Problems with Financial Markets and
How Financial Institutions Mitigate
Them
Reducing
Transactions
and Information
Costs
Obstacles to Matching Savers and
Borrowers
• Transactions costs: costs of buying and
selling a financial instrument.
• Financial intermediaries reduce
transactions costs by exploiting
economies of scale.
• Information costs: costs to determine
the creditworthiness and monitor the
use of funds.
Information imperfections and
incomplete contracts
• Incomplete contracts are pervasive.
• complete contract: the parties to an agreement
could specify their respective rights and duties for
every possible future state of the world, their
contract would be complete. There would be no
gaps in the terms of the contract.
• However, because it would be prohibitively
expensive to write a complete contract, contracts
in the real world are usually incomplete.
Retrieved from
"http://en.wikipedia.org/wiki/Complete_contract"
Information Problems
• Asymmetric information: one party has better
information than the other.
• Adverse selection: a market process in which
"bad" products or customers are more likely
to be selected.
• Moral hazard: the risk that one party to a
contract can change their behavior to the
detriment of the other party once the contract
has been concluded.
• Principal-Agent problems
Class of 2001
Adverse Selection
• Example: Insurance Market
• Smokers and Non-Smokers
• Insurance company cannot tell the difference between
smokers and non smokers and charges an average
premium for both smokers and non smokers
• This is good for the smokers, and not so good for the nonsmokers, who both know their behavior. So smokers buy
the insurance and non-smokers don’t.
• The insurance company realizes that it is making a loss,
since there are many claimants (mostly smokers take
insurance), and has to raise its premium to take into
account this problem.
• However this worsens the problem-now only the very
heavy smokers will take insurance, and the company has
to pay out even more, till it is run out of business
Adverse Selection in Financial Markets
• A lender has a population of borrowers to lend tothese are divided into safe and risky borrowers.
• Not knowing one from the other, the lender
charges an interest rate which is an average to
cover risk.
• Only the risky borrowers will borrow, because
there is a chance that they will make a return to
cover the interest (but more likely will fail)
• Stiglitz and Weiss (1981)- since lenders know
that borrowers are likely to default- there is a
backward bending supply curve of credit. Credit
Rationing
Credit Rationing
Definition:
Some borrower's demand for credit is turned down, even if the
borrower is willing to pay all the price and non-price elements of
the loan contract.
Baltensberger, E. (1978): Credit Rationing: Issues and Questions,
Journal of Money Credit and Banking, 10(2), 170{83
Interest
Rate
Quantity
Adverse Selection
• Lemons problem: asymmetric information in a
market leads to adverse selection.
• Lemons problems in the bond market lead to
credit rationing.
• Lemons problem raises lending costs (firms
need other finance)
• Many countries set information disclosure
requirements if a firm sells securities (also
other solutions raise the collateral required
and so on)
Moral Hazard
• Changing of behavior after contract has been
written
• Example: After I get car insurance, I drive
recklessly. I build my house near a hurricane
zone, knowing that I will receive insurance a
hurricane arrives. What could be the moral
hazard involved if I give you class notes
before the week?
Moral Hazard
• Regulations on reporting by firms reduce the
chance of fraud in equity financing.
• Principal-agent problem: managers have
different goals than the firm’s owners.
(questions as to who should have more
power)
• Debt financing reduces moral hazard
problems relative to equity financing.
• Moral hazard in debt financing is reduced
with the use of restrictive covenants.
Principal Agent Problems
• Various mechanisms may be used to try to
align the interests of the agent with those of
the principal, such as profit sharing, stock
options, piece rates, commisions, higher
wages,the agent posting a bond, or fear of
firing. The principal-agent problem is found in
most employer/employee relationships, for
example, when stockholders hire top
executives of corporations. (wikipedia)
Information Costs and Financial
Intermediaries
• Financial intermediaries reduce adverse
selection by specializing in gathering
default risk information.
• Banks’ information advantage largely
accounts for their role in providing
external financing.
• Financial intermediaries deal with moral
hazard through monitoring.
We have many types of financial
institutions
• All were regulated to perform certain
functions and to maximize the benefits
of intermediation subject to the
problems of asymmetric information.
Five main financial institutions
– Securities market institutions: investment banks;
brokerage firms; organized exchanges
– Investment institutions: mutual funds; finance
companies
– Contractual saving institutions: insurance
companies; pension funds
– Depository institutions: commercial banks; savings
institutions; credit unions
– Government institutions: direct lending; indirect
lending (loan guarantee)
Securities Market Institutions
• Securities market institutions : investment
banks, brokers, dealers- all of whom work
with securities primarily (not considered
financial intermediaries)
• Investment banks help raise new capital in
primary markets, help consolidate (mergers
and acquisitions) new stock issues; debt
restructuring
• Brokers and dealers help facilitate exchange
in secondary markets.
Underwriting
• Underwriting of Securities
• Issuance of shares and corporate debt
• Underwriter provides advice for issuer, distribution of
securities, sharing of risks of issue, and stabilization
of aftermarket.
• Underwriter also “certifies” the issue by putting its
reputation behind the issue.
• Two Basic Kinds of Offerings
• Bought deal (synonym: Firm commitment offering):
The underwriter agrees to buy all shares that are not
sold
• Best efforts: the underwriter says that if the issue is
not sold, deal collapses.
(1) advising
• timing of offering
• terms of security
• pricing
• regulation
(2) underwriting
• optional
• investment bank buys securities from
issuer,
then resells to public
• investment bank bears the price risk
• price set 2 days prior to issue
– security floatation
– firm commitment
• resale price - guaranteed price
= gross spread
= underwriter’s discount
• size of discount depends on
– type of security
-- bonds lowest, stock IPOs highest
– size of issue
-- smaller issues have larger discount
– market conditions
– .5% - 7% (table 14-1)
group of investment banks
• several investment banks bear price risk
– lead underwriter
-- bulge bracket firm
– syndicates help underwrite
• selling group
– syndicate AND
– other firms
-- help sell issue, do not underwrite
tombstone
• advertisement
• lists all of the underwriters
• details of issue
• after sale has taken place
– to get more underwriting business
26,000,000 Shares
Hartford Life, Inc.
Class A Common Stock
(par value $.01 per share)
Price $28.25 Per Share
Upon request, a copy of the Prospectus describing these securities and the business of the company may be obtained within any state from any
underwriter who may legally distribute it within such state. The securities are offered only by means of the Prospectus, and this announcement is
neither an offer to sell nor a solicitation of an offer to buy.
20,800,000 Shares
This portion of the offering is being offered in the United States by the undersigned.
Goldman Sachs International
Merrill Lynch International
Morgan Stanley Dean Witter
Smith Barney Inc.
Credit Suisse First Boston
A. G. Edwards & Sons, Inc.
Prudential Securities Incorporated
Conning & Company
Edward D. Jones & Co., L.P.
Advest, Inc.
Dain Bosworth
Stephens Inc.
J.C. Bradford & Co.
Legg Mason Wood Walker
Piper Jaffray Inc.
Incorporated
Raymond James & Associates, Inc.
Sutro & Co. Incorporated
Interstate/Johnson Lane
PaineWebber Incorporated
Sanford C. Bernstein & Co., Inc
Fox-Pitt, Kelton Inc.
Incorporated
Principal Financial Securities, Inc.
Lehman Brothers
The Robinson-Humphrey Company, Inc.
Wheat First Butcher Singer
Dowling & Partners Securities, LLC
Janney Montgomery Scott Inc.
Neuberger & Berman, LLC
Corporation
5,200,000
This portion of the offering is bein offered outside the United States by the undersigned.
Goldman Sachs International
Merrill Lynch International
Morgan Stanley Dean Witter
Smith Barney Inc.
ABN AMRO Rothschild
Dresdner Kleinwort Benson
June 4, 1997
Banque Nationale de Paris
Barclays de Zoete Wedd Limited
Yamaichi International (Europe) Limited
Underwriting
• Analysis of the purchase price.
• Financing to purchase the company.
• Provide the equity
Details on Mergers
•
•
•
•
•
•
A "merger" or "merger of equals" is often financed by an all stock deal (a stock swap). An all stock deal
occurs when all of the owners of the outstanding stock of either company get the same amount (in value) of
stock in the new combined company. The terms "demerger," "spin-off" or "spin-out" are sometimes used to
indicate the effective opposite of a merger, where one company splits into two, the second often being a
separately listed stock company if the parent was a stock company. Merger is a legal process and one or
more of the companies lose their identity.
Acquisition
An acquisition (of un-equals, one large buying one small) can involve a cash and debt combination, or just
cash, or a combination of cash and stock of the purchasing entity, or just stock. The Sears-Kmart
acquisition is an example of a cash deal. In addition, the acquisition can take the form of a purchase of the
stock or other equity interests of the target entity, or the acquisition of all or substantially of its assets.
High-yield
In some cases, a company may acquire another company by issuing high-yield debt (high interest yield,
"junk" rated bonds) to raise funds (often referred to as a leveraged buyout). The reason the debt carry a
high yield is the risk involved. The owner can not or does not want to risk his own money in the deal, but
third party companies are willing to finance the deal for a high cost of capital (a high interest yield).
The combined company will be the borrower of the high-yield debt and it will be on its balance sheet. This
may result in the combined company having a low shareholders' equity to loan capital ratio (equity ratio).
Why mergers
• Economies of scale:
• Increased revenue/Increased Market Share:
• Synergy: Better use of complementary
resources.
• Taxes: A profitable company can buy a loss
maker to use the target's tax write-offs.
• Geographical or other diversification: This is
designed to smooth the earnings results of a
company, which over the long term smoothes
the stock price of a company
What is the role of the investment
banks?
• If the company wants to merge with another,
it must attain a fair market value for its shares
to be swapped which would involve an
investment bank. If it wants to buy the other
company with borrowed money, it would most
likely borrow directly from investors in the
form of bonds through a private placement,
engineered by the investment bank. Thus,
Investment Banks position themselves to act
as advisors on mergers and acquisitions and
usually charge large fees for doing so.
Mergers and Acquisitions
business strategy for merging and/or acquiring of
different companies.
Also called: M & A
Brokers, Dealers Exchanges &
ECNs
• Brokers deal with public. Example: Merrill
Lynch
• Dealers execute trades
• Exchanges are places where dealers
operate. Examples: NYSE, Nasdaq, Arizona
Exchange
• Electronic Communications Networks (ECNs)
allow investors to communicate with each
other, and to exchange. Examples: Island,
Instinet (now Inet)
Brokers
• Churning versus providing information. Churning:
Excessive trading in a client's account by a broker
seeking to maximize commissions regardless of the
client's best interests, in violation
• SEC penalizes “rogue brokers” who churn.
• Stockbroker Robert Magnan (Paine Webber) was
convicted of criminal offense of churning, and barred
from securities industry for life, 1999.
• Magnan’s clients had an annual turnover rate of 11,
and investments would have had to earn annual
return of 50% to pay transactions costs.
Investment Institutions
• Investment institutions raise funds to invest in
loans and securities.
• Mutual funds convert small individual claims
into diversified portfolios. Closed-end (nonredeemable vs. Open ended mutual funds
(redeemable)
• Finance companies sell securities to make
small loans to households and businesses.
• No load funds- earn income from fees. Load
funds earn income from comissions as well.
Performance of the largest fund families
The top 10 by assets
Cap-weighted
10-year
performance
Assets
Nov. 2001
($mil)
13.5%
$258,951
Fidelity
13.3
356,308
American Funds
13.3
195,962
T Rowe Price
12.9
60,178
Janus
11.6
65,950
MFS
11.5
58,047
Putnam
10.9
115,238
Amer Express
10.1
45,452
Amer Century
9.9
54,865
Fund family
Vanguard
Contractual Saving: Insurance
Companies
• Contractual saving institutions transfer risk
and provide means for disciplined savings.
• Insurance companies write contracts to
protect risk of loss from particular events.
• “Law of large numbers” enables insurance
companies to predict loss for large groups.
• Insurance companies face problems of
adverse selection and moral hazard.
Details on Insurance companies
• Insurance companies face moral hazard
in a way that most other financial
institutions don’t.
• Widespread use of restrictive covenants
(e.g fire insurance).
• Principles- risk based premiums,
deductibles, coinsurance
Type of Insurance companies
• Life Insurance (mutual companies owned by the policy holders;
stock companies held by the public) . LIC companies control
about $4 trillion
• Whole life versus term life. Whole life, constant payments incan get whole amount at retirement or annuities). Tax breaks.
Term life, payable upon death
• Life insurance companies have been moving to handling
pension funds, stabilizing their share– see table 12.1
• Property and Casualty insurance (control about $1 trillion). Tax
breaks. Intrinsically more risky because of concentrated
risk.New insurance concerns-- terrorism
Battle over Twin Towers insurance
A US federal jury has begun hearing a case to decide
whether the leaseholder of the World Trade Center can
claim insurance for one attack or two.
Developer Larry Silverstein wants insurance firms to
pay out for two attacks on 11 September, 2001.
The insurance companies dispute the claim, saying the
attacks on the twin towers amounted to a single event.
Mr Silverstein would receive $7bn for two attacks, as
opposed to $3.5 bn if the attacks are classified as one.
The property magnate says the attacks were two events
because the hijacked aircraft hit the World Trade
Center 15 minutes apart.
Jury Rules WTC Destruction Was Two
Separate Events
Wall Street Journal 6dec04
[More below]
NEW YORK — A federal jury ruled Monday that
the Sept. 11 attack on the World Trade Center was
two occurrences for insurance purposes, meaning
leaseholder Larry Silverstein stands to collect up
to $2.2 billion from nine insurers.
The verdict in U.S. District Court in Manhattan
was the latest twist in Mr. Silverstein's efforts to
turn his $3.5 billion insurance policy on the trade
center complex into a $7 billion payout.
The insurance companies involved in the case
were: Travelers Indemnity Co., Industrial Risk
Insurers, Royal Indemnity Co., Allianz Insurance
Co., Tokio Marine and Fire Insurance Co., Twin
City Fire Insurance Co., Tig Insurance Co.,
Westfield WTC LLC and Zurich American
Insurance Co.
Figure 12.1 Financial Assets of U.S.
Insurance Companies
Contractual Saving:
Pension Funds
• Pension funds invest to provide for retirement
benefits. Control 5.5 trillion dollars of assets.
• Defined contribution plan: benefit is based on
invested contributions.
• Defined benefit plan: benefit is based on earnings
and years of service (excess will go to the institution).
• Defined contribution plans are fully funded
(employees fund themselves).
• Defined benefit plans may be underfunded
(depending on cohort, projected earnings, could be
underfunded).
Regulation of Pension Funds
• Pension Fund Guaranty Corporation
insures pension benefits. Moral hazard?
• New force in 401K/ IRA accountsportable, tax free after retirement.
Figure 12.2 Assets of Pension Funds
Pension Funds are Powerful- the case
of Calpers
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•
•
•
•
•
•
•
Governor's Plan Could Erode CalPERS Clout
By Dale Kasler -- Bee Staff Writer
Published 2:15 am PST Monday, February 28, 2005
Sacramento Bee
One in a series of reports examining public pension proposals under discussion at the state
Capitol. California's public pension funds have been throwing their weight around since
1984, when they took on Texaco Inc. over a sweetheart deal.
Now the funds may be forced onto a starvation diet.
Gov. Arnold Schwarzenegger's proposal to make 401(k)-style plans of the two big funds the California Public Employees' Retirement System and the California State Teachers'
Retirement System - could gradually erode their ability to pursue activist shareholder
agendas, say experts.
In recent years, the two funds - especially CalPERS - have used their investing clout to
launch crusades over everything from CEO salaries and market reform to socioeconomic
matters like tobacco and the environment.
Taking that influence away "could be a devastating blow, not just to the role CalPERS plays,
but to corporate governance all over the United States," said Nell Minow, a nationally known
advocate for shareholder rights.
"No one is anywhere near CalPERS," said Minow, editor of a Web site called The Corporate
Library. "They're bigger than anyone else, and they have the staff and the focus and the
muscle to play a meaningful role."
Schwarzenegger drops pension privatization plan
By Andrew LaMar
Knight Ridder
SACRAMENTO -- In a major reversal, Gov. Arnold Schwarzenegger today withdrew his
support of a pension reform initiative that ignited stiff opposition from police officers
and firefighters concerned about losing death benefits.
At a morning press conference, the Republican governor said he would focus on
crafting legislation palatable to public safety employees and their unions. Also,
Schwarzenegger said he will rewrite the measure, aiming for the June 2006 ballot if he
cannot forge a legislative compromise.
``There should be no doubt they will be protected,'' the governor said of police and
firefighters. Dropping his current proposal ``will spark a whole new fresh start in the
Legislature.''
The dramatic change in direction comes after Schwarzenegger spent days meeting
with public safety groups that have assailed the plan with emotional ads featuring
tearful widows of cops and others killed in the line of duty.
Unions pointed to Attorney General Bill Lockyer's assessment that the measure, which
would move all non-federal government employees to a 401(k)-style pension system in
July 2007, would eliminate death and disability benefits. The governor and his aides
have said Lockyer's analysis is wrong.
Government Financial Institutions
• Federal credit agencies make loans in
the interest of public policy.
• U.S. government lends to farmers, to
the housing market, and to students.
• U.S. government also guarantees loans
made by private financial institutions.
Main Organizations- Housing,
Education
•
•
•
•
the Federal National Mortgage Association (FNMA) (NYSE: FNM), commonly
known as Fannie Mae, in 1938 to establish a secondary market for mortgages
insured by the Federal Housing Administration (FHA). Fannie Mae buys
mortgages on the secondary market, pools them and sells them as mortgagebacked securities to investors on the open market
The Federal Home Loan Mortgage Corporation ("Freddie Mac") NYSE: FRE,
a government sponsored enterprise, is a stockholder-owned, publicly-traded
company chartered by the United States federal government in 1970 to
purchase mortgages and related securities, and then issue securities and bonds
in financial markets backed by those mortgages in secondary markets
SLM Corporation (NYSE: SLM), commonly known as Sallie Mae, is the United
States' number one college student loan company, managing more than $122.5
billion in debt for more than 8 million borrowers, and employing 10,000
individuals at offices nationwide.
The company primarily provides federally guaranteed student loans originated
under the Federal Family Education Loan Program (FFELP), and offers
comprehensive information and resources to assist students, parents and
guidance professionals with the financial aid process
Depository Institutions
• Commercial banks accept deposits and
make loans and offer other services.
• Borrowers with smaller credit needs rely
on depository institutions.
• Savings institutions suffered from
maturity mismatch which led to a crisis.
• Credit union members work at the same
firm or in the same industry.
Table 12.2 Services Provided by
Financial Intermediaries
Table 12.2 Services Provided by
Financial Intermediaries (cont’d)
Table 12.1 Financial Intermediaries
in the United States
Financial Institutions: Blurring
the Lines
• During the 1930s, barriers were created that
restricted competition across providers.
• Now financial services are organized more by
function than by provider identity.
• The Gramm-Leach-Bliley Financial Services
Modernization Act of 1999 removed many of
the regulatory lines among financial
institutions.
Mergers among Commercial
Banks, Investment Banks &
Insurance Companies
• Travelers’ Group (insurance) and Citicorp
(commercial bank) 1998 to produce
Citigroup,. Brokerage Smith Barney
• Chase Manhattan Bank (commercial bank)
acquires JP Morgan (investment bank) (2000)
for $34.5 billion
• UBS Switzerland buys Paine Webber
(brokerage) 2000
• Credit Suisse buys Donaldson Lufkin Jenrette
(investment bank) 2000
Exercise: What type of institution?
• A person with $15,000 in savings would like
to earn a decent return at low risk but knows
nothing about the stock market.
• A person has $ 300 she wants to keep safe
• A person wants to open a flower arrangement
business and needs $10,000 for
Exercise: What type of institution?
• A person is recently married and wants
to make sure his family is taken care of
in the future.
• A person has just received a large
inheritance and wants to invest it into
tech stocks
• A person with no credit history wants to
buy a car
Exercise: What type of institution?
• A president of a small company wants
to list it on a stock exchange.
• A person wants to invest for retirement
• A person wants to avoid the risk that her
new house will catch fire and she will
lose her life savings.