FIN Ch. 5 Q&A
In 2005, prior to the financial crisis, Timothy Geithner, then president of the Federal Reserve Bank of New York, thought that hedge fund leverage was rising, "probably because of heightened competitive pressure." Why might competitive pressure lead a hedge fund manager to take on more leverage? Would the same reasoning apply to managers of an investment bank? Briefly explain.
Hedge funds compete for investor funding by offering higher rates of return than alternative investments. If a hedge fund manager sees that other hedge funds are earning higher rates of return because of the leverage they employ, the manager may feel the need to increase the leverage at his or her fund to compete. The same reasoning applies to investment banks and their proprietary trading.
What incentives would the partners in an investment bank have to turn it into a public corporation? If becoming a public corporation increases the risk in investment banking, how do publicly traded investment banks succeed in selling stock to investors?
If an investment bank went public, it would have more access to capital because it could sell stock to the public and not have to rely entirely on the funds contributed by the firm's partners. Going public also reduces the risk involved to the top executives, as it is not solely their money that is being invested. Although investment banks may take on more risk than commercial banks or most other financial firms, they also may deliver higher returns. Investors who find this trade-off between risk and return to be ttractive will buy the investment banks' stock.
In a discussion of the financial crisis, the problems affecting Merrill Lynch investment bank were described as: "too much leverage, too much relying on short-term borrowing, and assets, especially real estate, of dubious value." Why might too much leverage be a problem for an investment bank? Why might relying too much on short-term borrowing be a problem?
Leverage magnifies profit, but it also magnifies loss. Relying too much on short-term borrowing creates a large mismatch between the maturity of assets (loans) and the maturity of liabilities, and when lenders become concerned about the quality of an investment bank's assets, they stop rolling-over their short-term loans to the bank. Without access to short-term borrowing, an investment bank may be forced to raise funds by selling assets, possibly at low prices. Falling asset values can force the bank into insolvency.
Why have runs on commercial banks become rare while multiple shadow banking firms experienced runs during the financial crisis?
A run on a financial firm is the attempt by investors to get their money out before the firm fails. Commercial banks do not typically have bank runs because their deposits are insured by the Federal Deposit Insurance Corporation (FDIC) which reduces the risk to depositors. The shadow banking industry, however, is not covered by the FDIC because their short-term borrowing is not in the form of deposits.
In what ways are contractual savings institutions similar to commercial banks? In what ways are they different?
Contractual savings institutions are similar to commercial banks because like all financial intermediaries, they raise funds and invest them in loans and securities. Unlike commercial banks, however, contractual savings institutions do not raise funds through deposits but rather, receive payments from individuals as a result of a contract. They also have access to a wider range of assets than commercial banks.
How are banks able to attract small savers if small savers can usually receive a higher interest rate from money market mutual funds than from bank savings accounts?
Deposits in bank savings accounts are covered by federal deposit insurance whereas money market mutual fund shares are not. Also, money market mutual funds restrict savers to writing checks only above a specified amount, such as $500 (Money market savings aren't as liquid as bank deposits.)
In what ways are insurance companies financial intermediaries?
Insurance companies are financial intermediaries in that they obtain funds by charging premiums to policyholders and then use these funds to make investments.
Suppose that insurance companies in Ohio are reluctant to offer fire insurance to firms in low-income neighborhoods because of the prevalence of arson fires in those neighborhoods. Suppose that the Ohio state legislature passes a law stating that insurance companies must offer fire insurance to every business in the state and may not consider the prevalence of arson fires when setting insurance premiums. What will be the likely effect on the market for fire insurance in Ohio?
Insurance companies are likely to respond to the law by raising premiums for everyone, although doing this will increase adverse selection problems. Businesses in areas with high rates of arson will still be willing to pay the higher premiums because the probability of them filing claims is high. Some businesses in safer areas, though, are like to drop their fire insurance following the premium increase. As a result, the pool of insured businesses will include a higher percentage of businesses likely to make claims. This could result in insurance companies raising rates even higher which will further exacerbate adverse selection problems. Eventually, some insurance companies are likely to stop offering fire insurance policies in the state and it is possible that ultimately fire insurance policies may no longer be available by private insurers. (Think about what happened to hurricane insurance in Florida a few years ago after a severe hurricane season followed by the Florida legislature denying insurance companies the rate increases they requested.)
What are the key differences between investment banks and commercial banks?
Investment banking involves, among other activities, underwriting new security issues and providing advice on mergers and acquisitions, whereas commercial banking primarily involves taking deposits and making loans.
An article in the Economist magazine says about investment banks: "By unlocking the capital markets and helping firms to manage risks, investment banks are important conduits of credit." How do investment banks 'unlock capital markets'? How do investment banks help firms to manage risk? How do these activities make investment conduits of credit?
Investment banks 'unlock capital markets' by knowing the ins and outs of financial markets and knowing the current willingness of investors to buy different types of securities as well as the price investors are likely to require. Investment banks use this knowledge to help firms raise funds through stock and bond issues. Investment banks help firms use derivative contracts and design new securities to help corporations manage risk. Investment banks are conduits of credit for all of the above mentioned reasons. In this role, they help match savers and borrowers and decrease the risk of borrowing and lending.
In what ways are investment institutions similar to commercial banks? In what ways are they different?
Investment institutions are similar to commercial banks because they are financial intermediaries that raise funds and invest them in loans and securities. Unlike commercial banks, investment institutions do not raise funds through deposits and they have access to a wider variety of investment assets than commercial banks.
During the 2000s, why did investment banks become more reliant on repo financing and also, more highly leveraged? In your answer, be sure to define repo financing and leverage.
Repo financing is a way of borrowing funds through the use of repurchase agreements. A repurchase agreement is the selling of securities under the condition that the seller is to buy back the securities at a slightly higher price within a short period of time (typically, the next day or within a few days.) Repos are short-term loans with the securities serving as collateral. Leverage is the financing of investments by borrowing rather than using capital. Investment banks became more reliant on repo financing and more highly leveraged because by the 1990s most of these banks had converted from partnerships to publicly traded companies. As proprietary trading became a more important source of profits, investment banks increasingly borrowed to finance investments in securities and direct loans to firms.
What became of the large, standalone investment banks during the financial crisis of 2007-2009?
The large stand-alone investment banks either went bankrupt, were taken over, or converted to bank holding companies to obtain access to Federal Reserve lending to survive the financial meltdown.
Many investment banks practice an 'up or out' policy. New hires are either fired or promoted within a few years. Many large law firms and accounting firms use a similar policy, as do colleges, with respect to their tenure-track faculty. Most firms, however, do not use this policy. In a typical firm, after a probationary period, most employees continue to work for the firm, indefinitely, with no set time before they are considered for promotion. What are the advantages and disadvantages to employees? If there are no advantages to employees, how are investment banks able to find people willing to work for them?
The advantage of the 'up or out' policy to investment banks and other firms is that workers have an incentive to work very hard during their first years with the firm to demonstrate that they are worthy of being promoted. A disadvantage is that risk averse people may not apply for jobs at investment banks or other firms using the up or out policy do to fear of being fired after just a few years. Some people who don't apply may actually be more productive than some people who end up being promoted at these firms. People are willing to work for these firms if they believe that they can quickly demonstrate their high productivity, earn a promotion, and have a secure job. To attract new hires, many 'up and out' firms offer an above-average starting salary.
In 2009, Congress and the president set up a commission to investigate the causes of the financial crisis. At a hearing of the commission in 2010, Robert Rubin, who had served in top management at Goldman Sachs, had been secretary of the Treasury in the Clinton administration, and had served on the board of directors at Citigroup during the crisis, testified that "all of us in the financial industry failed to see the potential for this serious crisis." Why might the financial crisis have been hard to foresee, even by people working in high-level positions in the financial system? Were there changes in the financial system that, with hindsight, might have indicated that by 2007 a financial crisis had become more likely? Briefly explain.
The financial crisis may have been difficult to foresee because of the complexity of some of the financial securities that been introduced over the previous decade and because of how quickly the financial markets have changed. Some people saw the potential for a financial crisis because of the increased use of unregulated credit derivatives and because of the growth in the unregulated shadow banking system where financial leverage was high and no FDIC insurance existed.
During the financial crisis, the U.S. Treasury implemented a program which insured investors against losses on their existing money market mutual fund shares. (The program expired in September 2009.) In explaining the program, a Treasury statement said: "Maintaining confidence in the money market mutual fund industry was critical to protecting the integrity and stability of the global financial system." Why is the money market mutual fund industry so important? If money market mutual funds have problems, can't savers just deposit their money in banks?
The money market mutual fund industry is important because these institutions hold so much short-term debt. In particular, money market mutual funds buy large amounts of commercial paper, which many firms rely on to meet payroll and other operating costs. Problems with money market mutual funds would sharply reduce firms' access to this source of funding. People can deposit money in banks rather than buying money market mutual shares, but they will receive a lower return on their funds. If a rise in deposits resulted in significantly decreasing the amount of investment into money market mutual funds, the ability of firms to borrow through the commercial paper market would be greatly reduced.
In what ways does the shadow banking system differ from the commercial banking system?
The shadow banking system is a collection of nonbank financial institutions that channel money from savers to borrowers. Shadow banking firms are less regulated than commercial banks and so can invest in more risky assets and become more highly leveraged than commercial banks. Unlike commercial banks, there is no federal deposit insurance for the investors who provide funds to the shadow banking system.
A journalist described what happened with the Reserve Primary Fund, a money market mutual fund, on September 16, 2008: At 4:15p.m., the fund issued a press release. The Lehman paper in its portfolio was worthless and the fund's shares were worth not $1, but only 97 cents: breaking the buck. The news triggered a run that spread through the $3.4 trillion money market mutual fund industry. a. What is 'Lehman paper'? Why was the Lehman paper in the fund's portfolio worthless? b. What does 'breaking the buck' mean? Why was it significant to the financial system? c. What is a 'run' and what is 'contagion'? Why would one money market mutual fund having broken the buck cause a run on other money market mutual funds?
a. 'Lehman paper' is commercial paper that Lehman Brothers had issued to raise funds. The Lehman paper was worthless because Lehman Brothers had gone bankrupt. b. 'Breaking the buck' means that the net asset value of the money market fund had fallen below $1 to $0.97. As a result, investors in the mutual fund would take a capital loss of 3% when they redeemed their shares. 'Breaking the buck' was significant because it was highly unusual for a money market mutual fund to allow the price of its shares to drop below $1. Investors in money market mutual funds were willing to accept the relatively low interest rates these funds offered relative to some other investments only if they were sure that they would not suffer a capital loss from a decline in the value of the shares. 'Breaking the buck' badly hurt investor faith in money markets and reminded them that their higher return had come at the acceptance of higher risk. c. A run is a rush to withdraw money before everyone else does. One money market mutual fund breaking the buck signaled that other money market mutual funds might also do so. Investors became worried about the value of the assets in their money market mutual funds and whether they would be able to redeem their shares at the usual value of $1 per share. Given the low interest rates paid on money market mutual fund shares, investors were not willing to risk capital losses on their investments. The fear generated by the 'breaking of the buck' by one money market mutual fund spread to the whole industry. This is 'contagion'.
A Yale University professor has compared repurchase agreements used by shadow banks to bank deposits in commercial banks. He notes: "If the depositors become concerned that their deposits are not safe, they can withdraw from the bank by not renewing their repo." a. In what way is a repurchase agreement like a bank deposit? b. What would be the consequences for a shadow bank if "depositors" failed to renew their repos?
a. A repurchase agreement is a short-term loan that pays a small amount of interest. In this sense, repos are equivalent to you "lending" funds to your bank by depositing them in your checking account in return for a small interest payment. b. If "depositors" (lenders) refuse to renew their repos, it is the equivalent of depositors making a withdrawal from a commercial bank. The shadow bank would need to pay off the loans of the lenders who did not renew their lending through repos. Given that the shadow banks typically invested the borrowed funds in longer-term assets, they would have to sell some of these long-term assets to pay off the loans. If the longer-term assets lost value, as mortgage-backed securities did during the financial crisis, then the shadow banks could be in serious financial trouble. NOTE: Although repurchase agreements can be compared to deposits in that they are both short-term loans, deposits are backed by the FDIC and so are very unlikely to cause a run on a commercial bank, whereas, repurchase agreements are not backed by FDIC and a far more likely (and did) contribute to a run on parts of the shadow banking industry (Lehman Brothers).
In March 2008, the U.S. Treasury and the Fed arranged for the sale of the Bear Stearns investment bank to JPMorgan Chase to prevent Bear Stearns from having to declare bankruptcy. A columnist for the New York Times said: It was an old-fashioned bank run that forced Bear Stearns to turn to the federal government for salvation. The difference is that Bear Stearns is not a commercial bank, and therefore, is not eligible for the protections of those banks 75 years ago when Franklin D. Roosevelt halted bank runs with government guarantees. a. How can an investment bank be subject to a run? b. What 'government guarantees' did commercial banks receive 75 years ago? c. How did these government guarantees halt commercial bank runs?
a. An investment bank can be subject to a run when investors do not renew their repurchase agreements, do not purchase the investment bank's commercial paper, or other counterparties want to cash investments out. b. Government guarantees refer primarily to federal deposit insurance through the FDIC. c. The creation of the FDIC eliminated the incentive for depositors to run on the bank because their money was insured if the bank failed.
Referring to the collapse of the Long-Term Capital Management hedge fund in 1998, a New York Times article stated: Starting with just $5 billion in capital, the fund was able to get $125 billion in additional funds. Using that leverage, it took on trading positions with an estimated potential value of $1.25 trillion. a. What is leverage? What information from this excerpt indicates that Long-Term Capital Management was highly leveraged? b. What risks did Long-Term Capital Management's high leverage pose to the firm? What risks did it pose to the financial system?
a. Leverage involves using borrowed funds to invest rather than using capital or equity to invest. The excerpt indicates that the Long-Term Capital Management hedge fund used $5 billion in capital to get an additional $125 billion in funds. The $125 billion in funds were then used to control $1.25 trillion in securities. So, Long-Term Capital Management was highly leveraged because it used relatively little capital and a great amount of borrowing to control investments that were many times larger. b. Leverage is a double-edged sword. It can increase profits, but it also magnifies losses. These losses were so massive that they created systemic risk to the rest of the system. If Long-Term Capital Management had defaulted on its loans, many other financial firms would have taken large losses as well.
In an Oct. 2012 speech, a Federal Reserve Governor made the following observation: "Money market funds remain a major part of the shadow banking system and a key potential systemic risk even in the post-crisis financial environment." He went on to say that he did not believe that existing regulations "are sufficient to mitigate the run potential in money market funds." a. What is 'systemic risk'? b. What is the 'run potential' in money market mutual funds? How is this 'run potential' related to systemic risk in the financial system?
a. Systemic risk is the risk to the entire financial system rather than to individual firms or investors. b. The 'run potential' in money market mutual funds refers to the possibility that real or perceived bad news about the quality of money market mutual fund assets could cause investors to redeem their shares and trigger runs on other money market mutual funds, shutting down the commercial paper market. Shutting down the commercial paper market would cause problems for many financial and nonfinancial firms that raise funds by issuing commercial paper. The run potential in money market mutual funds generates a risk throughout the financial system. A run can easily become a contagion.
British investment banker Siegmund Warburg believed: Investment banking should not be about gambling, but about financial intermediation built on client relationships, not speculative trading. Warburg was always uneasy about profits made from investing the firm's own capital, preferring income from advising and underwriting fees. a. What is underwriting? In what sense is an investment bank that engages in underwriting acting as a financial intermediary? b. Is an investment bank that buys securities with its own capital acting as a financial intermediary? Briefly explain.
a. Underwriting is where investment banks guarantee (typically) a price to the issuing firm for new stocks or bonds and then sell the new issue at a higher price in financial markets or directly to investors (private placement.) Underwriting is financial intermediation because the bank brings together savers and the firms who issue new securities. b. An investment bank that buys securities with its own capital is not acting as a financial intermediary. It is buying securities with the expectation of profit from the yield or from changes in the prices of the securities. Investing in this way does not involve acting as an intermediary by funneling funds from savers to borrowers.
