This page is intentionally left blank FINANCIAL INSTITUTIONS, MARKETS, AND MONEY This page is intentionally left blank E L E V E N T H E D I T I O N FINANCIAL INSTITUTIONS, MARKETS, AND MONEY David S Kidwell University of Minnesota David W Blackwell Texas A&M University David A Whidbee Washington State University Richard W Sias University of Arizona John Wiley & Sons, Inc VICE PRESIDENT AND EXECUTIVE PUBLISHER George Hoffman PROJECT EDITOR Jennifer Manias ASSISTANT EDITOR Emily McGee EDITORIAL ASSISTANT MEDIA EDITOR Erica Horowitz Greg Chaput CREATIVE DIRECTOR SENIOR DESIGNER Harold Nolan Maureen Eide SENIOR PHOTO EDITOR Lisa Gee PRODUCTION MANAGER Dorothy Sinclair SENIOR PRODUCTION EDITOR Trish McFadden PRODUCTION MANAGEMENT SERVICES Aptara COVER DESIGN Wendy Lai COVER PHOTO Amy Uratsu/Photodisc/Getty Images This book was set in 10.5/12 Janson Text by Aptara, Inc and printed and bound by RRD/JC The cover was printed by RRD/JC This book is printed on acid free paper ϱ Copyright © 2012 John Wiley & Sons, Inc All rights reserved No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978)750-8400, fax (978)750-4470 or on the web at www.copyright.com Requests to the publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030-5774, (201)748-6011, fax (201)748-6008, or online at http://www.wiley.com/go/permissions Evaluation copies are provided to qualified academics and professionals for review purposes only, for use in their courses during the next academic year These copies are licensed and may not be sold or transferred to a third party Upon completion of the review period, please return the evaluation copy to Wiley Return instructions and a free of charge return shipping label are available at HYPERLINK “http://www.wiley.com/go/return” www.wiley.com/go/returnlabel Outside of the United States, please contact your local representative ISBN 13: 978-047-056108-9 ISBN 10: 047-056108-4 Printed in the United States of America 10 P REFACE TO TH E STU D ENT We hope you are as excited about taking a course on financial institutions and markets as we were about writing the book The core topics covered in the book are at the heart of what happens every day in the financial sector of the economy When you have finished the course, reading the Wall Street Journal, the Financial Times, or the business section of the New York Times will be a piece of cake Your friends, family, and fellow students will marvel at your insights into the financial system In the book, we stress fundamental concepts with an emphasis on understanding how things work in the real world We hope that we have captured the vibrancy and excitement created by the dramatic changes taking place in the U.S financial system You are taking the course at a unique time in economic history, following the global financial crisis of 2007–2009 and the longest and most severe recession since the Great Depression of the 1930s These events are radically reshaping the financial system Our goal is to provide a book that can guide you to a confident mastery and understanding of the U.S financial system in an interesting and, hopefully, entertaining manner The book is your passport to linking your classroom experience to what is happening in the economy and financial markets What you learn will be applicable to your business career or in managing your personal financial affairs WHY READ THIS BOOK? TO TH E FACU LT Y The focus of the eleventh edition of Financial Institutions, Markets, and Money is the same as that of the previous editions: to provide a balanced introduction to the operation, mechanics, and structure of the U.S financial system On the other hand, the book is remarkably different in that the global financial crisis of 2007–2009 resulted in major changes to the structure of the financial system, in regulation, and in how central banks operate These changes have required major rewrites of nearly every chapter in the book We hasten to add that changes in the financial system are still under way as we write this preface in July 2011 Economists and government officials are still sifting through the economic rubble from the financial crisis and the subsequent severe recession Though changes abound, the core coverage in the book still emphasizes financial institutions, markets, and instruments Special attention is given to the Federal Reserve System and the impact of monetary policy on interest rates We discuss how financial institutions manage risk caused by interest rate and economic changes Finally, the book is written with a strong historical perspective Throughout the book we give attention to the historical development of financial institutions and v vi Preface markets and discuss important historical events We believe that relating historical events to the book’s fundamental concepts gives students a richer understanding of the material and a better perspective from which to evaluate current developments Teacher Friendly In revising the book, we are mindful of the demands on faculty who are asked to more with less We want to help make your course on financial institutions and markets as successful as possible To that end, we worked hard to write in a clear and understandable manner Also, we put much effort into updating and improving the chapter learning features, several of which are new to the eleventh edition, such as Learning by Doing applications, the end-of-chapter Summary of Learning Objectives, and enhanced quantitative content Finally, we provide first-rate teaching and learning aids such as the instructor’s manual, test bank, study guide, and PowerPoint presentations that accompany each chapter The Book’s Evolution Our book, like the financial system, has had to adapt to the rapidly changing economic environment When we published our first edition, the existing textbooks were primarily descriptive, merely describing the activities of financial institutions, or they were de facto money and banking texts, primarily focused on the banking system and monetary policy In our first edition, we broke new ground by emphasizing both financial institutions and markets, and how monetary policy affected financial institutions At that time, our “free-market” approach to regulation, which emphasized market-oriented rather than government-imposed solutions to problems, was not mainstream and, to some, was considered controversial As technology, regulation, and financial innovation changed the financial landscape, our book has had to evolve In subsequent editions, we increased our emphasis on how interest rates are determined and on the structure of interest rates We also increased our emphasis on the risks faced by financial institutions and on how institutions manage these risks using financial markets Over the years, we expanded our coverage of financial markets, and now, for example, the book has separate chapters on equity markets, mortgage markets, derivatives markets, and international markets The Competitive Edge Our approach to the topic made our book very successful in the early editions, and it continues to be successful today Imitation is the sincerest form of flattery, and we have seen a number of imitators of our approach, which, apart from the wide use of this book, is the best evidence of its appeal to both students and faculty Our competitive edge, however, comes from our adherence to the approach for the book that was set in the first edition First, we stress the mastery of fundamental material, placing an emphasis on how things really work in a market context Second, we have a balanced coverage of the U.S financial system, with strong emphasis on both institutions and markets Third, we continually update the book to reflect major new developments in the financial system or to highlight changing trends Finally, we focus on writing a book for the students, our most important audience, which facilitates learning and makes the study of financial institutions and markets an enjoyable experience Let Us Hear from You We thank the faculty who adopted our book and the students who purchased our book As you go through your course, we hope that we live up to our promise of providing a clear, concise, well-written, and academically sound text on the U.S financial system If you find a mistake or have concerns about a particular section, we would like to hear from you Contact us via our e-mail addresses, which are listed at the end of the preface Preface vii We believe this edition of the book is better than the tenth edition for a number of reasons Apart from the customary detailed updating of facts and exhibits throughout the book, we worked painstakingly to improve the readability and the chapter features in this edition to better facilitate student learning In this edition, especially in the chapters on financial markets, we continue our emphasis on how to read and interpret actual financial data, such as that reported in the Wall Street Journal or the Financial Times We also continue to refine the chapter pedagogical features We have also substantially revised the chapter contents to reflect the impact of the global financial crisis of 2007–2009 WHY THIS EDITION IS BETTER THAN PREVIOUS ONES PEDAGO GICA L F E AT U R ES This section summarizes the pedagogical features and highlights additions or improvements in the eleventh edition The features that are new or have been substantially revised are indicated with an asterisk (*) Chapter Opening Vignette Each chapter begins with an opening vignette that describes a real company or business situation The vignettes illustrate concepts that will be presented in the chapter and are also meant to heighten student interest and demonstrate the real-life relevance of the chapter material Learning Objectives The opening vignette is accompanied by a set of learning objectives that identify the most important material for students to understand while reading the chapter At the end of the chapter appears a feature, “Summary of Learning Objectives,” highlighting the relevant chapter content Learning by Doing.* Chapters with quantitative content now have more in-text examples These chapters now include a new feature: Learning by Doing These applications contain quantitative problems with step-by-step solutions that provide guidance on how to approach similar problems By including several exercises in each chapter where applicable we provide students with additional practice to hone their problem-solving skills Do You Understand? Each chapter includes several sets of Do You Understand? questions that usually appear at the end of a major section These questions check student understanding of critical concepts in the material just covered, or ask students to apply what they have just read to real-world situations To give students feedback on the Do You Understand? questions, we include the answers on the book’s website (discussed later) and in the Instructor’s Manual People & Events.* Each chapter includes at least one People & Events box The People & Events boxes describe current or historical real-world situations to emphasize the applicability of one or more key concepts developed in the chapter Over half of the People & Events boxes have been replaced and many others have been substantially revised In the eleventh edition the People & Events boxes are particularly focused on the anatomy of the financial crisis of viii Preface 2007–2009, the impact of the crisis on financial institutions and markets, and the emerging recovery from the crisis Exhibit Captions Where appropriate we provide captions for the exhibits to inform students of the exhibits’ main points Summary of Learning Objectives.* At the end of each chapter, you will find summaries of the key chapter content relevant to each of the Learning Objectives Key Terms We include a list of key terms at the end of each chapter The terms appearing in the list are printed in boldface in the chapter The definitions of all key terms appear in the glossary at the end of the book Questions and Problems.* Each chapter ends with a set of questions and problems Because students rely heavily on example questions and problems with solutions as a learning device, we have increased the number of end-of-chapter questions and problems We have placed particular emphasis on increasing the number of quantitative problems or questions to correspond with the enhanced quantitative content as appropriate to the chapter The answers to questions and problems are in the Instructor’s Manual Internet Exercises We provide an Internet Exercise at the end of each chapter These exercises direct students to websites from which they can obtain additional information about the chapter’s topic or analyze data that illustrate key points from the chapter Glossary.* The book contains an easy-to-use glossary defining the Key Terms listed at the end of each chapter SUMMARY OF CONTENTS AND MAJOR CHANGES All chapters in the book have been updated to reflect recent events A major change in the book is an increase in the quantitative content We have noted that employers are increasingly expecting students to be well versed in problem-solving skills As a result, we have increased the computational skill level, while maintaining our historic strength of being a conceptually focused book Our goal is to provide students and instructors with a book that strikes a balance between helping students understand key financial and economic concepts and providing them with the necessary problem-solving skills Below we summarize the contents and major changes to the eleventh edition Part 1: The Financial System Chapter 1, providing an overview of the U.S financial system, has gone through a major contextual update reflecting changes in the financial system resulting from the 2007–2009 global financial crisis The section on investment banking was expanded and now includes a new section on risk A new section was added on the regulation of the financial system, which includes an analysis of the Financial Regulatory Reform Act of 2010 The section 694 Index Bank management asset management, 639–641 bank liquidity and, 638 bank solvency and, 638 capital management, 489–493 credit risk management, 644–648 interest rate risk and, 649–657 liability management, 641–643 liquidity management, 639–641 operational risk and, 643 profitability versus safety, 637–639 return on average assets, 438–439 return on average equity, 438–439 Bank of America, 60, 101, 224, 230, 410, 421, 456 Bank of Commerce and Credit International (BCCI), 468 Bank panics, 42–43, 105, 476 Bank regulators, 503–505 Bank reserve requirements, 418 Bank runs, 105 Bank solvency, 638 Banker’s acceptances commercial bank operations and, 415 creation of, 227–228 history of, 226 international markets and, 393 transaction sequence and, 227 Banking Act of 1933 See Glass–Steagall Act of 1933 Banking industry See also Commercial banks; International banking; Investment banking; Regulation bank holding companies and, 410, 439–441 branching and consolidation and, 407–409 crisis of, 105–106 deposit distribution in, 409 mergers in, 408 number of banks, 406–407 overview of, 3, 406–410 size distribution of banks, 409–410 stabilization of, 93 Banknotes, 41–42 Bankruptcy See also Lehman Brothers financial crisis and, 101 money markets and, 203 price risk and, 163 Banks for Cooperatives (Co-ops), 214 Barclays, 108, 456 Basel Accord, 490–493, 643 Basis points, 152 Basis risk, futures and, 353 Bear Stearns, 101, 230, 231, 233, 366, 585 Bearer bonds, 254 Beige book, 63 Berkshire Hathaway, 307 Bernanke, Ben, 64, 75, 88, 107, 108, 132 Best-efforts offering, 587 Beta, 324 Bid–ask spreads, 310 Bid-ask spreads, 593 Bid-to-cover ratio, 209 Big Mac Index, 382–383 Bills of lading, 392 "Black Monday,” 99, 328 Blue book, 63 Blue-sky laws, 263, 317 Board of Governors (Fed), 44, 46, 47, 48–49 Boeing, 315 Bond duration bond price volatility and, 158–160 bond properties and, 156–158 definition of, 156 duration-matching approach and, 161–165 financial institutions and, 165 interest rate risk and, 155–156, 160, 161–162 maturity-matching approach and, 161 portfolios and, 160–161 zero coupon approach and, 161 Bond funds, 612–613 Bond price volatility, 151–154 Bond ratings, 184–186 Bondholder, 141 Bonds See also Bond duration; Bond ratings bearer bonds, 254 bond price formula, 142–143 bond yields, 151 call options and, 192 commercial banks and, 415–416 contract terms of, 141 conversion options and, 192, 193–194 convertible bonds, 255, 306 convexity and, 159–160 corporate bonds, 254–259 coupon payments, 141 coupon rate, 141 debenture bonds, 255 default risk and, 146, 182–188 definition of, 141 discount bonds, 143, 144 expected yields and, 148–149 general obligation bonds, 249–250 industrial development bonds, 250 interest rate risk and, 155–156 international markets and, 264 investment-grade, 185 issuers, 141 junk bonds, 185 marketability of, 191 mortgage-backed bonds, 290 municipal, 249–254 par bonds, 143 premium bonds, 144 price risk and, 146 price volatility and coupon rate, 153–155 price volatility and maturity, 151–153 prices and yields, 151 pricing of, 141–146 pricing relationships and, 151–155 principle and, 141 put options and, 192–193 realized yields and, 149 registered bonds, 254 reinvestment risk and, 146 revenue bonds, 249, 250 Samurai bonds, 264 semiannual compounding and, 144 speculative-grade, 185 taxable yields, 189–190 tax-exempt yields, 189–190 term-to-maturity, 141 total return and, 149–150 typical price–yield relationship, 159 Yankee bonds, 264 yield to maturity and, 146–148 zero coupon bonds, 144–145 Book-entry accounts, 210 Book-entry securities, 210 Borrowed funds, 413–414 Borrower income, mortgage qualifying and, 279–280 Branches, bank, 453–455 Breaking the buck, 234 Bretton Woods system, 388–389 Bridge financing, 592 Bridge loans, 420 British Airways, 315 Brokerage firms See Investment banking Brokerage services, bank, 428 Broker-dealer, 593–594 Brokered markets, 310 Brokers, 10 Broker’s call loan rate, 594 Budget deficits, Keynesian theories and, 87 Budget positions, Buffett, Warren, 335 Building societies, 511, 514 Bureau of Consumer Financial Protection (BCFP), 502, 541–542 Bush, George W (and administration), 107, 108 Business credit, finance companies and, 537–538 Business cycles default risk and, 183–184 interest rate behavior and, 194–196 yield curves and, 179–181 Business owner’s policy (BOP), 566 Buyout private equity, 596, 601–602 C Call interest premium, 192 Call loans, 43, 594 Call options, 192, 355–357 exercise of, 357 gains and losses and, 358 value of, 359–360 Call price, 192 Call provisions, 192, 255 Call reports, 494 Call risk, 291 CAMELS rating system, 494–496 Capital accounts, 376–378 Capital accounts, 416 Capital adequacy regulation, 490–493 Capital asset pricing model (CAPM), 325 Capital flight, 387 Capital flows exchange rates and, 383–387 international investment position, 386 Index investment capital flows, 385 political capital flows, 385, 387 Capital gains, 146, 190–191 Capital goods, 16 Capital management, bank, 489–493 Capital markets common stock, 16 corporate bonds, 16–17 definition of, 241 financial guarantees, 260–261 financial market regulators and, 263 functions of, 241–243 government agency securities, 243–249 inflation-indexed notes and bonds, 245–246 international, 394–397 mortgage market relationship and, 297–298 mortgages, 17 municipal bonds, 17, 249–254 net financial positions of economy, 242 participants in, 242–243 securitized credit instruments, 261–263 selected instruments outstanding, 243 size of, 243 STRIPS, 244, 246–249 U.S Treasury notes and bonds, 243–245 worldwide, 264 Capital notes, 415–416 Capital ratios, savings institutions and, 520–521 Capital stock, 416 Capital-gains yield, 320 Caps, interest rate risk and, 658 Captive insurance companies, 557–558 Captive sales finance companies, 534 Carried interest, 597 Cash assets, commercial banks and, 418 Cash drains, 99 Cash items in process of collection (CIPC), 60 Cash value, insurance and, 560 Cash-flow underwriting, 550 Cash-settled futures, 662 Casualty insurance companies, financial intermediation and, 28 Catastrophic events, insurance and, 548, 549 Central banks See also Federal Reserve System; International markets financial crisis and, 106 foreign exchange markets and, 379 Central Liquidity Facility (CLF), 527 Certificates of deposit (CDs), 413 Chartering restrictions, finance companies and, 541 Check clearing and collection, 62–63, 418 Checking accounts, 412 Chicago Board of Trade (CBOT), 12, 13, 344 Chicago Board Options Exchange (CBOE), 13, 362 Chicago Mercantile Exchange (CME), 12, 344 Circuit breakers, 328 CIT Group, 534 Citibank, 225 Citigroup, 101, 105 Citron, Robert, 163 Claims adjusters, 550 Cliff vesting, 573 Closed-end funds assets and number of, 621 discount, 619 premium, 619 selected data on, 620 CME Group, 344 Coinsurance, 549 Collars, interest rate risk and, 658 Collateral, 419 Collateralized debt obligations (CDOs), 365 Collateralized mortgage obligations (CMOs), 288–289 Commercial banks See also Bank loans; Bank management; Banking industry; Regulation agricultural loans and, 420–421 assets of, 417, 422 balance sheet for, 410 balances at other banks and, 418 bank credit cards and, 421 banker’s acceptances and, 415 base-rate loan pricing and, 423–424 bonds and, 415–416 borrowed funds and, 413–415 as brokers, 428 capital accounts and, 416 capital notes and, 415–416 cash assets of, 418 certificates of deposit and, 413 commercial and industrial loans, 420 competition with investment banks, 583–584 consumer loans and, 421 correspondent banking and, 428 credit unions and, 532 currency options and, 381 demand deposits and, 412 deposit distribution in, 409 derivative securities and, 431–432 earnings, 433–438 Eurodollars and, 415 federal funds and, 216–217, 414, 418 Federal Home Loan bank advances and, 415 Federal Reserve bank loans and, 415 Federal Reserve deposits and, 418 fee-based services and, 428–429 financial intermediation and, 26–27 fixed assets and, 422 fixed-rate loans and, 419–420 floating-rate loans and, 419–420 foreign branches of, 454–455 foreign exchange markets and, 379 fund sources of, 411–416 government agency securities and, 243–249 income statement for, 434 insurance and, 428–429 interest rate risk and, 649–651 695 investment portfolios and, 419 investment services and, 428–429 lease financing and, 422 letters of credit and, 430–431 liabilities and capital accounts of, 411 loan brokerage and, 432 loan commitments and, 429–430 loan pricing and, 422–423 loans and leases and, 419–422 matched-funding loan pricing, 425 money market deposit accounts and, 412–413, 497 mortgage markets and, 293–294 municipal securities and, 189 negotiable certificates of deposit and, 413 nonprice adjustments and, 424–425 NOW accounts and, 412 off-balance-sheet banking and, 429–433 performance, 438–439 promissory notes and, 419 real estate loans and, 420 regulators and, 503–505 relationship with investment banking, 579–585 repurchase agreements and, 414–415 reverse repurchase agreements and, 418–419 savings accounts and, 412 savings deposits and, 412–413 secured loans and, 419 securitization and, 432–433 security activities of, 584 swap contracts and, 363 time deposits and, 413 trading account assets and, 422 trading liabilities and, 415 transaction accounts and, 412 trust operations and, 428 unsecured loans and, 419 uses of funds by, 416–422 vault cash and, 418 Commercial letter of credit, 430 Commercial package policy (CPP), 566 Commercial paper credit ratings and, 223 definition of, 221 finance companies and, 29, 539 financial crisis and, 232–233 history of, 221–222 issue of, 223–224 market for, 222 maturities and, 15 MMMFs and, 234 yields, 223–224 Commercial Paper Funding Facility (CPFF), 234, 235 Commitments, private equity, 597 Committee on Uniform Security Identification Procedures (CUSIP), 248 Commodity Exchange (COMEX), 344 Commodity Futures Modernization Act of 2000, 366 Commodity Futures Trading Commission (CFTC), 361–362 696 Index Common bond requirements, 525 Common stock, 303–305 capital-gains yield and, 320 constant dividend growth rate and, 318–320 definition of, 16 dividend yield and, 308 dividends and, 304 limited liability and, 304 residual claims and, 304 voting rights and, 304–305 Common stock valuation, 318–321 Community Reinvestment Act (CRA), 32, 51, 440, 468, 496, 501 Compensating balances, 424–425 Competitive bids T-bills and, 208 underwritten securities and, 587 Competitive Equality in Banking Act (CEBA) of 1987, 478 Competitive offerings, 256 Competitive sale, 256 Compounding, 139 Concentration ratios, 646 Consolidation, banking industry and, 407–409 Construction-to-permanent mortgages, 279 Consumer Credit Protection Act, 32, 51, 499–500, 541 Consumer loans, 421 Consumer Price Index (CPI), 89, 131, 132 Consumer Price Index for All Urban Consumers (CPI-U), 245 Consumer protection regulations, 32 Consumer receivables, finance companies and, 535–536 Consumption expenditures, money supply and, 96–98 Contingent assets, bank, 429 Contingent deferred sales charge, 617 Contingent liabilities, bank, 429 Contractionary fiscal policy, 86 Contractual savings institutions, 27–28 Contributory plans, 571 Conversion options, bond, 192, 193–194 Conversion yield discount, 193 Convertible arbitrage, 629 Convertible bonds, 255, 306 Convertible preferred stock, 306 Convertible term insurance, 559 Convexity, 159–160 Cooke, Jay, 581 Corporate bond funds, 612 Corporate bonds See also Bond ratings; Bonds bearer bonds, 254 convertible bonds, 255 debenture bonds, 255 definition of, 16–17 indenture and, 255 investors in, 255–256 junk bonds, 257–259 primary market for, 256–257 private placement of, 256–257 public sales of, 256 registered bonds, 254 secondary market for, 257 term bonds, 254 Corporate central credit unions, 529–530 Corporate subsidiaries, venture capital and, 597 Correspondent balances, 217 Correspondent banking, 428, 454 Corrigan, Gerald, 99 Counterparty, forward markets and, 337 Countertrade, 378 Country (sovereign) risk, 264, 459, 460– 461, 463–464 Countrywide Financial, 224 Coupon income, tax treatment of, 188–190 Coupon payments, 141 Coupon rate, 141 Covalence Ethical Rankings, 444 Covered options, 358 Credit, foreign exchange markets and, 378 Credit cards, 421, 429 Credit default swaps (CDSs), 365–366, 452, 648 Credit derivatives, 648 Credit insurance, 648 Credit ratings commercial paper, 223 financial guarantees and, 260–261 Credit reports, checking, 426 Credit risk bond yields and, 146 brokerage and, 646 concentration ratios and, 646 credit derivatives and, 648 financial institutions and, 30 individual loans and, 644 internal credit risk ratings and, 645 international loans and, 460 loan portfolios and, 644–646 loan sales and, 646 loans and, 425–427 mortgages and, 269 pricing of, 103–104 regulation and, 452 repos and, 220 securitization and, 646 Credit risk diversification, financial intermediaries and, 23 Credit scoring, 426–427 Credit spreads, 187, 265–266 Credit swaps, 648 Credit Union Homeowners Affordability Relief Program (HARP), 527 Credit Union Membership Access Act of 1998, 532 Credit Union National Association (CUNA), 526, 530, 532–533 Credit unions See also Savings institutions assets of, 528–530, 531 capital and, 530 commercial banks compared, 532 common bonds and, 525 federal insurance and, 482 financial intermediation and, 27 investments by, 529–530 liabilities of, 530, 531 operations and balance sheets, 527–528 regulators and, 526–527 selected ratios for, 529 share-draft accounts and, 527 trade and service associations, 530, 532–533 trends and, 528 undivided earnings and, 530 Creditor remedy regulation, finance companies and, 540–541 Credit-rating agencies, 186, 187 Critically undercapitalized banks, 491–492 Cross-hedging, 353 Cumulative feature, preferred stock and, 305 Cumulative voting, common stocks and, 304–305 Currency options, 381 Currency quotations, 372–374 Currency risk, 459, 461 Currency transformation, financial intermediaries, 23 Current accounts, 374–376 D De facto branching, 439–440 De novo branching, 497 Dealer markets, 310 Dealers, 10 Debenture bonds, 255 Debt securities, options on, 192–194 Decreasing term insurance, 559 Deductibles, insurance and, 549 Default, 182 Default risk See Credit risk Default risk premiums business cycle and, 183–184 loan credit risk and, 427 yield spreads and, 184 Defensive stocks, 324 Deferred availability cash items (DACI), 59 Deficit spending units (DSUs), 6–8, 19, 23 Deficits, 377–378 Defined benefit plans, 571–572 Defined contribution plans, 572 Deflation, 123, 195 Demand deposits, 412 Demographic changes, savings, 526 Demutualization, 552 Denomination divisibility, financial intermediaries and, 23 Deposit insurance, 450 bank failures and, 477–478, 482–484 debt holders and, 488 history of, 482 insurance agencies as “police,” 487–488 issues regarding, 485–488 moral hazard problems and, 485–486 premiums and, 488 stockholders and, 488 Index systemic risk provision and, 486–487 too-big-to-fail policy and, 486–487 Deposit Insurance Fund (DIF), 479 Deposit variability, 641 Depository institutions, 218 Depository Institutions Act (DIA) of 1982, 50, 478, 497, 520 Depository Institutions Deregulation and Monetary Control Act (DIDMCA), 50, 51, 412, 447, 478, 497, 515 Deposits, bank income and, 433 Deposit-type institutions, 25–27 Depreciation, currency, 372 Deregulation, mortgage loans, 103 Derivative markets See Forward markets; Futures markets Derivative securities, 13 Derivative securities, 431–432 Direct financing, 7–8 Direct search markets, 309–310 Discount, closed-end mutual funds, 619 Discount bonds, 143, 144 Discount brokers, 594 Discount factor, 140 Discount instruments, 207 Discount rate, 59, 81 Discount window, 59, 66–67, 72 Discount yield, 211–212 Discounting, 140 Disinflation, 123, 195 Disintermediation, 258 Distressed securities, hedge funds and, 629 Distribution, securities, 10, 589 District banks (Fed), 45–47 Diversification equity risk and, 322 international loans and, 463 Dividend yield, 308 Dividends common stock and, 304 preferred stocks and, 305 Document of title, 392 Dodd, Chris, 34 Dodd-Frank Wall Street Reform and Consumer Protection Act, 366, 432, 480, 487, 502–503, 505, 595, 627 Dollar value, interest rates and, 98 Dollarization, 399 Domestic markets, 14 Douglas Amendment, 497 Dow Jones Index futures, 347 Dow Jones Industrial Average (DJIA), 99, 328, 329–330 Down payments, mortgage qualifying and, 280 Drafts, 391 Drawdown, private equity, 597 Drexel Burnham Lambert, 258 Dual banking system, 500 Dual-class firms, 304 Due diligence, 592 Duration GAP analysis, 653–655 Duration-matching strategy, bonds, 161–165 E Earnings, 304 Earnings per share (EPS), 309 Easy money policies, 43 Ebbers, Bernard, 142 Economic and Monetary Union (EMU), 372 Economic Growth and Tax Relief Reconciliation Act (TEFRA), 570 Economic growth, monetary objectives and, 91–92 Economic models, interest rate forecasting and, 132–133 Economic Recovery Tax Act (ERTA), 570 Economic variables, monetary policy and, 97 Economies of scale, financial intermediaries and, 22 Economist, The, 382 Edge, Walter E., 445 Edge Act corporations, 455 Edge Act of 1919, 445 Effective federal funds rate, 218 Elastic money supply, 43 Emergency Economic stabilization Act of 2008, 53, 60–61, 105, 108, 480 Employee Retirement Income Security Act (ERISA), 572–573 Employee Retirement Income Security Act (ERISA) minimum funding standards and, 573 plan fiduciary and, 573 portability and, 573 vesting and, 573 Employment Act of 1946, 54, 88–89 Enron, 187 Equal Credit Opportunity Act (ECOA), 51, 501 Equifax, 502 Equilibrium rate of interest See Real rate of interest Equity funds, 610–612 Equity markets, 595–596 See also Private equity; Stock markets initial public offerings and, 306 international, 314–315 primary markets, 306–307 private placements and, 307 regulation of, 317 rights offerings and, 307 seasoned offerings and, 306 secondary markets and, 308–311 shelf registration and, 307 underwriter spreads and, 307, 308 Equity risk beta and, 324 diversification and, 322 market risk premium and, 325 risk premium and, 325 security market line and, 325–326 systematic risk, 323 unsystematic risk, 322–323 Equity securities See also Equity markets common stock, 16, 303–305 convertible securities, 306 preferred stock, 305 697 Equity trading electronic quotation systems and, 312 NASDAQ and, 311–313, 314–315, 330 NYSE and, 311, 313–314 over-the-counter market, 311–312 specialists and, 313 Equity valuation common stock valuation, 318–321 preferred stock valuation, 321 Euro, 372–374 Euro Interbank Offered Rate (EURIBOR), 396 Eurobond markets, 264, 394, 396–397 Eurobonds, 396–397 Eurocurrency markets, 394–395 Eurodollars borrowing, 67 deposits of, 415 market for, 14, 264 overview, 394–396 Euronext, 315 European Central Bank (ECB), 374 European Union (EU), 455–456 European-style options, 355 Event-driven investing, 629 Excess reserves (ER), 58, 77 Exchange controls, 461 Exchange fees, mutual fund, 617 Exchange rates capital flows and, 383–387 currency quotations and, 372–374 definition of, 371 dollar value and, 94 fixed exchange rates, 388–389 floating exchange rates, 397–398 forward prices, 372 inflation and, 389 politics and, 390 Exchange regulation, 362–363 Exchange-traded funds (ETFs), 622–625 creation and redemption mechanism of, 622–624 net assets of, 623 number of, 623 selected, 624 unit investment trusts, 624–625 Exercise price, 355 Eximbank loan guarantee program, 462 Expansion financing, venture capital and, 598 Expansionary fiscal policy, 86 Expectation theory, 172–173 Expected yields, 148–149 Experian, 502 Extension risk, 291 F Face value, 141 Factoring, 538 Fair, Isaac, and Company (FICO), 426 Fair and Accurate Credit Transactions (FACT) Act, 426, 502 Fair Credit Billing Act (FCBA), 51, 500–501 698 Index Fair Credit Reporting Act (FCRA), 501–502 Fair Isaac Corporation (FICO), 282 Fannie Mae See Federal National Mortgage Association (FNMA— Fannie Mae) Farm bill of 1985, 214 Farm credit system (FCS), 214 FDIC Savings Association Insurance Fund (FDIC-SAIF), 517 Fed funds rate See also Federal Reserve System definition of, 75, 79 discount rate adjustments and, 81 importance of, 82 long-term control over, 82 market environment and, 81–82 market equilibrium interest rate and, 79–80 monetary policy and, 81 open-market operations and, 81 reserve requirement adjustments and, 81 Fed watching, 65, 67 Federal agencies, financial intermediation and, 29 Federal agency, 213 Federal agency securities agencies authorized to issue debt, 214 agency debt characteristics, 215–216 farm credit system and, 214 Federal Financing Bank and, 215 housing credit agencies and, 215 Federal Bankruptcy Reform Act of 1978, 536 Federal Credit Union Act of 1934, 526 Federal Deposit Insurance Corporation (FDIC) bank failures and, 480, 483–484 bank regulation and, 503–505 capital adequacy and, 491–492 deposit accounts and, 412 deposit insurance premiums and, 485 examiners and, 487 insurance premiums and, 488 international banking and, 450–451 market discipline and, 486 payoff policy of, 482–483 reorganization of, 479 Federal Deposit Insurance Corporation Improvement Act (FDICIA), 479, 486, 488, 501 Federal Farm Loan Act of 1916, 214 Federal Financing Bank (FFB), 215 Federal funds (fed funds), 15, 216–218, 233, 414 Federal funds sold, 418 Federal Home Loan Bank Board (FHLBB), 517, 520 Federal Home Loan Bank (FHLB), 215, 415, 514, 517, 520 Federal Home Loan Mortgage Corporation (FHLMC—Freddie Mac) bailout of, 60, 101, 215–216 characteristics of, 296 conservatorship of, 480 mortgage bankers and, 297 mortgage pools and, 294 mortgage-backed securities and, 284, 287– 288, 290 Federal Housing Administration (FHA), 280, 283 Federal Housing Administration (FHA) insurance, 294–295 Federal Housing Finance Agency (FHFA), 216 Federal intermediate credit banks (FICBs), 214 Federal land bank (FLB), 214 Federal National Mortgage Association (FNMA—Fannie Mae) bailout of, 60, 101, 215–216 characteristics of, 296 conservatorship of, 480 mortgage bankers and, 297 mortgage pools and, 294 mortgage-backed securities and, 283–284, 287–288, 290 Federal Open Market Committee (FOMC), 44, 47–48, 64, 65 Federal Reserve Act of 1913, 43–44, 445 Federal Reserve Bank, investment banking and, Federal Reserve Bank of Kansas City, 331 Federal Reserve Bank of New York, 48 Federal Reserve Bank of St Louis model, 133, 134 Federal Reserve System See also Monetary policy actual reserves and, 78 assets of, 59–60 bailout of the financial system, 53, 60–61 balance sheet and, 56–62 bank failure prevention and, 476–477 bank reserves and, 418 beige book and, 63 blue book and, 63 Board of Governors and, 44, 46, 47, 48–49 capital and, 59 cash drains and, 99 cash items in process of collection and, 60 charter and, 54 check clearing and, 62–63 current structure of, 44–48 deferred availability cash items and, 59 demand deposits and, 412 depository institution reserves and, 56, 58 discount window borrowing and, 59, 66–67, 72 district banks and, 45–47 economy and, 95–98 excess reserves and, 58, 77 fed funds rate and see Fed funds rate Federal Open Market Committee and, 44, 47–48 federal reserve notes and, 56 fiscal agent role of, 215 floats and, 60 formation of, 43–44 government securities and, 59 green book forecast and, 63 independence of, 53–55 inflation rate and, 54–55 interest payment on reserves, 70–71, 79 interest rate and, 79–83 international banking and, 51, 450–451, 454 as lender of last resort, 93, 94 liabilities and capital of, 56–59 liquidity trap, 83 loanable funds and, 121–122 loans to commercial banks, 59, 415 margin requirements and, 51 member banks and, 47 monetary base and, 56, 77–79 money importance, 83 money market crisis and, 234–235 money markets and, 14 money supply and, 65, 76–79 money tool comparison and, 71–72 National Banking Acts and, 42–43 open-market operations and, 56, 59, 63, 65–66, 71–72 origins of, 40–44 overview of, Regulation B, 501 Regulation Q, 50 Regulation Z, 51 regulatory powers of, 47, 49–53 reserve requirements and, 58, 67–69, 72, 78 Treasury deposits and, 58–59 Federal Savings and Loan Insurance Corporation (FSLIC), 478, 479, 482, 517 Federal supervision of banks, 503 FHA mortgages, 280 FICO scores, 282 Fidelity Management and Research, 303–304 Final prospectus, 590 Finance companies assets of, 534–535 automobile credit and, 535 branching and chartering restrictions and, 541 business credit and, 537–538 captive finance companies, 534 commercial paper and, 539 consumer finance companies, 534 consumer protection regulations and, 541–542 consumer receivables and, 535–536 creditor remedy regulation and, 540–541 debt and, 539–540 financial intermediation and, 29 industrial bank charters and, 540 lease paper and, 538 merger restrictions and, 541 mobile home credit and, 535 Index net worth and, 539–540 overview, 533–534 personal loans and, 535 private-label credit plans and, 56 rate ceilings and, 540 real estate lending and, 536–537 receivable securitization and, 538–539 regulation of, 540–542 Regulation Z and, 541 retail paper and, 537 revolving consumer installment credit and, 535–536 sales finance companies, 534 second-mortgage lending and, 536–537 securitization of receivables, 538–539 transfer credit and, 539 types of, 534 wholesale paper and, 537 Financial claims, 6, 12 Financial crisis, anatomy of See also Financial crisis of 2007-2009 asset bubble bursts and, 104 balance sheet deterioration and, 103–104 banking crisis and, 105–106 factors causing a financial crisis, 102–103 low interest rates and, 104–105 subprime lending market and, 101–102 toxic securities, 102 2007-2009 recession, 108 uncertainty and, 105 Financial crisis of 2007-2009 See also Financial crisis, anatomy of asset-backed securities and, 262–263 bailout and, 53, 60–61 bank failures and, 32–33 bond markets and, 265–266 central bank’s credit policies and, 106 comovement of money market and fed fund rates, 236 credit risk pricing and, 106 derivative use and, 432 federal funds and, 218 government-owned agencies debt and, 215–216 housing bubble and, 106 insurance limits, 25 interest rates and, 92 investment banking and, investment banks and, 498–499 Lehman Brothers bankruptcy and, 107, 108 MMMFs and, 29 money markets and, 231–236 mutual funds and, 609, 616 overview of, 3, 100–101 preventing the collapse and, 107–108 regulatory powers and, 51–53, 480 swap market regulation and, 366 Wall Street and, 11 Financial guarantees, 260–261 Financial holding companies (FHCs), 439–441, 498 Financial Industry Regulatory Authority (FINRA), 312, 593, 617 Financial institutions See also Bank management capital markets and, 17 defined, 4–5 duration and, 165 federal funds and, 218 risks managed by, 30–32 Financial Institutions Reform, Recovery, and Enforcement (FIRRE) Act, 478–479, 523 Financial intermediaries See also Commercial banks; Credit unions; Finance companies casualty insurance companies, 28 contractual savings institutions, 27–28 credit risk diversification and, 23 currency transformation and, 23 denomination divisibility and, 23 deposit-type institutions, 25–27 federal agencies, 29 indirect financing and, 17–24 investment funds, 28–29 life insurance companies, 27 liquidity and, 12, 23–24 maturity flexibility and, 23 money market mutual funds, 28–29 mutual funds, 28 pension funds, 294 role of, thrift institutions, 27 types of, 24–29 yield curves and, 181–182 Financial markets See also individual entries, e.g., Capital markets; International markets access, 10 defined, direct financing, 7–8 domestic markets, 14 exchanges, 12 futures market, 13–14 option markets, 13–14 over-the-counter markets, 12–13 primary markets, 12 private placements, 13 public, 13 secondary markets, 10, 12 types of, 12–14 Financial Reform Act of 2010, 35 Financial Regulatory Reform Act of 2010, 34, 47, 52 Financial Service Modernization Act, 580 Financial Services Modernization Act of 1999, 440, 451, 468, 479, 498, 504– 505, 585 Financial Stability Oversight Council (FSOC), 52, 53, 487, 505 Financial system, preview, 5–6 Financial system stability, monetary policy and, 93 Firm commitment deal, 10 Fiscal agents, 58, 215 Fiscal policy, U.S Treasury and, 84–87 Fisher, Irving, 124, 126 699 Fisher equation, 124–125, 195, 246 Fitch Ratings, 184, 185, 186 Fixed assets, 422 Fixed exchange rates, 388–389 Fixed-income arbitrage, 628 Fixed-rate bank loans, 419–420 Fixed-rate mortgage (FRM), 271–272 Flight-to-quality argument, 184 Floating exchange rates, 397–398 Floating-rate bank loans, 419–420 Floor-plan financing, 537 Floors, interest rate risk and, 658 Flow-of-funds account forecasting, 133 Ford Motor Company, 24, 240 Foreign bank operations, 464–468 See also International banking affiliate banks, 455 Financial Services Modernization Act and, 468 Foreign Bank Supervision Enhancement Act and, 468 growth of in U.S., 464–467 International Banking Act of 1978, 467 regulation in U.S., 467–468 top banks in U.S assets, 467 Foreign Bank Supervision Enhancement Act of 1991 (FBSEA), 468 Foreign branches, 454–455 Foreign Credit Insurance Association (FCIA), 462 Foreign Direct Investment Program (FDIP), 447 Foreign exchange markets See also Exchange rates; International markets countertrade and, 378 credit and, 378 forward transactions and, 378 government intervention in, 387–390 hedging and, 378 major participants in, 379 overview, 14 stability of, 93–94 structure, 378 trading foreign exchange, 379 transfer process, 379 Foreign exchange risk, 31 Foreign subsidiary banks, 455 Fortis, 456 Forward contracts, 337 Forward interest rates, term structure formula and, 175–176 Forward markets, 337–339 differences from future markets, 338–339 forward price and, 337 long position and, 337 margin money and, 339 marking-to-market and, 339 short position and, 337 spot market and, 338 spot price and, 337 Forward prices, 337, 372 Forward rate, 172, 380 401(k) plans, 571 700 Index Freddie Mac See Federal Home Loan Mortgage Corporation (FHLMC— Freddie Mac) Free Banking era, 44 Frictional unemployment, 90 Friedman, Milton, 83, 85 Front-end load, 617 Full employment, 90–91 Full Employment and Balance Growth Act, 88–89 Full Employment and Balanced Growth Act of 1978, 54, 88–89 Full-service brokers, 594 Fully contributory plans, 571 Functional regulation, 498 Fund families, 618–619 Fund sources, commercial bank, 411–416 Funds-transfer process, international, 379 Future value, 139 Futures commission merchants (FCMs), 352 Futures contracts, 338 Futures exchange, 339 Futures market See also Hedging basis risks and, 353 delivery on contracts and, 342–344 differences from forward markets, 338–339 exchange traded contracts example, 345 fixed-rate loans and, 351–353 fund costs and, 350–351 hedging and, 346, 348–349, 353, 657–658 initial margin requirement and, 342 instruments, 344–345 manipulation risks and, 353–354 margin calls and, 342 margin requirements and, 342 margin risks and, 354 options, 658–661 overview, 13–14 participants in, 346–347 payoff diagrams and, 341 regulation of, 361–363 related-contract risks and, 353 risks in, 353–354 speculators and, 346 spreads and, 346 stock portfolios risk and, 347–348 stock-index program trading, 350 straddles and, 346 trade agreements and, 340–342 traders and, 346 transaction example and, 339–344 transfer of futures contracts, 343 uses of, 347–348 G GAP analysis duration analysis, 653–655 incremental GAPs, 653 maturity analysis, 651–653 negative duration GAP, 653 positive maturity GAP, 653 Garn–St Germain Act of 1982, 478, 497, 520 GE Capital, 223, 534, 535 Geithner, Timothy, 107, 108, 203 General Motors Acceptance Corporation (GMAC), 222 General obligation bonds, 249–250 Ginnie Mae See Government National Mortgage Association (GNMAGinnie Mae) Glass–Steagall Act of 1933 aftermath of, 582–583 commercial bank activities and, 579–580 deposit insurance and, 477 deposit rates and, 497 equity securities and, 498 history of, 9, 93 regulation and, 50, 473 repeal of, 451 Global and International bond funds, 612 Global communications, 93, 398 Global equity funds, 611 Global hedge strategies, 628 Global stock markets, 314–315 Global village concept, 398 Globalization See also International markets America as debtor nation and, 398 dollarization and, 398–399 floating exchange rates and, 397–398 of insurance industry, 557–558 rise of multinational companies and, 398 technology breakthroughs and, 398 Wall Street and, 11 Going long, 346 Going short, 346 Goldman, Marcus, 582 Goldman Sachs, 101, 107, 230, 306, 585, 586, 595–596 Government bond funds, 612 Government expenditure model, 85–86 Government holdings, mortgage markets and, 294 Government National Mortgage Association (GNMA-Ginnie Mae) characteristics of, 296 mortgage-backed securities, 283–284, 287 Government pension plans, 570–571 Government securities, 229, 249 Graduated vesting, 573 Gramm-Leach-Bliley Act, 440, 451, 468, 479, 498, 504–505, 585 Great Depression, 9, 93, 476, 569 Green book forecast, 63 Greenspan, Alan, 49, 64, 91–92, 99, 100, 104, 106 Gross domestic product, 98 See also Nominal GDP; Real GDP Gross interest expense, 433, 435 Gross interest income, 433, 435 Gross national product (GNP), fiscal policy and, 86 Growing perpetuity, 318 Growth and income funds, 611 Growth funds, 611 H Haircut, 219 Hard insurance market, 550 Health insurance, 562–563 Hedge funds characteristics of, 626 closed-end fund arbitrage, 628 convertible arbitrage and, 629 difference from mutual funds, 626–627 distressed securities and, 629 Dodd-Frank Wall Street Reform and Consumer Protection Act and, 627 event-driven investing and, 629 fixed-income arbitrage and, 628 global macro strategies and, 628 index arbitrage and, 628 investment strategies, 627–629 market-neutral strategies and, 628 performance of, 629 risk arbitrage and, 629 sector strategies and, 628 short selling and, 628 special situations and, 629 Hedgers, 346 Hedging cross-hedging, 353 financial futures and, 657–658 financial futures options and, 658, 661 foreign exchange markets and, 378 futures market and, 346, 348–349, 353, 657–658 interest rate risk and, 657–665 interest rate swaps and, 661–662 macrohedging, 657 microhedging, 657 Hicks, Sir John, 172 High-yield bond funds, 612 Holding companies, bank, 439–441 Home equity lines of credit, 279 Home equity loans, 279 Home Mortgage Disclosure Act of 1975, 32 Housing boom, 101–102, 104 Housing bubble, 106 Housing credit agencies, 215 Housing investment, interest rates and, 98 Humphrey–Hawkins Act, 88–89 Hybrid adjustable-rate mortgages, 274 Hybrid funds, 613 Hybrid markets, 313 Hyperinflation, 87 I IBM, 308–309, 311 IBM Global Financing, 534 Immediately available funds, 217 Implied forward rates, 175–176 Import transactions example, 392–393 Income statement, bank, 434 Income-equity funds, 611 Incremental GAPs, 653 Indenture, 255 Independence, Federal Reserve, 53–55 Index arbitrage, 628 Index Index funds, 611–612 Indirect financing adverse selection, 21 asymmetric information, 20–22 definition of, intermediation services, 23–24 moral hazard, 21–22 overview, 17 protection for market failures, 22 SSU and DSU flow, 17–18 summary, 22–23 transaction costs, 19–20 Individual equity, 571 Industrial bank charters, finance companies and, 540 Industrial bank loans, 420 Industrial banks, 540 Industrial development bonds (IDBs), 250 Inflation definition of, 89 exchange rates and, 389 inflation-indexed bonds, 245–246 inflation-indexed notes, 245–246 interest rates and, 98, 123, 130–131 loan contracts and, 123–124 nominal rate of interest and, 117 problems with, 89–90 trade-off and unemployment, 94–95 Inflation targeting, 88 Initial margin requirements, 342 Initial public offerings (IPOs) investment banks and, 586 pricing of, 587 as primary offering, 306 returns of, 588 underpricing of, 587 Insolvency, bank, 638 See also Bank failures Insurance See also Insurance industry all-risk coverage and, 565–566 annuities and, 561–562 benefits of, 547 cash value and, 560 cash-flow underwriting and, 550 catastrophic events and, 548, 549 characteristics of, 547 coinsurance and, 549 credit, 648 deductibles and, 549 health insurance, 562–563 interest rate risk and, 550–551 law of large numbers and, 547 liability insurance, 565–568 life insurance, 558–565 marine insurance, 566 mortgage, 294–295 multiple line policies, 566–567 named-perils coverage and, 565 objective risk and, 547–549 participating policies, 552 pricing of, 550 property insurance, 565–568 reinsurance and, 549 requirements of privately insurable risk and, 549–550 risk and, 546–547 term insurance, 559 underwriting and, 547–548 underwriting cycle and, 550 universal life insurance, 560–561 variable life insurance, 561 whole life insurance, 559–560 Insurance industry captive insurance companies, 557–558 corporate bonds and, 255–256 globalization of, 557–558 liquidation of insurers, 557 Lloyd’s associations and, 552–553 market structure of, 551 mortgage markets and, 294 municipal bonds and, 253 mutual companies and, 552 organizational forms of, 551–553 reciprocal exchanges and, 552 regulation of, 555–557 securitization of risk and, 558 size and number of companies, 554–555 stock companies and, 551–552 top companies by revenues, 55, 554 Insured pension plans, 572 Interbank clearing systems, 379 Interbank lending rate, 79 Interest Equalization Tax (IET), 447 Interest expense, banks, 433, 435 Interest income, banks, 433, 435 Interest margins, banks, 433 Interest rate risk, 649–657 See also Interest rates bonds and, 155–156, 160, 161–162 concept of, 31 duration GAP analysis and, 653–655 effects on commercial banks, 649–651 financial futures and, 657–658 financial futures options and, 658–661 hedging of, 248–249, 657–665 insurance companies and, 550–551 interest rate swaps and, 661–665 maturity GAP analysis and, 651–653 measurement of, 651–655 mortgages and, 269 net cash flow and, 650 value at risk and, 655–657 zero coupons and, 161 Interest rate stability, monetary policy objectives and, 92 Interest rates See also Interest rate risk; Term structure; Yield curves adjustable-rate mortgages and, 274–275 allocative function of, 116–117 business cycle and, 194–196 business spending and, 98 definition of, 116 dollar value and, 98 economic models and, 132–133 expectation theory and, 172–173 Fed’s control over, 79–83 financial crisis and, 104–105 Fisher equation and, 124–125 fixed income securities and, 96 701 flow-of-funds account forecasting and, 133 forecasting of, 132–134 housing investment and, 98, 102, 104–105 implied forward rates and, 175–176 inflation and, 130–131 loan contracts and inflation and, 123–124 loanable funds and, 120–123 money market, 235–236 negative interest rates and, 129–130 nominal, 117 prediction of, 181 price expectations and, 123–131 price-level changes and, 125–127 real rate of interest, 117–119 realized real rate of return and, 127–128 reserve payments and, 70–71, 79 spreads, 424 swaps, 661–665 tax treatment and, 188–191 term structure of, 170–182 Interest-only (IO) securities, 289 Interest-only mortgage, 278 Interest-only tranches, 288 Interest-sensitive life insurance, 561 Intermediation financing See Investment banking Internal credit risk ratings, 645 Internal Revenue Service (IRS), 84 International banking See also International loans; International markets; International trade financing agreement corporations and, 455 allowable banking activities and, 451 correspondent banks and, 454 delivery of services and, 452–457 development of, 445–448 Edge Act corporations, 455 EU and cross-border M&A, 455–456 expansion period and, 446–447 facilities and, 457 foreign banks in U.S., 464–468 foreign branches and, 454–455 foreign subsidiaries and affiliates, 455 future directions and, 468–469 growth of, 447–448 international loan characteristics, 458–459 lending and, 457–464 organizational structure possibilities and, 453 recent activity and, 448 regulation of, 448–452 representative offices and, 452–453 risk and, 459–464 shell branches and, 453–454 thrift institutions and, 533 world’s largest banks, 449 International Banking Act (IBA) of 1978, 450–451, 467–468 International banking facilities (IBFs), 457 International Finance Corporation (IFC), 464 International funds, 611 International Lending Supervision Act, 450 702 Index International loans, 457–464 characteristics of, 458–459 country risk and, 460–461, 463–464 credit risk and, 460 currency risk and, 461 diversification and, 463 less-developed countries and, 459 participation loans and, 463 pooling risk and, 463 rescheduling and, 460–461 risk evaluation and, 461–462 risk reduction and, 462–463 rollover pricing and, 459 syndicated loans, 459 third-party help and, 462 unsecured, 459 International markets See also Globalization; International banking balance of payments and, 374–378 capital account and, 376–378 capital flight and, 387 capital flows and exchange rates, 383–385 currency derivatives and, 380–381 currency options and, 381 currency quotations and, 372–374 current account and, 374–376 difficulties of trade, 370–371 equity securities and, 315–316 eurobond markets, 394 eurocurrency markets, 394 exchange rates and, 371–374 financing of trade and, 390–393 fixed exchange rates and, 388–389 foreign exchange markets, 378–379 globalization of, 397–399 government intervention and, 387–390 inflation and exchange rates, 389 investment capital flows and, 385 investment position, 386 money and capital markets, 394–397 overview, 14 political capital flows and, 385, 387 politics and exchange rates, 390 purchasing power parity and, 381–383 spot and forward transactions and, 379–383 International Monetary Fund (IMF), 389 International trade financing, 390–393 banker’s acceptances, 393 bills of lading and, 392 import transaction example, 392–393 letters of credit and, 391 sight drafts and, 391 time drafts and, 391 Interstate Banking and Branching Efficiency Act (IB&BEA), 497, 501 Interstate banking regulations, 440, 497, 501 Intrinsic value, of call option, 359–360 Investment banking See also Glass–Steagall Act of 1933 arbitrage activities and, 594–595 asset management and, 595–596 bringing securities to market and, 586–592 broker-dealers and, 593–594 competition with commercial banks, 583–584 competitive bidding and, 587 current structure of, direct financing and, 7–8 discount brokerage and, 594 distribution and, 10, 589, 591 early history of, 9, 580–582 fee structure and, 597 Financial Services Modernization Act of 1999 and, 585 industry structure, 580 initial public offerings and, 586, 588 loan comparison and, 416–417 margin trading and, 593–594 as market maker, 593 mergers and acquisitions and, 591–592 negotiated offerings and, 587 origination and, 10 private equity and, 596–602 private placements and, 587, 591 proprietary trading and, 594–595 prospectus and, 589, 590 public offerings and, 587 registration statement and, 589 relationship with commercial banking, 579–585 role of, security services and, 595–596 services of, 586–596 trading and brokerage and, 10 trading and principal investments and, 592–595 underwriting and, 10, 587, 589 Investment capital flows, 385 Investment companies closed-end mutual funds, 619–622 exchange-traded funds, 622–625 hedge funds, 626–629 open-end mutual funds, 606–619 overview, 605–606 real estate investment trusts, 630–633 Investment Company Act of 1940, 605, 606, 623, 626, 630 Investment funds, financial intermidiation and, 28–29 Investment portfolios, commercial banks, 419 Investment securities, bank earnings and, 433–435 Investment spending, monetary policy and, 98 Investment-grade bonds, 185 IOUs, Issuer, bond, 141 J Jobs, Steve, 303, 304 Joint-and-survivor annuity, 562 Jones, Alfred, 626–627 JPMorgan, 225, 230, 231, 580 JPMorgan Chase, 101, 448, 481, 580 Jumbo CDs, 413 Junior debt, 255 Junk bonds bond ratings and, 185 default rates and, 257–259 demand for, 258 supply of, 258 K Kerviel, Jerome, 142 Keynes, John Maynard, 83, 84 Keynesian economists, 83–87 Keynesian theory, 87 Knutson, Brian, 142 L Law of large numbers, 547 LEAPS (Long-term Equity Anticipation Securities), 355–356 Lease financing, bank, 422 Lease paper, 538 Leasing, finance companies and, 538 Lehman Brothers bankruptcy of, 108, 203, 230, 234, 452, 480, 585, 616 financial crisis and, 101, 107 repos and, 221 systemic risk and, 486–487 Lender of last resort, 43, 476 Lending risk, international banking and, 459–464 Less developed countries (LDCs), 459 Letters of credit (LC), 227, 391, 392, 430–431 Leverage ratio, 491 Leveraged buyout (LBO) deals, 592, 601–602 Liability insurance, 565–568 Liability management, 641–643 Liberty Mutual Insurance Company, 555 Life insurance annuities and, 561–562 balance sheets and, 563–564 financial intermediation and, 27 term insurance, 559 universal life insurance, 560–561 variable life insurance, 561 whole life insurance, 559–560 Limit orders, 316 Limited liability, common stock and, 304 Line of credit, 429 Liquidity asset management, 639–641 bank, 638 financial intermediaries and, 12, 23–24 Liquidity premiums, 177 Liquidity risks, 31 Liquidity traps, 83 Lloyd’s Associations, 552–553 Lloyd’s of London, 553 Load funds, 617 Loan brokerage, commercial banks and, 432 Loan commitments, 429–430 Loan loss provisions bank, 435–436 savings institutions and, 523 Loan origination fees, 297 Index Loan pricing, 422–423 Loan rate ceilings, 499 Loan workouts, 644 See also Bank loans Loanable funds aggregate demand schedule for, 121–122 equilibrium rate of interest and, 122–123 interest rate determination and, 120 sources of supply and demand for, 120–122 Loans, bank See Bank loans; Commercial banks; International loans Loeb, Solomon, 582 London Interbank Offering Rate (LIBOR), 395–396, 415, 458–459 Long position, 337 Long-term asset loans, 420 Loss reserves, 564 M M1, 77 M2, 77 Macrohedging, 657 Maintenance margin, 342 Management fees, mutual fund, 617 Manipulation risks, futures and, 353–354 Margin calls, 342 Margin money, 316, 339 Margin requirements, 51 Margin risks, futures and, 354 Margin trading, 593–594 Marine insurance, 566 Market capitalization real estate trusts, 631 secondary markets and, 308 Market economy, 89 Market environment, fed funds rate and, 81–82 Market equilibrium interest rate, 79–80 Market imperfections, 19–20 Market maker, 593 Market orders, 316 Market risk premium, 325 Market value–weighted indexes, 329 Marketability, 12, 191 Market-neutral hedge strategies, 628 Market-segmentation theory, 177–178 Marking-to-market, 339 MasterCard credit cards, 421 Matched funding, 425 Matched funding, 425 Maturity, bond price volatility and, 151–153 Maturity flexibility, financial intermediaries and, 23 Maturity GAP analysis, 651–653 Maturity-matching approach, bonds, 161 MBIA, 260–261 McCarran–Ferguson Act (Public Law 15), 555–556 McFadden–Pepper Act of 1927, 496 Member banks of Federal Reserve, 47 Merger restrictions, finance companies and, 541 Mergers and acquisitions (M&As) cross-border, 455–456 investment banks and, 591–592 Merrill Edge, 594 Merrill Lynch, 60, 101, 230, 578, 585 Microhedging, 657 Minimum funding standards (ERISA), 573 Mobile home credit, finance companies and, 535 Monetarist economists, 83 Monetary base Federal Reserve and, 56 money supply changes and, 77–79 Monetary policy See also Federal Reserve System anatomy of a financial crisis, 100–108 complications of, 99–100 economic growth and, 91–92 economic role of, 85 economic variables and, 97 expenditure channels and, 95–98 fed funds rate and, 81 financial system stability and, 93 foreign exchange market stability and, 93–94 full employment and, 90–91 goals of, 87–95 inflation targeting, 88 interest rate stability and, 92 investment spending and, 98 possible conflicts among goals and, 94–95 price stability and, 88, 89–90 Monetary powers, Board of Governors (Fed), 48–49 Monetary theory, 83 Money future value of, 139 present value of, 139–140 time value of, 138–140 Money center banks, 8, Money market deposit accounts (MMDAs), 412–413, 497 Money market mutual funds (MMMFs) characteristics of, 230, 613 commercial paper and, 234 competition with banks, 614 deposit rates and, 497 financial intermediation and, 28–29 portfolio composition of, 614 Money markets balance sheet positions and, 228 banker’s acceptances and, 226–228 bankruptcy and, 203, 230 characteristics of instruments, 206–207 commercial banks and, 216–217, 228–229 commercial paper and, 15, 221–224 co-movement of yields, 236 definition of, 204 economic role of, 206 federal agency securities, 213–216 federal funds and, 15 Federal Reserve System and, 229 financial crisis of 2007-2009 and, 231–236 instruments outstanding, 205 interest rate relationships, 235–236 international, 394–397 major instruments outstanding and, 218–221 703 negotiable certificates of deposit and, 15, 224–226 nonfinancial corporations and, 230–231 operation of, 205–206 overview, 14–15 repurchase agreements, 218–221 Treasury bills, 15, 207–213 Treasury Department and, 229–230 Treasury security dealers and, 229–230 Money supply See also Federal Reserve System consumption expenditures and, 96–98 Federal Reserve and, 65, 76–79 increase in, 96, 98 measures of, 76–77 monetary base and, 77–79 Monolines, 260–261 Moody’s Investors Service, 184, 185, 186–188 Moral hazard, 485–486 Morgan, J Pierpont, 581 Morgan Stanley, 230, 585 Morningstar style box, 610 Mortgage bankers, 296–297 Mortgage insurance, 294–295 Mortgage markets See also Financial crisis, anatomy of adjustable-rate mortgages, 272, 274–276 balances and payments, 273 balloon payment mortgages, 277 banks and, 293–294 borrower income and, 279–280 capital market relationship and, 297–298 characteristics of, 269 construction-to-permanent mortgages, 279 down payment and, 280 extension risk and, 291 FHA mortgages, 280 government holdings and, 294 government-sponsored enterprises and, 294 home equity lines of credit, 279 home equity loans, 279 insurance companies and, 294 interest-only mortgages, 278 mortgage bankers and, 296–297 mortgage prepayment risk, 290–292 mortgage qualifying, 279–282 mortgage-backed securities, 269, 283–290 mortgages outstanding by holder, 293 participants in, 293–297 pension funds and, 294 pools and, 294 prepayment risk, 290–292 private mortgage insurance, 280–281 qualifying for, 279–282 refinancing, 290–291 renegotiated-rate mortgages, 277 reverse annuity mortgages, 279 rollover mortgages, 277 standard fixed-rate mortgages, 271–272 subprime mortgages and, 282 thrift institutions and, 293–294 types of, 271–279 unique nature of, 270–271 Veterans Administration mortgages, 280 704 Index Mortgage-backed bonds, 250, 290 Mortgage-backed securities (MBSs) characteristics of, 269, 284–286 collateralized mortgage obligations, 288–289 credit default swaps and, 365 Fannie Mae and, 283–284, 287–288 Freddie Mac and, 284, 287–288 Ginnie Mae and, 283–284, 287 mortgage-backed bonds, 290 pass-through mortgage securities, 287–288 real estate mortgage investment conduit, 289 regulation and, 452 savings institutions and, 518 secondary markets and, 17 STRIPped mortgage–backed securities, 289 subprime mortgages and, 102 Multiple line insurance policies, 566–567 Municipal bond funds, 612–613 Municipal bonds after-tax yield comparisons, 253–254 characteristics of, 250–251 definition of, 17 general obligation bonds, 249–250 industrial development bonds, 250 investors in, 252–253 market for, 254 mortgage-backed bonds, 250 primary market for, 254 revenue bonds, 249, 250 secondary market for, 254 serial bond issues, 250–251 Tax Reform Act of 1986, 250 tax-exempt feature of, 251–252 type and use of, 249–250 Municipal securities, 188–189 Mutual fund families, 618–619 Mutual fund share classes, 617–618 Mutual funds, 606–619 account maintenance fees and, 617 advisory fees and, 617 aggressive growth funds, 611 balanced funds, 613 banks marketing of, 428 bond funds, 612–613 cash holdings and, 608–609 closed-end, 619–622 contingent deferred sales charges and, 617 difference from hedge funds, 626–627 equity funds and, 610–612 exchange fees and, 617 families of, 618–619 fees and, 617–618 financial intermediation and, 28 growth and income funds, 611 growth funds, 611 hybrid funds and, 613 income-equity funds, 611 index funds, 611–612 international and global equity funds, 611 load funds, 617 management fees and, 617 money market mutual funds, 613–616 mutual fund families, 618–619 net asset value, 607, 616 net assets of, 615 no-load funds, 617 portfolio holdings of, 614 pricing of, 606–608 redemption fees and, 617 redemption policies and, 608–609 sizes of, 615 specialty funds, 611 12b-1 fees and, 617 types of, 609–610 Mutual institutions, 514 Mutual insurance companies, 552 N Naked options, 358 Named-perils coverage, 565 NASDAQ, 311–313, 314–315, 330 National Association of Federal Credit Unions (NAFCU), 530, 532–533 National Association of Insurance Commissioners (NAIC), 556 National Association of Real Estate Investment Trusts (NAREIT), 630 National Association of Securities Dealers (NASD), 263, 312, 593 National Banking Acts, 42–43 National Bureau of Economic Research (NBER), 108 National Credit Union Administration (NCUA), 526–527 National Credit Union Share Insurance Fund (NCUSIF), 482, 526–527 National debt (U.S.), 398 National Housing Act of 1934, 283, 482 National Securities Markets Improvement Act of 1996, 606 Negative amortization, 275 Negative duration GAP, 653 Negative interest rates, 129–130 Negotiable certificates of deposit (CDs), 413 market background, 225 maturities of, 224 negotiable yields and, 225–226 overview, 15 Negotiated offerings, 256, 587 Negotiated sale, 256 Net asset value (NAV), 607–608, 616 Net cash flow, interest rates and, 650 Net interest income, 433 Net interest margin, 433 New York Board of Trade, 13 New York Futures Exchange (NYFE), 344 New York Mercantile Exchange (NYMEX), 344 New York Stock Exchange Composite Index, 347 New York Stock Exchange (NYSE), 12 New York Stock Exchange (NYSE), 311, 313–314 New York Stock Exchange (NYSE), 315 No-load funds, 617 Nominal GDP, 98 Nominal rate of interest, 117 Noncompetitive bids, T-bills and, 209–210 Noncontributory plans, 571 Nonfinancial corporations, 230–231 Nonfinancial corporations, money markets and, 230–231 Noninsured pension plans, 572 Noninterest expense, 437 Noninterest income, 436–437 Nonparticipating feature, preferred stock and, 305 Nonprice adjustments, bank loans and, 424–425 Notional principal, 363 NOW accounts, 412 NYSE Euronext, 315 O Obama, Barack, 35, 480 Objective risk, insurers and, 547–549 Off-balance-sheet activities, 642 Off-balance-sheet banking, 429–433 Office of the Comptroller of the Currency (OCC), 450, 454, 494 Office of the Comptroller of the Currency (OCC), 500 Office of Thrift Supervision (OTS), 481, 517 OMX, 315 On-site bank examinations, 494 On-site bank examinations, 494 Open interest, 340 Open-end mutual funds See Mutual funds Open-market operations, 56, 59, 63, 65–66, 71–72, 81 Open-market transaction, 205 Open-outcry, 344 Operational risk, bank, 643 Opportunity cost, 140 Option exercise, 357–358 Option markets American options, 355 call options, 355–357 covered options, 358 debt securities and, 192–194 European options, 355 exercise prices and, 355 gains and losses and, 355 naked options, 358 nature of options, 355–360 option exercise, 357 option premiums and, 355 options versus futures, 360–361 overview, 13–14 put options, 355–357 regulation of, 361–363 strike prices and, 355 value of options, 359–360 Option premiums, 355 Options, 355 Origination, securities, 10, 588–589 Origination fees, 297 OTC Bulletin Board, 312 Index Overseas banking See International banking Overseas Private Investment Corporation (OPIC), 462 Over-the-counter markets (OTC), 12–13, 311–312 P Paper gold, 377 Par bonds, 143 Par value, 141 Participating insurance policies, 552 Participation certificates (PCs), 287 Participation loans, 463 Pass-through mortgage securities, 287–288 Patient Protection and Affordable Care Act, 563 Paulson, Henry, 107, 108, 203 Payment caps, adjustable-rate mortgages and, 275 Payoff and liquidate policy, 482 Payoff diagrams, treasury note futures and, 341 Pay-off policy (by FDIC), 482–483 Pension Benefit Guarantee Corporation (PBGC), 573 Pension plans See also Social Security old-age benefits contributory plans, 571 corporate bonds and, 256 defined benefit plans, 571–572 defined contribution plans, 572 financial intermediation and, 28 fully contributory plans, 571 government, 570–571 history of, 569–570 insured pension plans, 572 legislation and, 572–573 mortgage markets and, 294 noncontributory plans, 571 private, 571–572 qualified plans, 571 Pension Reform Act of 1978, 570 Perfect positive correlation, 322 Perils, 565 Perpetuity, 318 Personal auto policy (PAP), 566 Personal loans, finance companies and, 535 Pink OTC Markets, Inc., 312 Plan fiduciary (ERISA), 573 Points, 297 Policyholders’ surplus, 564 Political capital flows, 385, 387 Political risk financial institutions and, 31–32 international loans and, 462 Politics, exchange rates and, 390 Pooling insurance and, 547 international loans and, 463 mortgage markets and, 294 Portability (ERISA), 573 Portfolio, loan, 644–646 Portfolio duration, bonds, 160–161 Positive maturity GAP, 653 Positive time preference, 118 Predatory lending practices, 473 Preferred stock valuation, 321 Preferred stocks, 303, 305 Preferred-habitat theory, 178 Preliminary prospectus, 589 Premature death, 559 Premium, closed-end mutual funds, 619 Premium bonds, 144 Premiums, deposit insurance, 488 Prepayment risk, 290–292 Present value, 139–140 Price expectations, interest rates and Fisher equation and, 124–125 loan contracts and inflation and, 123–124 negative interest rates and, 129–130 price level changes and, 125–127 realized real rate of return and, 127–128 Price level changes, 125–127 Price risk, 146, 155, 156, 163 Price stability, monetary policy objectives and, 88, 89–90 Price volatility bond price and coupon rate, 153–155 bond price and maturity, 151–153 Price/earnings (P/E) ratio, 309 Price-weighted indexes, 328–329 Pricing relationships, bonds, 151–155 Pricing risk transfers, adjustable-rate mortgages and, 275–276 Primary equity markets, 306–307 Primary financial markets, 12 Primary markets, 12, 254, 306 Primary offerings, 586 Primary reserves, bank asset management and, 640 Prime broker, 596 Prime rate, 422–423 Principal, 141 Private banks, 581 Private equity, 596–602 buyout, 601–602 fee structure and, 597 organizational structure of, 596–597 venture capital and, 597–600 Private mortgage insurance (PMI), 280– 281, 295 Private pension plans, 571–572 Private placements, 13, 256–257, 307, 587, 591 Private-label credit, 536 Privately issued pass-throughs (PIPs), 288 Problem loans, identification of, 644 Program trading, 628 Promised yield, 146–148 Promissory notes, commercial banks and, 419 Prompt corrective actions, 479 Property insurance, 565–568 Proprietary trading, 594 Prospectus, 589, 590 Provision for loan losses, 435–436 Proxy, 304 705 Public markets, 13 Public offerings, 587 See also Initial public offerings Public sale, corporate bonds, 256 Purchase and assumption agreements, 483–484 Purchase power parity (PPP), 381–383 Pure risks, 547 Put interest discount, 193 Put options, 192–193, 355–357 See also Option markets Pyramiding of reserves, 42 Q Qualified plans, 571 R Rate adjustments, adjustable-rate mortgages and, 272, 274 Rate ceilings, 540 Rate-sensitive assets (RSA), 652 Rate-sensitive liabilities (RSL), 652 Real estate investment trusts (REITs), 631 assets of, 632 characteristics of, 630 growth of, 630–631 historical market capitalization and, 631 number of, 632 performance versus stock market, 633 Real estate investments, bank, 420 Real estate lending, 536–537 Real estate loans, 420 See also Mortgage market Real estate markets, financial crisis and, 100–101 Real estate mortgage investment conduit (REMIC), 289 Real GDP (gross domestic product), 91–92, 98 Real output, 117 Real rate of interest demand factors, 118–119 equilibrium condition and, 118 fluctuation in the real rate and, 118–119 positive time preference and, 118 return on investment and, 117–118 supply factors and, 119 Realized real rate of return, 127–128 Realized yields, 149 Receivable securitization, finance companies and, 538–539 Recessions bank failures and, 43 business cycle and, 194–196 employment and, 90 Keynesian theories and, 87 prediction of, 180–181 stock market and, 331 2007-2009 recession, 108, 128 Reciprocal exchange, 552 Redemption fees, 617 Redlining, 501 706 Index Refinancing, 290–291 Registered bonds, 254 Registration statement, 589 Regulation balance sheet restrictions, 498 bank examinations and, 494–496 bank failures and, 32–33, 476–482 bank regulators, 503–505 branching limitations and, 496–497 of capital adequacy, 489–493 capital requirements and, 489–493 commercial and investment banking separation, 497–498 consumer protection regulations, 32, 499–503 credit unions and, 526–527 deposit insurance and, 477–478, 482–488 deposit rate ceilings and, 497 early history of, 33–35 of equity markets, 317 Federal Reserve powers, 47, 49–53 federal supervision of banks, 476–477 finance companies and, 540–542 financial crisis of 2007-2009 and, 498–499 of foreign bank operations, 448–452 functional regulation, 498 of futures market, 361–363 of insurance companies, 555–557 of international banking, 448–452 major bank legislation since 1900, 474–475 of options market, 361–363 reasons for, 472–475 reform, 35 regulatory dialectic, 473 of savings institutions, 514–517 of stock-index options, 362 of swap markets, 366 Regulation B, 501 Regulation Q, 50, 447, 497 Regulation Z (truth-in-lending), 51, 500, 541 Regulatory dialectic, 473 Regulatory Reform Act of 2010, 11 Reinsurance, 549 Reinvestment risk, 146, 155–156 Related-contract risks, futures and, 353 Renegotiated-rate mortgages (RRMs), 277 Renewable term insurance, 559 Repo, 218–221 Representative nonbanking offices, 452–453 Repurchase agreements (RPs), 218–221, 414–415 Required reserves (RR), 58, 67–69, 72, 78, 81 Rescheduling, international loans and, 460–461 Reserve repurchase agreements, 418–419 Reserves See also Required reserves actual, 78 excess, 58, 77 pyramiding of, 42 Residual claims, common stock and, 304 Retail paper, finance companies and, 537 Retained earnings, 304 Retirement savings, 569 See also Pension plans Return on average assets (ROAA), 438–439 Return on average equity (ROAE), 438–439 Return on investment, 117–118 Revenue bonds, 249, 250 Reverse annuity mortgages (RAMs), 279 Reverse repos, 520 Reverse repurchase agreement (reverse repo), 218 Revolving credit, 429, 535–536 Riegle–Neal Interstate Banking and Branching Efficiency Act of 1994, 440 Rights offerings, 307 Risk, 546 Risk arbitrage, 629 Risk management See Bank management; Credit risk; Interest rate risk Risk premium, 325 Risk securitization, 558 Risk transfer, 547 Risk-weighted assets, 491 Rogue traders, 142 Rolling over paper, 223 Rolling stock, 255 Rollover mortgages (ROMs), 277 Rollover pricing, 459 Royal Bank of Scotland Group, 456 Rule 144A, 257 Running a deficit, 377–378 Russell 1000 index, 330 Russell 2000 index, 330 Russell 3000 index, 330 S Sales finance companies, 534 Samuelson, Paul, 331 Samurai bonds, 264 Sarbanes–Oxley Act of 2002, 11 Savings accounts, 412 Savings and loan associations (SLAs), 514 Savings Association Insurance Fund (SAIF), 479 Savings associations, 514, 521–524 See also Savings institutions Savings deposits, 412–413 Savings institutions, 512 See also Credit unions; Savings associations assets of, 518–520 borrowed funds and, 413–415 capital and, 520–521 contraction of, 518 demographic changes and, 526 deposits and, 520 historical development of, 513–517 liabilities of, 520 loan loss provisions for, 523 mortgages and, 518–519 net income for, 524 net interest margin of, 522 nonmortgage loans and, 520 number and assets of, 516 operations of, 517–524 problem assets and, 522 regulation of, 514–517 Saxon, James, 422 Seasonal loans, 420 Seasoned offerings, 586 Secondary equity markets auction markets, 311 brokered markets, 310 dealer markets, 310–311 direct search markets, 309–310 example of, 308–309 Secondary reserves, bank asset management, 640 Second-mortgage lending, 536–537 Sector hedge strategies, 628 Secured bank loans, 419 Securities Act of 1933, 317 Securities and Exchange Act of 1934, 256 Securities and Exchange Commission (SEC), 11, 13, 263, 362 Securities Exchange Act of 1934, 317 Securitization, 51, 102, 103–104, 261–263, 432–433 Securitization of risk, 558 Securitized credit instruments, 261–263 Security activities, commercial banks and, 584 Security brokers See Investment banking Security Investor Protection Corporation (SIPC), 593 Security market line (SML), 325–326 Seed financing, 598 Seigniorage, 399 Self-Employed Individuals Tax Retirement Act of 1962, 570 Semiannual compounding, 144 Senior debt, 255 Separate Trading of Registered Interest and Principal Securities (STRIPS), 246–249 September 11 terrorist attacks, 94, 548 Serial bond issue, 250–251 Settlement date, forward contracts and, 337 Share-draft accounts, 527 Shelf registration, 307 Shell branches, 453–454 Short position, 337 Short sales, 315–316 Short squeezes, 353 Sight drafts, 226 Sight drafts, 391 Sinking fund provision, 255 Smooth interest rates, 72 Index Social adequacy, 571 Social Security Act, 570 Social Security old-age benefits, 570–571 Société Générale, 142 Soft insurance market, 550 Solvency, bank, 638 Sovereign borrowers, 459 Sovereign loans, 459, 460 Special drawing rights (SDRs), 377 Special reserve accounts, 416 Specialists, equity trading and, 313 Specialized funds, 611 Speculative bubbles, 52 Speculative risks, 547 Speculative-grade bonds, 185 Speculators, futures market and, 346 Spitzer, Eliot, 578 Spot market, 338 Spot price, 337 Spot rate, 174 Spreads, 346 Stagflation, 85 Standard & Poor’s, 184, 185, 186, 330, 347 Standard deviation of returns, 322 Standby letter of credit (SLC), 430–431 Starbucks, 314 Startup financing, venture capital and, 598 State Farm Insurance, 555 State government bonds, 249–254 State housing revenue bonds, 290 Stateless money, 395 Statistical discrepancy, current account and, 377 Stock associations, 514 Stock insurance companies, 551–552 Stock markets, 317 See also Equity markets crash of, 99 Dow Jones averages and, 329–330 global, 314–315 indexes, 327–330 market value–weighted indexes, 329 NASDAQ composite index and, 311–313, 314–315, 330 as predictor of economic activity, 331 price-weighted indexes, 328–329 Russell 3000 index and, 330 Standard & Poor’s indexes and, 330, 347 Wilshire 5000, 330 Stock-index futures contracts, 347 Stock-index options, 362 Stock-index program trading, 350 Stocks See Equity markets; Stock markets Stop, 209 Stop buy orders, 317 Stop loss orders, 316 Stop-out rate, 209 Straddles, 346 Straight term insurance, 559 Straight voting, common stocks and, 305 Strategic income bond funds, 612 Street name, 593 Strike price, 355 STRIPped mortgage–backed securities (SMBSs), 289 Strong-dollar policies, 390 Structural unemployment, 90 Subordinated debt, 255 Subprime mortgage markets collapse of, 60, 480 financial crisis and, 9, 11, 52, 100–102, 231, 452 overview, 282 pricing credit risk and, 103–104 Superannuation, 560, 569 Surplus spending units (SSUs), 6–8, 19, 23 Swap contracts, 363 Swap markets credit default, 365–366 dealers and, 364–365 example of swap, 364 interest rate risk and, 363 regulation of, 366 Swaps, 363 Swaps, credit, 648 Syndicated loans, 459 System risk, 52 Systematic risk, 323, 347–348 Systemic risk, 486–487 T Tariffs, 371 Tax avoidance, bank holding companies and, 440 Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), 570 Tax Reform Act of 1986, 250, 289 Taxation of capital gains income, 190–191 of coupon income, 188–190 municipal bonds and, 251–252 Taxpayer Relief Act of 1997, 191 Teaser rates, mortgage, 275 Technical factors, 99 Telecommunications breakthroughs, 398 Tenders, 208 Term bonds, 254 Term insurance, 559 Term loans, 429 Term structure formula, 173–175 implied forward rates and, 175–176 liquidity premiums and, 177 Term structure of interest rates, 170 Term-to-maturity, 141, 170 Tesla Motors, 306 Thin, 257 Thrift institutions See also Credit unions; Savings associations financial intermediation and, 27 international, 533 mortgage markets and, 293–294 types of, 512 Tier capital, 491 Tier capital, 491 Time decay, 360 Time deposits, 413 707 Time drafts, 391 Time value of money, 138–140 Too big to fail (TBTF), 21–22, 53, 102, 105, 486–487 Total reserves (TR), bank, 58 Total return, bonds, 150 Toxic securities, 102 Trade agreements, futures market and, 340–342 Trade barriers, 383 Traders, futures market and, 346 Trading account assets, 422 Trading desk, Federal Reserve and, 48 Trading foreign exchange, 379 Trading liabilities, 415 Tranche A, 261 Tranche B, 261–262 Tranches, 288–289, 365 Trans Union, 502 Transaction accounts, 412 Transaction costs, financial intermediaries and, 19–20 Transfer credits, finance companies and, 539 Treasury Automated Auction Processing System (TAAPS), 208 Treasury bills (T-bills) auction results, 209 auctioning of, 208–210 book-entry securities, 210 competitive bids and, 208 default risk and, 15, 207–208 denominations of, 207 financial crisis and, 232 noncompetitive bids and, 209–210 pricing of, 210–213 quotations, 210 risk-free rate and, 207–208 Treasury bonds, 243–245 Treasury Direct program, 244 Treasury Inflation Protection Securities (TIPS), 132, 245, 246, 247 Treasury notes, 243–245 Treasury rates, ten-year, 92 Treasury securities risk premiums for, 183 yield curves for, 171 Troubled Asset Relief Program (TARP), 107–108, 225, 480 Troubled Asset Relief Program (TARP), 585 Trust operations, bank, 428 Truth-in-Lending Act, 32, 51, 499–500, 541 12b-1 fees, 617 U Undercapitalized banks, 491–492 Underpricing, initial public offerings, 587 Underwriter’s spreads, 307, 308 Underwriting insurance and, 547–548 investment banking and, 10 public offerings and, 587 standards, 297 708 Index Underwriting cycle, 550 Underwriting syndicate, 589 Underwritten offerings, 307 Undivided earnings, 530 Unemployment, 90, 94–95, 108, 331 Unit investment trusts, 624–625 Universal banks, 580 Universal life insurance, 560–561 Unseasoned offerings, 586 Unsecured bank loans, 419 Unsystematic risk, 322–323, 347 U.S Central Credit Union, 529–530 U.S Treasury, 14 U.S Treasury, fiscal policy and, 84–87 USAA Insurance Company, 552, 558 V Value at risk (VAR), 655–657 Variable life insurance, 561 Vault cash, 56, 418 Velocity of money, 100 Venture capital, 597–600 corporate subsidiaries and, 597 expansion financing and, 598 public equity investors comparison of, 598 rates of return and, 598 seed financing and, 598 startup financing and, 598 valuation of, 598–600 Venture capital private equity, 596 Vesting, 573 Veterans Administration (VA) insurance, 295 Veterans Administration (VA) mortgages, 280 Visa credit cards, 421 Volcker, Paul, 49 Voluntary Foreign Credit Restraint (VFCR), 447 Voting rights common stock and, 304–305 preferred stocks and, 305 W Wachovia Bank, 101, 105 Wall Street, global competition and, 11 Wall Street Journal, 372 Wal-Mart, 264 Washington Mutual, 101, 105, 225, 481 Weak-dollar policies, 390 Whole life insurance, 559–560 Wholesale financing, 537 Wholesale paper, finance companies and, 537 Wildcat banks, 44 Wilshire 5000, 330 World Bank, 464, 469 Worldcom, 183 Y Yankee bonds, 264 Yield calculation, repurchase agreements and, 220 Yield curves business cycle and, 179–181 expectation theory and, 172–173 financial intermediaries and, 181–182 liquidity premiums effects on, 177 predicting interest rates and, 181 preferred-habitat theory and, 178 segmentation theory and, 177–178 term structure formula and, 173–175 for treasury securities, 170–172 Yield spread (YS), 180, 184 Yields bonds, 151 commercial paper, 223–224 expected yields, 148–149 negotiable certificates of deposit, 225–226 promised yields, 146–148 realized yields, 149 repo, 219–220 Yield-to-maturity, 146–148 Z Zero coupon bonds, 144–145, 161 ... intentionally left blank FINANCIAL INSTITUTIONS, MARKETS, AND MONEY This page is intentionally left blank E L E V E N T H E D I T I O N FINANCIAL INSTITUTIONS, MARKETS, AND MONEY David S Kidwell University... Contents FINANCIAL MARKETS 201 Chapter Money Markets 203 Chapter Preview 204 Learning Objectives 204 7.1 How the Money Markets Work 205 7.2 Economic Role of the Money Markets 206 7.3 Features of Money. .. emphasis on the risks faced by financial institutions and on how institutions manage these risks using financial markets Over the years, we expanded our coverage of financial markets, and now, for