Download 11:00 Issues in Depository Institutions and Hedging

Lesson 4:
Issues in Depository Institutions
and Hedging
A. Bank Issues of Securities
• Federal Funds markets allow banks and other depository
institutions to borrow from one another to meet Federal Reserve
requirements. Excess reserves of one bank may be loaned to other
banks for satisfaction of reserve requirements. The rate at which
these loans are extended is referred to as the Federal Funds Rate.
• Negotiable Certificates of Deposit (a type of Jumbo C.D.) are
tradable depository institution CDs with denominations exceeding
$100,000.
• Banker's Acceptances are originated when a bank accepts
responsibility for paying a client's loan or assuming other financial
responsibilities.
• Repurchase Agreements (Repos) are issued by financial institutions
(usually securities firms) acknowledging the sale of assets and a
subsequent agreement to re-purchase at a higher price.
• The counterparty transaction is a reverse repo.
B. Eurocurrency Issues
• Eurodollars are freely convertible dollar-denominated time deposits
outside the United States.
• Eurocredits (e.g., Eurodollar Credits) are bank loans denominated in
currencies other than that of the country where the loan is extended.
Their rates are generally tied to LIBOR (the London Interbank Offered
Rate) and U.S. rates.
• Eurobonds are generally underwritten, bearer bonds denominated in
currencies other than that of the country where the loan is extended.
• Euro-Commercial paper is the term given to short-term (usually less than
six months) notes issued by large, particularly "credit-worthy" institutions.
Most commercial paper is not underwritten. The notes are generally very
liquid (much more so than syndicated loans) and most are denominated in
dollars. They are usually pure discount instruments.
• Euro-Medium Term Notes (EMTN's) are interest-bearing instruments
usually issued in installments. Most are not underwritten. Eurobonds are
generally underwritten, bearer bonds denominated in currencies other
than that of the country where the loan is extended.
C. Banks as Monitors and Fiduciaries
• Banks could be ideal corporate monitors.
– large financial resources necessary to take large positions
– clients provide significant important and relevant information not be available
to the public
• While effective in some respects, bank monitoring has not proven to be a
panacea.
– Lending relationships skew incentives from maximizing shareholder wealth.
– Banks may use their control to maximize creditor wealth rather than
shareholder wealth.
– Overlapping directorships and other business relationships that skew
monitoring incentives.
– Banks may monitor less aggressively in order to support other business
relationships with their clients.
• Banks are in ideal positions to obtain information from clients in the event
of financial distress.
– Japanese banks tend to actively support clients facing financial distress
– German banks tend to provide much less support to their distressed clients.
Bank Trusts
• Bank trusts act as fiduciaries for clients and as principals.
• Banks might not be sufficiently motivated to actively monitor on
behalf of beneficiary-shareholders.
• Usually, trusts are irrevocable such that trust beneficiaries have
little recourse if returns are low.
• Trust beneficiaries cannot discipline banks to improve investment
performance. Compensation to bank and officer trustees is not
normally related to investment performance.
• Banks vote the shares that they hold in trust.
• Most banks derive most of their business from corporations,
creating conflicts of interest and reduced incentives to monitor.
• Many banks and corporations have overlapping directorships and
other business relationships.
D. Structured Lending
• Structured finance activities involve the pooling of
debts such as loans, bonds and mortgages and
subsequent issuance of a prioritized and collateralized
structure of claims known as tranches against these
pools.
• Repackaging and pooling of these original instruments
allows redistribution of risks.
• During the late 1990s and early part of this century, use
of structured lending increased dramatically, bolstered
by favorable ratings by credit agencies, leading to
overvaluation and a subsequent bubble and crash.
Structured Lending Products
E. Thrift Institutions
• The thrift industry (except credit unions) exists
primarily to provide low-cost, fixed interest-rate
mortgages specifically for housing.
• The three types of thrift institutions are:
– Savings and Loans Institutions (S&Ls),
– Savings Banks
– Credit Unions, which tend to emphasize consumer loans.
• Many thrift institutions were established as mutual
organizations.
• More recently, many S&Ls have re-organized under
stock charters.
Redlining
• Establishment of the FHA encouraged redlining, the denying, or
discouraging services such as banking and insurance to residents
in usually racially-determined regions and neighborhoods.
• The FHA drew maps of most larger and medium-size U.S. cities,
which defined minority (particularly African-American, but also
Hispanic, Asian and Jewish) neighborhoods, and declaring such
neighborhoods as being ineligible to receive financing.
• The practice of redlining significantly and simultaneously
contributed to the growth of suburbs and the decay of inner
cities.
• The Fair Housing Act of 1968 was passed to eradicate the
practice of redlining and other discriminatory practices.
The S&L Crisis: The Lead-Up
• Because long-term mortgages were financed primarily with short-term
deposits, interest rate increases in the 1970's and early 1980's caused the
thrift industry to experience difficulties.
• The response by Congress was to enable thrift institutions to raise and
invest funds in manners that were previously prohibited, while increasing
deposit insurance ceilings.
• Until passage of the Depository Institutions Deregulation and Monetary
Control Act of 1980 (DIDMCA), thrift institutions were prohibited from
making commercial loans and issuing checking accounts.
• At the same time, equity capitalization standards were reduced and redefined, enabling institutions to continue operations when technically
insolvent.
• Furthermore, the Reagan administration reduced thrift examination staffs
as part of its budget-cutting initiatives, enabling thrifts to initiate and
continue operations which would have been prevented by regulatory
agencies.
The S&L Crisis
• These new activities and lack of effective monitoring
led to massive failure in the industry by the late 1980s.
• Ultimately, between 1986 and 1995, the number of
U.S. federally insured savings and loans institutions
declined from 3,234 to 1,645. Institutional abuses
including fraud and insider transactions were rampant.
• Thrift institutions were generally not as impacted by
the financial crisis of 2008 as were commercial banks.
There were some important exceptions, as Washington
Mutual Savings Bank, the largest thrift institution in the
U.S. and Indy Mac both failed.
Credit Unions
• A credit union is a member-owned, not-for-profit cooperative
financial institution established to encourage savings, offer
competitive interest rates on deposits and use deposits to make
loans at low interest rates to its members.
• The World Council of Credit Unions reported that at the end of
2010, there were 52,945 credit unions in 100 countries serving 188
million members and holding $1.5 trillion in assets.
• Most credit unions limit membership to specific groups of
individuals sharing a common bond, such as employees of a given
organization or members of a given association, and are prohibited
from serving the general public.
• Credit unions are cooperatives or mutually owned organizations,
controlled by their members who make deposits or loans.
F. Asset-Liability Hedging
• Fixed income instruments provide for fixed
interest payments at fixed intervals along with
principal repayments.
• In the absence of default and liquidity risk,
uncertainties in interest rate shifts are the
primary source of pricing risk for many fixed
income instruments.
Bond Yields and Sources of Risk
• A bond maturing in n periods with a face value of F pays
interest annually at a rate of c with yield y.
n
cF
F
PV  

t
n
(
1

y
)
(
1

y
)
t 1
• In general, bond risk might be categorized as follows:
– Default or credit risk: the bond issuer may not fulfill all of its
obligations
– Liquidity risk: there may not exist an efficient market for investors to
resell their bonds
– Interest rate risk: market interest rate fluctuations affect values of
existing bonds.
Fixed Income Portfolio Dedication
• Assume that a fund needs to make payments of
$12,000,000 in one year, $14,000,000 in two years,
and $15,000,000 in three years.
•
•
•
•
12,000,000 = 40bA + 60bB + 0bC
14,000,000 = 1040bA + 60bB + 0bC
15,000,000 =
1060bB + 1100bC
we find from this system that bA = 2,000, bB =
198,666.67 and bC = -195,586.67.
Solution with Matrices
60
0  b A 
12,000,000  40
14,000,000 = 1040 60
 b 
0

 
  B
15,000,000  0
1060 1000 bC 
cfL
=
CF
b
To solve this system we first invert Matrix CF, then use it to pre-multiply Vector cfL to obtain
vector b:
.001
0 
 2000  bA    .001
 198666.67  = b  =  .0173333  .0006667 0 

  B 

 195586.67 bC   .018373 .00070667 .001
b =
CF-1
12,000,000
14,000,000


15,000,000
This simple matrix system yields the same results as our system above.
cfL