economics_of_money_banking__financial_markets

www.federalreserve.gov /Releases/G20/current /default.htm

Federal reserve information about financial companies.

Mutual Funds

cial intermediation process of finance companies can be described by saying that they borrow in large amounts but often lend in small amountsÑa process quite different from that of banking institutions, which collect deposits in small amounts and then often make large loans.

A key feature of finance companies is that although they lend to many of the same customers that borrow from banks, they are virtually unregulated compared to commercial banks and thrift institutions. States regulate the maximum amount they can loan to individual consumers and the terms of the debt contract, but there are no restrictions on branching, the assets they hold, or how they raise their funds. The lack of restrictions enables finance companies to tailor their loans to customer needs better than banking institutions can.

There are three types of finance companies: sales, consumer, and business.

1.Sales finance companies are owned by a particular retailing or manufacturing company and make loans to consumers to purchase items from that company. Sears, Roebuck Acceptance Corporation, for example, finances consumer purchases of all goods and services at Sears stores, and General Motors Acceptance Corporation finances purchases of GM cars. Sales finance companies compete directly with banks for consumer loans and are used by consumers because loans can frequently be obtained faster and more conveniently at the location where an item is purchased.

2.Consumer finance companies make loans to consumers to buy particular items such as furniture or home appliances, to make home improvements, or to help refinance small debts. Consumer finance companies are separate corporations (like Household Finance Corporation) or are owned by banks (Citigroup owns Person-to- Person Finance Company, which operates offices nationwide). Typically, these companies make loans to consumers who cannot obtain credit from other sources and charge higher interest rates.

3.Business finance companies provide specialized forms of credit to businesses by making loans and purchasing accounts receivable (bills owed to the firm) at a discount; this provision of credit is called factoring. For example, a dressmaking firm might have outstanding bills (accounts receivable) of $100,000 owed by the retail stores that have bought its dresses. If this firm needs cash to buy 100 new sewing machines, it can sell its accounts receivable for, say, $90,000 to a finance company, which is now entitled to collect the $100,000 owed to the firm. Besides factoring, business finance companies also specialize in leasing equipment (such as railroad cars, jet planes, and computers), which they purchase and then lease to businesses for a set number of years.

www.ici.org/facts_figures /factbook_toc.html

The Mutual Fund Fact Book published by Investment Company Institute includes information about the mutual funds industryÕs history, regulation, taxation, and shareholders.

Mutual funds are financial intermediaries that pool the resources of many small investors by selling them shares and using the proceeds to buy securities. Through the asset transformation process of issuing shares in small denominations and buying large blocks of securities, mutual funds can take advantage of volume discounts on brokerage commissions and purchase diversified holdings (portfolios) of securities. Mutual funds allow the small investor to obtain the benefits of lower transaction costs in purchasing securities and to take advantage of the reduction of risk by diversifying the portfolio of securities held. Many mutual funds are run by brokerage firms, but others are run by banks or independent investment advisers such as Fidelity or Vanguard.

Money Market

Mutual Funds

Hedge Funds

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to the asset value of the fund. Mutual funds also can be structured as a closed-end fund, in which a fixed number of nonredeemable shares are sold at an initial offering and are then traded like a common stock. The market price of these shares fluctuates with the value of the assets held by the fund. In contrast to the open-end fund, however, the price of the shares may be above or below the value of the assets held by the fund, depending on factors such as the liquidity of the shares or the quality of the management. The greater popularity of the open-end funds is explained by the greater liquidity of their redeemable shares relative to the nonredeemable shares of closedend funds.

Originally, shares of most open-end mutual funds were sold by salespeople (usually brokers) who were paid a commission. Since this commission is paid at the time of purchase and is immediately subtracted from the redemption value of the shares, these funds are called load funds. Most mutual funds are currently no-load funds; they are sold directly to the public with no sales commissions. In both types of funds, the managers earn their living from management fees paid by the shareholders. These fees amount to approximately 0.5% of the asset value of the fund per year.

Mutual funds are regulated by the Securities and Exchange Commission, which was given the ability to exercise almost complete control over investment companies in the Investment Company Act of 1940. Regulations require periodic disclosure of information on these funds to the public and restrictions on the methods of soliciting business.

An important addition to the family of mutual funds resulting from the financial innovation process described in earlier chapters is the money market mutual fund. Recall that this type of mutual fund invests in short-term debt (money market) instruments of very high quality, such as Treasury bills, commercial paper, and bank certificates of deposit. There is some fluctuation in the market value of these securities, but because their maturity is typically less than six months, the change in the market value is small enough that these funds allow their shares to be redeemed at a fixed value. (Changes in the market value of the securities are figured into the interest paid out by the fund.) Because these shares can be redeemed at a fixed value, the funds allow shareholders to redeem shares by writing checks on the fundÕs account at a commercial bank. In this way, shares in money market mutual funds effectively function as checkable deposits that earn market interest rates on short-term debt securities.

In 1977, the assets in money market mutual funds were less than $4 billion; by 1980, they had climbed to over $50 billion and now stand at $2.1 trillion, with a share of financial intermediary assets that has grown to nearly 9% (see Table 1). Currently, money market mutual funds account for around one-quarter of the asset value of all mutual funds.

Hedge funds are a special type of mutual fund, with estimated assets of more than $500 billion. Hedge funds have received considerable attention recently due to the shock to the financial system resulting from the near collapse of Long-Term Capital Management, once one of the most important hedge funds (Box 3). Well-known hedge funds include Moore Capital Management and the Quantum group of funds associated with George Soros. Like mutual funds, hedge funds accumulate money from many people and invest on their behalf, but several features distinguish them from traditional mutual funds. Hedge funds have a minimum investment requirement

Federal Credit

Agencies

The government has become involved in financial intermediation in two basic ways: first, by setting up federal credit agencies that directly engage in financial intermediation and, second, by supplying government guarantees for private loans.

To promote residential housing, the government has created three government agencies that provide funds to the mortgage market by selling bonds and using the proceeds to buy mortgages: the Government National Mortgage Association (GNMA, or ÒGinnie MaeÓ), the Federal National Mortgage Association (FNMA, or ÒFannie MaeÓ), and the Federal Home Loan Mortgage Corporation (FHLMC, or ÒFreddie MacÓ). Except for Ginnie Mae, which is a federal agency and is thus an entity of the U.S. government, the other agencies are federally sponsored agencies (FSEs) that function as private corporations with close ties to the government. As a result, the debt of sponsored agencies is not explicitly backed by the U.S. government, as is the case for Treasury bonds. As a practical matter, however, it is unlikely that the federal government would allow a default on the debt of these sponsored agencies.

Agriculture is another area in which financial intermediation by government agencies plays an important role. The Farm Credit System (composed of Banks for Cooperatives, Farm Credit banks, and various farm credit associations) issues securities and then uses the proceeds to make loans to farmers.

Investment

Banking

Mutual funds sold directly to the public on which no sales commissions are charged.

www.ipo.com

The site reports initial public offering news and information and includes advanced search tools for IPO offerings, venture capital research reports, and so on.

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ket (and so are secondhand). Investment banks assist in the initial sale of securities in the primary market; securities brokers and dealers assist in the trading of securities in the secondary markets, some of which are organized into exchanges.

When a corporation wishes to borrow (raise) funds, it normally hires the services of an investment banker to help sell its securities. (Despite its name, an investment banker is not a banker in the ordinary sense; that is, it is not engaged in financial intermediation that takes in deposits and then lends them out.) Some of the well-known U.S. investment banking firms are Merrill Lynch, Salomon Smith Barney, Morgan Stanley Dean Witter, Goldman Sachs, Lehman Brothers, and Credit Suisse First Boston, which have been very successful not only in the United States but outside it as well.

Investment bankers assist in the sale of securities as follows. First, they advise the corporation on whether it should issue bonds or stock. If they suggest that the corporation issue bonds, investment bankers give advice on what the maturity and interest payments on the bonds should be. If they suggest that the corporation should sell stock, they give advice on what the price should be. This is fairly easy to do if the firm has prior issues currently selling in the market, called seasoned issues. However, when a firm issues stock for the first time in what is called an initial public offering (IPO), it is more difficult to determine what the correct price should be. All the skills and expertise of the investment banking firm then need to be brought to bear to determine the most appropriate price. IPOs have become very important in the U.S. economy, because they are a major source of financing for Internet companies, which became all the rage on Wall Street in the late 1990s. Not only have IPOs helped these companies to acquire capital to substantially expand their operations, but they have also made the original owners of these firms very rich. Many a nerdy 20to 30-year- old became an instant millionaire when his stake in his Internet company was given a high valuation after the initial public offering of shares in the company. However, with the bursting of the tech bubble in 2000, many of them lost much of their wealth when the value of their shares came down to earth.

When the corporation decides which kind of financial instrument it will issue, it offers them to underwritersÑinvestment bankers that guarantee the corporation a price on the securities and then sell them to the public. If the issue is small, only one investment banking firm underwrites it (usually the original investment banking firm hired to provide advice on the issue). If the issue is large, several investment banking firms form a syndicate to underwrite the issue jointly, thus limiting the risk that any one investment bank must take. The underwriters sell the securities to the general public by contacting potential buyers, such as banks and insurance companies, directly and by placing advertisements in newspapers like the Wall Street Journal (see the ÒFollowing the Financial NewsÓ box).

The activities of investment bankers and the operation of primary markets are heavily regulated by the Securities and Exchange Commission (SEC), which was created by the Securities and Exchange Acts of 1933 and 1934 to ensure that adequate information reaches prospective investors. Issuers of new securities to the general public (for amounts greater than $1.5 million in a year with a maturity longer than 270 days) must file a registration statement with the SEC and must provide to potential investors a prospectus containing all relevant information on the securities. The issuer must then wait 20 days after the registration statement is filed with the SEC before it can sell any of the securities. If the SEC does not object during the 20-day waiting period, the securities can be sold.

Organized

Exchanges

www.nyse.com

At the New York Stock Exchange home page, you will find listed companies, member information, real-time market indices, and current stock quotes.

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trading on insider information, nonpublic information known only to the management of a corporation.

The forces of competition led to an important development: Brokerage firms started to engage in activities traditionally conducted by commercial banks. In 1977, Merrill Lynch developed the cash management account (CMA), which provides a package of financial services that includes credit cards, immediate loans, checkwriting privileges, automatic investment of proceeds from the sale of securities into a money market mutual fund, and unified record keeping. CMAs were adopted by other brokerage firms and spread rapidly. The result is that the distinction between banking activities and the activities of nonbank financial institutions has become blurred (see Box 5). Another development is the growing importance of the Internet in securities markets (Box 6).

As discussed in Chapter 2, secondary markets can be organized either as over-the- counter markets, in which trades are conducted using dealers, or as organized exchanges, in which trades are conducted in one central location. The New York Stock Exchange (NYSE), trading thousands of securities, is the largest organized exchange in the world, and the American Stock Exchange (AMEX) is a distant second. A number of smaller regional exchanges, which trade only a small number of securities (under 100), exist in places such as Boston and Los Angeles.

Organized stock exchanges actually function as a hybrid of an auction market (in which buyers and sellers trade with each other in a central location) and a dealer