Problems with Financial Markets and How Financial Institutions MitigateThem

Reducing Transactions and Information Costs

Obstacles to Matching Savers and Borrowers

• Transactions costs: costs of buying and selling a financial instrument.

• Financial intermediaries reduce transactions costs by exploiting economies of scale.

• Information costs: costs to determine the creditworthiness and monitor the use of funds.

Information imperfections and incomplete contracts• Incomplete contracts are pervasive. • complete contract: the parties to an agreement

could specify their respective rights and duties for every possible future state of the world, their contract would be complete. There would be no gaps in the terms of the contract.

• However, because it would be prohibitively expensive to write a complete contract, contracts in the real world are usually incomplete. Retrieved from "http://en.wikipedia.org/wiki/Complete_contract"

Information Problems

• Asymmetric information: one party has better information than the other.

• Adverse selection: a market process in which "bad" products or customers are more likely to be selected.

• Moral hazard: the risk that one party to a contract can change their behavior to the detriment of the other party once the contract has been concluded.

• Principal-Agent problems

Class of 2001

Adverse Selection

• Example: Insurance Market• Smokers and Non-Smokers• Insurance company cannot tell the difference between

smokers and non smokers and charges an average premium for both smokers and non smokers

• This is good for the smokers, and not so good for the non-smokers, who both know their behavior. So smokers buy the insurance and non-smokers don’t.

• The insurance company realizes that it is making a loss, since there are many claimants (mostly smokers take insurance), and has to raise its premium to take into account this problem.

• However this worsens the problem-now only the very heavy smokers will take insurance, and the company has to pay out even more, till it is run out of business

Adverse Selection in Financial Markets

• A lender has a population of borrowers to lend to- these are divided into safe and risky borrowers.

• Not knowing one from the other, the lender charges an interest rate which is an average to cover risk.

• Only the risky borrowers will borrow, because there is a chance that they will make a return to cover the interest (but more likely will fail)

• Stiglitz and Weiss (1981)- since lenders know that borrowers are likely to default- there is a backward bending supply curve of credit. Credit Rationing

Credit Rationing

Definition:

Some borrower's demand for credit is turned down, even if the borrower is willing to pay all the price and non-price elements of the loan contract.

Baltensberger, E. (1978): Credit Rationing: Issues and Questions, Journal of Money Credit and Banking, 10(2), 170{83

Quantity

InterestRate

Adverse Selection

• Lemons problem: asymmetric information in a market leads to adverse selection.

• Lemons problems in the bond market lead to credit rationing.

• Lemons problem raises lending costs (firms need other finance)

• Many countries set information disclosure requirements if a firm sells securities (also other solutions raise the collateral required and so on)

Moral Hazard

• Changing of behavior after contract has been written

• Example: After I get car insurance, I drive recklessly. I build my house near a hurricane zone, knowing that I will receive insurance a hurricane arrives. What could be the moral hazard involved if I give you class notes before the week?

Moral Hazard

• Regulations on reporting by firms reduce the chance of fraud in equity financing.

• Principal-agent problem: managers have different goals than the firm’s owners. (questions as to who should have more power)

• Debt financing reduces moral hazard problems relative to equity financing.

• Moral hazard in debt financing is reduced with the use of restrictive covenants.

Principal Agent Problems

• Various mechanisms may be used to try to align the interests of the agent with those of the principal, such as profit sharing, stock options, piece rates, commisions, higher wages,the agent posting a bond, or fear of firing. The principal-agent problem is found in most employer/employee relationships, for example, when stockholders hire top executives of corporations. (wikipedia)

Information Costs and Financial Intermediaries

• Financial intermediaries reduce adverse selection by specializing in gathering default risk information.

• Banks’ information advantage largely accounts for their role in providing external financing.

• Financial intermediaries deal with moral hazard through monitoring.

We have many types of financial institutions

• All were regulated to perform certain functions and to maximize the benefits of intermediation subject to the problems of asymmetric information.

Five main financial institutions

– Securities market institutions: investment banks; brokerage firms; organized exchanges

– Investment institutions: mutual funds; finance companies

– Contractual saving institutions: insurance companies; pension funds

– Depository institutions: commercial banks; savings institutions; credit unions

– Government institutions: direct lending; indirect lending (loan guarantee)

Securities Market Institutions

• Securities market institutions : investment banks, brokers, dealers- all of whom work with securities primarily (not considered financial intermediaries)

• Investment banks help raise new capital in primary markets, help consolidate (mergers and acquisitions) new stock issues; debt restructuring

• Brokers and dealers help facilitate exchange in secondary markets.

Underwriting• Underwriting of Securities• Issuance of shares and corporate debt• Underwriter provides advice for issuer, distribution of

securities, sharing of risks of issue, and stabilization of aftermarket.

• Underwriter also “certifies” the issue by putting its reputation behind the issue.

• Two Basic Kinds of Offerings• Bought deal (synonym: Firm commitment offering):

The underwriter agrees to buy all shares that are not sold

• Best efforts: the underwriter says that if the issue is not sold, deal collapses.

(1) advising

• timing of offering

• terms of security

• pricing

• regulation

(2) underwriting

• optional

• investment bank buys securities from issuer,

then resells to public

• investment bank bears the price risk

• price set 2 days prior to issue– security floatation

– firm commitment

• resale price - guaranteed price

= gross spread

= underwriter’s discount

• size of discount depends on– type of security

-- bonds lowest, stock IPOs highest

– size of issue

-- smaller issues have larger discount

– market conditions

– .5% - 7% (table 14-1)

group of investment banks

• several investment banks bear price risk– lead underwriter

-- bulge bracket firm

– syndicates help underwrite

• selling group– syndicate AND

– other firms

-- help sell issue, do not underwrite

tombstone

• advertisement

• lists all of the underwriters

• details of issue

• after sale has taken place– to get more underwriting business

26,000,000 Shares

Hartford Life, Inc.

Class A Common Stock(par value $.01 per share)

Price $28.25 Per Share

Upon request, a copy of the Prospectus describing these securities and the business of the company may be obtained within any state from anyunderwriter who may legally distribute it within such state. The securities are offered only by means of the Prospectus, and this announcement is

neither an offer to sell nor a solicitation of an offer to buy.

20,800,000 SharesThis portion of the offering is being offered in the United States by the undersigned.

Goldman Sachs International Merrill Lynch International

Morgan Stanley Dean WitterSmith Barney Inc.

Credit Suisse First Boston A. G. Edwards & Sons, Inc. Edward D. Jones & Co., L.P. Lehman Brothers PaineWebber Incorporated

Prudential Securities Incorporated Advest, Inc. Sanford C. Bernstein & Co., Inc J.C. Bradford & Co.

Conning & Company Dain Bosworth Fox-Pitt, Kelton Inc. Legg Mason Wood Walker Incorporated Incorporated

Piper Jaffray Inc.

Principal Financial Securities, Inc. Raymond James & Associates, Inc. The Robinson-Humphrey Company, Inc.

Stephens Inc. Sutro & Co. Incorporated Wheat First Butcher Singer Dowling & Partners Securities, LLC

Interstate/Johnson Lane Corporation

Janney Montgomery Scott Inc. Neuberger & Berman, LLC

5,200,000This portion of the offering is bein offered outside the United States by the undersigned.

Goldman Sachs International Merrill Lynch International

Morgan Stanley Dean WitterSmith Barney Inc.

ABN AMRO Rothschild Banque Nationale de Paris Barclays de Zoete Wedd Limited

Dresdner Kleinwort Benson Yamaichi International (Europe) Limited

June 4, 1997

Underwriting

• Analysis of the purchase price.

• Financing to purchase the company.

• Provide the equity

Details on Mergers

• A "merger" or "merger of equals" is often financed by an all stock deal (a stock swap). An all stock deal occurs when all of the owners of the outstanding stock of either company get the same amount (in value) of stock in the new combined company. The terms "demerger," "spin-off" or "spin-out" are sometimes used to indicate the effective opposite of a merger, where one company splits into two, the second often being a separately listed stock company if the parent was a stock company. Merger is a legal process and one or more of the companies lose their identity.

• Acquisition• An acquisition (of un-equals, one large buying one small) can involve a cash and debt combination, or just

cash, or a combination of cash and stock of the purchasing entity, or just stock. The Sears-Kmart acquisition is an example of a cash deal. In addition, the acquisition can take the form of a purchase of the stock or other equity interests of the target entity, or the acquisition of all or substantially of its assets.

• High-yield• In some cases, a company may acquire another company by issuing high-yield debt (high interest yield,

"junk" rated bonds) to raise funds (often referred to as a leveraged buyout). The reason the debt carry a high yield is the risk involved. The owner can not or does not want to risk his own money in the deal, but third party companies are willing to finance the deal for a high cost of capital (a high interest yield).

• The combined company will be the borrower of the high-yield debt and it will be on its balance sheet. This may result in the combined company having a low shareholders' equity to loan capital ratio (equity ratio).

Why mergers

• Economies of scale:• Increased revenue/Increased Market Share:• Synergy: Better use of complementary

resources. • Taxes: A profitable company can buy a loss

maker to use the target's tax write-offs. • Geographical or other diversification: This is

designed to smooth the earnings results of a company, which over the long term smoothes the stock price of a company

What is the role of the investment banks?

• If the company wants to merge with another, it must attain a fair market value for its shares to be swapped which would involve an investment bank. If it wants to buy the other company with borrowed money, it would most likely borrow directly from investors in the form of bonds through a private placement, engineered by the investment bank. Thus, Investment Banks position themselves to act as advisors on mergers and acquisitions and usually charge large fees for doing so.

Mergers and Acquisitionsbusiness strategy for merging and/or acquiring of different companies. Also called: M & A 

Brokers, Dealers Exchanges & ECNs

• Brokers deal with public. Example: Merrill Lynch

• Dealers execute trades

• Exchanges are places where dealers operate. Examples: NYSE, Nasdaq, Arizona Exchange

• Electronic Communications Networks (ECNs) allow investors to communicate with each other, and to exchange. Examples: Island, Instinet (now Inet)

Brokers

• Churning versus providing information. Churning: Excessive trading in a client's account by a broker seeking to maximize commissions regardless of the client's best interests, in violation

• SEC penalizes “rogue brokers” who churn.

• Stockbroker Robert Magnan (Paine Webber) was convicted of criminal offense of churning, and barred from securities industry for life, 1999.

• Magnan’s clients had an annual turnover rate of 11, and investments would have had to earn annual return of 50% to pay transactions costs.

Investment Institutions

• Investment institutions raise funds to invest in loans and securities.

• Mutual funds convert small individual claims into diversified portfolios. Closed-end (non-redeemable vs. Open ended mutual funds (redeemable)

• Finance companies sell securities to make small loans to households and businesses.

• No load funds- earn income from fees. Load funds earn income from comissions as well.

Performance of the largest fund families

The top 10 by assets

 

Fund family

Cap-weighted10-year

performance

AssetsNov. 2001

($mil)

Vanguard 13.5% $258,951

Fidelity 13.3 356,308

American Funds 13.3 195,962

T Rowe Price 12.9 60,178

Janus 11.6 65,950

MFS 11.5 58,047

Putnam 10.9 115,238

Amer Express 10.1 45,452

Amer Century 9.9 54,865

AIM 9.6 59,030

Contractual Saving: Insurance Companies

• Contractual saving institutions transfer risk and provide means for disciplined savings.

• Insurance companies write contracts to protect risk of loss from particular events.

• “Law of large numbers” enables insurance companies to predict loss for large groups.

• Insurance companies face problems of adverse selection and moral hazard.

Details on Insurance companies

• Insurance companies face moral hazard in a way that most other financial institutions don’t.

• Widespread use of restrictive covenants (e.g fire insurance).

• Principles- risk based premiums, deductibles, coinsurance

Type of Insurance companies

• Life Insurance (mutual companies owned by the policy holders; stock companies held by the public) . LIC companies control about $4 trillion

• Whole life versus term life. Whole life, constant payments in- can get whole amount at retirement or annuities). Tax breaks. Term life, payable upon death

• Life insurance companies have been moving to handling pension funds, stabilizing their share– see table 12.1

• Property and Casualty insurance (control about $1 trillion). Tax breaks. Intrinsically more risky because of concentrated risk.New insurance concerns-- terrorism

Battle over Twin Towers insurance

A US federal jury has begun hearing a case to decide whether the leaseholder of the World Trade Center can claim insurance for one attack or two. Developer Larry Silverstein wants insurance firms to pay out for two attacks on 11 September, 2001. The insurance companies dispute the claim, saying the attacks on the twin towers amounted to a single event. Mr Silverstein would receive $7bn for two attacks, as opposed to $3.5 bn if the attacks are classified as one. The property magnate says the attacks were two events because the hijacked aircraft hit the World Trade Center 15 minutes apart.

Jury Rules WTC Destruction Was Two Separate Events 

Wall Street Journal 6dec04[More below]                                NEW YORK — A federal jury ruled Monday that the Sept. 11 attack on the World Trade Center was two occurrences for insurance purposes, meaning leaseholder Larry Silverstein stands to collect up to $2.2 billion from nine insurers.The verdict in U.S. District Court in Manhattan was the latest twist in Mr. Silverstein's efforts to turn his $3.5 billion insurance policy on the trade center complex into a $7 billion payout.The insurance companies involved in the case were: Travelers Indemnity Co., Industrial Risk Insurers, Royal Indemnity Co., Allianz Insurance Co., Tokio Marine and Fire Insurance Co., Twin City Fire Insurance Co., Tig Insurance Co., Westfield WTC LLC and Zurich American Insurance Co.

Figure 12.1 Financial Assets of U.S. Insurance Companies

Contractual Saving: Pension Funds

• Pension funds invest to provide for retirement benefits. Control 5.5 trillion dollars of assets.

• Defined contribution plan: benefit is based on invested contributions.

• Defined benefit plan: benefit is based on earnings and years of service (excess will go to the institution).

• Defined contribution plans are fully funded (employees fund themselves).

• Defined benefit plans may be underfunded (depending on cohort, projected earnings, could be underfunded).

Regulation of Pension Funds

• Pension Fund Guaranty Corporation insures pension benefits. Moral hazard?

• New force in 401K/ IRA accounts- portable, tax free after retirement.

Figure 12.2 Assets of Pension Funds

Pension Funds are Powerful- the case of Calpers

• Governor's Plan Could Erode CalPERS Clout• By Dale Kasler -- Bee Staff Writer

Published 2:15 am PST Monday, February 28, 2005Sacramento Bee

• One in a series of reports examining public pension proposals under discussion at the state Capitol. California's public pension funds have been throwing their weight around since 1984, when they took on Texaco Inc. over a sweetheart deal.

• Now the funds may be forced onto a starvation diet. • Gov. Arnold Schwarzenegger's proposal to make 401(k)-style plans of the two big funds -

the California Public Employees' Retirement System and the California State Teachers' Retirement System - could gradually erode their ability to pursue activist shareholder agendas, say experts.

• In recent years, the two funds - especially CalPERS - have used their investing clout to launch crusades over everything from CEO salaries and market reform to socioeconomic matters like tobacco and the environment.

• Taking that influence away "could be a devastating blow, not just to the role CalPERS plays, but to corporate governance all over the United States," said Nell Minow, a nationally known advocate for shareholder rights.

• "No one is anywhere near CalPERS," said Minow, editor of a Web site called The Corporate Library. "They're bigger than anyone else, and they have the staff and the focus and the muscle to play a meaningful role."

Schwarzenegger drops pension privatization plan By Andrew LaMarKnight Ridder SACRAMENTO -- In a major reversal, Gov. Arnold Schwarzenegger today withdrew his support of a pension reform initiative that ignited stiff opposition from police officers and firefighters concerned about losing death benefits. At a morning press conference, the Republican governor said he would focus on crafting legislation palatable to public safety employees and their unions. Also, Schwarzenegger said he will rewrite the measure, aiming for the June 2006 ballot if he cannot forge a legislative compromise. ``There should be no doubt they will be protected,'' the governor said of police and firefighters. Dropping his current proposal ``will spark a whole new fresh start in the Legislature.'' The dramatic change in direction comes after Schwarzenegger spent days meeting with public safety groups that have assailed the plan with emotional ads featuring tearful widows of cops and others killed in the line of duty. Unions pointed to Attorney General Bill Lockyer's assessment that the measure, which would move all non-federal government employees to a 401(k)-style pension system in July 2007, would eliminate death and disability benefits. The governor and his aides have said Lockyer's analysis is wrong.

Government Financial Institutions

• Federal credit agencies make loans in the interest of public policy.

• U.S. government lends to farmers, to the housing market, and to students.

• U.S. government also guarantees loans made by private financial institutions.

Main Organizations- Housing, Education

• the Federal National Mortgage Association (FNMA) (NYSE: FNM), commonly known as Fannie Mae, in 1938 to establish a secondary market for mortgages insured by the Federal Housing Administration (FHA). Fannie Mae buys mortgages on the secondary market, pools them and sells them as mortgage-backed securities to investors on the open market

• The Federal Home Loan Mortgage Corporation ("Freddie Mac") NYSE: FRE, a government sponsored enterprise, is a stockholder-owned, publicly-traded company chartered by the United States federal government in 1970 to purchase mortgages and related securities, and then issue securities and bonds in financial markets backed by those mortgages in secondary markets

• SLM Corporation (NYSE: SLM), commonly known as Sallie Mae, is the United States' number one college student loan company, managing more than $122.5 billion in debt for more than 8 million borrowers, and employing 10,000 individuals at offices nationwide.

• The company primarily provides federally guaranteed student loans originated under the Federal Family Education Loan Program (FFELP), and offers comprehensive information and resources to assist students, parents and guidance professionals with the financial aid process

Depository Institutions

• Commercial banks accept deposits and make loans and offer other services.

• Borrowers with smaller credit needs rely on depository institutions.

• Savings institutions suffered from maturity mismatch which led to a crisis.

• Credit union members work at the same firm or in the same industry.

Table 12.2 Services Provided by Financial Intermediaries

Table 12.2 Services Provided by Financial Intermediaries (cont’d)

Table 12.1 Financial Intermediaries in the United States

Financial Institutions: Blurring the Lines

• During the 1930s, barriers were created that restricted competition across providers.

• Now financial services are organized more by function than by provider identity.

• The Gramm-Leach-Bliley Financial Services Modernization Act of 1999 removed many of the regulatory lines among financial institutions.

Mergers among Commercial Banks, Investment Banks & Insurance Companies• Travelers’ Group (insurance) and Citicorp

(commercial bank) 1998 to produce Citigroup,. Brokerage Smith Barney

• Chase Manhattan Bank (commercial bank) acquires JP Morgan (investment bank) (2000) for $34.5 billion

• UBS Switzerland buys Paine Webber (brokerage) 2000

• Credit Suisse buys Donaldson Lufkin Jenrette (investment bank) 2000

Exercise: What type of institution?

• A person with $15,000 in savings would like to earn a decent return at low risk but knows nothing about the stock market.

• A person has $ 300 she wants to keep safe

• A person wants to open a flower arrangement business and needs $10,000 for

Exercise: What type of institution?

• A person is recently married and wants to make sure his family is taken care of in the future.

• A person has just received a large inheritance and wants to invest it into tech stocks

• A person with no credit history wants to buy a car

Exercise: What type of institution?

• A president of a small company wants to list it on a stock exchange.

• A person wants to invest for retirement

• A person wants to avoid the risk that her new house will catch fire and she will lose her life savings.