1. Chapter 13 Nonbank Finance

2. © 2016 Pearson Education, Inc. All rights reserved.13-2 Preview This chapter examines how institutions which engaged in nonbank finance operate and how they are regulated.

3. © 2016 Pearson Education, Inc. All rights reserved.13-3 Learning Objectives Summarize the different types of insurance products and the ways in which insurance companies can reduce asymmetric information problems. Summarize the distinctions between defined-benefit and defined-contribution pensions and the key features of private and public pension plans. List and describe the different types of finance companies.

4. © 2016 Pearson Education, Inc. All rights reserved.13-4 Learning Objectives Summarize the roles of investment banks, securities brokers and dealers, and organized exchanges. Describe the role and activities of mutual funds in financial intermediation. Summarize the key distinctions between hedge funds and mutual funds. Define private equity and venture capital, and summarize their advantages as investment funds. Describe the two types of government financial intermediation.

5. © 2016 Pearson Education, Inc. All rights reserved.13-5 Insurance Life insurance –Permanent (whole, universal, and variable) –Term Property and Casualty –Hold more liquid assets than life insurance companies –Reinsurance

6. © 2016 Pearson Education, Inc. All rights reserved.13-6 Insurance Competitive threat from the banking industry Credit insurance –Credit default swaps AIG blowup –Monoline insurance

7. © 2016 Pearson Education, Inc. All rights reserved.13-7 Table 1 Relative Shares of Total Financial Intermediary Assets, 1970–2013 (percent)

8. © 2016 Pearson Education, Inc. All rights reserved.13-8 Application: Insurance Management To lower moral hazard and adverse selection –Screening –Risk-based premiums –Restrictive provisions –Prevention of fraud –Cancellation of insurance –Deductibles –Coinsurance –Limits on the amounts of insurance

9. © 2016 Pearson Education, Inc. All rights reserved.13-9 Pension Funds Defined-contribution plan Defined-benefit plan –Fully-funded; underfunded Private pension plans –Employee Retirement Income Security Act (ERISA) of 1974 Pension Benefit Guarantee Corporation (PBGC, Penny Benny)

10. © 2016 Pearson Education, Inc. All rights reserved.13-10 Pension Funds Public pension plans –Social Security Pay as you go system Massive underfunding Possible reforms proposed

11. © 2016 Pearson Education, Inc. All rights reserved.13-11 FYI: Should Social Security Be Privatized? Privatization proposals take three basic forms: –Government investment of trust fund assets in corporate securities –Shift of trust fund assets to individual accounts that can be invested in private assets –Individual accounts in addition to those in the trust fund

12. © 2016 Pearson Education, Inc. All rights reserved.13-12 Finance Companies Virtually unregulated compared to commercial banks and thrifts institutions Sales finance companies Consumer finance companies Business finance companies –Factoring –Leasing equipment

13. © 2016 Pearson Education, Inc. All rights reserved.13-13 Securities Market Operations Financial facilitators –Investment banks –Securities brokers and dealers –Organized exchanges

14. © 2016 Pearson Education, Inc. All rights reserved.13-14 Investment Banking Assist in the sale of securities –Advise the corporation on whether it should issue bonds or stock. –Bonds: advise on maturity and interest payments –Stocks: advice on price Seasoned issues or initial public offering –Underwrites

15. © 2016 Pearson Education, Inc. All rights reserved.13-15 Investment Banking Regulated by SEC –Registration statement –Provide potential investors with a prospectus –20 day waiting period

16. © 2016 Pearson Education, Inc. All rights reserved.13-16 Securities Brokers and Dealers Securities brokers and dealers conduct trading in secondary markets Brokers –Agents for investors, match buyers and sellers –Paid brokerage commission Dealers –Stand ready to buy and sell –Hold inventories –Paid by the ‘spread’ Brokerage firms –Act as brokers, dealers, and investment bank –Regulated by SEC

17. © 2016 Pearson Education, Inc. All rights reserved.13-17 Organized Exchanges NYSE: largest organized exchange in the world. Hybrid of auction market and dealer market. Specialist Regulated by SEC –Authority to impose regulation and to alter the rules set by the exchanges Securities Amendments Act of 1975 Growing internationalization

18. © 2016 Pearson Education, Inc. All rights reserved.13-18 Mutual Funds Pool the resources of many small investors by selling shares and using the proceeds to buy securities Sovereign wealth funds –Estimated to hold $3 trillion in assets –Concerns Size (can cause market instability) National security issues Provide very little information about their operations Open-end fund and closed-end fund

19. © 2016 Pearson Education, Inc. All rights reserved.13-19 Mutual Funds Load funds and no-load funds Regulated by Securities and Exchange Commission Money market mutual funds –Function as checkable deposits that earn interest.

20. © 2016 Pearson Education, Inc. All rights reserved.13-20 Hedge Funds Similar to mutual funds but: –Minimum investment typically $1 million –No more than 99 investors –Net worth requirement for investors –Long-term commitment –Speculates on spreads

21. © 2016 Pearson Education, Inc. All rights reserved.13-21 Private Equity and Venture Capital Funds Private equity fund –Long-term investments in companies that are not traded in public markets. Two types –Venture capital funds –Capital buyout funds (leveraged buyout) Carried interest

22. © 2016 Pearson Education, Inc. All rights reserved.13-22 Government Financial Intermediation Mortgage market –GNMA, Ginnie Mae –FNMA, Fannie Mae (GSE) –FHLMC, Freddie Mac (GSE) Farm Credit System Federal Credit Reform Act of 1990 The creation of GSEs has led to conflict of interest and moral hazard problems.

23. © 2016 Pearson Education, Inc. All rights reserved.13-23 FYI: The Global Financial Crisis and the Bailout of Fannie Mae and Freddie Mac Legislation passed in 1992 assigned Fannie and Freddie a federal regulator and supervisor, the Office of Federal Housing Enterprise Oversight (OFHEO), but this regulator was quite weak. With weak regulation and strong incentives to take on risk, Fannie and Freddie grew wildly, and by 2008 these firms had purchased or were guaranteeing over $5 trillion of mortgages and mortgage-backed securities.

24. © 2016 Pearson Education, Inc. All rights reserved.13-24 FYI: The Global Financial Crisis and the Bailout of Fannie Mae and Freddie Mac Amidst the losses that came with the subprime mortgage default, the federal government was ultimately forced to takeover both institutions.