FIN320 Midterm Study Guide （need to complete within 5 hours）

Non-bank Financial Ins/tu/ons

Professor Lamont Black FIN320 Week 5

Shadow Banks

•  “Shadow Bank”: a financial ins/tu/on that provides services similar to a bank – Paul McCulley (PIMCO)

•  Short-term funding (like deposits) •  Providing credit to borrowers (loans)

•  Financial crisis… 2

Investment Banking •  Investment banks: Goldman Sachs, Merrill Lynch, JPMorgan…

•  Investment banking ac/vi/es 1.  Providing advice on new securi/es 2.  Underwri/ng new securi/es 3.  Providing advice and financing for M&A 4.  Financial engineering, incl. risk management 5.  Research 6.  Proprietary (prop) trading and market making

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IB Ac/vi/es •  Providing advice on new securi/es – Exper/se on how to raise funds in capital markets

•  Underwri/ng new securi/es – “Underwri(ng”: guaranteeing a price to issuing firm – “Spread”: difference between sold price and guaranteed price (E.g. 6 to 8% on IPO)

– Also secondary (seasoned) offerings – Makes a secondary market in the securi/es – Syndicates underwrite large issues

•  Lead bank prepares the prospectus and does road show

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IB Ac/vi/es cont. •  Providing advice and financing for M&A – Advise “buy side” and “sell side” – Premium above market value – Arranging financing (leverage)

•  Financial engineering, incl. risk management – Developing new securi/es or strategies – Deriva/ves – Complexity – “Quants”

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IB Ac/vi/es cont. •  Research –  Analysts (equity, bond) –  “Buy”, “Sell”, “Hold” –  Market info for trading desks –  Bill Dudley (NY Fed)

•  Proprietary (prop) trading and market making –  Prop trading is trading your own money –  Grew in importance beginning in 1990s –  Interest-rate risk, credit risk, and funding risk –  Volcker Rule (park of Dodd Frank 2010) –  What is a “market maker” (inventory)?

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IB Funding Risks •  Wholesale funding: non-retail funding beyond the partners (publicly-traded IBs)

•  High leverage (assets rela/ve to capital) – More than commercial banks – 30 to 1

•  Repurchase agreements (repos) – Short-term loans backed by collateral – E.g., sell T-bill and agree to buy back at higher price the next day (secured overnight loan)

•  Asset-liability mismatch (maturity and liquidity) – Counterparty risk

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Leverage in IB

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IB Industry •  Glass-Steagall Act in 1933 legally separated investment

banking from commercial banking –  Underwri/ng losses with market crash of 1929 –  Insured deposits at risk

•  An/-compe//ve?

•  Gramm-Leach-Bliley Act (FSMA) of 1999 repealed Glass- Steagall –  “Universal Banks”: JPMorgan, Ci/

•  Was the repeal a mistake? (Senator Warren) –  Too-big-to-fail

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Where Did All the Investment Banks Go?

•  Financial crisis had profound effect on IB industry •  Mortgage-backed securi/es (MBS) were a product of financial engineering

•  Bear Stearns sold to JPM in March 2008 •  Lehman Brothers bankrupt in September 2008 •  Merrill Lynch sold to BofA soon aier •  GS and MS became financial-holding companies in October 2008 – Borrow from Fed and receive TARP

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Is IB for you?

•  Hard to get in •  Pays a lot

•  Long hours •  Challenging culture

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Investment Ins/tu/ons

•  Investment ins(tu(ons: financial firms that raise funds to invest in loans and securi/es

•  “Asset managers” – Assets under management (AUM)

•  Mutual funds •  Hedge funds •  Finance companies 12

Mutual Funds

•  Mutual funds are financial intermediaries that allow savers to purchase shares in a porjolio of financial assets – Reduced transac/on costs – Diversifica/on – Dates back to 1924

•  Vanguard and Fidelity

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Types of Mutual Funds •  Price of mutual fund share /ed to net asset value (NAV), which is market value of assets

•  Closed-end funds: fixed number of nonredeemable shares

•  Open-end funds (more common): variable number of redeemable shares

•  Exchange-traded funds (ETFs): trade throughout the day

•  Load (commission) vs. no-load funds •  Low management fees (Ac/vely managed vs. passive)

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Money Market Mutual Funds

•  MMMFs hold high-quality, short-term assets – Treasury bills – Nego/able CDs and commercial paper (“Prime”)

•  Allow savers to write checks above an amount

•  In 1980s, MMMFs began compe/ng with banks – Buy commercial paper vs. make short-term loan – Higher rates for savers

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MMMFs and the Crisis

•  “Rollover risk” (funding risk): the difficulty of selling new commercial paper when exis/ng commercial paper matures

•  “Breaking the buck”: When Reserve Primary Fund NAV fell to $0.97 following Lehman bankruptcy

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Hedge Funds •  Hedge funds are similar to mutual funds: collect money

from savers for inves/ng

•  But hedge funds are typically organized differently –  Partnerships of 99 investors or fewer –  Accredited investors (wealthy) –  Unregulated –  Alterna/ve strategies (e.g., shor/ng) –  10,000 opera/ng in U.S. in 2016 –  Keep a share of profits –  Illiquid –  Risk: Long-Term Capital Management (LTCM) in 1998 –  Create liquidity?

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Funds and Lending

•  Direct lending strategy – A number of funds recently closed direct lending pools

– Fortress Investment Group is an example •  PE firm that delisted in 2017

– Why? •  “Asset managers see an opening as banks grapple with s/ffer regula/on and yield-hungry investors look to deploy cash in alterna/ves.”

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Finance Companies

•  Finance companies are nonbank financial intermediaries that raise money through wholesale markets and use fund to make small loans to households and firms

•  Consumer finance: cars, appliances, etc. •  Business finance: Secured lending (e.g., CIT) – AR/INV, equipment

•  Sales finance: cap/ve finance (e.g., John Deere)

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Contractual Savings Ins/tu/ons •  Contractual savings ins/tu/ons: payments made to them are the result of a contract, either insurance or pension

•  Pension funds – Employer savings account – Defined benefit plan – Defined contribu+on plan (401K) – 17% of household assets) – Underfunding of local government pensions is a major policy concern (IL and Chicago!)

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Assets of Pension Funds in 2016

•  Tempta/on: “Reach for Yield” 21

Insurance Companies •  Insurance companies are financial intermediaries that write

insurance contracts and collect insurance premiums

•  Life insurance (death and disability) –  Term life: coverage for a set /me –  Whole life: permanent coverage that grows

•  Property and casualty insurance –  Auto –  Home

•  Risk pooling, screening, deduc/bles

•  Long-term investors (especially life) 22

Insurance Investments

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Risk, Regula/on, and Shadow Banking

•  Shadow banking system grew prior to crisis –  Became larger than commercial banking

•  Did it play a role in the crisis?

•  Systemic risk: Risk to the en/re financial system rather than to individual firms or investors

•  Fragility of shadow banking (runs) •  Systemic risk leads to bail-outs

•  Regula(on of shadow banking. Too much or too lirle?

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