Lecture #1             BUSINESS CYCLESThere is more or less a pattern of expansion(recovery) and contraction (recession) i...
Lecture #2                   MARKETSWhat are they ??What makes a good market ??Can we name some “bad” markets ?? FINANCIAL...
The players in the market are households,businesses and governments. How they play andwhat motivates them to play is criti...
Lecture #3              FLOW OF FUNDSWho are the players?     Households     Businesses     Governments     Rest of the Wo...
Intermediaries also incur risks……… I/R risk FX risk Credit or default riskWhat about Foreign Mkts & Intermediaries ? Provi...
What is an interest rate ?    Compensation for lending or giving up one’s    abilitiy to spend today.    Can be a measurin...
The Present Value calculation converts cashflows received in the future to a valueassuming receipt today (the PRESENT ).Ho...
Where do you hear the concept of PresentValue applied quite often ?      U.S. Savings Bonds      Winning the lotteryBack t...
WHAT DETERMINES THE LEVEL OF I/RAT ANY GIVEN POINT IN TIME ?The supply and demand of loanable funds.Same concept as the su...
What might cause the curves to shift ?  SUPPLY:     I/R     Wealth     Risk     Near term spending needs     Monetary Expa...
Begin with the “real interest rate “  Direct correlation between inflation & i/r..  U.S. Treasuries become the benchmark.....
Liquidity Premium TheoryMarket Segmentation Theory                                      Lecture #7What does the yield curv...
What exactly are bonds ?Debt instruments – Secured/UnsecuredCoupon or ZeroPV = Face Value = ParPV> Face Value= PremiumPV <...
Price and yield are inversely related. Why ?Duration – measure of the weighted averagetime to maturity. That is, it takes ...
Objectives:    Moderate long-term i/r    Maintain high level of employment    Stable prices    Economic growthIt’s duties:...
12 Regional Banks7 Member Board of Governors    5 of Regional Bank Presidents + Board of    Governors comprise the Federal...
In essence it is an attempt to influence theamount of reserves that remain in the bankingsystem….which in turn affects i/r...
lowered 11 time in 2001 in an attempt tostimulate the economy.Bank reserves:   Required – currently 10%   ExcessHow do the...
M1    M2The FED selects a target and uses MonetaryPolicy to get to that target.Most popular targets:    Money Supply    In...
Active secondary market/ very liquidCapital markets > 1 yearCharacteristics of money market instruments: Large – usually $...
Benchmark for other securities pricing  Refinancing debt/govt. deficit/tax timing  Sold at auction weekly  Shortest maturi...
FED sets the lending rate.For all practical purposes are just lending cashbetween two banks.REPURCHASE AGREEMENTS (REPOS) ...
Corporates with good credit can oftenborrow cheaper in the cp mkt. than from theirbanks. (see chart on page 135)…comparing...
Bank issued promissory notes. Specificmaturity and rate. Trade in secondary marketat negotiated price.Normal maturities ar...
Issuer              InvestorT-bills     Treasury            Fed/Banks/CorFed Funds Banks                 BanksRepos       ...
The Fed – for controlling the money supply.Banks – to meet reserve requirement and as aplace to use excess reserves.Broker...
Foreigners are major investors in Treasuries  Diversification and default freeKeep deposits in foreign countries to facili...
Bonds are capital market instruments withmaturities of greater than one year.Typically fixed income ….offering interest as...
accrued interest..or discount the price toaccount for it.            MUNICIPAL BONDSDebt instruments issued by state and l...
Secondary market very thin.            CORPORATE BONDSComprise about 57% of o/s bonds.Normally issued to fund long term ob...
INTERNATIONAL BOND MARKETSEurobonds – Sold outside the country of thecurrency in which they are issued. Could bedollar den...
75% of mortgages are for single familydwellings.Characteristics of a mortgage:  Size, term, i/r, collateralQualifications ...
Sold off in secondary market thrusecuritization. Allows FI to enhance theirliquidity and reduce i/r and credit risk.What i...
Equity/ownershipHow does one make a return from stock ownership ?Common/PreferredDividendsLimited liability of ownershipIP...
Indices:    DOW / S & P 500 / Wilshire 5000What causes prices to change on the Market ?Efficient market theory / Random wa...
The foreign exchange rate is the ratio of onecurrency to another. How yen equal one dollar ?Initially had fixed currency r...
Capital Account :   Direct investment   Portfolio investment                                    Lecture #16               ...
Swaps, caps, floors, etc. are examples of these.Most deal with the i/r or credit markets.Spot contracts - discussed in FX ...
Can hold contracts to maturity or trade….mostliquidate before maturity.If hold to maturity you takepossession of the under...
You can purchase indices made up of the majorstocks….Dow/ S & P 500, etc. You can use these tohedge (as a derivative) othe...
Caps (ceilings) – limit the upside exposure.Floors – protect the bottomCollars – give up a little to establish a range of ...
Loans are assets/Deposits are liabilities. How thendo banks make a profit when their chief assets andliabilities are just ...
Biggest problems:    Default    Fixed rate lending    Mismatch of maturitiesKeys to successful asset management:    Lend t...
Generally checking, savings and CD’s.The remainder of funding comes from direct bondissuance, discount window and fed fund...
Serves as a cushion against a drop in assets. Whathappens when liabilities exceed assets ?Japan banking crisisWhat happens...
Commercial banking – International    U.S. banks going abroad:       Less regulation       New business       Follow their...
Savings assoc. (formerly S & L’s)…population hasdeclined by 75% over last 20 years. Now about1200.Traditionally made long ...
SAVINGS BANKSEssentially S & L or Savings Assoc. in the NE.Less than 400 exist.Balance sheets similar to Savings Assoc. ex...
Should be able to offer better rates to customers andmake a higher ROA because of tax status.REGULATION OF THRIFTS;    Off...
Life insurance – allows individual to protectthemselves and their benefactors against the loss ofincome from death.Insures...
Premiums are assets – long lived    Investments ?    Policies are liabilitiesRegulation is at state level. Business gettin...
Investment banks…..Activities:    Investing    Investment banking    Market making    Trading    Cash management    M&AOth...
1. Sales Finance Institutions    2. Personal Credit    3. Business CreditAsset makeup / LiabilitiesSubprime ???How do they...
ProspectusesHow do you make money in a mutual fund ?How do mutual fund companies make money ?401-k growthRegulation       ...
Private plans:    401-k    IRA    KeoghPublic plans   State & local   Federal                                  Lecture #24...
Credit AllocationConsumer ProtectionInvestor ProtectionEntry & CharteringReg. of Product & Geographic Expansion   Prior to...
What is history of foreign banks ?Social Security problems / solutions                                       Lecture #25  ...
Interest Rate – MismatchingMarket – TradingOff Balance Sheet - draw downs/derivativesFX –Sovereign –Technology – Operation...
What is the best way for a FI to lessen its risk ofextending bad credit ?Real estate lending:   Ability to pay   Collatera...
Small business lending looks at cash flow of thebusiness.Mid-market focuses more on the businessitself….cash flow/customer...
How much is a relationship worth ?                                     Lecture# 27          MANAGING LIQUIDITY RISKI WANT ...
FDICFed Discount WindowLife Insurance Co. liquidity riskProperty and Casulty liquidity riskMutual Funds liquidity risk    ...
The Repricing GapThe Duration ModelWhat is Capital and how is it Valued ??                                    Lecture #29 ...
Accounting Rules / Bank RegulationsOptions / Swaps                                Lecture #30     LOAN SALES AND SECURITIZ...
What is the Market ? Who are the Players ?What drives the Market ?How is Loan Securitization different from LoanSales ?   ...
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Fin.354 lecture notes

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Fin.354 lecture notes

  1. 1. Lecture #1 BUSINESS CYCLESThere is more or less a pattern of expansion(recovery) and contraction (recession) ineconomic activity around the path of trendgrowth.At cyclical peak- economic activity is highrelative to trend.At cyclical trough ??Over time what causes the trend line to change ? More resources Factors not fully employed all the time.What is inflation ?Why worry about inflation instead of unempmt.? 1
  2. 2. Lecture #2 MARKETSWhat are they ??What makes a good market ??Can we name some “bad” markets ?? FINANCIAL MARKETS & INSTITUTIONS I. Financial markets exist to aid in the most efficient allocation of capital II. Financial Institutions facilitate this allocation of capital. 2
  3. 3. The players in the market are households,businesses and governments. How they play andwhat motivates them to play is critical to thewell being of economies. TYPES OF MARKETS Primary – New fund raising Secondary – Trading There are specialized markets for fund raising and trading. The most important of these are: Money Markets – Maturities < 1 yr. Capital Markets – Maturities > 1 yr. 3
  4. 4. Lecture #3 FLOW OF FUNDSWho are the players? Households Businesses Governments Rest of the WorldAll act at one point in time or another asborrowers and providers.Funds arrive directly or indirectlyWhat is the role of Financial Intermediaries ? To lower transaction costs To lower risk To provide better market information 4
  5. 5. Intermediaries also incur risks……… I/R risk FX risk Credit or default riskWhat about Foreign Mkts & Intermediaries ? Provide for borrowing or investing abroad Important source of diversification Lecture #4 5
  6. 6. What is an interest rate ? Compensation for lending or giving up one’s abilitiy to spend today. Can be a measuring guideline governing corportate investing. Why do we care about interest rates ? They influence the allocation of capital. They impact the economy and decision making.How do we look at interest rates and time ? Concept of Present Value Present value allows you to place a value onfuture funds. What might $10 today be worth 10years from now ? 6
  7. 7. The Present Value calculation converts cashflows received in the future to a valueassuming receipt today (the PRESENT ).How much is $3000 received in two yearsworth today if the interest rate is 4% ?How much is $2000 next year and $3000 theyear after worth today if the interest rate is5%? 7
  8. 8. Where do you hear the concept of PresentValue applied quite often ? U.S. Savings Bonds Winning the lotteryBack to our first example : PV of $3000 received in 2 years @ 4% =If the i/r is 2%....is PV higher or lower ?If the i/r is 6%.... is PV higher or lower ? Why ???? Lecture #5 8
  9. 9. WHAT DETERMINES THE LEVEL OF I/RAT ANY GIVEN POINT IN TIME ?The supply and demand of loanable funds.Same concept as the supply and demand ofgoods and services you studied in Economics.So there is a supply and demand curve here aswell.SUPPLY Households Businesses Governments Foreign investorsDEMAND Households Businesses Governments ForeignWhat might the supply and demand curve looklike ? 9
  10. 10. What might cause the curves to shift ? SUPPLY: I/R Wealth Risk Near term spending needs Monetary Expansion Economic Conditions DEMAND: Current utility Economic conditions Restrictiveness of nonprice conditions. Lecture #6What are the factors that can affect the i/r foran individual security ? 10
  11. 11. Begin with the “real interest rate “ Direct correlation between inflation & i/r.. U.S. Treasuries become the benchmark..What factors influence nominal i/r ? Default risk Liquidity risk Covenants- puts/calls Term to MaturityUbiased Expectations Theory 11
  12. 12. Liquidity Premium TheoryMarket Segmentation Theory Lecture #7What does the yield curve tell us ? 12
  13. 13. What exactly are bonds ?Debt instruments – Secured/UnsecuredCoupon or ZeroPV = Face Value = ParPV> Face Value= PremiumPV < Face Value = DiscountThese reflect the price of bonds. How doesthat relate to Yield…. 13
  14. 14. Price and yield are inversely related. Why ?Duration – measure of the weighted averagetime to maturity. That is, it takes into accountthe timing of payments. Any received beforematurity will result in a shorter duration thatthe maturity date…..Higher interest rates shorten duration. Why ? Lecture #8 THE FEDERAL RESERVE SYSTEM 14
  15. 15. Objectives: Moderate long-term i/r Maintain high level of employment Stable prices Economic growthIt’s duties: Conduct monetary policy Supervise/regulate depository institutions Maintain stability of financial system Provide payments services for governments Also check clearing & wire transfersIndependent of Executive BranchOversight by CongressChairman/Vice Chair appointed by President 15
  16. 16. 12 Regional Banks7 Member Board of Governors 5 of Regional Bank Presidents + Board of Governors comprise the Federal Open Market Committee (FOMC)The objectives shown above are their job….What is important is how they do it…. Lecture #9 MONETARY POLICYWhat is it and how does it affect us ? 16
  17. 17. In essence it is an attempt to influence theamount of reserves that remain in the bankingsystem….which in turn affects i/r and theavailability of credit…which ultimately affectsthe levels of employment, output, and prices andinflation. In other words the money supply. MONETARY POLICY TOOLSOpen Market OperationsDiscount RateReserve RequirementsThe FOMC impacts the economy thru itspractice of buying and selling governmentsecurities in the open market. In so doing theyare either adding money (expanding) to theexisting supply or taking it out (contracting).Discount rate – Rate Fed. Charges bank toborrow from it….In reality is only used as asignal to the market as to which way the Fedwants to see rates go. The discount rate was 17
  18. 18. lowered 11 time in 2001 in an attempt tostimulate the economy.Bank reserves: Required – currently 10% ExcessHow do these tools help expand the moneysupply ?How do these tools help contract the moneysupply ?Definitions of the money supply Base 18
  19. 19. M1 M2The FED selects a target and uses MonetaryPolicy to get to that target.Most popular targets: Money Supply Interest Rate Lecture #10 MONEY MARKETS Short term debt instruments < 1 year 19
  20. 20. Active secondary market/ very liquidCapital markets > 1 yearCharacteristics of money market instruments: Large – usually $1 mil. + Low default risk Maturity of 1 year or lessCorporates and governments usually sellmoney market instruments to meet short termneeds.TREASURY BILLS Default risk free 20
  21. 21. Benchmark for other securities pricing Refinancing debt/govt. deficit/tax timing Sold at auction weekly Shortest maturity is 13 weeks. Sold at a discountSuppose you buy a 26 week T-bill for $9500whose face value is $10,000. What is thediscount yield ?i = 10000-9500/10000 x 360/182 = 9.89%FEDERAL FUNDSPrimarily overnight loans between banks.One of the uses of their excess reserves. 21
  22. 22. FED sets the lending rate.For all practical purposes are just lending cashbetween two banks.REPURCHASE AGREEMENTS (REPOS) Actual sale of securities between two partieswith agreement to repurchase at set date andprice. Is collaterized most often with govt.securities. Normally 1-14 days but can go 90. More secure than Fed Funds so has loweryield…often as much as 25 basis points. Lecture #11COMMERCIAL PAPER (CP) An unsecured promissory note issued bycorporations. 22
  23. 23. Corporates with good credit can oftenborrow cheaper in the cp mkt. than from theirbanks. (see chart on page 135)…comparing cprates to prime rate. Normally held to maturity….up to 270 days. Lower rated corporates can issue cp backedby LOC’s or bank lines of credit. Expensiveby effective….better than issuing long term ifimproving credit. Purchasers get internal approval on a creditand return again again.Cp usually sold thru dealers like GoldmanSachs…agree to repurchase in event ofdefault.Rates are quoted on a discount basisNEGOTIABLE CD’s 23
  24. 24. Bank issued promissory notes. Specificmaturity and rate. Trade in secondary marketat negotiated price.Normal maturities are 14-360 days.Unsecured issuance so yield is higher.BANKERS ACCEPTANCES A draft for payment backing a LOC issuedagainst imported goods.Importer gets LOC guaranteeing payment toexporter. BA allows them to draw downmoney before delivery. Importer thenreimburses the bank.There is a secondary market for BA’s.MONEY MARKET PARTICIPANTS 24
  25. 25. Issuer InvestorT-bills Treasury Fed/Banks/CorFed Funds Banks BanksRepos Fed/Banks Fed/Banks/CorCp Banks/Corps Corps/FI’sNeg. CD Banks FI’s/CorpsBA’s Banks Banks/CorpsWhere are there secondary markets ?Where are yields the highest/lowest ?Who are the important FI’s ?Summary – Money markets are important to: 25
  26. 26. The Fed – for controlling the money supply.Banks – to meet reserve requirement and as aplace to use excess reserves.Broker-Dealers – Keep the market movingCorporations - source of short term fundingand as a place to invest short term cash.Other FI’s – A place to maintain liquidity. INTERNATIONAL MONEY MARKETS 26
  27. 27. Foreigners are major investors in Treasuries Diversification and default freeKeep deposits in foreign countries to facilitateexhange into $.LIBOR is major lending rate.Now major rate measurement for all types ofloans, not just foreign.Borrowing is usually quoted as a spread overLIBOR…might be 350, 30 or 3…dependingon the risk associated with the borrower. Lecture #12 THE BOND MARKET 27
  28. 28. Bonds are capital market instruments withmaturities of greater than one year.Typically fixed income ….offering interest aset time periods and the return of principal atmaturity. A bond with a coupon of 8% wouldnormally pay interest every six months, 4% ata time.Treasury notes >1<10 yearsTreasury bonds >10 <31 yearsThey comprise about 26% of total bondmarket securities.Both pay semi-annual interest and are sold atauction..but are sold at par unlike T-bills.Treasury also issues inflation adjusted bondscalled TIPS.They also sell STRIPS where each couponpayment is sold separately.The secondary market in Treasury issues ishuge. If a bond is sold between couponpayments the seller must pay the buyer the 28
  29. 29. accrued interest..or discount the price toaccount for it. MUNICIPAL BONDSDebt instruments issued by state and localgovernments. About 17% of all bonds o/s.Interest not taxed by feds or state investorlives in for bonds issued in that state.Tax exemption lowers cost of bonds issuancefor the governments because investors take alower yield.General obligation – backed by taxing powerRevenue bonds – backed by revenue of aproject. General tax receipts cannot be used topay off a revenue bond…thus is riskier.Industrial development bonds – normally forjob creation.How are municipal bonds sold ?Underwritten/best efforts/negotiated basis 29
  30. 30. Secondary market very thin. CORPORATE BONDSComprise about 57% of o/s bonds.Normally issued to fund long term obligations.Rating agency comments are critical to price.Debentures – no collateralSubordinated debentures – junior in statusConvertible bonds – debt that converts toequity at some point in time if certain thingsoccur.Callable bondsSinking fundsMoody’s/S & P / FitchWho are buyers of the various types of bonds?Which bonds likely carry the highest andlowest yields ? 30
  31. 31. INTERNATIONAL BOND MARKETSEurobonds – Sold outside the country of thecurrency in which they are issued. Could bedollar denominated bonds sold in Japan.Foreign bonds – Bonds issued outside thehome country but denominated in the hostcountry currency…Samurai bonds are dollardenominated bonds issued by Japaneseborrowers in the U.S.Brady bonds – bonds substituted in arestructuring of a less developed country’sdebt. Longer term and lower rates. Backed bythe U.S. TreasurySovereign bonds – specific country issued . Lecture #13 MORTGAGESLoans to purchase real property such as ahome, land or building. 31
  32. 32. 75% of mortgages are for single familydwellings.Characteristics of a mortgage: Size, term, i/r, collateralQualifications – fairly standard, income tovalue ratio (can you make the payments)Down payment – reduces default riskConventional vs. Insured.Maturity – 15/30 yr….. balloon paymentI/R – Fixed vs. ARMGreenspan ARM quotes.Amortization scheduleRefinancing depending upon rate cycle.Originate with FI’s most of whom do notcontinue to carry them on their balance sheet. 32
  33. 33. Sold off in secondary market thrusecuritization. Allows FI to enhance theirliquidity and reduce i/r and credit risk.What is securitization and how does itwork?Why securitize ?Mortgage market very cyclical. Govt.subsidies are key to role housing plays in therobustness of the economy. Home buildingmay suffer as rates go up… Lecture #14 STOCK MARKETSWhat is stock anyway ? 33
  34. 34. Equity/ownershipHow does one make a return from stock ownership ?Common/PreferredDividendsLimited liability of ownershipIPO’s /Seasoned offeringsPrimary vs. secondary markets.SEC/Registration/Red Herring/Shelf registrationThe Markets: NYSE/NASDAQ/AMEXHow does trading occur on each market ? 34
  35. 35. Indices: DOW / S & P 500 / Wilshire 5000What causes prices to change on the Market ?Efficient market theory / Random walk Lecture #15 FOREIGN EXCHANGEGlobal trade requires that we exchange currencies. 35
  36. 36. The foreign exchange rate is the ratio of onecurrency to another. How yen equal one dollar ?Initially had fixed currency rates. And Gold !!Eventually floating. Now the Euro !!Can use spot or forward markets to make exchangerate more predictable.What causes exchange rate differentials betweencountries ?Economic flows between countries are measured bythe balance of payments.Current Account: Merchandise trade balance Service sector Unilateral transfers 36
  37. 37. Capital Account : Direct investment Portfolio investment Lecture #16 DERIVATIVESFinancial instruments tailored to change where risklies. 37
  38. 38. Swaps, caps, floors, etc. are examples of these.Most deal with the i/r or credit markets.Spot contracts - discussed in FX context. Is a givenprice today….a guarantee. When investing usingspot contracts you are investing looking forappreciation.Forwards are contracts to buy something at a givenprice in the future at a price determined today.Hedging future price change by locking in today.Example: Airlines buying fuel for their fleets.Locking in a mortgage rate could involve a forwardcontract.Futures contracts are like forward buy are traded ona formal exchange. No default risk versus total withforwards. Futures are revalued every day.Futures are generally in 3 areas: i/r currency index 38
  39. 39. Can hold contracts to maturity or trade….mostliquidate before maturity.If hold to maturity you takepossession of the underlying asset.So in each of these markets you are betting onchange.Options are a contract giving you the right but notthe obligation to buy or sell something within aspecific period of time.Call options give you the right to buy (call awayfrom the seller)..a security at a predetermined price.This is the exercise or strike price.Selling an option…you write a call option.Put option…You can buy stock options on many of the majorcompanies in the world on the NYSE or NASD.Cheap way to invest..What happened to markets after 9-11 ?What would have happened to your options ? 39
  40. 40. You can purchase indices made up of the majorstocks….Dow/ S & P 500, etc. You can use these tohedge (as a derivative) other stocks you own.SWAPS – the most used derivative…great fun !!Two parties agree to swap cash flows some time inthe future based upon some underlying asset.Terrific tool for companies to manage i/r risk,currency risk and credit risk.Sold bond last year - $100 mil. 10yr – 7% coupon.Now I think rates are going to trend down. What canI do about it now ?Nothing changes with the underlying assets…onlythe cash flows tied to them.Currency swaps – evening out exposureSwap markets –Counterparty risk 40
  41. 41. Caps (ceilings) – limit the upside exposure.Floors – protect the bottomCollars – give up a little to establish a range of risk. .Lecture #17 COMMERCIAL BANKSServe as principal channel for government monetarypolicy. 41
  42. 42. Loans are assets/Deposits are liabilities. How thendo banks make a profit when their chief assets andliabilities are just pieces of paper ??ASSETS: Loans – A promise to repay – Approx. 60% ofassets. Loans to whom ? Business – 25% of total Revolving lines of credit Seasonal (inventory) Floor plans Fixed – collateralized Real Estate – 46% of total Commercial and residential Mortgages/equity lines of credit Consumer credit – 16% International Investments 42
  43. 43. Biggest problems: Default Fixed rate lending Mismatch of maturitiesKeys to successful asset management: Lend to good customers Invest in low risk securities DiversifyTHERE IS A FINE LINE BETWEENPROFITABILITY AND SAFETY.LIABILITIES Why are deposits liabilities ?Deposits represent aout 2/3 of total bank funding. 43
  44. 44. Generally checking, savings and CD’s.The remainder of funding comes from direct bondissuance, discount window and fed fundsborrowings.Liability characteristics: Shorter term and more liquid than assets TransitoryMajor problems: Maturity mismatches I/R riskBANK EQUITYRegulators mandate a minimum level ofequity(capital) to assets.. Today this number is about9%. So banks are really highly levered.Capital is primarily common stock and retainedearnings. It also includes reserves for losses. 44
  45. 45. Serves as a cushion against a drop in assets. Whathappens when liabilities exceed assets ?Japan banking crisisWhat happens in a recession to bank business ?Banks frequently have lots of business off theirbalance sheets. Swaps, derivative contracts, someloan commitments, foreign exchange contracts, etc.Why would they do this ?Commercial bank companies have been growingbecause of the change in the law allowing branching.This has brought on major merger/acquisitionactivity.More income coming from non-interest/fee basedbusiness. 45
  46. 46. Commercial banking – International U.S. banks going abroad: Less regulation New business Follow their customers Risks are higher – As are returns Credit Political CurrencyBanking around the WorldJapan-China-EuroThe Regulators Lecture #18 THRIFTSHistorically small institutions serving specializedneeds of local groups. 46
  47. 47. Savings assoc. (formerly S & L’s)…population hasdeclined by 75% over last 20 years. Now about1200.Traditionally made long term fixed rate mortgages toindividuals funded by short term deposits.Problems of the 1970’s / Regulation QDisintermediationGarn-St. Germain Act of 1982 / NOW-MMDAOil collapse / Regulators failed / New regulatorsAssets: Mortgages and mortg. Backed sec. 73% Comm. Loans – 3%What happens in an economic downturn ?Thrift liabilities: Over 60% is small deposits. Fed. Home Loan Bank borrowings = 22% Equity (capital) = 8.2 %What happens in an economic downturn ? 47
  48. 48. SAVINGS BANKSEssentially S & L or Savings Assoc. in the NE.Less than 400 exist.Balance sheets similar to Savings Assoc. except thatare more highly capitalized. CREDIT UNIONSEvolved from employer owned institutions.Are now nonprofits owned by their depositors.Customers must have a common bond.Consumer loans make up 37% of assets withmortgages at 29%.Portfolio is more liquid and has lower default riskthan that of banks and SA’s.Credit Union Liabilities: Member deposits = 89% Primarily savings, CD’s, and NOW accts.Equity (capital) is in excess of 9% 48
  49. 49. Should be able to offer better rates to customers andmake a higher ROA because of tax status.REGULATION OF THRIFTS; Office of Thrift Supervision (part of Treasury) FDIC provides insurance State assoc. are regulated by states. Natl. Credit Union Admin. Board charters and Insures credit unions.Will these institutions exist 10 years from now ? Lecture #19 INSURANCE COMPANIES 49
  50. 50. Life insurance – allows individual to protectthemselves and their benefactors against the loss ofincome from death.Insures pool risks – why /What happens if they are wrong ?Types of life insurance: Ordinary life Term life Whole life Endowment life Variable life Universal lifeGroup lifeCredit lifeAnnuitiesGIC’sAccident and HealthWhat do the balance sheets of Insurers look like ? 50
  51. 51. Premiums are assets – long lived Investments ? Policies are liabilitiesRegulation is at state level. Business getting morecompetitive with brokerages, banks entering.Property & Casualty: Fire Homeowners Commercial Auto LiabilityPremiums are assets / claims are liabilitiesHow do these companies ever lose money ? Lecture#20 SECURITIES FIRMS & INVESTMENT BANKINGSecurities firms….. 51
  52. 52. Investment banks…..Activities: Investing Investment banking Market making Trading Cash management M&AOthers: Research……the scandals…tying arrgmts.SEC / Spitzer Lecture #21 FINANCE COMPANIESLenders to consumers, businesses, mortgages.How are they different from Banks ? 52
  53. 53. 1. Sales Finance Institutions 2. Personal Credit 3. Business CreditAsset makeup / LiabilitiesSubprime ???How do they fund their business ?How much equity capital do they employ ?Why do they even exist ? Lecture #22 MUTUAL FUNDS & HEDGE FUNDSFinancial instruments that pool funds.Various funds have different objectives: Growth, international, bond, etc. 53
  54. 54. ProspectusesHow do you make money in a mutual fund ?How do mutual fund companies make money ?401-k growthRegulation Lecture #23 PENSION FUNDSSavings plans through which participantsaccumulate tax deferred savings for retirement.Defined benefit planDefined contribution plan 54
  55. 55. Private plans: 401-k IRA KeoghPublic plans State & local Federal Lecture #24REGULATION OF DEPOSITORY INSTITUTIONSCrucial – Confidence in FI’s key for domestic and International business.Safety & SoundnessMonetary Policy 55
  56. 56. Credit AllocationConsumer ProtectionInvestor ProtectionEntry & CharteringReg. of Product & Geographic Expansion Prior to crash Glass – Stegall Section 20 Glass – Stegall repealGeog. Expansion- Unit/restricted branching/interstate branchingFDICFSLICWhy did problems of the 1980’s arise ?Balance Sheet Regulations: Focus on leverageCapital to assets ratios become triggers: >5% all the way to <2%On balance sheet versus including off balance sheet 56
  57. 57. What is history of foreign banks ?Social Security problems / solutions Lecture #25 FINANCIAL INSTITUTION RISKSCredit – Bad investments/ Bad loans Firm specific risk Systemic riskLiquidity – High withdrawals/ “run” 57
  58. 58. Interest Rate – MismatchingMarket – TradingOff Balance Sheet - draw downs/derivativesFX –Sovereign –Technology – OperationalInsolvency Lecture #26 MANAGING CREDIT RISKHave had bouts of bad credit ….. 1980’s – thrifts/real estate 1990’s – junk bonds/credit cards 2000 – telecom’s/tech/sovereign debt 58
  59. 59. What is the best way for a FI to lessen its risk ofextending bad credit ?Real estate lending: Ability to pay CollateralAbility to pay: How long have you lived somewhere / Job Credit history Other obligationsCalculate ratiosCredit scoring also used. Compares your situation toothers like you. If you look like those who havedefaulted then assumption is you will also.Collateral : Perfect security interest/lienDefault and they foreclose.Non-mortgage consumer loans just based on abilityto pay. 59
  60. 60. Small business lending looks at cash flow of thebusiness.Mid-market focuses more on the businessitself….cash flow/customer book/cyclicalityIn the end, how predictable is the cash flow /Credit analysis of the smaller firms is critical.The 5 C’s…. Character/Capacity/Collateral/Conditions/CapitalHaircutsRatiosLarge borrowers: Tougher sell for the FI. More options. Information is better.Once you have decided to make the loan how do youdecide what to charge for it ? In other words, how doyou make money at this game ?RAROC 60
  61. 61. How much is a relationship worth ? Lecture# 27 MANAGING LIQUIDITY RISKI WANT MY MONEY NOW !!!Can purchase liquidity or use stored liquidity.Runs and panics 61
  62. 62. FDICFed Discount WindowLife Insurance Co. liquidity riskProperty and Casulty liquidity riskMutual Funds liquidity risk Lecture #28 INTEREST RATE & INSOLVENCY RISKMeasuring the Risk…..Rate Sensitive Assets and Liabilities 62
  63. 63. The Repricing GapThe Duration ModelWhat is Capital and how is it Valued ?? Lecture #29 MANAGING DERIVATIVE RISKSReview Contracts: Spot / Forwards / FuturesHedging with Contracts 63
  64. 64. Accounting Rules / Bank RegulationsOptions / Swaps Lecture #30 LOAN SALES AND SECURITIZATIONWhat are Loan Sales ? Why did they come to be ?Participations / Assignments 64
  65. 65. What is the Market ? Who are the Players ?What drives the Market ?How is Loan Securitization different from LoanSales ? 65

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