Recent Changes in The United States Financial Services Industry

1
Recent Changes in The United States Financial
Services Industry
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Introduction

• Thank you for inviting me to visit your
  university
• Tom Root
• PhD Economics University of Kansas
• Tom.Root_at_Drake.edu
• Drake University
• Des Moines, Iowa
• Approximately 4,000 students

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Outline

• Recent changes in U. S. Financial Markets
• Overview of the role of the Financial Services
  Industry in an Economy
• Regulatory Changes, Recent Trends, and Current
  Events
• Financial Services Modernization Act
• Securitization and Role of Government Sponsored
  Enterprises.
• Recent Scandals
• Mutual Funds
• Corporate Governance

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Trends in the Market

• Market Broadening Instruments
• Increase liquidity of the market attracts new
  investors and provides opportunities for
  borrowers. Securitization
• Risk Management Instruments
• Reallocate financial risks to those willing and
  able to accept them.
• Arbitraging Instruments
• Allow investors and borrowers to take advantage
  of differences between markets

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Regulation

• Given the important roles played by the Financial
  Services Industry in the economy, it is highly
  regulated.

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Justification of Regulation of FIs

• Safety and Soundness Regulation
• Monetary Policy Regulation
• Promotion of Fair Competition
• Credit Allocation Regulation
• Consumer Protection Regulation
• Investor Protection Regulation
• Entry Regulation

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Regulatory Overview

• 1933 Glass-Steagall Act
• Separates securities and banking activities
• Prohibited commercial banks from most
  underwriting of securities. Fear of conflict of
  interest
• Established Federal Deposit Insurance Corporation
• National banks allowed to branch state wide if
  state chartered banks were allowed to do so.

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1999 Financial ServicesModernization Act

• Allowed banks, insurance companies, and
  securities firms to enter each others business
  areas
• Streamlined regulation of Bank Holding Companies
• Prohibited FDIC assistance to affiliates and
  subsidiaries of banks and savings institutions
• Provided for national treatment of foreign banks
• Federal Crime to steal account information

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Trends in the US
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Competition among FIs
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Impact on US Market

• Increased merger and acquisition activity in
  financial services industry.
• Demutualization of insurance firms and savings
  and loans

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Asset Securitization

• Securitization is the pooling and repackaging of
  loans so they have the characteristics of
  security instruments which enable them to be more
  easily resold.
• Creates both Maturity Intermediation and
  Denomination Intermediation while spreading
  credit risk
• Should broaden the market and decrease risk

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Use of Securitization in the Mortgage Market

• The market that has been impacted the most by
  increased securitization is the secondary market
  for mortgages.
• The largest participants in this market are
  government sponsored enterprises (GSE).

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Government Sponsored Enterprises

• Privately owned, government sponsored entities.
• Created to lower the cost of capital for a
  specific sector
• Generally issue two types of notes and debt

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Special Treatment of GSEs

• Debt and mortgage backed securities are exempt
  from SEC registration
• Agencies are exempt from state and local taxes
• Treasury can purchase up to 2.2 B of FNMA and
  4B of FHLB debt via line of credit
• Banks can make unlimited investment in debt
  issued by GSEs
• GSE securities are eligible as collateral for
  public deposits and for loans from the Federal
  Reserve

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GSEs and Mission

• Federal National Mortgage Association (Fannie
  Mae) Federal Home Loan Mortgage Association
  (Freddie Mac) promote secondary market for
  mortgages
• Government National Mortgage Association (Ginnie
  Mae) promote secondary market for government
  sponsored mortgages
• Federal Home Loan Bank Liquidity in banking
  system

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GSEs and Mission

• Student Loan Marketing Association (Sallie Mae)
  promote a secondary market for student loans
• Federal Farm Credit Bank promote a secondary
  market for lending in agricultural industry

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Mortgage Pass Through Securities

• GSE Purchases a pool of mortgages from
  originators
• GSE issues a new pass through security. Interest
  and Principle are collected on the mortgage pool
  by the GSE who then transfers (passes through)
  the payments to the owners of new securities
  backed by the mortgages.
• Neither the amount or timing of the cash flows
  actually matches the cash flows on the pool of
  mortgages.
• When a mortgage is included in a pool it is said
  to be securitized.

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Cash Flows

• Neither the amount or timing of the cash flows
  actually matches the cash flows on the pool of
  mortgages.
• Servicing and other fees are removed from the
  cash flows received from the mortgage prior to
  being passed through to the holder of the pass
  through security. There is also a delay in the
  pass through process.

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Terminology

• The pool of mortgages will have a variety of
  different rates and maturities. Therefore, the
  description of the pass through is based upon
  weighted averages of the coupon and maturity.

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WAC, WAM and WARM

• WAC weighted average coupon rate
• Weighting the mortgage rate of each mortgage in
  the pool by the outstanding principal balance
• WAM weighted average maturity
• Weighting the number of months to maturity of
  each mortgage in the pool by the outstanding
  principal balance
• WARM weighted average remaining maturity
• After prepayments have started the maturity
  changes.

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Guarantee Types

• Fully Modified Pass Throughs Guarantees that
  the principal and interest will be paid
  regardless of whether the borrower is late.
• Modified Pass Through Guarantees the timely
  payment of interest, the principal is passed
  through when it is received.

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Possible Benefits of Securitization

• Benefits to Issuers
• Diversification Broadens funding source
• Ability to manage capital requirements
• Provides Fee Income
• Manage interest rate volatility
• Benefits to investors
• Increased Liquidity
• Reduced Credit Risk
• Benefits to Borrowers
• Reduced spreads

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Composition of US Debt Market Sept 2003 (Total
value 22.6 Trillion)
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of Outstanding Debt Market
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Average Daily Trading Volume (Billions)
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Issuance by GSEs ( Billions)
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Outstanding Mortgage and Asset Backed Securities
in US
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Current Questions in the Market Place relating to
GSEs

• Are the GSEs, especially Fannie Mae and Freddie
  Mac growing too fast?
• Do they pose a systematic risk for the US
  economy?
• Should the special treatment they receive be
  changed?

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Recent Study by Federal Reserve

• Wayne Passmore, an economist at the Federal
  Reserve Bank has recently completed a study on
  the impact of GSEs
• The GSEs have a funding advantage
• Slightly lower mortgage rtes for a few borrowers
• Implicit subsidy from government relationship
• Implicit subsidy responsible for much of GSE
  Market Value
• MBS have not increased homebuilding

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Mutual Fund Industry

• In the fall of 2003 the US mutual fund industry
  was impacted by a wave of scandals revolving
  around market timing activity.
• Market Timing Activity The movement of funds
  into and out of an asset in an attempt to take
  advantage of short term fluctuations in the value
  of the asset.

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Mutual Funds

• Investors own a pro rata share of overall
  investment portfolio.
• Manager of funds actively buys and sells shares
  in the portfolio.
• Net Asset Value the market value of the
  portfolio minus the liabilities of the mutual
  fund split evenly among the shareholders

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Open End Funds

• NAV is determined a the close of each day and all
  new investment into the fund or withdraws from
  the fund are priced at NAV. (NAV price)
• The total number of shares in the fund increases
  if there are more investments than withdraws.

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Open End Funds

• Either changes in the price of securities held in
  the portfolio or in the amount of funds invested
  can change the price of a share of the fund.
• New funds provide cash which must be invested.
  Withdraws require cash, and may force the sale of
  securities in the portfolio.

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Open End Funds

• Whenever the fund sells securities if there is a
  capital gain, there is a tax for the holder of
  the fund.

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Closed End Fund

• The number of shares remain constant, similar to
  the shares of a corporation. However the fund
  cannot issue new shares
• Shares are sold in a secondary market.
• Demand and Supply for the shares determine the
  price of the shares along with the NAV.
• Price may not equal NAV

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Closed End Funds

• Shares may sell at a discount (below NAV) if
  investors expect future liabilities to decrease
  its profitability (taxes for example)
• Shares may sell at a premium (above NAV) if
  investors value access to a specific market or
  professional management of the portfolio.

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Market Timing Activity

• Groups of mutual funds were allowing institutions
  and individuals to move money between different
  mutual funds, for example an international fund
  and a fund designed to follow the SP 500.
• In theory this can decrease the long run return
  of a shareholder who is buying into the fund and
  holding the asset.

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Impact of timing on Long run Shareholder

• Increased transaction costs in the fund decrease
  return
• Increased holding of cash decrease return
• Increased tax burden from the fund being forced
  to sell securities

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Legality of Timing Activity

• Timing on its own is legal. Each group of funds
  has the right to restrict or not restrict the
  activity.
• Violations
• Allowing preferred investors to time, while not
  allowing the average shareholder to do the same
• Allowing preferred investors into the fund late,
  after the close of trading (at the previous NAV)

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Basis for legal claims and possible new
regulation

• Investor Protection and Consumer protection
• Possible violation of fiduciary responsibility to
  shareholders
• Violation of rules specified in the funds
  prospectus

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Other Current Topics

• Social Security
• Derivative Reporting on Financial Statements
• Corporate Governance and Increased Accountability
  of Management
• Consolidated Risk Management

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Saving for Retirement

• Two main ways US residents plan for retirement
• Private Pension Plans
• Social Security (required by the government)

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Social Security Introduction

• Approximately 6 of your income is withheld by
  your employer and sent to the Social Security
  Administration.
• Your employer matches the amount withheld and
  sends it to the Social Security administration as
  well.
• Upon retirement you receive benefits based upon
  total contributions, and your last 5 years
  contributions.

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Social Security and other Public Pension plans

• Social Security is essentially a public defined
  benefit plan that all employees participate in
  via payroll taxes.
• Private pension plans are required to be Fully
  Funded
• Social Security is partially a pay as you go
  system. Any amount collected above that needed
  to make payments is sent to a trust fund.
• Investment is entirely in US treasury securities.

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Fully Funded Pension Plans

• Fully funded plans are required to maintain a
  balance that is capable of covering future
  expected payouts.
• The interest rates allowed in the calculation are
  set based upon long term US treasuries.
• Declining interest rates have forced US firms to
  contribute more to their Retirement Funds,
  impacting earnings.

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Pay as You Go

• Pay as you go pension plans take current
  contributions and use the contributions to pay
  for the current benefits of the retirees in the
  plan.
• Any amount above the amount needed for current
  payouts can be saved for future payouts.
• Currently the US Social Security system is
  receiving payments greater than needed to pay
  benefits and the excess funds are placed in a
  trust account

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Social Security

• In 2000 there are 3.4 workers paying into social
  security for each person receiving benefits. By
  2030 it is estimated that there will be 2 workers
  paying into the system for each receiving
  benefits.
• It is estimated that by 2015 outlays will be
  greater than payments into the system and the
  trust fund will decline, reaching a zero balance
  in 2037.
• In 2037 it is estimated that contributions will
  equal 70 of needed outlays.

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Privatizing Social Security

• Should the Social Security Trust Fund be allowed
  to invest a portion of its assets in other
  markets such as corporate equity?
• Increase return potential, increase risk

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Corporate Governance

• Recently there has been increased interest in the
  accountability of upper level management.
• Enron, Tyco, MCI World Com and other firms have
  recently disclosed mistakes in their financial
  reports, including intentionally misrepresenting
  the financial statements.

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Sarbanes Oxly Act of 2002

• Established Auditing Board under the SEC
• Increased accountability on the Board of
  Directors of firms for accuracy in audits.
• Separated auditing functions from investment
  banking functions

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Consolidated Risk Management

• The increased interaction of different
  institutions has required a new approach to risk
  management.
• The key is looking at risk management on a firm
  wide basis and coordinating between differenet
  business lines.

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Consolidated Risk Management

• A coordinated process of measuring and managing
  risk on firmwide basis.
• Requires a system that includes identification of
  risks, measurement of risk, methods for
  controlling the level of risk accepted, checks
  and balances, review and oversight at all levels
  of management (including the board of directors)
  

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Benefits of Consolidating Risk Management

• Diversification benefits are ignored without
  consolidation, leading to increased risk
  management costs
• Lack of coordination can increase firm wide risk
  in times of market problems (unwinding similar
  position in different business lines for
  example).
• Without consolidation contagion risks are ignored
  
• Improves the internal capital market of the
  firm.
• Promote more transparency and better risk
  analysis by creditors.

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Barriers to Consolidated Risk Management

• Consolidation of financial firms has produced
  increased product and geographic diversification
  which has made business wide risk management more
  difficult.
• Information Costs
• The cost of integrating, recording and analyzing
  risk across separate business lines.

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Barriers to Consolidated Risk Management

• Regulatory Costs
• Consolidation has created a framework where firms
  are required to respond to multiple regulators.
• Capital and Liquidity requirements may prohibit
  the movement of funds from one business line to
  another.
• Cost associated with managing the separate
  regulatory requirements including opportunity
  costs