Finance 301 1st Edition Lecture 2 Outline of Last Lecture II Financial Market III Role of Financial Market IV Primary vs Secondary Markets V Securities Traded in Financial Markets VI Valuation of Securities VII Use of Form to Make Investment Decisions VIII International Security Transactions Outline of Current Lecture I Role of Financial Institutions II Comparison of Roles among Financial Institutions III How the Internet Facilitates Roles of Financial Institutions IV Summary of Institutional Sources and Uses of Funds V Organizational Structure of a Financial Conglomerate VI Credit Risks for Financial Institutions VII Credit Crisis Current Lecture I Role of Financial Institutions a Financial institutions are needed to resolve the limitations caused by market imperfections such as limited information regarding the creditworthiness of borrowers b Role of depository institutions i Offer liquid deposit accounts to surplus units 1 Checking savings accounts liquid key word can have a bank run which means everyone decides to take all of their money out at once ii Provide loans of the size and maturity desired by deficit units 1 Their job is to make loans Banks try to make loans of all sizes banks can work together to make loans iii Accept the risk on loans provided in part These notes represent a detailed interpretation of the professor s lecture GradeBuddy is best used as a supplement to your own notes not as a substitute 1 Banks don t hold every loan that they make banks want loans that are 7 years or less they don t want to take a lot of house loans they send them to mortgage specialists iv Have more expertise in evaluating creditworthiness 1 Can develop credit scores they underwrite v Diversify their loans among numerous deficit units 1 Write as many loans as possible they are the ones that vary the length of the amount and they vary it around different types of people its like diversifying stocks c Depository institutions include i Commercial banks 1 Their main business is short term loans and would rather make higher interest 2 The most dominant type of depository institution ii Savings institutions 1 Also called thrift institutions and include Savings and Loans S Ls and Savings Banks 2 They want your mortgages they hold your mortgages and make interest off of them iii Credit Unions 1 Nonprofit organization 2 What makes them different is because they offer lower interest rates and you have to be a member in order to take the loan d Role of non depository institutions i Finance companies 1 Second mortgages want really high interest rates loan to anyone ii Mutual funds 1 Company that invests for other people buy the investments iii Securities firms 1 Investment brokerage when you have money you go to these people and ask them to help you invest iv Insurance companies 1 Company that takes on your risk good at predicting life insurance they want to make money in the end v Pension funds 1 Take retirement funds investment II Comparison of Roles among Financial Institutions a Financial institutions facilitate the flow of funds from individual surplus units investors to deficit units b c Financial institutions also serve as monitors of publicly traded firms i By serving as activist shareholders they can help ensure that managers of publicly held corporations are making decisions that are in the best interests of the shareholders 1 Activist shareholders for us 2 Tell a company if they do not like the way a company is being run 3 Example Ichen time warner made a terrible merge with AOL and he went in and told them how bad they screwed up and he told them they needed to split the company into 4 different companies made time warner buy back their own stocks III How the Internet Facilitates Roles of Financial Institutions a The Internet has enabled financial institutions to perform their roles more efficiently i Instantaneous transactions ii See bank statements less mail iii Pay bills online automatic payment iv Convenience IV Summary of Institutional Sources and Uses of Funds a V Organizational Structure of a Financial Conglomerate a b c d e f One stock shop Three things have merged commercial banks insurance and finance Example Regions bank regions financial Making bigger entities Is this good Shopping around would be difficult in as we have less options no specializations increases market risk g It is convenient you can do everything at one time VI Credit Risk for Financial Institutions a Following the abrupt increase in home prices in the 2004 2006 period many financial institutions increased their holdings of mortgages and mortgage backed securities b In 2007 2008 periods mortgage defaults increased and home values declined substantially c Mortgage Crisis bunch of small banks went under it was everyone s fault i Bad ARM qualification adjustable rate mortgage didn t t know how to qualify people for loans they were qualifying for the intro rate 2 to 7 people had to foreclose lendents should not have qualified for the loans ii No Doc Loans blame Freddie Mae and Freddie Mac they buy mortgages that are sold by banks There are no documentation all you needed was a credit score investors being stupid iii Overbuilding Florida Georgia Arizona Las Vegas prices went sky high iv Credit default swap derivative made by the insurance they didn t have enough money to pay it off AIG almost went under v Community reinvestment act politician making laws to invest in places even if you were not making money like making loans to investors and taking risks vi Too much debt like credit cards VII Credit Crisis a Systemic Risk is the spread of financial problems among financial institutions and across financial markets which could cause a collapse in the financial system b Mortgage defaults affected financial firms in several ways i Mortgage originators sold mortgages to other financial institutions i e Countrywide BOA etc so losses occurred ii Many other financial institutions invested in derivatives and were exposed to the crisis iii Some financial institutions relied on short term funding i e commercial paper etc and used MBS as collateral iv Decline in home building activity caused a decrease in the demand for related businesses leading to a weak economy c Government response to credit crisis i Federal Reserve Actions 1 Fed provided emergency loans to many securities firms those were not subject to its regulation 2 Fed bought mortgage backed securities to support the mortgage markets ii Wanted to 1 Tarp