Finance 301 1st Edition Lecture 2 Outline of Last Lecture II. Financial MarketIII. Role of Financial MarketIV. Primary vs Secondary MarketsV. Securities Traded in Financial MarketsVI. Valuation of SecuritiesVII. Use of Form to Make Investment DecisionsVIII. International Security TransactionsOutline of Current LectureI. Role of Financial InstitutionsII. Comparison of Roles among Financial InstitutionsIII. How the Internet Facilitates Roles of Financial InstitutionsIV. Summary of Institutional Sources and Uses of FundsV. Organizational Structure of a Financial ConglomerateVI. Credit Risks for Financial InstitutionsVII. Credit CrisisCurrent LectureI. 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 institutionsi. Offer liquid deposit accounts to surplus units1. Checking, savings accounts, liquid=key word. can have a bank run which means everyone decides to take all of their money out at onceii. Provide loans of the size and maturity desired by deficit units1. Their job is to make loans. Banks try to make loans of all sizes, banks can work together to make loansiii. 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 specialistsiv. Have more expertise in evaluating creditworthiness1. Can develop credit scores they underwritev. Diversify their loans among numerous deficit units1. 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 stocksc. Depository institutions includei. Commercial banks1. Their main business is short term loans and would rather make higher interest2. The most dominant type of depository institutionii. Savings institutions1. Also called thrift institutions and include Savings and Loans (S&Ls) and Savings Banks2. They want your mortgages, they hold your mortgages and make interest off of themiii. Credit Unions1. Nonprofit organization2. What makes them different is because they offer lower interest rates and you have to be a member in order to take the loand. Role of non-depository institutionsi. Finance companies1. Second mortgages, want really high interest rates, loan to anyoneii. Mutual funds1. Company that invests for other people, buy the investmentsiii. Securities firms1. Investment brokerage, when you have money you go to these people and ask them to help you investiv. Insurance companies1. Company that takes on your risk, good at predicting life insurance,they want to make money in the endv. Pension funds1. Take retirement funds investmentII. Comparison of Roles among Financial Institutionsa.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 us2.Tell a company if they do not like the way a company is being run3.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 stocksIII. How the Internet Facilitates Roles of Financial Institutionsa. The Internet has enabled financial institutions to perform their roles more efficiently.i. Instantaneous transactionsii. See bank statements, less mailiii. Pay bills online, automatic paymentiv. ConvenienceIV. Summary of Institutional Sources and Uses of Fundsa.V. Organizational Structure of a Financial Conglomeratea.b. One stock shopc. Three things have merged… commercial banks insurance and finance d. Example. Regions bank regions financial e. Making bigger entitiesf. 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 timeVI. Credit Risk for Financial Institutionsa. Following the abrupt increase in home prices in the 2004-2006 period, many financial institutions increased their holdings of mortgages and mortgage-backedsecurities.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 faulti. 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 loansii. “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 stupidiii. Overbuilding Florida, Georgia, Arizona, Las Vegas prices went sky highiv. Credit default swap-derivative made by the insurance they didn’t have enough money to pay it off AIG almost went underv. Community reinvestment act – politician making laws to invest in places even if you were not making money like making loans to investors and taking risksvi. Too much debt like credit cardsVII. Credit Crisisa. 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 crisisi. Federal Reserve Actions1. Fed provided emergency loans to many securities firms those were not subject to its