Financial Systems Final Exam Review

Chapter 7: Mortgage Markets

Mortgage Securitization: mortgages are packaged and sold as assets backing publicly traded or privately held debt
instruments (i.e. mortgage-backed securities (MBs)) FIs use this to remove mortgages from their balance sheets Securitization can reduce liquidity/interest rate/credit risk of FIs loan portfolios Conventional Mortgages: mortgages issued by financial institutions that are not federally insured Federally Insured Mortgages: mortgages originated by financial institutions, with repayment guaranteed by either the Federal Housing Association (FHA) or the Veterans Administration (VA) ARMs (Adjustable-Rate Mortgages): tie the borrowers interest rate to some market interest rate or interest rate index Required monthly payments can increase over the life of the mortgage Yearly interest rates are often capped Borrowers assume interest rate risk ARMs can increase default risk Fixed-Rate Mortgages: lock in the borrowers interest rate Required monthly payments are fixed over the life of the mortgage Lenders assume interest rate risk

Chapter 15: Insurance Companies

Ordinary Life Insurance: marketed to individuals policyholders make periodic premium payments in return for
insurance coverage

Term Life

Whole Life

Beneficiary receives payout at time of death If insured lives beyond the term of contract no benefits are paid; no savings feature Policy protects over whole life Beneficiary receives face value of contract upon death Beneficiary receives payment at time of death If insured lives beyond term of contract, insured receives face value of contract Premiums are invested in market securities Value of policies depends on value of securities Allows the insured to change both the premiums and the maturity of the contract Combines features of variable and universal life

Endowment Life Variable Life

Universal Life

Variable Universal Life

Group Life Insurance: covers a large number of persons under a single policy
Contributory: both the employer and the employee cover a share of the premiums Noncontributory: costs are borne entirely on the employer Annuity: investment vehicle that liquidates a fund over a large period of time

Insurance Companies Balance Sheets Assets

73.4% -- corporate bonds and stocks 10.4% -- government securities 7.5% -- policy loans 6.4% -- MBSs

Liabilities & Capital 43.9% -- policy reserves 39.8% -- separate account business 7.0% -- deposit type contracts 5.4% -- capital and surplus reserves Combined Ratio: measure of overall profitability Equals loss ratio plus LAE to premiums written plus commissions and other expenses to premiums written

Operating Ratio: also a measure of overall profitability

States regulate insurance companies using NAIC system

Equals the combined ratio minus the investment yield

Chapter 16: Investment Companies

Underwriting: assisting in the issue of new securities In best efforts underwriting, IBs act only as an agent on a fee basis related to their success in placing the issue with
investors In firm commitment underwriting, IBs act as a principal, purchasing the securities from the issuer at one price and seeking to place them with public investors at a slightly higher price Securities and Exchange Commission (SEC): primary regulator of the securities industry Initial Public Offering (IPO): first time debt and equity issues by a firm Private Placement (PP): a securities issue placed with one or a few large institutional investors Venture Capital: a professionally managed pool of money used to finance new and often high-risk firms institutional venture capital firms angel venture capital firms

Chapter 17: Mutual Funds & Hedge Funds

Mutual Funds (MF) and Hedge Funds (HF): financial institutions that pool the financial resources of individuals and
companies and invest those resources in portfolios of assets Open-End MF: a fund for which the supply of shares is not fixed but can increase or decrease daily with purchases and redemptions of shares Closed-End Investment Company: a specialized investment company that has a fixed supply of outstanding shares, but invests in the securities and assets of other firms Real Estate Investment Trusts (REITs): closed-end investment company that specializes in investing in mortgages, property, or real estate company shares Index Funds: funds in which managers buy securities in proportions similar to those included in a specified major index Involve little research or management, resulting in lower management fees and higher returns than actively managed funds Exchange Traded Funds (ETFs): also designed to replicate market indexes Traded on exchanges at prices determined by the market Lower management fees than actively traded funds Unlike index funds, ETFs can be traded during the day, sold short, and purchased on margin Short-Term Funds: invest in securities with original maturities of less than one year Money Markey Mutual Funds (MMMFs): funds consisting of various mixtures of money market securities Provide an alternative investment to interest-bearing deposits at commercial banks; although bank deposits are relatively less risky, because they are FDIC insured, they generally offer lower returns than MMMFs Taxable Funds

Tax-Exempt MMMFs

Long-Term Funds: invest in portfolios of securities with original maturities of more than one year Equity Funds consist of common and preferred stock Bond Funds consist of fixed-income capital market debt securities
Capital Appreciation, World Equity, Total Return Corporate Bond, High-Yield Bond, World Bond, Government Bond, Strategic Income, State Municipal, National Municipal Hybrid Funds consist of both stock and bond securities

Tax-Exempt Funds

SEC is primary regulator of Mutual Funds; also some oversight from the National Association of Securities Dealers (NASD)
MF investor returns reflect three components: Income and dividends on portfolio assets Capital gains on assets bought and sold at higher prices Capital appreciation on assets held in the fund

Net Asset Value (NAV): of an MF share is equal to market value of the assets in the MF portfolio divided by the number
of shares outstanding Sarbanes-Oxley: requires public companies, including MFs, to make sure at least one member of their boards audit committees is familiar with GAAP and has experience with internal auditing controls, preparing or auditing financial statements of generally comparable issuers, and applying GAAP principles for estimates, accruals, and reserves Load Fund: MF with an up-front sales or commission charge that the investor must pay No-Load Fund: MF that does not charge up-front sales or commission charges on the sale of MF shares to investors 12b-1 Fees: fees related to the distribution costs of MF shares Hedge Funds: investment pools that invest funds for (wealthy) individuals and other investors (e.g. commercial banks)

Other Chapters
Interest Rate Risk: the risk incurred by an FI when the maturities of its assets and liabilities are mismatched and interest rates are volatile Refinancing Risk: the risk that the cost of rolling over or re-borrowing funds will rise above the returns being earned on asset investments FIs face this when its assets are longer-term than its liabilities Reinvestment Risk: the risk that the returns on funds to be reinvested will fall below the cost of funds FIs face this when its assets are shorter-term than its liabilities Off-Balance-Sheet (OBS) Risk: the risk incurred by an FI as the result of activities related to contingent assets and liabilities OBS activity can increase FIs interest rate risk, foreign exchange risk, and credit risk In contrast, OBS activity can also be used to hedge FIs interest rate, foreign exchange, and credit risks Large commercial banks (CBs) in particular engage in OBS activity

Fannie Mae & Freddie Mac

Federal National Mortgage Association (FNMA) and Federal Home Loan Mortgage Association (FMAC) Directly involved in the creation of pass-through securities, along with GNMA Arent directly backed by full faith and credit of U.S. government, therefore carry some default risk Loan Sale: an FI originates a loan and then subsequently sells it Participation: the act of buying a share in a loan syndication with limited contractual control and rights over the borrower Large banks sell participations to smaller FIs Vulture Funds: specialized funds that invests in distressed loans Loan Securitization: packaging and selling of loans and other security-backed assets issued by an FI Generally takes one of three forms: Pass-Through Mortgage Securities: pass through promised payments by households of interest and principal on pools of mortgages created by FIs to secondary market investors holding an interest in these pools Each pass-through security represents a fractional ownership share in a mortgage pool Originally developed by government-sponsored programs to enhance the liquidity of residential mortgages Ginnie Mae, Fannie Mae, Freddie Mac Mortgage-Backed Bonds (MBBs): bonds collateralized by a pool of mortgages Allow FIs to raise long-term low-cost funds without removing mortgages from their balance sheets FIs usually back MBBs with excess collateral, resulting in a higher investment for the MBB than the issuing FI MBBs differ from pass-throughs and CMOs A group of mortgage assets is pledged as collateral against the MBB, but there is no direct link between the cash flows of the mortgages and the cash flows on the MBB Mortgages remain on the balance sheet MBB costs MBBs tie up mortgages on the balance sheet for long periods of time The FI is subject to prepayment risk on the underlying mortgages The FI continues to face capital adequacy and reserve requirement taxes as the mortgages remain on the balance sheet Collateralized Mortgage Obligations (CMOs): multiclass mortgage-backed bonds issued with multiple bondholder classes, or tranches CMOs are usually created by placing existing pass-through securities in a trust off-the-balance-sheet Each tranche has a different guaranteed coupon payment Tranches are differentiated by the order in which each class is paid off

Prepayments of principal retire sequentially to only one class of bondholder at a time Thus, some classes of bondholders are more protected against prepayment risk than others

The Federal Reserve System is an independent central bank in that its decisions do not have to be ratified by the
president or another member of the executive branch The system is, however, subject to U.S. congress under its authority to coin money Its duties incorporate four major functions: conducting monetary policy, supervising and regulating depository institutions, maintaining the stability of the financial system, and providing payment and other financial services to the U.S government, the public, financial institutions, and foreign official institutions. The Federal Reserve System consists of 12 member institutions Functions Performed by the Federal Reserve Banks (FRBs) Assistance in the conduct of monetary policy Federal Reserve Bank presidents serve on the Federal Open Market Committee. FRBs set and change discount rates Supervision and regulation FRBs have supervisory and regulatory authority over the activities of banks located in their district

The Board of Governors of the FRS

Consumer protection and community affairs Write regulations to implement many of the major consumer protection laws Establish programs to promote community development and fair and impartial access to credit Government services Serve as the commercial bank for the U.S. Treasury New currency issue FRBs are responsible for the collection and replacement of damaged currency from circulation Check clearing Process, route, and transfer funds from one bank to another as checks clear through the Federal Reserve System Wire transfer services FRBs and their member banks are linked electronically through the Federal Reserve Communications System Research services Each FRB has a staff of professional economists who gather, analyze, and interpret economic data and developments in the banking sector in their district and economy wide

The Federal Open Market Committee (FOMC)

7 member board headquartered in Washington, D.C. President appoints and Senate confirms members to nonrenewable 14-year terms President appoints and Senate confirms Chairman and Vice-Chairman to renewable 4-year terms Formulates and conducts monetary policy and supervises/regulates banks Consists of 12 members 7 members of the Board of Governors The president of the Federal Reserve Bank of NY The presidents of 4 other FRBs (on a rotating basis) The monetary policy-making body of the FRS Policies seek to promote full employment, economic growth, price stability, and a sustainable pattern of international trade Sets ranges for growth of monetary aggregates and the fed funds rate, and also directs FR functions in FX markets Open Market Operations are the main policy tool used to achieve monetary targets Involve the purchase and sale of U.S. government and federal agency securities Are implemented by the Federal Reserve Board Trading Desk of the New York Federal Reserve Bank Charters national banks, which are members of the Federal Reserve System FRS member banks own the 12 Federal Reserve Banks Affects the macroeconomy by influencing the supply and demand for excess bank reserves Influences the money supply and the level of short-term and long-term interest rates Affects foreign exchange rates, the amount of money and credit in the economy, and the levels of unemployment, output, and prices

The Office of the Comptroller of the Currency (OCC) Monetary Policy

Policy directive of the FOMC is forwarded to the Federal Reserve Board Trading Desk at the Federal Reserve Bank of New York Trading Desk manager buys or sells U.S. Treasury securities in the over-the-counter (OTC) market, which keeps the fed funds rate near its desired target Monetary Policy (contd) Open Market Operations (contd) FRBNY acts through the Trading Desk to implement policy directives each business day Operations may be permanent or temporary May use repurchase agreements for temporary increases/decreases in excess reserves Discount Rate: the rate Federal Reserve Banks charge on loans to depository institutions in their district The Federal Reserve rarely uses the discount rate as a policy tool Discount rate changes are strong signals of the Feds intentions There is no guarantee that banks will borrow Reserve Requirements: the reserve assets depository institutions must keep to back transaction deposits Reserve assets include: Vault cash Deposits at FRBs Expansionary Monetary Policy Open market purchases of securities by the Fed Discount rate decreases Reserve requirement ratio decreases

Open Market Operations

International Monetary Policy

Contractionary Monetary Policy Open market sales of securities by the Fed Discount rate increases Reserve requirement ratio increases The Federal Reserve generally allows foreign exchange rates to fluctuate freely Foreign Exchange intervention Commitments between countries about the institutional aspects of their intervention in the foreign exchange markets Similar to open market purchases and sales of Treasury securities