Lecture 6: Other Financial Institutions and Intermediaries
1) Classes:
a. Depository – commercial banks, S&L, credit unions
b. Securities Market Institutions – I banks, brokerages, exchanges
c. Investment Institutions – mutual funds, venture capital, finance companies
d. Contractual Savings – Insurance and Pension funds
e. Government agencies – FNMA, GNMA, FHLMC
2) Securities Market Institutions
a. Primary function is the development, sales, and trading of financial
instruments.
b. Purpose is to create a viable securities market that gives individual firms
direct access to fund sources (savers/investors) without having to go
through a bank
c. Facilitate risk-sharing (as opposed to providing risk-sharing) – these firms
are not intermediaries
d. Match supply and demand for money (savers / borrowers)
e. Provide liquidity and efficient information services
3) Investment Banks
a. Mission: To Create and Sell Financial Securities
i. Create – they actually assist in the creation, technically, it is the
firm issuing the security that creates it
ii. Purchase – they purchase the initial offering, and resell it in the
primary market
b. Underwriting – the process of agreeing to buy (and resell) a security issue
i. Process involves structuring an issue, conducting research and
providing financial disclosure about the firm, and marketing of the
issue to buyers (in the primary market)
ii. Disclosure must be in accordance with SEC guidelines
iii. Fees are based on an agreed spread – percentage of issue –
between the issuer and bank
iv. Syndication – underwriting by more than one bank
c. Engagement Types:
i. IPO’s
ii. Seasoned Issues
iii. New Capital / Refinancing(s)
iv. Corporate Restructurings – altering composition of equity/debt
v. Mergers and Acquisitions
vi. Bonds, Stocks, and More Recently, Derivatives (Warrants etc.)
d. Types of Sales:
i. Negotiated – Bank and issuer come to an agreement without
competitive bidding between banks
ii. Competitive – Banks competitively bid for a security issue
iii. Best efforts – no guarantees – sell as much as possible
e. Other Services – Financial Advisory
i. Bank hired by firm as Financial Advisor in creation of an issue
ii. Issue is sold by competitive bid to other I-banks
iii. Advisory services essentially entail providing disclosure and
ensuring SEC requirements are met
iv. Not nearly as lucrative as underwriting
4) Underwriting Process
a. Negotiated Sale
i. Terms negotiated with issuer, or competitive bidding of terms up
front bidding (Example: LATC metro-rail)
ii. Syndication group established (if any) – lead bank responsible for
development of issue (does all work)
iii. Due diligence and issue development – this means structuring the
issue and conducting research about the firm, project, and
associated risks
iv. Securing Credit Ratings and/or Insurance (Bonds) – involves
negotiation and essentially a sales pitch to bond insurers and rating
agencies
v. Red Herring and Prospectus – these are the disclosure statements
required by the SEC, the Prospectus is the final sale document
given to investors
vi. Marketing and Sale – contacting investors (major investors: mutual
funds, insurance co.’s etc.) and pre-selling securities (IPO’s may
involve several weeks – road show by Capital Markets Group)
vii. Closing – delivery
b. Competitive Sale
i. Financial Advisor – develops disclosure documents for issuer
ii. Issue development – structuring issue and conducts financial
research
iii. Prospectus / Offering Memorandum – announcing the competitive
sale and providing disclosure
iv. Competitive Bids – on sale date, often arriving within minutes
before close of bidding
v. Closing – delivery
5) Players
a. Investment Banker – underwriter
b. Financial Advisor
c. Bond Council – certifies legality of documents
d. Underwriter Council
e. Trustee
f. Bond Insurer or Rating Agency (Bonds Only)
g. Escrow Supplier (Re-financings)
h. Other Minor Players – The Cusip Bureau (Registration), Depository Trust
Company (DTC) – Retains bonds for bondholders
Relationship between Players:
Insurer and/or
Rating Agency
Financial
Advisor
Underwriter
Council
Investment
Banker
Client
Communications:
Strong
Adversarial
Limited
Bond
Council
Trustee
Flow of Funds at Closing:
Insurer and/or
Rating Agency
Financial
Advisor
Funds
Funds
Bonds
Bonds
Bond
Council
-
Investment
Bank
Trustee
Client
-
Underwriter
Council
Primary fund flows
Payments for services
When the Trustee certifies that it has received both the funds and the bonds, the
Bond Council orders their release
The Trustee is also charged with ensuring payment of the Bond Council and
Insurer or Rating Agency from the fund
6) Examples:
a. LATC Metro-Rail
i. Negotiated Sale with Competitive Bidding up-front
ii. Involved use of derivatives and syndication
iii. Floor fight over product structure
iv. FA valuation of derivative structure
b. Orange Cove
i. Refinancing of defaulted issue
ii. Speculative – Community Facilities District bonds used to finance
housing tract infrastructure
c. Crossover Refinancing
i. Complex issue requiring escrow to pay new bond debt service for
several years then crossover, to pay debt service on original issue
ii. Example of Adversarial Bond Council
d. Chowchilla Union Hospital Default – Marks-Roos Bond Pooling
i. Pooling of several different bond issues with option for issuers not
to participate
ii. Had some of everything – structuring problems, defaulting clients,
misuse of funds, conflicts of interest (bankers convinced good
credit issuers not to participate after issue completed).
iii. Default and Investor Law suit – prime example of sloppiness and
greed
7) Why an I-bank?
a. Lower information costs
i. Centralized due diligence
ii. Expertise by bankers
b. Rely on Reputation
i. Investors don’t have time or expertise
ii. Reputation becomes paramount – lose it, and you cannot sell
product
c. Lower cost of funding
i. Securities are tradable (as opposed to loans)
ii. Can access investor funds directly
iii. Ability to engage in contracts other than Debt
8) Other components of I-banks
a. Capital Markets group
i. Sales and product development are often separated at the major
banks
ii. Bankers in the Capital Markets Group are responsible for placing
issues, and for maintaining sales relationships with primary
market clients (as opposed the bankers in product development
who have the relationship with the issuer)
iii. The Capital Markets Group must coordinate with the product
development side to assure salability of the product
b. Securities trading
i. I-banks maintain their own trading floors with traders placing
orders for the exchanges and the OTC
ii. The floors are broken up into different regions: equities, bonds,
derivatives, foreign exchange, and then subdivided among industry
types – each of these is called a desk
iii. There is a head trader in charge of each area that is responsible for
the trades made and positions (risk) assumed
iv. These heads report to a Head trader in charge of all trading
c. Research Departments
i. Virtually every area for which there is trading has a research
department
ii. The department is usually staffed with Ph.D.’s, there could be just
one, or several
iii. The Ph.D.’s are charged with product development and evaluation
of existing models – e.g. coming up with new trading strategies
iv. Examples: Evaluating and testing a modified version of Dispersion
Trading, Evaluating derivative pricing models
v. In general, research people are very good with computers and have
a sound understanding of economics
d. Market Analysts
i. Analysts follow the stock, bond, derivatives, and equity markets
ii. Make recommendations regarding positions on the various
securities
iii. Responsible for providing written reports – often due within hours
iv. Bond and derivative analysts tend to have a greater technical
orientation, and are often Ph.D.’s
v. Can be a great deal of specialization – for example, being the FX
options strategist
vi. Often relied on to develop new trading ideas
vii. Have to be able to interface directly with clients
e. Risk Management (the Police)
i. Purpose is to control the risk of the positions taken by the traders
ii. Often at odds with trading
iii. Usually have representatives evaluating the positions of every
major desk
iv. Employs seasoned traders, and some Ph.D.’s
f. Back-office
i. Back-office is where trade accounting occurs
ii. Manage the actually flow of funds
g. Brokerage Services
i. Most I-banks have brokers working to sell stocks
ii. Usually divided into public brokerage services and high-net worth
9) Brokers, Dealers, Exchanges, and the OTC
a. Mission: Trade/Facilitate trade of existing security issues
b. Purpose: create a market for securities thereby increasing liquidity
c. Investment Banks operate in the Primary Market, Brokers and Dealers
operate in the Secondary Market trading existing issues
d. Chief Players in the Secondary Market:
i. Brokers – earn commissions by selling securities (liquidity
services)
ii. Dealers – hold inventories (liquidity services) – earn spread
between what they buy and sell for (bid-ask spread)
e. Exchanges – provide centralized trading
i. Liquidity services – facilitates trading
ii. Financial information (current prices)
iii. Specialists – acts as both a broker and dealer
f. Over The Counter Market (OTC) – provides much of the same services as
the exchange. E.g. NASDAQ
10) How does an exchange work?
a. The heart of the exchange is the pit
b. Bid and sell orders are verbally shouted and accepted
c. Specialists have seats at the exchange and maintain positions in popularly
traded stocks ready to bid or sell at a given price that fluctuates with the
market.
11) Mutual Funds – Investment portfolios
a. Investment Portfolios that a small investor can buy shares of that invests in
a variety of securities – stocks, bonds, and other instruments
i. Diversification and liquidity for small investor
ii. Purchase portfolio shares
iii. Closed-end vs. Open-end
iv. Load vs. No-load (How fees are earned)
b. Normally small investors do not have sufficient funds for diversification,
Index funds provide this
c. Funds also may invest in specific classes or types of securities
i. Stock funds (e.g. Fidelity Destiny, Alliance, etc.)
ii. Bond funds (Hartford Government Bond Fund)
iii. Hybrid Funds (Bonds and Stocks)
iv. Money Market Mutual Funds – Short term asset funds designed for
liquidity
v. Foreign market funds – will be a stock, bond, or hybrid that invests
in specific foreign assets (Mexico Fund, Asian Tigers, etc.)
vi. Specialty Funds: Invest in a particular sector (e.g. utilities, oil) or
market (e.g. small-caps, mid-caps, emerging markets, index funds)
d. Fund Net Asset Value (NAV)
i. Assets minus Liabilities per share
ii. Measures the market value per share of fund holdings
iii. Closed-end fund prices often deviate from the NAV
e. Households now own the majority of fund shares (approx 80%), this is
almost a 15 fold (1500%) increase from 1980
i. Over 50% is held in money market funds
ii. Approximately 25% in Equity Funds
f. Fund Information – Guides that provide information about fund
performance and NAV’s
i. Morningstar guide to mutual funds, closed-end funds, …
ii. Value-Line
12) Organization of the Mutual Fund and who works there?
a. Divided into Product Areas: Fixed Income and Equities
b. Domestics and International
c. Domestics often divided by aggressiveness, Putnam for example:
i. Core
ii. Growth
iii. Small Cap
iv. Value
d. Employs
i. Portfolio Managers
ii. Traders
iii. Fundamentals Analysts (MBA’s) – statement and qualitative
analysis. Analysts visit firms and interact with management
iv. Quant Analysts (Ph.D.’s) – Develop quantitative trading models
for a segment of the market, can act as portfolio managers for that
segment
v. Marketers – the fund’s internal brokers that permit you to purchase
fund shares directly
Portfolio
Manager
Quant Analysts
Traders
Fundamentals
Analysts
e. Asset Allocation also influenced by risk management for entire fund
i. Risk Management will supply additional funds to portfolio
managers in equities or fixed income depending on risk assessment
Asset
Allocation
Fixed
Income
Equities
f. Sources of Business
i. Retail Side – sales directly to public through marketers or external
brokers
ii. Institutional Sales – Defined Benefit/Contribution Programs (e.g.
401K)
13) Hedge Funds
a. A special type of mutual fund that focuses on using ‘Market-Neutral’
strategies to obtain returns
b. Hedge funds attempt to identify and exploit pricing anomalies, by taking
theoretically offsetting positions that only make money on the anomaly
c. For example: A hedge fund may take a long and short position in two
bonds of the same maturity because they feel the former bond will
appreciate in value relative to the latter
i. The eventual price of either bond is of little consequence
ii. So long as the former appreciates more than the latter, the fund
makes money
iii. The strategy is said to be ‘Market-Neutral’ because it does not
matter what happens to the actual value of the instruments – gains
or losses due to market movements should offset each other
d. Federal Law limits Hedge funds to a maximum of 99 (or 499) members –
e.g. you must be a high net worth investor to participate
e. Members could be individuals, firms, or other financial institutions
i. This was why the FED was concerned when Long Term Capital
went under
ii. Several major financial institutions had invested capital in LTC
f. Hedge funds are relatively unregulated in comparison with mutual funds,
and unlike mutual funds, do not require an independent board of Directors
14) Venture Capital
a. Focus on developing firms
i. Firms in gestation – not ripe for market
ii. Products in varying stages of development
iii. Cannot find funding through debt or equity markets – to
speculative, likewise, cannot achieve sufficient bank credit
iv. Often require equity because cash-flows will be insufficient or
negative for quite some time (no bank will lend money)
v. Venture capitalists create funds or invest their own funds, the
provide seed money to companies
b. Venture Capitalists are Investment Bankers
i. Typically ex-investment bankers or high-level managers
ii. Experience in valuing companies and assessing business plans
iii. Also requires understanding of operational issues
c. Reduce Asymmetric Information
i. Most focus on reducing Adverse Selection or Moral Hazard
ii. Reduced by holding seats on board of directors – this feature is
unique among financial institutions
iii. Funding is released in stages, as benchmarks are achieved – this
reduces the potential for significant loss (this also reduces Moral
Hazard)
d. Established as Limited Partnerships or Mutual Funds
i. Limited Partnerships eliminate reporting requirements and reduce
regulation
ii. Requires participation from high-net worth investors or investment
institutions (e.g. Pension funds)
e. Make Money through Long Run Returns
i. The goal is to profit from an Eventual IPO
ii. Many projects fail, so venture capitalists are looking for one to
succeed big
15) Finance companies
a. Provide alternatives to Bank financing
i. Companies can sell receivables as opposed to borrowing
ii. Finance companies will retain, or sell as commercial paper
b. Aggregate loans and sell as commercial paper
i. E.g. credit card receivables, housing loans, car loans (GMAC)
ii. Sale of paper renews available capital, this is often used to support
a primary business, e.g. GM car sales, Visa credit loans etc.
iii. Typically market to pension, mutual funds or insurance companies
c. Risk Reduction is created through Portfolio Diversification
d. Regulation Z—truth in lending law, and Usury Statutes
Other Intermediaries—Insurance Companies and Pension Funds
1) Contractual Savings – Insurance / Pension funds
a. Contractual – either event contingent, or contribution contract
b. Insurance Companies work on the theory of risk-diversification
c. Pension Funds are essentially Mutual Funds that invest to provide
retirement income
2) What is Insurance?
a. Certainty Equivalent—Purchase insurance to prevent a large loss by
paying a certain amount today
b. The likelihood of the loss may be small, however, if it occurs, it may be
too large to recover from
c. Inefficient (or impossible) to set sufficient reserves aside
d. Cost is based on the law of large numbers and the statistical probability of
a loss
3) Adverse Selection and Moral Hazard
a. Effect the Cost, Structure, and Availability of Insurance
b. Adverse Selection
 Those more likely to need insurance seek it—drives up costs
 Can be controlled by Segmenting Populations
 Charging Risk Based Premiums
 Pre-existing condition covenants
c. Moral Hazard
 Careless behavior because of insurance
 Control by use of deductibles and limiting conditions under
which insurance applies
4) Insurance companies
a. Risk-diversification (pooling of risk)
b. Earn fees on premium (based on statistical payouts)
c. Invest in security portfolios
 Stocks and Bonds
 Mortgages, Loans, Commercial Paper
d. Re-insurance—the selling of risk to other firms
e. Products
 Property & Casualty, Life, Health
 Term-Life—Insurance Only
 Whole-Life—Includes savings component used to pay premium
in later years
f. Stock vs. Mutual Company—owned by shareholders/ policyholders
g. Largely Regulated by states in which they operate
5) Pension Funds
a. Pension Types:
 Defined Benefit (annuities)
 Defined Contribution
b. Manage securities portfolio
 Largest Institutional Investors
 Major Primary Market participants—often approached by firms
and investment bankers for IPO’s
c. Defined Benefit
 Pensioner is guaranteed payment at retirement
 Fund may be under or over-funded
 Under-funded pensions may be disastrous in bankruptcy
 Firms and Municipalities often raid pension funds
 Social Security is essentially a Defined Benefit Plan
d. Defined Contribution
 Company contributes to a 401k, 403b, 457 etc.
 The money belongs to the pensioner and moves with him/her
 There are no guarantees on retirement payments—investment is
the pensioner’s responsibility
 What’s the problem with investing your pension in company
stock?
e. How does this differ from a mutual fund?
6) Social Security—the Under-Funded Pension
a. Insufficient funds to cover obligations past 2036
b. Problems stem from:
 Baby boom generation—there will be less working adults and
more pensioners: http://www.cbo.gov/
 Raiding of the Social Security Trust fund to balance the budget
and fund other programs
 When SS began, there were 18 workers for every pensioner, now
there are 3.3. By 2038, there will be 2.
c. Possible Solutions:
 Payoff current Pensioners and Move to a Defined Contribution
Plan over time (all this amounts to is an enforced savings system
since you’re the one paying the social security taxes)—you
manage funds
 Maintain current structure, but invest surplus in capital markets
 Permit creation of supplemental accounts
 REDUCE BENEFITS—increase retirement age and reduce
payments on retirement
 INCREASE Social Security TAXES from 12-18%

Euthanasia for retirees—Hugely unpopular with elderly
Links to information about financial careers:
Equity Research Analyst
http://www.fins.com/Finance/Articles/SB129865507633389853/So-You-Want-to-Be-anEquity-Research-Analyst?
http://www.fins.com/Finance/Articles/SB130012931154994473/How-to-Craft-aWinning-Equity-Analyst-Resume?
Financial Advisory
http://www.fins.com/Finance/Articles/SBB0001424052970204616504577170942421584
290/The-Road-to-Becoming-a-Financial-Adviser
http://www.fins.com/Finance/Articles/SBB0001424052970204661604577185091279683
330/The-Perfect-Financial-Adviser-Resume
http://www.fins.com/Finance/Articles/SB128344557778933641/The-First-365-DaysHow-to-Set-Up-For-a-Successful-Career-as-a-Financial-Advisor?
Investment Banking
http://www.fins.com/Finance/Articles/SB129113644770361701/How-to-Write-thePerfect-Investment-Banking-Resume
http://www.fins.com/Finance/Sectors/7/Investment-Banking
(scroll down to see description below)
http://www.fins.com/Finance/Articles/SB127955825970118641/The-Perfect-M-AResume
http://www.fins.com/Finance/Sectors/13/Strategy-Corporate-Development-M-A
(scroll down to see description below)
Retail Banking
http://www.fins.com/Finance/Articles/SBB0001424052970204136404577211291090075
100/The-Perfect-Retail-Banking-Resume
Trader
http://www.fins.com/Finance/Articles/SBB0001424052970204468004577165513940669
008/So-You-Want-to-be-a-Foreign-Exchange-Trader
http://www.fins.com/Finance/Articles/SB126020222912980063/The-Perfect-span-classsearchkeywordbg-Sales-span-and-Trading-Resume
Job Seeking in general
http://www.fins.com/Finance/Articles/SB130409085766811861/Seven-Ways-to-KeepYour-Resume-Out-of-the-Trash
http://www.fins.com/Finance/Articles/SBB0001424052702303768104577462483789678
786/How-to-Get-Off-the-Career-Ladder-and-onto-the-Lattice?
http://www.fins.com/Finance/Articles/SB124602481242960765/Finding-a-Finance-JobAbroad
http://www.fins.com/Finance/Articles/SBB0001424052970204781804577272044012778
530/Ten-Dumb-Things-People-Have-Said-During-Job-Interviews
http://student.fins.com/Articles/SBB0001424052702303734204577468820423928592/Th
e-Stupid-Stuff-Recruiters-Ask-Job-Candidates
http://www.fins.com/Finance/Articles/SBB0001424052702303772904577334061709599
508/Oh-the-Decision-M-B-A-or-a-Masters-in-Finance
http://student.fins.com/Articles/SBB0001424052970204136404577210932095586656/W
here-the-Finance-Jobs-Are-in-2012
http://www.fins.com/Finance/Articles/SBB0001424052702303918204577448203883942
844/Seven-Tips-for-Success-on-Day-One-of-a-New-Job