Role Of Financial Markets And Institutions ESSAY

Role Of Financial Markets And Institutions

1 Role of Financial Markets and Institutions

CHAPTER OBJECTIVES

The specific objectives of this chapter are to:

· ▪ describe the types of financial markets that facilitate the flow of funds,

· ▪ describe the types of securities traded within financial markets,

· ▪ describe the role of financial institutions within financial markets, and

· ▪ explain how financial institutions were exposed to the credit crisis.

A financial market is a market in which financial assets (securities) such as stocks and bonds can be purchased or sold. Funds are transferred in financial markets when one party purchases financial assets previously held by another party. Financial markets facilitate the flow of funds and thereby allow financing and investing by households, firms, and government agencies. This chapter provides some background on financial markets and on the financial institutions that participate in them.

1-1 ROLE OF FINANCIAL MARKETS

Financial markets transfer funds from those who have excess funds to those who need funds. They enable college students to obtain student loans, families to obtain mortgages, businesses to finance their growth, and governments to finance many of their expenditures. Many households and businesses with excess funds are willing to supply funds to financial markets because they earn a return on their investment. If funds were not supplied, the financial markets would not be able to transfer funds to those who need them.

Those participants who receive more money than they spend are referred to as surplus units (or investors). They provide their net savings to the financial markets. Those participants who spend more money than they receive are referred to as deficit units . They access funds from financial markets so that they can spend more money than they receive. Many individuals provide funds to financial markets in some periods and access funds in other periods.

EXAMPLE

College students are typically deficit units, as they often borrow from financial markets to support their education. After they obtain their degree, they earn more income than they spend and thus become surplus units by investing their excess funds. A few years later, they may become deficit units again by purchasing a home. At this stage, they may provide funds to and access funds from financial markets simultaneously. That is, they may periodically deposit savings in a financial institution while also borrowing a large amount of money from a financial institution to buy a home.

Many deficit units such as firms and government agencies access funds from financial markets by issuing securities , which represent a claim on the issuer. Debt securities represent debt (also called credit, or borrowed funds) incurred by the issuer. Deficit units that issue the debt securities are borrowers. The surplus units that purchase debt securities are creditors, and they receive interest on a periodic basis (such as every six months). Debt securities have a maturity date, at which time the surplus units can redeem the securities in order to receive the principal (face value) from the deficit units that issued them.

Equity securities (also called stocks) represent equity or ownership in the firm. Some large businesses prefer to issue equity securities rather than debt securities when they need funds but might not be financially capable of making the periodic interest payments required for debt securities.

1-1a Accommodating Corporate Finance Needs

A key role of financial markets is to accommodate corporate finance activity. Corporate finance (also called financial management) involves corporate decisions such as how much funding to obtain and what types of securities to issue when financing operations. The financial markets serve as the mechanism whereby corporations (acting as deficit units) can obtain funds from investors (acting as surplus units).

1-1b Accommodating Investment Needs

Another key role of financial markets is accommodating surplus units who want to invest in either debt or equity securities. Investment management involves decisions by investors regarding how to invest their funds. The financial markets offer investors access to a wide variety of investment opportunities, including securities issued by the U.S. Treasury and government agencies as well as securities issued by corporations.

Financial institutions (discussed later in this chapter) serve as intermediaries within the financial markets. They channel funds from surplus units to deficit units. For example, they channel funds received from individuals to corporations. Thus they connect the investment management activity with the corporate finance activity, as shown in Exhibit 1.1 . They also commonly serve as investors and channel their own funds to corporations.

WEB

www.nyse.com

New York Stock Exchange market summary, quotes, financial statistics, and more.

www.nasdaq.com

Comprehensive historic and current data on all Nasdaq transactions.

1-1c Primary versus Secondary Markets

Primary markets facilitate the issuance of new securities. Secondary markets facilitate the trading of existing securities, which allows for a change in the ownership of the securities. Many types of debt securities have a secondary market, so that investors who initially purchased them in the primary market do not have to hold them until maturity. Primary market transactions provide funds to the initial issuer of securities; secondary market transactions do not.

EXAMPLE

Last year, Riverto Co. had excess funds and invested in newly issued Treasury debt securities with a 10-year maturity. This year, it will need $15 million to expand its operations. The company decided to sell its holdings of Treasury debt securities in the secondary market even though those securities will not mature for nine more years. It received $5 million from the sale. In also issued its own debt securities in the primary market today in order to obtain an additional $10 million. Riverto’s debt securities have a 10-year maturity, so investors that purchase them can redeem them at maturity (in 10 years) or sell them before that time to other investors in the secondary market.

Exhibit 1.1 How Financial Markets Facilitate Corporate Finance and Investment Management

An important characteristic of securities that are traded in secondary markets is liquidity , which is the degree to which securities can easily be liquidated (sold) without a loss of value. Some securities have an active secondary market, meaning that there are many willing buyers and sellers of the security at a given moment in time. Investors prefer liquid securities so that they can easily sell the securities whenever they want (without a loss in value). If a security is illiquid, investors may not be able to find a willing buyer for it in the secondary market and may have to sell the security at a large discount just to attract a buyer.

Treasury securities are liquid because they are frequently issued by the Treasury, and there are many investors at any point in time who want to invest in them. Conversely, debt securities issued by a small firm may be illiquid, as there are not many investors who may want to invest in them. Thus investors who purchase these securities in the primary market may not be able to easily sell them in the secondary market.

1-2 SECURITIES TRADED IN FINANCIAL MARKETS

Securities can be classified as money market securities, capital market securities, or derivative securities.

1-2a Money Market Securities

Money markets facilitate the sale of short-term debt securities by deficit units to surplus units. The securities traded in this market are referred to as money market securities , which are debt securities that have a maturity of one year or less. These generally have a relatively high degree of liquidity, not only because of their short-term maturity but also because they are desirable to many investors and therefore commonly have an active secondary market. Money market securities tend to have a low expected return but also a low degree of credit (default) risk. Common types of money market securities include Treasury bills (issued by the U.S. Treasury), commercial paper (issued by corporations), and negotiable certificates of deposit (issued by depository institutions).

1-2b Capital Market Securities

Capital markets facilitate the sale of long-term securities by deficit units to surplus units. The securities traded in this market are referred to as capital market securities . Capital market securities are commonly issued to finance the purchase of capital assets, such as buildings, equipment, or machinery. Three common types of capital market securities are bonds, mortgages, and stocks, which are described in turn.

WEB

www.investinginbonds.com

Data and other information about bonds.

Bonds Bonds are long-term debt securities issued by the Treasury, government agencies, and corporations to finance their operations. They provide a return to investors in the form of interest income (coupon payments) every six months. Since bonds represent debt, they specify the amount and timing of interest and principal payments to investors who purchase them. At maturity, investors holding the debt securities are paid the principal. Bonds commonly have maturities of between 10 and 20 years.

Treasury bonds are perceived to be free from default risk because they are issued by the U.S. Treasury. In contrast, bonds issued by corporations are subject to default risk because the issuer could default on its obligation to repay the debt. These bonds must offer a higher expected return than Treasury bonds in order to compensate investors for that default risk.

Bonds can be sold in the secondary market if investors do not want to hold them until maturity. Because the prices of debt securities change over time, they may be worthless when sold in the secondary market than when they were purchased.

Mortgages Mortgages are long-term debt obligations created to finance the purchase of real estate. Residential mortgages are obtained by individuals and families to purchase homes. Financial institutions serve as lenders by providing residential mortgages in their role as a financial intermediary. They can pool deposits received from surplus units, and lend those funds to an individual who wants to purchase a home. Before granting mortgages, they assess the likelihood that the borrower will repay the loan based on certain criteria such as the borrower’s income level relative to the value of the home. They offer prime mortgages to borrowers who qualify based on these criteria. The home serves as collateral in the event that the borrower is not able to make the mortgage payments.

Subprime mortgages are offered to some borrowers who do not have sufficient income to qualify for prime mortgages or who are unable to make a down payment. Subprime mortgages exhibit a higher risk of default, thus the lenders providing these mortgages charge a higher interest rate (and additional up-front fees) to compensate. Subprime mortgages received much attention in 2008 because of their high default rates, which led to the credit crisis. Many lenders are no longer willing to provide subprime mortgages, and recent regulations (described later in this chapter) raise the minimum qualifications necessary to obtain a mortgage.

Commercial mortgages are long-term debt obligations created to finance the purchase of commercial property. Real estate developers rely on commercial mortgages so they can build shopping centers, office buildings, or other facilities. Financial institutions serve as lenders by providing commercial mortgages. By channeling funds from surplus units (depositors) to real estate developers, they serve as a financial intermediary and facilitate the development of commercial real estate.

Mortgage-Backed Securities Mortgage-backed securities are debt obligations representing claims on a package of mortgages. There are many forms of mortgage-backed securities. In their simplest form, the investors who purchase these securities receive monthly payments that are made by the homeowners on the mortgages backing the securities.

EXAMPLE

Mountain Savings Bank originates 100 residential mortgages for home buyers and will service the mortgages by processing the monthly payments. However, the bank does not want to use its own funds to finance the mortgages. It issues mortgage-backed securities that represent this package of mortgages to eight financial institutions that are willing to purchase all of these securities. Each month, when Mountain Savings Bank receives interest and principal payments on the mortgages, it passes those payments on to the eight financial institutions that purchased the mortgage-backed securities and thereby provided the financing to the homeowners. If some of the homeowners default on their payments, the payments, and thus the return on investment earned by the financial institutions that purchased the mortgage-backed securities, will be reduced. The securities they purchased are backed (collateralized) by the mortgages.

In many cases, the financial institution that originates the mortgage is not accustomed to the process of issuing mortgage-backed securities. If Mountain Savings Bank is unfamiliar with the process, another financial institution may participate by bundling Mountain’s 100 mortgages with mortgages originated by other institutions. Then the financial institution issues mortgage-backed securities that represent all the mortgages in the bundle. Thus any investor that purchases these mortgage-backed securities is partially financing the 100 mortgages at Mountain Savings Bank and all the other mortgages in the bundle that are backing these securities.

As housing prices increased in the 2004–2006 period, many financial institutions used their funds to purchase mortgage-backed securities, some of which represented bundles of subprime mortgages. These financial institutions incorrectly presumed that the homes would serve as sufficient collateral if the mortgages defaulted. In 2008, many subprime mortgages defaulted and home prices plummeted, which meant that the collateral was not adequate to cover the credit provided. Consequently, the values of mortgage-backed securities also plummeted, and the financial institutions holding these securities experienced major losses.

Stocks Stocks (or equity securities) represent partial ownership in the corporations that issue them. They are classified as capital market securities because they have no maturity and therefore serve as a long-term source of funds. Investors who purchase stocks (referred to as stockholders) issued by a corporation in the primary market can sell the stocks to other investors at any time in the secondary market. However, stocks of some corporations are more liquid than stocks of others. More than a million shares of stocks of large corporations are traded in the secondary market on any given day, as there are many investors who are willing to buy them. Stocks of small corporations are less liquid, because the secondary market is not as active.

Some corporations provide income to their stockholders by distributing a portion of their quarterly earnings in the form of dividends. Other corporations retain and reinvest all of their earnings in their operations, which increase their growth potential.

As corporations grow and increase in value, the value of their stock increases; investors can then earn a capital gain from selling the stock for a higher price than they paid for it. Thus, investors can earn a return from stocks in the form of periodic dividends (if there are any) and in the form a capital gain when they sell the stock. However, stocks are subject to risk because their future prices are uncertain. Their prices commonly decline when the firm performs poorly, resulting in negative returns to investors.

1-2c Derivative Securities

In addition to money market and capital market securities, derivative securities are also traded in financial markets. Derivative securities are financial contracts whose values are derived from the values of underlying assets (such as debt securities or equity securities). Many derivative securities enable investors to engage in speculation and risk management.

WEB

www.cboe.com

Information about derivative securities.

Speculation Derivative securities allow an investor to speculate on movements in the value of the underlying assets without having to purchase those assets. Some derivative securities allow investors to benefit from an increase in the value of the underlying assets, whereas others allow investors to benefit from a decrease in the assets’ value. Investors who speculate in derivative contracts can achieve higher returns than if they had speculated in the underlying assets, but they are also exposed to higher risk.

Risk Management Derivative securities can be used in a manner that will generate gains if the value of the underlying assets declines. Consequently, financial institutions and other firms can use derivative securities to adjust the risk of their existing investments in securities. If a firm maintains investments in bonds, it can take specific positions in derivative securities that will generate gains if bond values decline. In this way, derivative securities can be used to reduce a firm’s risk. The loss on the bonds is offset by the gains on these derivative securities.

1-2d Valuation of Securities

Each type of security generates a unique stream of expected cash flows to investors. The valuation of a security is measured as the present value of its expected cash flows, discounted at a rate that reflects the uncertainty surrounding the cash flows.

Debt securities are easier to value because they promise to investors specific payments (interest and principal) until they mature. The stream of cash flows generated by stocks is more difficult to estimate because some stocks do not pay dividends, and so investors receive cash flow only when they sell the stock. All investors sell the stock at different times. Thus some investors choose to value a stock by valuing the company and then dividing that value by the number of shares of stock.

Impact of Information on Valuation Investors can attempt to estimate the future cash flows that they will receive by obtaining information that may influence a security’s future cash flows. The valuation process is illustrated in Exhibit 1.2 .

Some investors rely mostly on economic or industry information to value a security, whereas others rely more on published opinions about the firm’s management. When investors receive new information about a security that clearly indicates the likelihood of higher cash flows or less uncertainty surrounding the cash flows, they revise their valuations of that security upward. As a result, investors increase the demand for the security. In addition, investors that previously purchased that security and were planning to sell the security in the secondary market may decide not to sell. This results in a smaller supply of that security for sale (by investors who had previously purchased it) in the secondary market. Thus the market price of the security rises to a new equilibrium level.

Conversely, when investors receive unfavorable information, they reduce the expected cash flows or increase the discount rate used in valuation. The valuations of the security are revised downward, which results in a lower demand and an increase in the supply of that security for sale in the secondary market. Consequently, there is a decline in the equilibrium price.

Exhibit 1.2 Use of Information to Make Investment Decisions

In an efficient market , securities are rationally priced. If a security is clearly undervalued based on public information, some investors will capitalize on the discrepancy by purchasing that security. This strong demand for the security will push the security’s price higher until the discrepancy no longer exists. The investors who recognized the discrepancy will be rewarded with higher returns on their investment. Their actions to capitalize on valuation discrepancies typically push security prices toward their proper price levels, based on the information that is available.

Impact of the Internet on Valuation The Internet has improved the valuation of securities in several ways. Prices of securities are quoted online and can be obtained at any given moment by investors. For some securities, investors can track the actual sequence of transactions. Because much more information about the firms that issue securities is available online, securities can be priced more accurately. Furthermore, orders to buy or sell many types of securities can be submitted online, which expedites the adjustment in security prices to new information.

WEB

finance.yahoo.com

Market quotations and overview of financial market activity.

Impact of Behavioral Finance on Valuation In some cases, a security may be mispriced because of the psychology involved in the decision making. Behavioral finance is the application of psychology to make financial decisions. It offers a reason why markets are not always efficient.

EXAMPLE

When Facebook issued stock to the public in May 2012, many critics suggested that the initial high stock price was influenced by market hype rather than fundamentals (such as its expected cash flows). Some of Facebook’s customers may invest in Facebook’s stock because they commonly use Facebook’s services, without really considering whether the stock price was appropriate. Facebook’s stock price declined by about 50 percent in a few months as the hype in the stock market wore off.

Behavioral finance can sometimes explain the movements of a security’s price or even of the entire stock market. In some periods, investors seem to be excessively optimistic, and their stock-buying frenzy can push the prices of the entire stock market higher. This leads to a stock price bubble that bursts once investors consider fundamental characteristics (such as a firm’s cash flows) rather than hype when valuing a stock.

Uncertainty Surrounding Valuation of Securities Even if markets are efficient, the valuation of a firm’s security is subject to much uncertainty because investors have limited information available to value that security. Furthermore, the return from investing in a security over a particular period is typically uncertain because the cash flows to be received by investors over that period is uncertain. The higher the degree of uncertainty, the higher is the risk from investing in that security. From the perspective of an investor who purchases a security, risk represents the potential deviation of the security’s actual return from what was expected. For any given type of security, risk levels among the issuers of that security can vary.

EXAMPLE

Nike stock provides cash flows to investors in the form of quarterly dividends and when an investor sells the stock. Both the future dividends and the future stock price are uncertain. Thus the cash flows that Nike stock will provide to investors over a future period are uncertain, which means that the return from investing in Nike stock over that period is uncertain.

Yet the cash flow provided by Nike’s stock is less uncertain than that provided by a small, young, publicly traded technology company. Because the return on the technology stock over a particular period is more uncertain than the return on Nike stock, the technology stock has more risk.

1-2e Securities Regulations

Much of the information that investors use to value securities issued by firms is provided in the form of financial statements by those firms. In particular, investors rely on accounting reports of a firm’s revenue and expenses as a basis for estimating its future cash flows. Although firms with publicly traded stock are required to disclose financial information and financial statements, a firm’s managers still possess information about its financial condition that is not necessarily available to investors. This situation is referred to as asymmetric information. Even when information is disclosed, an asymmetric information problem may still exist if some of the information provided by the firm’s managers is intentionally misleading in order to exaggerate the firm’s performance.

Required Disclosure Many regulations exist that attempt to ensure that businesses disclose accurate financial information. Similarly, when information is disclosed to only a small set of investors, those investors have a major advantage over other investors. Thus another regulatory goal is to provide all investors with equal access to disclosures by firms. The Securities Act of 1933 was intended to ensure complete disclosure of relevant financial information on publicly offered securities and to prevent fraudulent practices in selling these securities.

WEB

www.sec.gov

Background on the Securities and Exchange Commission, and news releases about financial regulations.

The Securities Exchange Act of 1934 extended the disclosure requirements to secondary market issues. It also declared illegal a variety of deceptive practices, such as misleading financial statements and trading strategies designed to manipulate the market price. In addition, it established the Securities and Exchange Commission (SEC) to oversee the securities markets, and the SEC has implemented additional regulations over time. Securities laws do not prevent investors from making poor investment decisions; they seek only to ensure full disclosure of information and thereby protect against fraud.

Regulatory Response to Financial Reporting Scandals Financial scandals that occurred in the 2001–2002 period proved that the existing regulations were not sufficient to prevent fraud. Several well-known companies such as Enron and WorldCom misled investors by exaggerating their earnings. They also failed to disclose relevant information that would have adversely affected the prices of their stock and debt securities. Firms that have issued stock and debt securities must hire independent auditors to verify that their financial information is accurate. However, in some cases, the auditors who were hired to ensure accuracy were not meeting their responsibility.

In response to the financial scandals, the Sarbanes-Oxley Act (discussed throughout this text) was passed to require that firms provide more complete and accurate financial information. It also imposed restrictions to ensure proper auditing by auditors and proper oversight by the firm’s board of directors. These rules were intended to regain the trust of investors who supply the funds to the financial markets. Through these measures, regulators tried to eliminate or at least reduce the asymmetric information problem.

However, the Sarbanes-Oxley Act did not completely eliminate questionable accounting methods. In 2011 and 2012, Groupon Inc. used accounting methods that inflated its reported earnings. As these accounting methods were criticized by the financial media during 2012, the stock price of Groupon declined by about 85 percent.

1-2f International Securities Transactions

Financial markets are continuously being developed throughout the world to improve the transfer of securities between surplus units and deficit units. The financial markets are much more developed in some countries than in others, and they also vary in terms of the volumes of funds transferred from surplus to deficit units. Some countries have more developed financial markets for specific securities, and other countries (in Eastern Europe and Asia, for example) have established financial markets recently.

Under favorable economic conditions, the international integration of securities markets allows governments and corporations easier access to funding from creditors or investors in other countries to support their growth. In addition, investors and creditors in any country can benefit from the investment opportunities in other countries. Yet, under unfavorable economic conditions, the international integration of securities markets allows one country’s financial problems to adversely affect other countries. The U.S. financial markets allow foreign investors to pursue investment opportunities in the United States, but during the U.S. financial crisis, many foreign investors who invested in U.S. securities experienced severe losses. Thus the U.S. financial crisis spread beyond the United States.

Many European governments borrow funds from creditors in many different countries, but as the governments of Greece, Portugal, and Spain struggled to repay their loans, they caused financial problems for some creditors in other countries. Economic conditions are more closely connected because of the international integration of securities markets, and this causes each country to be more exposed to the economic conditions of other countries.

Foreign Exchange Market International financial transactions normally require the exchange of currencies. The foreign exchange market facilitates this exchange. Many commercial banks and other financial institutions serve as intermediaries in the foreign exchange market by matching up participants who want to exchange one currency for another. Some of these financial institutions also serve as dealers by taking positions in currencies to accommodate foreign exchange requests.

Like securities, most currencies have a market-determined price (exchange rate) that changes in response to supply and demand. If there is a sudden shift in the aggregate demand by corporations, government agencies, and individuals for a given currency, or a shift in the aggregate supply of that currency for sale (to be exchanged for another currency), the price of the currency (exchange rate) will change.

1-2g Government Intervention in Financial Markets

In recent years, the government has increased its role in financial markets. Consider the following examples.

· 1. During the credit crisis, the Federal Reserve purchased various types of debt securities. The intervention was intended to ensure more liquidity in the debt securities markets, and therefore encourage investors to purchase debt securities.

· 2. New government regulations changed the manner by which the credit risk of bonds were assessed. The new regulations occurred because of criticisms about the previous process used for rating bonds that did not effectively warn investors about the credit risk of bonds during the credit crisis.

· 3. The government increased its monitoring of stock trading, and prosecuted cases in which investors traded based on inside information about firms that was not available to other investors. The increased government efforts were intended to ensure that no investor had an unfair advantage when trading in financial markets.

These examples illustrate how the government has increased its efforts to ensure fair and orderly financial markets, which could encourage more investors to participate in the markets, and therefore could increase liquidity.

1-3 ROLE OF FINANCIAL INSTITUTIONS

Because financial markets are imperfect, securities buyers and sellers do not have full access to information. Individuals with available funds are not normally capable of identifying credit worthy borrowers to whom they could lend those funds. In addition, they do not have the expertise to assess the creditworthiness of potential borrowers. Financial institutions are needed to resolve the limitations caused by market imperfections. They accept funds from surplus units and channel the funds to deficit units. Without financial institutions, the information and transaction costs of financial market transactions would be excessive. Financial institutions can be classified as depository and nondepository institutions.

1-3a Role of Depository Institutions

Depository institutions accept deposits from surplus units and provide credit to deficit units through loans and purchases of securities. They are popular financial institutions for the following reasons.

· ▪ They offer deposit accounts that can accommodate the amount and liquidity characteristics desired by most surplus units.

· ▪ They repackage funds received from deposits to provide loans of the size and maturity desired by deficit units.

· ▪ They accept the risk on loans provided.

· ▪ They have more expertise than individual surplus units in evaluating the creditworthiness of deficit units.

· ▪ They diversify their loans among numerous deficit units and therefore can absorb defaulted loans better than individual surplus units could.

To appreciate these advantages, consider the flow of funds from surplus units to deficit units if depository institutions did not exist. Each surplus unit would have to identify a deficit unit desiring to borrow the precise amount of funds available for the precise time period in which funds would be available. Furthermore, each surplus unit would have to perform the credit evaluation and incur the risk of default. Under these conditions, many surplus units would likely hold their funds rather than channel them to deficit units. Hence, the flow of funds from surplus units to deficit units would be disrupted.

When a depository institution offers a loan, it is acting as a creditor, just as if it had purchased a debt security. The more personalized loan agreement is less marketable in the secondary market than a debt security, however, because the loan agreement contains detailed provisions that can differ significantly among loans. Potential investors would need to review all provisions before purchasing loans in the secondary market.

A more specific description of each depository institution’s role in the financial markets follows.

Commercial Banks In aggregate, commercial banks are the most dominant depository institution. They serve surplus units by offering a wide variety of deposit accounts, and they transfer deposited funds to deficit units by providing direct loans or purchasing debt securities. Commercial bank operations are exposed to risk because their loans and many of their investments in debt securities are subject to the risk of default by the borrowers.

Commercial banks serve both the private and public sectors; their deposit and lending services are utilized by households, businesses, and government agencies. Some commercial banks (including Bank of America, J.P. Morgan Chase, Citigroup, and Sun Trust Banks) have more than $100 billion in assets.

Some commercial banks receive more funds from deposits than they need to make loans or invest in securities. Other commercial banks need more funds to accommodate customer requests than the amount of funds that they receive from deposits. The federal funds market facilitates the flow of funds between depository institutions (including banks). A bank that has excess funds can lend to a bank with deficient funds for a short-term period, such as one to five days. In this way, the federal funds market facilitates the flow of funds from banks that have excess funds to banks that are in need of funds.

WEB

www.fdic.gov

Information and news about banks and savings institutions.

Commercial banks are subject to regulations that are intended to limit their exposure to the risk of failure. In particular, banks are required to maintain a minimum level of capital, relative to their size, so that they have a cushion to absorb possible losses from defaults on some loans provided to households or businesses. The Federal Reserve (“the Fed”) serves as a regulator of banks.

Savings Institutions Savings institutions, which are sometimes referred to as thrift institutions, are another type of depository institution. Savings institutions include savings and loan associations (S&Ls) and savings banks. Like commercial banks, savings institutions offer deposit accounts to surplus units and then channel these deposits to deficit units. Savings banks are similar to S&Ls except that they have more diversified uses of funds. Over time, however, this difference has narrowed. Savings institutions can be owned by shareholders, but most are mutual (depositor owned). Like commercial banks, savings institutions rely on the federal funds market to lend their excess funds or to borrow funds on a short-term basis.

Whereas commercial banks concentrate on commercial (business) loans, savings institutions concentrate on residential mortgage loans. Normally, mortgage loans are perceived to exhibit a relatively low level of risk, but many mortgages defaulted in 2008 and 2009. This led to the credit crisis and caused financial problems for many savings institutions.

Credit Unions Credit unions differ from commercial banks and savings institutions in that they (1) are nonprofit and (2) restrict their business to credit union members, who share a common bond (such as a common employer or union). Like savings institutions, they are sometimes classified as thrift institutions in order to distinguish them from commercial banks. Because of the “common bond” characteristic, credit unions tend to be much smaller than other depository institutions. They use most of their funds to provide loans to their members. Some of the largest credit unions (e.g., the Navy Federal Credit Union, the State Employees Credit Union of North Carolina, the Pentagon Federal Credit Union) have assets of more than $5 billion.

1-3b Role of Nondepository Financial Institutions

Nondepository institutions generate funds from sources other than deposits but also play a major role in financial intermediation. These institutions are briefly described here and are covered in more detail in Part 7.

Finance Companies Most finance companies obtain funds by issuing securities and then lend the funds to individuals and small businesses. The functions of finance companies and depository institutions overlap, although each type of institution concentrates on a particular segment of the financial markets (explained in the chapters devoted to these institutions).

Mutual Funds Mutual funds sell shares to surplus units and use the funds received to purchase a portfolio of securities. They are the dominant nondepository financial institution when measured in total assets. Some mutual funds concentrate their investment in capital market securities, such as stocks or bonds. Others, known as money market mutual funds , concentrate in money market securities. Typically, mutual funds purchase securities in minimum denominations that are larger than the savings of an individual surplus unit. By purchasing shares of mutual funds and money market mutual funds, small savers are able to invest in a diversified portfolio of securities with a relatively small amount of funds.

WEB

finance.yahoo.com/funds

Information about mutual funds.

Securities Firms Securities firms provide a wide variety of functions in financial markets. Some securities firms act as a broker , executing securities transactions between two parties. The broker fee for executing a transaction is reflected in the difference (or spread ) between the bid quote and the ask quote . The markup as a percentage of the transaction amount will likely be higher for less common transactions, since more time is needed to match up buyers and sellers. The markup will also likely be higher for transactions involving relatively small amounts so that the broker will be adequately compensated for the time required to execute the transaction.

Furthermore, securities firms often act as dealers , making a market in specific securities by maintaining an inventory of securities. Although a broker’s income is mostly based on the markup, the dealer’s income is influenced by the performance of the security portfolio maintained. Some dealers also provide brokerage services and therefore earn income from both types of activities.

In addition to brokerage and dealer services, securities firms also provide underwriting and advising services. The underwriting and advising services are commonly referred to as investment banking, and the securities firms that specialize in these services are sometimes referred to as investment banks. Some securities firms place newly issued securities for corporations and government agencies; this task differs from traditional brokerage activities because it involves the primary market. When securities firms underwrite newly issued securities, they may sell the securities for a client at a guaranteed price or may simply sell the securities at the best price they can get for their client.

Some securities firms offer advisory services on mergers and other forms of corporate restructuring. In addition to helping a company plan its restructuring, the securities firm also executes the change in the client’s capital structure by placing the securities issued by the company.

Insurance Companies Insurance companies provide individuals and firms with insurance policies that reduce the financial burden associated with death, illness, and damage to property. These companies charge premiums in exchange for the insurance that they provide. They invest the funds received in the form of premiums until the funds are needed to cover insurance claims. Insurance companies commonly invest these funds in stocks or bonds issued by corporations or in bonds issued by the government. In this way, they finance the needs of deficit units and thus serve as important financial intermediaries. Their overall performance is linked to the performance of the stocks and bonds in which they invest. Large insurance companies include State Farm Group, Allstate Insurance, Travelers Group, CNA Insurance, and Liberty Mutual.

Pension Funds Many corporations and government agencies offer pension plans to their employees. The employees and their employers (or both) periodically contribute funds to the plan. Pension funds provide an efficient way for individuals to save for their retirement. The pension funds manage the money until the individuals with draw the funds from their retirement accounts. The money that is contributed to individual retirement accounts is commonly invested by the pension funds in stocks or bonds issued by corporations or in bonds issued by the government. Thus pension funds are important financial intermediaries that finance the needs of deficit units.

1-3c Comparison of Roles among Financial Institutions

The role of financial institutions in facilitating the flow of funds from individual surplus units (investors) to deficit units is illustrated in Exhibit 1.3 . Surplus units are shown on the left side of the exhibit, and deficit units are shown on the right. Three different flows of funds from surplus units to deficit units are shown in the exhibit. One set of flows represents deposits from surplus units that are transformed by depository institutions into loans for deficit units. A second set of flows represents purchases of securities (commercial paper) issued by finance companies that are transformed into finance company loans for deficit units. A third set of flows reflects the purchases of shares issued by mutual funds, which are used by the mutual funds to purchase debt and equity securities of deficit units.

The deficit units also receive funding from insurance companies and pension funds. Because insurance companies and pension funds purchase massive amounts of stocks and bonds, they finance much of the expenditures made by large deficit units, such as corporations and government agencies. Financial institutions such as commercial banks, insurance companies, mutual funds, and pension funds serve the role of investing funds that they have received from surplus units, so they are often referred to as institutional investors.

Securities firms are not shown in Exhibit 1.3 , but they play an important role in facilitating the flow of funds. Many of the transactions between the financial institutions and deficit units are executed by securities firms. Furthermore, some funds flow directly from surplus units to deficit units as a result of security transactions, with securities firms serving as brokers.

Exhibit 1.3 Comparison of Roles among Financial Institutions

Institutional Role as a Monitor of Publicly Traded Firms In addition to the roles of financial institutions described in Exhibit 1.3 , financial institutions also serve as monitors of publicly traded firms. Because insurance companies, pension funds, and some mutual funds are major investors in stocks, they can influence the management of publicly traded firms. In recent years, many large institutional investors have publicly criticized the management of specific firms, which has resulted in corporate restructuring or even the firing of executives in some cases. Thus institutional investors not only provide financial support to companies but also exercise some degree of corporate control over them. By serving as activist shareholders, they can help ensure that managers of publicly held corporations are making decisions that are in the best interests of the shareholders.

1-3d How the Internet Facilitates Roles of Financial Institutions

The Internet has also enabled financial institutions to perform their roles more efficiently. Some commercial banks have been created solely as online entities. Because they have lower costs, they can offer higher interest rates on deposits and lower rates on loans. Other banks and depository institutions also offer online services, which can reduce costs, increase efficiency, and intensify competition. Many mutual funds allow their shareholders to execute buy or sell transactions online. Some insurance companies conduct much of their business online, which reduces their operating costs and forces other insurance companies to price their services competitively. Some brokerage firms conduct much of their business online, which reduces their operating costs; because these firms can lower the fees they charge, they force other brokerage firms to price their services competitively.

1-3e Relative Importance of Financial Institutions

Together, all of these financial institutions hold assets equal to about $45 trillion. Commercial banks hold the most assets of any depository institution, with about $12 trillion in aggregate. Mutual funds hold the largest amount of assets of any nondepository institution, with about $11 trillion in aggregate.

Exhibit 1.4 summarizes the main sources and uses of funds for each type of financial institution. Households with savings are served by depository institutions. Households with deficient funds are served by depository institutions and finance companies. Large corporations and governments that issue securities obtain financing from all types of financial institutions. Several agencies regulate the various types of financial institutions, and the various regulations may give some financial institutions a comparative advantage over others.

1-3f Consolidation of Financial Institutions

In recent years, commercial banks have acquired other commercial banks so that a given infrastructure can generate and support a higher volume of business. By increasing the volume of services produced, the average cost of providing the services (such as loans) can be reduced. Savings institutions have consolidated to achieve economies of scale for their mortgage lending business. Insurance companies have consolidated so that they can reduce the average cost of providing insurance services.

Exhibit 1.4 Summary of Institutional Sources and Uses of Funds

FINANCIAL INSTITUTIONS

MAIN SOURCES OF FUNDS

MAIN USES OF FUNDS

Commercial banks

Deposits from households, businesses, and government agencies

Purchases of government and corporate securities; loans to businesses and households

Savings institutions

Deposits from households, businesses, and government agencies

Purchases of government and corporate securities; mortgages and other loans to households; some loans to businesses

Credit unions

Deposits from credit union members

Loans to credit union members

Finance companies

Securities sold to households and businesses

Loans to households and businesses

Mutual funds

Shares sold to households, businesses, and government agencies

Purchases of long-term government and corporate securities

Money market funds

Shares sold to households, businesses, and government agencies

Purchases of short-term government and corporate securities

Insurance companies

Insurance premiums and earnings from investments

Purchases of long-term government and corporate securities

Pension funds

Employer/employee contributions

Purchases of long-term government and corporate securities

During the last 10 years, different types of financial institutions were allowed by regulators to expand the types of services they offer and capitalize on economies of scope. Commercial banks merged with savings institutions, securities firms, finance companies, mutual funds, and insurance companies. Although the operations of each type of financial institution are commonly managed separately, a financial conglomerate offers advantages to customers who prefer to obtain all of their financial services from a single financial institution. Because a financial conglomerate is more diversified, it may be less exposed to a possible decline in customer demand for any single financial service.

EXAMPLE

Wells Fargo is a classic example of the evolution in financial services. It originally focused on commercial banking but has expanded its nonbank services to include mortgages, small business loans, consumer loans, real estate, brokerage, investment banking, online financial services, and insurance. In a recent annual report, Wells Fargo stated: “Our diversity in businesses makes us much more than a bank. We’re a diversified financial services company. We’re competing in a highly fragmented and fast growing industry: Financial Services. This helps us weather downturns that inevitably affect anyone segment of our industry.”

Typical Structure of a Financial Conglomerate A typical organizational structure of a financial conglomerate is shown in Exhibit 1.5 . Historically, each of the financial services (such as banking, mortgages, brokerage, and insurance) had significant barriers to entry, so only a limited number of firms competed in that industry. The barriers prevented most firms from offering a wide variety of these services. In recent years, the barriers to entry have been reduced, allowing firms that had specialized in one service to expand more easily into other financial services. Many firms expanded by acquiring other financial services firms. Thus many financial conglomerates are composed of various financial institutions that were originally independent but are now units (or subsidiaries) of the conglomerate.

Exhibit 1.5 Organizational Structure of a Financial Conglomerate

Impact of Consolidation on Competition As financial institutions spread into other financial services, the competition for customers desiring the various types of financial services increased. Prices of financial services declined in response to the competition. In addition, consolidation has provided more convenience. Individual customers can rely on the financial conglomerate for convenient access to life and health insurance, brokerage, mutual funds, investment advice and financial planning, bank deposits, and personal loans. A corporate customer can turn to the financial conglomerate for property and casualty insurance, health insurance plans for employees, business loans, advice on restructuring its businesses, issuing new debt or equity securities, and management of its pension plan.

Global Consolidation of Financial Institutions Many financial institutions have expanded internationally to capitalize on their expertise. Commercial banks, insurance companies, and securities firms have expanded through international mergers. An international merger between financial institutions enables the merged company to offer the services of both entities to its entire customer base. For example, a U.S. commercial bank may specialize in lending while a European securities firm specializes in services such as underwriting securities. A merger between the two entities allows the U.S. bank to provide its services to the European customer base (clients of the European securities firm) and allows the European securities firm to offer its services to the U.S. customer base. By combining specialized skills and customer bases, the merged financial institutions can offer more services to clients and have an international customer base.

The adoption of the euro by 17 European countries has increased business between those countries and created a more competitive environment in Europe. European financial institutions, which had primarily competed with other financial institutions based in their own country, recognized that they would now face more competition from financial institutions in other countries.

Many financial institutions have attempted to benefit from opportunities in emerging markets. For example, some large securities firms have expanded into many countries to offer underwriting services for firms and government agencies. The need for this service has increased most dramatically in countries where businesses have been privatized. In addition, commercial banks have expanded into emerging markets to provide loans. Although this allows them to capitalize on opportunities in these countries, it also exposes them to financial problems in these countries.

1-4 CREDIT CRISIS FOR FINANCIAL INSTITUTIONS

Following the abrupt increase in home prices in the 2004–2006 period, many financial institutions increased their holdings of mortgages and mortgage-backed securities, whose performance was based on the timely mortgage payments made by homeowners. Some financial institutions (especially commercial banks and savings institutions) aggressively attempted to expand their mortgage business in order to capitalize on the strong housing market. They commonly applied liberal standards when originating new mortgages and often failed to verify the applicant’s job status, income level, or credit history. Home prices were expected to continue rising over time, so financial institutions presumed (incorrectly) that the underlying value of the homes would provide adequate collateral to back the mortgage if homeowners could not make their mortgage payments.

In the 2007–2009 period, mortgage defaults increased, and there was an excess of unoccupied homes as homeowners who could not pay the mortgage left their homes. As a result, home prices plummeted, and the value of the property collateral backing many mortgages was less than the outstanding mortgage amount. By January 2009, at least 10 percent of all American homeowners were either behind on their mortgage payments or had defaulted on their mortgage. Many of the financial institutions that originated mortgages suffered major losses.

1-4a Systemic Risk during the Credit Crisis

The credit crisis illustrated how financial problems of some financial institutions spread to others. Systemic risk is defined as the spread of financial problems among financial institutions and across financial markets that could cause a collapse in the financial system. It exists because financial institutions invest their funds in similar types of securities and therefore have similar exposure to large declines in the prices of these securities. In this case, mortgage defaults affected financial institutions in several ways. First, many financial institutions that originated mortgages shortly before the crisis sold them to other financial institutions (i.e., commercial banks, savings institutions, mutual funds, insurance companies, securities firms, and pension funds); hence even financial institutions that were not involved in the mortgage origination process experienced large losses because they purchased the mortgages originated by other financial institutions.

Second, many other financial institutions that invested in mortgage-backed securities and promised payments on mortgages were exposed to the crisis. Third, some financial institutions (especially securities firms) relied heavily on short-term debt to finance their operations and used their holdings of mortgage-backed securities as collateral. But when the prices of mortgage-backed securities plummeted, large securities firms such as Bear Stearns and Lehman Brothers could not issue new short-term debt to pay off the principal on maturing debt.

Furthermore, the decline in home building activity caused a decrease in the demand for many related businesses, such as air-conditioning services, roofing, and landscaping. In addition, the loss of income by workers in these industries caused a decline in spending in a wide variety of industries. The weak economy also created more concerns about the potential default on debt securities, causing further declines in bond prices. The financial markets were filled with sellers who wanted to dump debt securities, but there were not many buyers willing to buy securities. Consequently, the prices of debt securities plunged.

Systemic risk was a major concern during the credit crisis because the prices of most equity securities declined substantially, since the operating performance of most firms declined when the economy weakened. Thus most financial institutions experienced large losses on their investments during the credit crisis even if they invested solely inequity securities.

1-4b Government Response to the Credit Crisis

The government intervened in order to correct some of the economic problems caused by the credit crisis.

Emergency Economic Stabilization Act On October 3, 2008, Congress enacted the Emergency Economic Stabilization Act of 2008 (also referred to as the bailout act), which was intended to resolve the liquidity problems of financial institutions and to restore the confidence of the investors who invest in them. The act directed the Treasury to inject $700 billion into the financial system, primarily by investing money into the banking system by purchasing the preferred stock of financial institutions. In this way, the Treasury provided large commercial banks with capital to cushion their losses, thereby reducing the likelihood that the banks would fail.

Federal Reserve Actions In 2008, some large securities firms such as Bear Stearns and Lehman Brothers experienced severe financial problems. The Federal Reserve rescued Bear Stearns by financing its acquisition by a commercial bank (J.P. Morgan Chase) in order to calm the financial markets. However, when Lehman Brothers was failing six months later, it was not rescued by the government, and this caused much paranoia in financial markets.

At this time, the Fed also provided emergency loans to many other securities firms that were not subject to its regulation. Some major securities firms (such as Merrill Lynch) were acquired by commercial banks, while others (Goldman Sachs and Morgan Stanley) were converted into commercial banks. These actions resulted in the consolidation of financial institutions and also subjected more financial institutions to Federal Reserve regulations.

Financial Reform Act of 2010 On July 21, 2010, President Obama signed the Financial Reform Act (also referred to as the Wall Street Reform Act or Consumer Protection Act), which was intended to prevent some of the problems that caused the credit crisis. The provisions of the act are frequently discussed in this text when they apply to specific financial markets or financial institutions.

One of the key provisions of the Financial Reform Act of 2010 is that mortgage lenders verify the income, job status, and credit history of mortgage applicants before approving mortgage applications. This provision is intended to prevent applicants from receiving mortgages unless they are creditworthy.

In addition, the Financial Reform Act called for the creation of the Financial Stability Oversight Council, which is responsible for identifying risks to financial stability in the United States and makes regulatory recommendations that could reduce any risks to the financial system. The council consists of 10 members who represent the heads of regulatory agencies that regulate key components of the financial system, including the housing industry, securities trading, depository institutions, mutual funds, and insurance companies.

Furthermore, the act established the Consumer Financial Protection Bureau (housed within the Federal Reserve) to regulate specific financial services for consumers, including online banking, checking accounts, credit cards, and student loans. This bureau can set rules to ensure that information regarding endorsements of specific financial products is accurate and to prevent deceptive practices.

1-4c Conclusion about Government Response to the Credit Crisis

In general, the government response to the credit crisis was intended to enhance the safety of financial institutions. Since financial institutions serve as intermediaries for financial markets, the tougher regulations on financial institutions can stabilize the financial markets and encourage more participation by surplus and deficit units in these markets.

SUMMARY

· ▪ Financial markets facilitate the transfer of funds from surplus units to deficit units. Because funding needs vary among deficit units, various financial markets have been established. The primary market allows for the issuance of new securities, and the secondary market allows for the sale of existing securities.

· ▪ Securities can be classified as money market (short-term) securities or capital market (long-term) securities. Common capital market securities include bonds, mortgages, mortgage-backed securities, and stocks. The valuation of a security represents the present value of future cash flows that it is expected to generate. New information that indicates a change in expected cash flows or degree of uncertainty affects prices of securities in financial markets.

· ▪ Depository and nondepository institutions help to finance the needs of deficit units. The main depository institutions are commercial banks, savings institutions, and credit unions. The main nondepository institutions are finance companies, mutual funds, pension funds, and insurance companies. Many financial institutions have been consolidated (due to mergers) into financial conglomerates, where they serve as subsidiaries of the conglomerate while conducting their specialized services. Thus, some financial conglomerates are able to provide all types of financial services. Consolidation allows for economies of scale and scope, which can enhance cash flows and increase the financial institution’s value. In addition, consolidation can diversify the institution’s services and increase its value through the reduction in risk.

· ▪ The credit crisis in 2008 and 2009 had a profound effect on financial institutions. Those institutions that were heavily involved in originating or investing in mortgages suffered major losses. Many investors were concerned that the institutions might fail and therefore avoided them, which disrupted the ability of financial institutions to facilitate the flow of funds. The credit crisis led to concerns about systemic risk, as financial problems spread among financial institutions that were heavily exposed to mortgages.

POINT COUNTER-POINT

Will Computer Technology Cause Financial Intermediaries to Become Extinct?

Point Yes. Financial intermediaries benefit from access to information. As information becomes more accessible, individuals will have the information they need before investing or borrowing funds. They will not need financial intermediaries to make their decisions.

Counter-Point No. Individuals rely not only on information but also on expertise. Some financial intermediaries specialize in credit analysis so that they can make loans. Surplus units will continue to provide funds to financial intermediaries, rather than make direct loans, because they are not capable of credit analysis even if more information about prospective borrowers is available. Some financial intermediaries no longer have physical buildings for customer service, but they still require agents who have the expertise to assess the creditworthiness of prospective borrowers.

Who Is Correct? Use the Internet to learn more about this issue and then formulate your own opinion.

QUESTIONS AND APPLICATIONS

· 1. Surplus and Deficit Units Explain the meaning of surplus units and deficit units. Provide an example of each. Which types of financial institutions do you deal with? Explain whether you are acting as a surplus unit or a deficit unit in your relationship with each financial institution.

· 2. Types of Markets Distinguish between primary and secondary markets. Distinguish between money and capital markets.

· 3. Imperfect Markets Distinguish between perfect and imperfect security markets. Explain why the existence of imperfect markets creates a need for financial intermediaries.

· 4. Efficient Markets Explain the meaning of efficient markets. Why might we expect markets to be efficient most of the time? In recent years, several securities firms have been guilty of using inside information when purchasing securities, thereby achieving returns well above the norm (even when accounting for risk). Does this suggest that the security markets are not efficient? Explain.

· 5. Securities Laws What was the purpose of the Securities Act of 1933? What was the purpose of the Securities Exchange Act of 1934? Do these laws prevent investors from making poor investment decisions? Explain.

· 6. International Barriers If barriers to international securities markets are reduced, will a country’s interest rate be more or less susceptible to foreign lending and borrowing activities? Explain.

· 7. International Flow of Funds In what way could the international flow of funds cause a decline in interest rates?

· 8. Securities Firms What are the functions of securities firms? Many securities firms employ brokers and dealers. Distinguish between the functions of a broker and those of a dealer, and explain how each is compensated.

· 9. Standardized Securities Why do you think securities are commonly standardized? Explain why some financial flows of funds cannot occur through the sale of standardized securities. If securities were not standardized, how would this affect the volume of financial transactions conducted by brokers?

· 10. Marketability Commercial banks use some funds to purchase securities and other funds to make loans. Why are the securities more marketable than loans in the secondary market?

· 11. Depository Institutions Explain the primary use of funds by commercial banks versus savings institutions.

· 12. Credit Unions With regard to the profit motive, how are credit unions different from other financial institutions?

· 13. Nondepository Institutions Compare the main sources and uses of funds for finance companies, insurance companies, and pension funds.

· 14. Mutual Funds What is the function of a mutual fund? Why are mutual funds popular among investors? How does a money market mutual fund differ from a stock or bond mutual fund?

· 15. Impact of Privatization on Financial Markets Explain how the privatization of companies in Europe can lead to the development of new securities markets.

Advanced Questions

· 16. Comparing Financial Institutions Classify the types of financial institutions mentioned in this chapter as either depository or nondepository. Explain the general difference between depository and nondepository institution sources of funds. It is often said that all types of financial institutions have begun to offer services that were previously offered only by certain types. Consequently, the operations of many financial institutions are becoming more similar. Nevertheless, performance levels still differ significantly among types of financial institutions. Why?

· 17. Financial Intermediation Look in a business periodical for news about a recent financial transaction involving two financial institutions. For this transaction, determine the following:

· a. How will each institution’s balance sheet be affected?

· b. Will either institution receive immediate income from the transaction?

· c. Who is the ultimate user of funds?

· d. Who is the ultimate source of funds?

· 18. Role of Accounting in Financial Markets Integrate the roles of accounting, regulation, and financial market participation. That is, explain how financial market participants rely on accounting and why regulatory oversight of the accounting process is necessary.

· 19. Impact of Credit Crisis on Liquidity Explain why the credit crisis caused a lack of liquidity in the secondary markets for many types of debt securities. Explain how such a lack of liquidity would affect the prices of the debt securities in the secondary markets.

· 20. Impact of Credit Crisis on Institutions Explain why mortgage defaults during the credit crisis adversely affected financial institutions that did not originate the mortgages. What role did these institutions play in financing the mortgages?

· 21. Regulation of Financial Institutions Financial institutions are subject to regulation to ensure that they do not take excessive risk and can safely facilitate the flow of funds through financial markets. Nevertheless, during the credit crisis, individuals were concerned about using financial institutions to facilitate their financial transactions. Why do you think the existing regulations were ineffective at ensuring a safe financial system?

· 22. Impact of the Greece Debt Crisis European debt markets have become integrated over time, so that institutional investors (such as commercial banks) commonly purchase debt issued in other European countries. When the government of Greece experienced problems in meeting its debt obligations in 2010, some investors became concerned that the crisis would spread to other European countries. Explain why integrated European financial markets might allow a debt crisis in one European country to spread to other countries in Europe.

· 23. Global Financial Market Regulations Assume that countries A and B are of similar size, that they have similar economies, and that the government debt levels of both countries are within reasonable limits. Assume that the regulations in country A require complete disclosure of financial reporting by issuers of debt in that country but that regulations in country B do not require much disclosure of financial reporting. Explain why the government of country A is able to issue debt at a lower cost than the government of country B.

· 24. Influence of Financial Markets Some countries do not have well-established markets for debt securities or equity securities. Why do you think this can limit the development of the country, business expansion, and growth in national income in these countries?

· 25. Impact of Systemic Risk Different types of financial institutions commonly interact. They provide loans to each other, and take opposite positions on many different types of financial agreements, whereby one will owe the other based on a specific financial outcome. Explain why their relationships cause concerns about systemic risk.

Interpreting Financial News

“Interpreting Financial News” tests your ability to comprehend common statements made by Wall Street analysts and portfolio managers who participate in the financial markets. Interpret the following statements.

· a. “The price of IBM stock will not be affected by the announcement that its earnings have increased as expected.”

· b. “The lending operations at Bank of America should benefit from strong economic growth.”

· c. “The brokerage and underwriting performance at Goldman Sachs should benefit from strong economic growth.”

Managing in Financial Markets

Utilizing Financial Markets As a financial manager of a large firm, you plan to borrow $70 million over the next year.

· a. What are the most likely ways in which you can borrow $70 million?

· b. Assuming that you decide to issue debt securities, describe the types of financial institutions that may purchase these securities.

· c. How do individuals indirectly provide the financing for your firm when they maintain deposits at depository institutions, invest in mutual funds, purchase insurance policies, or invest in pensions?

FLOW OF FUNDS EXERCISE

Roles of Financial Markets and Institutions

This continuing exercise focuses on the interactions of a single manufacturing firm (Carson Company) in the financial markets. It illustrates how financial markets and institutions are integrated and facilitate the flow of funds in the business and financial environment. At the end of every chapter, this exercise provides a list of questions about Carson Company that requires the application of concepts presented in the chapter as they relate to the flow of funds.

Carson Company is a large manufacturing firm in California that was created 20 years ago by the Carson family. It was initially financed with an equity investment by the Carson family and 10 other individuals. Over time, Carson Company obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to market interest rates and is adjusted every six months. Thus Carson’s cost of obtaining funds is sensitive to interest rate movements. It has a credit line with a bank in case it suddenly needs additional funds for a temporary period. It has purchased Treasury securities that it could sell if it experiences any liquidity problems.

Carson Company has assets valued at about $50 million and generates sales of about $100 million per year. Some of its growth is attributed to its acquisitions of other firms. Because of its expectations of a strong U.S. economy, Carson plans to grow in the future by expanding its business and by making more acquisitions. It expects that it will need substantial long-term financing and plans to borrow additional funds either through loans or by issuing bonds. It is also considering issuing stock to raise funds in the next year. Carson closely monitors conditions in financial markets that could affect its cash inflows and cash outflows and thereby affect its value.

· a. In what way is Carson a surplus unit?

· b. In what way is Carson a deficit unit?

· c. How might finance companies facilitate Carson’s expansion?

· d. How might commercial banks facilitate Carson’s expansion?

· e. Why might Carson have limited access to additional debt financing during its growth phase?

· f. How might securities firms facilitate Carson’s expansion?

· g. How might Carson use the primary market to facilitate its expansion?

· h. How might it use the secondary market?

· i. If financial markets were perfect, how might this have allowed Carson to avoid financial institutions?

· j. The loans that Carson has obtained from commercial banks stipulate that Carson must receive the bank’s approval before pursuing any large projects. What is the purpose of this condition? Does this condition benefit the owners of the company?

INTERNET/EXCEL EXERCISES

· 1. Review the information for the common stock of IBM, using the website finance.yahoo.com . Insert the ticker symbol “IBM” in the box and click on “Get Quotes.” The main goal at this point is to become familiar with the information that you can obtain at this website. Review the data that are shown for IBM stock. Compare the price of IBM based on its last trade with the price range for the year. Is the price near its high or low price? What is the total value of IBM stock (market capitalization)? What is the average daily trading volume (Avg Vol) of IBM stock? Click on “5y”just below the stock price chart to see IBM’s stock price movements over the last five years. Describe the trend in IBM’s stock over this period. At what points was the stock price the highest and lowest?

· 2. Repeat the questions in exercise 1 for the Children’s Place Retail Stores (symbol PLCE). Explain how the market capitalization and trading volume for PLCE differ from that for IBM.

WSJ EXERCISE

Differentiating between Primary and Secondary Markets

Review the different tables relating to stock markets and bond markets that appear in Section C of the Wall Street Journal. Explain whether each of these tables is focused on the primary or secondary markets.

ONLINE ARTICLES WITH REAL-WORLD EXAMPLES

Find a recent practical article available online that describes a real-world example regarding a specific financial institution or financial market that reinforces one or more concepts covered in this chapter.

If your class has an online component, your professor may ask you to post your summary of the article there and provide a link to the article so that other students can access it. If your class is live, your professor may ask you to summarize your application of the article in class. Your professor may assign specific students to complete this assignment or may allow any students to do the assignment on a volunteer basis.

For recent online articles and real-world examples related to this chapter, consider using the following search terms (be sure to include the prevailing year as a search term to ensure that the online articles are recent):

· 1. secondary market AND liquidity

· 2. secondary market AND offering

· 3. money market

· 4. bond offering

· 5. stock offering

· 6. valuation AND stock

· 7. market efficiency

· 8. financial AND regulation

· 9. financial institution AND operations

· 10. financial institution AND governance

Term Paper on the Credit Crisis

Write a term paper on one of the following topics or on a topic assigned by your professor. Details such as the due date and the length of the paper will be provided by your professor.

Each of the topics listed below can be easily researched because considerable media attention has been devoted to the subject. Although this text offers a brief summary of each topic, much more information is available at online sources that you can find by using a search engine and inserting a few key terms or phrases.

· 1. Impact of Lehman Brothers’ Bankruptcy on Individual Wealth Explain how the bankruptcy of Lehman Brothers (the largest bankruptcy ever) affected the wealth and income of many different types of individuals whose money was invested by institutional investors (such as pension funds) in Lehman Brothers’ debt.

· 2. Impact of the Credit Crisis on Financial Market Liquidity Explain the link between the credit crisis and the lack of liquidity in the debt markets. Offer some insight as to why the debt markets became inactive. How were interest rates affected? What happened to initial public offering (IPO) activity during the credit crisis? Why?

· 3. Transparency of Financial Institutions during the Credit Crisis Select a financial institution that had serious financial problems as a result of the credit crisis. Review the media stories about this institution during the six months before its financial problems were publicized. Were there any clues that the financial institution was having problems? At what point do you think that the institution recognized that it was having financial difficulties? Did its previous annual report indicate serious problems? Did it announce its problems, or did another media source reveal the problems?

· 4. Cause of Problems for Financial Institutions during the Credit Crisis Select a financial institution that had serious financial problems as a result of the credit crisis. Determine the main underlying causes of the problems experienced by that financial institution. Explain how these problems might have been avoided.

· 5. Mortgage-Backed Securities and Risk Taking by Financial Institutions Do you think that institutional investors that purchased mortgage-backed securities containing subprime mortgages were following reasonable investment guidelines? Address this issue for various types of financial institutions such as pension funds, commercial banks, insurance companies, and mutual funds (your answer might differ with the type of institutional investor). If financial institutions are taking on too much risk, how should regulations be changed to limit such excessive risk taking?

· 6. Pension Fund Investments in Lehman Brothers’ Debt At the time that Lehman Brothers filed for bankruptcy, financial institutions serving municipalities in California were holding more than $300 billion in debt issued by Lehman. Do you think that municipal pension funds that purchased commercial paper and other debt securities issued by Lehman Brothers were following reasonable investment guidelines? If a pension fund is taking on too much risk, how should regulations be changed to limit such excessive risk taking?

· 7. Future Valuation of Mortgage-Backed Securities Commercial banks must periodically “mark to market” their assets in order to determine the capital they need. Identify some advantages and disadvantages of this method, and propose a solution that would be fair to both commercial banks and regulators.

· 8. Future Structure of Fannie Mae Fannie Mae plays an important role in the mortgage market, but it suffered major problems during the credit crisis. Discuss the underlying causes of the problems at Fannie Mae beyond what has been discussed in the text. Should Fannie Mae be owned completely by the government? Should it be privatized? Offer your opinion on a structure for Fannie Mae that would avoid its previous problems and enable it to serve the mortgage market.

· 9. Future Structure of Ratings Agencies Rating agencies rated the so-called tranches of mortgage-backed securities that were sold to institutional investors. Explain why the performance of these agencies was criticized, and then defend against this criticism on behalf of the agencies. Was the criticism of the agencies justified? How could rating agencies be structured or regulated in a different manner in order to prevent the problems that occurred during the credit crisis?

· 10. Future Structure of Credit Default Swaps Explain how credit default swaps maybe partially responsible for the credit crisis. Offer a proposal for how they could be structured in the future to ensure that they are used to enhance the safety of the financial system.

· 11. Sale of Bear Stearns Review the arguments that have been made for the government-orchestrated sale of Bear Stearns. If Bear Stearns had been allowed to fail, what types of financial institutions would have been adversely affected? In other words, who benefited from the government’s action to prevent the failure of Bear Stearns? Do you think Bear Stearns should have been allowed to fail? Explain your opinion.

· 12. Bailout of AIG Review the arguments that have been made for the bailout of American International Group (AIG). If AIG had been allowed to fail, what types of financial institutions would have been adversely affected? That is, who benefited from the bailout of AIG? Do you think AIG should have been allowed to fail? Explain your opinion.

· 13. Executive Compensation at Financial Institutions Discuss the compensation received by executives at some financial institutions that experienced financial problems (e.g., AIG, Bear Stearns, Lehman Brothers, Merrill Lynch, Washington Mutual). Should these executives be allowed to retain the bonuses that they received in the 2007-2008 period? Should executive compensation at financial institutions be capped?

· 14. Impact of the Credit Crisis on Commercial Banks versus Securities Firms Both commercial banks and securities firms were adversely affected by the credit crisis, but for different reasons. Discuss the reasons for the adverse effects on commercial banks and securities firms and explain why the reasons were different.

· 15. Role of the Treasury and the Fed in the Credit Crisis Summarize the various ways in which the U.S. Treasury and the Federal Reserve intervened to resolve the credit crisis. Discuss the pros and cons of their interventions. Offer your own opinion regarding whether they should have intervened.

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