Non-Bank Financial Intermediaries Chapter 12 Types of Intermediaries Insurance Companies Pension Funds Finance Companies Mutual Funds Gov’t Agencies Securities Market Operations (psudeointermediary) Insurance Companies 2 types Life Insurance Property/Causality Insurance Relative share of Intermediary assets decline 1970: 19.1% 2006: 16.6% Life Insurance Presbyterian Ministers Fund in Philly (1759) Now there are 1700 companies State Regulated: never experienced widespread failure Adequate liquid assets Limited risky assets Honest sales practices Stock and Mutual Stock Companies, owned by stockholders, are 90% of companies Mutual companies, owned by policy holders, are 10% of companies However, mutuals (Met Life, Prudential) own 50% of assets in the market Shifting Tactics Weak returns in 1970’s forced companies to become innovative Also 1974 legislation pushed pension funds to give management to life insurance comp Also sell annuities, or investment vehicle similar to pension fund Now 50% of insurance company assets Sources/Uses Payout statistically predictable High yield, less liquid Sources High yield corporate stocks Long term bonds Commercial mortgages Uses Life insurance policies and annuities Two type of policies Temporary (Term) Insurance: premiums grow every year as chance of death increases Permanent Insurance (Whole life, Universal Life): Constant premium Accrues cash value early in life, declines later Graph Property/Causality Insurance 3000 firms Stock or Mutual Examples: State Farm and Allstate Regulated by states Insure against ANYTHING for a price Fires, malpractice, earthquakes, theft For large risk, companies join together and co-insure Shifting Tactics Rates skyrocketed into the 90s Double and triple rates, even refuse service Low interest rates stopped flow of high investment income Growth of lawsuits and size of awards Elliot Spitzer MMC and AIG, 2003-5 Insurance broker rigging (moral hazard) Regulation by states likely to increase Sources/Uses Payouts less predictable (e.g. nat. disasters) Low yield, high liquidity Sources Municipal Gov’t bonds (tax-free) U.S. gov’t bonds More than half their assets Uses Policies Reinsurance Insure payments on bonds/securities Insurance Issues The downfall of the independent insurance agent Banks State banks entering market Repeal of Glass-Steagal Office of the Comptroller Can sell annuities (20% of market) Encourage entering to diversify Insurance Mgmt The Job: convert one asset into another (premiums to bonds/stocks) and then pay out claims by policyholders WHILE STILL MAKING A PROFIT Also… Adverse selection: those with higher insurance risk will seek it out the most Moral Hazard: once insured, policyholder will increase risk-taking Tools to manage risk Screening Adverse Selection Gather information Discrimination issues Risk-based premiums Adverse selection Male drivers pay more Restrictive provisions Moral Hazard Wear helmets on the job More tools Limits on Insurance Moral Hazard Coinsurance Moral Hazard Percentage amount of claim reduced Deductible Moral hazard Fixed amount of claim reduced Why a company require deductible over coinsurance? Fraud Prevention Moral hazard Investigation on claims Private Pension Funds Relative share of intermediary assets increase 1970: 13% 2005: 24% Because of employer and employee share tax deductible Self employed open own tax-sheltered plan Sources/Uses Predictable payout Sources Employer contributions Employee contributions Uses High interest bonds Stocks Mortgages Stock market behemoth Pension funds own 25% of all stock 70% of daily volume are by pension or mutual funds 2/3 of pension assets are in stock market Two types Defined contribution plan: simply get what you put in Defined benefit: set target in advance Fully funded or underfunded Why would be underfunded Companies go under and can’t make payments Market slows down and target can’t be met ERISA Disclosure of Information Regulation by Dept. of Labor Rules on investment Vesting: length of time someone must be enrolled to receive interest (to have a vested interest) Created Penny Benny (like FDIC) $45 Billion underfunded (GM $12 billion) Currently insures 1/3 of workers Moral Hazard Public Pension Plans Similarly handled as private EXCEPT for Social Security Sources FICA: Income taxes Uses Pensions Medicare Disability pensions Problem Underfunded by $1 trillion Pay-as-you-go system (not invested) Created as way around market shocks (Roosevelt) Excess goes to gov’t bonds Working/Retiree ratio decline Was 17/1 Now closer to 3/1 Solutions: Higher tax deductions, lower pensions, or privatization Finance Companies Make specialty, highly ‘tailored’ loans Virtually unregulated, gain advantage over banks % of Intermediary market 1970: 4.9% 1990: 5.9% 2005: 3.9% Sources/Uses Sources Company issued stocks, bonds, and commercial paper Uses Sales Finance Owned by company Auto industry Business Finance Lease capital (planes, construction equipment) Factoring: purchasing accounts receivable at a discount Consumer Finance Lender of last resort (high interest rates) Particular consumer items Mutual Funds Pool resources of small investors to buy securities Regulated by the SEC Many of same companies as life insurance/inv. banking In 1960 3% of financial intermediary assets Only 6% of households owned a MF Today 25% of financial intermediary assets 50% of households own MFs Households hold 80% of MF Sources/Uses Sources Sell shares to investors Two types Open-ended: redeemed any time Closed-ended: traded like stock OE more common Uses Buy high yield securities Advantages Institutional Investors Expertise Have cloud in market Can afford to investigate, monitor (AS) Can even force changes inside companies Small investors can Lower their transaction costs Diversify Disadvantages Moral Hazard Excessive risk taking Favored customers/insider trading Until 2003, untainted record Spitzer again (late hour trading) “Betting on the horse race after the horses have crossed the finish line” Load vs.. No-load No-load funds Commission (0.5%) of asset value per year Most common (obviously) Load funds Additional commission paid up-front to broker Money Market Mutual Funds Invests in low risk, short term debt instruments T-bills Commercial paper Bank CDs Shares redeemed at fixed value Checkable deposits 1/3 of all mutual funds Hedge Funds Special mutual fund for rich Low regulation Allows risk taking Long term commitment Allows strategy High buy-in $1 mil in assets, $200,000 in income Federal regulation, otherwise too risky Market neutral strategy Federal Credit Agencies Farm Credit Bureau Issues securities Makes loans to farmers Home mortgages FNMA (Fannie Mae), GNMA (Ginny Mae), and FHLMC (Freddy Mac) Only Ginny Mae is actually federal Sally Mae, student loans, private Moral Hazard Gov’t won’t let go under Public vs.. Private allegiance Small capital to asset ratio Securities Market Operations Not actually financial intermediary, but more like a ‘financial facilitator’ Primary Securities Investment Banks Secondary Securities Brokers Dealers Investment Banks Merrill Lynch, Goldman Sachs, etc Two jobs Give advice on investment tool and price Seasoned issue IPO (Tech stocks, China) Underwrite security Guarantee price to corporation then sell it on the market for more Joint underwriting for large issues Moral Hazard Brokers, Dealers, and Specialists Brokers :Agents for investors in security deals Dealers: Holder of securities that links buyers and sellers (higher risk) Specialist: Dealer/Broker Brokerage Firms: perform brokerage, dealing, and investment banking (Merrill Lynch) Organized exchanges is where activity takes place Internationalization Technology