Co.

trading on insider information, nonpublic information known only to the management

of a corporation

The forces of competition led to an important development: Brokerage firmsstarted to engage in activities traditionally conducted by commercial banks In 1977,Merrill Lynch developed the cash management account (CMA), which provides apackage of financial services that includes credit cards, immediate loans, check-writing privileges, automatic investment of proceeds from the sale of securities into amoney market mutual fund, and unified record keeping CMAs were adopted byother brokerage firms and spread rapidly The result is that the distinction betweenbanking activities and the activities of nonbank financial institutions has becomeblurred (see Box 5) Another development is the growing importance of the Internet

in securities markets (Box 6)

As discussed in Chapter 2, secondary markets can be organized either as counter markets, in which trades are conducted using dealers, or as organizedexchanges, in which trades are conducted in one central location The New YorkStock Exchange (NYSE), trading thousands of securities, is the largest organizedexchange in the world, and the American Stock Exchange (AMEX) is a distant second

over-the-A number of smaller regional exchanges, which trade only a small number of ties (under 100), exist in places such as Boston and Los Angeles

securi-Organized stock exchanges actually function as a hybrid of an auction market(in which buyers and sellers trade with each other in a central location) and a dealer

Organized

Exchanges

Box 5

The Return of the Financial Supermarket?

In the 1980s, companies dreamed of creating

“finan-cial supermarkets” in which there would be one-stop

shopping for financial services Consumers would be

able to make deposits into their checking accounts,

buy mutual funds, get a mortgage or a student loan,

get a car or life insurance policy, obtain a credit card,

or buy real estate In the early 1980s, Sears, which

already owned Allstate Insurance and a consumer

finance subsidiary, bought Coldwell Banker Real

Estate and Dean Witter, a brokerage firm It also

acquired a $6 billion California-based savings bank

and introduced its Discover Card Unfortunately, the

concept of the financial supermarket never worked at

Sears (Indeed, the concept was derided as “stocks ’n’

socks.”) Sears’s financial service firms lost money and

Sears began to sell off these businesses in the late

1980s and early 1990s

Sears is not the only firm to find it difficult to

make a go of the financial supermarket concept In

the 1980s, American Express bought Shearson, LoebRhodes, a brokerage and securities firm, only to find

it unprofitable Similarly, Bank of America’s purchase

of Charles Schwab, the discount broker, also proved

to be unprofitable

Citicorp and Travelers Group, which merged inOctober 1998 with the view that Congress wouldremove all barriers to combining banking and non-banking businesses in a financial service firm (whichthe Congress subsequently did in 1999), bet that thefinancial supermarket is an idea whose time has come.Citigroup hopes that the time is right to take advan-tage of economies of scope With Citicorp’s success atretail banking and the credit card business—it is thelargest credit card issuer, with over 60 million out-standing—and Travelers’ success in the insurance andsecurities business, the merged company, Citigroup,hopes to generate huge profits by providing conven-ient financial shopping for the consumer

www.nyse.com

At the New York Stock

Exchange home page, you

will find listed companies,

member information, real-time

market indices, and current

stock quotes.

market (in which dealers make the market by buying and selling securities at givenprices) Securities are traded on the floor of the exchange with the help of a special

kind of dealer-broker called a specialist A specialist matches buy and sell orders

submitted at the same price and so performs a brokerage function However, if buyand sell orders do not match up, the specialist buys stocks or sells from a personalinventory of securities, in this manner performing a dealer function By assumingboth functions, the specialist maintains orderly trading of the securities for which he

or she is responsible

Organized exchanges in which securities are traded are also regulated by the SEC.Not only does the SEC have the authority to impose regulations that govern the behav-ior of brokers and dealers involved with exchanges, but it also has the authority to alterthe rules set by exchanges In 1975, for example, the SEC disallowed rules that set min-imum brokerage commission rates The result was a sharp drop in brokerage commis-sion rates, especially for institutional investors (mutual funds and pension funds), whichpurchase large blocks of stock The Securities Amendments Act of 1975 confirmed theSEC’s action by outlawing the setting of minimum brokerage commissions

Furthermore, the Securities Amendments Act directed the SEC to facilitate anational market system that consolidates trading of all securities listed on the nationaland regional exchanges as well as those traded in the over-the-counter market usingthe National Association of Securities Dealers’ automated quotation system (NASDAQ).Computers and advanced telecommunications, which reduce the costs of linkingthese markets, have encouraged the expansion of a national market system We thussee that legislation and modern computer technology are leading the way to a morecompetitive securities industry

The growing internationalization of capital markets has encouraged another trend

in securities trading Increasingly, foreign companies are being listed on U.S stockexchanges, and the markets are moving toward trading stocks internationally, 24hours a day

The Internet Comes to Wall Street

An important development in recent years is the

growing importance of the Internet in securities

mar-kets Initial public offerings of stock are now being

sold on the Internet, and many brokerage firms allow

clients to conduct securities trades online or to

trans-mit buy and sell orders via e-mail In June of 1999,

Wall Street was rocked by the announcement that itslargest full-service brokerage firm, Merrill Lynch,would begin offering online trading for as little as

$29.95 a trade to its five million customers Nowonline trading is ubiquitous The brokerage businesswill never be the same

Box 6: E-Finance

Summary

1.Insurance providers, which are regulated by the states,

acquire funds by selling policies that pay out benefits if

catastrophic events occur Property and casualty

insurance companies hold more liquid assets than life

insurance companies because of greater uncertaintyregarding the benefits they will have to pay out Allinsurers face moral hazard and adverse selectionproblems that explain the use of insurance management

tools, such as information collection and screening of

potential policyholders, risk-based premiums,

restrictive provisions, prevention of fraud, cancellation

of insurance, deductibles, coinsurance, and limits on

the amount of insurance

2. Pension plans provide income payments to people

when they retire after contributing to the plans for

many years Pension funds have experienced very rapid

growth as a result of encouragement by federal tax

policy and now play an important role in the stock

market Many pension plans are underfunded, which

means that in future years they will have to pay out

higher benefits than the value of their contributions and

earnings The problem of underfunding is especially

acute for public pension plans such as Social Security

To prevent abuses, Congress enacted the Employee

Retirement Income Security Act (ERISA), which

established minimum standards for reporting, vesting,

and degree of underfunding of private pension plans

This act also created the Pension Benefit Guarantee

Corporation, which insures pension benefits

3. Finance companies raise funds by issuing commercial

paper and stocks and bonds and use the proceeds to

make loans that are particularly suited to consumer and

business needs Virtually unregulated in comparison tocommercial banks and thrift institutions, financecompanies have been able to tailor their loans tocustomer needs very quickly and have grown rapidly

4. Mutual funds sell shares and use the proceeds to buysecurities Open-end funds issue shares that can beredeemed at any time at a price tied to the asset value

of the firm Closed-end funds issue nonredeemableshares, which are traded like common stock They areless popular than open-end funds because their sharesare not as liquid Money market mutual funds holdonly short-term, high-quality securities, allowingshares to be redeemed at a fixed value using checks.Shares in these funds effectively function as checkabledeposits that earn market interest rates All mutualfunds are regulated by the Securities and ExchangeCommission (SEC)

5. Investment bankers assist in the initial sale of securities

in primary markets, whereas securities brokers anddealers assist in the trading of securities in thesecondary markets, some of which are organized intoexchanges The SEC regulates the financial institutions

in the securities markets and ensures that adequateinformation reaches prospective investors

hedge fund, p 299initial public offering (IPO), p 303load funds, p 299

no-load funds, p 299

open-end fund, p 298reinsurance, p 290seasoned issue, p 303specialist, p 306underfunded, p 294underwriters, p 303

Questions and Problems

Questions marked with an asterisk are answered at the end

of the book in an appendix, “Answers to Selected Questions

and Problems.”

*1.If death rates were to become less predictable than

they are, how would life insurance companies change

the types of assets they hold?

2. Why do property and casualty insurance companieshave large holdings of municipal bonds but life insur-ance companies do not?

*3. Why are all defined contribution pension plans fullyfunded?

4. How can favorable tax treatment of pension plansencourage saving?

QUIZ

*5. “In contrast to private pension plans, government

pension plans are rarely underfunded.” Is this

state-ment true, false, or uncertain? Explain your answer

6. What explains the widespread use of deductibles in

insurance policies?

*7. Why might insurance companies restrict the amount

of insurance a policyholder can buy?

8. Why are restrictive provisions a necessary part of

insurance policies?

*9. If you needed to take out a loan, why might you first

go to your local bank rather than to a finance

com-pany?

10. Explain why shares in closed-end mutual funds

typi-cally sell for less than the market value of the stocks

they hold

*11.Why might you buy a no-load mutual fund instead of

a load fund?

12. Why can a money market mutual fund allow its

shareholders to redeem shares at a fixed price but

other mutual funds cannot?

*13.Why might government loan guarantees be a

high-cost way for the government to subsidize certain

activities?

14. If you like to take risks, would you rather be a dealer,

a broker, or a specialist? Why?

*15.Is investment banking a good career for someone who

is afraid of taking risks? Why or why not?

b What is the next IPO to be offered to the public?

c How many IPOs were priced this year?

2. The Federal Reserve maintains extensive data on financecompanies Go to www.federalreserve.gov/releasesandscroll down until you find G.20 Finance Companies.Click on “Releases” and find the current release

a Review the terms of credit for new car loans What

is the most recent average interest rate and what isthe term to maturity? How much is the averagenew car loan offered by finance companies?

b Do finance companies make more consumer loans,real estate loans, or business loans?

c Which type of loan has grown most rapidly overthe last 5 years?

PREVIEW Starting in the 1970s and increasingly in the 1980s and 1990s, the world became a

riskier place for the financial institutions described in this part of the book Swings ininterest rates widened, and the bond and stock markets went through some episodes

of increased volatility As a result of these developments, managers of financial tutions became more concerned with reducing the risk their institutions faced Giventhe greater demand for risk reduction, the process of financial innovation described

insti-in Chapter 9 came to the rescue by producinsti-ing new finsti-inancial insti-instruments that help

financial institution managers manage risk better These instruments, called financial derivatives, have payoffs that are linked to previously issued securities and are

extremely useful risk reduction tools

In this chapter, we look at the most important financial derivatives that managers

of financial institutions use to reduce risk: forward contracts, financial futures,options, and swaps We examine not only how markets for each of these financialderivatives work but also how they can be used by financial institutions to managerisk We also study financial derivatives because they have become an importantsource of profits for financial institutions, particularly larger banks, which, as we saw

in Chapter 10, have found their traditional business declining

Hedging

Financial derivatives are so effective in reducing risk because they enable financial

institutions to hedge; that is, engage in a financial transaction that reduces or

elimi-nates risk When a financial institution has bought an asset, it is said to have taken a

long position, and this exposes the institution to risk if the returns on the asset are

uncertain On the other hand, if it has sold an asset that it has agreed to deliver to

another party at a future date, it is said to have taken a short position, and this can

also expose the institution to risk Financial derivatives can be used to reduce risk by

invoking the following basic principle of hedging: Hedging risk involves engaging in

a financial transaction that offsets a long position by taking an additional short position, or offsets a short position by taking an additional long position In other

words, if a financial institution has bought a security and has therefore taken a long position, it conducts a hedge by contracting to sell that security (take a short position)

at some future date Alternatively, if it has taken a short position by selling a security that it needs to deliver at a future date, then it conducts a hedge by contracting to buy

309

Chap ter

Financial Derivatives

13