1. Chapter 5: The Performance of Nontraditional Banking Companies

2. The Performance of Nontraditional Banking Companies Goldman Sachs: – The world’s premier investment bank for many years. – Converted to financial holding company in 2008 in response to the global credit crisis. Mutual of Omaha Bank – Subsidiary of Mutual of Omaha and run as in independent company. BMW Bank of North America – Industrial loan corporation (ILC) owned by BMW Financial Services, a division of BMW North America.

3. The Disappearance of Large Investments Banks Financial Services Modernization Act (1999): – Allowed commercial and investment banks to merge. – Encouraged consolidation and new business expansion. Investment Banking Activities: – Securities underwriting – Advisory services – Market making – Propriety trading and investing

5. Securities Underwriting and Advisory Services Securities Underwriting: – Investment banks assist with stocks and bonds issues. – First-time placement called an Initial Public Offering (IPO). Advisory Services: – Numerous fee-based services that assist managing risks. Providing advice concerning mergers and acquisitions and spin- offs of lines of business. Managing investable assets, pension funds and investments. Making risk management decisions involving the uses of foreign currencies, commodities, and derivatives.

6. Market Making Investment bank may be willing to buy securities from participants who want to sell and sell to participants who want to buy. – Profit from the bid-ask spread. – Additional profit from the difference between the yield on the securities owned and the interest paid on debt. – Bank acts as a broker and does not take ownership of the underlying security.

7. Proprietary Trading and Principal Investing Proprietary trading occurs when an investment bank commits its own funds to take a risk position in a security, commodity or asset. – Hopes to profit later by reversing the trade. Principal investing occurs when the bank takes a position in a security, derivative or stock with the expectation to hold the position for some time, perhaps even years, before trading out of it. – In this context, investment banks have operated as hedge funds or private equity funds.

8. Proprietary Trading and Principal Investing Hedge Fund: – An investment fund that is limited to a small number of sophisticated investors. – The fund’s managers take positions that are of any type and not subject to regulation. – Managers generally charge a 2 percent fee applied to the amount of assets under management plus a 20 percent performance fee equal to 20 percent of the profit generated during a year. This 2 + 20 fee structure generates an extraordinary profit for the managers with limited downside risk.

9. Proprietary Trading and Principal Investing Private Equity Fund: – Accept investments from institutional investors in the form of limited partnership investments. – The funds use the proceeds to buy companies and make other investments, but usually have a longer investment horizon than hedge funds when entering transactions. – Fund managers earn a management fee plus a percentage (usually 20 percent) of profits in excess of some minimum rate of return.

10. Goldman Sachs Group and Goldman Sacs Bank USA Goldman Group was a $939 billion organization at the end of 2012. Separates operations into four segments: – Investment banking – Institutional client services – Investing and lending – Investment management

13. Goldman Group and Goldman Bank Balance Sheets Financial instruments owned include cash and derivative securities. Collateralized agreements: – Borrowed securities and other financial instruments purchased under an agreement to resell at a later date. Profit from earning interest on these securities net of interest paid on their financing. – Collateralized financings consist of securities loaned and instruments sold under agreements to repurchase. These figures should be netted as they reflect transactions designed to generate interest income net of financing costs.

14. Goldman Group and Goldman Bank Balance Sheets Receivables: – Amounts owed to Goldman by brokers, firm customers, and counterparties to derivative and other contracts. – These amounts might be matched with the payables to the same groups listed under liabilities. Unsecured borrowings: – Represent “hot money” that can not be relied on to be rolled over in a crisis situation.

17. Key Performance Ratios Generating returns comparable to Goldman has been difficult for most banks. – Earnings were generally higher than almost all other large financial institutions. Events in 2008 demonstrated that Goldman’s business model was not sustainable. – Severe liquidity crisis in 2008 due to housing market collapse and declines in the values of assets owned. – Stock price fell from $240 to under $70. – Goldman reported its first quarterly loss in since it began trading as a public company.

19. Risks Faced by Goldman Sachs Credit crisis of 2007–2009 caused money and capital markets to stop functioning normally. – Commercial paper market froze and large institutions were hesitant to lend to each other. – Goldman faced a potential run on the firm as lenders were hesitant to roll over debts and Goldman was unable to sell a sufficient volume of assets to readily access cash. Management decided to covert to a financial holding company which allowed access to more stable core deposits for its funding. On the negative side, Goldman agreed to be regulated by the Federal Reserve as a bank.

20. Goldman Group’s Risk Profile Risks listed in Goldman’s 2007 annual report: – Increasing and/or high rates and widening credit spreads. – Market fluctuations that may adversely affect the value of large trading and investment positions. – Declines in the number and size of securities under- writings and mergers and acquisitions that may lower revenues. – Declines in equity values that may lower asset management fees.

21. Goldman Group’s Risk Profile Risks listed in Goldman’s 2007 annual report: – Possible decline in the volume of transactions executed by the firm as a specialist or market maker. – An increase in market volatility that may cause the firm to reduce its proprietary trading. Each of these risk factors appeared to be to the detriment of Goldman Group in 2008. – Goldman holds many different types of securities, some of which are difficult to value. Under FASB 157, they are required to classify assets as Level 1, Level 2, or Level 3.

22. Accounting for Fair Market Value of Securities Under FASB 157 Level 1 Assets: – Valuations based on observable market prices for the identical asset or liability (marking to market). – Publicly traded stock, government and agency bonds, listed options and futures and mutual funds. Level 2 Assets: – Valuations based on observable market data for similar assets or liabilities (marking to matrix) with price quotes typically obtained from dealer pricing services. – Bonds that trade infrequently, mortgage-backed securities and other asset-backed securities not publicly traded.

23. Accounting for Fair Market Value of Securities Under FASB 157 Level 3 Assets: – Valuations based on management’s best judgment of what the underlying asset is worth (marketing to myth). – Management may use any pricing model and make its own assumptions regarding the parameters. – Price quotes are the least reliable of all valuation techniques. – Some assets may be substantially overpriced or underpriced depending on the model analytics.

24. Goldman Group’s Risk Profile Subject to higher capital requirements as a financial holding company. – Reduced balance sheet and the amount of level 3 assets and increased capital. – Bank regulators have required Goldman Group to lower its financial leverage. Dodd-Frank Volker Rule (2014) is expected to have a significant impact on the company. – Prohibits proprietary trading using FDIC funds and limits hedge fund and private equity fund investing.

25. The Financial Performance of Mutual of Omaha Bank Mutual of Omaha (MO) is an insurance company offering a wide range of insurance products along with annuities and mutual funds. – In 2007, opened Mutual of Omaha Bank (MO Bank) with 13 locations in Nebraska and Colorado through the acquisition and merger of three existing banks – MO Bank’s strategic objective is to “acquire community banks in fast-growing cities with a high density of Mutual of Omaha insurance customers.” – Has a thrift charter granted by the Office of Thrift Supervision.

26. The Financial Performance of Mutual of Omaha Bank In 2007, MO Bank had over $7 million in assets and grew to $5.9 billion by the end of 2012. During 2008 acquired two failed banks and opened new lending operations. Bank continues to acquire other locations in fast-growing states. Second phase of MO Bank’s strategy is the creation of a virtual online bank where customers can transact business online from anywhere in the U.S.

29. Mutual of Omaha Bank’s Risk Profile MO Bank faces the same types of risk that other commercial banks face. – Primary exposure is to credit risk. – During 2012 charged off.53 percent of loans which is in line with other banks of similar size. MO Bank benefits from the strong capital based and low-risk profile of its parent. – The principal benefit from operating as part of MO is the diversification and access to capital.

31. The Financial Performance of BMW Financial Services and BMW Bank of North America Many firms in financial services and the auto industry own Industrial Loan Companies (ILCs). – Originated in the early 1900s to make loans to borrowers who could not get loans at commercial banks. – Over time, ILCs were granted the right to issue deposits insured by the FDIC. – FDIC put a moratorium on extending FDIC insurance to ILC’s in 2006, so no new ones have been chartered since. – Historically, most ILCs operated to assist their parent organization in some facet of the firm’s core business.

32. The Financial Performance of BMW Financial Services and BMW Bank of North America ILCs gained notoriety when Wal-Mart applied for an ILC charter in 2005 and Home Depot followed. – Community banks argued against granting Wal-Mart a charter because they were concerned that traditional banking services would be offered in all stores and potentially drive them out of business. – Criticisms against the charter included: There should be a separation between commerce and banking to protect customers from potential conflicts of interest. Firms like Wal-Mart could dominant business in communities. ILCs are not subject to the same regulations as commercial banks which may create safety and soundness problems.

33. The Financial Performance of BMW Financial Services and BMW Bank of North America BMW Bank of North America is an ILC owned by BMW Financial Services. – BMW Financial Services offers loans, leases, and credit cards via BMW Bank and insurance services in conjunction with Liberty Mutual Insurance Company. – Operates from a single office in Utah, collects deposits and uses borrowed funds to underwrite loans and leases for the purchase of automobiles at BMW dealers. – Due to its affluent customer base, operates somewhat like a private bank within a large commercial banking organization.

36. BMW Bank’s Risk Profile Reported higher ROE and ROA than peer averages due to much lower noninterest expenses to average assets. Invested proportionately more in loans and investment securities than peers. Earns a higher yield on loans and securities but pays much higher rates on its interest-bearing liabilities. Gets very little funding from demand deposits, raising its overall cost of funds. Efficiency ratio is significantly lower than peers. Lower loan charge-offs and provisions for loan losses than traditional commercial banks.