Reading: Lesson 4 - Financial Institutions & Markets

1.4.A - Financial Institutions & Markets

1. Investment Banks and Brokerage Activities

1. Investment banking houses help companies raise capital. Such organizations underwrite security offerings, which means they (1) advise corporations regarding the design and pricing of new securities, (2) buy these securities from the issuing corporation, and (3) resell them to investors.
   
2. Although the securities are sold twice, this process is really one primary market transaction, with the investment banker acting as a facilitator to help transfer capital from savers to businesses.
   
3. An investment bank often is a division or subsidiary of a larger company. For example, JP Morgan Chase & Co. is a very large financial services firm, with over $2 trillion in managed assets. One of its holdings is J.P. Morgan, an investment bank.
   
4. In addition to security offerings, investment banks also provide consulting and advisory services, such as merger and acquisition (M&A) analysis and investment management for wealthy individuals. Most investment banks also provide brokerage services for institutions and individuals (called “retail” customers).
   
5. At one time, most investment banks were partnerships, with income generated primarily by fees from their underwriting, M&A consulting, asset management, and brokering activities. When business was good, investment banks generated high fees and paid big bonuses to their partners. When times were tough, investment banks paid no bonuses and often fired employees.

In the 1990s most large investment banks were reorganized into publicly traded corporations (or were acquired and then operated as subsidiaries of public companies). For example, in 1994 Lehman Brothers sold some of its own shares of stock to the public via an IPO. Like most corporations, Lehman Brothers was financed by a combination of equity and debt. A relaxation of regulations in the 2000s allowed investment banks to undertake much riskier activities than at any time since the Great Depression. The new regulations allowed investment banks to use an unprecedented amount of debt to finance their activities—Lehman used roughly $30 of debt for every dollar of equity. In addition to their fee-generating activities, most investment banks also began trading securities for their own accounts. In other words, they took the borrowed money and invested it in financial securities. If you are earning 12% on your investments while paying 8% on your borrowings, then the more money you borrow, the more profit you make. But if you are leveraged 30 to 1 and your investments decline in value by even 3.33%, your business will fail. This is exactly what happened to Bear Stearns, Lehman Brothers, and Merrill Lynch in the fall of 2008. In short, they borrowed money, used it to make risky investments, and then failed when the investments turned out to be worth less than the amount they owed. Note that it was not their traditional investment banking activities that caused the failure, but the fact that they borrowed so much and used those funds to speculate in the market.

2. Deposit-Taking Financial Intermediaries

1. Mutual savings banks (MSBs) are similar to S&Ls, but they operate primarily in the northeastern states. Today, most S&Ls and MSBs have been acquired by banks.
   
2. Credit unions are cooperative associations whose members have a common bond, such as being employees of the same firm or living in the same geographic area. Members’ savings are lent only to other members, generally for auto purchases, home-improvement loans, and home mortgages. Credit unions are often the cheapest source of funds available to individual borrowers.
   
3. Commercial banks raise funds from depositors and by issuing stock and bonds to investors. For example, someone might deposit money in a checking account. In return, that person can write checks, use a debit card, and even receive interest on the deposits. Those who buy the banks’ stocks expect to receive dividends and interest payments. Unlike non-financial corporations, most commercial banks are highly leveraged in the sense that they owe much more to their depositors and creditors than they raised from stockholders.
   
4. Banks are vitally important for a well-functioning economy, and their highly leveraged positions make them risky. As a result, banks are more highly regulated than non-financial firms. Given the high risk, banks might have a hard time attracting and retaining deposits unless the deposits were insured, so the Federal Deposit Insurance Corporation (FDIC), which is backed by the U.S. government, insures up to $250,000 per depositor. As a result of the global economic crisis, this insured amount was increased from $100,000 in 2008 to reassure depositors.
   
5. Without such insurance, if depositors believed that a bank was in trouble, they would rush to withdraw funds. This is called a “bank run,” which is exactly what happened in the United States during the Great Depression, causing many bank failures and leading to the creation of the FDIC in an effort to prevent future bank runs. Not all countries have their own versions of the FDIC, so international bank runs are still possible. In fact, a bank run occurred in September 2008 at the U.K. bank Northern Rock, leading to its nationalization by the government.
   
6. Most banks are small and locally owned, but the largest banks are parts of giant financial services firms. For example, JPMorgan Chase Bank, commonly called Chase Bank, is owned by JPMorgan Chase & Co., and Citibank is owned by Citicorp.
   

Example:

A typical bank has about $90 of debt for every $10 of stockholders’ equity. If the bank’s assets are worth $100, we can calculate its equity capital by subtracting the $90 of liabilities from the $100 of assets: Equity capital = $100 − $90 = $10. But if the assets drop in value by 5% to $95, the equity drops to $5 = $95 − $90, a 50% decline.

3. Investment Funds

1. Mutual funds are corporations that accept money from savers and then use these funds to buy financial instruments. These organizations pool funds, which allows them to reduce risks by diversification and achieve economies of scale in analyzing securities, managing portfolios, and buying/selling securities. Different funds are designed to meet the objectives of different types of savers. Hence, there are bond funds for those who desire safety and stock funds for savers who are willing to accept risks in the hope of higher returns. There are literally thousands of different mutual funds with dozens of different goals and purposes. Some funds are actively managed, with their managers trying to find undervalued securities, while other funds are passively managed and simply try to minimize expenses by matching the returns on a particular market index.
   
2. Money market funds invest in short-term, low-risk securities, such as Treasury bills and commercial paper. Many of these funds offer interest-bearing checking accounts with rates that are greater than those offered by banks, so many people invest in money market funds as an alternative to depositing money in a bank. Note, though, that money market funds are not required to be insured and so are riskier than bank deposits.
   
3. Most traditional mutual funds allow investors to redeem their share of the fund only at the close of business. A special type of mutual fund, the exchange traded fund (ETF), allows investors to sell their share at any time during normal trading hours. ETFs usually have very low management expenses and are rapidly gaining in popularity.
   
4. Hedge funds raise money from investors and engage in a variety of investment activities. Unlike typical mutual funds, which can have thousands of investors, hedge funds are limited to institutional investors and a relatively small number of high-net-worth individuals. Because these investors are supposed to be sophisticated, hedge funds are much less regulated than mutual funds. The first hedge funds literally tried to hedge their bets by forming portfolios of conventional securities and derivatives in such a way as to limit their potential losses without sacrificing too much of their potential gains. Many hedge funds had spectacular rates of return during the 1990s. This success attracted more investors, and thousands of new hedge funds were created. Much of the low-hanging fruit had already been picked, however, so the hedge funds began pursuing much riskier (and unhedged) strategies, including the use of high leverage in unhedged positions. Perhaps not surprisingly (at least in retrospect), some funds have produced spectacular losses. For example, many hedge fund investors suffered huge losses in 2007 and 2008 when large numbers of sub-prime mortgages defaulted.
5. Private equity funds are similar to hedge funds in that they are limited to a relatively small number of large investors. They differ in that they own stock (equity) in other companies and often control those companies, whereas hedge funds usually own many different types of securities. In contrast to a mutual fund, which might own a small percentage of a publicly traded company’s stock, a private equity fund typically owns virtually all of a company’s stock. Because the company’s stock is not traded in the public markets, it is called “private equity.” In fact, private equity funds often take a public company (or subsidiary) and turn it private, such as the 2007 privatization of Chrysler by Cerberus. (Fiat is now the majority owner.) The general partners who manage private equity funds usually sit on the companies’ boards and guide their strategies with the goal of later selling the companies for a profit.

1. Life insurance companies take premiums, invest these funds in stocks, bonds, real estate, and mortgages, and then make payments to beneficiaries. Life insurance companies also offer a variety of tax-deferred savings plans designed to provide retirement benefits.
   
2. Traditional pension funds are retirement plans funded by corporations or government agencies. Pension funds invest primarily in bonds, stocks, mortgages, hedge funds, private equity, and real estate. Most companies now offer self-directed retirement plans, such as 401(k) plans, as an addition to or substitute for traditional pension plans. In traditional plans, the plan administrators determine how to invest the funds; in self-directed plans, all individual participants must decide how to invest their own funds. Many companies are switching from traditional plans to self-directed plans, partly because this shifts the risk from the company to the employee.
   

5. Regulation of Financial Institutions

1. In 1933, the Glass-Steagall Act was passed with the intent of preventing another great depression. In addition to creating the FDIC to insure bank deposits, the law imposed constraints on banking activities and separated investment banking from commercial banking. The regulatory environment of the post-Depression era included a prohibition on nationwide branch banking, restrictions on the types of assets the institutions could buy, ceilings on the interest rates they could pay, and limitations on the types of services they could provide. Arguing that these regulations impeded the free flow of capital and hurt the efficiency of our capital markets, policymakers took several steps from the 1970s to the 1990s to deregulate financial services companies, culminating with the Gramm– Leach–Bliley Act of 1999, which “repealed” Glass-Steagall’s separation of commercial and investment banking.
   
2. One result of deregulation was the creation of huge financial services corporations, which own commercial banks, S&Ls, mortgage companies, investment-banking houses, insurance companies, pension plan operations, and mutual funds. Many are now global banks with branches and operations across the country and around the world.
   
3. The financial crisis of 2008–2009 and the continuing global economic crisis are causing regulators and financial institutions to rethink the wisdom of deregulating conglomerate financial services corporations. To address some of these concerns, the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in 2010. We discuss Dodd-Frank and other regulatory changes in Section 1.13, where we explain the events leading up to the global economic crisis.
   

1. Financial markets bring together people and organizations needing money with those having surplus funds. There are many different financial markets in a developed economy. Each market deals with a somewhat different type of instrument, customer, or geographic location.
   
2. Physical asset markets (also called “tangible” or “real” asset markets) are those for such products as wheat, autos, real estate, computers, and machinery. Financial asset markets, on the other hand, deal with stocks, bonds, notes, mortgages, derivatives, and other financial instruments.
   
3. Spot markets and futures markets are markets where assets are being bought or sold for “on-the-spot” delivery (literally, within a few days) or for delivery at some future date, such as 6 months or a year into the future.
   
4. Money markets are the markets for short-term, highly liquid debt securities, while capital markets are the markets for corporate stocks and debt maturing more than a year in the future. The New York Stock Exchange is an example of a capital market. When describing debt markets, “short term” generally means less than 1 year, “intermediate term” means 1 to 5 years, and “long term” means more than 5 years.
   
5. Mortgage markets deal with loans on residential, agricultural, commercial, and industrial real estate, while consumer credit markets involve loans for autos, appliances, education, vacations, and so on.
   
6. World, national, regional, and local markets also exist. Thus, depending on an organization’s size and scope of operations, it may be able to borrow or lend all around the world, or it may be confined to a strictly local, even neighborhood, market.
   
7. Primary markets are the markets in which corporations raise new capital. If Microsoft were to sell a new issue of common stock to raise capital, this would be a primary market transaction. The corporation selling the newly created stock receives the proceeds from such a transaction. The initial public offering (IPO) market is a subset of the primary market. Here firms “go public” by offering shares to the public for the first time. For example, Google had its IPO in 2004. Previously, founders Larry Page and Sergey Brin, other insiders, and venture capitalists owned all the shares. In many IPOs, the insiders sell some of their shares and the company sells newly created shares to raise additional capital. Secondary markets are markets in which existing, already outstanding securities are traded among investors.
   
8. Private markets, where transactions are worked out directly between two parties, are differentiated from public markets, where standardized contracts are traded on organized exchanges. Bank loans and private placements of debt with insurance companies are examples of private market transactions. Because these transactions are private, they may be structured in any manner that appeals to the two parties. By contrast, securities that are issued in public markets (for example, common stock and corporate bonds) are ultimately held by a large number of individuals. Public securities must have fairly standardized contractual features because public investors cannot afford the time to study unique, non-standardized contracts. Hence private market securities are more tailor-made but less liquid, whereas public market securities are more liquid but subject to greater standardization.