COMPARING FINANCIAL SYSTEMS

Transcription

1 COMPARING FINANCIAL SYSTEMS Lesson 6 The US financial system 2 What you will learn in this lesson The nature of non-depository financial institutions in the USA The features of the US financial markets 1

2 Securities firms Securities firms engage in a variety of activities, most of which can be classified as investment banking or brokerage. They consist of securities brokers and dealers, investment banks and advisers and stock exchanges. A brokerage firm, is a financial institution that facilitates the buying and selling of financial securities between a buyer and a seller. Brokerage firms serve a clientele of investors who trade public stocks and other securities, usually through the firm's agent stockbrokers. A traditional, or "full service", brokerage firm usually undertakes more than simply carrying out a stock or bond trade. The staff of this type of brokerage firm is entrusted with the responsibility of researching the markets to provide appropriate recommendations. These firms also offer margin loans for certain approved clients to purchase investments on credit, subject to agreed terms and conditions. When a brokerage firm, in addition to buying and selling for clients, transacts for its own account, it is known as a broker-dealer. Securities firms regulation The securities industry is overseen by the Securities and Exchange Commission (SEC), which regulates the issue of securities, and the various securities exchanges. There is also self-regulation of the industry through the National Association of Securities Dealers (NASD). The Federal Reserve Board has some regulatory influence through determining the credit limits or margin requirements in securities markets. 2

3 Securities firms There are around 5,000 securities firms in the US. Over the last decades mergers and acquisitions have been important here as well as among banks and savings institutions. Of these, more than 30% involved the purchase of securities firms by banks. A strict consequence of the easing of restrictions on the non-banking activities of commercial banks in Gramm Leach Bliley Financial Services Modernization Act (1999) In recent years the large US securities firms have spread throughout the world. At the same time, foreign-owned institutions, notably the very large Japanese banks, have entered strongly into wholesale banking and the securities industry in the US. The US securities industry was perhaps best known in relation to the issue of junk bonds. Junk bonds Junk bonds are high-yield bonds (non-investment-grade bond, speculativegrade bond) that the credit-rating agencies regard as below investment grade (rated lower than investment grade BBB) because they judge that the issuing companies might not be able to meet interest or principal payments. These bonds have a higher risk of default or other adverse credit events, but typically pay higher yields than better quality bonds in order to make them attractive to investors. They are speculative bonds and are attractive investment vehicles for certain types of portfolios and strategies. Many pension funds and other investors (banks, insurance companies), however, are prohibited in their by-laws from investing in bonds which have ratings below a particular level. Junk bonds have a different investor base than investment-grade bonds. 3

4 Junk bonds The value of speculative bonds is affected to a higher degree than investment grade bonds by the possibility of default. In a recession, interest rates may drop increase in the value of investment grade bonds. However, a recession tends to increase the possibility of default in speculativegrade bonds, too. In the late 1970s the market consisted largely of debt securities of companies that had been successful in the past but had run into difficulties ( fallen angels ). However, from 1984 onwards, Michael Milken, of the securities firm Drexel Burnham Lambert, transformed the market by selling high-yield bonds as a means of raising finance for corporate raiders and shell companies without earnings or assets to undertake leveraged buyouts. The bonds yielded an average of basis points more than Treasury bonds. Junk bonds Milken found a ready home for the bonds among insurance companies and thrift institutions which were seeking to diversify away from fixed-interest lending and were willing to take risks to maintain returns, pension plans, the mutual funds and even the public directly. In 1980 there had been 46 issues of junk bonds for a total of $1.38bn. By 1986 this had grown to 210 issues for a total of $29.83bn. Drexel charged very high commissions to the issuing firms (up to three or four per cent of the principal) and paid very high bonuses to their traders. In 1987 Milken received $550m for his services. However, in 1989 Drexel was heavily fined for mail and securities fraud and the following year Milken was heavily fined and later jailed for securities violations which included cheating some customers and helping others to break securities law. The value of most junk bonds declined sharply in late 1989 and S&Ls were required under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 to sell their junk bond holdings. Drexel Burnham Lambert went bankrupt in February

5 Debt repackaging and subprime crisis High-yield bonds can also be repackaged into collateralized debt obligations (CDOs). CDO raise the credit rating of the senior tranches above the rating of the original debt. The senior tranches of high-yield CDOs can thus meet the minimum credit rating requirements of pension funds and other institutional investors despite the significant risk in the original high-yield debt. When such CDOs are backed by assets of dubious value, such as subprime mortgage loans, and lose market liquidity, the bonds and their derivatives become what is referred to as "toxic debt". Holding such "toxic" assets led to the demise of several investment banks such as Lehman Brothers and other financial institutions during the subprime mortgage crisis of This led the US Treasury to seek congressional appropriations to buy those assets in September 2008 to prevent a systemic crisis of the banks. Such assets represent a serious problem for purchasers because of their complexity. Debt repackaging and subprime crisis Having been repackaged perhaps several times, it is difficult and time-consuming for auditors and accountants to determine their true value. As the recession of bit, their value decreased further as more debtors defaulted, so they represented a rapidly depreciating asset. Even those assets that might have gone up in value in the long-term depreciated rapidly, quickly becoming "toxic" for the banks that held them. Toxic assets, by increasing the variance of banks' assets, can turn otherwise healthy institutions into a liquidity crisis. Potentially insolvent banks made too few good loans, creating a debt overhang problem. Alternatively, potentially insolvent banks with toxic assets sought out very risky speculative loans to shift risk onto their depositors and other creditors. 5

6 Geithner s Programs On March 23, 2009, U.S. Treasury Secretary Timothy Geithner announced a Public-Private Investment Partnership (PPIP) to buy toxic assets from banks' balance sheets. The major stock market indexes in the United States rallied on the day of the announcement rising by over six percent with the shares of bank stocks leading the way. PPIP had two primary programs. The first is the Legacy Loans Program, which attempted to buy residential loans from banks' balance sheets. The Federal Deposit Insurance Corporation will provided non-recourse loan guarantees for up to 85% of the purchase price of legacy loans. Private sector asset managers and the U.S. Treasury will provided the remaining assets. Geithner s Programs The second program was called the legacy securities program, which bought mortgage backed securities (RMBS) that were originally rated AAA and commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS) which are rated AAA. The funds came in many instances in equal parts from the U.S. Treasury's Troubled Asset Relief Program, private investors, and from loans from the Federal Reserve's Term Asset Lending Facility (TALF). The initial size of the Public Private Investment Partnership was projected to be $500 billion. 6

7 Insurance Companies The US has the largest insurance market in the world. In the US it is common to divide insurance into three groups: 1. property/casualty (covering motor vehicle, home and commercial insurance); 2. life/health (life insurance and annuity products); 3. health (private health insurance plans). All types of insurance are regulated by states. Each state has its own set of statutes and rules. State insurance departments are responsible for insurer solvency and market conduct. There have been several proposals for the introduction of federal regulation to provide a more uniform system, whith companies being given a choice between being state-regulated or federally regulated along the lines of the banking system. However, these ideas continue to be resisted. Insurance regulation The industry self-regulation authority is the National Association of Insurance Commissioners (NAIC), a non-profit organization established in The NAIC provides a basis for coordination among states. However, it is not itself a regulator. The NAIC proposes nationwide standards for capital adequacy and for state guarantee funds. It also proposes model laws and regulations, but the states decide whether and to what extent to implement the models. 7

8 Insurance companies disintermediation In the 1970s and 1980s, life insurance companies ran into the same disintermediation difficulties as the S&Ls. At the beginning of the 1970s the assets of life insurance companies were longterm fixed interest (usually acquired years before when interest rates were low). Liabilities were very largely whole life policies. As market interest rates rose in the 1970s and as money market mutual funds developed offering much higher returns than were available on life policies, the competitiveness of the life insurance industry was much reduced. Life insurance policies in fact consist of two elements: 1. the insurance element 2. saving and accumulation element. Policyholders found that they could unbundle their policies by taking out shortterm life policies and undertaking the accumulation element in other ways. Insurance companies crisis Between 1970 and 1984, premiums on life policies fell from 3% to 2% of disposable income while whole of life policies declined from 82% to 22% of new policies written. Lapses and surrenders of both old and new policies doubled to 12% of all policies in force in Attempts by US companies to follow the UK practice of acquiring claims to real streams of goods and services (such as the earnings of industrial and commercial enterprises or holdings of real estate and property) were restricted by state regulations covering the types of assets life offices could hold. Nonetheless, they diversified as much as possible, often into riskier products with higher rates of return including junk bonds and doubtful commercial real estate loans. The sharp downturn in the junk bond market in 1989 caused problems for a number of life insurance companies, mainly those small ones. Forty-three companies failed in 1989, another 30 in 1990 and more in 1991, including some rather larger companies. 8

9 Mergers between banks and nsurance companies Insurance companies responded to the pressure on their profits seeking to market more flexible types of policies and to enter new product markets. Some companies began to offer certificates of deposit or cash management accounts in direct competition with commercial banks. Others merged with brokerage firms and began to offer a wide range of securitiesrelated services. Insurance companies also began to offer mutual funds to investors. The Gramm Leach Bliley Financial Services Modernization Act,1999, removed the long-lived restriction on mergers between commercial banks and securities and insurance firms. cross-industry mergers, involving bank holding and insurance companies. However, there have been fewer mergers than had been expected. Concentration of the insurance industry Banks have naturally wished to add insurance products to the range of products they offer. However, they have more often achieved this by buying existing agencies and brokers or establishing their own agencies rather than by buying insurance companies. Some of the largest insurance brokerages now belong to banks. Insurance companies have, in turn, been more likely to set up thrifts or banking divisions rather than to acquire existing banks. Nonetheless, there has been a continued steady movement towards the concentration of the industry. 9

10 Mutual Funds Mutual funds (open-end funds that are the equivalent of unit trusts in the UK) are investment companies that invest pools of money into a number of investment options. They have been in existence since the 1920s and are regulated by the Securities and Exchange Commission (SEC) under the Investment Company Act, The Act sets fiduciary standards as well as reporting and disclosure requirements. Funds usually specialize in particular types of investment, including growth stocks, income-producing stocks, small-firm stocks, short- or long-term bonds, tax-exempt bonds, precious metals or international stocks. The development of money market mutual funds (MMMFs) from 1975 onwards had a profound effect on banks, thrifts and insurance companies. They specialize in high-grade, short-term securities that offer market returns on cash equivalents, and permit cheque-writing privileges. Thus they were able to offer rates of return that reflected the higher rates of shortterm interest produced in the late 1970s by world economic events and the Fed s response to them. Mutual Funds Between the beginning of 1979 and the end of 1982, the assets of money market mutual funds jumped from $12bn to $230bn. Mutual funds continued to grow rapidly after The share of household assets held in these funds roughly doubled between 1990 and By the end of this period nearly 20% of household assets were held in them. Half of all US households owned shares in a mutual fund. There was particularly rapid growth in equity mutual funds, with the assets mutual funds invested in equities having expanded nearly twentyfold in this period. About 60% of this growth reflected the rise in equity prices in the stock market boom of the late 1990s. The other 40% come from net new cash flow into the funds. The poor performance of stock markets in 2001 and 2002 led to a loss of market share for the mutual funds. By the end of 2003, the share of money market mutual funds in consumer savings had fallen back to 16.8%. 10

11 Mutual Funds Mutual Funds Overall mutual funds have more assets under management than commercial banks. Much of the growth in mutual funds was through pension plans and other investment accounts, especially Individual Retirement Accounts (IRAs), which benefited from changes in taxation rules. More than 80% of mutual fund assets are held by households. They hold over 90% of the assets of the equity mutual funds since institutional investors are more likely to invest in money market funds than in the longer-term equity, bond and hybrid funds. At the time of the major financial crises (Asian financial crisis and the Russian debt default in 1998 and financial crisis of ) there was a flight from equity funds to the lower-risk money market and short-term bond funds. This was soon reversed after the crises. This reflects a movement of households away from the direct ownership of equities to indirect ownership of them through the mutual funds. 11

12 Finance companies Other non-depository institutions include finance companies, mortgage bankers and brokers and pension funds. Finance companies specialize in the provision of short- and medium-term credit to firms and households. Consumer companies lend to consumers for the purchase of motor vehicles or large household items such as furniture or domestic appliance, for home improvements or for the refinancing of small debts. Business finance companies lend to wholesalers and manufacturers, engage in factoring (purchasing accounts receivable at a discount) and engage in motor vehicle, aircraft and equipment leasing. Finance companies also offer credit cards and in recent years have moved strongly into the real estate market. Some finance companies are subsidiaries of bank holding companies or insurance companies or themselves have subsidiaries which offer banking or commercial services. Some are affiliated with motor vehicle or appliance manufactures. Finance companies Finance companies compete with banks, savings institutions and credit unions. The sector is twice as large as the credit union sector. It has the same size as thrifts and is one-fifth as large as commercial banks. Funds are raised mainly through bank loans or the issue of commercial paper or bonds. However, some states allow finance companies to seek customer deposits under particular circumstances. Finance companies are for the most part regulated by the states and regulations vary between states. However, there are generally limits placed on the size and the maturity of loans finance companies can make and on the interest rates they can charge. 12

13 Social security system The pensions provided through the social security system in the United States are funded on a pay-as-you-go basis with a buffer fund invested in government debt to smooth short-term fluctuations. The system covers all workers. Pensions are linked to average earnings. The ratio of the social security pensions to earnings, termed the replacement ratio, is low. Private pensions are given a number of tax advantages. Contributions and asset returns are tax free, and only benefits are taxed. Pension funds Pension funds have developed in much the same way as in the UK. The performance of their portfolios is very susceptible to market conditions. Criticisms of the operation of pension funds led to the Employee Retirement Income Security Act, 1974 (ERISA, revised in 1989) which introduced rules regarding: 1. the length of membership of the fund needed before a pension would be paid; 2. transfers from one fund to another. The act also stipulated that contributions should be invested in a prudent manner. This requires that managers carry out sensible portfolio diversification, and there are no specific limits on portfolio distributions. The act also set up the Pension Benefit Guarantee Corporation (PBGC), which guarantees the benefits of funds in default. The ERISA requirements for funding pensions provide protection for the PBGC. Higher premiums for the PBGC are charged on underfunded schemes. Private pension schemes cover about 46% of the workforce. Pension funds are also subject to state regulation. 13

14 The home mortgage market In the US there are life insurance companies and government sponsored enterprises like Fannie Mae which operates in the secondary mortgage market. They aim to ensure that mortgage bankers and other lenders have enough funds to lend to home buyers at low rates. Before the financial crisis of , the home mortgage market has expanded rapidly, with loans outstanding doubling from $501.1 bn to $1,019.2 bn between the end of 2002 and In 2006, loans in the residential mortgage section of the market accounted for more than 40% of the growth in lending by banks. The market expansion was assisted by the low interest rates of the period and contributed to a house price bubble which continued from 2001 to The expansion in home mortgages was also partly due to the big increase in subprime and non traditional mortgages offered. Subprime mortgages The subprime category of residential mortgages includes loans made to borrowers who had one or more of the following characteristics: 1. weakened credit histories (payments delinquencies, charge-offs, judgements, or bankruptcies); 2. reduced payment capacity as measured by credit scores or debt-to-income ratios; 3. incomplete credit history. Thus, subprime mortgages are riskier than average and so carry higher than average interest rates. In periods with low interest rates, rising house prices, and hence few defaults, they offered lenders high profits. With house prices high, even defaults present few problems to lenders. Subprime lending expanded greatly, reaching around 20% of all new mortgages in

15 Non-traditional mortgages Mortgages in the US had traditionally been simple fixed interest rate mortgages. This began to change as lenders designed products to attract new borrowers into the market and regulators encouraged this trend. Non-traditional or exotic mortgages include: 1. fixed rate mortgages that quickly convert to variable rates; 2. adjustable rate mortgages (ARMs), in which the interest rate is adjusted periodically according to a preselected index; 3. interest-only mortgages (mainly ARMs) in which the borrower pays only the interest on the capital for a set term and then, usually after five or seven years, has to refinance the balance in a lump sum or start paying the principal; 4. pick a payment loans, for which borrowers choose their monthly payment (full payment, interest only or a minimum payment which may be lower than the payment required to reduce the balance of the loan). Almost all of these not only carry higher interest rates but also involve increasing interest rate payments as interest rates grow in the economy. Non-traditional mortgages In 2006 there also was a significant increase in the number of piggyback mortgages (two loans taken out in tandem and worth up to 100% of the value of the property). A growing number of borrowers that had no equity in their house and had little incentive to go on paying when the interest payments rose sharply. This was especially the case when house prices began to fall causing the size of the loan to be repaid to be greater than the market value of the house. The way in which many of the mortgage loans were financed also contributed to the problems that later developed. All types of lenders had engaged in the expansion of subprime mortgages but commercial banks were not greatly involved. Only in about 5% of US commercial banks mortgages made up more than 20% of residential mortgage loans on their books. 15

16 The subprime crisis Much of the subprime lending had been carried out by non-depository finance companies often financed by bundling the mortgages into mortgage-backed securities (MBSs) sold on to investment banks, hedge funds and other investors. This passed the risks associated with the subprime mortgages on to other institutions. As long as financial markets remained confident and willing to buy these securities, the lenders could go on expanding. However, by the last quarter of 2006, the market was slowing down. Construction of new houses was in decline, the increase in house prices was slowing down and concern started to be expressed about delinquency rates of subprime mortgages. The position deteriorated in the first quarter of 2007 and the number of defaults in the subprime market increased rapidly. The financial crisis of As the defaults increased, investors became nervous and began to switch towards more secure investments. The demand for subprime mortgage-backed assets dried up and the finance companies found that they could no longer raise the finance to back their mortgages or could only do so at large discount. Finance companies began to fail in large numbers. Other closed departments, put off staff or were taken over by other banks. Banks demanded higher interest rates for lending in the interbank market and the credit crunch developed. Hedge funds that had invested heavily in subprime mortgages-backed assets failed or needed to be rescue. In the middle of 2007, all international markets became nervous and the US crisis became of global concern. Many poor and vulnerable people, who had been encouraged far beyond their means, lost out. 16

17 The US financial markets The US financial markets are varied and deep. There has been extensive financial innovation since World War II, which accelerated in the 1970s and 1980s. This financial innovation has helped to strengthen the market orientation of the financial system by introducing: 1. new financial products such as various mortgage-backed securities and other securitized assets; 2. derivative instruments such as swaps and complex options. These have all had a virtual explosion in volume. At the same time, new exchanges for financial futures, options, and other derivative securities have appeared and become major markets. The US financial markets The financial assets of households are mostly in equities (45% of the total) and bonds, (28%). Cash and cash equivalents are relatively unimportant at 19%, and the other remaining categories are even smaller. Over the long term, there has been a shift away from individuals' holding equity directly toward intermediaries holding it. Much of this has been transferred into indirect holdings through pension and mutual funds. The share of pension funds and mutual funds to a large degree has risen to replace the fall in individual holdings. The assets of insurance companies have remained constant during this period. In addition to the question of how individuals hold their savings, there is also the important issue of how firms raise their funds. Retentions are by far the most important. Loans, trade credit, and bonds are also significant. 17

18 The US financial markets Financialization There is clear evidence of an expansion of the size and importance of financial markets, financial institutions, and financial interests in the US economy. The financial sector, in terms of the national accounts, has expanded as a share of the US economy. Incomes based on financial returns (rentier incomes) have grown. Activity in financial markets has grown exponentially. Corporations, businesses and commodity markets, which were traditionally seen as non-financial entities, have exhibited a growing level of financial activities and increased dependence on financial institutions. Corporate governance has changed to emphasize financial returns, rather than profits from productive activities. All these trends have emerged since the 1980s, in correspondence with a steady weakening of the U.S. financial regulatory system. 18

19 Financialization Overall, the broadly based phenomenon of financialization represents a fundamental shift in the US economy over the past three decades. Moreover, in the US, market-based finance is twice as big as depository banking. Shadow banks provide firms and households with valuable economic services. A number of financial strategies, disconnected from real economic performance, emerged in order to raise share prices. The process of using the financial resources of the company to buy its own stock increased share prices. The increase in share price caused by buybacks would be unrelated to profitability and corporate performance. Similarly, strategic mergers and takeovers whose primary goal is to increase stock prices are often unrelated to company performance. Financialization 19

20 Financialization Financialization 20

21 Financialization References Bain K., Howells P., The Economics of Money, Banking and Finance. A European Text, Pearson Education, 2008, ch. 4 Allen F., Gale D., Comparing Financial Systems, MIT Press, 2001, ch. 3 21