Drake DRAKE UNIVERSITY UNIVERSITE D’AUVERGNE Recent Changes in The United States Financial Services Industry

UNIVERSITE D’AUVERGNE Drake Drake University Introduction Thank you for inviting me to visit your university Tom Root PhD Economics University of Kansas Drake University Des Moines, Iowa Approximately 4,000 students

UNIVERSITE D’AUVERGNE Drake Drake University 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

UNIVERSITE D’AUVERGNE Drake Drake University 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.

UNIVERSITE D’AUVERGNE Drake Drake University 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.

UNIVERSITE D’AUVERGNE Drake Drake University 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

UNIVERSITE D’AUVERGNE Drake Drake University 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

UNIVERSITE D’AUVERGNE Drake Drake University 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).

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

UNIVERSITE D’AUVERGNE Drake Drake University 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

UNIVERSITE D’AUVERGNE Drake Drake University 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

UNIVERSITE D’AUVERGNE Drake Drake University 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)

UNIVERSITE D’AUVERGNE Drake Drake University 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.

UNIVERSITE D’AUVERGNE Drake Drake University Roles played by FI’s 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)

UNIVERSITE D’AUVERGNE Drake Drake University Special Roles played by FI’s 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

UNIVERSITE D’AUVERGNE Drake Drake University Special Roles played by FI’s 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

UNIVERSITE D’AUVERGNE Drake Drake University 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

UNIVERSITE D’AUVERGNE Drake Drake University Regulation Given the important roles played by the Financial Services Industry in the economy, it is highly regulated.

UNIVERSITE D’AUVERGNE Drake Drake University Justification of Regulation of FI’s Safety and Soundness Regulation Monetary Policy Regulation Promotion of “Fair” Competition Credit Allocation Regulation Consumer Protection Regulation Investor Protection Regulation Entry Regulation

UNIVERSITE D’AUVERGNE Drake Drake University 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.

UNIVERSITE D’AUVERGNE Drake Drake University 1999 Financial Services Modernization 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

UNIVERSITE D’AUVERGNE Drake Drake University Trends in the US

UNIVERSITE D’AUVERGNE Drake Drake University Competition among FI’s

UNIVERSITE D’AUVERGNE Drake Drake University Impact on US Market Increased merger and acquisition activity in financial services industry. Demutualization of insurance firms and savings and loans

UNIVERSITE D’AUVERGNE Drake Drake University 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

UNIVERSITE D’AUVERGNE Drake Drake University 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).

UNIVERSITE D’AUVERGNE Drake Drake University 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

UNIVERSITE D’AUVERGNE Drake Drake University Special Treatment of GSE’s 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 GSE’s GSE securities are eligible as collateral for public deposits and for loans from the Federal Reserve

UNIVERSITE D’AUVERGNE Drake Drake University GSE’s 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

UNIVERSITE D’AUVERGNE Drake Drake University GSE’s 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

UNIVERSITE D’AUVERGNE Drake Drake University 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.

UNIVERSITE D’AUVERGNE Drake Drake University 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

UNIVERSITE D’AUVERGNE Drake Drake University Composition of US Debt Market Sept 2003 (Total value $22.6 Trillion)

UNIVERSITE D’AUVERGNE Drake Drake University Bond Market Association 2003 is as of Sept 30,2003 % of Outstanding Debt Market

UNIVERSITE D’AUVERGNE Drake Drake University Bond Market Association 2003 as of Sept 30,2003 Average Daily Trading Volume ($Billions)

UNIVERSITE D’AUVERGNE Drake Drake University Bond Market Associattion 2003 as of Sept 30, 2003 Issuance by GSE’s ($ Billions)

UNIVERSITE D’AUVERGNE Drake Drake University Securitization Davidson et al Wiley Pub Outstanding Mortgage and Asset Backed Securities in US

UNIVERSITE D’AUVERGNE Drake Drake University Current Questions in the Market Place relating to GSE’s Are the GSE’s, 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?

UNIVERSITE D’AUVERGNE Drake Drake University Recent Study by Federal Reserve Wayne Passmore, an economist at the Federal Reserve Bank has recently completed a study on the impact of GSE’s The GSE’s 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

UNIVERSITE D’AUVERGNE Drake Drake University 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.

UNIVERSITE D’AUVERGNE Drake Drake University 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.

UNIVERSITE D’AUVERGNE Drake Drake University 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 Assume that you believe that the most the yield will increase in the next day is.2%. The new value of the bond is The difference would represent the value at risk.

UNIVERSITE D’AUVERGNE Drake Drake University 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?

UNIVERSITE D’AUVERGNE Drake Drake University 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.

UNIVERSITE D’AUVERGNE Drake Drake University 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.

UNIVERSITE D’AUVERGNE Drake Drake University 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.