R GLENN HUBBARD ANTHONY PATRICK O’BRIEN Money, Banking, and the Financial System © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER 11 Investment Banks, Mutual Funds, Hedge Funds, and the Shadow Banking System LEARNING OBJECTIVES After studying this chapter, you should be able to: 11.1 Explain how investment banks operate 11.2 Distinguish between mutual funds and hedge funds and describe their roles in the financial system 11.3 Explain the roles that pension funds and insurance companies play in the financial system 11.4 Explain the connection between the shadow banking system and systemic risk © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER 11 Investment Banks, Mutual Funds, Hedge Funds, and the Shadow Banking System WHEN IS A BANK NOT A BANK? WHEN IT’S A SHADOW BANK! •During the financial crisis of 2007–2009, a variety of “nonbank” financial institutions were acquiring funds that had previously been deposited in banks, and they were using these funds to provide credit that banks had previously provided The newly developed securities they were creating were not fully understood •A key issue for policymakers in dealing with the crisis was the role the Fed should play in dealing with a financial crisis that involved many nonbank financial firms •An Inside Look at Policy on page 338 discusses whether a panic in the shadow banking system caused the financial crisis © 2012 Pearson Education, Inc Publishing as Prentice Hall Key Issue and Question Issue: During the 1990s and 2000s, the flow of funds from lenders to borrowers outside of the banking system increased Question: What role did the shadow banking system play in the financial crisis of 2007–2009? © 2012 Pearson Education, Inc Publishing as Prentice Hall of 49 11.1 Learning Objective Explain how investment banks operate © 2012 Pearson Education, Inc Publishing as Prentice Hall of 49 What Is an Investment Bank? Investment banking Financial activities that involve underwriting new security issues and providing advice on mergers and acquisitions Investment bankers are involved in the following activities: Providing advice on new security issues Underwriting new security issues Providing advice and financing for mergers and acquisitions Financial engineering, including risk management Research Proprietary trading Investment Banking © 2012 Pearson Education, Inc Publishing as Prentice Hall of 49 Providing Advice on New Security Issues • Firms turn to investment banks for advice on how to raise funds by issuing stock or bonds or by taking out loans Underwriting New Security Issues Underwriting An activity in which an investment bank guarantees to the issuing corporation the price of a new security and then resells the security for a profit, or spread Initial public offering (IPO) The first time a firm sells stock to the public • An investment bank typically earns 2% to 4% of the dollar amount raised in a secondary offering (or seasoned offering) • In return for the spread, the investment bank takes on the risk that it cannot profitably resell the securities being underwritten Investment Banking © 2012 Pearson Education, Inc Publishing as Prentice Hall of 49 Syndicate A group of investment banks that jointly underwrite a security issue • In a syndicated sale, a lead investment bank keeps part of the spread, and the remainder is divided among the syndicate members • Once a firm has chosen the investment bank that will underwrite its securities, the bank carries out a due diligence process, during which it researches the firm’s value The investment bank then prepares a prospectus, which the Securities and Exchange Commission (SEC) requires of every firm before allowing it to sell securities to the public • During the financial crisis of 2007–2009, investor confidence about the ability of investment banks to gather information was shaken when investment banks underwrote mortgage-backed securities that turned out to be very poor investments Investment Banking © 2012 Pearson Education, Inc Publishing as Prentice Hall of 49 Providing Advice and Financing for Mergers and Acquisitions • Investment banks are very active in mergers and acquisitions (M&A) They advise both buyers—the “buy side mandate”—and sellers—the “sell side mandate.” • When advising a firm seeking to be acquired, investment banks attempt to find an acquiring firm willing to pay significantly more than the book value of the firm • Advising on M&A is particularly profitable for investment banks because the bank does not have to invest its own capital Its only significant costs are the salaries of the bankers involved in the deal Investment Banking © 2012 Pearson Education, Inc Publishing as Prentice Hall of 49 Financial Engineering, Including Risk Management • Financial engineering involves developing new financial securities or investment strategies using sophisticated mathematical models • Derivative securities, used by firms to hedge, are the result of financial engineering • Investment banks supply knowledge of financial markets to properly assess the best way to raise funds by selling stocks and bonds, and construct risk management strategies for firms in return for a fee • During the financial crisis, investment bank managers greatly underestimated the risk that the prices of these derivatives might fall if housing prices declined and people began to default on their mortgages Investment Banking © 2012 Pearson Education, Inc Publishing as Prentice Hall 10 of 49 Figure 11.3 Financial Assets of U.S Insurance Companies Life insurance companies have larger asset portfolios than property and casualty insurance companies Property and casualty insurance companies hold more municipal bonds because the interest on them is tax exempt, while life insurance companies hold more corporate bonds because they payer higher interest rates Contractual Savings Institutions: Pension Funds and Insurance Companies © 2012 Pearson Education, Inc Publishing as Prentice Hall 35 of 49 Risk Pooling • Insurance companies use the law of large numbers to make predictions They rely on the average occurrences of events for large numbers of people • By issuing a sufficient number of policies, insurance companies take advantage of risk pooling and diversification to estimate the size of reserves needed to pay potential claims • Statisticians known as actuaries compile probability tables to help predict the risk of an event occurring in the population Contractual Savings Institutions: Pension Funds and Insurance Companies © 2012 Pearson Education, Inc Publishing as Prentice Hall 36 of 49 Reducing Adverse Selection through Screening and Risk-Based Premiums • People most eager to buy insurance are those with the highest probability of requiring an insurance payout • To reduce adverse selection problems, insurance company managers gather information to screen out poor insurance risks • Insurance companies also reduce adverse selection by charging risk-based premiums, which are premiums based on the probability that an individual will file a claim Contractual Savings Institutions: Pension Funds and Insurance Companies © 2012 Pearson Education, Inc Publishing as Prentice Hall 37 of 49 Reducing Moral Hazard with Deductibles, Coinsurance, and Restrictive Covenants • Policyholders may change their behavior once they have insurance To reduce the likelihood that an insured event takes place, some of the policyholder’s money is also put at risk Insurance companies this by requiring a deductible • To further hold down costs, insurance companies may offer coinsurance as an option in exchange for charging a lower premium • To cope with moral hazard, insurers also sometimes use restrictive covenants, which limit risky activities by the insured if a subsequent claim is to be paid • These tools to reduce adverse selection and moral hazard problems align the interests of policyholders with the interests of the insurance companies The cost of insurance is reduced and the savings translate into lower premiums Contractual Savings Institutions: Pension Funds and Insurance Companies © 2012 Pearson Education, Inc Publishing as Prentice Hall 38 of 49 Making the Connection Why Did the Fed Have to Bail Out Insurance Giant AIG? • One of the most dramatic events of the financial crisis was the collapse of American International Group (AIG), the largest insurance company in the United States • It was surprising that a stable insurance company would be involved in the crisis AIG, however, expanded beyond the basic insurance activities • In 1998 AIG Financial Products, based in London, decided to begin writing credit default swap contracts on CDOs, or insuring the value of CDOs At first, the CDOs included relatively high-quality corporate bonds, with only a few mortgage-backed securities • But at the height of the housing boom, AIG was issuing hundreds of billions of dollars worth of credit default swaps against CDOs consisting largely of mortgage-backed securities Contractual Savings Institutions: Pension Funds and Insurance Companies © 2012 Pearson Education, Inc Publishing as Prentice Hall 39 of 49 Making the Connection (continued) Why Did the Fed Have to Bail Out Insurance Giant AIG? • AIG was earning $250 million annually from the premiums and, although housing prices had begun to decline in 2006, AIG remained optimistic • By September 2008, AIG had lost $25 billion on the credit default swaps The owners of the swaps were insisting that AIG post collateral against the possibility of further losses The firm did not have sufficient assets to use as collateral and without government assistance, it would need to declare bankruptcy • The U.S Treasury and the Federal Reserve were afraid that if AIG failed, the losses suffered by other firms would deepen the crisis, and decided to bail out the company Contractual Savings Institutions: Pension Funds and Insurance Companies © 2012 Pearson Education, Inc Publishing as Prentice Hall 40 of 49 11.4 Learning Objective Explain the connection between the shadow banking system and systemic risk © 2012 Pearson Education, Inc Publishing as Prentice Hall 41 of 49 Systemic Risk and the Shadow Banking System • Financial institutions, such as investment banks, hedge funds, and money market mutual funds are nonbank financial institutions known as the “shadow banking system.” • On the eve of the financial crisis, the size of the shadow banking system was greater than the size of the commercial banking system • The FDIC and the SEC were created with the goal to protect depositors from the likelihood that the failure of one bank would lead depositors to withdraw their money from other banks, a process called contagion Congress was less concerned with the risk to individual depositors than with systemic risk to the entire financial system Systemic risk Risk to the entire financial system rather than to individual firms or investors Systemic Risk and the Shadow Banking System © 2012 Pearson Education, Inc Publishing as Prentice Hall 42 of 49 • Deposit insurance succeeded in stabilizing the banking system, but there is no equivalent to deposit insurance in the shadow banking system • In the shadow banking system, short-term loans consist of repurchase agreements, purchases of commercial paper, and purchases of money market mutual fund shares rather than deposits • With the exception of a temporary guarantee to owners of money market mutual fund shares during the crisis, the government does not reimburse investors who suffer losses when they make loans to shadow banks • During the financial crisis, the shadow banking system was subject to the same type of systemic risk that the commercial banking system experienced during the years before Congress established the FDIC in 1934 Systemic Risk and the Shadow Banking System © 2012 Pearson Education, Inc Publishing as Prentice Hall 43 of 49 Regulation and the Shadow Banking System There have been two main rationales for exempting many nonbanks from restrictions on the assets they can hold and the degree of leverage they can have: • Policymakers did not see these firms as being important to the financial system as were commercial banks, and regulators did not believe that the failure of these firms would damage the financial system • These firms deal primarily with other financial firms, institutional investors, or wealthy private investors rather than with unsophisticated private investors Policymakers assumed that these investors could look after their own interests without the need for federal regulations Systemic Risk and the Shadow Banking System © 2012 Pearson Education, Inc Publishing as Prentice Hall 44 of 49 • In 1934, Congress gave the SEC broad authority to regulate the stock and bond markets, and in 1974, it established the Commodity Futures Trading Commission (CFTC) to regulate futures markets • Securities that were not traded on exchanges were not subject to regulation By the time of the financial crisis, trillions of dollars worth of securities were being traded in the shadow banking system with little oversight, and subject to significant counterparty risk • When derivatives are traded on exchanges, the exchange serves as the counterparty, which reduces the default risk to buyers and sellers • In 2010, Congress enacted regulatory changes that would push more trading in derivatives onto exchanges Systemic Risk and the Shadow Banking System © 2012 Pearson Education, Inc Publishing as Prentice Hall 45 of 49 The Fragility of the Shadow Banking System We can summarize the vulnerability of the shadow banking system as follows: •Many firms in the shadow banking system were borrowing short term and lending long term •These firms were also more vulnerable to incurring substantial losses and possible failure The investors in investment banks and hedge funds had no federal insurance against loss of principal, increasing the probability of a run Being largely unregulated, shadow banks could invest in more risky assets and become more highly leveraged than commercial banks •Finally, during the 2000s when housing prices began to decline, many shadow banking firms suffered heavy losses and some were forced into bankruptcy Given the increased importance of these firms in the financial system, the result was the worst financial crisis since the Great Depression Systemic Risk and the Shadow Banking System © 2012 Pearson Education, Inc Publishing as Prentice Hall 46 of 49 Answering the Key Question At the beginning of this chapter, we asked the question: “What role did the shadow banking system play in the financial crisis of 2007– 2009?” Although we will discuss the financial crisis of 2007–2009 more completely in the next chapter, this chapter has provided some insight into the role of the shadow banking system Many shadow banks, particularly investment banks and hedge funds, were overly reliant on financing long-term investments with short-term borrowing, were highly leveraged, and held securities that would lose value if housing prices fell When housing prices did fall, these firms suffered heavy losses, and some were forced into bankruptcy Given the importance of shadow banking to the financial system, the result was a financial crisis Systemic Risk and the Shadow Banking System © 2012 Pearson Education, Inc Publishing as Prentice Hall 47 of 49 AN INSIDE LOOK AT POLICY Did a Shadow Bank Panic Cause the Financial Crisis of 2007– 2009? WASHINGTON POST, Explaining FinReg: Shadow Bank Runs, or the Problem Behind the Problem Key Points in the Article • Yale University economist Gary Gorton argues that a bank run in the shadow banking system caused the financial crisis that began in 2007, which was triggered by rising delinquencies and foreclosures in the subprime mortgage market • Without deposit insurance, depositors demanded collateral, which took the form of highly rated mortgage-backed securities • When the subprime mortgage crisis began, no one knew which banks were most at risk, and investors lost confidence in all institutions in the shadow banking market • The shadow banking system was subject to great disruption from new information—something that commercial banks avoid with deposit insurance © 2012 Pearson Education, Inc Publishing as Prentice Hall 48 of 49 AN INSIDE LOOK AT POLICY The table below shows the widespread decline from 2007 to 2008 in the issuance of securitized and corporate debt © 2012 Pearson Education, Inc Publishing as Prentice Hall 49 of 49 ... operate 11. 2 Distinguish between mutual funds and hedge funds and describe their roles in the financial system 11. 3 Explain the roles that pension funds and insurance companies play in the financial. .. play in the financial system 11. 4 Explain the connection between the shadow banking system and systemic risk © 2012 Pearson Education, Inc Publishing as Prentice Hall CHAPTER 11 Investment Banks,... of the banking system increased Question: What role did the shadow banking system play in the financial crisis of 2007–2009? © 2012 Pearson Education, Inc Publishing as Prentice Hall of 49 11. 1