Recent Changes in The United States Financial Services Industry

1
Recent Changes in The United States Financial
Services Industry
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Introduction

• Thank you for inviting me to visit your
  university
• Tom Root
• PhD Economics University of Kansas
• Tom.Root_at_Drake.edu
• Drake University
• Des Moines, Iowa
• Approximately 4,000 students

3
Background

• Recent changes in U. S. Financial Markets
• Overview of the role of the Financial Services
  Industry in an Economy
• Regulatory Changes, Recent Trends, and Current
  Events
• Financial Services Modernization Act
• Securitization and Role of Government Sponsored
  Enterprises.
• Recent Scandals
• Mutual Funds
• Corporate Governance

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Risk Management

• The changes have increased the need for managing
  risks in the financial marketplace.
• This includes both measuring risk and developing
  products designed to eliminate risk.

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Outline of Classes

• After the introduction we will cover
• Securitization
• How the process of securitization should decrease
  credit risk for individual institutions. However
  did is also change systematic risk?
• Value at Risk
• measuring risk in the market place
• Derivatives
• How options and other derivative products are
  used to decrease risks faced by institutions.

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Background

• Financial Institutions (FI) Channel funds from
  individuals and institutions with a surplus of
  funds to (suppliers) to those with a shortage or
  funds (users of capital).
• Depository Institutions Banks, Savings and Loans,
  Credit Unions
• Non Depository Institutions Insurance Companies,
  Mutual Funds, Pension Funds
• Total assets 2000 in US 14.75 trillion

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Similar Risks and Rewards

• All Financial Institutions
• Hold Assets that are subject to default (or
  credit) risk
• Are exposed to interest rate risk
• Change in value of assets
• Matching maturity assets and liabilities
• Exposed to liquidity (withdraw) risks
• Face operational costs and risks

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Bringing Together Borrowers and Lenders

• Direct Financings vs. Indirect Financing
• Funds are either exchanged between the borrower
  and lender directly (Direct Financing) or via a
  financial institution (indirect financing).

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Direct Financing Private Placement Brokers
Dealers Investment Bankers
Surplus Funds Households Business Government
Deficit Funds Households Business Government
Direct Claims
Direct Claims
Dollars
Dollars
Indirect Financing (intermediaries) Banks
Thrifts Finance Companies Insurance Firms Pension
Funds Mutual Funds
Direct Claims
Indirect Claims
Dollars
Dollars
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Examples

• Commercial Bank Accept Deposits (short term)
  and use the cash to make loans to other
  participants (both households and businesses
  Long Term)
• Mutual Fund Firm Pooling Funds of individuals
  and uses them to buy a portfolio of securities

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The Roles of Financial Intermediation

• Maturity and Denomination Intermediation
• The intermediary can produce assets of varying
  maturities. It transforms demand deposits into
  long term commercial loans for example.
• Similarly the intermediaries can produce a wide
  variety of denominations in the new assets via
  pooling and separating of funds

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The Roles of Intermediation

• Diversification
• The firm is able to change the risk
  characteristics of the claims.
• For example a mutual fund which takes a
  relatively small sum of money form an individual
  investor but invests in a portfolio of assets.
  (Decreases Credit Risk).
• The size of the firm allows it to be more cost
  effective at producing this risk reduction . An
  individual doing this alone, faces high costs.
  (there is an economy of scale in the
  intermediaries operations)

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The Roles of Intermediation

• Information Cost Reduction
• Specialization allows the intermediary to focus
  on investment analysis. This is a costly process
  for the individual. It also allows a reduction
  in loan contracting costs.
• Providing a payment mechanism
• The firms provide a means of noncash payment
  (checks, debit card etc). The intermediaries
  also provide many claims that are highly liquid,
  allowing individuals to invest in less liquid
  assets indirectly.

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Roles played by FIs

• Brokerage Function
• Research and information provider (reduces
  information costs such as agency costs)
• Economies of Scale (decreases transaction costs
  and information costs)
• Asset Transformation Function
• Purchase primary claims and issue secondary
  claims backed by the primary claims (reducing
  contracting costs)
• Allows for risk sharing via diversification
  (reduces price and liquidity risk)

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Special Roles played by FIs

• Economy - Wide Services
• Information, Liquidity, Price risk reduction,
  Transaction cost and Maturity intermediation
  services
• Institution Specific Services
• Monetary policy transmission (depository
  Institutions), Credit allocation (thrifts, farm
  banks), Intergenerational Transfers (Insurance
  and pensions, payments services (depository
  institutions) and Denomination intermediation

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Special Roles played by FIs

• Transmission of Monetary Policy
• The liquid nature of depository institutions make
  them the main way monetary policy is transmitted
  to the public
• Credit Allocation
• Primary suppliers of capital to special sectors
  of the economy (Residential lending for example)
• Intergenerational Transfer of Wealth
• Insurance and pension funds allow transfer across
  generations

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Trends in the Market

• Market Broadening Instruments
• Increase liquidity of the market attracts new
  investors and provides opportunities for
  borrowers. Securitization
• Risk Management Instruments
• Reallocate financial risks to those willing and
  able to accept them.
• Arbitraging Instruments
• Allow investors and borrowers to take advantage
  of differences between markets

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Regulation

• Given the important roles played by the Financial
  Services Industry in the economy, it is highly
  regulated.

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Justification of Regulation of FIs

• Safety and Soundness Regulation
• Monetary Policy Regulation
• Promotion of Fair Competition
• Credit Allocation Regulation
• Consumer Protection Regulation
• Investor Protection Regulation
• Entry Regulation

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Regulatory Overview

• 1933 Glass-Steagall Act
• Separates securities and banking activities
• Prohibited commercial banks from most
  underwriting of securities. Fear of conflict of
  interest
• Established Federal Deposit Insurance Corporation
• National banks allowed to branch state wide if
  state chartered banks were allowed to do so.

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1999 Financial ServicesModernization Act

• Allowed banks, insurance companies, and
  securities firms to enter each others business
  areas
• Streamlined regulation of Bank Holding Companies
• Prohibited FDIC assistance to affiliates and
  subsidiaries of banks and savings institutions
• Provided for national treatment of foreign banks
• Federal Crime to steal account information

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Trends in the US
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Competition among FIs
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Impact on US Market

• Increased merger and acquisition activity in
  financial services industry.
• Demutualization of insurance firms and savings
  and loans

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Asset Securitization

• Securitization is the pooling and repackaging of
  loans so they have the characteristics of
  security instruments which enable them to be more
  easily resold.
• Creates both Maturity Intermediation and
  Denomination Intermediation while spreading
  credit risk
• Should broaden the market and decrease risk

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Use of Securitization in the Mortgage Market

• The market that has been impacted the most by
  increased securitization is the secondary market
  for mortgages.
• The largest participants in this market are
  government sponsored enterprises (GSE).

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Government Sponsored Enterprises

• Privately owned, government sponsored entities.
• Created to lower the cost of capital for a
  specific sector
• Generally issue two types of notes and debt

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Special Treatment of GSEs

• Debt and mortgage backed securities are exempt
  from SEC registration
• Agencies are exempt from state and local taxes
• Treasury can purchase up to 2.2 B of FNMA and
  4B of FHLB debt via line of credit
• Banks can make unlimited investment in debt
  issued by GSEs
• GSE securities are eligible as collateral for
  public deposits and for loans from the Federal
  Reserve

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GSEs and Mission

• Federal National Mortgage Association (Fannie
  Mae) Federal Home Loan Mortgage Association
  (Freddie Mac) promote secondary market for
  mortgages
• Government National Mortgage Association (Ginnie
  Mae) promote secondary market for government
  sponsored mortgages
• Federal Home Loan Bank Liquidity in banking
  system

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GSEs and Mission

• Student Loan Marketing Association (Sallie Mae)
  promote a secondary market for student loans
• Federal Farm Credit Bank promote a secondary
  market for lending in agricultural industry

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Mortgage Pass Through Securities

• GSE Purchases a pool of mortgages from
  originators
• GSE issues a new pass through security. Interest
  and Principle are collected on the mortgage pool
  by the GSE who then transfers (passes through)
  the payments to the owners of new securities
  backed by the mortgages.
• Neither the amount or timing of the cash flows
  actually matches the cash flows on the pool of
  mortgages.
• When a mortgage is included in a pool it is said
  to be securitized.

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Possible Benefits of Securitization

• Benefits to Issuers
• Diversification Broadens funding source
• Ability to manage capital requirements
• Provides Fee Income
• Manage interest rate volatility
• Benefits to investors
• Increased Liquidity
• Reduced Credit Risk
• Benefits to Borrowers
• Reduced spreads

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Composition of US Debt Market Sept 2003 (Total
value 22.6 Trillion)
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of Outstanding Debt Market
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Average Daily Trading Volume (Billions)
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Issuance by GSEs ( Billions)
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Outstanding Mortgage and Asset Backed Securities
in US
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Current Questions in the Market Place relating to
GSEs

• Are the GSEs, especially Fannie Mae and Freddie
  Mac growing too fast?
• Do they pose a systematic risk for the US
  economy?
• Should the special treatment they receive be
  changed?

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Recent Study by Federal Reserve

• Wayne Passmore, an economist at the Federal
  Reserve Bank has recently completed a study on
  the impact of GSEs
• The GSEs have a funding advantage
• Slightly lower mortgage rtes for a few borrowers
• Implicit subsidy from government relationship
• Implicit subsidy responsible for much of GSE
  Market Value
• MBS have not increased homebuilding

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Risk Management

• The increased competition among financial
  institutions and the expansion into new business
  lines has placed increased importance on
  Consolidated Risk Management.
• This includes methods of measuring risk and
  methods of reducing risk.

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Value at Risk

• Value at Risk measures the market value of assets
  that may be lost given a change in the market
  place (for example, a change in interest rates)
  that may occur with a corresponding probability
• We are going to apply this to look at market risk.

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A simple example

• Assume you own a 10 coupon bond that makes semi
  annual payments with 5 years until maturity with
  a YTM of 9.
• The current value of the bond is then 1039.56
• Assume that you believe that the most the yield
  will increase in the next day is .2. The new
  value of the bond is 1031.50
• The difference would represent the value at risk.

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Value at Risk

• Methods based upon Value at Risk have become a
  common component of risk management.
• For example the Basel II standards use value at
  risk methodology in some portions of risk
  measurement.
• How effective is it? What are the limitations of
  the methodology?

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Limiting Risk Exposure

• In addition to measuring the amount of risk
  financial managers are interested in products
  that can be used to limit exposure to risk.
• Options provide an excellent vehicle for this.
• We will cover the basic option pricing
  methodology and discuss combining options to
  create products designed to limit risk exposure.

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Option Pricing and Asset Value

• Additionally many financial products include
  options embedded in the product for example a
  call option on a corporate bond. These options
  increase the risk of holding the product.
• We will use a second option pricing model to
  value call options and put options in fixed
  income securities.

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Other Risk Management Techniques

• Swaps exchanging one cash flow stream for
  another in an attempt to change the asset or
  liability structure of the firm.
• Time permitting, we will describe a basic swap
  and discuss the use of swaps in managing risk.