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U.S. Financial Regulation
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Last Update: October 7, 2009
1
Part 1
Depository Financial Institutions:
Commercial Banks
2
 Overview of Banking Regulation
¶ Regulatory Goals and Tools
 “Reserve Requirements” To ensure sufficient liquidity to
convert notes (now deposits) into Specie (now notes),
thereby avoiding bank runs
 ”Capital Requirements” To ensure sufficient capital to allow
banks to survive declines in asset prices
 ”Interbank Relations Rules” To ensure competition among
banks and between banks and other institutions
• Rules on Mergers and New Bank Formation
• Rules on Deposit Interest Rates
 ”Interindustry Relations Rules” to ensure that combinations
between bank and non-bank companies do not weaken banks
3
 ”Asset Allocation Rules” To ensure diversification
 Fractional Reserve Banking
4
 First Bank of the United States (1791 – 1811)
¶ Formation
 Private Bank Formed By Congress With 20 Year Term
 Advocated By Alexander Hamilton, First Treasury Secretary
And Leading Federalist (Democrat) Under Washington
 Opposed By Jefferson, Madison And Most Republicans
5
 First Bank of the United States (1791 – 1811)
¶ Functions
 Manage State War Debts Recently Assumed By New Federal
Government
 Establish The Public Credit Of The U.S.
 Provide Strong Central Currency As Alternative To State Banks
 Act As Federal Fiscal And Monetary Agent
• Receive Federal Tax Deposits And Make Payments
• Manage U.S. Mint’s Minting of Coin And Purchase/Sale of
Specie
 Act As Private Bank
• Make Loans (Excluding Loans to Federal Government)
• Issue Bank Notes Convertible Into Specie and Legal
Tender For Federal Tax Payment
6
 First Bank of the United States (1791 – 1811)
¶ Financing The Bank
 $10 Million Capitalization
• $2 Million From U.S. Treasury
- 100% Borrowed From Bank
• $8 Million From Private Sources
- 25% ($2M) Payable In Specie
- 75% ($6M) Payable In Treasury Bonds and Scrip
¶ Revenue Sources
 Investment And Loan Portfolio
 Customs Excise Taxes
 Tax On Whiskey Sales
7
 First Bank of the United States
¶ Opposition To First Bank, Primarily In The South
 Agricultural States Viewed The Bank As
• A Tool Of Northern Commercial Interests
• A Source Of Weakened Southern Banks
• A Source Of Tighter Farm Credit
• An Infringement On States’ Rights
 South Objected To The Excise Tax On Alcohol Used To
Finance The Bank’s Interest Payments On States’ Debts
• Whiskey Was “A Necessity of Southern Life”
• Controversy Led To Shay’s Rebellion (“The Whiskey
Rebellion”) in 1794
¶ Charter Allowed To Expire In 1811 (Under Madison)
8
 Second Bank of the United States (1816 – 1836)
¶ Formation
 Private Bank Formed By Congress With 20 Year Term
 Advocated By The Democrats (Federalists) With
Madison, A Republican, As President
¶ Functions
 Manage War Of 1812 Debts
 Provide Strong Central Currency As Alternative To State Banks
 Act As Federal Fiscal And Monetary Agent
• Receive Federal Tax Deposits And Make Payments
• Manage U.S. Mint’s Minting of Coin And Purchase/Sale of
Specie
 Act As Private Bank
• Make Loans Including Loans to Federal Government
• Issue Bank Notes Convertible Into Specie and Legal 9
Tender For Federal Tax Payment
 Second Bank of the United States
¶ Opposition To Bank Was Primarily In The South
 Agricultural States Viewed The Bank As
•
•
•
•
A Tool Of Northern Commercial Interests
A Source Of Weakened Southern Banks
A Source Of Tighter Farm Credit
An Infringement On States’ Rights
 In Early Years Bank Was Haunted By Corruption
• Loans To Political Supporters
• Nicholas Biddle Became President In 1822 And Ended
Corrupt Practices
10
 Second Bank of the United States
¶ Andrew Jackson Was Strong Opponent
 Objected To Elite Central Institution Not Responsible To “The
People”
 Attempted To End Bank In 1832 By Transferring Federal
Deposits To State Banks; Congress Over-Ruled
 Bank Became Pawn In Jackson-Clay Presidential Campaign
 Bank Charter Allowed To Expire n 1836
11
 The “Free Banking” Era (1836 – 1863)
¶ State Banking
 All Banks Chartered And Supervised By States
 State Supervision Focused On
• Capital Requirements
• Bank Note Reserve Requirements (Usually Specie
Plus Eligible Paper)
¶ Era Of Frequent Bank Failures
 General Relaxation Of Capital And Reserve Requirements
 Banks Chose To Charter In Easy States
 Southern Agricultural Banks Most “At Risk”
• Agricultural PricesVolatility and Weak Supervision
12
 The National Banking Act Of 1863 (Dual Banking)
¶ Established Federally-Chartered Banks
 Civil War Took Southern Opponents To “National” Banking
Out Of Congress
 Office Of The Comptroller Was Created To Supervise
National Banks
 Federally-Chartered Banks Tended To Have Weak Capital
Requirements But Strong Reserve Requirements To
Maintain Convertibility
• Reserve Requirements Could Be Satisfied By Holding
Treasury Securities, Thereby Enhancing War Finance
• National Banks Were Required To Accept Each Others ‘13
Notes At Par
 The National Banking Act Of 1863
¶ Congress Actively Favored National Banks
 Levied A 10% Tax On Notes Of State Banks, Effectively
Driving State Bank Note Issuance Out Of Existence
• State Banks Responded By Shifting Issuance From Notes
To Deposits
 The Act Prohibited Interstate Banking
• State Banks Could No Longer Shop For Favorable Charters
• State Banks Declined Significantly In Importance
14
 The National Banking Act Of 1863
¶ The Act Did Not Prevent Bank Failures
 The Panic Of 1873
• Agricultural Prices Collapsed
• “The Crime Of 1873”
 The Panics Of the 1890s
• International Gold Flows
• The Silver Purchase Act Of 1890
 The Panic Of 1907
15
 The Federal Reserve Act Of 1913
¶ Background
 Crop Cycles And The “Inelastic Currency”
• During Harvest Season Demand For Money And Credit
Increased But No Source Of Increased Supply
• Severe Seasonal Credit Crunches Occurred
• Only Moderating Factors Were Inflows Of Foreign Credit
And Lending By Clearing Houses
16
 The Federal Reserve Act Of 1913
¶ Background
 The Panic Of 1907
• Weakening Economy Coincided With Financial Scandal
And Harvest Time
• Trust Company Failures In NYC Led To Major Credit
Lockup
• Problem Spread To Interior Banks As NY Correspondents
Failed
• Resolved By J.P. Morgan And Intervention By Clearing
Houses, Treasury, And Strong Banks/Trust Companies
17
 The Federal Reserve Act Of 1913
¶ Federal Reserve System Structure
 Managed By 7-Member “Board Of Governors” In DC
 Created 12 “Branches,” Called Federal Reserve Districts
 Federal Reserve Bank Of New York Was Major District Bank

Federal Open Market Committee Formed In 1930s
• Function Was To Conduct Monetary Policy
• 12 Members--7 BOG Members Plus 5 Regional Bank
Presidents In Rotation
18
 The Federal Reserve Act Of 1913
¶ Federal Reserve System Functions
 Lend To Member Banks At Discount Window
• Loans Made On “Real Bills” At “Discount Rate”
• Loans For “Need,” Not “Profit”
 Supervise Member Banks
 Provide Services To Member Banks
• Check Clearing
• Coin Sorting
 Establish Reserve Requirements For Member Banks
19
 The Banking Act Of 1933 (Glass-Steagall Act)
¶ Main Features
 Prohibited Commercial Bank Ownership Of Investment
Banks And Insurance Companies
 Prohibited Payment Of Interest On Demand Deposits
 Established The FDIC To Insure Bank Deposits
 Authorized Fed To Supervise Member Banks
• Establish Capital Requirements For Member Banks
 Authorized Fed To Issue Federal Reserve Notes, Limited
To 4 times Gold Stock Held
20
 The Banking Act Of 1933 (Glass-Steagall Act)
¶ Main Features
 Expanded Authority Of The Federal Reserve System
• Fed Could Set Ceilings On Rates Paid On “Time And
Saving Deposits”
• Fed Could Set Limits On Margin Loans By Banks And
Others
21
 Federal Reserve System Responses To 1933 Act
¶ Subsequent Developments
 Implemented Authority To Restrict “Margin Loans”
• Established Regulation “T” For Security Lending By BrokerDealers (1934)
• Established Regulation “U” Controlling Security Lending
By Banks (1936)
• Established Regulation “G” Controlling Security Lending By
Non-Bank Domestic Lenders (1968)
• Established Regulation “X” Controlling Security Lending By
Foreign Lenders (1968)
22
 Federal Reserve System Responses To 1933 Act
¶ Subsequent Developments
 Implemented Regulation “Q” Setting Ceilings On Interest
Rates Paid On Bank Time And Saving Deposits (1933)
 Implemented Regulation “D” Creating Uniform Reserve
Requirements For Member Bank Deposits
23
 The Bank Holding Company Act Of 1956
¶ Prohibited Banks From Buying Or Being Owned By
Non-Bank Non-Financial Entities (e.g., Industrial
Corporations)
 Concern That Industrial Companies Would Borrow From
Banks At Advantageous Terms, Thereby Weakening Banks
 Concern That BHCs Were Being Used To Circumvent
Prohibition Of Interstate Branching via “Chain Banking”
 Excluded One-Bank Holding Companies
24
 Bank Holding Company Act Amendments Of 1970
¶ Extended To One-Bank Holding Companies The BHCA
Limitations On Mergers With Non-Banking Companies
25
 The Community Reinvestment Act Of 1977 (CRA)
¶ Introduced Social Criteria Into Bank Lending
 Initiated By Concerns About “Redlning”
 FDIC-Insured anks Evaluated On Basis Of Lending Within
Deposit-Generating Communities
• Focuses On Limiting Deposit Drains To Outside Areas
• CRA Does Not Require Making Loans With High Default
Prospects
 Federal Reserve System Was Charged With Evaluating CRA
Compliance
26
 The Community Reinvestment Act Of 1977 (CRA)
¶ Government Sponsored Entities (FNMA, FHLMC) Also
Required To Meet Social Criteria
 Monitored By HUD
 HUD Introduced “Special Affordable Loan” Requirement
• GSEs Must Have A Minimum Share Of New Loans To
Borrowers With Incomes Below 60% Of Community Median
• GSEs SAL Minimum Started at 12% of New Mortgages In
1996, Rose to 28% in 2008
27
 The Depository Institutions Deregulation And
Monetary Control Act of 1980 (DIDMCA)
¶ Initiated Removal Of Glass-Steagall Restrictions
 Established Uniform Reserve Requirements For Banks and
Thrift Institutions
 Phased Out Requlation Q, Allowing Unlimited Interest
Payments on Time And Saving Deposits
 Allowed Interest Payments On Substitutes For Demand
Deposits (NOW Accounts)
28
 The Depository Institutions Deregulation And
Monetary Control Act of 1980 (DIDMCA)
¶ Other Actions
 Liberalized Investment Authority of Thrift Institutions
• S&Ls Could Invest Up To 20% In Non-Mortgage Assets
• MSBs Coukd Invest Up To 5% In Non-Mortgage
 Increased FDIC Deposit Insurance To $100K from $40K
 Required Federal Reserve System To Price Its Services
(Check Clearing, Coin Sorting, FedWire, ACH, etc.)
29
 The Financial Industry Modernization Act of 1999
[Called Gramm-Leach-Bliley Act, Or GLB Act]
¶ Continued Dismantling Of Glass-Steagall Act
 In 1994 CitiBank Bought Travelers Insurance And Salomon
Brothers’ Smith-Barney Brokerage To Form CtiGroup
• CitiGroup Formation Illegal Under Glass-Steagall
• CitiBank Received Waiver To Allow Merger
 GLB Act Formalized Approval Of CitiGroup By Allowing Any
Commercial Bank To Undertake Cross-Industry Mergers
• Chase Bank Buys JPMorgan to Create JPMorganChase
 Cross-Industry Merger Approval Conditioned On
“Satisfactory” CRA Rating In Most Recent Evaluation
30
Part 1.2
Bank Supervisory
Agencies
31
 Supervisory Agency Structure
Comptroller of the Currency
1863
National Chartered Banks
Federal Reserve System
1913
State Chartered FRB Members
Federal Deposit Insurance Corp
1933
National Chartered Banks
State Chartered Banks
Savings Banks
State Banking Commissions
Various
State Chartered Banks
Office of Thrift Supervision, FDIC,
And State Banking Commisions
Various
Savings and Loan Associations
Savings Banks
32
 Supervisory Agency Ratings
¶ The CAMELS System (1978)
 CAMELS Criteria
• Capital Adequacy
• Asset Quality
• Management Ability
• Earnings Performance
• Liquidity
• Sensitivity To Market Risk
 The CAMELS Ratings
• Rating Based On Call Reports, Field Visits
- Scored From 1 (Poor) To 5 (Excellent)
- Results Are Not Public
• Rating Assigned By Lead Supervisory Agency
33
 The Basle Accords
¶ Basle I (1988)
 Established International Standards For Bank Supervision
 Defined “Capital”
• Tier 1 Capital = Common Equity Paid In
+ Cumulative Retained Earnings
+ Noncumulative Preferred Stock
• Tier 2 Capital =
+
+
+
Hybrid Debt
Subordinated Debt
Loan Loss Reserves
Contingency Reserves
34
 The Basle Accords
¶ Basle I (1988)
 Established Capital Composition Standards
• At Least 50% Of Capital Had To Be Tier 1
• No More Than 50% Of Tier 2 Capital In Subordinated Debt
 Set “Risk-Based” Capital Requirements (Credit Risk Only)
35
 The Basle Accords
¶ Basle II (2004)
 Extended Types Of Risk Evaluated
• Credit Risk
• Operational Risk
• Market Risk
 Credit Risk Requirements
• Standard Method—e.g. 8% of Average Risk-Adjusted
Assets
• Internal Risk-Based Analysis (Option For Large Banks)
 Market Risk
• Basle II Recommends “Value At Risk” (VaR)
36
 Basle II: Measuring Market Risk By VaR
Example of VaR Analysis of Capital Required
(Cumulative Probability Distribution Of Gain or
1.00
0.90
Capital Required for 5% Wipeout
and 40% Volatility
= 67% of Net Assets
0.70
0.60
Capital Required for 5% Wipeout
and 20% Volatility
= 33.5% of Net Assets
0.50
0.40
Expected Net Asset Increase
in Next Y ear = 0.0%
0.30
0.20
0.10
5% Critical Probability
2.65
2.50
2.35
2.20
2.05
1.90
1.75
1.60
1.45
1.30
1.15
1.00
0.85
0.70
0.55
0.40
0.25
0.10
-0.05
-0.20
-0.35
-0.50
-0.65
-0.80
-0.95
-1.10
-1.25
-1.40
-1.55
-1.70
-1.85
0.00
-2.00
Cumulative Prbability
0.80
Percentage Gain or Loss
Low Volatility (s=0.20)
high volatility (s=0.40)
37
 Problems With VaR
¶ Non-Normality In Distribution Of Returns
 Above-Normal Probability Of Large Asset Price Declines
• Fat Tails And
• “Black Swans”
¶ Use Of Historical Data
 Historical Measurement Of Correlations Between Asset
Returns
 Dramatic Changes In Correlations In Crisis Periodx
 Failure To Incorporate Connections Between Markets
38
 What Went Wrong With Commercial Banks In 2008?
¶ Off Balance Sheet Investments
 Structured Investment Vehicles
• Independent Entities Created By Banks
- Sold To Investors (Hedge Funds, High-Wealth)
- Investors Financed Purchase Wiyj Short-Term Loans
(Commercial Paper)
- Banks Had No Explicit Obligation To Redeem
- Bank’s Did Provide Letters of Credit (Commitments To
Replace Short-Term Loans If Normal Lenders Withdrew)
39
 What Went Wrong With Commercial Banks In 2008?
¶ Off Balance Sheet Investments
 The Collapse Of SIVs
• During Credit Freeze In Fall, Banks Forced To Make Loans
To SIVs, Selling Assets And Restricting Bank Loans
• Banks Faced Implicit Commitents To Repurchase SIV
Assets (”Reputational Put)
40
 What Went Wrong With Commercial Banks In 2008?
¶ Changes In Supervisory Philosophy
 The Shift To Internal Risk Assessment (Basle II)
• Applied To Large Banks
• Rested On Poor Assumptions
- Quantitative Risk Management Methods (VaR) Were
Suitable
- Management Incentives Were Aligned With Shareholders
41
Part 2
Depository Financial Institutions:
Thrift Institutions
Savings And Loan Associations
And
Mutual Savings Banks
42
 Thrift Institutions
¶ Designed To Collect Savings Deposits And Invest In
Residential Mortgages
¶ S&L Deposits Insured By Federal Savings And Loan
Insurance Corporation (FSLIC)L Institutions; MSB
Deposits Insured By State Insurance Funds
43
 Thrift Institutions
¶ Fatal Flaws
 Borrowed Short-Term (Deposits) And Made
Long-Term Loans (Mortgages)
• Viability Required Upward-Sloping Yield Curve And
Stable Interest Rates
 Undiversified Assets--Entirely In Residential Mortgages
44
 Important Legislation
¶ Federal Home Loan Bank Act of 1932
 Created FHLB System
 Modeled After Federal Reserve System
• Twelve Regional Banks
• Authority To Lend To S&Ls On Mortgage
Collateral
 Allowed Federally Chartered S&Ls
45
 Important Legislation
¶ Federal Savings And Loan Insurance Act Of 1934

Created FSLIC
• Modeled After FDIC
• Supervised By FHLB Board
• Insured S&L Deposits
46
 Important Legislation
¶ Formation Of Government Sponsored Entities
 Federal National Mortgage Association (1938)
• Purchased FHA/VA-Insured Mortgages
• Financed By Bonds And “Pass-Thru” Securities
• “Privatized” In 1968
 Government National Mortgage Association (1968)
• Supervised By HUD
• Purchased Conventional And FHA/VA Mortgages
47
 Important Legislation
¶ Formation Of Government Sponsored Entities
 Federal Home Loan Mortgage Corp (1970)
• Supervised By FHLB Board
• Purchased Conventional Mortgages
48
 Important Legislation
¶ Interest Rate Control Act of 1966

Subjected S&L Deposits to Regulation Q Ceiling
Plus +.25%

Goals:
• Protect Income Of Thrift Institutions
• Allow Thrifts A Small Deposit Rate Advantage
Over Commercial Banks
49
 Important Legislation
¶ DIDMCA of 1980

Liberalized Investment Authority of Thrift Institutions
•
S&Ls Could Invest Up To 20% In Non-Mortgage Assets
•
MSBs Could Invest Up To 5% In Non-Mortgage Assets

Eliminated Interest Rate Ceilings On Deposits (Reg Q)

Required Federal Reserve To Price Services To Banks
(Check Clearing, Coin Sorting, Currency Replacement)
50
 Important Legislation
¶ Depository Institutions Act Of 1982 (Garn-St. Germain)

Broadened Powers of S&Ls
• Allowed Investment of Up To 40% In Commercial
Mortgages And 10% In Commercial Loans
• Allowed S&Ls To Borrow An Unlimited Amount In
Non-Deposit Loans
• Shifted Risk Management Responsibility From
Regulators To Bank/S&L Management
• Allowed Any Depository Institution To Borrow
From FDIC Or FSLIC To Replenish Capital
51
 Other Important Events
¶ Advent Of Junk Bonds


Michael Milken Sees That Below-Investment-Grade
Bonds Earn More Than High-Rated Bonds After
Adjusting For Defaults
Drexel, Burnham, Lambert Creates A Market For Junk
Bonds
•
Junk Bonds Allowed Smaller Companies To Get
Access To Long-Term Financing
•
S&Ls Bought Junk Bonds On A Large Scale As A
Way To Diversify Beyond Mortgages and Get High
Returns
52
 What Went Wrong With Thrifts?
¶ Interest Rates Rose, Especially Short Rates

Long-Term Rate Increases Created Losses In
Value Of Mortgage Assets, Wiping Out Capital

Yield Curve Tilt Created Losses On Income
Account, Threatening Liquidity
53
 What Went Wrong With Thrifts?
¶ S&Ls Invested Heavily In Bad Loans

Oil Prices and Home Prices Broke In The Mid-1980s

Lack of Familiarity With New Lending Opportunities

Scandalous Abuses In S&L Investing: The Keating
Episode

Mortgage Foreclosures Increased And S&Ls Began
Failing, First in The South Then Elsewhere
54
 Resolution: The Financial Institution Reform, Recovery,
And Enforcement Act Of 1989 (FIRREA)
¶ Forced Insolvent S&Ls to Fail Or Be Bought By
Stronger Institutions
¶ FSLIC Paid Off Depositors of Failed S&Ls And Acquired
S&L Assets For Resale
¶ Resolution Trust Company (RTC) Was Formed to Sell
Foreclosed Homes And Other Assets Acquired From
S&Ls

RTC Dissolves in 1993 After Cost To Taxpayer Of
$150-$300 Billion
55
 The Financial Institution Reform, Recovery,
And Enforcement Act Of 1989 (FIRREA)
¶ Regulatory Restructuring

The FHLBB Was Dissolved

The Office Of Thrift Supervision (OTS) Was Formed
To Regulate All Thrift-Type Institutions (S&Ls And
Mutual Savings Banks)
56
Part 3
Security Markets
57
 Important Legislation
¶ Securities Act Of 1933

Required Registration Of Issued Securities
With The SEC With Some Exceptions:
•
Securities Issued By Banks And S&Ls
•
Securities Issued By Religious And Charitable
Organizations
•
Life Insurance And Pension Policy Liabilities
•
Notes With Less Than 270-Day Maturity
(Commercial Paper)
•
58
Private Placements
 Important Legislation
¶ Securities Act Of 1933

Registration Statements Must Specify:
• Risk Factors
• Any Material Information

Civil Penalties Levied For Failure To Register Or To
Properly Disclose Relevant Information
59
 Important Legislation
¶ Securities Exchange Act Of 1934

Created Extensive Regulation Of Companies
Issuing Securities, Of Security Broker-Dealers, And
Of Security Exchanges

Periodic Reporting To SEC By Companies With
Publicly-Traded Securities
• Form Annual 10-K And Quarterly 10Ql Reports
• Form 8-K Reorts Of Unusual Events
• Reports Of Insider Transaction
• Reports Of Acquistions Of Over 5% Of Any
Security Class
60
 Important Legislation
¶ Securities Exchange Act Of 1934

Broker-Dealer Regulation
•
Segregation Of Accounts (Except net free credit)
•
Net Capital Rule: $100K Or 2% Of Debit
Balances (50:1 Leverage)
•
Duty To Act In Clients’ Interest
- Churning and Excessive Fees
- Conflicts Of Interest In Proprietary Trading
(Front Running)
61
 Important Legislation
¶ Securities Exchange Act Of 1934

Prohibition Of “Market Manipulation” And Of
Preferential Treatment Of Customers
•
Stock Gunning
•
Links Between Underwriting And Trading Desks
•
IPO Flipping And IPO Allocation Preferences
•
Insider Trading On Private Information
•
Disproportional Allocation Of Gains/Losses
62
 Important Legislation
¶ Securities Exchange Act Of 1934

SEC Regulation Of Security Exchanges
•
Authority To Set Margin Requirements For
Member Firms (Delegated To Fed)
•
Authority To Regulate Exchange-Traded Options
(Delegated tp CBOE And Other SROs)
•
Authority To Regulate Futures Markets
(Delegated tp CFTC)
63
 Important Legislation
¶ Investment Company Act Of 1940

Regulates Investment Companies
• Unit Trusts: Fixed Asset Composition
• Management Companies: Variable Portfolio
- Open-End Investment Companies (Mutual Funds)
• Shares Sold And Redeemed By Company
• Shares Continuously Distributed
• Shares Priced Daily At Net Asset Value (NAV)
- Closed-End Investment Companies
• Shares Sold At IPO And Traded On Exchanges
• Shares Priced Continuously At Market
• Share Price Can Be At Premium Or Discount To
NAV
64
 Important Legislation
¶ Investment Company Act Of 1940

Aspects Of Investment Companies Act
• Requires Registration With SEC
• All Securities Must Be Held In Trust Account
• Must Pay Out At Least 90% Of Income To Avoid
Being Taxed At Trust Level
• Prohibited From Borrowing Except From Banks For
Temporary Purposes (Redemptions)--No “Margin”
• Prohibited From Issuing “Senior Securities”
- Debt Or Preferred Stock, Short Sales
65
 Important Legislation
¶ Investment Company Act Of 1940

Mutual Fund Shennanigans (“Spitzerisms”)
•
Market Timing
- Use Of After-Hours Info To Place Fund Orders
- Example: Int’l Securities Close At 10AM USEST
Or Later So Price Info Not Embedded In 4PM
Closing NAV On Prior Day
•
Late Trading
- Placing Orders After 4PM To Be Executed At 4PM
NAV
•
Cherry-Picking Asset Sales To Meet Redemptions 66
- Selling Most Marketable Assets to Pay Out Cash
 Important Legislation
¶ Investment Advisors Act Of 1940
Requires Registration With SEC Of Any Investment
Advisor Who Uses The Mail Or Any Form Of
Interstate Commerce In The Conduct Of Business
• Exceptions
- Advisors Whose Clients All Reside Within The State
Of The Advisor’s Office And Who Do Not Advise On
Securities Traded On Listed Exchanges
- Advisors Whose Only Clients Are Insurance
Companies
- Advisors Who Have Fewer Than 15 Clients And
Who Do Not Represent Themselves To The Public
- Advisors Who Are Charitable Organizations Or The
Employees Of, Or Volunteers To, Such Entities
67

 Important Legislation
¶ Securities Investors Protection Act (SIPA) Of 1970

Establishes SIPC
•
SIPC Authorized To Borrow $1 Billion From Treasury
•
All Registered Broker-Dealers Must Be Members
•
Members Pay Flat Insurance Premium
- 1/2 Of 1% Of Gross Revenues
68
 Important Legislation
¶ Securities Investors Protection Act (SIPA) Of 1970

Insures Broker-Dealer Accounts Up To $500K
•
Coverage
- Direct Client Accounts (“Feeder” Is Insured Entity)
- All Fully Paid Securities In Cash Accounts
- “Free Cash Balances” In Margin Accounts
- Cash Covered Up To $100K
69
 What Went Wrong In Securities Markets In 2008?
¶ Mutual Funds: Collateral Damage

Redemptions In Excess Of Cash Balances
•
Withdrawal Of Bank Letters Of Credit
•
Forced Sales Of Securities
70
 What Went Wrong In Securities Markets In 2008?
¶ Stock Markets: Collateral Damage

Breach Of Maintenance Margin Requirements
•

Forced Sales Of Securities By Customers
Breach Of Broker-Dealer Collateral Requirements
•
Banks Call Loans To Brokers’ Trading Departments
•
Forced Sales Of Securities By Broker-Dealers
71
Part 4
Commodities Futures
And
Derivative Securities
72
Commodities Futures
73
 Essentials Of Commodity Trading
¶ Occurs Primarily Through Futures Contracts


Contract To Deliver Or Take Delivery Of A Commodity
At A Specific Date And Place And At A Specific Price
Parties To Contract
•
Hedgers
- Short Hedgers: Hold Or Expect To Have Commodity
Units At A Future Date (e.g., Fuel Oil Producer)
- Long Hedgers: Committed To Sell Commodity at
Future Date (e.g., Fuel Oil Company)
•
Speculators
- Short Speculators: Sell In Expectation Of Price Decline
74
- Long Speculators: Buy In Expectation Of Price Increase
 Essentials Of Commodity Trading
¶ Economic Functions Of Futures Contracts

Price Discovery
•
Provide Current Economic Agents With Information
About Future Prices
- Example: Farmers Can Plan Crop Amounts More
Efficiently--Plant Less When Prices Are Expected To
Fall, More When Prices Expected To Rise
75
 Essentials Of Commodity Trading
¶ Economic Functions Of Futures Contracts

Create Efficient Intertemporal Allocation Of Supply
•
If Prices Expected To Rise, Producers Will Store Product
Now And Sell In Future--Thereby Aiding Consumers By
Providing More Supply In Scarcer Times
•
If Prices Expected To Fall, Producers Will Reduce
Stockpiles Now And Restore In Future At Lower Prices-Thereby Aiding Consumers By Shifting Supply From
Low-Price Future To High-Price PresentStore Product
Now And Sell In Future--Thereby Aiding Consumers By
Providing More Supply In Scarcer Times
76
 Essentials Of Commodity Trading
¶ Characteristics Of Commodity Prices

Determined In Auction Market (Pit) By Open Outcry
•
Clearing Price Is That For Which
Long Hedges+Long Specs = Short Hedges+Short Specs
•
Storeable Commdities Typically Are In “Contango”
(Futures Price Exceeds Spot Price by Cost Of Carry)
•
Perishable Commodities (Onions) Have No Normal
Future
vs. Spot Relationship
77
 Essentials Of Commodity Trading
¶ Role Of Exchange Clearing House

Guarantee Completion Of Payments (Counterparty Risk)

Establish Characteristics Of Standardised Contract

Maintain Records On Contracts Traded And Contracting
Parties

Mark Accounts To Market Daily, And Transfer Losses To
Gaining Accounts
78
Federal Regulation Of Commodities Futures
¶ Early Acts

Grain Futures Act (1922)

Commodity Exchange Act (1936)
• Supplanted Grain Futures Act
• Established Commodities Exchange Commission
• Prohibited Market Manipulations And Fraudulent and
Abusive Behavior
• Regulation Applied Only To Agricultural Futures
Contracts
• Required All Futures Contracts To Be Traded On
Exchanges

Onion Futures Act (1958)
• Prohibited Trading Of Onion Futures
79
 Federal Regulation Of Futures Contracts
¶ Commodity Futures Trading Commission (1974)
 Amended 1936 Act To Extend Regulation To “All Futures
Contracts” Traded On Exchanges
 Response To Rise Of Non-Agricultural Futures
(Financials And Currencies)
 Excluded Forward Contracts And OTC Contracts Between
“Sophisticated Parties.”
 Left Status Of Swap Agreements Uncertain, Excluding
Them By CFTC Action Rather Than Congressional
Mandate
80
 Federal Regulation Of Futures Contracts
¶ Commodity Futures Modernization Act (2000)

Clarified Legal Status Of OTC Contracts

Excluded OTC Instruments
• Forward Contracts Between Private Parties
• Swap Agreements (Financial, Currency and Credit
Default Swaps)

Authorized Trading Of Single Stock Futures (Prior
Authorization Had Been Only For Index Futures)
81
Financial Derivatives
82
 Futures Contracts For Common Stocks
¶ Stock Index Futures

Trading Began In 1983 With Value Line Index
•
Same Principles As Physical Commodities
•
Most Traded On NYSE/AMEX
•
Index Arbitrage: Establishes Relationship Between
Futures And Spot Prices
- Futures Price Equals Expected Spot Price Discounted @(1+r)
- Changes In Futures Price Affect Spot Price
83
 Futures Contracts For Common Stocks
¶ Single Stock Futures Contract


Illegal Prior To Commodities Exchange Modernization Act
(2000)
First Single Stock Futures Contracts Traded in 2002
84
 Options On Common Stocks
¶ Types Of Options


Call Option
•
Option, But Not Obligation, To Buy Stock At A Fixed
Price (The Strike Price) On Or Before A Specified Date
•
Holder Profits If Price At Exercise Exceeds Strike Price
Put Option
•
Option, But Not Obligation, To Sell Stock At A Fixed
Price (The Strike Price) On Or Before A Specified Date
•
Holder Profits If Price At Exercise Is Less Than The
Spot Price
85
 Options On Common Stocks
¶ Option Trading

OTC Prior To 1973

CBOE Created In 1973

•
Standardized Contracts: Expiration Dates, Strike Prices
•
Clearing House (OCC) To Bear Counterparty Risk And
Monitor Trading In Options
CBOE And NYSE/AMEX (NYSE/EuroNext) Are The
Major Exchanges
86
 Options On Common Stocks
¶ Option Regulation

SEC - CFTC Turf Disputes

SEC Is Primary Regulator Of Options On Stocks
And Stock Indexes
 CFTC Is Primary Regulator Of Options On Futures
Contracts
87
 Credit Default Swaps
¶ Characteristics

Created As Unregulated OTC Contracts

Significant Counterparty Risk
•
No Clearing House
•
Buyer Requires Collateral From Seller
88
 Credit Default Swaps
¶ Payment Triggered By “Credit Events” Specified In
Particular Contracts
•
Buyer Pays Premium Based On Risk (Standard is 5%
Of Protected Value)
•
Seller Pays Net Loss
- Can Buy Securities At Face Value Or Pay Net Loss
89
 What Went Wrong In 2008?
¶ The OTC Swap Market--Particularly CDSs--Had Created
Extreme Interconnectedness Among Financial Institutions
¶ Trouble In One Market Was Rapidly Transmitted To Other
Instruments And Markets
 Bank Loans To SIVs To Replace Commercial Paper
Created Short-Term Credit Squeeze
 Credit Freeze Arising From Bank SIVs Resulted In High
Libor Rates Used In Financial Swap Agreements
 Trading Departments At Investment Banks Faced
Collateral Calls From Counterparties, Forcing Asset
Sales
 Failure Of Lehman And AIG Triggered An Escalation In
Counterparty Risk
90