The Mortgage Melt-Down

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The Mortgage Melt-Down

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Title: The Mortgage Melt-Down

1
U.S. Financial Regulation
Online Economic Seminars www.econseminars.com
Last Update October 7, 2009
2
Part 1Depository Financial InstitutionsCommer
cial Banks
3
? Overview of Banking Regulation
Regulatory Goals and Tools ? Reserve
Requirements To ensure sufficient liquidity to
convert notes (now deposits) into
Specie (now notes), thereby
avoiding bank runs ? Capital
Requirements To ensure sufficient capital to
allow banks to survive declines in
asset prices ? Interbank Relations
Rules To ensure competition among
banks and between banks and other institutions
Rules on Mergers and New Bank
Formation Rules on Deposit
Interest Rates ? Interindustry
Relations Rules to ensure that combinations
between bank and non-bank companies do
not weaken banks ? Asset Allocation
Rules To ensure diversification
4
? Fractional Reserve Banking
5
? First Bank of the United States (1791
1811) Formation ?
Private Bank Formed By Congress With 20 Year
Term ? Advocated By Alexander
Hamilton, First Treasury Secretary
And Leading Federalist (Democrat) Under
Washington ? Opposed By
Jefferson, Madison And Most Republicans
6
? First Bank of the United States (1791
1811) Functions ? Manage
State War Debts Recently Assumed By New Federal
Government ? Establish
The Public Credit Of The U.S. ?
Provide Strong Central Currency As Alternative To
State Banks ? Act As Federal Fiscal And
Monetary Agent Receive
Federal Tax Deposits And Make Payments
Manage U.S. Mints Minting of Coin And
Purchase/Sale of Specie
? Act As Private Bank
Make Loans (Excluding Loans to Federal
Government) Issue Bank Notes
Convertible Into Specie and Legal
Tender For Federal Tax Payment
7

? First Bank of the United States (1791 1811)
Financing The Bank
? 10 Million Capitalization
2 Million From U.S. Treasury
- 100 Borrowed From Bank
8 Million From Private Sources
- 25 (2M) Payable In Specie
- 75 (6M) Payable In Treasury
Bonds and Scrip
Revenue Sources
? Investment And Loan Portfolio
? Customs Excise Taxes
? Tax On Whiskey Sales

? First Bank of the United States
Opposition To First Bank, Primarily In The
South
? Agricultural States Viewed The Bank
As
A Tool Of Northern Commercial
Interests
A Source Of Weakened Southern
Banks
A Source Of Tighter Farm
Credit
An Infringement On States
Rights
? South Objected To The Excise Tax On
Alcohol Used To
Finance The Banks Interest
Payments On States Debts
Whiskey Was A Necessity of
Southern Life
Controversy Led To Shays
Rebellion (The Whiskey
Rebellion) in 1794
Charter Allowed To Expire In 1811 (Under
Madison)

9
? Second Bank of the United States (1816
1836) Formation ? Private Bank
Formed By Congress With 20 Year Term ?
Advocated By The Democrats (Federalists) With
Madison, A Republican, As President
Functions ? Manage War Of 1812
Debts ? Provide Strong Central Currency
As Alternative To State Banks ? Act As
Federal Fiscal And Monetary Agent
Receive Federal Tax Deposits And Make
Payments Manage U.S. Mints
Minting of Coin And Purchase/Sale of
Specie ? Act As Private Bank
Make Loans Including Loans to
Federal Government Issue Bank
Notes Convertible Into Specie and Legal
Tender For Federal Tax Payment
10

? Second Bank of the United States
Opposition To Bank Was Primarily In The
South
? Agricultural States Viewed The Bank
As
A Tool Of Northern Commercial
Interests
A Source Of Weakened Southern
Banks
A Source Of Tighter Farm
Credit
An Infringement On States
Rights
? In Early Years Bank Was Haunted By
Corruption
Loans To Political Supporters
Nicholas Biddle Became
President In 1822 And Ended
Corrupt Practices

? Second Bank of the United States
Andrew Jackson Was Strong Opponent
? Objected To Elite Central Institution
Not Responsible To The
People
? Attempted To End Bank In 1832 By
Transferring Federal
Deposits To State Banks Congress
Over-Ruled
? Bank Became Pawn In Jackson-Clay
Presidential Campaign
? Bank Charter Allowed To Expire n 1836

? The Free Banking Era (1836 1863)
State Banking
? All Banks Chartered And Supervised By States
? State Supervision Focused On
Capital Requirements
Bank Note Reserve Requirements (Usually
Specie
Plus Eligible Paper)
Era Of Frequent Bank Failures
? General Relaxation Of Capital And
Reserve Requirements
? Banks Chose To Charter In Easy
States
? Southern Agricultural Banks Most At
Risk
Agricultural PricesVolatility and Weak
Supervision

13
? The National Banking Act Of 1863 (Dual
Banking) Established Federally-Chartered
Banks ? Civil War Took Southern Opponents To
National Banking Out Of Congress ? Office
Of The Comptroller Was Created To Supervise
National Banks ? Federally-Chartered Banks
Tended To Have Weak Capital Requirements But
Strong Reserve Requirements To Maintain
Convertibility Reserve Requirements
Could Be Satisfied By Holding Treasury
Securities, Thereby Enhancing War Finance
National Banks Were Required To Accept Each
Others Notes At Par
14

? The National Banking Act Of 1863
Congress Actively Favored National Banks
? Levied A 10 Tax On Notes Of State Banks,
Effectively
Driving State Bank Note Issuance Out Of
Existence
State Banks Responded By Shifting
Issuance From Notes
To Deposits
? The Act Prohibited Interstate Banking
State Banks Could No Longer Shop For
Favorable Charters
State Banks Declined Significantly In
Importance

? The National Banking Act Of 1863
The Act Did Not Prevent Bank Failures
? The Panic Of 1873
Agricultural Prices Collapsed
The Crime Of 1873
? The Panics Of the 1890s
International Gold Flows
The Silver Purchase Act Of 1890
? The Panic Of 1907

16
? The Federal Reserve Act Of 1913
Background ? Crop Cycles And The
Inelastic Currency During Harvest
Season Demand For Money And Credit
Increased But No Source Of Increased Supply
Severe Seasonal Credit Crunches Occurred
Only Moderating Factors Were Inflows Of
Foreign Credit And Lending By Clearing
Houses
17

? The Federal Reserve Act Of 1913
Background
? The Panic Of 1907
Weakening Economy Coincided With
Financial Scandal
And Harvest Time
Trust Company Failures In NYC Led To
Major Credit
Lockup
Problem Spread To Interior Banks As NY
Correspondents
Failed
Resolved By J.P. Morgan And Intervention
By Clearing
Houses, Treasury, And Strong Banks/Trust
Companies

18
? The Federal Reserve Act Of 1913 Federal
Reserve System Structure ? Managed
By 7-Member Board Of Governors In DC ?
Created 12 Branches, Called Federal Reserve
Districts ? Federal Reserve Bank Of New York
Was Major District Bank ? Federal Open
Market Committee Formed In 1930s
Function Was To Conduct Monetary Policy
12 Members--7 BOG Members Plus 5 Regional Bank
Presidents In Rotation
19
? The Federal Reserve Act Of 1913 Federal
Reserve System Functions ? Lend To
Member Banks At Discount Window
Loans Made On Real Bills At Discount Rate
Loans For Need, Not Profit
? Supervise Member Banks ? Provide Services To
Member Banks Check Clearing
Coin Sorting ? Establish Reserve Requirements
For Member Banks
20

? The Banking Act Of 1933 (Glass-Steagall Act)
Main Features
? Prohibited Commercial Bank Ownership
Of Investment
Banks And Insurance Companies
? Prohibited Payment Of Interest On
Demand Deposits
? Established The FDIC To Insure
Bank Deposits
? Authorized Fed To Supervise Member
Banks
Establish Capital Requirements For Member
Banks
? Authorized Fed To Issue Federal Reserve Notes,
Limited
To 4 times Gold Stock Held

21
? The Banking Act Of 1933 (Glass-Steagall Act)
Main Features ? Expanded
Authority Of The Federal Reserve System
Fed Could Set Ceilings On Rates Paid On Time And
Saving Deposits Fed Could Set
Limits On Margin Loans By Banks And
Others
22

? Federal Reserve System Responses To 1933 Act
Subsequent Developments
? Implemented Authority To Restrict Margin
Loans
Established Regulation T For Security
Lending By Broker-
Dealers (1934)
Established Regulation U Controlling
Security Lending
By Banks (1936)
Established Regulation G Controlling
Security Lending By
Non-Bank Domestic Lenders (1968)
Established Regulation X Controlling
Security Lending By
Foreign Lenders (1968)

? Federal Reserve System Responses To 1933 Act
Subsequent Developments
? Implemented Regulation Q Setting
Ceilings On Interest
Rates Paid On Bank Time And Saving
Deposits (1933)
? Implemented Regulation D Creating
Uniform Reserve
Requirements For Member Bank
Deposits

24
? The Bank Holding Company Act Of 1956
Prohibited Banks From Buying Or Being Owned By
Non-Bank Non-Financial Entities (e.g.,
Industrial Corporations) ?
Concern That Industrial Companies Would Borrow
From Banks At Advantageous Terms,
Thereby Weakening Banks ? Concern
That BHCs Were Being Used To Circumvent
Prohibition Of Interstate Branching via
Chain Banking ? Excluded One-Bank
Holding Companies
25
? Bank Holding Company Act Amendments Of
1970 Extended To One-Bank Holding
Companies The BHCA Limitations On
Mergers With Non-Banking Companies
26
? The Community Reinvestment Act Of 1977 (CRA)
Introduced Social Criteria Into Bank
Lending ? Initiated By Concerns
About Redlning ? FDIC-Insured
anks Evaluated On Basis Of Lending Within
Deposit-Generating Communities
Focuses On Limiting Deposit Drains To
Outside Areas CRA Does Not
Require Making Loans With High Default
Prospects ? Federal
Reserve System Was Charged With Evaluating CRA
Compliance
27
? The Community Reinvestment Act Of 1977 (CRA)
Government Sponsored Entities (FNMA,
FHLMC) Also Required To Meet Social
Criteria ? Monitored By HUD
? HUD Introduced Special Affordable Loan
Requirement GSEs Must Have A
Minimum Share Of New Loans To
Borrowers With Incomes Below 60 Of Community
Median GSEs SAL Minimum Started
at 12 of New Mortgages In 1996,
Rose to 28 in 2008
28

? The Depository Institutions Deregulation And
Monetary Control Act of 1980 (DIDMCA)
Initiated Removal Of Glass-Steagall
Restrictions
? Established Uniform Reserve
Requirements For Banks and
Thrift Institutions
? Phased Out Requlation Q, Allowing
Unlimited Interest
Payments on Time And Saving
Deposits
? Allowed Interest Payments On
Substitutes For Demand
Deposits (NOW Accounts)

? The Depository Institutions Deregulation And
Monetary Control Act of 1980 (DIDMCA)
Other Actions
? Liberalized Investment Authority of
Thrift Institutions
SLs Could Invest Up To 20 In
Non-Mortgage Assets
MSBs Coukd Invest Up To 5 In
Non-Mortgage
? Increased FDIC Deposit Insurance To
100K from 40K
? Required Federal Reserve System To
Price Its Services
(Check Clearing, Coin Sorting,
FedWire, ACH, etc.)

30
? The Financial Industry Modernization Act of
1999 Called Gramm-Leach-Bliley Act, Or GLB
Act Continued Dismantling Of
Glass-Steagall Act ? In 1994
CitiBank Bought Travelers Insurance And Salomon
Brothers Smith-Barney Brokerage To
Form CtiGroup CitiGroup
Formation Illegal Under Glass-Steagall
CitiBank Received Waiver To Allow
Merger ? GLB Act Formalized Approval
Of CitiGroup By Allowing Any
Commercial Bank To Undertake Cross-Industry
Mergers Chase Bank Buys
JPMorgan to Create JPMorganChase ?
Cross-Industry Merger Approval Conditioned On
Satisfactory CRA Rating In Most
Recent Evaluation
31
Part 1.2Bank Supervisory Agencies
32
? Supervisory Agency Structure
Comptroller of the Currency 1863 National Chartered Banks
Federal Reserve System 1913 State Chartered FRB Members
Federal Deposit Insurance Corp 1933 National Chartered Banks State Chartered Banks Savings Banks
State Banking Commissions Various State Chartered Banks
Office of Thrift Supervision, FDIC, And State Banking Commisions Various Savings and Loan Associations Savings Banks
33

? Supervisory Agency Ratings
The CAMELS System (1978)
? CAMELS Criteria
Capital Adequacy
Asset Quality
Management Ability
Earnings Performance
Liquidity
Sensitivity To Market Risk
? The CAMELS Ratings
Rating Based On Call Reports,
Field Visits
- Scored From 1 (Poor) To 5 (Excellent)
- Results Are Not Public
Rating Assigned By Lead Supervisory Agency

? The Basle Accords
Basle I (1988)
? Established International Standards
For Bank Supervision
? Defined Capital
Tier 1 Capital Common Equity Paid In
Cumulative Retained
Earnings
Noncumulative
Preferred Stock
Tier 2 Capital Hybrid Debt
Subordinated Debt
Loan Loss Reserves
Contingency
Reserves

? The Basle Accords
Basle I (1988)
? Established Capital Composition Standards
At Least 50 Of Capital Had To Be Tier 1
No More Than 50 Of Tier 2 Capital In
Subordinated Debt
? Set Risk-Based Capital Requirements (Credit
Risk Only)

? The Basle Accords
Basle II (2004)
? Extended Types Of Risk Evaluated
Credit Risk
Operational Risk
Market Risk
? Credit Risk Requirements
Standard Methode.g. 8 of Average
Risk-Adjusted
Assets
Internal Risk-Based Analysis (Option For
Large Banks)
? Market Risk
Basle II Recommends Value At Risk (VaR)

37
? Basle II Measuring Market Risk By VaR
38

? Problems With VaR
Non-Normality In Distribution Of Returns
? Above-Normal Probability Of Large
Asset Price Declines
Fat Tails And
Black Swans
Use Of Historical Data
? Historical Measurement Of Correlations Between
Asset
Returns
? Dramatic Changes In Correlations In Crisis
Periodx
? Failure To Incorporate Connections Between
Markets

? What Went Wrong With Commercial Banks In 2008?
Off Balance Sheet Investments
? Structured Investment Vehicles
Independent Entities Created By
Banks
- Sold To Investors (Hedge
Funds, High-Wealth)
- Investors Financed Purchase
Wiyj Short-Term Loans
(Commercial Paper)
- Banks Had No Explicit
Obligation To Redeem
- Banks Did Provide Letters of
Credit (Commitments To
Replace Short-Term Loans If
Normal Lenders Withdrew)

? What Went Wrong With Commercial Banks In 2008?
Off Balance Sheet Investments
? The Collapse Of SIVs
During Credit Freeze In Fall, Banks Forced To
Make Loans
To SIVs, Selling Assets And Restricting Bank
Loans
Banks Faced Implicit Commitents To Repurchase
SIV
Assets (Reputational Put)

? What Went Wrong With Commercial Banks In 2008?
Changes In Supervisory Philosophy
? The Shift To Internal Risk Assessment
(Basle II)
Applied To Large Banks
Rested On Poor Assumptions
- Quantitative Risk Management Methods
(VaR) Were
Suitable
- Management Incentives Were Aligned With
Shareholders

42
Part 2Depository Financial InstitutionsThrift
InstitutionsSavings And Loan Associations
And Mutual Savings Banks
43

? Thrift Institutions
Designed To Collect Savings Deposits And
Invest In
Residential Mortgages
SL Deposits Insured By Federal Savings
And Loan
Insurance Corporation (FSLIC)L
Institutions MSB
Deposits Insured By State Insurance
Funds

? Thrift Institutions
Fatal Flaws
? Borrowed Short-Term (Deposits) And
Made
Long-Term Loans (Mortgages)
Viability Required Upward-Sloping
Yield Curve And
Stable Interest Rates
? Undiversified Assets--Entirely In
Residential Mortgages

? Important Legislation
Federal Home Loan Bank Act of 1932
? Created FHLB System
? Modeled After Federal Reserve
System
Twelve Regional Banks
Authority To Lend To SLs On
Mortgage
Collateral
? Allowed Federally Chartered SLs

? Important Legislation
Federal Savings And Loan Insurance
Act Of 1934
? Created FSLIC
Modeled After FDIC
Supervised By FHLB Board
Insured SL Deposits

? Important Legislation
Formation Of Government Sponsored
Entities
? Federal National Mortgage
Association (1938)
Purchased FHA/VA-Insured
Mortgages
Financed By Bonds And
Pass-Thru Securities
Privatized In 1968
? Government National Mortgage
Association (1968)
Supervised By HUD
Purchased Conventional And
FHA/VA Mortgages

? Important Legislation
Formation Of Government Sponsored
Entities
? Federal Home Loan Mortgage Corp
(1970)
Supervised By FHLB Board
Purchased Conventional
Mortgages

? Important Legislation
Interest Rate Control Act of 1966
? Subjected SL Deposits to
Regulation Q Ceiling
Plus .25
? Goals
Protect Income Of Thrift
Institutions
Allow Thrifts A Small Deposit
Rate Advantage
Over Commercial Banks

? Important Legislation
DIDMCA of 1980
? Liberalized Investment Authority
of Thrift Institutions
SLs Could Invest Up To 20
In Non-Mortgage Assets
MSBs Could Invest Up To 5 In
Non-Mortgage Assets
? Eliminated Interest Rate Ceilings
On Deposits (Reg Q)
? Required Federal Reserve To Price
Services To Banks
(Check Clearing, Coin Sorting,
Currency Replacement)

51
? Important Legislation
Depository Institutions Act Of 1982 (Garn-St.
Germain) ? Broadened Powers of SLs
Allowed Investment of Up To 40
In Commercial Mortgages And 10
In Commercial Loans Allowed
SLs To Borrow An Unlimited Amount In
Non-Deposit Loans Shifted
Risk Management Responsibility From
Regulators To Bank/SL Management
Allowed Any Depository Institution To Borrow
From FDIC Or FSLIC To Replenish
Capital
52
? Other Important Events
Advent Of Junk Bonds ? Michael
Milken Sees That Below-Investment-Grade
Bonds Earn More Than High-Rated Bonds
After Adjusting For Defaults
? Drexel, Burnham, Lambert Creates
A Market For Junk Bonds
Junk Bonds Allowed Smaller
Companies To Get Access
To Long-Term Financing
SLs Bought Junk Bonds On A Large Scale As A
Way To Diversify Beyond
Mortgages and Get High
Returns
53

? What Went Wrong With Thrifts?
Interest Rates Rose, Especially Short
Rates
? Long-Term Rate Increases Created
Losses In
Value Of Mortgage Assets, Wiping Out
Capital
? Yield Curve Tilt Created Losses
On Income
Account, Threatening Liquidity

? What Went Wrong With Thrifts?
SLs Invested Heavily In Bad Loans
? Oil Prices and Home Prices Broke In
The Mid-1980s
? Lack of Familiarity With New
Lending Opportunities
? Scandalous Abuses In SL Investing
The Keating
Episode
? Mortgage Foreclosures Increased And
SLs Began
Failing, First in The South Then
Elsewhere

? Resolution The Financial Institution Reform,
Recovery,
And Enforcement Act Of 1989 (FIRREA)
Forced Insolvent SLs to Fail Or Be
Bought By
Stronger Institutions
FSLIC Paid Off Depositors of Failed
SLs And Acquired
SL Assets For Resale
Resolution Trust Company (RTC) Was
Formed to Sell
Foreclosed Homes And Other Assets
Acquired From
SLs
? RTC Dissolves in 1993 After Cost
To Taxpayer Of
150-300 Billion

? The Financial Institution Reform, Recovery,
And Enforcement Act Of 1989 (FIRREA)
Regulatory Restructuring
? The FHLBB Was Dissolved
? The Office Of Thrift Supervision
(OTS) Was Formed
To Regulate All Thrift-Type
Institutions (SLs And
Mutual Savings Banks)

57
Part 3Security Markets
58

? Important Legislation
Securities Act Of 1933
? Required Registration Of
Issued Securities
With The SEC With Some
Exceptions
Securities Issued By
Banks And SLs
Securities Issued By
Religious And Charitable
Organizations
Life Insurance And
Pension Policy Liabilities
Notes With Less Than
270-Day Maturity
(Commercial Paper)
Private Placements

? Important Legislation
Securities Act Of 1933
? Registration Statements Must
Specify
Risk Factors
Any Material Information
? Civil Penalties Levied For
Failure To Register Or To
Properly Disclose Relevant
Information

? Important Legislation
Securities Exchange Act Of 1934
? Created Extensive Regulation
Of Companies
Issuing Securities, Of Security
Broker-Dealers, And
Of Security Exchanges
? Periodic Reporting To SEC By
Companies With
Publicly-Traded Securities
Form Annual 10-K And
Quarterly 10Ql Reports
Form 8-K Reorts Of
Unusual Events
Reports Of Insider
Transaction
Reports Of Acquistions Of
Over 5 Of Any
Security Class

? Important Legislation
Securities Exchange Act Of 1934
? Broker-Dealer Regulation
Segregation Of Accounts
(Except net free credit)
Net Capital Rule 100K
Or 2 Of Debit
Balances (501 Leverage)
Duty To Act In Clients
Interest
- Churning and Excessive
Fees
- Conflicts Of Interest In
Proprietary Trading
(Front Running)

? Important Legislation
Securities Exchange Act Of 1934
? Prohibition Of Market
Manipulation And Of
Preferential Treatment Of
Customers
Stock Gunning
Links Between Underwriting
And Trading Desks
IPO Flipping And IPO
Allocation Preferences
Insider Trading On Private
Information
Disproportional
Allocation Of Gains/Losses

? Important Legislation
Securities Exchange Act Of 1934
? SEC Regulation Of Security
Exchanges
Authority To Set Margin
Requirements For
Member Firms (Delegated To
Fed)
Authority To Regulate
Exchange-Traded Options
(Delegated tp CBOE And Other
SROs)
Authority To Regulate
Futures Markets
(Delegated tp CFTC)

? Important Legislation
Investment Company Act Of 1940
? Regulates Investment Companies
Unit Trusts Fixed Asset
Composition
Management Companies Variable
Portfolio
- Open-End Investment Companies
(Mutual Funds)
Shares Sold And Redeemed
By Company
Shares Continuously
Distributed
Shares Priced Daily At Net
Asset Value (NAV)
- Closed-End Investment
Companies
Shares Sold At IPO And
Traded On Exchanges
Shares Priced
Continuously At Market
Share Price Can Be At
Premium Or Discount To
NAV

? Important Legislation
Investment Company Act Of 1940
? Aspects Of Investment Companies
Act
Requires Registration With SEC
All Securities Must Be Held In
Trust Account
Must Pay Out At Least 90 Of
Income To Avoid
Being Taxed At Trust Level
Prohibited From Borrowing Except
From Banks For
Temporary Purposes
(Redemptions)--No Margin
Prohibited From Issuing Senior
Securities
- Debt Or Preferred Stock, Short
Sales

? Important Legislation
Investment Company Act Of 1940
? Mutual Fund Shennanigans
(Spitzerisms)
Market Timing
- Use Of After-Hours Info To
Place Fund Orders
- Example Intl Securities
Close At 10AM USEST
Or Later So Price Info Not
Embedded In 4PM
Closing NAV On Prior Day
Late Trading
- Placing Orders After 4PM To Be
Executed At 4PM
NAV
Cherry-Picking Asset Sales To
Meet Redemptions
- Selling Most Marketable Assets
to Pay Out Cash

? Important Legislation
Investment Advisors Act Of 1940
? Requires Registration With SEC Of
Any Investment
Advisor Who Uses The Mail Or Any
Form Of
Interstate Commerce In The Conduct
Of Business
Exceptions
- Advisors Whose Clients All
Reside Within The State
Of The Advisors Office And Who
Do Not Advise On
Securities Traded On Listed
Exchanges
- Advisors Whose Only Clients
Are Insurance
Companies
- Advisors Who Have Fewer Than
15 Clients And
Who Do Not Represent Themselves
To The Public
- Advisors Who Are Charitable
Organizations Or The
Employees Of, Or Volunteers To,
Such Entities

68
? Important Legislation Securities
Investors Protection Act (SIPA) Of 1970
? Establishes SIPC
SIPC Authorized To Borrow 1 Billion From
Treasury All Registered
Broker-Dealers Must Be Members
Members Pay Flat Insurance Premium
- 1/2 Of 1 Of Gross Revenues

69

? Important Legislation
Securities Investors Protection Act
(SIPA) Of 1970
? Insures Broker-Dealer
Accounts Up To 500K
Coverage
- Direct Client Accounts
(Feeder Is Insured Entity)
- All Fully Paid
Securities In Cash Accounts
- Free Cash Balances In
Margin Accounts
- Cash Covered Up To 100K

70
? What Went Wrong In Securities Markets In
2008? Mutual Funds Collateral Damage
? Redemptions In Excess Of Cash
Balances Withdrawal Of Bank
Letters Of Credit Forced
Sales Of Securities
71
? What Went Wrong In Securities Markets In
2008? Stock Markets
Collateral Damage ? Breach Of
Maintenance Margin Requirements
Forced Sales Of Securities By Customers
? Breach Of Broker-Dealer Collateral
Requirements Banks Call
Loans To Brokers Trading Departments
Forced Sales Of Securities By
Broker-Dealers
72
Part 4Commodities FuturesAnd Derivative
Securities
73
Commodities Futures
74
? Essentials Of Commodity Trading Occurs
Primarily Through Futures Contracts ?
Contract To Deliver Or Take Delivery Of A
Commodity At A Specific Date And
Place And At A Specific Price ?
Parties To Contract Hedgers
- Short Hedgers Hold Or Expect To Have
Commodity Units At A Future
Date (e.g., Fuel Oil Producer) -
Long Hedgers Committed To Sell Commodity at
Future Date (e.g., Fuel Oil
Company) Speculators
- Short Speculators Sell In Expectation Of
Price Decline - Long Speculators
Buy In Expectation Of Price Increase

75
? Essentials Of Commodity Trading
Economic Functions Of Futures Contracts
? Price Discovery Provide
Current Economic Agents With Information
About Future Prices -
Example Farmers Can Plan Crop Amounts More
Efficiently--Plant Less When Prices
Are Expected To Fall, More
When Prices Expected To Rise
76
? Essentials Of Commodity Trading
Economic Functions Of Futures Contracts
? Create Efficient Intertemporal Allocation Of
Supply If Prices Expected To
Rise, Producers Will Store Product
Now And Sell In Future--Thereby Aiding Consumers
By Providing More Supply In
Scarcer Times If Prices
Expected To Fall, Producers Will Reduce
Stockpiles Now And Restore In Future At
Lower Prices-- Thereby Aiding
Consumers By Shifting Supply From
Low-Price Future To High-Price PresentStore
Product Now And Sell In
Future--Thereby Aiding Consumers By
Providing More Supply In Scarcer Times

77
? Essentials Of Commodity Trading
Characteristics Of Commodity Prices ?
Determined In Auction Market (Pit) By Open Outcry
Clearing Price Is That
For Which Long HedgesLong Specs
Short HedgesShort Specs
Storeable Commdities Typically Are In Contango
(Futures Price Exceeds Spot Price
by Cost Of Carry) Perishable
Commodities (Onions) Have No Normal Future
vs. Spot Relationship
78
? Essentials Of Commodity Trading
Role Of Exchange Clearing House ?
Guarantee Completion Of Payments (Counterparty
Risk) ? Establish Characteristics Of
Standardised Contract ? Maintain
Records On Contracts Traded And Contracting
Parties ? Mark Accounts To
Market Daily, And Transfer Losses To
Gaining Accounts
79

Federal Regulation Of Commodities Futures
Early Acts
? Grain Futures Act (1922)
? Commodity Exchange Act (1936)
Supplanted Grain Futures Act
Established Commodities Exchange
Commission
Prohibited Market
Manipulations And Fraudulent and
Abusive Behavior
Regulation Applied Only To
Agricultural Futures
Contracts
Required All Futures Contracts
To Be Traded On
Exchanges
? Onion Futures Act (1958)
Prohibited Trading Of Onion
Futures

? Federal Regulation Of Futures Contracts
Commodity Futures Trading Commission
(1974)
? Amended 1936 Act To Extend
Regulation To All Futures
Contracts Traded On Exchanges
? Response To Rise Of Non-Agricultural
Futures
(Financials And Currencies)
? Excluded Forward Contracts And OTC
Contracts Between
Sophisticated Parties.
? Left Status Of Swap Agreements
Uncertain, Excluding
Them By CFTC Action Rather Than
Congressional
Mandate

? Federal Regulation Of Futures Contracts
Commodity Futures Modernization Act (2000)
? Clarified Legal Status Of OTC
Contracts
? Excluded OTC Instruments
Forward Contracts Between Private
Parties
Swap Agreements (Financial,
Currency and Credit
Default Swaps)
? Authorized Trading Of Single Stock
Futures (Prior
Authorization Had Been Only For
Index Futures)

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Financial Derivatives
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? Futures Contracts For Common Stocks
Stock Index Futures ? Trading Began In
1983 With Value Line Index Same
Principles As Physical Commodities
Most Traded On NYSE/AMEX Index
Arbitrage Establishes Relationship Between
Futures And Spot Prices
- Futures Price Equals Expected Spot Price
Discounted _at_(1r) - Changes In
Futures Price Affect Spot Price
84
? Futures Contracts For Common Stocks
Single Stock Futures Contract ?
Illegal Prior To Commodities Exchange
Modernization Act (2000) ?
First Single Stock Futures Contracts Traded in
2002
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? Options On Common Stocks Types Of
Options ? Call Option
Option, But Not Obligation, To Buy Stock At A
Fixed Price (The Strike Price)
On Or Before A Specified Date
Holder Profits If Price At Exercise Exceeds
Strike Price ? Put Option
Option, But Not Obligation, To Sell Stock
At A Fixed Price (The Strike
Price) On Or Before A Specified Date
Holder Profits If Price At Exercise Is Less
Than The Spot Price
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? Options On Common Stocks Option
Trading ? OTC Prior To 1973
? CBOE Created In 1973
Standardized Contracts Expiration Dates, Strike
Prices Clearing House (OCC) To
Bear Counterparty Risk And
Monitor Trading In Options ? CBOE
And NYSE/AMEX (NYSE/EuroNext) Are The
Major Exchanges
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? Options On Common Stocks
Option Regulation ? SEC - CFTC
Turf Disputes ? SEC Is Primary
Regulator Of Options On Stocks And
Stock Indexes ? CFTC Is Primary
Regulator Of Options On Futures
Contracts
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? Credit Default Swaps
Characteristics ? Created As
Unregulated OTC Contracts ?
Significant Counterparty Risk
No Clearing House Buyer
Requires Collateral From Seller
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? Credit Default Swaps
Payment Triggered By Credit Events Specified
In Particular Contracts
Buyer Pays Premium Based On Risk (Standard is
5 Of Protected Value)
Seller Pays Net Loss -
Can Buy Securities At Face Value Or Pay Net Loss

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