FIN3244 EXAM 2 STUDY GUIDE Exam on Wednesday March 5 2014 STUDY FOR EXAM CHAPTER 5 Bank Runs In the great depression people ran to the bank and tried to withdraw all their money Banks back then were small and had problems with liquidity o Most of the customer s money had been loaned out so not everyone was able to get their funds from the bank because it was now insolvent Bank runs were caused by a lack of confidence o This however was fixed with the creation of the FDIC Currently banks use about 60 of their funds for loans mostly real estate mortgages Currently about 73 of all banks funding comes from deposits o Checkable Deposits are demand deposits and account for approximately 11 6 of a banks funding sources Short term liabilities Demand Deposits invested in long term assets Mortgages creates liquidity problems within banks o To avert this banks can borrow money from the Federal Reserve The Federal Funds Market The Federal Funds Market is interbank trading o Typically this occurs overnight o This does NOT involve the FED Investment Banks vs Commercial Banks The difference between commercial banks and investment banks are that investment banks do not accept deposits from individuals Investment banking used to be very small It was referred to as Shadow Banking o Overtime Investment banks grew and are now substantially larger than commercial banks Investment Banks Shadow Banking Traditional Activities included o New Security Issues Advice Underwriting IPO s and Seasoned offerings Promote Assist in mergers acquisitions More Recent Activities o Financial Innovation Engineering including Risk Management Complexity Sophisticated mathematical models developed by people with advanced degrees in economics finance and mathematics o Firm Research Analysis Helping to mitigate the Adverse Selection Problem Did rating agencies have conflicts of interest Proprietary Trading REPOS When investment banks or any institution is trading its own money Page 1 of 11 o REPOS Repurchase Agreements One bank sells treasury bills or another type of collateral asset to another bank An agreement is made to buy it back maybe the next morning for slightly more than they sold it for If confidence is lost and you have no faith in the counter party to repurchase the asset Moral Hazard would you do the deal Lehman Brothers was an investment bank that bought and sold mortgage backed securities When mortgage backed securities failed the value of them plummeted to nothing o Because of this Lehman brothers could not get any more money due to the fact that no one would buy their mortgage backed securities lack of confidence o This led to a run on the investment banks which were not FDIC insured as well as the failure of Lehman Brothers and the Crisis of Credit o After seeing this the Federal Government helped J P Morgan and Golden Sachs acquire other Investment banks to save the financial system Greed by Investors and CEO s Leverage borrowed funds to finance proprietary trading Reputation Problems o Leverage Cost of Stock How much of my money is invested If a stock costs 100 and I invest 100 of my own money then my leverage 1 If a stock costs 100 and I invest 10 and borrow 90 my leverage 10x If I spend 1000 for 10 shares of stock costing 100 each but only invest 100 of my own money and borrow 900 my leverage 10x o When you magnify up you win more When you magnify down you lose more o When using leverage and you have a high ratio you can lose a lot When people banks think you may be shaky they will quit lending to you and put you out of business reputation problem Shadow Banks Runs o Insufficient Government Regulations o No FDIC o No borrowing from Federal Reserve The Financial Crisis of 2009 The Financial Crisis of 2009 A run on the Shadow Banks o 1st Financial Crisis in U S History to not start in the Commercial Banking System Non Bank financial institutions now move more between borrowers savers than commercial banks o AIG Swaps AIG insured mortgage backed securities in the event of default Banks were not worried about default risk because they had this insurance Page 2 of 11 However if all of the securities were to fail at the same time AIG could go under as well as the Investment Banks o Investment Banks reorganized to be Bank Holding Companies Holding Companies refer to a single bank with two divisions Commercial Bank and an Investment Bank o Bank Holding Companies can borrow funds from the FED o Bank Holding Companies are regulated by the FED Now only 2 Bank Holding Companies exist and they are HUGE Goldman Sachs Morgan Stanley o In 1999 Gramm Leach Biley Act repealed Glass Steagall o Too BIG to fail Ramifications of investment banks failing were tremendous Could possibly bring down the whole economy The government decided to bail them out Non Bank Financial Institutions ETF s Mutual Funds and Hedge Funds are all part of the Shadow Banking System Mutual Funds Hold a portfolio of securities o Mutual Funds Reduce investor transaction costs Are diversified within limits of what they hold Are liquid they must buy back your share of the mutual fund o Money Market Mutual Funds Invest only in high quality short term assets Firms start depending on commercial paper loan sales to Mutual Funds for short term loans rather than get bank loans Problem Mutual funds stop buying commercial paper because they fear loss Hedge Funds o Financial firms organized as a partnership of wealthy investors that make relatively high risk speculative investments Large amount of assets Finance Companies o Sell commercial paper and make small loans Consumer Finance Firms Make loans for consumers to buy cars furniture appliances do home improvements refinance household debts etc Business Finance Firms Participate in Factoring Where a company buys an Accounts Receivable for less than the total amount Sales Finance Firms Affiliated with companies that manufacture or sell big ticket goods like Sears Offer in store financing like a Sears Credit Card Page 3 of 11 o Advantages of Finance Companies Monitoring Collateral Value Receive higher interest rates Little regulation allows non standardized loans o Retirement accounts 20 of all U S Financial Assets Pension Funds Insurance Firms o Specialize in contracts o Premiums for protection from specific events o Mitigate Adverse Selection Law of Large Numbers risk pooling Diversification Risk based premiums information gathering o Mitigate Moral Hazard Deductibles co insurance Restrictive covenants
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