Recent Changes in The United States Financial Services Industry

1. Recent Changes in The United States Financial Services Industry

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

3. 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

4. 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

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

6. Justification of Regulation of FI’s • Safety and Soundness Regulation • Monetary Policy Regulation • Promotion of “Fair” Competition • Credit Allocation Regulation • Consumer Protection Regulation • Investor Protection Regulation • Entry Regulation

7. 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.

8. 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

9. Trends in the US

10. Competition among FI’s

11. Impact on US Market • Increased merger and acquisition activity in financial services industry. • Demutualization of insurance firms and savings and loans

12. 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

13. 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).

14. 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

15. Special Treatment of GSE’s • 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 GSE’s • GSE securities are eligible as collateral for public deposits and for loans from the Federal Reserve

16. GSE’s 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

17. GSE’s 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

18. 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.

19. 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.

20. 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.

21. 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.

22. 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.

23. 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

24. Composition of US Debt Market Sept 2003 (Total value $22.6 Trillion)

25. % of Outstanding Debt Market Bond Market Association 2003 is as of Sept 30,2003

26. Average Daily Trading Volume ($Billions) Bond Market Association 2003 as of Sept 30,2003

27. Issuance by GSE’s ($ Billions) Bond Market Associattion 2003 as of Sept 30, 2003

28. Outstanding Mortgage and Asset Backed Securities in US Securitization Davidson et al Wiley Pub. 2003

29. Current Questions in the Market Place relating to GSE’s • Are the GSE’s, 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?

30. Recent Study by Federal Reserve • Wayne Passmore, an economist at the Federal Reserve Bank has recently completed a study on the impact of GSE’s • The GSE’s 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

31. 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.

32. 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

33. 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.

34. 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.

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

36. 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

37. 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.

38. 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 S&P 500. • In theory this can decrease the long run return of a shareholder who is buying into the fund and holding the asset.

39. 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

40. 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)

41. 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

42. Other Current Topics • Social Security • Derivative Reporting on Financial Statements • Corporate Governance and Increased Accountability of Management • Consolidated Risk Management

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

44. 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.

45. 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.

46. 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.

47. 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”

48. 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.

49. 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

50. 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.