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Overview of the Financial Environment -- Ch. 1. Role of Financial Markets and Institutions -- Ch. 2. Determination of Interest Rates -- Ch. 3. Structure of Interest Rates -- Pt. 2. The Fed Description Financial Markets and Institutions (11th Edition) By Jeff Madura – eBook PDF. Gain a clear understanding of how financial institutions serve financial markets, why do 01/01/ · Financial institutions are the key intermediaries in financial markets because they transfer funds from savers to the individuals, firms, or government agencies that need Jeff Madura Financial Markets And Institutions 11th Edition is handy in our digital library an online right of entry to it is set as public thus you can download it instantly. Our digital library Financial Markets and Institutions 12th Edition Madura Solutions Manual University Ghana Technology University College Course Laws on financial institutions (BAN) Academic ... read more
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SKU: financial-markets-and-institutionsth-edition-by-jeff-madura-ebook-pdf Categories: E-Books , Education , Non Fiction , Others , PDF , Textbooks Tags: , 11e , , , Jeff Madura , Maduras. To throw some light on this controversy, this paper examines perfor- mance by the four bodies the FDIC, the Fed, the OCC, and the OTS in their oversight responsibilities. To do so, it relies on the Material Loss Reviews MLRs conducted by the inspectors general IGs of the federal agencies responsible for supervising the institutions that failed in the calendar years , , and —the years in which failures of insured banks and thrifts escalated from the zero readings recorded for and Nevertheless, the MLRs are revealing.
They show that supervision was deficient, so much so that it contributed to the thwarting of prompt corrective action. The following four sections analyze, in turn, the MLRs of the four federal supervisors. Section 7 generalizes and concludes. Bank and Thrift Failures and Material Losses Figure 1. GARCIA the third Friday in December. There were few failures early in the decade and none in and , but their numbers escalated thereafter to peak so far at 24 in July Table 1. During this three-year Table 1. b Numbers and deposits of institutions are taken from FDIC Summary of Deposit data for National Totals by Charter Class. FDIC data include FDIC-supervised savings banks. OTS data include federally chartered and OTS-supervised savings associations. Data are for June of each year. c FDIC Historical Statistics on Failures and Assistance Transactions, which include cases of assistance under a systemic risk determination.
period there were bank and thrift failures. Estimated material losses over the three-year period show a loss rate of This percentage is comparable to that of the FDIC, whose IG had completed 31 reviews. Fisher , p. to do an incentive compensation study for senior officers. FDIC Material Loss Reviews 2. As serious exercises in analysis that span between 30 and 60 pages, they are published prominently in a separate section of the Web site www. It shows that high-loss failures among FDIC-supervised banks occurred in 15 states, particularly in states that have experienced heavy real estate development in recent years—especially Georgia with seven MLRs and California with five. Eighteen of the failures were at new banks—those less and often much less than ten years old.
Twenty-four of the MLR banks exaggerated their capital levels by maintaining inadequate loan loss reserves. Thirty MLRs mention fast, aggressive growth as a critical factor contributing to failure. Undue con- centration of assets was emphasized in 25 MLRs. Asset concentration was not so much in risky types of home mortgages, which were mentioned in only six MLRs or in mortgage backed securities, but rather in excessive acquisition, development and construction ADC lending, which was criticized in 27 MLRs, and overlending for commercial real estate CRE , which was cited in 22 MLRs. Earnings: 17 Misused interest reserves. Liquidity: 18 Non core funds; 19 Brokered deposits; 20 FHLB advances. GARCIA a problematic business model—funding risky long-term assets with volatile short-term funds.
A dominant individual was prominent in 12 of the failures. Inadequate control over risks was blamed in all 31 MLRs. Weak incentive compensation systems that encouraged risky lending were criticized in ten reviews. With regard to earnings, banks were criticized for exag- gerating earnings, and therefore capital, in 15 MLRs through their abuse of interest reserves. In short, the MLRs attribute the 31expensive failures to long-recognized problematic behavior. An Office of Inspector General OIG report in , which summarized failures from through , summarizes four stages of deterioration: 1 weak corporate governance, 2 poor risk management, 3 lending concentration, and 4 failure.
The MLRs reflect these concerns and show little that is new. But supervisors let the banks pursue this well-worn path to failure. Fast growth, especially in lending for acquisition, development, con- struction, and for commercial real estate were cited in 27 and 22, of the 31 MLRs, respectively. Management was weak, unable to handle the risks the institutions faced, maintained poor underwriting and credit admini- stration policies and practices, was often dominated by one individual, ignored supervisory concerns, and violated laws and regulations. Banks exaggerated their earnings and capital by holding insufficient reserves against loan losses, misusing interest reserves, violating accounting rules, and delaying reporting adverse changes. The failed institutions relied on volatile, wholesale sources of funds and were often dependent on brokered deposits and FHLB advances. Auditors showed that MLR banks were funding their assets, which were largely risky long-term assets, from volatile, noncore sources.
BANKING FROM RICHES TO RAGS 15 can delay reporting inadequate capital, market discipline can force risky institutions to default through shortages of liquidity. FDICIA contains a provision to prevent weak institutions from dodging this discipline by funding themselves with high-rate brokered deposits, as they had done during the bank and thrift crises of the s and early s. Yet 27 of the MLR banks relied on volatile sources of funding, 24 of them using high percentages of brokered deposits. Although these institutions were able to maintain well-capitalized desig- nations and so could continue to garner brokered deposits until the last minute, the FDIC Risk Management manual urges examiners not to wait for the PCA restriction on brokered deposits to be triggered, but rather to question the safety and soundness of relying on volatile sources of funding, particularly among new institutions.
Yet even after it revised its business plan in , FDIC examiners allowed Main Street Bank to draw 67 percent of its funding from brokered deposits. Lender of last resort provisions have long been made available to prevent sound banks from failing for lack of liquidity. This is one of the purposes of Federal Reserve discount window lending. Banks became reluctant to use Fed loans during the s, fearing that their borrowing would become public knowledge and that this would tarnish their reputa- tion. Instead, banks came to rely more and more on FHLB advances, which had became available to banks, as well as to savings institutions, that joined the system in the s. This was the situa- tion at Main Street Bank MSB in , which was able to obtain FHLB advances even though it was operating under a Cease and Desist order.
FHLB advances represented 31 percent of the estimated loss to the FDIC when MSB failed. Advances also subsidize risk taking, because they relax the market discipline that fear of illiquidity imposes. GARCIA board and senior management, but failed to follow up to ensure that they were corrected. They were almost universally slow and ineffective in their follow up and enforcement. In 24 cases the board of directors and senior managers were allowed to ignore the many warnings that examiners gave. Auditors, summarizing, for example, their audit FDIC OIG, , AUD, p. Researchers at the OCC and the FDIC have long recognized that new banks fail at higher rates than established banks De Young and Hassan, and that they invest in risky real estate assets Yom, They are therefore supposed to be given especial attention by examiners and careful off-site monitoring. Extending de novo oversight from three to seven years as recently proposed may not be enough to contain the risks that new insti- tutions pose.
The FDIC issued guidance on concentrated commercial real estate lending in December FDIC, This guidance prescribed extra scrutiny of CRE lending but not restrictions on it. The banking system is not being supervised adequately when only those institutions that exceed peer group averages are criticized for their behavior. The audit reports typically explained that this was because prompt corrective actions were triggered when banks breached capital thresholds and that capital is a lagging indicator. Referring to the failure of the long-established Community Bank — auditors wrote AUD, p.
Repeatedly the MLRs show that institutions reported artificially high capital levels almost until they failed. They did this by using, for example, interest reserves to make underperforming loans appear to be current, thus avoiding putting aside reserves against them and exaggerating earnings and overestimating capital. Failed banks made inaccurate call reports and ignored supervisory warnings. GARCIA of the act. The MLRs typically reported that PCA was properly executed, which is surprising because it manifestly failed to achieve its purposes. Institutions maintained their well-capitalized status by overstating their earnings and capital almost until they failed, so the graduated corrective measures were not applied, and institutions continued to garner brokered deposits and rely on FHLB advances. Supervisors refrained from using their discretionary PCA powers to reign in errant banks, as was occasionally noted in the MLRs. Federal Reserve Material Loss Reviews One Fed-supervised bank failed with a material loss to the FDIC in , and ten failed with material losses during the first nine months of The results of these reviews are presented in tables 1.
One bank focused on residential mortgages and mortgage- backed securities; all three held large portfolios of acquisition, development, and construction loans; and two also concentrated on commercial real estate. Earnings: 17 Misuse of interest reserves. GARCIA Fast growth was perceived as less frequent a problem than among FDIC-supervised banks. Management and boards were judged to be weak—unable to control risks—conducting inadequate underwriting and credit administration, although not dominated by individuals. There was no mention of violations of laws or regulations, or inadequate accounting, or overstatement of earnings.
Like the FDIC reviews, the Fed MLRs perceived liquidity to be a problem with heavy reliance on volatile sources of funds, such as brokered deposits, and also on FHLB advances. Nevertheless, as shown in table 1. Enforcement actions were issued late too late in the process of failing bank deterioration. The IG considered that PCA mandates had been followed, despite the fact supervisors did not use the discretion they had under PCA in Sections and of FDICIA to reign in unsafe and unsound practices and avoid losses to the Deposit Insurance Fund DIF. Asset portfolios had been increasing rapidly and were heavily concentrated—in commercial real estate in five of the cases. GARCIA Table 1.
Key: Structure: 1. Capital: 4. Assets: 5. Management: 7. Weak underwriting and credit administration; Weak risk management; Earnings: Misused interest reserves. Liquidity: Management was typically dominated by one individual, had inadequate control over risks, maintained weak underwriting and credit administration policies and practices, and was found to be unresponsive to supervisory criticism in four of the failures. Liquidity was threatened by reliance on volatile sources of funding—frequently brokered deposits, which were sometimes supplemented by FHLB advances. OCC undertook no informal enforcement actions against banks that later failed with material losses to the DIF. Unfortunately, the banks typically ignored these warnings and supervisors failed to follow them up and so were slow and ineffective in their oversight.
Not only were there no informal enforce- ment actions against these failed banks, but formal actions were typically delayed until the bank was about to be closed. The IG criticized the agency for delaying formal action against Omni Bank, but OCC management rejected the criticism and maintained that it needed the time it took to justify and document the need for formal action. The IG in turn disagreed with the OCC and instead took into consideration that prompt corrective action was delayed by six months as a result. With regard to Omni Bank, the MLR Department of the Treasury, Office of the Insopector General, Audit Report OIG, p. Neither did he note that the bank was replacing fore- closed loans with larger loans to hide the losses. Nevertheless, OCC manage- ment disagreed with the IG that more timely enforcement action had been needed for Omni Bank, which had relied on appreciation for repayment of its loans and submitted inaccurate call reports.
Even then they were delayed for six months by a disagreement with the external auditor. Formal enforcement action was delayed to obtain legal support for its actions until October , just days before the bank was closed, even though a new examiner had recommended it in February. I do not agree, however, that the facts of this case support a conclusion that the OCC pro- cess used to issue the consent order, in response to the examination findings, was slow and requires review. The three most expensive failures were California thrifts, including IndyMac and Downey Savings. The failed thrifts typically belonged to a hold- ing company and grew rapidly in the years before they failed. They were unresponsive to supervisory concerns expressed to them in reports of examination. Assets were heavily concentrated, especially on risky types of residential mortgages, which were intended to be converted into mortgage-backed securities until this mar- ket collapsed.
Lending for commercial real estate and acquisition and develop- ment were less of a problem than for the banks except for one MLR thrift. Capital and earnings were overstated in a number of ways that ranged from overvaluing assets, accounting violations, holding insufficient reserves against losses, misusing interest reserves, and backdating capital contributions from the holding company Department of Treasury, OIG, Such actions thwarted PCA by allowing thrifts to be treated as well-capitalized, free from regulatory restraint and able to garner brokered deposits, on which they were heavily dependent, without the otherwise necessary FDIC waiver, almost until they failed. FHLB advances were important to three of the failed thrifts. Management was warned but allowed to ignore the warnings. In one case, however the examiner who was in charge for four years missed the red flags and failed to point them out to management. Supervisors failed to enforce laws or regulations or failed to follow agency guidance according to five of the MLRs.
OTS did utilize informal enforcement actions, but again, they reserved formal action until the thrift was about to be closed. It noted Department of the Treasury, FSB OIG, p. We disagree. Key: 1. Year opened; 2. Year of change of control or supervisor; 3. Size assets ; 5. Estimated loss; 6. Supervisors failed to follow up; 7. Bank was allowed to ignore supervisory concerns; 9. Work papers were insufficient; Supervisors failed to enforce laws or regulations or to follow agency guidance; Enforcement actions—informal: formal. The OIG report Department of the Treasury, OIG , p. IndyMac needed the signed interim review in order to file a complete quarterly report 10Q , as required, with the Securities and Exchange Commission on May 15, On page 19 of the report the OIG explained the significance of back-dating to another of five thrifts—unnamed because they were still operating—that had been found to have backdated capital contributions.
Conclusions Newspapers have focused on risky home mortgages and the collapse of the mortgage-backed securities markets as a major cause of bank and thrift failures. But MLRs for banks supervised by the FDIC, the Fed, and the OCC point to other aspects of the real estate markets as generating failures— lending for acquisition, construction, and real estate development and for commercial real estate, especially in fast growing bank portfolios. Fast growth, especially in the real estate markets, has long been internationally seen as a red flag Lindgren, Garcia, and Saal, Clearly the regulators did not perceive—or if they perceived, did not act on their perception—that the U. banking sector as a whole was over exposed to the real estate markets. GARCIA this macro red flag. If everyone was doing something—ACD or CRE lending, funding by brokered deposits or FHLB advances—supervisors judged it to be acceptable.
Only if an institutions stood out as undertaking a lot more or possibly in some cases less of it, was it seen as a cause for concern. Supervision by peer comparison needs to be rethought if supervision is, in future, to consider the banking sector as a whole instead of focusing on individual institutions. A surprising number of new FDIC-supervised banks failed. Agencies typically monitored de novo banks more closely than older banks for three years, although the FDIC recently extended this more intensive oversight to seven years. But a number of the MLR banks had been opened almost ten years previously.
Is seven years of extensive oversight sufficient? It is well known that capital is a lagging indicator that can delay supervisory action beyond the point that it is needed. But supervisors did not use them to reign in the abuses they observed at the MLR institutions. Institutions knew how to manipulate their capital levels to avoid trig- gering the PCA provisions of FDICIA. FDI supervisors allowed them to do so by ignoring their discretionary powers to call troubled institutions to order. Instead of using them, supervisors argued that they could not act because institutions appeared to be profitable and well-capitalized. OTS supervi- sors even connived to keep capital appearing at well-capitalized levels by allowing, even requiring, capital contributions from the holding company to be backdated. The European Union EU has been attracted to the concept of PCA and is considering adopting it Garcia, Lastra, and Nieto, Before it does so, it should draw lessons from the failure of PCA in the United States.
It should design its own PCA scheme appropriately. The author thanks George Blackford, Andrew Campbell, Robert Eisenbeis, George Kaufman, Raymond LaBrosse, Joseph Mason, and Maria Nieto for comments on an earlier draft of this paper, but remains responsible for any errors. Notes 1. Currently, the OCC supervises national banks. Banks chartered by the states are overseen by their state regulator, while state banks that are members of the Federal Reserve System are also supervised by the Fed. State nonmember banks and savings banks report to the FDIC. The OTS supervises federal and most state-chartered savings associations. The paper does not examine supervisory red flags overlooked by the Fed in its oversight of financial holding companies, the Securities and Exchange Commission SEC , or the Commodity Futures Exchange Commission CFTC , nor the problems in the insurance industry exacerbated, perhaps, by the absence of a federal insurance supervisor.
See, for example, Paletta See, for example, Milbank A bank may lend to fund construction and also to allow the borrower to pay the interest that falls due during the period before the project earns revenue. Such an interest reserve may be misused to obscure problems in the construc- tion project—problems that the bank should recognize by classifying the loan as nonperforming. For example, auditors wrote FDIC OIG, , AUD, p. In addition, the interest reserve loans were being modified and extended to bring potentially delinquent borrowers current. This provision is captured in Section , Part See of FDIC Rules and Regulations—Interagency Guidelines for RE Lending Policies.
MLRs are pending for Michigan Heritage Bank, Community Bank of West Georgia, Neighborhood Community Bank GA , First Bank SD , Community First Bank OR , Community Bank of Nevada, Capital South Bank AL , and Irwin Union Bank and Trust IN. National Commerce Bank failed by concentrating on what it thought were safe government-sponsored-entity GSE securities. GARCIA The MLR for Westsound Bank noted in the Executive Summary p. Kaufman and R. Litan Washington, DC, The Brookings Institution , — Department of the Treasury, Office of the Inspector General Audit Report: Safety and Soundness: OTS Involvement with Backdated Capital Contributions by Thrifts.
OIG, May Safety and Soundness: Material Loss Review of Omni National Bank. OIG, December 9, at www. pdf, accessed December 21, Safety and Soundness: Material Loss Review of American Sterling Bank, OIG, December 9, at www. pdf accessed December 21, Safety and Soundness: Material Loss Review of IndyMac Bank, FSB, OIG, at www. pdf accessed December 21 De Young, Robert, and Hekkar Hasan Eisenbeis, Robert A. Wall Should They Be? Kaufman Greenwich, CT, JAI Press , pp. FDIC, Division of Supervision and Consumer Protection. Risk Management Manual. Formal and Informal Action Procedures Manual at www. The FDIC and RTC Experience: Managing the Crisis Washington, DC, Federal Deposit Insurance Corporation. FDIC, Office of Inspector General Observations from FDIC OIG Material Loss Reviews Conducted through , Report No. pdf accessed November 22, Material Loss Review of Silver Falls Bank, Silverton, Oregon, Report No.
AUD, September. Material Loss Review of Haven Bank and Trust, Duluth, GA, Report No. AUD, August. Material Loss Review of MagnetBank, Salt Lake City, UT, Report No. BANKING FROM RICHES TO RAGS 35 ——— Material Loss Review of Silver State Bank, Hendersen, NV, Report No. The Role of Prompt Corrective Action as Part of the Enforcement Process, OIG Report No. Guidance on Concentration on Commercial Real Estates Lending: Sound Risk Management Practices, Financial Institution Letter, , December Fisher, Richard W. Garcia, Gillian G. Lastra, and Maria J. Nieto Kane, Edward J. Kaufman, George G. Prompt Corrective Action in Banking: 10 Years Later. Research in Financial Services: Private and Public Policy Stamford, CT, JAI Press. Lindgren, Carl Johan, Gillian Garcia, and Matthew Saal Bank Soundness and Macroeconomic Policy Washington, DC, International Monetary Fund.
Milbank, Dana Paletta, Damian A1 and A Yom, Chiwon, Many of these flaws were associated with financial instru- ments that were issued by the shadow banking system, especially securitized assets. The volume and complexity of securitized assets grew rapidly during the run-up to the financial crisis that began in The investor-intermediary risk cycle in this crisis is common to other crises. However, there are a number of factors that may have made the crisis more severe. Among them are the length of the precrisis period, the shift from financial intermediaries to the shadow banking system, the increasing interconnectedness among financial firms, and the increased leverage at some financial firms.
Introduction The financial crisis that began in may change the way firms and individuals borrow and save. The period leading up to the crisis was one where there was a rapidly expanding array of products that facilitated funds getting from savers to borrowers. ROSEN Corporate and household debt 15 Household debt service ratio LHS 14 14 Percentage 13 13 12 12 11 Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Figure 2. In retrospect, it appears that many borrowers were given loans they should not have been or were given loans at interest rates that were too low to reflect the riskiness of the loan. The financial crisis brought a swift halt to this. In this paper, I describe the changes that preceded the crisis, then examine why they occurred and how they may have contributed to the crisis.
Much of the evolution of financial markets and institutions in recent years resulted in the movement of financing away from traditional bank lending see, e. Many of the new alternatives for borrowers and investors came, directly or indirectly, from what is sometimes called the shadow banking system SBS. However, they offer a more complex array of products than just simple loans, and they are often subject to less intensive regulation. As part of the move from bank financing to the SBS, one way that financial markets changed dramatically from the mids through the onset of the financial crisis in was in the rise of structured finance. Securitization is the issuance of bonds backed by the payments on a pool of assets. It allows banks and other lenders to origi- nate assets without the need to hold them on their balance sheets for an extended period of time. The initial securitizations involved pools of home mortgages, with the bonds issued called mortgage-backed securities MBS.
MBS were soon followed by so-called asset-backed securities ABS , which were bonds backed by the payments on pools of loans such as automobile and credit card loans. In the last twenty years, the types of assets that were part of securitizations expanded to include large corporate loans and mortgages as well as more obscure assets there was a securitization backed by the royalties on recordings by David Bowie. There have also been securitizations that are backed by the payments on pools of securitized bonds from different deals collateralized debt obligations, or CDOs.
Instead of making a loan and holding it on its balance sheet until maturity, a lender could make originate a loan, then immediately sell it. The ability of lenders to use the OTD model is frequently cited as one of the factors that contributed to the financial crisis. One argument goes as follows Diamond and Rajan, A glut of foreign savings with a desire for safe securities led to an increase in demand for bonds such as highly rated MBS and ABS securities. The demand for these securities gave banks an incentive to create them by originating and selling loans. Problems crept into valuations, but rising home prices covered up these problems and allowed lenders to keep originating and selling new loans.
When home prices started falling, losses became apparent. Since many holders of MBS, including banks and derivative conduits such as structured investment vehicles SIVs 3, were either leveraged Adrian and Shin, or held longer-term assets along with short-term liabilities Brunnermeier, ; Diamond and Rajan, , the home price declines led to questions about the institutions viability. This, in turn, might have sparked a run on these institutions Gorton and Metrick, Hidden in this line of thinking is why, as noted above, mispricing crept into valuations. In other words, why did the problems that followed once housing prices started to fall seem to surprise so many market participants? I explore why several tendencies of investors, and the ability of intermediaries to take advantage of these tendencies, may have made seemingly surprising deviations of prices from fundamentals more likely. The SBS facilitated innovations such as the advances in securitization, but many of the innovations shifted the responsibility for screening and monitoring borrowers from lenders to investors in securitized bonds.
ROSEN Traditionally, much intermediated finance was done by banks. The bank, because it kept the loan on its balance sheet, would have an incentive to screen potential borrowers to make sure they were creditworthy and to monitor the loan to maximize the chance it got repaid. Many of the new products facilitated by the SBS shifted some of this responsibility from banks to investors. This introduced two possible problems. First, investors were at least one step further removed from the actual lending decisions, making their ability to screen and monitor more difficult. Second, many of the investors in securities made available by the SBS were, in fact, agents for other investors, leading to potential incentive problems.
I discuss how these two potential problems, especially following a long period of stability and growth in the financial system, can make a crisis more likely. Why would the financially sophisticated investors that participate in structured finance markets be willing to purchase extremely complicated securities? The strong performance of structured finance in general gave three incentives for investors to purchase structured securities such as securitized bonds. First, behavioral finance has identified a number of circumstances where overconfidence affected investor decision making see, e. The high returns on structured securities in the run-up to the crisis may have led investors to believe the securities were better than they actually were.
Second, the credit ratings on these securities had proved reliable in the recent past see, e. It may have been rational for busy investors to rely on the recent track record of the securities and the rating agencies rather than to care- fully examine each security they planned to purchase. Finally, many of these investors were investing for others such as mutual fund managers acting on behalf of their fund investors , and this gave them an incentive to reach for yield and to follow the herd see, e. The factors that attracted investors to structured securities such as MBS could also explain some of the evolution of the securitization market over time. As noted above, securitizations became more complex over time.
This is consistent with the intermediaries involved in issuing structure securities taking advantage of overconfidence and rational inattention, since overconfident investors are likely to believe they can evaluate the more complicated securities and inattentive investors are unlikely to notice as securities become gradually more complicated as long as credit rating agencies continue to give them strong ratings. The pattern in the years leading up to the crisis was that investors successfully invested in new securities, often ones promising them extra returns.
The successful investments led to new investments and an increased reliance on simple guideposts. The investors were pushed toward similar but riskier investments by issuers or advisors. Finally, there was a reckoning as many of the risky securities saw a sharp decline in value. This investor-intermediary risk cycle fits not only the most recent crisis, but a number of prior examples such as the Asian currency crises in the late s. Thus, the current crisis may have been more extreme than prior incidents, but a number of the factors that led to it were also present in previous incidents. The remainder of the chapter is organized as follows. The next section gives some background on the U. financial system and its evolution. There is a particular focus on lending and the role of the SBS.
In Section 2, I discuss why investors would buy securities that do not have a positive expected return. After that, I explore whether the run-up to the crisis was fundamentally different from anything in the past. Finally, Section 4 offers some concluding comments. Background This section gives some background on how the evolution of financial institutions and markets in the United States set the stage for the financial crisis. I start with a basic comparison of intermediated versus market- based financing and then discuss the specifics for the United States. Understanding the rise of the SBS means understanding both the financial system structure and the incentives of the participants in the financial system.
The structure and incentives in arose in part because of choices made in the last major crisis in the s. The traditional role of banks is transforming deposits into loans. Depositors and other bank liability holders generally value liquidity, so most bank liabilities are short term. Borrowers, on the other hand, often want longer-term loans. This mismatch between the desired maturities of savers and borrowers leaves a role for financial intermediaries such as banks. Banks are able to manage balance sheets with many assets and liabilities of different maturities. This allows them to transform short- term liabilities into long-term loans and small deposits into large loans. A value added from having banks do asset transformation is that they are set up to screen potential borrowers and then to monitor the borrowers they eventually lend to.
ROSEN In contrast to the traditional role of banks, the traditional role of other financial market participants such as investment banks and securities dealers is to help the sale of securities in markets. In this role, investment banks and securities dealers serve as brokers, holding securities for at most a short time period as part of the sale or underwriting process. In their traditional roles, investment banks and securities dealers help facilitate market-based finance. Market-based finance can have lower overhead costs than intermediated finance and can give borrowers access to a wider pool of potential investors. Countries differ in the relative importance of bank-oriented and market-based finance.
The United States has historically had a strong market-based finance sector. This is largely a function of laws and regulations that helped strengthen an independent investment banking sector. The most important law that affected the structure of the financial sec- tor in the United States in the period leading up to the financial crisis is the Glass-Steagall Act in Glass-Steagall, a response to the financial crisis that led into the Great Depression in the s, effectively separated commercial banking from investment banking. While the separation between commercial and investment banks was not complete, for the most part, each type of firm completed in its own type of market. The separation of commercial and investment banking in the United States also resulted in investment banks that, in the s, were not struc- tured to compete with banks in the loan market. Realizing this, investment banks worked at innovations that would allow them to compete with banks.
In the s, investment banks got many large firms to replace loans with commercial paper CP. To make CP attractive to investors, the borrowers typically had a backup guarantee of repayment, which often came from banks. Investment banks liked CP because it generated fees for them, and investors liked it because it was a high-quality liquid security, but these features were not the only reasons for its success. One big difference between the CP and loans is that a bank loan is reflected on the balance sheet of the bank. Banks are subject to capital requirements and reserve requirements. Both of these require- ments impose costs on banks that can be avoided—or arbitraged—if a firm funds in the CP market rather than by using a bank loan.
Later, investment banks pioneered high-yield bonds. Typically, the only firms that could issue public debt bonds were those with an investment- grade rating BBB or better from the credit rating agencies. But starting in the s, investment banks were able to market high-yield, or noninvest- ment grade, debt. High-yield bonds served as a substitute for bank loans. Again, regulatory arbitrage may have been one of the factors that contrib- uted to the start of the high-yield bond market. One characteristic of both the CP market and the high-yield bond market is that intermediated debt bank loans was replaced by market-based nonintermediated debt. The private securitization market, which started in , but did not expand rapidly until the late s, was a different sort of innovation than CP and high-yield debt because securitization is a form of intermediation. In addition, participants include both traditional banks and investment banks.
Securitization was one of the first activities where investment banks competed with commercial banks as intermediaries. The first securitizations in the United States preceded the private secu- ritization market. Starting in , banks and other lenders put together pools of home mortgages that were then guaranteed by the government agency known as Government National Mortgage Association GNMA, also known as Ginnie Mae. The broad structure of these securitizations, except for the GNMA guarantee, was similar to most of the deals that followed. The lenders sold their loans to intermediaries sponsored by com- mercial and investment banks see Rosen, , for a fuller description of the securitization process. For legal reasons, the loans were owned by so-called special purpose vehicles SPV; sometimes these are called special purpose entities rather than by the sponsoring institution.
An SPV would collect some loans into a pool, and then issue MBS. The bondholders were repaid based on the payments on the loans in the pool. The initial GNMA securitizations passed through all payments less fees. Each bond would share the same coupon rate and other features, and importantly, each would have a similar claim on all payments. MBS are structured so that interest payments on the mortgages are at least sufficient to cover the interest payments due on the bonds plus the fees of the intermediaries. Principal payments either scheduled payments or prepayments on the mortgages are used to pay down the principal on the bonds. The role of GNMA was to guarantee principal repayment. This leaves bondholders exposed to interest rate risk and the risk that the mortgage loans would be repaid early. As with the GNMA, the GSEs guaranteed payments on the mortgages in the pool backing its MBS.
The private securitization market started in when Bank of America issued an MBS without guarantees from Ginnie Mae or the GSEs. The market did not grow appreciably, however, until a law was passed in that allowed regulated financial institutions such as banks to own MBS. Then, in , the ABS market started with securities backed by computer leases and automobile loans. Private-label MBS those without guarantees from Ginnie Mae or the GSEs and ABS have a basic structure much like the GNMA-guaranteed MBS, but with some important differ- ences. The firm putting together a private-label MBS or ABS deal sets up an SPV to purchase a pool of securities, then issues bonds with payments that are based on the payments on the loans in the underlying pool. However, since private-label MBS and ABS do not have government or GSE guarantees, they are structured with built in protections, something I discuss below. The private-label MBS and ABS markets grew rapidly in the following years, as figure 2.
Securitization changes what banks do from screening, monitoring, and funding loans to originating loans after an initial screening, then selling the loans. This new process, known as the OTD model, can lead to an agency problem as it reduces the incentives of banks to carefully screen and monitor the loans they are planning to sell e. This is why most of the early securitizations involved large pools of small, somewhat homogenous loans such as mortgages and automobile loans. So, reducing the incentives to monitor was not a big issue.
In addition, the banks that sold loans into a pool were able to give aggregate statistics on the loan pool, giving investors in the MBS a good idea of the overall default and prepayment characteristics of the pool. In addition to any contractual prohibitions against fraud, the desire to be able to sell future loans gave banks an incentive to report the information they learned from screening the loans. Another feature common in private-label MBS and ABS is tranching. Starting in , the securities offered in a securitization were split into different classes, or tranches.
Many investors were willing to sacrifice some return for very safe, predictable payment streams while others were willing to accept more risk to get high yields. Bonds issued in a tranched deal gen- erally differed in payment priority, and therefore risk. For example, a deal could have two classes of bonds, senior and junior. The interest payments on the underlying assets would be used to pay interest on both classes of bonds. Principal payments, whether scheduled or prepayments, would first be used to repay the principal of the senior bonds. Once these bonds were repaid, principal payments would be used to repay the junior bonds.
Thus, the senior notes would have a shorter and more predictable maturity and be safer since initial principal losses would be borne by the junior bonds. Many securitizations had a large number of tranches, leading to complicated payment dynamics if a large number of the underlying loans defaulted. Most private-label MBS and ABS also use overcollateralization and excess spread to provide a default buffer for all bondholders. ROSEN refers to the difference between the principal balance on the loans in the pool and the principal balance on the outstanding MBS or ABS; excess spread is the difference between the interest payments coming in loan payments minus any fees and the weighted average payments going to bondholders. They are related in that excess spread can be used to build up overcollateralization. The first use of excess spread is to cover default losses. If any excess spread is left, it can be used to build up a cushion against future losses.
As noted above, the tranche structure of a securitization can be extremely complicated as the payment and default risk are split up in different ways. A higher level of sub- ordination means that there would have to be a larger share of defaults before the bond suffered a principal loss. One objective of tranching is to get one or more class of bonds that are rated AAA by a credit rating agency. The intermediaries involved in issuing these bonds henceforth, the issuers often wanted to issue as large a percent of the bonds with a AAA rating as they could. There was a complicated dance between issuers and the credit rating agencies about the level of subordination of the AAA bonds.
One of the ways in which the credit rating agencies were accused of working with issuers during the boom was in structuring the tranches in a securitization so that the issuer had an attractive set of bonds to sell Kane, As the securitization market expanded and demand for securitized bonds increased, issuers started to include different types of assets in the pools backing the securitizations. Collateralized loan obligations CLOs are securities that are backed by the payments on a pool of commercial loans. CLOs differ from earlier ABS in part because the loans in the pool are large. Absent securitization, banks typically monitor even performing commercial loans. The need to monitor increases the agency problems with these loans, but market participants believed that the structure of the securitizations and reputational issues were enough to get the lenders to monitor them.
CLOs were followed by CDOs. The pool of assets backing CDO bonds varied, but in the mids often included bonds from other securitiza- tions and commercial loans including commercial real estate loans. There were also CDOs that included bonds from other CDOs these were often referred to as CDO-squared. Most CDOs were very difficult to value because of their complexity. The expansion of securitization rested on three pillars. One pillar was regulatory arbitrage see, e. As noted earlier, there are regu- latory costs for keeping a loan on a bank balance sheet. In addition, under the risk-based capital guidelines, banks that want to hold the exposure to a certain class of loans can reduce their risk-weighted assets by holding securitized bonds rather than whole loans.
The second pillar that facilitated the expansion of securitization was valuation. Technological advances made it easier to analyze large amounts of data in an attempt to price MBS and ABS bonds. Related to this was the willingness of credit rating agencies to rate the bonds. Together, these made investors comfortable purchasing what were often very complex securities. It is this second pillar that has crumbled during the recent crisis. As the rapid decline in value of some MBS and ABS bonds during the crisis shows, there were significant problems in the valuations and ratings. In the next section, I return to the question of why investors would purchase bonds that were difficult to price. The third pillar is the ability to distribute risk inherent in securitization. Tranching allows issuers to divide the risk in the underlying assets in an almost unlimited way.
They can design bonds with a broad variety of payment and risk characteristics. In theory, this allows investors to buy bonds with the characteristics that most appeal to them. Of course, as noted below, banks ended up holding much of the risk from structured securities Shin, Underlying the move to securitization, in particular, and the SBS, in general, was an attempt by financial firms to capture business from their rivals. Investment banks attempted to break down the Glass-Steagall bar- riers by innovating around them with products such as CP, high-yield bonds, and securitization. At the same time, banks were attempting to get into the underwriting field, formerly the province of investment banks. While some of these innovations offered potential improvements such as securitization allowing risks to be divided , innovation was also aimed at regulatory arbitrage.
In , in an effort to level the playing field between banks and investment banks and, coincidentally, reduce incentives for regulatory arbitrage , the United States implemented the Gramm-Leach- Bliley Act. Gramm-Leach-Bliley allowed commercial and investment banking in the same financial firm. This meant that the largest financial firms had both lending and investment banking arms, changing their incentives to innovate Boot and Thakor, The evolution of the financial industry and the rise of the SBS may have been motivated by efforts of industry players to capture revenue, but it drastically changed how firms profited from financial intermediation. As the lending process moved away from bank loans to either market- based alternatives such as CP or intermediation-based alternatives such as securitization, revenues for banks moved from interest-based to fee-based.
ROSEN This only accelerated once commercial and investment banks could merge. The move to fee-based earnings reduced the incentives for banks to worry about the long run, and in particular, to worry about the risk of the loans or securities they were selling. This risk was shifted to the buyers. As long as there was someone to buy them, the banks had an incentive to sell them. This leaves the issue of what motivated the purchasers. Many of the structured finance securities described in the last section were quite popular in the period leading up to the financial crisis. Between and , the value of mortgages that were issued to subprime borrowers and were then securitized more than tripled fig. This reflected a general increase in the share of MBS that were issued without a government or GSE guarantee fig.
When housing prices started to fall in and , it was the most recent vintage of securities those issued closest to the crisis that did the worst Demyanyk and Van Hemert, Why did investors continue flocking into these markets until sometime in ? One possibility is that the investors were right ex ante, but the crisis was just extremely bad luck. This hypothesis cannot be rejected, but given what is known today about the quality of some of the assets in structured securities, bad luck does not seem to be a complete explanation. In this section, I consider some alternative hypotheses. ABS and MBS typically had higher yields than corporate bonds with equivalent ratings fig.
In the remainder of this section, I discuss some reasons why investors may have purchased securities that, at least in retrospect, seem to be bad investments. The last reason can explain why investors may purchase a security that they believe has a worse risk-return tradeoff than alternative investments. In the back- ground of these arguments is the role of the credit rating agencies. ROSEN Yield spreads to corporate bonds for structured finance products HEL ABS CMBS Auto ABS Basis points 50 0 Jan Jan Jan Jan Jan Jan Jan Jan Jan Figure 2. Still, for many of the complex securities, there is no consensus valuation, or even valuation method see, e. This excess of material and lack of con- sensus on valuation complicates the decision of whether to buy a security at a given price. The literature on behavioral finance offers a number of psychology-based reasons why investors may not act as pure profit maximizers.
One aspect of behavior evident from prior work is that investors tend to be overly optimistic or overconfident I will generally use overconfidence to cover both overoptimism and overconfidence. There is also evidence of confirmation bias, the tendency to interpret evidence in a way that is consistent with prior beliefs. Confirmation bias leads individuals to put more weight on evidence that confirms their prior beliefs than on evidence that contradicts the beliefs. These aspects of investor behavior may have played a role in the evolution of structured finance and in setting the conditions for the financial crisis that started in Several studies have explored whether so-called rational inattention can be used to explain macroeconomic phenomena see, e.
Sims, , and Reis, This can lead prices to deviate from their fundamental values. A form of rational inattention, especially when combined with overoptimism and overconfidence, may have helped set the stage for the financial crisis.
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Jeff Madura Financial Markets And Institutions 11th Edition is handy in our digital library an online right of entry to it is set as public thus you can download it instantly. Our digital library Download Solution Manual For Financial Markets And Institutions 12th Edition By Jeff blogger.com Description Financial Markets and Institutions (11th Edition) By Jeff Madura – eBook PDF. Gain a clear understanding of how financial institutions serve financial markets, why do 06/02/ · ANSWER: A war in Iraq places upward pressure on U.S. interest rates because it (1) increased inflationary expectations in the United States as oil prices increased abruptly, and Overview of the Financial Environment -- Ch. 1. Role of Financial Markets and Institutions -- Ch. 2. Determination of Interest Rates -- Ch. 3. Structure of Interest Rates -- Pt. 2. The Fed 01/01/ · Financial institutions are the key intermediaries in financial markets because they transfer funds from savers to the individuals, firms, or government agencies that need ... read more
One possible reason is that it may not be optimal for investors with limited capital to try to bet against non—profit-maximizing investors see, e. c FDIC Historical Statistics on Failures and Assistance Transactions, which include cases of assistance under a systemic risk determination. Management was typically dominated by one individual, had inadequate control over risks, maintained weak underwriting and credit administration policies and practices, and was found to be unresponsive to supervisory criticism in four of the failures. During periods when investors suddenly become fearful that stocks are overvalued, they dump their stocks, and the stock market experiences a major decline. Enforcement actions were issued late too late in the process of failing bank deterioration.
FHLB advances were important to three of the failed thrifts. Some believe that these problems at least partially stem from conflicting incentives that can lead the credit rating agencies to sacrifice ratings accuracy in an effort to satisfy other concerns Mason and Rosner, ; Partnoy, Although financial institutions overlap in the services they offer, the services that can be offered are distinctly different. Earnings: 17 Misuse of interest reserves. A higher level of sub- ordination means that there would have to be a larger share of defaults before the bond suffered a principal loss.
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