Test 4 Notes Beginning April 3 2012 Chapter 12 I What financial Institutions Do o Security Markets Institutions Investment banks brokers dealers and organized exchanges Reduce the costs of matching savers and borrowers and provide risk sharing liquidity and information services that enable financial markets to function smoothly Not financial intermediaries because they do not acquire funds They have the same physics but are clearly different Bank of Tallahassee have a broker dealer but hardly the same as from savers to invest in borrowers o Investment Bank Goldman Sachs Broker Dealer Merryl Lynch Like baseball t ball and the pros Goldman Sachs Don t have the same investment arm It could be outsourced o Investment banking institution what are they doing They are involved in underwriting Good thing to have but expensive Look into value of company Assessing the risk o Manages peoples money investment advisor o Investment institution Investment fund Mutual fund Different services on o Commercial Savings Institution A bank Credit Union o Contractual V Depository Saving Institutions Contractual bound to make a series of payments to reap the benefits You have agreed to something in writing Depository commercial banks savings and loan associations mutual II Underwriting savings banks credit union o Underwriting securities institutions assessing risk investment bankers do this o Investment banks assist businesses in raising new capital in primary markets and advise them on the best way to do so either by recommending a stock issue or by structuring debt contracts to attract investors They do this by underwriting a firms new stock or bond issue Underwriters guarantee a price to the issuing firm sell the issue at a higher price and keep the profit or spread In exchange for this the underwriting investment bank assumes risk of not being able to re sell the securities If investment banker is involved and underwriting is involved you are in the PRIMARY market being born Secondary it s already there Underwriting lowers the information costs between lenders and borrowers because investment banks put their reputations behind the firms they underwrite Example I m going to give you a million dollars giving you my best effort Your confidence is pretty high to listen to this Best efforts who is in control of satisfactory in the agreement it is the person telling you that you are relying on When someone else is involved in your happiness Not good You want to be in control of your own outcome You do not want to be in the Hope category hoping that things will work out Best effort implies no particular agreement that you will do something It is like selling something for consignment Underwriting value not the firm itself Financiers used investment banks to raise large amounts of risky debt through junk bonds bonds with ratings of less than Baa or BBB S P Investment bankers became masters of deleveraging helping firms to raise equity in public markets to reduce their debt burdens Exchange a physical place where securities are traded Shelf Registration SEC o All the boxes were checked and it was properly registered Does Goldmansachs want to do this in a flat bear and bull market Bull Market prices are going up and it will be worth so much down the road Only able to dump the shares on the market during a rising market Merchant Banks do NOT underwrite Example junk bonds Merchant food retail etc Look at business through institutional eyes Why does the primary market need a secondary market Secondary market stock exchange NYSE o It sets the price how much you can sell it for o POP price Public Offer Price o P 426 Tombstone picture its an ad announcing on behalf of the investment bank Yes we are involved in this underwriting Primary market needs secondary market to provide shareholders a place to sell their shares o Capital Capital Markets stocks and bonds o Money Market short term o People lie and tell knowledge that doesn t really exist if you know your information you can see who is lying and who is not III Financial Market Institution o Finance Companies Intermediaries that raise large amounts of money through the sale of commercial paper and securities Used to make generally small loans to businesses and households Three types consumer finance business finance and sales firm finance Consumer Finance make loans to enable consumers to buy cars furniture and appliances to finance home improvements and refinance household debts o Higher risk of default than good quality bank customers so they are charged higher rates Business finance engage in factoring purchase of accounts receivable of small firms at a discount and then holds the receivables to maturity to earn a profit Sales Finance affiliated with companies that manufacture or sell big ticket goods retailer o Promote the business of the underlying manufacturer or GMAC offers financing to customers when they buy new GM cars Department stores offer credit cards with customers who shop at stores to finance purchases Increased their role in consumer and business lending over the years o Contractual Saving Institutions Allow individuals to pay money to transfer risk of financial hardship to someone else or to save in a disciplined manner for retirement o Insurance Companies Financial intermediaries that specialize in writing contracts to protect their policyholders from the risk of financial loss associated with particular events Fees called premiums are used so that the insurance company assumes the risk Ex Allstate Aetna Prudential Insurance policies are the worst way to save money for your future Built into each policy is a mortality expense and the insurance company decides the Internal Rate of Return IRR o Two types of insurance life insurance and property and casualty insurance Life Insurance sell policies to protect households against a loss of earnings from disability retirement or death of an insured person 2 types mutual companies are owned by the policyholders and stock companies are owned by the shareholders Issued whole life or term life Buy term life insurance instead because there is no cash build After term is over there is likely no more need for life up insurance College funds retirement etc should already be built up P C Property and Casualty Sell policies to protect households and firms from the risks of illness theft fire accidents or natural disasters Insurance companies profitability depends in large on their ability to reduce
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