Transcript Chapter_12 - rpstudygroup.com

Non-Bank Financial
Intermediaries
Chapter 12
Types of Intermediaries
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Insurance Companies
Pension Funds
Finance Companies
Mutual Funds
Gov’t Agencies
Securities Market Operations (psudeointermediary)
Insurance Companies
 2 types
 Life Insurance
 Property/Causality Insurance
 Relative share of Intermediary assets
decline
 1970: 19.1%
 2006: 16.6%
Life Insurance
 Presbyterian Ministers Fund in Philly (1759)
 Now there are 1700 companies
 State Regulated: never experienced widespread
failure
 Adequate liquid assets
 Limited risky assets
 Honest sales practices
Stock and Mutual
 Stock Companies, owned by stockholders,
are 90% of companies
 Mutual companies, owned by policy
holders, are 10% of companies
 However, mutuals (Met Life, Prudential)
own 50% of assets in the market
Shifting Tactics
 Weak returns in 1970’s forced companies to
become innovative
 Also 1974 legislation pushed pension funds
to give management to life insurance comp
 Also sell annuities, or investment vehicle
similar to pension fund
 Now 50% of insurance company assets
Sources/Uses
 Payout statistically predictable
 High yield, less liquid
 Sources
 High yield corporate stocks
 Long term bonds
 Commercial mortgages
 Uses
 Life insurance policies and annuities
Two type of policies
 Temporary (Term) Insurance: premiums
grow every year as chance of death
increases
 Permanent Insurance (Whole life, Universal
Life): Constant premium
 Accrues cash value early in life, declines later
 Graph
Property/Causality Insurance
 3000 firms
 Stock or Mutual
 Examples: State Farm and Allstate
 Regulated by states
 Insure against ANYTHING for a price
 Fires, malpractice, earthquakes, theft
 For large risk, companies join together and co-insure
Shifting Tactics
 Rates skyrocketed into the 90s
 Double and triple rates, even refuse service
 Low interest rates stopped flow of high
investment income
 Growth of lawsuits and size of awards
 Elliot Spitzer
 MMC and AIG, 2003-5
 Insurance broker rigging (moral hazard)
 Regulation by states likely to increase
Sources/Uses
 Payouts less predictable (e.g. nat. disasters)
 Low yield, high liquidity
 Sources
 Municipal Gov’t bonds (tax-free)
 U.S. gov’t bonds
 More than half their assets
 Uses
 Policies
 Reinsurance
 Insure payments on bonds/securities
Insurance Issues
 The downfall of the independent insurance agent
 Banks
 State banks entering market
 Repeal of Glass-Steagal
 Office of the Comptroller
 Can sell annuities (20% of market)
 Encourage entering to diversify
Insurance Mgmt
 The Job: convert one asset into another
(premiums to bonds/stocks) and then pay
out claims by policyholders WHILE STILL
MAKING A PROFIT
 Also…
 Adverse selection: those with higher insurance
risk will seek it out the most
 Moral Hazard: once insured, policyholder will
increase risk-taking
Tools to manage risk
 Screening
 Adverse Selection
 Gather information
 Discrimination issues
 Risk-based premiums
 Adverse selection
 Male drivers pay more
 Restrictive provisions
 Moral Hazard
 Wear helmets on the job
More tools
 Limits on Insurance
 Moral Hazard
 Coinsurance
 Moral Hazard
 Percentage amount of claim reduced
 Deductible
 Moral hazard
 Fixed amount of claim reduced
 Why a company require deductible over coinsurance?
 Fraud Prevention
 Moral hazard
 Investigation on claims
Private Pension Funds
 Relative share of intermediary assets
increase
 1970: 13%
 2005: 24%
 Because of employer and employee share tax
deductible
 Self employed open own tax-sheltered plan
Sources/Uses
 Predictable payout
 Sources
 Employer contributions
 Employee contributions
 Uses
 High interest bonds
 Stocks
 Mortgages
Stock market behemoth
 Pension funds own 25% of all stock
 70% of daily volume are by pension or
mutual funds
 2/3 of pension assets are in stock market
Two types
 Defined contribution plan: simply get what
you put in
 Defined benefit: set target in advance
 Fully funded or underfunded
 Why would be underfunded
 Companies go under and can’t make payments
 Market slows down and target can’t be met
ERISA
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Disclosure of Information
Regulation by Dept. of Labor
Rules on investment
Vesting: length of time someone must be enrolled
to receive interest (to have a vested interest)
 Created Penny Benny (like FDIC)
 $45 Billion underfunded (GM $12 billion)
 Currently insures 1/3 of workers
 Moral Hazard
Public Pension Plans
 Similarly handled as private
 EXCEPT for Social Security
 Sources
 FICA: Income taxes
 Uses
 Pensions
 Medicare
 Disability pensions
Problem
 Underfunded by $1 trillion
 Pay-as-you-go system (not invested)
 Created as way around market shocks (Roosevelt)
 Excess goes to gov’t bonds
 Working/Retiree ratio decline
 Was 17/1
 Now closer to 3/1
 Solutions: Higher tax deductions, lower pensions, or
privatization
Finance Companies
 Make specialty, highly ‘tailored’ loans
 Virtually unregulated, gain advantage over
banks
 % of Intermediary market
 1970: 4.9%
 1990: 5.9%
 2005: 3.9%
Sources/Uses
 Sources
 Company issued stocks, bonds, and commercial paper
 Uses
 Sales Finance
 Owned by company
 Auto industry
 Business Finance
 Lease capital (planes, construction equipment)
 Factoring: purchasing accounts receivable at a discount
 Consumer Finance
 Lender of last resort (high interest rates)
 Particular consumer items
Mutual Funds
 Pool resources of small investors to buy securities
 Regulated by the SEC
 Many of same companies as life insurance/inv.
banking
 In 1960
 3% of financial intermediary assets
 Only 6% of households owned a MF
 Today
 25% of financial intermediary assets
 50% of households own MFs
 Households hold 80% of MF
Sources/Uses
 Sources
 Sell shares to investors
 Two types
 Open-ended: redeemed any time
 Closed-ended: traded like stock
 OE more common
 Uses
 Buy high yield securities
Advantages
 Institutional Investors
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Expertise
Have cloud in market
Can afford to investigate, monitor (AS)
Can even force changes inside companies
 Small investors can
 Lower their transaction costs
 Diversify
Disadvantages
 Moral Hazard
 Excessive risk taking
 Favored customers/insider trading
 Until 2003, untainted record
 Spitzer again (late hour trading)
 “Betting on the horse race after the horses have
crossed the finish line”
Load vs.. No-load
 No-load funds
 Commission (0.5%) of asset value per year
 Most common (obviously)
 Load funds
 Additional commission paid up-front to broker
Money Market Mutual Funds
 Invests in low risk, short term debt instruments
 T-bills
 Commercial paper
 Bank CDs
 Shares redeemed at fixed value
 Checkable deposits
 1/3 of all mutual funds
Hedge Funds
 Special mutual fund for rich
 Low regulation
 Allows risk taking
 Long term commitment
 Allows strategy
 High buy-in
 $1 mil in assets, $200,000 in income
 Federal regulation, otherwise too risky
 Market neutral strategy
Federal Credit Agencies
 Farm Credit Bureau
 Issues securities
 Makes loans to farmers
 Home mortgages
 FNMA (Fannie Mae), GNMA (Ginny Mae), and
FHLMC (Freddy Mac)
 Only Ginny Mae is actually federal
 Sally Mae, student loans, private
 Moral Hazard
 Gov’t won’t let go under
 Public vs.. Private allegiance
 Small capital to asset ratio
Securities Market Operations
 Not actually financial intermediary, but
more like a ‘financial facilitator’
 Primary Securities
 Investment Banks
 Secondary Securities
 Brokers
 Dealers
Investment Banks
 Merrill Lynch, Goldman Sachs, etc
 Two jobs
 Give advice on investment tool and price
 Seasoned issue
 IPO (Tech stocks, China)
 Underwrite security
 Guarantee price to corporation then sell it on the market for
more
 Joint underwriting for large issues
 Moral Hazard
Brokers, Dealers, and Specialists
 Brokers :Agents for investors in security deals
 Dealers: Holder of securities that links buyers and
sellers (higher risk)
 Specialist: Dealer/Broker
 Brokerage Firms: perform brokerage, dealing, and
investment banking (Merrill Lynch)
 Organized exchanges is where activity takes place
 Internationalization
 Technology