R. GLENN HUBBARD ANTHONY PATRICK O’BRIEN

R. GLENNHUBBARDANTHONY PATRICKO’BRIEN Money,Banking, andthe Financial System

Investment Banks, Mutual Funds,Hedge Funds, and the ShadowBanking System 11 C H A P T E R LEARNING OBJECTIVES After studying this chapter, you should be able to: Explain how investment banks operate 11.1 Distinguish between mutual funds and hedge funds and describe their roles in the financial system 11.2 Explain the roles that pension funds and insurance companies play in the financial system 11.3 Explain the connection between the shadow banking system and systemic risk 11.4

Investment Banks, Mutual Funds,Hedge Funds, and the ShadowBanking System 11 C H A P T E R • WHEN IS A BANK NOT A BANK? WHEN IT’S A SHADOW BANK! • During the financial crisis of 2007–2009, a variety of “nonbank” financial institutions were acquiring funds that had previously been deposited in banks, and they were using these funds to provide credit that banks had previously provided. The newly developed securities they were creating were not fully understood. • A key issue for policymakers in dealing with the crisis was the role the Fed should play in dealing with a financial crisis that involved many nonbank financial firms. • An Inside Look at Policy on page 338 discusses whether a panic in the shadow banking system caused the financial crisis.

Key Issue and Question Issue:During the 1990s and 2000s, the flow of funds from lenders to borrowers outside of the banking system increased. Question: What role did the shadow banking system play in the financial crisis of 2007–2009?

11.1 Learning Objective Explain how investment banks operate.

Investment Banking What Is an Investment Bank? Investment banking Financial activities that involve underwriting new security issues and providing advice on mergers and acquisitions. • Investment bankers are involved in the following activities: • 1. Providing advice on new security issues • 2. Underwriting new security issues • 3. Providing advice and financing for mergers and acquisitions • 4. Financial engineering, including risk management • 5. Research • 6. Proprietary trading

Providing Advice on New Security Issues • Firms turn to investment banks for advice on how to raise funds by issuing stock or bonds or by taking out loans. Underwriting New Security Issues Underwriting An activity in which an investment bank guarantees to the issuing corporation the price of a new security and then resells the security for a profit, or spread. Initial public offering (IPO) The first time a firm sells stock to the public. • An investment bank typically earns 2% to 4% of the dollar amount raised in a secondary offering (or seasoned offering). • In return for the spread, the investment bank takes on the risk that it cannot profitably resell the securities being underwritten. Investment Banking

Syndicate A group of investment banks that jointly underwrite a security issue. • In a syndicated sale, a lead investment bank keeps part of the spread, and the remainder is divided among the syndicate members. • Once a firm has chosen the investment bank that will underwrite its securities, the bank carries out a due diligence process, during which it researches the firm’s value. The investment bank then prepares a prospectus, which the Securities and Exchange Commission (SEC) requires of every firm before allowing it to sell securities to the public. • During the financial crisis of 2007–2009, investor confidence about the ability of investment banks to gather information was shaken when investment banks underwrote mortgage-backed securities that turned out to be very poor investments. Investment Banking

Providing Advice and Financing for Mergers and Acquisitions • Investment banks are very active in mergers and acquisitions (M&A). They advise both buyers—the “buy side mandate”—and sellers—the “sell side mandate.” • When advising a firm seeking to be acquired, investment banks attempt to find an acquiring firm willing to pay significantly more than the book value of the firm. • Advising on M&A is particularly profitable for investment banks because the bank does not have to invest its own capital. Its only significant costs are the salaries of the bankers involved in the deal. Investment Banking

Financial Engineering, Including Risk Management • Financial engineering involves developing new financial securities or investment strategies using sophisticated mathematical models. • Derivative securities, used by firms to hedge, are the result of financial engineering. • Investment banks supply knowledge of financial markets to properly assess the best way to raise funds by selling stocks and bonds, and construct risk management strategies for firms in return for a fee. • During the financial crisis, investment bank managers greatly underestimated the risk that the prices of these derivatives might fall if housing prices declined and people began to default on their mortgages. Investment Banking

Research • Investment banks assign research analysts to particular firms or industries, to gather research notes used to advice investors on mergers and acquisitions. • Research analysts also advice investors to “buy,” “sell,” or “hold” particular stocks. Overweight is a term used for a stock they recommend and underweight for a stock they do not. • The opinions of senior analysts at large investment banks can have a significant impact on the market. • They also provide useful information for the investment bank’s trading desks, where traders buy and sell securities. • Analysts also engage in economic research, writing reports on economic trends and providing forecasts of macroeconomic variables. Investment Banking

Proprietary Trading • Beginning in the 1990s, proprietary trading, or buying and selling securities for the bank’s own account rather than for clients, became a major part of operations and an important source of profits for investment banks. • Proprietary trading exposes banks to both interest-raterisk and credit risk. During the financial crisis, it became clear that credit risk was the most significant risk that investment banks faced. Credit risk is the risk that borrowers might default on their loans. • The problems investment banks faced during the financial crisis were made worse because they had used large amounts of borrowed funds to finance their proprietary trading. Using borrowed funds increases leverage, which increases risk. Investment Banking

“Repo Financing” and Rising Leverage in Investment Banking • Among the sources of funds for investment banks are the bank’s capital—funds from shareholders and retained profits—and short-term borrowing. • During the 1990s and 2000s, most large investment banks converted from partnerships to publicly traded corporations, and proprietary trading became a more important source of profits. • Financing investments by borrowing rather than by using capital, or equity, increases leverage. • As we saw in chapter 10, the ratio of a bank’s assets to its capital is its leverage ratio. Because a bank’s return on equity (ROE) equals its return on assets (ROA) multiplied by its leverage ratio, the higher the leverage ratio, the greater the ROE for a given ROA. But the relationship holds whether the ROA is positive or negative. Investment Banking

11.1 Solved Problem The Perils of Leverage Suppose that an investment bank is buying $10 million in long-term mortgage-backed securities. Consider three possible ways that the bank might finance its investment: 1. The bank finances the investment entirely out of its equity. 2. The bank finances the investment by borrowing $7.5 million and using $2.5 million of its equity. 3. The bank finances the investment by borrowing $9.5 million and using $0.5 million of its equity. • a. Calculate the bank’s leverage ratio for each of these three ways of financing the investment. • For each of these ways of financing the investment, calculate the return on its equity investment that the bank receives, assuming that: • The value of the mortgage-backed securities increases by 5% during the year after they are purchased. • The value of the mortgage-backed securities decreases by 5% during the year after they are purchased. Investment Banking

11.1 Solved Problem Solved Problem The Perils of Leverage Solving the Problem Step 1Review the chapter material. Step 3 Answer the first part of question (b) by calculating the bank’s return on its equity investment for each of the three ways of financing the investment. Step 2 Answer question (a) by calculating the leverage ratio for each way of financing the investment. Step 4 Answer the second part of question (b) by calculating the return for each of the three ways of financing the investment. Investment Banking

“Repo Financing” and Rising Leverage in Investment Banking • Federal banking regulations put limits on the size of a commercial bank’s leverage ratio. But these regulations did not apply to investment banking. • Investment banks increasingly relied on borrowed funds to finance their investments and, as a group, became much more highly leveraged than commercial banks. • The process of reducing leverage is called deleveraging. • Investment banks borrowed primarily by either issuing commercial paper or by using repurchase agreements (short-term loans backed by collateral). • If the funds raised are used to invest in mortgage-backed securities or to make long-term loans to, for instance, commercial real estate developers, investment banks face a maturity mismatch. Investment Banking

Figure 11.1 Leverage in Investment Banks Panel (a) shows that at the start of the financial crisis in 2007, large investment banks were more highly leveraged than were large commercial banks. Panel (b) shows that during 2008 and 2009, Goldman Sachs and Merrill Lynch reduced their leverage ratios, or deleveraged. Investment Banking

Making the Connection Did Moral Hazard Derail Investment Banks? • By the time of the financial crisis, all the large investment banks had become publicly traded corporations. • With corporations, there is a separation of ownership from control. The moral hazard involved can result in a principal–agent problem, as top managers may take actions that are not in the best interest of the shareholders. • Underwriting complex financial securities, such as CDOs and CDS contracts, are activities that shareholders and boards of directors do not understand and therefore cannot effectively monitor. • Some commentators argue, however, that since top managers also suffered significant losses during the crisis, the moral hazard problem could not have been so severe. Investment Banking

The Investment Banking Industry • The Glass-Steagall Act in 1933 separated investment banking from commercial banking after the great stock market crash of October 1929 resulted in heavy losses from underwriting. • Years later, economists argued that the act had protected the investment banking industry from competition, which enabled it to earn larger profits than the commercial banking industry. • In 1999, the Gramm-Leach-Bliley (or Financial Services Modernization) Act repealed the Glass-Steagall Act. • The Gramm-Leach-Bliley Act also authorized new financial holding companies that would allow securities and insurance firms to own commercial banks, and allowed commercial banks to participate in securities, insurance, and real estate activities. Large investment banks, known as “bulge bracket” banks were separated from standalone investment banks, and smaller, or “boutique,” banks. Investment Banking

Where Did All the Investment Banks Go? The effect of the financial crisis of 2007-2009 was labeled “The End of Wall Street” because the investment banks that ran into difficulties had long been seen as the most important financial firms in the stock and bond markets. Investment Banking

Making the Connection So, You Want to Be an Investment Banker? • Over the past 20 years, investment banking has been one of the most richly rewarded professions in the world. • The pay of top executives has been controversial. Some argue that not only is their pay out of line with their economic contributions, but also that they may have helped bring on the crisis by promoting mortgage-backed securities. • New college graduates are hired as analysts who spend 80 hours per week or more researching industries, helping in the due diligence process, and with mergers and acquisitions. • After two to four years, the bank either promotes an analyst to the position of associate or asks him or her to leave the firm. MBA graduates are sometimes hired directly as associates. Investment Banking

11.2 Learning Objective Distinguish between mutual funds and hedge funds and describe their roles in the financial system.

Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies • In addition to investment banks, investment institutions are financial firms that raise funds to invest in loans and securities. • The most important investment institutions are mutual funds, hedge funds, and finance companies. Investment institution A financial firm, such as a mutual fund or a hedge fund, that raises funds to invest in loans and securities.

Mutual Funds Mutual fund A financial intermediary that raises funds by selling shares to individual savers and invests the funds in a portfolio of stocks, bonds, mortgages, and money market securities. • Mutual funds help to reduce transaction costs, provide risk-sharing benefits, and gather information about different investments. • The mutual fund industry in the United States dates back to 1924, with the creation of the Massachusetts Investors Trust, State Street Investment Corporation, and Putnam Management Company, which remain major players today. Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies

Types of Mutual Funds • In closed-end mutual funds, a fixed number of nonredeemable shares is issued, with the price of a share fluctuating with the market value of the assets—called the net asset value, or NAV. • In more common open-end mutual funds, investors can redeem shares after the markets close for a price tied to the value of the assets in the fund. • Exchange-traded funds (ETFs), like closed-end mutual funds, trade continually throughout the day. With ETFs, market prices track the prices of the assets. • Large institutional investors who purchase above a certain number of shares of an ETF—called a creation unit aggregation—have the right to redeem those shares for the assets in the fund. • Mutual funds that do not charge a commission, or “load,” are called no-load funds. Load fundscharge buyers a commission to both buy and sell shares. • An index fund consists of a fixed-market basket of securities, such as the stocks in the S&P 500 stock index. Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies

Money Market Mutual Funds Money market mutual fund A mutual fund that invests exclusively in short-term assets, such as Treasury bills, negotiable certificates of deposit, and commercial paper. • Most money market mutual funds allow savers to write checks above a specified amount against their accounts. • They are popular with small savers as an alternative to commercial bank checking and savings accounts, which typically pay lower rates of interest. • Money market mutual funds brought additional competition for commercial banks. Rather than taking out loans from banks, firms sold commercial paper to the funds. The interest rates the firms paid on the paper was lower than banks charged on loans. Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies

Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies Hedge Funds Hedge fund Financial firms organized as a partnership of wealthy investors that make relatively high-risk, speculative investments. • Hedge funds are typically organized as partnerships of 99 investors or fewer, all of whom are either wealthy individuals or institutional investors, such as pension funds. They are largely unregulated and free to make risky investments. • Modern hedge funds typically make investments that involve speculating, rather than hedging, so their name is no longer an accurate description of their strategies. • Although reliable statistics on hedge funds are difficult to obtain, in 2010, there were as many as 10,000 operating in the United States, managing more than $1 trillion in assets. Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies

Finance Companies Finance company A nonbank financial intermediary that raises money through sales of commercial paper and other securities and uses the funds to make small loans to households and firms. • A lower degree of regulation allows finance companies to tailor loans closer to the needs of borrowers than do the standard loans that more regulated institutions can provide. • The three main types of finance companies are consumer finance, business finance, and sales finance firms. • Many economists believe that finance companies fill an important niche in the financial system because they have an advantage over commercial banks in monitoring the value of collateral, making them logical players in lending for consumer durables, inventories, and business equipment. Investment Institutions: Mutual Funds, Hedge Funds, and Finance Companies

11.3 Learning Objective Explain the roles that pension funds and insurance companies play in the financial system

Contractual Savings Institutions: Pension Funds and Insurance Companies Contractual saving institution A financial intermediary such as a pension fund or an insurance company that receives payments from individuals as a result of a contract and uses the funds to make investments.

Pension Funds Pension fund A financial intermediary that invests contributions of workers and firms in stocks, bonds, and mortgages to provide for pension benefit payments during workers’ retirements. • Representing about $10 trillion in assets in the United States in 2010, private and state and local government pension funds are the largest institutional participants in capital markets. • To receive pension benefits, an employee must be vested. Vestingis the number of years you must work in order to receive benefits after retirement. Contractual Savings Institutions: Pension Funds and Insurance Companies

Figure 11.2 Assets of Pension Funds, 2009 Both private and state and local pension funds concentrate their investments in stocks, bonds, and other capital market securities. Contractual Savings Institutions: Pension Funds and Insurance Companies

Employees prefer pension plans to personal savings for three reasons: • (1) pension plans can manage a portfolio more efficiently and at a lower cost; • (2) benefits such as annuities are expensive for individuals to obtain; and • (3) the tax treatment of pension funds benefits the employee. • In a defined contribution plan, the firm invests contributions for the employees, who own the value of the funds in the plan. Pension income during retirement depends on the profitability of the pension plan’s investments. These are the most common plans today. • In a defined benefit plan, the firm promises employees a particular dollar benefit payment, based on each employee’s earnings and years of service. • 401(k) plans are one segment of defined contribution plans. An employee can make tax-deductible contributions through regular payroll deductions, subject to an annual limit, and pay no tax on accumulated earnings until retirement. Some employers match employee contributions up to a certain amount. Contractual Savings Institutions: Pension Funds and Insurance Companies

Insurance Companies Insurance company A financial intermediary that specializes in writing contracts to protect policyholders from the risk of financial loss associated with particular events. • Insurers obtain funds by charging premiumsto policyholders and use these funds to make investmentsin stocks, bonds, mortgages, and direct loans to firms known as private placements. • The insurance industry has two segments: • Life insurance companies sell policies to protect households against a loss of earnings from the disability, retirement, or death of the insured person. • Property and casualty companies sell policies to protect households and firms from the risks of illness, theft, fire, accidents, or natural disasters. Contractual Savings Institutions: Pension Funds and Insurance Companies

Figure 11.3 Financial Assets of U.S. Insurance Companies Life insurance companies have larger asset portfolios than do property and casualty insurance companies. Property and casualty insurance companies hold more municipal bonds because the interest on them is tax exempt, while life insurance companies hold more corporate bonds because they payer higher interest rates. Contractual Savings Institutions: Pension Funds and Insurance Companies

Risk Pooling • Insurance companies use the law of large numbers to make predictions. They rely on the average occurrences of events for large numbers of people. • By issuing a sufficient number of policies, insurance companies take advantage of risk pooling and diversification to estimate the size of reserves needed to pay potential claims. • Statisticians known as actuaries compile probability tables to help predict the risk of an event occurring in the population. Contractual Savings Institutions: Pension Funds and Insurance Companies

Reducing Adverse Selection through Screening and Risk-Based Premiums • People most eager to buy insurance are those with the highest probability of requiring an insurance payout. • To reduce adverse selection problems, insurance company managers gather information to screen out poor insurance risks. • Insurance companies also reduce adverse selection by charging risk-based premiums, which are premiums based on the probability that an individual will file a claim. Contractual Savings Institutions: Pension Funds and Insurance Companies

Reducing Moral Hazard with Deductibles, Coinsurance, andRestrictive Covenants • Policyholders may change their behavior once they have insurance. To reduce the likelihood that an insured event takes place, some of the policyholder’s money is also put at risk. Insurance companies do this by requiring a deductible. • To further hold down costs, insurance companies may offer coinsuranceas an option in exchange for charging a lower premium. • To cope with moral hazard, insurers also sometimes use restrictive covenants, which limit risky activities by the insured if a subsequent claim is to be paid. • These tools to reduce adverse selection and moral hazard problems align the interests of policyholders with the interests of the insurance companies. The cost of insurance is reduced and the savings translate into lower premiums. Contractual Savings Institutions: Pension Funds and Insurance Companies

Making the Connection Why Did the Fed Have to Bail Out Insurance Giant AIG? • One of the most dramatic events of the financial crisis was the collapse of American International Group (AIG), the largest insurance company in the United States. • It was surprising that a stable insurance company would be involved in the crisis. AIG, however, expanded beyond the basic insurance activities. • In 1998 AIG Financial Products, based in London, decided to begin writing credit default swap contracts on CDOs, or insuring the value of CDOs. At first, the CDOs included relatively high-quality corporate bonds, with only a few mortgage-backed securities. • But at the height of the housing boom, AIG was issuing hundreds of billions of dollars worth of credit default swaps against CDOs consisting largely of mortgage-backed securities. Contractual Savings Institutions: Pension Funds and Insurance Companies

(continued) Making the Connection Why Did the Fed Have to Bail Out Insurance Giant AIG? • AIG was earning $250 million annually from the premiums and, although housing prices had begun to decline in 2006, AIG remained optimistic. • By September 2008, AIG had lost $25 billion on the credit default swaps. The owners of the swaps were insisting that AIG post collateral against the possibility of further losses. The firm did not have sufficient assets to use as collateral and without government assistance, it would need to declare bankruptcy. • The U.S. Treasury and the Federal Reserve were afraid that if AIG failed, the losses suffered by other firms would deepen the crisis, and decided to bail out the company. Contractual Savings Institutions: Pension Funds and Insurance Companies

11.4 Learning Objective Explain the connection between the shadow banking system and systemic risk.

Systemic Risk and the Shadow Banking System Systemic Risk and the Shadow Banking System • Financial institutions, such as investment banks, hedge funds, and money market mutual funds are nonbank financial institutions known as the “shadow banking system.” • On the eve of the financial crisis, the size of the shadow banking system was greater than the size of the commercial banking system. • The FDIC and the SEC were created with the goal to protect depositors from the likelihood that the failure of one bank would lead depositors to withdraw their money from other banks, a process called contagion. Congress was less concerned with the risk to individual depositors than with systemic risk to the entire financial system. Systemic risk Risk to the entire financial system rather than to individual firms or investors.

Deposit insurance succeeded in stabilizing the banking system, but there is no equivalent to deposit insurance in the shadow banking system. • In the shadow banking system, short-term loans consist of repurchase agreements, purchases of commercial paper, and purchases of money market mutual fund shares rather than deposits. • With the exception of a temporary guarantee to owners of money market mutual fund shares during the crisis, the government does not reimburse investors who suffer losses when they make loans to shadow banks. • During the financial crisis, the shadow banking system was subject to the same type of systemic risk that the commercial banking system experienced during the years before Congress established the FDIC in 1934. Systemic Risk and the Shadow Banking System

Regulation and the Shadow Banking System • There have been two main rationales for exempting many nonbanks from restrictions on the assets they can hold and the degree of leverage they can have: • Policymakers did not see these firms as being important to the financial system as were commercial banks, and regulators did not believe that the failure of these firms would damage the financial system. • These firms deal primarily with other financial firms, institutional investors, or wealthy private investors rather than with unsophisticated private investors. Policymakers assumed that these investors could look after their own interests without the need for federal regulations. Systemic Risk and the Shadow Banking System

In 1934, Congress gave the SEC broad authority to regulate the stock and bond markets, and in 1974, it established the Commodity Futures Trading Commission (CFTC) to regulate futures markets. • Securities that were not traded on exchanges were not subject to regulation. By the time of the financial crisis, trillions of dollars worth of securities were being traded in the shadow banking system with little oversight, and subject to significant counterparty risk. • When derivatives are traded on exchanges, the exchange serves as the counterparty, which reduces the default risk to buyers and sellers. • In 2010, Congress enacted regulatory changes that would push more trading in derivatives onto exchanges. Systemic Risk and the Shadow Banking System

The Fragility of the Shadow Banking System • We can summarize the vulnerability of the shadow banking system as follows: • Many firms in the shadow banking system were borrowing short term and lending long term. • These firms were also more vulnerable to incurring substantial losses and possible failure. The investors in investment banks and hedge funds had no federal insurance against loss of principal, increasing the probability of a run. Being largely unregulated, shadow banks could invest in more risky assets and become more highly leveraged than commercial banks. • Finally, during the 2000s when housing prices began to decline, many shadow banking firms suffered heavy losses and some were forced into bankruptcy. Given the increased importance of these firms in the financial system, the result was the worst financial crisis since the Great Depression. Systemic Risk and the Shadow Banking System

Answering the Key Question At the beginning of this chapter, we asked the question: “What role did the shadow banking system play in the financial crisis of 2007–2009?” Although we will discuss the financial crisis of 2007–2009 more completely in the next chapter, this chapter has provided some insight into the role of the shadow banking system. Many shadow banks, particularly investment banks and hedge funds, were overly reliant on financing long-term investments with short-term borrowing, were highly leveraged, and held securities that would lose value if housing prices fell. When housing prices did fall, these firms suffered heavy losses, and some were forced into bankruptcy. Given the importance of shadow banking to the financial system, the result was a financial crisis. Systemic Risk and the Shadow Banking System

AN INSIDE LOOK AT POLICY Did a Shadow Bank Panic Cause the Financial Crisis of 2007–2009? WASHINGTON POST, Explaining FinReg: Shadow Bank Runs, or the Problem Behind the Problem Key Points in the Article • Yale University economist Gary Gorton argues that a bank run in the shadow banking system caused the financial crisis that began in 2007, which was triggered by rising delinquencies and foreclosures in the subprime mortgage market. • Without deposit insurance, depositors demanded collateral, which took the form of highly rated mortgage-backed securities. • When the subprime mortgage crisis began, no one knew which banks were most at risk, and investors lost confidence in all institutions in the shadow banking market. • The shadow banking system was subject to great disruption from new information—something that commercial banks avoid with deposit insurance.

AN INSIDE LOOK AT POLICY • The table below shows the widespread decline from 2007 to 2008 in the issuance of securitized and corporate debt.

R. GLENN HUBBARD ANTHONY PATRICK O’BRIEN