Fin Final Exam

Savings institutions manage interest rate risk using the following assets:

(1) adjustable-rate mortgages, (2) interest rate futures contracts, and (3) interest rate swaps. Adjustable-Rate Mortgages — Interest rates on adjustable-rate mortgages are tied to underlying indexes, such as the one-year Treasury bill rate, LIBOR, etc. The rate periodically adjusts according to a timeframe specified in the adjustable-rate mortgage contract. Thus, if savings institutions think interest rates will increase in the future, they could try to lend to more borrowers who are willing to accept adjustable-rate mortgages to hedge against interest rate risk. Interest Rate Futures Contracts — An interest rate futures contract allows the buyer to purchase a certain amount of a debt security for a certain price at a point in the future. Some savings institutions sell futures contracts that mimic fixed-rate mortgages in an attempt to mitigate interest rate risk. Treasury bond futures contracts are similar in nature to fixed-rate mortgages, so some savings institutions use them in place of underwriting fixed-rate mortgages. Interest Rate Swaps — Interest rate swaps allow institutions to swap their fixed-rate payments for another institution's variable-rate payments. When interest rates increase, the fixed-rate payments the institutiony makes remain steady, while the variable-rate payments they receive increase. As a result, engaging in interest rate swaps can have positive results when interest rates increase, offsetting some interest rate risk associated with fixed-rate mortgages.

Savings institutions are susceptible to three types of risk:

(1) liquidity risk, (2) credit risk, and (3) interest rate risk. Liquidity Risk — Savings institutions use short-term liabilities to finance long-term assets and, as a result, can suffer from liquidity problems if new deposits don't cover the withdrawal requests. Credit Risk — As mortgages are savings institutions' primary asset, they represent their largest source of risk. If savings institutions properly analyze their borrowers' credit, then they should have an accurate measurement on the borrowers' likelihood of defaulting. If institutions get careless with their credit analysis or underwrite mortgages to risky borrowers, then they are exposing themselves to a higher degree of credit risk. Interest Rate Risk — The last form of risk savings institutions encounter is interest rate risk. Because savings institutions rely mainly on short-term deposits as sources of funds and use the majority of their funds to provide long-term fixed-rate mortgages, they are subject to interest rate risk. This is because their liabilities are sensitive to changes in interest rates, but their assets are not. As a result, if interest rates increase, the spread between interest revenue and interest expenses decreases, reducing the savings institution's profits.

Credit unions are susceptible to three types of risk:

(1) liquidity risk, (2) credit risk, and (3) interest rate risk. Liquidity Risk: Credit union depositors are made up of members who have a common bond. As a result, they have a limited number of members, which means that a wave of withdrawals could be larger than the amount of new deposits the credit union receives. As a result, liquidity risk is a much bigger threat for credit unions than it is for other financial institutions. Credit Risk: As member loans are credit unions' primary asset, they represent their largest source of risk. If credit unions properly analyze their borrowers' credit, then they should have an accurate measurement on the borrowers' likelihood of defaulting. If institutions get careless with their credit analysis or underwrite mortgages to risky borrowers, then they are exposing themselves to a higher degree of credit risk. Interest Rate Risk: The last form of risk credit unions encounter is interest rate risk. Because credit unions offer mainly short- to medium- term maturity loans, they are subject to a limited amount of interest rate risk. Both their liabilities and assets are sensitive to changes in interest rates, which means that as interest rates fluctuate, the spread between interest revenue and interest expense stays relatively stable. Consequently, it can be said that of the types of risk credit unions are susceptible to, interest rate risk is the least threatening. Given all of this information, it can be said that this statement is true.

Most credit unions pay an annual premium of one-tenth of a percent of their share deposits. For each scenario, the premium that's paid can be calculated as:

(Premium/Share Deposit amount) × 100 = Premium percentage

There are five main sources of funds for finance companies:

1) Loans from Banks: Because finance companies can consistently renew bank loans, they can provide a continual source of funds for finance companies. That said, some banks use this source of funds mainly to help with seasonal swings in their business. 2) Commercial Paper: Finance companies, such as Essence Bancorp, can only use commercial paper for short-term financing, but they can create a permanent source of funds by repeatedly rolling over their issues. Although in recent years, more finance companies are using commercial paper, traditionally very few finance companies use this source to attract funds because it exposes investors to the risk of default. 3) Deposits: Although offering customers deposit services similar to those of depository institutions is not a major source of funds, some states allow finance companies to attract funds in this way. 4) Bonds: When a finance company, such as Purity Financial Services, is in need of long-term funds, it may choose to issue bonds, particularly if it feels that interest rates will rise over time because it can use the funds obtained from bonds to issue loans with variable interest rates. 5) Capital: The final way that finance companies, such as Spotlight Financial, can build their capital base is by retaining earnings or by issuing stock.

In an attempt to prevent conflicts of interest that could develop for securities firm analysts, the SEC instituted three main rules in the early 2000s:

1.Analysts from a securities firm that underwrites an IPO can no longer promote the stock within the first 40 days of the IPO. This allowed for the stock price to be driven by market forces, rather than by the analyst. 2.An analyst's pay can no longer be directly derived from the amount of business they bring to the securities firm, and they can no longer be supervised by their securities firm's investment banking department. This was intended to prevent investment bankers from pressuring analysts into providing inflated ratings of a firm's stock in order to draw in more underwriting business. 3.Analyst's ratings must now disclose all recent investment banking business provided by the securities firm that assigned the rating.

Which of the following is the key characteristic that distinguishes between defined-contribution and defined-benefit pension plans?

A defined-contribution plan allows employees to decide how to invest the money set aside for their retirement. Employees' freedom to decide how to invest the money set aside for their retirement in a defined-contribution plan is a key characteristic that distinguishes these pension plans from defined-benefit plans, for which the managers of the pension fund determine how the money set aside for retirement is invested. Some employees may favor a defined-contribution plan if they prefer to make their own investment decisions with their retirement money. Other employees may prefer a defined-benefit plan if they want to know the exact amount of benefits they will receive at retirement and do not want to be responsible for determining how to invest their retirement money. Employees with defined-benefit plans usually do not worry about how their pension fund money is invested until it is distributed to them, because the amount of retirement income that they will receive is defined by their plan. If employees want access to their money in a defined-contribution plan before retirement, this is often allowed; however, they are typically subject to a penalty for early withdrawal.

Other types of insurance

Business interruption insurance: covers the loss of income incurred in the event of a loss. Credit line insurance: covers the amount due on a loan should the borrower die. Key employee insurance: covers employees who are essential to the success of the firm. If the specified employee dies or becomes disabled, the firm receives a financial payout. Liability Insurance: covers damages from defective products, medical payments, advertising injury, and a wide variety of other losses. Property insurance: covers losses to a firm's building, furniture, and other assets. Umbrella liability insurance: covers losses that exceed the coverage of an existing insurance

Savings institutions then use these funds in a variety of ways in order to capitalize on investments and improve their value. The ways in which these institutions use the funds they collect are listed in the following:

Cash — Savings institutions need cash reserves in order to meet the reserve requirements set by the Fed, as well as to accommodate withdrawal requests from their depositors. In order to meet these needs, they keep some of the deposits in the form of cash. Mortgages — Savings institutions' primary asset is mortgages on residential as well as commercial properties. Mortgages are loans given to individuals or businesses used to purchase real estate that they otherwise could not afford. Mortgage-Backed Securities — MBSs are insurance on mortgages that can be bought in the event that an investor thinks their assets will default. Savings institutions use MBSs as a way to hedge against various forms of risk they incur by underwriting mortgage loans. Other Securities — Savings institutions commonly invest in low risk Treasury and corporate bonds, which they can quickly sell in secondary markets if they are in need of funds. Consumer and Commercial Loans — Savings institutions have extremely high credit default risk since their main asset is mortgages. As a result, they try to reduce this exposure by diversifying their investments to include consumer loans and commercial loans, which are commonly automobile loans, credit cards, student loans, personal loans, equipment loans, etc. Repurchase Agreements — Just as they can be on the borrowing side of a repurchase agreement, savings institutions are oftentimes on the lending side of these agreements.

There are several different ways for credit unions to obtain funding, which they then use primarily for loans to members. The different methods are described in the following:

Deposits: Credit unions offer share deposits that members can use as a way to store and/or invest their money. Their most common accounts are similar to commercial bank and savings institution passbook savings accounts. They also offer share certificate accounts, which are attractive to depositors who want higher interest payments and don't mind having their deposits sit in an account until a specified maturity date. Credit unions also offer checkable accounts, known as share drafts, which pay interest and allow the depositor to write an unlimited amount of checks. Borrowed Funds: Unlike savings institutions and commercial banks, credit unions do not borrow funds from the Federal Reserve or the federal funds market, but rather they borrow from the Central Liquidity Facility (CLF). Capital: Like savings institutions and commercial banks, credit unions' main source of capital is retained earnings.

There are several different ways for savings institutions to obtain funding, which they then use primarily for mortgage loans. The different methods are described in the following:

Deposits: Savings institutions offer a variety of savings and time deposits that depositors can use as a way to store and/or invest their money. The most common accounts are passbook savings accounts, retail certificate of deposit accounts, and money market deposit accounts. Borrowed Funds: When savings institutions don't have sufficient funding to cover their investing, they can obtain funds in three ways: (1) borrow from other depository institutions in the federal funds market, (2) engage in a repurchase agreement by selling government securities with the commitment of buying them back at a specified time and price in the future, and (3) borrow from the Federal Reserve. Capital: A savings institution's capital is comprised of retained earnings and new stock issuances. Capital is boosted by an increase in retained earnings in times when the institutions are performing well, but it is diminished by the reduction of retained earnings in times when the institutions are performing poorly. This being the case, the more effective way to boost capital (when it's needed) is to engage in a secondary stock offering. (Note: This way of increasing capital is available only to stock-owned savings institutions.)

One of the major reasons why savings institutions contributed to the credit crisis of 2008-2009 was that the economy had not been doing well and many savings institutions began restricting the amount of loans they were willing to offer.

False From 2003 to 2006, wages were high, unemployment was low, and all sorts of individuals applied for mortgage loans, which led to a residential housing boom. Because times were so good, savings institutions began offering subprime loans to even the most unqualified individuals, thinking that if the economy kept on its pace, they would surely be able to pay back their loans. Many savings institutions also began heavily investing in mortgage-backed securities, thinking it would provide a revenue stream on assets that could never fail at a rate that would significantly harm the institution. Because the underlying mortgages were extremely overrated and the collection of mortgages in the securities was actually worse than institutions thought, the economy began to experience slowed job growth, a decrease in consumption and retail sales, and falling wages, which caused many of the unqualified individuals who were granted subprime mortgages to default on those mortgages. Consequently, the securities became worthless, which in turn caused many savings institutions to fail.

There are several common performance indicators used in insurance regulation and valuation. Liquidity ratios are used to measure the insurer's ability to meet its financial obligations in a timely fashion. The following ratio can be used to measure liquidity:

Liquidity Ratio = Invested assets / Loss reserves and unearned premium reserves The higher the liquidity ratio is, the higher the chance of the insurance company meeting its financial obligations, and vice versa. Since, Floyds, Inc. has the highest liquidity ratio, they are the most capable of meeting their financial obligations.

Large pension funds are major participants in financial markets and interact with securities firms

Many investments made by pension funds require the brokerage services of securities firms. Managers of pension funds instruct securities firms on the type and amount of investment instruments to purchase. The latter offer investment advice to pension portfolio managers, execute securities transactions for pension funds, and underwrite newly issued stocks and bonds that are purchased by pension funds. Also commercial banks help manage pension funds and sell commercial loans to pension funds in the secondary market. Moreover, pension funds interact with insurance companies and mutual funds. Insurance companies create annuities for pension funds, whereas mutual funds serve as investments for some pension funds.

Suppose that Citizens National Savings Institution obtains the majority of its funds from passbook savings accounts, retail certificates of deposit, and money market deposit accounts, and that it uses those funds to provide fixed-rate residential and commercial mortgages to borrowers. If interest rates increase, Citizens National Savings Institution is taking on the interest rate risk. If, however, Citizens National Savings Institution provides mostly adjustable-rate mortgages, an increase in interest rates means that the interest rate risk is transferred to the borrower .

MutualOne Savings Institution will benefit from the exchange because the market value they purchase the securities for in the future will be lower than the value for which they sell them to Williams Savings Institution. Williams Savings Institution will be negatively impacted by the exchange, because the value they must purchase the Treasury bonds for is much higher than the value they could have purchased them for on the open market.

The federal government's decisions on whether or not to bail out failing financial institutions during the credit crisis were heavily criticized. Often times, they were trying to determine whether or not the failures would be systemic, thus creating a domino effect of failures in the banking industry.

Some of the major securities firms affected by the federal government's decisions were Bear Stearns, Merrill Lynch, and Lehman Brothers. Bear Stearns: was a very large securities firm specializing in bonds and mortgages. Bear Stearns had an extremely high level of financial leverage, which means it was constantly using debt to finance the acquisition of new assets. As a result, their returns were magnified when economic conditions were good, as well as when economic conditions were bad. During the credit crisis, economic conditions were bad, meaning Bear Stearns suffered heavy losses. Financial institutions lost faith in the securities firm because they did not believe in the quality of the mortgage assets they were using as collateral. As a result, they could not obtain funds to support their short-term operations, and they began to struggle with liquidity. The Federal Reserve stepped in to finance their short-term needs but soon discovered that they were at high risk for subprime mortgages and that they had amassed a large amount of contractual obligations with other financial institutions that they would likely not be able to meet. As a result, to prevent Bear Stearns from failing, the federal government coordinated the acquisition of the firm by JPMorgan Chase and promised to back the cost of the assets if they began to fail. Merrill Lynch: was a major financial intermediary that specialized in mortgage origination, securitization of mortgages, and investments in mortgage-backed securities. Merrill Lynch saw great returns from their investments prior to the financial crisis; however, when the economy (and specifically the housing market) took a downturn, their heavy investments in the mortgage industry caused them to endure significant losses, and they began to fail. Consequently, Merrill Lynch received over $10 billion in government funds from the Troubled Asset Relief Program (TARP) and was acquired by Bank of America. Lehman Brothers: was a very large securities firm that acted as a major financial intermediary in the financial system. They were heavily invested in residential and commercial real estate and had an extremely high level of financial leverage. As a result, their returns were magnified when economic conditions were good, as well as when economic conditions were bad. During the credit crisis, economic conditions were bad, meaning Lehman Brothers suffered heavy losses. Financial institutions lost faith in the securities firm because they did not believe in the quality of the mortgage assets they were using as collateral. The federal government attempted to coordinate an acquisition of the firm, but no financial institutions wanted to take them on, as they were suspicious that the true financial state of the firm was much worse than they let on. As a result, Lehman Brothers filed for bankruptcy and was not bailed out by the federal government.

Which of the following actions would worsen the credit risk a finance company faces? Vertex Bancshares decides to focus on subprime auto loans only in suburban areas where most residents must commute by car in order to get to work. Life Essence Financial now receives all of its funds through borrowing rather than deposits. State Holding Financial claims that they will approve loans for all borrowers regardless of credit history at a low interest rate. First Financial decides to increase funds by drawing in more deposits rather than borrowing.

State Holding Financial claims that they will approve loans for all borrowers regardless of credit history at a low interest rate.

Savings Institutions

Stock-owned has the key advantage of being able to issue stock to raise capital, while a depositor-owned institution lacks this ability. Stock-owned institutions give managers an incentive to improve upon the institution's value, so they, as well as the shareholders, benefit directly from high performance and growth. Owners of a mutual institution only benefit from high performance while they maintain deposits there, so they don't have a direct benefit from a high-performing institution because their claim to the net worth of the institution ends whenever they close their account. Since the shareholders hold the voting rights for stock-owned institutions, it makes them more susceptible to hostile takeovers, because the shareholders can vote on the direction of the company if they feel management is not living up to expectations. Depositor-owned institutions, on the other hand, are nearly impossible to take over because management generally holds all the voting rights, rather than the depositors.

Which regulator is responsible for supervising savings institutions that have at least $10 billion in assets?

The Consumer Financial Protection Bureau is responsible for supervising savings institutions that have at least $10 billion in assets. Because most savings institutions have assets amounting to less than $1 billion, the Consumer Financial Protection Bureau is seen as the regulator that supervises larger savings institutions.

Which regulator is responsible for supervising the parent holding company of a savings institution?

The Federal Reserve is responsible for supervising the parent holding company of a savings institution.

Suppose future payment obligations upon an employee's retirement could be predicted accurately.

The higher the expected future return on the money set aside for employees, the lower the amount of funds that must be invested today to satisfy future payments. It is difficult for a pension fund to perfectly forecast the amount of money that it will need to pay employees after their retirement because it depends on the employee's salary level and the number of years of full-time service. However, assuming that future payment obligations upon an employee's retirement is known, the amount of money that a defined-benefit pension plan would need to set aside in each pay period is still uncertain. This is because the rate of return that most of its investments will earn until the money is distributed to the retiree is uncertain. The higher the expected future return on the money set aside for employees, the lower the amount of funds that must be invested today to satisfy future payments.

Pension fund managers participate in various financial markets

The largest presence of pension funds is in the stock and bonds markets. This is because the composition of pension fund portfolios is usually dominated by stocks and bonds. Pension fund managers maintain a small proportion of liquid money market securities that can be liquidated when they wish to increase the pension fund's investment in stocks, bonds, or other alternatives. Pension fund managers also participate in mortgage markets to fill out the remainder of their portfolios and sometimes utilize the futures and options markets, as well as to partially insulate their portfolio performance from interest rate and stock market movements.

In addition to adverse selection and moral hazard, which of the following are considered when developing insurance premiums? The number of insurance policies that the insured currently maintains Transfer payments made by the government to the insured The probability of having to pay the insured for potential losses Insurance market competition

The probability of having to pay the insured for potential losses Insurance market competition Insurance underwriters calculate risks associated with various insurance policies. Premiums for these policies that are charged by insurance companies are based on the probability of having to pay the insured for potential losses and the potential size of claims to be paid to insureds. Insurance premiums are also influenced by the present value of potential claim payments, profit and overhead expenses for the insurance company, and the degree of market competition for the particular type of insurance.

Which of the following is true regarding insurance regulation? If an insurance company becomes insolvent, state guaranty funds are used to pay outstanding claims. The risk-based capital ratio is used to identify insurance companies with low risk exposure and force them to hold a high level of capital. Insurance agents must be licensed in order to sell insurance products. United States-based insurance companies that expand their business internationally are subject to foreign insurance regulations.

The risk-based capital ratio is used to identify insurance companies with low risk exposure and force them to hold a high level of capital. Insurance agents must be licensed in order to sell insurance products. United States-based insurance companies that expand their business internationally are subject to foreign insurance regulations.

Which of the following are factors that increase the valuation of a savings institution? The savings institution fires a manager that was making poor decisions and hires a new one that immediately improves the condition of the firm. The rate of return that investors require increases. The risk premium on a savings institution increases. The risk-free interest rate decreases.

The savings institution fires a manager that was making poor decisions and hires a new one that immediately improves the condition of the firm. The risk-free interest rate decreases.

Which of the following are true about depositor-owned savings institutions? They are less susceptible to hostile takeovers than stock-owned institutions. They can raise additional capital by issuing stock. Their owners benefit directly from high performance and growth. They are more susceptible to hostile takeovers than stock- owned institutions.

They are less susceptible to hostile takeovers than stock-owned institutions.

Which of the following are ways that savings institutions obtain funds? They borrow funds from the Federal Reserve. They offer money market deposit accounts to depositors. They offer eurodollar accounts to depositors. They borrow funds through the utilization of repurchase agreements.

They borrow funds from the Federal Reserve. They offer money market deposit accounts to depositors. They borrow funds through the utilization of repurchase agreements.

Which of the following are true about stock-owned savings institutions?

They can raise additional capital by issuing stock. They are more susceptible to hostile takeovers than depositor-owned institutions. Their owners benefit directly from high performance and growth.

Which of the following are ways that savings institutions use funds? They invest funds in mortgage-backed securities. They offer consumer loans. They offer residential mortgage loans. They invest funds in Treasury bonds.

They invest funds in mortgage-backed securities. They offer consumer loans. They offer residential mortgage loans. They invest funds in Treasury bonds.

How do savings institutions typically hedge against short-term liquidity risk? They obtain funds by borrowing from other financial institutions in the federal funds market. They sell Treasury securities on the secondary market. They sell mortgages on the secondary market. They obtain funds by engaging in repurchase agreements.

They obtain funds by borrowing from other financial institutions in the federal funds market. They obtain funds by engaging in repurchase agreements. Liquidity problems can be addressed by increasing liabilities or selling assets. Activities that involve increasing liabilities are engaging in repurchase agreements and borrowing funds from other savings institutions in the federal funds market. As an alternative to increasing liabilities, a savings institution could sell any number of its assets (mortgages, Treasury securities, etc.). Although selling assets boosts liquidity, it also reduces the institution's size and potential earnings. As a result, for minor short-term liquidity issues, it makes the most sense for institutions to increase their liabilities rather than selling their assets.

Often private pension funds are underfunded because they did not set aside sufficient funds each pay period to meet the expected payouts after the employees retired

This happens because employers have a natural motivation to assume that the money set aside in a pension fund will earn a relatively high rate of return, in that the allocation of money to the pension fund represents an expense. An underfunded pension fund will have to access additional funds to offset this deficiency so that it has sufficient funds to cover its payment obligations when employees retire. Corporations tend to be optimistic about projections of the rate of return to be earned on the money set aside in their pension funds because this allows them to set as idea smaller amount of funds in anticipation of future pension payment obligations.

True or False: Most savings institutions have assets amounting to more than $5 billion. True

This statement is false. Most savings institutions are relatively small and have assets amounting to less than $1 billion.

Pension Protection Act of 2006

To deal with the problem of underfunded pension plans, Congress passed the Pension Protection Act of 2006, which requires a company to periodically determine whether their pension fund is underfunded. Companies with an underfunded defined-benefit pension plan must increase their contributions to the pension plan to resolve the deficiency.

The number of credit unions in the United States exceeds the number of commercial banks; however, the total assets credit unions hold are much lower than that of commercial banks.Approximately 2,300 credit unions have assets amounting to less than $20 million.

True

Mortgages are the primary asset of savings institutions.

True Savings institutions are depository institutions that specialize in mortgage lending. Of all the assets savings institutions have, their primary asset is mortgages, approximately 90 percent of which are residential and the remaining 10 percent are commercial.

There were several savings institutions that offered loans to unqualified borrowers, invested in mortgage-backed securities, and had a low degree of liquidity and, as a result, contributed to the credit crisis of 2008-2009.

Washington Mutual: was the largest savings institution at the time, with assets amounting to more than $300 billion. After hearing rumors about Washington Mutual's financial struggles, depositors began to make a run on the institution. Because most of their assets were tied up in mortgages and mortgage-backed securities, they began to experience liquidity problems that would ultimately lead JPMorgan Chase to acquire them. Countrywide Financial: was the second-largest savings institution in the United States at the time and was known for being overly aggressive with their approval of subprime mortgage loans to unqualified borrowers. Due to the high default rate on these mortgages, Countrywide Financial began to fail and, as a result, was acquired by Bank of America. IndyMac: was the eighth-largest savings institution in the United States at the time. Due to their major investment in mortgages, as the mortgage default rate climbed, so did their losses, amounting to more than $32 billion. Similar to the case of Washington Mutual, rumors began to spread about the possible failure of IndyMac, causing depositors to make runs on the institution amounting to $100 million per day. They began to suffer liquidity problems, which ultimately led the FDIC to take over.

Securities Investor Protection Corporation (SIPC)

While the Federal Deposit Insurance Corporation is responsible for providing insurance on deposits to depository institutions, the Securities Investor Protection Corporation (SIPC) offers insurance of up to $250,000 on cash and $500,000 on securities deposited at brokerage firms.

types of life insurance policies:

Whole life insurance: is a policy that builds cash value and protects policyholders for the life of the insured or as long as the premiums are paid. The benefits paid to the beneficiary are typically fixed. Term life insurance: is a policy that is temporary, providing insurance coverage for a specified time period, and does not build a cash value for policyholders. The benefits and premiums are typically fixed through the specified time period. Variable life insurance: is a policy whose benefits paid to the beneficiary vary with the assets backing the policy, such as stocks, bonds, and money market funds. Universal life insurance: is a policy that is temporary, providing insurance coverage for a specified period and also builds cash value for the policyholder over time. Policyholders can submit payments greater than the base premium to increase the cash value of the policy.

The change in an insurance company's cash flows depends on several factors, including

a change in payouts, change in economic conditions, change in the risk-free interest rate, change in industry conditions, and change in management abilities: Δ(CF)=f[ΔPAYOUT, ΔECON, ΔR, ΔINDUS, ΔMANAB] The payouts on insurance claims are somewhat stable for most life insurance claims for most life insurance companies, relative to payouts on property and casualty (PC) insurance claims for PC insurance companies. A recession will most likely decrease an insurance company's cash flows, while economic growth could enhance cash flows. Assets, such as bonds, are negatively impacted by rising interest rates which could result in a decrease of cash flows for insurance companies. Insurance regulation, technology, and competition can also have a significant impact on an insurance company's cash flows. Finally, management skills are necessary in being able to forecast potential payouts, which could negatively affect cash flows if those skills are lacking.

Finance companies may offer a wide array of services, but they can typically be categorized into one or more of the following types:

a consumer finance company, a business finance company, or a captive finance subsidiary. A consumer finance company: provides financing for retail or wholesale customers. For example, this type of company may provide personal loans directly to customers seeking to make a large purchase, or it may support the store in creating a credit card for customers. Therefore, the scenario concerning cars describes an interaction with a consumer finance company. A business finance company: offers loans to small businesses. For example, if a local business must incur a significant cost for materials needed to produce the final good, they may take out a loan from a business finance company to finance that purchase until the final product is manufactured and sold. Therefore, the scenario concerning windows describes an interaction with a business finance company. A captive finance subsidiary: finances sales or leases of the parent company's products, provides wholesale financing to distributors of the parent company's products, and purchases receivables of the parent company. For example, in the past, automobile manufacturers were unable to finance dealers' inventories so they required immediate cash from each dealer. Since banks at the time viewed cars as a luxury item, they were unwilling to support installment plans offered by dealers. This led to the emergence of a finance subsidiary by automobile manufacturers. Therefore, the scenario concerning motorcycles best represents the existence of a captive finance subsidiary.

Bond insurance

a promise by the bond insurer to guarantee payments to the investor. It protects the investor from default risk.

In the insurance industry

adverse selection occurs when an insurance company insures a high-risk individual and charges an average premium because they are unaware of their higher-than-average risk potential. A moral hazard occurs when an insured takes greater risks after purchasing insurance, knowing that the insurer will cover potential losses.

Financial Services Modernization Act

allowed insurance companies to merge with commercial banks and securities firms, thus giving banks the ability to sell insurance.

defined-contribution plans

based on the accumulated contributions made to the fund while the employee is employed and by the fund's investment performance. With a defined-contribution plan, the employer allocates money to the fund on behalf of the employees each pay period. Employees are also often allowed to make their own contributions to the fund, which are deducted from their paycheck each pay period. This feature allows employees to increase the savings that will be available to them upon their retirement. Thus, Plan B is the defined-contribution plan. the sponsoring firm's main responsibility is its contributions to the fund. Often employees also make their own contributions to the fund, which are deducted from their paycheck each pay period to increase the savings that will be available to them upon their retirement. Employees cannot access money in a defined-contribution plan until retirement unless they are willing to incur a penalty for early withdrawal. Employees can invest in stock mutual funds, bond funds, money market funds, and real estate funds. Employees can designate what proportions of their money should be allocated to particular types of investments. Thus, even if two employees have the same amount of money set aside in their retirement accounts over time, the employee who makes better decisions about how to invest the money in the defined-contribution plan will have a larger account balance at the time of retirement.

Common types of stock mutual funds include

capital appreciation funds, growth and income funds, international and global funds, specialty funds, index funds, and multifund funds. Common types of bond mutual funds include income funds, tax-free funds, high-yield funds, and international and global funds. Hybrid funds such as asset allocation funds and target date funds combine stock and bond investments.

Credit unions have a variety of assets

cash, government securities, agency securities, mortgages, and a variety of loans to its members. The primary focus of most credit unions is its members, so of all of the assets they possess, member loans make up the largest amount.

Finance companies may choose to focus the use of their funds on

consumer or business lending. On the consumer side, finance companies may provide consumers with personal loans for items such as automobiles, or they may offer credit card loans through a retailer. Finance companies also offer real estate loans to consumers in the form of second mortgages on residential real estate. Commercial banks and credit unions remain the main competitors for finance companies in the consumer loan market. On the business side, finance companies provide business loans for a variety of reasons, such as supporting leveraged buyouts or funding the purchase of raw materials until the business generates enough cash for sales of the final good. Finance companies may also directly purchase machinery that a business needs and then lease it to that business so that it can avoid debt on its balance sheet. Additionally, businesses may turn to finance companies for commercial real estate loans.

Life insurance companies invest mostly in

corporate bonds, securities, and stocks. Corporate bonds are a popular asset for life insurance companies because of their low credit risk. The amount of stock investments has increased over the past few years due to an increase in popularity of annuity plans and variable life insurance. Insurance companies invest heavily in Treasury bonds because of their liquidity. They also invest in mortgage loans and earn interest on policy loans to whole life policy holders.

Mutual funds accommodate the financing needs of

corporations, the U.S. Treasury, and municipal governments by purchasing newly issued stocks and bonds in the primary market. They also frequently purchase securities in the secondary market. They enable individual investors to diversify their investments even when they have only a limited amount of funds available.

Finance companies participate in several markets depending on the transaction they are performing

if a finance company needs to issue stock to establish a capital base, this is done in the stock market. However, if they want to trade stock index futures to reduce the sensitivity of their stock portfolio to stock market movements, this is done in the futures markets. increases in expected cash flows have a positive effect on a company's valuation while increases in the required rate of return by investors have a negative effect on a company's valuation.

State agencies are responsible for ensuring that

insurance companies are operating in the best interest of consumers. The regulators oversee agent licensing and ensure that insurance companies are financially stable to cover potential losses of their insureds. They use the risk-based capital to identify insurance companies with high risk exposure and force them to maintain a high level of capital. State guaranty funds are used to pay outstanding claims if an insurance company becomes insolvent. United States-based insurance companies that expand their business internationally are subject to foreign insurance regulations.

Insurance companies face

interest rate risk: They are sensitive to changes in interest rates because they have substantial investments in long-term debt securities. Assets that are sensitive to interest rates may contribute to a decrease in their profitability and a decrease in their ability to pay claims. Credit Risk: Insurance companies are exposed to credit risk. Despite the credit risk that comes with investing in corporate bonds, insurance companies have shifted from investing in Treasury bonds to corporate bonds that have higher yields. Insurance companies invest their premiums heavily in common stock; therefore, they are also exposed to stock market risk. Liquidity risk: is the risk that insurers will not have sufficient resources to pay claims as they occur. Property and casualty insurance companies have more liquidity risk than life insurance companies because of the potential for catastrophic claims. During the credit crisis of 2008, many insurance companies experienced major losses. Many insurers experienced a 50 percent decline in the market value of their asset portfolios. As the credit crisis intensified in 2008, the Federal Reserve and the U.S. Treasury bailed out the largest insurance company in the world, American International Group (AIG). The U.S. government did not bail out the Lehman Brothers because it would have been too costly to taxpayers.

Money market funds (MMFs)

invest in short-term securities, such as commercial paper, repurchase agreements, CDs, and Treasury bills. The expected returns on MMFs are relatively low, but their risk levels are also low.

bridge loan

loan that acts as a temporary source of financing until the borrower is able to gain access to other sources of funding.

Credit unions are nonprofit institutions and, therefore

not subject to taxation. Due to this lack of taxation, credit unions incur lower operating costs than other financial institutions, and as a result, they can offer their members many benefits that other financial institutions cannot. The major benefits are listed in the following: 1.The fees on checking accounts are substantially lower, with many credit unions offering them fee-free. 2.The account minimum balance is substantially lower, oftentimes lower than $100, whereas other financial institutions typically require minimum balances of several hundred dollars. 3.Although the variety and size of loans they offer may not be the same as other financial institutions, their loan interest rates are often lower than others. 4.The interest (or dividends) paid on accounts are typically higher than other financial institutions

Like savings institutions and commercial banks, credit unions can

obtain state-issued or federally issued charters. Credit unions that obtain federally issued charters are regulated by the National Credit Union Association, while credit unions that obtain state-issued charters are regulated by their respective state agency. The respective state agency supervises federal credit union

Mortgage insurance

protects a lender from losses in case the borrower defaults on the loan. The insurance covers the lender's potential financial loss due to foreclosure. If the property sells for less than the remaining mortgage amount, the mortgage insurance will cover the difference. To avoid purchasing mortgage insurance, mortgage lenders typically require borrowers to make a down payment greater than 20 percent of the cost of the home. A credit default swap allows a lender to offset his risk of default with another investor.

value of a securities firm is modeled as

the present value of its future cash flows. As a result, a securities firm's value will fluctuate in response to changes in either expected cash flows of the required rate of return by investors. Factors that cause cash flows to increase will cause the institution's value to increase, while factors that cause investor's required rate of return to decrease will cause the institution's value to increase. Factors affecting expected cash flows — There are four main factors that cause a securities firm's expected cash flows to increase: (1) Factors that result in economic growth (decreasing the reserve requirement, for example) increase an institution's cash flows because the level of firm and consumer incomes increase, which in turn increases the demand for the securities firm's services. (2) Securities firm's cash flows are inversely related to the risk-free rate, so a decrease in the risk-free rate will result in an increase in cash flows. (3) Changes in industry conditions (like regulatory constraints, technology advancements, and changes in competition) have mixed effects on securities firm's cash flows, so it's hard to say what would generally happen to an institution's cash flows as a result of a change in industry conditions. (4) Finally, improvements in management competency will cause cash flows to increase, because a more competent manager will improve on the firm's efficiency and overall performance. Factors affecting the required rate of return — There are two main factors that cause investor's required rate of return to decrease, resulting in an increase in the valuation of a securities firms: (1) A decrease in the risk-free rate, caused by something like an increase in the money supply, places downward pressure on interest rates, reducing investors' required rates of return. (2) A decrease in a securities firm's risk premium boosts investor confidence and reduces the investors' required rate of return.

Finance companies are subject to various levels of regulation by

the state and federal government. The state imposes regulations pertaining to ceiling interest rates and maximum maturity, and it also requires justification from finance companies looking to expand. From the federal standpoint, finance companies have to comply with federal statutes regarding equal credit opportunity, proper disclosure, truth in lending, and the Financial Reform Act of 2010. Therefore, this statement is true.

Hedge funds sell shares to

wealthy individuals and financial institutions and use the proceeds to invest in securities. They are subject to minimal regulation and commonly pursue investments that can achieve high returns but are also exposed to a high degree of risk. Some hedge funds take short positions in stocks of companies that they perceive to be overvalued, based on financial statements that inflate the companies' earnings. In this way, hedge funds serve as a market control over fraudulent financial reporting.

The valuation of an insurance company depends on changes in its expected cash flows, CF, and changes in the required rate of return by investors, k:

Δ(V)=f[ΔE(CF),Δk]

The valuation (V) of a finance company changes in response to changes in its expected cash flows in the future (E(CF)) and to changes in the required rate of return (k):

ΔV = f[ΔE(CF),Δk]

four factors that affect a company's expected cash flows in the future:

•Economic Growth •Risk-Free Interest Rates •Industry Conditions •Management Abilities When an economy experiences an economic slowdown, this increases the rate at which consumers default on their loans, and it also decreases household demand for consumer loans.

Securities firms are the most versatile financial institutions in terms of services provided and their interactions with various financial markets and other financial institutions. The following exhibit outlines the different types of services that securities firms provide to financial market participants:

•Origination of stock and bond offerings — Firms or governments that want to issue stocks or bonds publicly can go to a securities firm for their origination services. The securities firm evaluates their client's current financial condition and makes recommendations about the amount of stocks or bonds that they should issue. •Underwriting of stock and bond offerings — Securities underwriting is the process by which securities firms raise capital from investors on behalf of the corporations or governments that plan to issue debt or equity securities. Often times, securities firms do not guarantee that a certain amount of capital will be raised; however, they do their best to fulfill their client's financial needs. •Distribution of stock and bond offerings — Once the agreements between the issuing firm or government and originating securities firm are finalized, the stocks or bonds must be registered and approved by the SEC. Upon the SEC's approval, the securities can be sold and distributed by the securities firm. •Advising during the origination stage of stock and bond offerings — Immediately after the securities have been issued, many securities firms begin advising their clients on their future financing needs. If the securities are not selling as well as they expected, it's possible another round of financing will be needed to achieve the client's goals. •Private placement of stock and bond offerings — In the case that a firm or government does not want the issuance of their securities to go public but would rather have their securities purchased by one or a few small entities, they can ask a securities firm to privately place the securities. •Securitization of mortgages — Rather than investing in single mortgages, many securities firms engage in the securitization of mortgages, which is the process by which the securities firm takes several individual mortgages, constructs a security out of the mortgages based on their level of risk, hires a rating agency to assign a rating to the new security, and sells it to an institutional investor. This service allows mutual funds, pension funds, and insurance companies to invest in large bundles of mortgages that have been assigned a risk rating, rather than investing in individual mortgages. •Advising corporations on restructuring — Securities firms act as advisors to firms who want to restructure their operations but need guidance on how to do so without hurting the firm financially. Common advisory services are provided for mergers and acquisitions, divestitures, carve-outs, and spinoffs. •Offering financing to corporations — When firms have borrowing restrictions and need financing for major investments, like the acquisition of a competing firm, securities firms have the ability to step in and provide whatever financing is needed by the firm. •Providing brokerage services — The most common activity that a securities firm engages in is executing buy and sell orders for clients. They can provide advisory services if they act as a full-service brokerage firm, but in the instance that they only execute on buying and selling orders, they act as a discount brokerage firm. •Operating mutual funds — Some securities firms operate stock, bond, and money market mutual funds where they may offer a collection of funds to investors who want to move money between different types of funds depending on how they want to invest at a given time. •Proprietary trading — In the event that a securities firm has its own funding it wants to invest, it can engage in proprietary trading, where they take positions on various securities for their own accounts.

There are two factors that affect a company's required rate of return:

•Risk-free interest rate •Risk premium When the risk-free interest rate rises, this causes the required rate of return by investors to increase. Similarly, when the risk premium rises, this is indicative of increased uncertainty about loan repayments, which also causes the required rate of return by investors to increase. Because the required rate of return is negatively correlated to a company's valuation, both of these events would cause the valuation of to decrease. On the other hand, when the risk-free interest rate falls, this causes the required rate of return by investors to decrease. Similarly, when the risk premium falls, this is indicative of strong economic growth, which also causes the required rate of return by investors to decrease. Because the required rate of return is negatively correlated to a company's valuation, both of these events would cause the valuation of to increase.

Savings institutions have two types of classifications:

(1) stock owned and (2) mutual (depositor owned).

Research on pension portfolio performance suggests that managed pension portfolios perform no better than market indexes. During the credit crisis, some pension portfolios performed much worse than benchmark market indexes because their managers invested heavily in risky mortgages and mortgage-backed securities.

A pension fund's performance can be evaluated by comparing it to a passive strategy benchmark representing the same mix of securities. If an actively managed pension fund has a stock portfolio, its risk-adjusted returns could be compared to a benchmark stock index (such as an exchange-traded fund representing the stock index). By the same token, the risk-adjusted returns on the pension fund's actively managed bond portfolio could be compared to a benchmark bond index. This comparison can determine whether the portfolio managers of the pension fund are achieving better performance than if the pension fund used a passive management strategy. Research on pension portfolio performance has found that managed pension portfolios perform no better than market indexes. During the credit crisis, some pension portfolios actually performed much worse than benchmark market indexes because their managers invested heavily in risky mortgages and mortgage-backed securities.

A matched funding method that suggests investing in long-term bonds to fund long-term liabilities and in intermediate bonds to fund intermediate liabilities is more suited for defined-benefit plans.

An informal method of matched funding is to invest in long-term bonds to fund long-term liabilities and in intermediate bonds to fund intermediate liabilities. The appeal of matching is in its assurance that future liabilities are covered regardless of market movements. This method might be especially useful for defined-benefit plans.

What is a projective funding strategy used by pension funds?

Constructing a portfolio that can benefit from expected market and interest rate movements A matched funding strategy is based on investment decisions made with the objective of generating cash flows that match planned outflow payments. A projective funding strategy offers managers more flexibility in constructing a pension portfolio that can benefit from expected market and interest rate movements. Some pension funds segment their portfolios, with a portion being used for matched funding and the rest for projective funding. Note that portfolio managers required to use matched funding would need to avoid callable bonds, because these bonds could potentially be retired before maturity.

Which type of risk are savings institutions most susceptible to? Liquidity risk Interest rate risk Credit risk Exchange rate risk

Credit Risk

How might pension funds be able to prevent corruption? Ensure that their trustees are not subject to potential conflicts of interest. Reduce the fees that the investment companies charge the pension fund for their portfolio management services. Switch their pension plans from defined-benefit to defined-contribution plans. Ensure proper oversight of investment decisions.

Ensure that their trustees are not subject to potential conflicts of interest. Switch their pension plans from defined-benefit to defined-contribution plans. Ensure proper oversight of investment decisions.

Finance companies interact with many other financial institutions

For example, securities firms work with finance companies by underwriting bonds that finance companies issue. On the other hand, commercial banks and savings institutions, credit unions, pension funds, and insurance companies all compete with finance companies or their subsidiaries. More specifically, both commercial banks and savings institutions and credit unions compete with finance companies for consumer loan business. Commercial banks and savings institutions also compete with finance companies for commercial loans and leasing.

Regulation Fair Disclosure (FD)

In the early 2000s, the Securities and Exchange Commission issued Regulation Fair Disclosure (FD), which was created to remove competitive advantages that investors would gain as a result of information leaking. Regulation FD requires firms to disclose any significant information to all market participants, at the same time.

Financial Services Modernization Act

In the late 1990s, the Financial Services Modernization Act was enacted to deregulate the financial industry. It permits financial holdings companies to own commercial banks, securities firms, and insurance companies as subsidiaries. By allowing all of these different types of financial institutions to become major conglomerates, the act essentially made it so that securities firms now competed with commercial banks and other financial institutions.

Which of the following are the characteristics of private pension plans that do not comply with the Employee Retirement Income Security Act (ERISA)? No tax benefits Available only for executive employees Higher levels of retirement benefits across wage levels Higher tax rate upon retirement

No tax benefits Available only for executive employees

Securities firms interact with a variety of financial institutions

Securities firms work with finance companies, mutual funds, and pension funds by underwriting stocks and bonds that finance companies issue. They perform a variety of other services for these institutions, including giving advice on buy and sell actions, executing securities transactions, and giving hedging advice. On the other hand, commercial banks, savings institutions, and insurance companies all compete with securities firms.

Private pension plans are considered "nonqualified" if they do not satisfy the criteria set by ERISA

Some private pension plans may be available only for executive employees so that they do not provide proportionately equal benefits across wage levels. Nonqualified private pension plans do not offer tax benefits. Any income that the employee contributes to the pension plan is taxed first, so the tax deferral benefit is not available.

Corruption

Some trustees of public pension plans are politicians who are campaigning for other political positions. Investment companies may make "contributions" to a trustee's election campaign in the hope of being hired by the trustee as a consultant to manage a portion of the pension funds. Pension funds might be able to prevent corruption if they can ensure that their trustees are not subject to potential conflicts of interest. Corruption is practically impossible with defined-contribution plans, because the plan participants (not the employers) are responsible for deciding how the money is to be invested. Therefore, employers might consider switching their pension plans from defined-benefit to defined-contribution plans to reduce the incidence of corruption. Sometimes trustees of public pension funds are hired for political reasons, which results in mismanagement, and the taxpayers or the pension fund participants may ultimately have to incur the cost of political hiring decisions. Proper oversight could have prevented such risky investments by the pension fund. Such actions as reducing the fees that the investment companies charge the pension fund for their portfolio management services or never issuing debt will not help fight corruption.

cash flow underwriting.

The insurance company charges a lower premium in order to gain more business in a weak market. This pricing strategy is called cash flow underwriting.

Government officials who used pension money for political favors instead of allocating the money toward pension funds have rarely been held accountable for the problems they caused.

They may even have become more popular while they were in office, because they had more money to spend on government services as a result of diverting funds from the government pension fund. That strategy may have provided immediate short-term benefits, with the adverse effects going unnoticed for several years. Holding government officials accountable for causing pensions to be underfunded is rather difficult because determining the amount of underfunding is not an exact science and public pension funds might be able to use creative accounting that would understate the degree of underfunding.

Insurance Regulatory Information System (IRIS)

a mechanism that state insurance departments use to determine the financial status of insurers.

Pension fund managers frequently conduct transactions in the

bond market. Generally, defined-contribution plans maintain a higher concentration of stocks than do defined-benefit plans, whereas portfolios of defined-benefit plans usually have a higher concentration of bonds than do defined-contribution plans.

savings institutions can hedge against interest rate risk

by selling interest rate futures contracts. An interest rate futures contract is an agreement whereby the buyer of the contract is agreeing to purchase an interest-bearing asset at a specific date and time, and the seller of the contract is agreeing to sell the interest-bearing asset to them at that specific date and time. Savings institutions can use a variety of interest-bearing assets for these contracts but often choose Treasury bonds, because their cash flow characteristics are similar to the cash flow characteristics of fixed-rate mortgages. As interest rates increase, value of the Treasury bonds will decrease (because bond values and interest rates are inversely related).

The degree of risk assumed by pension fund managers may be influenced by

by their compensation incentives. Some pension fund managers are rewarded if the portfolio performs very well but are not penalized if the portfolio performs poorly. Under these conditions, the portfolio managers have an incentive to take more risk than is appropriate.

Private pension portfolios are dominated by

common stock. By contrast, public pension portfolios are somewhat evenly invested in corporate bonds, stock, and other credit instruments, although the specific allocation can vary substantially among pension funds.

Property and casualty insurance

covers personal and professional liability losses, as well as property losses, due to fire, theft, and other events.

corruption such as bribes of trustees, unwarranted benefit payments, and lack of proper oversight by trustees are unlikely with

defined-contribution pension plans, because the plan participants are responsible for investing the money in the pension fund. However, such corruption is possible with defined-benefit plans, because the employer is responsible for deciding how the money is to be invested.

Securities firms participate in several markets

depending on the activity they are performing for themselves, or their customers. if a securities firm is attempting to hedge their interest rate risk by engaging in interest rate swaps, this is done in the swap market. if a securities firm is asked by a customer to underwrite commercial paper, this is done in the money market.

prospectus

document that discloses a firm's financial data and describes provisions applicable to the security that the firm plans to issue.

Private pension plans

governed by federal regulations and must comply with the Internal Revenue Service tax rules that apply to pension fund income. The rules for vesting in private pension plans were established by the Employee Retirement Income Security Act (ERISA) of 1974 (also called the Pension Reform Act) and its 1989 revisions. The ERISA provisions address transferability, tax benefits, and insurance of private pension plans. When employees change jobs, they are allowed to transfer any vested amount into the private pension plan of their new employer or to invest it in an individual retirement account (IRA) with taxes still deferred until retirement. Qualified private pension plans that satisfy the criteria set by ERISA offer tax benefits to employees that are proportionately equal across wage levels so that employees earning lower wages receive equal treatment. The Pension Benefit Guaranty Corporation (PBGC), a federally chartered agency, guarantees that participants in private defined-benefit pension plans will receive their full benefits upon retirement. If the private pension fund fails to provide the benefits promised, the PBGC will make up at least part of the difference.

managed care plan

healthcare services are only covered by providers in the plan's network. Cho participates in a managed care plan.

valuation and performance of stock mutual funds

highly influenced by stock market conditions, the prevailing conditions of the sectors in which the mutual fund invests, and the management abilities of their portfolio managers. The valuation and performance of bond mutual funds are relatively strong in periods when interest rates decline and when the credit risk premium on bonds declines.

insurance regulatory system is designed to

identify financial issues of an insurance company and propose solutions for recovery. They assess several characteristics, including the ability of the insurer to withstand unexpected or excessive claims, their ability to withstand a market decline that negatively impacts their investments, the insurer's return on investment, their operational efficiency and the liquidity of their current assets.

primary use of credit union funds is for

loans to their members for various expenses, including purchasing a new car, making improvements to their homes, credit cards, and other personal expenses. Because credit unions have limited funds (due to their small size) and are so focused on loans to its members, it's important for them to have liquid assets, rather than having their funds tied up in long-term investments, like mortgages. As a result, some credit unions make long-term investments, but the majority provide short-term loans and purchase government and agency securities to maintain adequate liquidity.

The stock portfolio's performance is usually closely related to

market conditions, performing well during the periods when market conditions were strong and performing poorly during the crisis. Also, within a given time period, stock portfolio performance varies among pension funds because of differences in the fund's management abilities. The competence and experience of the managers affects composition of the stocks in a pension fund's portfolio, as well as its operating efficiency. Thus, the change in the value of a pension fund's portfolio focusing on stocks can be modeled as Δ V=f(ΔMKT, ΔMANAB)

Credit unions

member-owned nonprofit financial institutions whose members share an affiliation like a residential area, employer, etc. Because their members share an affiliation, it often limits the number of depositors the institutions have. As a result, credit unions tend to be much smaller than commercial banks, and their total assets amount to less than 10 percent of the assets held by commercial banks. Although credit unions are much smaller than commercial banks, there are approximately 5,800 that operate in the United States, which is about 800 more than the number of commercial banks in the U.S. one of the smallest financial institutions in the United States. While many other institutions have assets in the hundreds of millions, approximately 40 percent (or 2,300) of credit unions have assets amounting to less than $20 million

Some pension funds are underfunded for

political reasons as governments may not set aside sufficient funding for their pension plans because they prefer to use the funds for other purposes. In the long run, this results in underfunding that will ultimately have to be corrected by either higher state taxes, reduced government employee pensions, or reduced spending on education or other services.

defined-benefit plan

requires the employer to set aside a specific amount of the benefits to be received by employees in the future. A defined-benefit plan uses a formula to determine how much the employer will provide to employees upon retirement based on their salary level and their number of years of full-time service. The specific formula varies among employers. The retirement income will be provided by the pension fund as long as the retiree is living. Thus, Plan A is the defined-benefit pension plan. Under defined-benefit plans, the amount of funds that should be set aside to cover an employee's retirement benefits is uncertain because the amount of the monthly pension payments that will be provided to an employee upon retirement is commonly influenced by the employee's maximum salary level, which is not known until the time of retirement, as well as the employee's retirement age and life expectancy, which also are not known while the employee is working. Technically, the obligations to the retirees covered by defined-benefit plans are not affected by weak market conditions because the employers are still obligated to cover the payouts to retirees. However, to fulfill the obligations, the employers will have to contribute additional cash to their defined-benefit plans to make up for the poor investment performance. It has been revealed in recent years that some public defined-benefit pension plans might not be able to cover their obligations to participating employees, because those plans have not set aside sufficient funds or have made poor investment decisions with those funds.

Closed-end funds

similar to mutual funds, except that they are closed to new investors and to redemptions and their shares are traded on a stock exchange. Exchange-traded funds (ETFs) are designed to mimic particular stock indexes and are traded on a stock exchange. Venture capital (VC) funds use money that they receive from wealthy individuals and some institutional investors to invest in young, growing firms that need equity funding but are not ready or willing to go public. Private equity funds pool money provided by individual and institutional investors and buy majority (or entire) stakes in businesses. Real estate investment trusts (REITs) are closed-end funds that invest in real estate or mortgages.

The value of a savings institution is modeled as

the present value of its future cash flows. As a result, a savings institution's value will fluctuate in response to changes in either expected cash flows of the required rate of return by investors. Factors that cause cash flows to increase will cause the institution's value to increase, while factors that cause investors' required rate of return to decrease will cause the institution's value to increase. Factors affecting expected cash flows — There are four main factors that cause a savings institution's expected cash flows to increase: (1) Factors that result in economic growth (decreasing the reserve requirement, for example) increase an institution's cash flows by increasing demand for consumer loans, commercial loans, residential mortgage loans, and commercial mortgage loans; (2) savings institutions' cash flows are inversely related to the risk-free rate, so a decrease in the risk-free rate will result in an increase in cash flows; (3) changes in industry conditions (like regulatory constraints, technology advancements, and changes in competition) have mixed effects on savings institutions' cash flows, so it's hard to say what would generally happen to an institution's cash flows as a result of a change in industry conditions; and (4) improvements in management competency will cause cash flows to increase, because a more competent manager will improve on the firm's efficiency and overall performance. Factors affecting the required rate of return — There are two main factors that cause investors' required rate of return to decrease, resulting in an increase in the valuation of a savings institution: (1) A decrease in the risk-free rate, caused by something like an increase in the money supply that places downward pressure on interest rates, reduces investors' required rates of return, and (2) a decrease in a savings institution's risk premium boosts investor confidence and reduces the investors' required rate of return.

Asset stripping

the process that occurs after a firm targeted for a merger is acquired and some of its resources are divested.

indemnity plan

usually allows an insured to visit any healthcare provider they choose.

spin-off

when a firm creates a new subsidiary and subsequently distributes shares of stock to existing shareholders.

A passive investment strategy has the following benefits:

•Avoidance of excessively risky investments •Avoidance of the large fees that pension funds commonly pay to investment companies hired to manage their money •Consistent alignment with the board's recommended long-term allocation across investments •No diversion of money to alternative investments triggered by corrupted trustees who oversee the pension fund •The transparency of the investment strategy, which benefits participants in the plan who rely on the pension for their retirement benefits

Finance companies are exposed to three types of risk:

•Liquidity risk: Because financial companies typically receive most of their funds from borrowings rather than deposits, they have much less liquidity risk compared to other financial institutions. However, if they decided to increase funds by drawing in more deposits, then they would be taking on more liquidity risk due to potential unexpected deposit withdrawals. •Interest rate risk: Finance companies can reduce their interest rate risk by shortening their average asset life or making greater use of adjustable rates. On the other hand, extending the terms of a loan or switching to fixed rates would tend to increase interest rate risk because the company would not be able to easily adjust to changing interest rates. •Credit risk: Finance companies are most concerned with credit risk particularly because the loan delinquency rate of finance companies is often higher than that of other lending financial institutions. Without charging a higher-than-average rate on their loans, finance companies would be more at risk. Moreover, even though many finance companies provide subprime auto loans, their credit risk can remain low because consumers need their car to get to work so their auto loan is often the first debt payment they will make.

Although the day-to-day investment decisions of the trust department are controlled by the managing institution, the corporation owning the pension fund usually specifies general guidelines that the institution should follow. These guidelines might include:

•The percentage of the portfolio that should be used for stocks or bonds •A desired minimum rate of return on the overall portfolio •The maximum amount to be invested in real estate •The minimum acceptable quality ratings for bonds •The maximum amount to be invested in any one industry •The average maturity of bonds held in the portfolio •The maximum amount to be invested in options •The minimum size of companies in which to invest

Securities firms are exposed to five types of risk:

•Market risk: Because many of the services securities firms offer are tied to stock market conditions, a securities firm's cash flows are directly related to the current stock market conditions. To hedge against this risk, securities firms can diversify the services they provide by beginning to offer services that are not as closely linked to the stock market. For example, they could begin to offer services like identifying and valuing merger targets, protecting companies against hostile takeovers, and facilitating the restructuring of firms. •Interest rate risk: Low interest rates can encourage financial market participants to issue more bonds, which leads to more demand for securities firms' underwriting services. Additionally, bond values are inversely related to interest rates, so the value of bonds in securities firms' portfolios is directly impacted by interest rate fluctuations. •Credit risk: Securities firms that invest in securities that are dependent on the ability of another party to meet their debt obligations incur credit risk. They can hedge against credit risk by selling off debt securities like mortgages, commercial paper, and low-rated corporate bonds. •Exchange rate risk: Because securities firms can operate outside of the United States, the earnings remitted by their foreign subsidiaries are impacted by the fluctuating exchange rates. As a result, to reduce this type of risk, securities firms can reduce the amount of exchange rate risk they incur by reducing their global presence. •Counterparty risk: Securities firms typically act as intermediaries in financial market transactions, but there are instances when they also act as the counterparty on a transaction for their clients. Counterparty risk occurs because there is a chance that the client fails to meet their financial obligations, resulting in significant losses for the securities firm. To reduce this form of risk, securities firms can take less of a counterparty role and more of an intermediary role when it comes to financial transactions.