Financial institutions management (6th edition) part 2

Find more at http://www.downloadslide.com Chapter Thirteen Off-Balance-Sheet Risk INTRODUCTION contingent assets and liabilities Assets and liabilities off the balance sheet that potentially can produce positive or negative future cash flows for an FI One of the most important choices facing an FI manager is the relative scale of an FI’s on- and off-balance-sheet (OBS) activities Most of us are aware of on-balancesheet activities because they appear on an FI’s published asset and liability balance sheets For example, an FI’s deposits and holdings of bonds and loans are on-balance-sheet activities By comparison, off-balance-sheet activities are less obvious and often are invisible to all but the best-informed investor or regulator In accounting terms, off-balance-sheet items usually appear “below the bottom line,” frequently just as footnotes to financial statements In economic terms, however, off-balance-sheet items are contingent assets and liabilities that affect the future, rather than the current, shape of an FI’s balance sheet As such, they have a direct impact on the FI’s future profitability and performance Consequently, efficient management of these OBS items is central to controlling overall risk exposure in a modern FI From a valuation perspective, OBS assets and liabilities have the potential to produce positive or negative future cash flows Fees from OBS activities provide a key source of noninterest income for many FIs, especially the largest and most creditworthy ones.1 For example, in just the first half of 2006, derivative securities trading revenues earned by commercial banks topped $10.9 billion, up 1,795 percent from $3.9 billion in the first six months of 1996 Further, FIs use some OBS activities (especially forwards, futures, options, and swaps) to reduce or manage their interest rate risk (see Chapters and 9), foreign exchange risk (see Chapter 14), and credit risk (see Chapters 11 and 12) exposures in a manner superior to what would exist without these activities However, OBS activities can involve risks that add to an FI’s overall risk exposure As a result, the true value of an FI’s capital or net worth is not simply the difference between the market value of assets and liabilities on its balance sheet today, but also reflects the difference between the current market value of its off-balance-sheet or contingent assets and liabilities This fee income can have both direct (e.g., a fee from the sale of a letter of credit) and indirect (through improved customer relationships) effects that have a positive income impact in other product areas In cases where customers feel aggrieved with respect to derivatives purchased from a dealer FI, off-balancesheet activities can have important negative reputational effects that have an adverse impact on the future flow of fees and other income 372 sau05140_ch13_372-399.indd 372 8/6/07 5:27:25 PM Find more at http://www.downloadslide.com Ethical Dilemmas IN FOCUS: SEC PROPOSAL COULD CLOUD OFF-BALANCE-SHEET PICTURE The SEC on Wednesday proposed to toughen its rules for disclosing off-balance-sheet items by all public companies Though others have offered more sweeping reforms— such as a Financial Accounting Standards Board plan that would restrict the use of off-the-books partnerships—experts said the SEC plan threatens to complicate the operation of special-purpose entities and similar arrangements popular with banks “Banks that have standby letters of credit, swap agreements, reverse-repurchase agreements, and hedging devices will have to assess the disclosure requirements carefully,” said V Gerard Comizio, a partner in the corporate and financial institutions practice at Thacher, Proffitt & Wood The corporate accounting scandals of the last year have put a sometimes unflattering spotlight on banks’ and other public companies’ use of off-the-books entities For example, lawmakers and news reports have asked whether Citigroup Inc and J P Morgan Chase & Co used special-purpose entities to help Enron disguise its debt In response to those concerns, the Sarbanes-Oxley Act directed the SEC to come up with disclosure requirements for off-balance-sheet arrangements that “may” be of material concern to the markets Under the SEC’s proposal, companies would disclose any transactions meeting the materiality standard in the management’s discussion and analysis section of public filings They would also describe the nature of the arrangements, aggregate contractual obligations in a table, and provide an overview of contingent liabilities and commitments Those steps, the SEC said, would give a “total picture in a single location” of off-balance-sheet exposure Though securities rules already require issuers to disclose off-balance-sheet arrangements that are “reasonably likely” to be material, the agency interpreted SarbanesOxley as dictating a stricter standard It plans to have the standard be transactions that have a “more than remote” chance of being material Source: Todd Davenport, The American Banker, November 4, 2002, p www.americanbanker.com This chapter examines the various OBS activities (listed in Table 13–1) of FIs We first discuss the effect of OBS activities on an FI’s risk exposure, return performance, and solvency We then describe the different types of OBS activities and the risks associated with each Because OBS activities create solvency risk exposure, regulators impose capital requirements on these activities These capital requirements are described in Chapter 20 While the discussion emphasizes that these activities may add to an FI’s riskiness, the chapter concludes with a discussion of the role of OBS activities in reducing the risk of an FI OFF-BALANACE-SHEET ACTIVITIES AND FI SOLVENCY off-balance-sheet asset An item or activity that, when a contingent event occurs, moves onto the asset side of the balance sheet An item or activity is an off-balance-sheet asset if, when a contingent event occurs, the item or activity moves onto the asset side of the balance sheet Conversely, an item or activity is an OBS liability if, when the contingent event occurs, the item or activity moves onto the liability side of the balance sheet For example, as we discuss in more detail later, FIs sell various performance guarantees, especially guarantees that their customers will not default on their financial and other obligations Examples of such guarantees include letters of credit and standby letters of credit Should a customer default occur, the FI’s contingent 373 sau05140_ch13_372-399.indd 373 8/6/07 5:27:27 PM Find more at http://www.downloadslide.com 374 Part Two Measuring Risk TABLE 13–1 Major Types of Off-Balance-Sheet Activities Schedule L Activities* Loan commitment Contractual commitment to make a loan up to a stated amount at a given interest rate in the future Letters of credit Contingent guarantees sold by an FI to underwrite the performance of the buyer of the guaranty Derivative contract Agreement between two parties to exchange a standard quantity of an asset at a predetermined price at a specified date in the future When-issued trading Trading in securities prior to their actual issue Loans sold Loans originated by an FI and then sold to other investors that (in some cases) can be returned to the originating institution in the future if the credit quality of the loans deteriorates Non–Schedule L Activities* Settlement risk Intraday credit risk, such as that associated with CHIPS wire transfer activities Affiliate risk Risk imposed on one holding company affiliate as a result of the potential failure of the other holding company affiliates *As discussed later in the chapter, Schedule L activities are those that banks have to report to the Federal Reserve as part of their quarterly Call Reports Non–Schedule L activities are those not subject to this requirement off-balance-sheet liability An item or activity that, when a contingent event occurs, moves onto the liability side of the balance sheet delta of an option The change in the value of an option for a unit change in the price of the underlying security sau05140_ch13_372-399.indd 374 liability (its guaranty) becomes an actual liability and it moves onto the liability side of the balance sheet Indeed, FI managers and regulators are just beginning to recognize and measure the risk of OBS activities and their impact on the FI’s value While some part of OBS risk is related to interest rate risk, credit risk, and other risks, these items also introduce unique risks that must be managed by FIs Indeed, the failure of the U.K investment bank Barings, the legal problems of Bankers Trust (relating to swap deals involving Procter & Gamble and Gibson Greeting Cards), the $2.6 billion loss incurred by Sumitomo Corp (of Japan) from commodity futures trading, and the $1.5 billion in losses and eventual bankruptcy of Orange County in California have all been linked to FI off-balance-sheet activities in derivatives For example, in May 1998 Credit Suisse First Boston paid $52 million to Orange County to settle a lawsuit alleging that it had been in part responsible for that county’s investments in risky securities and derivatives transactions Twenty other banks and securities firms have been similarly sued The Ethical Dilemmas box discusses how, more recently, questionable off-balance-sheet transactions between Citigroup, J P Morgan Chase, and Enron (in addition to other questionable accounting practices by many other firms) resulted in regulatory changes in 2002 regarding how off-balance-sheet activities are recorded by all public companies Table 13–2 lists some other big losses for FIs from trading in derivatives (Derivative securities [futures, forwards, options, and swaps] are examined in detail in Chapters 23 through 25 and defined in Table 13–3.) Since off-balance-sheet items are contingent assets and liabilities and move onto the balance sheet with a probability less than 1, their valuation is difficult and often highly complex Because many off-balance-sheet items involve option features, the most common methodology has been to apply contingent claims/option pricing theory models of finance For example, one relatively simple way to estimate the value of an OBS position in options is by calculating the delta of an option—the 8/6/07 5:27:27 PM Find more at http://www.downloadslide.com Chapter 13 TABLE 13–2 Off-Balance-Sheet Risk 375 Some Big Losses on Derivatives Source: Dan Atkinson, “UBS Pledged Derivatives Explanation,” Manchester Guardian, 1998; and update by author • September–October 1994: Bankers Trust is sued by Gibson Greeting and Procter & Gamble over derivative losses which amounted to $21 million for Gibson and a $200 million settlement for Procter & Gamble • February 1995: Barings, Britain’s oldest investment bank, announces a loss which ultimately totals $1.38 billion, related to derivatives trading in Singapore by trader Nicholas Leeson • December 1996: NatWest Bank finds losses of £77 million caused by mispricing of derivatives in its investment-banking arm Former trader Kyriacos Papouis was blamed for the loss, caused by two years of unauthorized trading by him, but NatWest Markets chief Martin Owen resigned over the incident • March 1997: Damian Cope, a former trader at Midland Bank’s New York branch, was banned by the Federal Reserve Board over the falsification of books and records relating to his interest-rate derivatives trading activities Midland parent HSBC said the amount of money involved was not significant • November 1997: Chase Manhattan was found to have lost up to $200 million on trading emerging-market notional value of an OBS item The face value of an OBS item debt; part of the problem was reportedly due to debt; part of the problem was reportedly due to exposure to emerging markets through complex derivatives products • January 1998: Union Bank of Switzerland was reported sitting on unquantified derivatives losses; UBS pledged full disclosure at a later date • August–September 1998: Long-Term Capital Management, a hedge fund with an exposure exceeding $1.25 trillion in derivatives and other securities, had to be rescued by a consortium of commercial and investment banks that infused an additional $3.65 billion of equity into the fund • July 2001: J P Morgan Chase and Citigroup exposed to $2.25 billion in losses on credit derivatives issued to a failing Enron • December 2001–January 2002: Allied Irish Banks incurs a $750 million loss from foreign exchange trades by rogue trader John Rusnak • September 2006: Amaranth Advisors loses $6 billion on investments in natural gas futures Total assets before loss were $9 billion sensitivity of an option’s value to a unit change in the price of the underlying security, which is then multiplied by the notional value of the option’s position (The delta of an option lies between and 1.) Thus, suppose an FI has bought call options on bonds (i.e., it has an OBS asset) with a face or notional value of $100 million and the delta is calculated at 25.2 Then the contingent asset value of this option position would be $25 million: d ϭ Delta of an option ϭ Change in the option’s price dO ϭ ϭ 25 dS Change in price of underlying securitty F ϭ Notional or face value of options ϭ $100 million The delta equivalent or contingent asset value = delta ϫ face value of option = 25 ϫ $100 million = $25 million Of course, to figure the value of delta for the option, one needs an option pricing model such as Black-Scholes or a binomial model (We provide a review of these models in Appendix 11B, located at the book’s Web site [www.mhhe.com/saunders6e].) In general, the delta of the option varies with the level of the price of the underlying security as it moves in and out A 1-cent change in the price of the bonds underlying the call option leads to a 0.25 cent (or quartercent) change in the price of the option sau05140_ch13_372-399.indd 375 8/6/07 5:27:27 PM Find more at http://www.downloadslide.com 376 Part Two TABLE 13–3 Measuring Risk Derivative Securities Held Off the Balance Sheet of FIs Forward contract An agreement between a buyer and a seller at time to exchange a nonstandardized asset for cash at some future date The details of the asset and the price to be paid at the forward contract expiration date are set at time The price of the forward contract is fixed over the life of the contract Futures contract An agreement between a buyer and a seller at time to exchange a standardized asset for cash at some future date Each contract has a standardized expiration, and transactions occur in a centralized market The price of the futures contract changes daily as the market value of the asset underlying the futures fluctuates Option A contract that gives the holder the right, but not the obligation, to buy or sell the underlying asset at a specified price within a specified period of time Swap An agreement between two parties to exchange assets or a series of cash flows for a specific period of time at a specified interval of the money;3 that is, < d < 1.4 Note that if the FI sold options, they would be valued as a contingent liability.5 Loan commitments and letters of credit are also off-balance-sheet activities that have option features Specifically, the holder of a loan commitment or credit line who decides to draw on that credit line is exercising an option to borrow When the buyer of a guaranty defaults, this buyer is exercising a default option Similarly, when the counterparty to a derivatives transaction is unable or unwilling to meet its obligation to pay (e.g., in a swap), this is considered an exercise of a default option With respect to swaps, futures, and forwards, a common approach is to convert these positions into an equivalent value of the underlying assets For example, a $20 million, 10-year, fixed–floating interest rate swap in which an FI receives 20 semiannual fixed–interest rate payments of percent per annum (i.e., percent per half year) and pays floating-rate payments every half year, indexed to LIBOR, can be viewed as the equivalent, in terms of valuation, of an on-balance-sheet position in two $20 million bonds That is, the FI can be viewed as being long $20 million (holding an asset) in a 10-year bond with an annual coupon of percent per annum and short $20 million (holding a liability) in a floating-rate bond of 10 years’ maturity whose rate is adjusted every six months.6 The market value of the swap can be viewed as the present value of the difference between the cash flows on the fixed-rate bond and the expected cash flows on the floating-rate bond This market value is usually a very small percent of the notional value of the swap For example, for an in-the-money call option the price of the underlying security exceeds the option’s exercise price For an out-of-the money call option, the price of the underlying security is less than the option’s exercise price In general, the relationship between the value of an option and the underlying value of a security is nonlinear Thus, using the delta method to derive the market value of an option is at best an approximation To deal with the nonlinearity of payoffs on options, some analysts take into account the gamma as well as the delta of the option (gamma measures the change in delta as the underlying security price varies) For example, the standardized model of the BIS used to calculate the market risk of options incorporates an option’s delta, its gamma, and its vega (a measure of volatility risk) See Bank for International Settlements, Standardized Model for Market Risk (Basel, Switzerland, BIS, 1996) See also J P Morgan, RiskMetrics, 4th ed., 1996 In the context of the Black-Scholes model, the value of the delta on a call option is d = N(d1), where N(.) is the cumulative normal distribution function and d1 ϭ [ln( SIX ) ϩ (r ϩ ␴ / 2)T ]/ ␴ T Note that a cap or a floor is a complex option—that is, a collection of individual options (see Chapter 24) An interest rate swap does not normally involve principal payments on maturity In the case above, the two principal amounts on the fixed- and floating-rate bonds cancel each other out sau05140_ch13_372-399.indd 376 8/6/07 5:27:27 PM Find more at http://www.downloadslide.com Chapter 13 TABLE 13–4 Off-Balance-Sheet Risk 377 Panel A: Traditional Valuation of an FI’s Net Worth Valuation of an FI’s Net Worth without and with OffBalance-Sheet Items Assets Market value of assets (A) 100 Liabilities Market value of liabilities (L) Net worth (E) 100 90 10 100 Panel B: Valuation of an FI’s Net Worth with On- and Off-Balance-Sheet Activities Valued Assets Market value of assets (A) Market value of contingent assets (CA) 100 50 Liabilities Market value of liabilities (L) Net worth (E) Market value of contingent liabilities (CL) 150 90 55 150 In our example of a $20 million swap, the market value is about percent of this figure, or $600,000.7 Given these valuation models, we can calculate, in an approximate sense, the current or market value of each OBS asset and liability and its effect on an FI’s solvency Consider Table 13–4 In panel A of Table 13–4 the value of the FI’s net worth (E) is calculated in the traditional way as the difference between the market values of its on-balance-sheet assets (A) and liabilities (L) As we discussed in Chapter 8: E ϭ AϪL 10 ϭ 100 Ϫ 90 Under this calculation, the market value of the stockholders’ equity stake in the FI is 10 and the ratio of the FI’s capital to assets (or capital–assets ratio) is 10 percent Regulators and FIs often use the latter ratio as a simple measure of solvency (see Chapter 20 for more details) A truer picture of the FI’s economic solvency should consider the market value of both its visible on-balance-sheet and OBS activities Specifically, as in panel B of Table 13–4, the FI manager should value contingent or future asset and liability claims as well as current assets and liabilities In our example, the current market value of the FI’s contingent assets (CA) is 50, while the current market value of its contingent liabilities (CL) is 55 Since the market value of contingent liabilities exceeds the market value of contingent assets by 5, this difference is an additional obligation, or claim, on the net worth of the FI That is, stockholders’ true net worth (E) is really: E ϭ ( A Ϫ L) ϩ (CA Ϫ CL) ϭ (100 Ϫ 90) ϩ (50 Ϫ 55) ϭ This is based on calculations by J Kambhu, F Keane, and C Benadon, “Price Risk Intermediation in the Over-the-Counter Derivatives Markets: Interpretation of a Global Survey,” Federal Reserve Bank of New York, Economic Policy Review, April 1996, pp 1–15 sau05140_ch13_372-399.indd 377 8/6/07 5:27:28 PM Find more at http://www.downloadslide.com 378 Part Two Measuring Risk rather than 10, as it was when we ignored off-balance-sheet activities Thus, economically speaking, contingent assets and liabilities are contractual claims that directly impact the economic value of the FI Indeed, from both the stockholders’ and regulators’ perspectives, large increases in the value of OBS liabilities can render an FI economically insolvent just as effectively as can losses due to mismatched interest rate gaps and default or credit losses from on-balance-sheet activities For example, in 1998, J P Morgan had to recognize $587 million in currency swaps as nonperforming, of which $489 million were related to currency swaps with SK, a Korean investment company Two of those swaps involved the exchange of Thai baht for Japanese yen in which SK would benefit if the Thai baht rose in value As it turned out, soon after the contract was entered into, the baht collapsed and SK disputed the legality of the contract.8 More recently, in June 2006, Huntington Bancshares held a loan loss allowance for unfunded loan commitments of $38.9 million This amount represented 12 percent of Huntington’s total loan loss allowance Concept Questions Define a contingent asset and a contingent liability Suppose an FI had a market value of assets of 95 and a market value of liabilities of 88 In addition, it had contingent assets valued at 10 and contingent liabilities valued at What is the FI’s true net worth position? RETURNS AND RISKS OF OFF-BALANCE-SHEET ACTIVITIES www.federalreserve.gov In the 1980s, rising losses on loans to less developed and Eastern European countries, increased interest rate volatility, and squeezed interest margins for on-balance-sheet lending due to nonbank competition induced many large commercial banks to seek profitable OBS activities By moving activities off the balance sheet, banks hoped to earn more fee income to offset declining margins or spreads on their traditional lending business At the same time, they could avoid regulatory costs or taxes, since reserve requirements, deposit insurance premiums, and capital adequacy requirements were not levied on off-balancesheet activities Thus, banks had both earnings and regulatory tax-avoidance incentives to move activities off their balance sheets.9 The dramatic growth in OBS activities caused the Federal Reserve to introduce a tracking scheme in 1983 As part of their quarterly Call Reports, banks began submitting Schedule L on which they listed the notional size and variety of their OBS activities We show these off-balance-sheet activities for U.S commercial banks and their distribution and growth for 1992 and 2006 in Table 13–5 We also show the 2006 distribution of OBS activities for J P Morgan Chase in Table 13–5 In Table 13–5 notice the relative growth of off-balance-sheet activities In 1992, the notional or face value of OBS bank activities was $10,200.3 billion compared with $3,476.4 billion in on-balance-sheet activities By the second quarter of 2006, the notional value of these OBS bank activities was $130,038.6 billion (an increase of 1,175 percent in 14 years) compared with $9,602.3 billion of on-balance-sheet activities (an increase of 115 percent) Likewise, in 2006 J P Morgan Chase had total OBS activities of $60,218.0 billion ($59,099.0 billion of which were derivative sau05140_ch13_372-399.indd 378 See “J P Morgan in Korean Battle on Derivatives,” New York Times, February 27, 1998, p D1 Chapter 26 goes into further details on incentives relating to loan sales 8/6/07 5:27:28 PM Find more at http://www.downloadslide.com Chapter 13 Off-Balance-Sheet Risk 379 TABLE 13–5 Aggregate Volume of Off-Balance-Sheet Commitments and Contingencies by U.S Commercial Banks (in billions of dollars) Source: FDIC, Statistics on Banking, various issues www.fdic.gov 1992 Commitments to lend Future and forward contracts (excludes FX) On commodities and equities On interest rates Notional amount of credit derivatives Bank is guarantor Bank is beneficiary Standby contracts and other option contracts Written option contracts on interest rates Purchased option contracts on interest rates Written option contracts on foreign exchange Purchased option contracts on foreign exchange Written option contracts on commodities and equities Purchased option contracts on commodities and equities Commitments to buy FX (includes US$), spot, and forward Standby LCs and foreign office guarantees (amount of these items sold to others via participations) Commercial LCs Participations in acceptances bought from others Securities lent Other significant commitments and contingencies Notional value of all outstanding interest rate, FX, and commodity swaps Mortgages sold, with recourse Outstanding principal balance of mortgages sold or swapped Amount of recourse exposure on these mortgages Total Total assets (on-balance-sheet items) 2006* Distribution J P Morgan 2006 Chase 2006* 349.0 $ 6,591.2 26.3 1,738.1 187.1 7,761.9 0.1 6.0 114.7 3,708.9 4.1 4.5 3,297.6 3,271.8 2.5 2.5 1,795.0 1,791.9 504.7 508.0 245.7 249.1 30.9 29.4 9,436.6 9,776.8 1,585.6 1,583.2 1,058.0 1,006.6 7.3 7.5 1.2 1.2 0.8 0.8 4,817.1 4,996.4 700.4 674.3 847.7 789.6 3,015.5 162.5 (14.9) 28.1 0.2 96.4 19.5 7,738.4 562.3 (212.9) 29.1 0.1 1,615.4 95.7 6.0 0.4 0.0 0.0 1.2 0.1 2,126.6 121.1 (32.2) 5.4 0.0 306.9 17.8 2,122.0 74,438.4 57.3 37,054.9 2.5 0.3 $130,038.6 $ 9,602.3 0.0 0.0 100.0% 10.7 6.3 $10,200.3 $ 3,476.4 5.1% $ $ 1,272.0 0.0 0.0 $ 60,218.0 $ 1,328.0 FX = foreign exchange, LC = letter of credit *Second quarter contracts [futures, forwards, swaps, options, and credit derivatives]) compared with on-balance-sheet assets of $1,328.0 billion Table 13–6 shows that much of the growth in OBS activities during the period 1992–2006 was due to derivative contracts Bank holdings of these contracts increased 1,260 percent, from $8,765 billion in 1992 to $119,243 billion in the second quarter of 2006 The vast majority of these OBS activities are conducted by just a few banks For example, in 2006 approximately 900 of the over 7,480 U.S banks held the OBS derivatives reported in Table 13–5, and the largest 25 banks held 99.6 percent of the derivatives outstanding While, as noted above, the notional value of OBS items overestimates their current market or contingent claims values, the growth of these activities is still nothing short of phenomenal Indeed, this phenomenal increase sau05140_ch13_372-399.indd 379 8/6/07 5:27:28 PM Find more at http://www.downloadslide.com 380 Part Two Measuring Risk TABLE 13–6 Derivative Contracts Held by Commercial Banks, by Contract Product (in billions of dollars)* Source: Office of the Comptroller of the Currency Web site, various dates www.occ treas.gov Futures and forwards Swaps Options Credit derivatives Total 1992 1996 2000 2004 2006 (second quarter) $4,780 2,417 1,568 — $8,765 $ 8,041 7,601 4,393 — $20,035 $ 9,877 21,949 8,292 426 $40,544 $11,343 56,411 17,750 2,347 $87,880 $13,788 74,438 24,447 6,569 $119,243 *Notional amount of futures, total exchange traded options, total over-the-counter options, total forwards, and total swaps Note that data after 1994 not include spot FX in the total notional amount of derivatives Credit derivatives were reported for the first time in the first quarter of 1997 Currently, the Call Report does not differentiate credit derivatives by product and thus they have been added as a separate category has pushed regulators to impose capital requirements on such activities and to explicitly recognize FIs’ solvency risk exposure from pursuing such activities These capital requirements came into affect on January 1, 1993; we describe them in Chapter 20 From Tables 13–5 and 13–6, the major types of OBS activities for U.S banks are: • • • • • Loan commitments Standby letters of credit and letters of credit Futures, forward contracts, swaps, and options When-issued securities Loans sold Larger thrifts and insurance companies engage in most of these OBS activities as well The next section analyzes these OBS activities in more detail and pays particular attention to the types of risk exposure an FI faces when engaging in such activities As we discussed earlier, precise market valuation of these contingent assets and liabilities can be extremely difficult because of their complex contingent claim features and option aspects At a very minimum, FI managers should understand not only the general features of the risk exposure associated with each major OBS asset and liability but also how each one can impact the return and profitability of an FI Loan Commitments loan commitment agreement A contractual commitment to make a loan up to a stated amount at a given interest rate in the future up-front fee The fee charged for making funds available through a loan commitment sau05140_ch13_372-399.indd 380 These days, most commercial and industrial loans are made by firms that take down (or borrow against) prenegotiated lines of credit or loan commitments rather than borrow spot loans (see Chapter 11’s discussion on C&I loans) In August 2006 over 80 percent of all C&I lending was made under commitment contracts.10 A loan commitment agreement is a contractual commitment by an FI to lend to a firm a certain maximum amount (say, $10 million) at given interest rate terms (say, 12 percent) The loan commitment agreement also defines the length of time over which the borrower has the option to take down this loan In return for making this loan commitment, the FI may charge an up-front fee (or facility fee) of, say, 1/8 percent of the commitment size, or $12,500 in this example In addition, the FI must stand 10 See Board of Governors of the Federal Reserve Web site, “Survey of Terms of Business Lending,” September 2006 8/6/07 5:27:28 PM Find more at http://www.downloadslide.com Chapter 13 FIGURE 13–1 Structure of a Loan Commitment Up-front fee of 1/8% on whole line back-end fee The fee imposed on the unused balance of a loan commitment EXAMPLE 13–1 Calculation of the Promised Return on a Loan Commitment Off-Balance-Sheet Risk 381 Back-end fee of 1/4% on unused portion year $10 million commitment ready to supply the full $10 million at any time over the commitment period—say, one year Meanwhile, the borrower has a valuable option to take down any amount between $0 and $10 million The FI also may charge the borrower a back-end fee (or commitment fee) on any unused balances in the commitment line at the end of the period.11 In this example, if the borrower takes down only $8 million in funds over the year and the fee on unused commitments is ¼ percent, the FI will generate additional revenue of ¼ percent times $2 million, or $5,000 Figure 13–1 presents a summary of the structure of this loan commitment It is quite easy to show how the unique features of loan commitments affect the promised return (1 ϩ k) on a loan In Chapter 11 we developed a model for determining (1 ϩ k) on a spot loan This can be extended by allowing for partial takedown and the up-front and backend fees commonly found in loan commitments For a one-year loan commitment, let: BR ϭ Interest on the loan ϭ 12% m ϭ Risk premium ϭ 2% % f1 ϭ Up-front fee on the whole commitment ϭ 8% f2 ϭ Back-end fee on the unused commitment ϭ 4% b ϭ Compensating balance ϭ 10% RR ϭ Reserve re quirements ϭ 10% td ϭ Expected (average) takedown rate (0 Ͻ td Ͻ 1) on the loan commitment ϭ 75% Then the general formula for the promised return (1 ϩ k) of the loan commitment is:12 f1 ϩ f2 (1 Ϫ td ) ϩ ( BR ϩ m) td td Ϫ [b(td )(1 Ϫ RR )] 00125 ϩ 0025(.25) ϩ (.12 ϩ 02).75 ϩ k ϭ 1ϩ 10)(.75)(.9)] 75 Ϫ [(.1 106875 ϩ k ϭ 1ϩ ϭ 1.1566 orr k ϭ 15.66% 682500 ϩ k ϭ 1ϩ 12 Note that only when the borrower actually draws on the commitment the loans made under the commitment appear on the balance sheet Thus, only when the $8 million loan is taken down exactly halfway through the one-year commitment period (i.e., six months later), does the balance sheet show a new $8 million 11 This can be viewed as an excess capacity charge This formula closely follows that in John R Brick, Commercial Banking: Text and Readings (Haslett, MI: Systems Publication, Inc., 1984), chap Note that for simplicity we have used undiscounted cash flows Taking into account the time value of money means that we would need to discount both f2 and BR ϩ m since they are paid at the end of the period If the discount factor (cost of funds) is d = 10 percent, then k = 14.25 percent 12 sau05140_ch13_372-399.indd 381 8/6/07 5:27:29 PM Find more at http://www.downloadslide.com Index Federal Reserve System—Cont minimum reserve requirements for cash reserves, 497 non-interest-bearing reserve requirements, 482 open market operations, 192–194 ownership of Fedwire, 391 power to approve or disapprove mergers, 668n Regulation F, 480 Regulation J, 478–479 Regulation Q ceilings, 199 repricing report, 199n restrictive monetary policy actions of, 383 role of, as supervisor of bank holding company, 650 seasonal credit program, 509–510, 572 Federal Savings and Loan Insurance Corporation (FSLIC), 552n, 553 collapse of, 596 Federated Investors, 138 Fed funds, 183 Fedwire system, 391, 461, 462, 476, 479, 571 Fees back-end, 381, 382 on hedge funds, 148 income from as reason for loan sales, 808 up-front, 380 Feinberg, Stephen, 147 FICO bonds, 562n Fidelity, 127, 128 Fiduciary accounts, stuffing, as conflict of interest, 648 Finance companies, 153–165, 303 assets of, 154–155, 157–161 balance sheet and recent trends, 157–163 captive, 164 equity of, 161–162 global issues for, 164–165 liabilities of, 154–155, 161–162 primary function of, 153 regulation of, 163–164 size, structure, and composition of industry, 154–157 types of, 155 Financial Accounting Standards Board (FASB), 221n, 373, 587, 590, 693, 810 Financial claim transformation, 295 Financial Crimes Enforcement Network, 676 Financial distress, 800 Financial environment as cause of depository fund insolvencies, 554–555 Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) (1989), 553, 554, 566, 657, 658 sau05140_index_853-874.indd 859 Financial intermediaries consolidation in, 466 duration and interest rate risk management on balance sheet of, 238–243 duration gap for, 238–243 efficient technological base for, 460 establishment of global presence by, 674 operational risk and, 487 as special, 295 Financial intermediation, risks of, 168–184 country or sovereign, 179 credit, 173–175 foreign exchange, 177–178 insolvency, 182–183 interest rate, 169–171 liquidity, 181–182 market, 171–173 off-balance-sheet, 176 other, and interaction of, 183–184 technology and operational, 180–181 Financial market data, 320 Financial risk, 458 Financial services interpretation of HerfindahlHirschman Index (HHI) in context of, 670 wholesale, 462–463 Financial services industry See Finance companies; Hedge funds; Investment banks; Mutual funds; Securities firms Financial Services Modernization Act (1999) (FSMA), 95, 96n, 101, 184, 300n, 393, 461n, 466n, 487–488, 563, 631, 633, 636, 638, 639, 642, 645, 649, 677, 809 Financial statement analysis, using return on equity (ROE) framework, 64 Financial theory, 320 Financing gap, 503–504 Financing requirement, 503–504 Fire-sale price, 494 Firm commitment offering, 643 Firm commitment underwriting, 634 Firm-specific credit risk, 175 First Boston, 835 First Chicago, 666, 673 First City Bancorporation of Texas, 662 First Interstate, 805 Fischer, P., 618n Fisher equation, 415n Fitch Investors Services, 846 Five Cs of credit, 316n Fixed costs, international expansion and, 686 Fixed-fixed currency swaps, 778–780 859 Fixed-floating currency swaps, 780–781 Fixed-income coupon bonds, 173 Fixed-income securities, market risk of, 270–272 Fixed-rate loan assignments, 801 Fixed-rate mortgages, 775 Flat term structure, problem of, 260–262 FleetBoston Financial Corp., 155, 296, 635 Fleet Financial, 635 Fleet Specialist Inc., 111 Fleming, M J., 479n Float, 462 Floating-rate bonds, 263–264 Floating-rate loans, 263–264, 300n, 797n, 801 Floors, 752, 755–756 credit risk and, 759 Folian, J R., 824n Ford Motor Corporation, 156, 161, 301, 383 Ford Motor Credit Corp (FMCC), 155, 156, 161 Foreign asset and liability positions, 409–416 multicurrency, 415–416 return and risk of investments, 409–411 risk and hedging, 411–415 Foreign banks as buyer in loan sales, 804 regulation of, in United States, 681–683 as seller in loan sales, 806 subsidiaries of, 679 Foreign Bank Supervision Enhancement Act (FBSEA) (1991), 680, 681, 682–683 Foreign currency trading, 404, 407–409 profitability of, 408–409 Foreign deposits, 134 Foreign exchange, 272–273, 287 Foreign-exchange market, fraud charges in, 402 Foreign exchange rates, 400–401 Foreign exchange risk, 107, 168, 177–178, 266, 400–420 asset and liability positions, 409–416 currency trading, 407–409 hedging, 708–715 interaction of interest rates, inflation, and exchange rates, 417–420 interest rate parity theorem, 419–420 purchasing power parity, 417–418 rates, 400–401 rate volatility and FX exposure, 406 sources of exposure, 403–406 transactions, 401–403 using options to hedge, 748–749 Foreign exchange transactions, 401–403 8/23/07 6:28:45 PM Find more at http://www.downloadslide.com 860 Index Foreign investments, return and risk of, 409–411 Forward contracts, 376, 387, 693, 695 hedging interest rate risk and, 696–697 over-the counter market, 719 Forward exchange rate, 414 Forward foreign exchange transaction, 403 Forward market for foreign exchange, 404 Forward purchases, 389–390 Forward rate, 324 Forwards, 691, 709 hedging credit risk with, 716–720 hedging with, 414–415 regulator policies toward, 719 Foundations approach to measuring credit risk-adjusted assets, 627–630 Frankel, Martin, 574 Fraser, D R, 673n Fraud risk, 480–482 Fraudulent conveyance, 809 Fred Alger & Co., 138 Freddie Mac, government sponsorship and oversight of, 833–834 Fremont General Corp., 163 Full amortization, 819 Full-service brokerage, 634n Full-service investment banks, 100n Fully amortized mortgages, 774 Funding gap, 195 Fund operating expenses, 132–134 Funds concentration, 462 Funds of funds, 145–146 Funds source, international expansion and, 685 Furlong, F., 560n Futures, 265, 691, 709 hedging credit risk with, 716–720 macrohedging with, 699–707 options hedging versus, 735 regulator policies toward, 719 Futures contracts, 376, 387, 695 catastrophe risk and, 718–719 exchange-traded, 719 hedging interest rate risk with, 697–708 interest rate, 205 Futures dollar-pound price, 709 Futures option, 741–742 Futures versus options, hedging interest rate risk with, 767 FX futures contracts, 709 G Gande, A., 357n, 445n, 651n, 802n sau05140_index_853-874.indd 860 Gap exposure, for pass-through securities, 818 Garbade, K D., 479n Garn-St Germain Depository Institutions Act (1982), 523n, 637, 657–658, 661–662 of money market deposit accounts (MMDAs), 536–537 Gartner Inc., 488 Gendell, Jeffrey, 147 General diversification limits, 360 General Electric, 154, 163, 483, 662 Capital Services, 156 General Electric Capital Corp (GECC), 154, 156, 165 Generally accepted accounting principles (GAAP), 139, 591, 685 General market risk charges, 284 General Motors, 111, 155, 301, 355, 383, 483, 656 General Motors Acceptance Corp (GMAC), 154, 155, 156, 310n General obligation (GO) bonds, 634 Geographic expansions, 656–686 advantages and disadvantages of international, 683–686 cost and revenue synergies impacting domestic, by merger and acquisition, 664–671 cost synergies, 664–667 merger guidelines for acceptability, 668–671 revenue synergies, 667–668 domestic, 656–657 global and international, 674–683 market- and firm-specific factors impacting domestic decisions, 671–672 regulatory factors impacting, 657–663 commercial banks, 658–663 insurance companies, 657 thrifts, 657–658 success of domestic, 672–673 German universal banks, 652n Gibson Greeting Cards, 374, 375 Gilkeson, J H., 260n Gilson, S C., 319n Glaessner, T., 480n Glass-Steagall Act (1933), 300n, 633–635, 647–649, 681, 809 Global and international expansions, 674–683 Global capital flows, 147 Global Crossings, 111 Global issues for finance companies, 164–165 in mutual fund industry, 141–143 GlobeNet ECN, 100 GMAC Commercial Mortgage Corp (GMACCM), 154 Goldman Sachs Group Inc., 95, 102, 109, 144, 296, 634, 647, 677, 800, 803, 811, 836 Good bank-bad bank as buyer in loan sales, 805–806 structure of, 797 Goodman, L S., 440, 440n, 618n Goodwill, 600 Gorton, G., 388n, 390n Government/government agencies as seller in loan sales, 806–807 Government loan sales, 810 Government National Mortgage Association (GNMA) (Ginnie Mae), 815 mortgage-backed securities of, 601–602 Government Securities Clearing Corp., 459 Government sponsorship and oversight of Federal National Mortgage Association (FNMA) and Freddie Mac, 833–834 Graham, S L., 673n Grammatikos, 456n Grandfathered subsidiary, 660 Grant Street National Bank, 805 Greek National Mortgage Bank, 682 Greenbaum, S I., 558n Greenberger, Michael, 787 Greenspan, Alan, 112, 691, 782, 798 Grobel, R A., 263n Grossman, S J., 314n Grupo Financiero Banamex-Accival, 678n Guaranteed investment contracts (GICS), 510n, 617 Gulf and Western, 639 H Handshake deal, 798 Haraf, W S., 393n Hard closing, 140 Harper, J T., 388n Harrington, S E., 619n Hart, O D., 314n Hassan, M K., 386n Hawawini, G., 224n, 228n, 262n Hazards, 555n Health savings accounts (HSAs), 638 Heavily indebted poor countries (HIPCs), 429 Hedge, naive, 696 Hedge funds, 119, 143–150 fees on, 148 8/23/07 6:28:45 PM Find more at http://www.downloadslide.com Index Hedge funds—Cont offshore, 148 regulation of, 148–150 types of, 144–148 Hedge ratio, 712 estimating, 713–715 Hedging, 178n of bond options using binomial model, 737–740 catastrophic risk with call spread options, 751 credit risks with options, 749–751 effectiveness of, 715 forward contracts in, for interest rate risks, 696–697 with forwards, 414–415 futures versus options, 735 of interest rate risk with futures contracts, 697–708 mechanics of, a bond or bond portfolio, 736–740 off-balance-sheet, 411 on-balance-sheet, 411, 412–413 routine, 698 selective, 698–699 using options in, for foreign exchange risk, 748–749 Hein, S E., 475n Hendricks, D., 290n Herfindahl-Hirschman Index (HHI), 668–670 Heritage Foundation, 437 Hermann, H., 679n Highly leveraged transactions loans, 799, 802 sales of, 800 High-water mark, 148 High-yield bonds, 321 Hillier, D., 434n Hirtle, B J., 290n, 388n, 598n Hisizinga, H., 684n Historic (back simulation) approach, 277, 279–282 RiskMetrics versus, 281–282 Hitachi Data Systems, 458 Home banking, 464, 465n, 532 Home Depot, 662 Home equity loans, 160, 301n Home State Savings Bank (HSSB), 182n Horizontal offsets, 286 between time zones, 286–287 within time zones, 286 Horowitz, Jed, 486n Hostile takeovers, 146 Household International, 162 Housing and Urban Development, U.S Department of, 807 Housing turnover, pass-through securities and, 824–825 sau05140_index_853-874.indd 861 Hrycay, M., 603n HSBC Finance Corp., 155, 156, 163, 375 HSBC Holdings, 162, 632 HSBC Private Bank, 144 Hudson United Bank, 676 Humphrey, D B., 473n, 479n, 667n Hunter, W C., 473n Huntington Bancshares, 378 Hurdle rate, 148 Hurricane Andrew, 511 Hurricane Katrina, 511 Hybrid funds, 122 I Iben, T., 739n IBM, 100, 299, 300, 355, 383, 656 Identities, 299–301 verification of, 463 Illiquidity excessive, 521 exposure, 818 Immunization, 697 as dynamic problem, 245–246 regulatory considerations and, 243–244 Implicit contract, 314 Implicit premiums, 555 Import ratio, 434 Income funds, 146 Index of Economic Freedom, 437 Indirect quote, 401 Individual loans, 296, 303–305 Individual Retirement Accounts (IRAs), 565 Industrial loan corporations (ILCs), 483, 662 Industry performance, 162 Information/monitoring costs, international expansion and, 685 Information transfer as conflict of interest, 648 ING Bank, 172n, 806 Initial public offerings (IPOs), 97, 146, 651 Innovations international expansion and, 684 in securitization, 841–845 Inputs, cost of, 458 Insider Trading and Securities Fraud Enforcement Act (1988), 136 Insolvency risk, 168, 182–183 capital and, 587–594 Institutional funds, 120 costs of, 121 Institutional Government Income mutual fund, 513n Institutional Investor Index, 430, 431–432 861 Insurance See also Deposit insurance; Life insurance actuarially fairly priced, 556 bond, 260n property casualty, 618–619 timing, 815 Insurance companies as buyer in loan sales, 804–805 geographic expansion and, 657 liability and liquidity risk management in, 544 Insurance premiums, 557–561 Insurance risk in life insurance, 617 Insured depositor transfer (IDT), 567, 568–569 Insured depositors, 564–566 Interaffiliate loans, 644 Interbank loan sales, 804 Interest-bearing bonds, duration of, 226–227 Interest-bearing checking (NOW) accounts, 535 costs of, 535 withdrawal risk of, 535 Interest elasticity, 232 Interest expense, 461 Interest income, 461 Interest rate equilibrium, 191–192 forecasting, 220 level and movement of, 191–195 level of, 315–316 repricing model, 195–203 weaknesses of, 203–205 term structure of, 191, 214–220 volatility of, 592 Interest rate cap, 387n Interest rate changes, large, and convexity, 246–248 Interest rate derivatives, 694 Interest rate futures contract, 205 Interest rate futures quote, from Wall Street Journal Online, 726–727 Interest rate parity theorem, 419–420 Interest rate risk, 107, 168, 169–171, 183, 190–265, 266, 382, 383, 587, 610 book value of capital and, 592 difficulties in applying duration model, 244–248 duration and, 222–224, 234–243 economic meaning of, 230–234 features of, 229–230 general formula for, 224–229 risk and, 234–243 forward contracts and hedging, 696–697 hedging with futures contracts, 697–708 with futures versus options, 767 8/23/07 6:28:46 PM Find more at http://www.downloadslide.com 862 Index Interest rate risk—Cont immunization and regulatory considerations, 243–244 incorporating convexity into duration model, 256–265 in life insurance, 617 macrohedge of using put option, 746 using short hedge, 704–706 macrohedging when basis risk exists, 708 market value of, 589–590 using options to hedge, on balance sheet, 743–748 Interest rate swaps, 376n, 694, 769, 770–778 realized cash flows on, 774 setting ratio on, 794–796 Intermediation approach, 473 Internal fraud, 613 Internal market risk models, development of, 283 Internal Ratings-Based (IRB) approach, 598, 614n to measuring credit risk-adjusted assets, 627–630 International Association of Swap Dealers, 787n International Banking Act (1978), 681–683 International expansion, advantages and disadvantages of, 683–686 International Monetary Fund (IMF), 179 loan to Mexico, 425 International Money Market (IMM), 695 International Swaps and Derivatives Association (ISDA), 484, 785 International technology transfer risk, electronic transfer payment system and, 480 Internet banking on, 467 effect on financial services, 458 transactions on, 481 Interstate banking, 466 pacts on, 661 restrictions on, 659–663 Interstate branching, 184 In-the-money call option, 376n Intrastate banking, restrictions on, 658–659 Inverse floater swap, 775 Investing, 97 Investment Advisers Act (1940), 136, 143 Investment banks, 93, 95, 97–98, 633, 806 as buyer in loan sales, 803–804 full-service, 100n Investment Company Act (1940), 136, 149 Investment Company Institute, 140–141 Investment funds, 511–513 sau05140_index_853-874.indd 862 Investment ratio, 435 Investor reaction, 672–673 Investor returns, from mutual fund ownership, 128–131 Investors, accredited, 143 IO strip, 842–843 Ip, Greg, 798n Irmler, E W., 265n Isaac, William, 508 The Island ECN, 100 Italian Banca Nazionale del Lavoro, 682 Ito, T., 640n Itradecurrency USA LLC, 402 Ivashina, V., 102n Ivy Asset Management, 144 Iwahara, S., 615n J J P Morgan Chase & Co., 96, 102, 109, 156, 163, 268, 275, 276n, 283, 296, 298, 365, 373, 374, 375, 376n, 378, 378n, 382, 386, 387, 402, 403, 408, 426, 430, 443n, 465n, 634, 638, 640, 648, 649, 650, 666, 667, 668, 672, 674, 675, 684, 786, 802, 805, 844, 845 Jackson, W E., III, 672n Jacobson, T., 603n Jafray, Piper, 513n Jagtiani, J A., 102n, 648n, 672n James, C., 314n Janus Capital, 138 Japan deposit insurance system in, 570 mutual fund industry in, 141 Japanese Nikkei Stock Market Index, 172–173 Japan Leasing Corporation ( JLC), 165 Jarrow, R., 320n, 558n Jayhawk Acceptance Corp., 159 Jefferies Group Inc., 140 Jenrette, Donaldson Lufkin, 635 Johansson, F., 277n John, K., 319n Johnson, Art, 484 Johnston, Erick, 730n Joint selling, 466 Jones, D S., 613n Jones, Paul Tudor, 147 Jordan, J S., 487n, 611n Junk bonds, 297, 321, 545 Justice, U.S Department of on concentrated market, 669–670 Horizontal Merger Guidelines, 668n K Kambhu, J., 377n Kane, E J., 559n, 570n, 656n, 660n, 673n Kansas City Board of Trade, 695n Kaufman, G., 238n, 244n, 262n, 590n Keane, F., 377n Keogh private pension plans, 565 Kim, Jane J., 193n King, K K., 613n Kiso, T., 640n Klein, R., 619n Klingebiel, D., 480n KMV Corporation, 332 Credit Monitor model, 354 Portfolio Manager model, 348, 353–356 KMV option model, 560 expected default frequency and, 335–337 Knife-edge management problem, liquidity management as, 532 Kooi, W J., 438n Kovner, Bruce, 147 Kunt, A., 556n Kupiec, P., 277n Kuttner, K N., 464n L Labor, 458 LaCour-Little, M., 613n Laeven, L., 647n Lagged reserve accounting system, 527 Lajaunie, J P., 496n Lampert, Eddie, 147 Lando, D., 320n Lang, L., 319n Large-bank internal models, Bank for International Settlements (BIS) regulations and, 288–290 Late trading, 137 abuses of, 140 Latinik, Walter, 488 Lazard, 102 LDC market prices, country risk analysis and, 446 Least-cost resolution, 566 Lee, S H., 448n Leeson, Nicholas, 172, 375 Legal concerns, loan sales and, 809–810 Lehman Brothers, 102, 109, 443n Letter of credit, 164, 176, 376 commercial, 384–385 electronic initiation of, 463 guarantees for, 176 risks associated with, 386 standby, 384, 385–386, 787 Leverage, 144, 314 Leveraged buyouts (LBOs), 146, 314 loans to finance, 802 Leverage ratio, 244n, 595–596 8/23/07 6:28:46 PM Find more at http://www.downloadslide.com Index Levine, R., 647n Levitz, Jennifer, 140n Levonian, M., 560n, 598n Levy, C B., 483n Lewis, C M., 459n Liabilities callable bonds as, 260n of finance companies, 154–155, 161–162 off-balance-sheet (OBS), 373 rate-sensitive, 198–200 structures for United States depository institutions, 542–543 Liability and liquidity risk management in insurance companies, 544 in other financial institutions, 544–545 Liability management, 532–533 Liability-side liquidity risk, 494–498 Liability structure, choice of, 533–541 Life insurance asset risk in, 616 business risk in, 617–618 capital requirements for, 616–618n insurance risk in, 617 interest rate risk in, 617 liquidity risk and, 510 Life insurance companies, 574–575 Lindé, J., 603n Linear discriminant models, 318–320 Linear probability model, 317–318 Linearity, 246 Lines of credit, 164 Ling, D C., 830n Lipsey, R., 679n Liquid asset portfolio, composition of, 522 Liquid assets buildup of prudential level of, 532 examples of, 520 management of, 520–522, 531–532 return-risk trade-off for, 523–532 Liquid assets ratio, 522 Liquidity management as knife-edge management problem, 532 measuring exposure, 500–507 planning, 505–507 reducing risk of crisis, 520 sources and uses of, 500–501 structures for United States depository institutions, 542–543 Liquidity index, 502–503 Liquidity premium theory, 217–219 Liquidity risk, 168, 181–182, 183, 493–514, 504–505 Bank of International Settlements (BIS), Maturity Ladder/ scenario analysis, 504–505 bank run, 508–509 sau05140_index_853-874.indd 863 Liquidity risk—Cont causes of, 493–494 at depository institutions, 494–510 discount window and deposit insurance, 509–510 financing gap and financing requirement, 503–504 investment funds, 511–513 liability-side, 494–498 life insurance companies and, 510 planning, 505–507 property-casualty insurers and, 511 as reason for loan sales, 808 unexpected deposit drains, and bank runs, 507–509 Litterman, R., 739n Load fund, 131–132 Loan(s) See also Mortgage(s) automobile, 844 borrower's payoff from, 332 business, 160–161 calculating return on, 306–309 commercial and industrial, 299–301 consumer, 157–160 contractually promised return on, 306–309 credit risks of, 797 debt holder's payoff from, 333 expected return on, 309 floating-rate, 263–264, 300n home equity, 301n individual (consumer), 303–305 noncallable, 305n nonperforming, 297n, 446 performing, 446 real estate, 301–303 revolving, 303 secured, 299 spot, 300 syndicated, 299 unsecured, 299 Loanable funds theory, 191 Loan commitment, 300, 312, 376, 380–384 Loan commitment agreement, 380 Loan concentrations, 348–350, 357 Loan contracts, trend toward, 801 Loan default rates, using, to estimate loan risk, 331 Loan loss ratio-based models, 359–360 Loan loss reserves, 425, 591 Loan migration matrix, 349 Loan origination fee, 307 Loan portfolio diversification, modern portfolio theory and, 350–360 Loan Pricing Corporation, 800, 802 Loan risk using duration to estimate, 329–331 using loan default rates to estimate, 331 863 Loan sales, 427, 456, 531, 797–811 bank market, 798–807 buyers and sellers, 803–807 definition of, 798–799 factors affecting growth, 809–810 government, 810 growth of asset securitization and, 593 purchase and sale of foreign, 811 reasons for, 808 risks associated with, 390 trends in, 802 types of, 799–800 Loan sales and securitization markets, growth of, 500n Loan sales contracts, types of, 800–802 Loan sharks, 159 Loans sold, 390 Loan syndications, assignments as common in, 801 Loan-to-value ratio rises, 303 Loan volume-based models, 356–359 Lockbox electronic, 462 wholesale, 462 Logit model, 317–318 London Inter-bank Offered Rate (LIBOR), 306, 431 London International Financial Futures Exchange (LIFFE), 393n, 695n Lone Pine Capital, 147 Long position, 144 Long-Term Capital Management (LTCM), 144, 147–148, 375, 394, 513, 567 Long-Term Credit Bank of Japan, 165 Long-term funds, 122, 135–136 Long-term rates, linkages between short-term rates and, 193 Loss control, 484 Loss financing, 485 Loss given default (LGD), 321n, 354 Loss insulation, 485 Loss prevention, 484 Lown, C S., 312n Lucchetti, Aaron, 703n Luxembourg, 148 M Macatawa Bank Corporation, 202 Macauley's duration, 224, 260 MacDonald, Alistair, 787n Macro funds, 145 Macrohedge, 697, 698 with futures, 699–707 of interest rate risk, 708 using put option, 746 using short hedge, 704–706 8/23/07 6:28:47 PM Find more at http://www.downloadslide.com 864 Index Macrohedge—Cont on- and off-balance sheet effects of, 706 put option, with basis risk, 747–748 with swaps, 775–778 Macys, 800 Magellan Fund, 128 Major money center banks, 805 Management fee, 132 Mandel, Stephen, 147 Marche a Terme International de France (MATIF), 695n Marginal default probability, 324 Marginal mortality rates, 327–328 Marine Midland, 681 Marked-to-market, 129, 695 Marker, J., 383n Market benchmarks, 357 Market data in measuring risk, 442–448 Market making, 99–100 Market neutral-arbitrage funds, 146 Market neutral-securities hedging funds, 146 Market Reform Act (1990), 136 Market risk, 107, 146, 168, 171–173, 183, 266–290, 610 calculating exposure, 267–268 defined, 266–267 of fixed-income securities, 270–272 historic (back simulation) approach, 277, 279–282 RiskMetrics Model, 268–277 Market segmentation theory, 219–220 Market timing, 137, 139, 145 Market to book ratio, 593 Market value, 587 of capital, 587–590, 588–590 of credit risk, 588–589 discrepancy between book values of equity and, 592–593 effects of, 203 of interest rate risk, 589–590 Market value accounting, 190, 221, 587, 615–616, 810 arguments against, 593–594 Market value-based maturity model, 190 Market value-based models of interest rate, 202 Market value gains and losses, 265 Market value risks, 169, 171 Marking-to-market process, 221, 695 Mark-to-market basis, 587 Martin, A D., 405n Massoud, N., 102n, 464n MasterCard, 303 Mathur, A., 353n Maturity, duration and, 229 Maturity Laddering method, 504–505 Maturity premium, 214 Mauer, L J., 405n McAndrews, J J., 464n sau05140_index_853-874.indd 864 McCall, J., 314n McFadden Act (1927), 659, 681, 804 MCI, 296 McKay, Peter A., 703n McNeil, Alexander J., 277n McNulty, J E., 474n McNutt, J J., 673n Medium-term notes, 541 Megamerger, 666 Mellon Financial Corp., 122, 296, 635, 805 Mercantile Bankshares, 666 Merck, 105 Merger bid premiums, 671–672 Mergers and acquisitions (M&As), 93–95, 101–102, 146, 162 guidelines for acceptability, 668–671 loans to finance, 802 transaction value of domestic, 93 Merrill Lynch, 93, 95, 102, 103, 108, 109, 138, 141, 163, 389n, 443n, 463–464, 635–636, 649, 662, 684n, 786, 804–805, 844 Merton, R C., 320n, 332, 332n, 334n, 559n, 560n, 736n Mester, L., 307n, 474n MetLife, 467 Mexico debt moratorium in, 425 devaluation in, 425 sale of sovereign bonds by, 445 upgraded credit rating, 442 MFS Investment Management, 138 Microhedging, 697–698 MidAmerica Commodity Exchange, 695n Midland Bank, 375 Migration analysis, 349 Milbourn, T T., 474n Millennium Partners, 138 Miller, S M., 474n Minimum risk portfolio, 353 Minton, B A., 693n Mitsubishi Bank, 681 Mitsubishi UFJ Financial Group, 632 Mizuho Financial Group, 632, 674 Mobile home loans, 160 Moderate risk funds, 145 Modern portfolio theory, loan portfolio diversification and, 350–360 Modified duration, 232 Monetary policy, 190, 192 implementation of, 521–522 Money laundering, efforts to combat, 111 Money market deposit accounts (MMDAs), 494n costs of, 537 withdrawal risk of, 536–537 Money market mutual funds (MMMFs), 118, 122–125, 134–135, 199n, 632 Monte Carlo simulation approach, 282–283, 607n Montgomery Securities, 635 Montreal Exchange, 695n Moody's, 297, 324n, 349, 353–356, 366 Moore, Stephen, 402 Moore Capital Management, 147 Moores, C T., 698n Moral hazard as cause of depository fund insolvency, 555–556 defined, 555 panic prevention versus, 556–557 More risky funds, 145 Morgan, D P., 312n, 383n Morgan, J P., 266n, 282n Morgan Stanley, 95, 102, 105, 109, 110, 138, 149, 483, 486, 677 Morningstar, Inc., 131 Morse, A., 159n Mortality rate derivation of credit risk, 326–328 Mortality rates, 326 marginal, 327–328 Mortgage(s), 160, 266 assumable, 824 calculating durations of, 265 financing, 153 fixed-rate, 775 fully amortized, 774 sale of, 807 securitization of, 160 servicing of, 160n Mortgage-backed bond (MBB), 840–841 gains to financial institutions from issuing, 840–841 Mortgage-backed securities, 247n, 266 calculating durations of, 265 Mortgage Bankers Association, 467 Mortgage bonds, 314 Mortgage coupon, 816 Mortgage pass-through strips, 842–844 Mortgagees, default risk by, 819 Mosebach, M., 385n Moser, J T., 693n Motor vehicles leases of, 157 loans on, 157 Mudd, Daniel, 242 MUFG, 674 Mukherjee, A., 353n Mukherjee, K., 474n Multibank holding companies (MBHCs), 392, 660 Multicurrency foreign asset-liability positions, 415–416 Multi-index arbitrage pricing theory (APT), 274 8/23/07 6:28:47 PM Find more at http://www.downloadslide.com Index Multiperiod debt instrument, probability of default on, 324–326 Multistrategy funds, 146 Multiyear restructuring agreements (MYRAs), 427, 455–456 Munich Re, 782 Municipal general obligation bond, 634n Municipal revenue bonds, 634n Munter, P H., 698n Mutual fund industry balance sheet and recent trends for, 134–136 global issues in, 141–143 growth of, 119 size, structure, and composition of, historical trends, 119–122 Mutual funds, 118, 138 characteristics of household owners of, 126 closed- and open-end bank loan, 804–805 costs of, 131–134 different types of, 122–125 investor ratings, 141 investor returns from ownership, 128–131 largest, by assets managed, 128 money market, 118, 122–125, 199n net new cash flows to equity, 120 number of, 124 objectives of, 126–128 open-ended, 118, 129–130 regulation of, 136–141 shareholder services offered by, 118n N Nabar, P., 307n Naik, N Y., 388n Nair, V., 102n Naive hedge, 696 Naked options, 735 National Asset Bank, 805 National Association of Insurance Commissioners (NAIC), 348, 360, 618 model of capital requirements for life insurance, 616–618 National Association of Securities Dealers (NASD), 109, 111, 136, 140 National Association of Securities Dealers Automated Quotations (NASDAQ), 100, 137, 560 National Australia Bank Ltd., 730 National Bank Act (1863), 633, 638–639 National Bank of North America, 681 National banking pacts, 661 National Conference of State Legislatures, 159 sau05140_index_853-874.indd 865 National Credit Union Administration (NCUA), 573–574 National Credit Union Insurance Fund (NCUIF), 553n, 573 Nationalization/expropriation, international expansion and, 685–686 National Loan Bank, 805 National Securities Markets Improvement Act (NSMIA) (1996), 108, 137 National treatment, 681 NationsBank, 635, 637, 666 NatWest Markets, 375 Neftci, Salih F., 277n Negative duration, 842 Negative net exposure position, 405 Negotiable instruments, 538 Net asset value (NAV), 129, 511 Net deposit drains, 495 Net interest income (NII), 190 exposure, 196 Net liquidity statement, 500 Net long in currency, 405 Net position exposure, 404 Net short in foreign currency, 405 Net short position, 178 Netting, swaps and, 786 Net wire payment transfers, 477 Net worth, 190, 587 New Century Financial, 153, 163 New York Agreement Company, 679–680 New York Futures Exchange (NYFE), 387, 695n New York Stock Exchange (NYSE), 100, 109, 111, 137, 153, 163, 560 Nguyen, T., 672n Nikkei Index, 686 No arbitrage, 324 No-load fund, 131–132 Nonbank banks, 662 subsidiaries of, 637 Nonbank financial service firms and commerce, 639 Noncallable loan, 305n Nonfinancial corporations, 805n Noninterest expenses, 461 Nonliquid assets, 520 Nonperforming loans, 297n, 446 Non-schedule L off-balance-sheet risks, 391–393 Non-U.S deposit insurance systems, 570–571 North American Free Trade Agreement (NAFTA) agreement, 678 Northern Trust Bank, 501 North Korea, debt repudiation in, 429 Norwest Corporation, 663 Notional value, 375 865 Not risk averse, 322n NOW accounts, 494n, 535 O Och-Ziff, 144 Off-balance-sheet (OBS) activities, 298 cash flows from, 205 financial institutions (FIs) solvency and, 373–378 growth in, 691 income from, 461 returns and risks of, 378–391 Off-balance-sheet (OBS) assets, 373 Off-balance-sheet (OBS) credit equivalent amount, assigning, to risk category, 608 Off-balance-sheet (OBS) hedging, 411 Off-balance-sheet (OBS) items, 372 Off-balance-sheet (OBS) liability, 373, 374 Off-balance-sheet (OBS) market contract credit risk-adjusted assets, calculating, 608–609 Off-balance-sheet (OBS) risks, 168, 176, 183, 372–391 activities and financial institutions solvency, 373–378 non-schedule, 391–393 returns of activities, 378–391 role of activities in reducing, 393–394 Off-balance-sheet (OBS) values, converting, into-on-balance-sheet credit equivalent amounts, 607–608 Off-market swap, 774 Offshore hedge funds, 148 Off-the-books partnerships, 373 Ohio Deposit Guarantee Fund (ODGF), 182n Oil companies, 303 Omnibus Budget Reconciliation Act (1993), 557 On-balance-sheet credit equivalent amounts, converting off-balancesheet (OBS) values into, 607–608 On-balance-sheet gap exposure, 205 On-balance-sheet hedging, 411, 412–413 One-bank holding company (OBHC), 660 expansion in activities, 663 One-period debt instrument, probability of default on, 321–323 Online banking, 465 On-the-run yield curve, 794 Open-end bank loan mutual funds as buyer in loan sales, 804–805 Open-end funds, 511 Open-end mutual fund, 118, 129–130 Open interest, 741 8/23/07 6:28:48 PM Find more at http://www.downloadslide.com 866 Index Open market paper, 134 Open position, 408 Operational cost savings, 458 Operational risks, 168, 181, 458, 483–485, 610–612 electronic transfer payment system and, 483–485 financial institutions (FIs) insolvency and, 487 loss event types, 613 regulatory issues and, 486–488 sources of, 459 Opportunistic fund, 146 Optimization, constrained, 523 Option(s), 265, 376, 387 basic features of, 728–732 call, 387, 729 defined, 728 delta of, 374–375 digital default, 750, 785n economic reasons for not writing, 733–734 futures versus hedging of, 735 hedging credit risk with, 749–751 in hedging foreign exchange risk, 748–749 in hedging interest rate risk on balance sheet, 743–748 naked, 735 put, 387 writing versus buying, 733–735 Option-adjusted spread, 829, 830 derivation of, 832–833 Option contracts, 387 Option models of default risk, 332–337 Option pricing model of deposit insurance, 559 Option pricing theory, 829 Options Clearing Corporation, 729 Options markets, growth of, 728–729 Option valuation model, applying, to calculation of default risk premiums, 334–335 Ott-Wadhawan, R L., 535n Out-of-the-money call option, 376n Overaggregation, 203–204 Overall loan portfolio, 295 Overseas Direct Investment Control Act (1964), 675 Over the counter forward contracts, 719 Over the counter swap market, growth of, 785 Owen, Martin, 375 P Pacific Investment Management Co., 703 Page, Scott, 798 Pages, H., 479n sau05140_index_853-874.indd 866 Paine Webber Group, 141, 635 Palia, D., 671–672, 673n Palmer, M., 440n Panic prevention, moral hazard versus, 556–557 Pantzalis, C., 438n Papouis, Kyriacos, 375 Park, S., 307n, 639n Parsley, D., 445n Participation in loans, 800–801, 802 Partnerships off-the-books, 373 Par value of shares, 591 Passbook savings, 264–265 costs of, 536 withdrawal risk of, 536 Pass-through securities, 160n, 814–835 Federal Home Loan Mortgage Corporation (FHLMC), 816 Federal National Mortgage Association (FNMA), 815–816 Government National Mortgage Association (GNMA) (Ginnie Mae), 815 government sponsorship and oversight of Federal National Mortgage Association (FNMA) and Freddie Mac, 833–834 incentives and mechanics of creation, 816–821 prepayment models, 826–833 prepayment risk on, 821–826 Pass-throughs over Treasuries, 829 Payday lender, 159 Payment of bills via telephone, 464 Payments in kind, 534 Payments system, technology and evolution of, 475–483 Payroll checks, preauthorized debits of, 532 PBHG Funds, 138 Pecora Commission, 633 Pedersen, L H., 445n Pemex, 425 Pennacchi, G., 390n, 561n Pennathur, A K., 462n Penn Square, 804 Pension Benefit Guaranty Corporation (PBGC), 552, 575–577 Pension funds as buyer in loan sales, 804 Pension Protection Act (2006), 576 Pentagon, terrorist attacks on, 458–459 Peregrine Investment Holding, Ltd., 426 Performance fees, 148 Performing loans, 446 Peristiani, S., 102n Permal Asset Management, 144 Personal cash loans, 160 Personal credit institutions, 155 Personal identification numbers (PINS), 480 Pessin, Jamie Levy, 110n Pickens, T Boone, 147 Pigeonhole approach, 348 Pilgrim, Baxter & Associates, 138 Piper Jaffray, 109 Pitney Bowes, 483, 662 Plain vanilla fixed-floating-rate swap, 772 Plante, Andrea, 615n PNC Financial Services Group, 155, 666 Point-of-sale (POS) debit cards, 464 Points, 302n Poisson process, 321n Political risks, 437, 676–677 Portfolio, barbell, 259 Portfolio aggregation, 274–277 Portfolio Manager, 354 Portfolio risk, trading, 278 Portfolio theory, partial applications of, 356–359 POS/debit cards, 467 Position trading, 100 Positive net exposure position, 405 Postmerger performance, geographic expansions and, 673 PO strips, 843–844 Potential exposure, 607 Prabhala, N R., 97n Preauthorized debits/credits, 464, 467 Preauthorized debits of payroll checks, 532 Prepayment effect IO strips and, 842–843 PO strips and, 844 Prepayment models, 826–833 Prepayment on pass-through securities, 820 Prepayment risk, 171n on pass-through securities, 821–826 Price risk, 436 Price-to-earnings ratio, 145 Primary credit, 572 Prime lending rate, 306 Principal, 98 Principal transactions, 100 Private-label credit card loans, 160 Private placement, 98, 111, 634 Probability cumulative, 326 of default on multiperiod debt instrument, 324–326 Procompetitive effects, 650–652 Procter & Gamble (P&G), 374, 375 Product diversification, 631–652 activity restrictions in United States versus other countries, 640–641 issues involved in diversification of offerings, 641–652 competition, 650–652 conflicts of interest, 647–649 8/23/07 6:28:48 PM Find more at http://www.downloadslide.com Index Product diversification—Cont deposit insurance, 649–650 economies of scale and scope, 645–647 regulatory oversight, 650 safety and soundness concerns, 643–645 risks of product segmentation, 631–632 segmentation in U.S financial services industry, 633–640 banking and insurance, 636–638 commercial and investment banking activities, 633–636 commercial banking and commerce, 638–639 nonbank financial service firms and commerce, 639 Product diversification benefit, 645 Product segmentation risks of, 631–632 in U.S financial services industry, 633–640 Production approach, 472 Profitability, technology innovation and, 459–461 Program trading, 101 Prompt corrective action (PCA), 563, 596 Property-casualty companies, 574–575 Property casualty insurance, capital requirements for, 618–619 Prudential Financial, 181 Prudential Securities, 138, 800 Prudent person concerns, 405 Public Securities Association, prepayment model developed by, 827–828 Pulley, L B., 473n Pull-to-par, 736 Purchased liquidity management, 496–497 Purchasing power parity (PPP), 417–418, 436n Pure arbitrage, 101 Pure credit swaps, 784–785 Puri, M., 97n, 651n, 809n Purnanandam, A., 558n Putnam Investments, 138 Put options, 387, 728 buying, on bond, 731–732 defined, 731 macrohedge with basis risk, 747–748 writing, on bond, 732 Q Qualitative models, 313–316 Quantity risk, 435 sau05140_index_853-874.indd 867 Quellos Capital Management, 144 Quinn, Kevin, 140 R Raisel, E B., 618n Rate sensitivity, 195–196 of assets, 195–198 equal changes in rates on, 200–201 unequal changes in rates on, 201–203 of liabilities, 195–196, 198–200 equal changes in rates on, 200–201 unequal changes in rates on, 201–203 Rating agencies, 321n Ratios capital-assets, 595–596 risk-based capital, 596, 598–601 setting, on interest rate swap, 794–796 Ray, S C., 474n Real estate investment trusts (REITs), 130 Real estate loans, 296, 301–303 Real estate mortgage investment conduits, 835n Real interest rates, 415 Real-time gross settlements (RTGS), 480n Recent trends, balance sheet and, 103–108 Recourse, 390, 798 Recovery time from system failures, 458 Reduced-form models, 320, 320n Refinancing, pass through securities and, 823–824 Refinancing risk, 170, 196 Region Financial, 665 Regional banking pacts, 661 Regional securities firms, 96 Regulation of finance companies, 163–164 of hedge funds, 148–150 of mutual funds, 136–141 of securities industry, 108–112 Regulation D, 808n Regulators, futures and forward policies of, 719 Regulatory avoidance, international expansion and, 685 Regulatory considerations, immunization and, 243–244 Regulatory discipline in controlling depository institution risk taking, 569–570 867 Regulatory factors, impact on geographic expansion, 657–663 Regulatory issues, technology and operational risks and, 486–488 Regulatory models, 360 Bank for International Settlements (BIS) framework, 283–288 Regulatory oversight, diversification of product offerings and, 650 Regulatory risk, electronic transfer payment system and, 482 Reinvestment risk, 170, 196 Relationship pricing programs, 306n Renaissance Technologies, 147 Reorganizations, 146 Repricing gap, 195, 202–203 Repricing model, 190, 195–203 weaknesses of, 203–205, 221 Republic New York Corp., 426 Repudiation, 429 Repurchase agreements, 107, 134, 183 costs of, 540 withdrawal risk of, 540 Reputational risk, 459 Rescheduling, 428 Reserve computation period, 524–525 Reserve maintenance period, 526–527 Reserve ratios, 522 Reserve requirement ratio, 521 Reserve requirement tax, 522 Reserve requirements, 307 as reason for loan sales, 808 Reserve target overshooting of, 530–531 undershooting of, 527–530 Resolution Trust Corporation (RTC), 807 Retail credit decisions, 310 Retail financial services, impact of technology on production, 462–465 Retail time deposits and CDs, 537–538 costs of, 537–538 withdrawal risk of, 537 Retailers, 303 Retained earnings, 591 Retirement Protection Act (1994), 576 Return on assets approach, 306 Return on the loan, 354 Return-risk trade-off, 173 for liquid assets, 523–532 Revco, 809 Revenues effect of technology on, 465–472 risk diversification and, 684 technology and, 466–467 Revenue synergies, 667–668 Reverse repurchase agreements, 107 Revolving loan, 303 Rhoades, S A., 667n Rice, T., 461n 8/23/07 6:28:49 PM Find more at http://www.downloadslide.com 868 Index Riegle-Neal Interstate Banking and Branching Efficiency Act (1994), 658, 663, 668n, 679, 804 Riggs National Bank, 481, 676 Risk-adjusted return on capital (RAROC) models, 328–331 Risk arbitrage, 101 Risk-avoidance funds, 146–147 Risk-based capital, 610–612 calculating overall position, 609 requirements for, 563 Risk-based capital ratios, 596, 598–601 calculating, 601–615 criticisms of, 612–615 rules of, 606–607 Risk-based deposit insurance program, 561 Risk-based premiums, implementing, 561–562 Risk Management Association (RMA), 316 RiskMetrics, 268–277, 406n historic (back simulation) model versus, 281–282 Risk-minimizing futures position, 700–704 Risk-neutral valuation method, 322n Risks affiliate, 392–393 associated with letters of credit, 386 country or sovereign, 179 of failure, 645 of financial intermediation, 168–184 country or sovereign risk, 179 credit risk, 173–175 foreign exchange risk, 177–178 insolvency risk, 182–183 interest rate risk, 169–171 liquidity risk, 181–182 market risk, 171–173 off-balance-sheet risk, 176 other, and interaction of risks, 183–184 technology and operational risks, 180–181 insolvency, 182–183 interaction of, 183–184 interest rate, 382 liquidity, 181–182 of loans, 354–355 market value, 171 prepayment, 171n refinancing, 170 reinvestment, 170 role of off-balance-sheet activities in reducing, 393–394 settlement, 391–392 takedown, 382 technology and operational, 180–181 sau05140_index_853-874.indd 868 Risk weights, 612–613 based on external credit rating agencies, 613 Ritcher, K., 487n RJR Nabisco, 809 Roger, C., 496n Rogoff, K., 442n Rohatgin, S., 312n Roland, K P., 474n Ronen, J., 390n Rosati, S., 477n Rosen, R., 388n Rosengren, E S., 487n, 611n RosZbach, K., 603n Roth, V., 487n Routine hedging, 698–699 Royal Bank of Scotland, 112, 632 Runoffs, problem of, 204 Russia, debt restructuring in, 442 Ryngaert, M D., 667n S SAC Capital Advisors, 147 SAC Capital Partners, 148 Safety net, 164 Saidenberg, M., 598n Sales finance institutions, 155 Salesperson's stake, conflict of interest and, 647–648 Salomon Brothers/Smith Barney, 95, 389n, 443, 638, 639 Sanders, T B., 440n Sanwa Bank, 681 Sarbanes-Oxley Act (2002), 110–111, 138, 316, 321n, 373 Satchell, S E., 448n Saunders, A., 102n, 282n, 298n, 307n, 320n, 322n, 328n, 351n, 353n, 354n, 357n, 365n, 434n, 456n, 464n, 472n, 555n, 598n, 603n, 613n, 631n, 642n, 648n, 651n, 786n, 802n, 809n Savings account contracts, 494n Savings and Loan Holding Company Act (1968), 637 Savings Association Insurance Fund (SAIF), 553 Savings deposits, 134 Savings institutions, 303 Scannell, Kara, 402n, 787n Schaefer, S., 736n Scholes, M., 332, 332n Scholnick, B., 464n Schwartz, E S., 736n Scott, H S., 615n Sears Roebuck, 303, 464n, 639, 656 Sears Roebuck Acceptance Corp., 155 Seasonal credit, 572 Seasonal effects, 507 Secok, S., 477n Secondary credit, 572 Secondary issues, 651 Secondary market for LDC debt, using market data to measure risk, 442–448 Secondary reserve function, 522 Second-order effect (dP2 / d2R), 256 Section 20 affiliates, 634, 647 Section 20 subsidiaries, 96n, 300n, 635, 636, 638 Secura Group, 508 Secured loans, 299 Securities Act (1933), 136, 143, 523 Securities affiliates, underwriting losses for, and bank failure, 644–645 Securities and Exchange Commission (SEC), 108–111, 140, 149, 594, 650, 719, 810 disclosure rules of, 164n regulation of derivatives, 719 regulation of hedge funds by, 149–150 regulation of mutual funds by, 136–137 Rule 15C 3-1, 615–616 Rule 144A, 111 Rule 415, 111 rules for disclosing off-balance sheet items, 373 Securities Exchange Act (1934), 136 Securities firms, 93, 95 balance sheet and recent trends, 103–108 capital requirements for, 615–616 global issues, 112–113 regional, 96 regulation, 108–112 size, structure, and composition of industry, 95–103 back-office and other service functions, 103 cash management, 101 investing, 97 investment banking, 97–98 market making, 99–100 mergers and acquisitions, 101–102 trading, 100–101 Securities industry profitability of, 104 regulation of, 108–112 Securities Investor Protection Act (1970), 575 Securities Investor Protection Corporation, 575 Securities trading, 95, 463 Securities underwriting, risk of, 643 Securitization, 531, 814–852 8/23/07 6:28:50 PM Find more at http://www.downloadslide.com Index Securitization—Cont Class A bonds, 838 Class B bonds, 838 Class C bonds, 838 Class R bonds, 838–839 Class Z bonds, 838 collateralized mortgage obligation, 835–839 creation of, 835–836 extension of, 845–846 innovations in, 841–845 mortgage-backed bond (MBB), 840–841 of mortgages, 160 of other assets, 844–845 pass-through securities, 814–835 Federal Home Loan Mortgage Corporation (FHLMC), 816 Federal National Mortgage Association (FNMA), 815–816 Government National Mortgage Association (GNMA) (Ginnie Mae), 815 government sponsorship and oversight of Federal National Mortgage Association (FNMA) and Freddie Mac, 833–834 incentives and mechanics of creation, 816–821 prepayment models, 826–833 prepayment risk on, 821–826 Securitized mortgage assets, 160 Security, duration and interest rate risk management on single, 234–238 Security Investors Protection Corporation (SIPC), 112, 552 Security Trust, 138 Seiles, M J., 277n Selective hedging, 698–699 Sellers in loan sales, 805–807 Semiannual coupon bonds, 233–234 September 11, 2001, terrorist attacks, 184 Sequential servicing rule, 551 Settlement risk, 391–392 Shared National Credit (SNC) database, 357 Shareholder services, offered by mutual funds, 118n Sharpe ratios, 146, 353n Shaw, David E., 147 Shelf-offerings, 111 Shell banks, 676 Sherman Antitrust Act, 649n Shinhan Bank of South Korea, 674 Short-bond shortage, 703 Short hedge, 704 macrohedge of interest rate using, 704–706 Short position, 144 sau05140_index_853-874.indd 869 Short-term funds, 122 Short-term rates, linkages between long-term rates and, 193 Siegel, M H., 618n Simoes, A P., 483n Simons, James H., 147 Simple duration gap approach, 708n Singapore International Monetary Exchange (SIMEX), 387, 695n Singleton, K J., 320n, 445n Sinkey, J F., Jr., 387n SLM Corp., 156 Slope effect (dP/dR), 256 Small business loans, 103, 845 Smart cards (store-value cards), 465, 475 SMFG, 811 Smith, C W., 607n, 796n Smith, Randall, 402n Smith, S D., 260n, 830n Smith Barney, 638, 639 Smithson, C W., 487n, 607n, 796n So-called lemons problem, 806 Société Générale, 144 Soft dollars, 103 Sondhi, A C., 390n Soros, George, 803 Southern Pacific Bank, 568 Sovereign bonds, 445–446 Sovereign debt early market for, 443 today's market for, 443–446 Sovereign risk, 107, 168, 179, 425–448 country evaluation, 430–448 credit risk versus, 428 debt repudiation versus debt rescheduling, 429–430 mechanisms for dealing with exposure, 453 Specialized electronic trading securities firms, 96 Special-situation funds, 146 Spinning, 648 Spot contracts, 693 Spot foreign exchange transactions, 401–403 Spot loan, 300 Spot market, 404 Spread effect, 202 Srinivasan, A., 102n, 298n Standard capital budgeting, 465–472 Standardized Approach, 487, 598, 611 Standard & Poor's (S & P), 297, 320–321, 324n, 349, 366 Standard & Poor's (S & P) 500 index, 97, 101, 118, 128, 141 Standby letters of credit, 384, 385–386, 787 Stangeland, D A., 438n Stanley, T O., 496n State Bank of India, 683 869 State Farm, 122 Statistical CRA models, problems with, 436–442 Statistical models, 432–434 Stephens, Robertson, 635 Stockholder discipline in controlling depository institution risk taking, 557–564 Stone, David H., 488 Stored liquidity management, 497–498 Stover, R., 102n Strategic risk, 459 Strock, E., 353n Strong Capital Management, 138 Structural models, 320n Subordinated debentures, 314–315 Subprime lender, 159 Subprime mortgages, originations of, 163 Subsidies, 534 Sumitomo Corp., 267 Sung, H M., 448n Superior Bank of Illinois, 553 Super-NOW accounts, 535n Surplus value of shares, 591 Surrender value of insurance policy, 510 Swap(s), 265, 376, 769–788 credit, 782–785 credit risk concerns and, 785–787 currency, 778–781 defined, 769 interest rate, 770–778 inverse floater, 775 macrohedging with, 775–778 netting and, 786 off-market, 774 policing, 787 pure credit, 784–785 total return, 782–784 Swap buyers, 770 Swap contract, 387n Swap dealers, 769 Swap markets, 769–770 Swapnotes, 393n Swap sellers, 770 Swaptions, 769n Swary, I., 673n Sweep accounts, 525 Sweep programs, 522n Swickle, Adam, 402 SWIFT, 463 Syndicated loan, 299 Systematic credit risk, 175 Systematic loan loss risk, 359 T Tail the hedge, 711 Takedown risk, 382, 383 8/23/07 6:28:50 PM Find more at http://www.downloadslide.com 870 Index Target bank, growth rate of, 672 Tax avoidance, electronic transfer payment system and, 482 Taylor, J D., 315n T-bills, 498n Technological innovation, 180, 458 Technologically oriented services, 532 Technology defined, 459 effect of, on revenues and costs, 465–472 effect on revenues and costs, 465–472 empirical findings on cost economies of scale and scope and implications for expenditures, 473–474 encryption, 463 impact of, on wholesale and retail financial service production, 462–465 operational risks and, 180–181 regulatory issues and, 486–488 profitability and, 459–461 regulatory issues and, 486–488 revenues and, 466–467 as source of operational risk, 459 Technology risk, 100, 168, 180, 183, 485 Tehranian, H., 673n Tennyson, S., 473n, 474n Term structure derivation of credit risk, 320–326 Term structure of interest rates, 191, 214–220 Terrorist attacks on World Trade Center, 105, 110, 193 Testing for economies of scale and economies of scope, 472–473 Texas Commerce, 661–662 Thacher Proffitt & Wood LLP, 484 Thakor, A V., 474n, 558n Third-party loans, 648 Thrift industry, capital adequacy in, 594–615 actual capital rules, 594–595 Thrifts, geographic expansion and, 657–658 Thrift Supervision, Office of, 506 Tie-ins as conflict of interest, 648 Tier I capital, 599–600, 601 Tier II capital, 600 Tier-one to tier-three (third-best) issuer, 301 Time deposits, 134 Time zones horizontal offsets between, 286–287 horizontal offsets within, 286 Timing insurance, 815 Timme, S B., 473n Tjarnberg, M., 277n Toevs, A., 262n sau05140_index_853-874.indd 870 Tombstone advertisement, 97 Tontine Partners, 147 Too-big-to-fail (TBTF) banks, 566, 567, 649–650 Toronto Dominion, 642 Total credit risk-adjusted assets, under Basel II, 609 Total return swaps, 782–784 Total risk-based capital ratio, 601 Tourous, W N., 736n Tower Group, 468 Toxic waste, 846 Toyne, M F., 673n Trading, 100–101 at discount, 130 position, 100 at premium, 130 program, 101 Transaction accounts, 523–524 Trans-European Automated Real-Time Gross-Settlement Express Transfer (TARGET), 477 Transition matrix, 349 Transition probabilities, 349 Travelers Group, 96, 180, 466, 631, 635, 636, 638, 639 Travlos, N G., 353n Treasury, U.S Department of, 149, 676, 677 Treasury management software, 463 Treasury strips, 321, 326 Tripp, J D., 673n Tucker Anthony, 508 Tudor Investment Corp., 147 Turkey, concerns over ability to meet debt obligations, 427 Turnbull, S., 320n Turtle, H J., 438n 12b-1 fees, 132–134 disclosure of, 137 Tyco International of America, 111, 301, 382 Tzang, D., 824n U UBS, 102, 109, 149, 407, 640 Uchibori, H., 640n Unbiased expectations theory, 216–217 Undershooting of reserve target, 527–530 Underwriting, 95, 649n domestic, 106 losses for securities affiliate and bank failure, 644–645 Unexpected deposit drains, 507–509 Uniform Fraudulent Conveyance Act, 810 Uninsured depositors, 566–569 Union Bancaire Privée, 144 Union Bank of Switzerland, 365, 375 Union Planters, 681 Unit banks, 658–659 United Bank of Switzerland, 632 United Currency Group Inc., 402 United States banks, abroad, 675 United States depository institutions, liquidity and liability structures for, 542–543 United States financial services industry, product segmentation in, 633–640 U.S government securities, 134 U.S Treasury securities, yield curve for, 214–215 Universal banks, 640 Universal financial intermediaries or financial institutions structure, 631 Unsecured loan, 299 Up-front fees, 139, 380 Upstreaming, 644 Urrutia, J L., 448n USA Patriot Act (2001), 111, 481, 676–677 Usury ceilings, 305, 482 V Value, notional, 375 Value additivity of collateralized mortgage obligations (CMOs), 836–837 Value-at-risk (VAR), 172 calculation of, 367–368 estimates of, 278 framework of, 365 models of, 190, 267 Value funds, 146 Vanguard, 127 Variance of export revenue (VAREX), 435–436 Venture capital firms, 97 Verification of identities, 463 Vertical offsets, 284–286 Veteran Administration (VA), mortgage loans issued by, 815 Visa, 303 Vlaar, P J G., 441n Voehmer and Megginson model to determine LDC secondary market loan price, 447 Vulture funds as buyer in loan sales, 803–804 W Wachovia, 100, 163, 465n, 488, 802 Wakeman, L M., 796n Wal-Mart Stores, 464n, 483, 484, 662 8/23/07 6:28:51 PM Find more at http://www.downloadslide.com Index Walter, I., 472n, 631n, 642n, 651n Walter, S., 598n Washington Mutual, 163, 667 Weatherstone, Dennis, 268 Weekend game, 525 Wei, R., 459n Weighted-average life, 826–827 Weir, P., 314n Weiss, M A., 473n, 474n Wells Fargo & Co., 163, 296 Whalen, G., 677n When-issued (WI) securities, 389 risks associated with, 389–390 sales of, 389–390 White, L J., 555n, 590n White-collar crime, 480 Whitehouse, Mark, 703n Wholesale certificates of deposit (CDs), 538–539 costs of, 538 withdrawal risk of, 538 Wholesale credit decisions, 310–312 Wholesale financial services, 462–463 impact of technology on production, 462–465 Wholesale lockbox, 462 Wilcox, J A., 472n Wilford, D S., 607n sau05140_index_853-874.indd 871 Williams, B., 685n Wilson, B., 555n Wingender, J R., 388n Wireless communications technologies, effect on financial services, 458 Withdrawal risk of demand deposits, 534–535 of federal funds, 539 of money market deposit accounts, 536–537 of NOW accounts, 535 of passbook savings, 536 of repurchase agreements, 540 of retail time deposits and CDs, 537 of wholesale certificates of deposit, 538 Wolfe, Daniel, 488n Working capital, 318n Working capital services, 462 World Bank, 179 assessment of country risk by, 428 WorldCom Inc., 105, 111, 296, 336, 648, 846 World Trade Center, terrorist attacks on, 105, 110, 193, 458–459 World Trade Organization (WTO), 678 Wright, D., 598n 871 X X-efficiencies, 665, 667 Xerox, 639 X-inefficiencies, 474 Y Yadav, P K., 388n Yamaichi Securities, 141, 426 Yang, W., 558n Yasuda Life Insurance Co., 141 Yawitz, J B., 323n Yield, duration and, 229–230 Yield curve on discount bonds, 261n Z Zaik, Edward, 331n Zell, Sam, 803 Zero-coupon bonds, 321 duration of, 228 Z ratio, 324n Z score, 318n, 324n, 432, 434 8/23/07 6:28:51 PM Find more at http://www.downloadslide.com sau05140_index_853-874.indd 872 8/23/07 6:28:52 PM Find more at http://www.downloadslide.com ... 7.90 82 2338.09 Wed 3.09 02 1. 325 2 3770 2. 13 72 1.1365 1.1355 1.1334 1.1303 527 .98 7.9077 23 47.97 04467 04430 1694 1681 1.0000 1.0000 17 42 1744 128 4 128 5 004804 004 721 022 11 022 08 0001094 0001093 23 39... 1 .25 72 1 .25 33 1 .24 61 1 .23 59 33.179 37.313 1.4588 5 325 5 324 5 321 5319 3.6 724 10.8460 1.5074 6.7751 60.606 3 .24 25 49. 925 3.1075 26 .947 3.7509 1.5760 29 .28 3 7.6104 955.38 7.3855 1 .27 06 1 .26 68 1 .25 91... Wed 323 8 323 6 7598 7546 2. 6 525 2. 6 526 4671 4679 8866 8799 8874 8807 8891 8 823 8914 8847 001901 001894 126 5 126 5 000 427 7 000 425 9 Thu 3.0883 1.3161 3770 2. 1409 1. 127 9 1. 126 9 1. 124 7 1. 121 8 526 .04