Charters and regulations of mutual savings banks

Mutual can be chartered by either the sates or the federal government. Moreover, state and federal governments also share responsibility for insuring their deposits. About 70 percent of all savings banks have their deposits insured by the Federal Deposit Insurance Corporation (up to $100,000); the remainders are covered by state insurance programs. Today, only 17 states permit the chartering of mutual within their borders, but these institutions are not bound by geography in raising funds or making loans and investment. Their mortgage-lending activities reach nationwide and occasionally even abroad to support the building of commercial and residential projects. The largest mutual savings bank in the United States is the Philadelphia savings fund society of Pennsylvania, which at year-end 1979 reported total deposited of almost $5.9 billion. Close behind was Bowery Savings Bank of New York City, with $4.7 billion in total deposits. Of the10 largest mutual in the United States, all but 3 are headquartered in the state of New York.

Number and distribution of mutual savings banks

The number of mutual operating today is small- less than 500. Moreover, the savings bank population has been on the decline through most of this century. For example, in 1990 there were 626 mutual operating in the United States, and the total number rose to a peak of 637 in 1910. Thereafter, a progressive decline set in until the number of savings banks totaled only 463 at year-end 1979.
Nevertheless, industry assets and deposit have grown quite rapidly. In 1950 total assets of all mutual stood at $22 billion, but at year-end 1980, industry assets had reached almost $172 billion. Of course, with declining numbers and rapidly expanding assets, the average size of mutual savings banks has grown tremendously and now exceeds $300 million in total assets. Thus, the average mutual savings bank is far larger than most credit unions, savings and loan associations, or even commercial banks. This increase in average size has aided mutual in offerings a greater variety of services and in keeping their operating costs low.
Mutual savings banks are not evenly distributed across the United States but rather are located primarily in New England and the Middle Atlantic States. For example, Massachusetts leads the list with 163 mutual operating as of year-end 1979, followed by New York with 112. other states which have mutual headquartered within their borders include Alaska, Connecticut, Delaware, Indiana, Maine, Maryland, Minnesota, New Hampshire, New jersey, Oregon, Pennsylvania, Rhode Island, Vermont, Washington, and Wisconsin.

How municipal bonds are marketed?

The selling of municipals is usually carried out through a syndicate of banks and securities dealers. These institutions underwrite municipals by purchasing them from the issuing unit of government and reselling the securities in the open market, hopefully at a higher price. Prices paid by the underwriting firms may be determined either by competitive bidding among several syndicates or by negotiation with a single securities dealer or syndicate. Competitive bidding normally is employed in the marketing of general obligation (GO) bonds, while revenue bonds more frequently are placed through negotiation.
In competitive bidding, syndicates interested in a particular bond issue will estimate its potential reoffer price in the open market and their desired underwriting commission. Each syndicate wants to bid a price high enough to win the bid, but low enough so that the securities can later be sold in the open market at a price sufficient to protect the group's commission. That is,
Bid price+ underwriting commission= market reoffer price
The winning bid carries the lowest net interest cost (NIC) to the issuing unit of government. The NIC is simply the sum of all interest payments that will be owed on the new issues of municipal bonds is a treacherous business. Prices, interest rates, and market demand for municipals all change rapidly, often without warning. In fact, the tax-exempt securities market is one of the most volatile of all financial markets. This is due in part to the dominant role of commercial banks, whose demand for municipals fluctuates with their net earnings and loan demand. Legal interest-rate ceilings, which prohibit some local governments from borrowing when market rates climb above those ceilings, also play a significant role in the volatility of municipal trading. These combined factors render the tax-exempt market highly sensitive to the business cycle, monetary policy, inflation, and a host of other economic and financial factors. The spectre of high interest rates often forces the postponement of hundreds of millions of dollars of new issues, while the onset of lower rates may unleash a flood of new security offerings.
There is trend today away from competitive bidding and toward negotiated sales of new state and local bonds, due partly to the treacherous character of the tax-exempt market. For example, during 1978 an estimated 53 percent of bonds issued in the market for long-term municipals were negotiated, compared with only 15 percent a dozen years before. This trend has aroused some concern among financial analysis because competitive bidding should result in the lowest net interest cost, reducing the burden on local taxpayers. A recent study sponsored by the Municipal Finance Officers Association (MFOA) concluded that taxpayers have borne some added interest burden as a result of the recent emphasis upon negotiated, rather than combative, sale.
This problem is especially severe in certain states. For example, the AFOA-sponsored study found that in Pennsylvania, where competitive bidding is not required by law, about 95 percent of all bonds sold by local governments were handled through negotiation with a single underwriter group. It was estimated that Pennsylvania local governments paid approximately $14 million in excess interest costs on bond sales totaling about $360 million. On the other side of the coin, underwriting firms argue that they provide extra services to borrowing governments during the negotiation process-services not generally available through competitive bidding. These include preparing legal offering statements, scheduling the sale of new securities, helping to secure desirable credit ratings, and contacting potential buyers.

Operational Problems in Offering Credit Cards

Banks and other companies offering credit cards must solve several significant operational problems. First, the break-even point in card operations appears to be relatively high, placing pressure on credit card companies to sign up enough merchants to accept the cards and enough individuals to use them. The two problems are, of course, interrelated. Merchants are willing to accept a card only if they believe there will be sufficient customers using it to make the program worthwhile. Similarly, individuals are willing to make use of their cards only if a large number of merchants will accept them in payment for goods and services. One problem that has plagued credit-card operations for many years is losses due to customer fraud. Recent estimates by the Federal Reserve System find that fraud losses represent 15 to 20 percent of total card charge-offs for most plans.
During the late 1960s some U.S. banks tried to overcome the card-acceptance barrier by mass mailing of unsolicited cards, resulting in large-scale credit and fraud losses. Fearing that the safety and soundness of the banking system might be jeopardized and public confidence in banks shaken, Congress Passed the Consumer Credit Protection act, which prohibits unsolicited mailing of credit cards. Moreover, once the card-issuing company has been notified, the customer is no longer liable for any unauthorized use of his or her card. Prior to notification, the cardholder can only be held responsible for a maximum of $50 in unauthorized charges per card. Moreover, the customer cannot be held liable for unauthorized use of his or her credit card if the card was not requested or used, if it carries a means of identifying the authorized user (such as a signature or photograph), or if the customer was not notified of the $50 maximum liability. In addition, card issuers must provide the customer with a means of notifying them in case of card loss or theft.
Federal legislation has done much to enhance public acceptance of credit cards. Most cards are issued to customers today only after a careful analysis of their credit standing. That is why cardholders frequently are able to use their cards as a credit reference to aid in the cashing of checks or to obtain other forms of credit. Most merchants know that charge-card holders tend to have higher incomes and better payment record than the general population.
The most profitable credit-card accounts from the point of view of the issuing companies are those with high balances which are not paid off immediately (I.e., those held by installment users). However, less than half the sales volume experienced by most card programs winds up as carry-over balances subject to finance charges. Most card users are convenience users, who pay off their credit purchases within the normal billing cycle. Banks have found that they cannot make significant profits on their credit card operations when over half their cardholders are only convenience users. Moreover, cards users with the highest incomes and best repayment records typically economize on their cash balances and delay payment as long as possible, which further reduces the earnings from card operations. However, the performance of credit-card programs does improve with experience. Card companies become more skillful at identifying profitable groups of customers and at minimizing fraud and bad-debt losses. In addition, credit card programs bring in customers who may purchase other financial services from the same institution, such as installment loans and savings plans.

The determinants of consumer borrowing

Consumers represent one of the largest groups of borrowers in the financial system. Yet individual consumers differ widely in their use of credit and their attitudes toward borrowing money. What factors appear to influence the volume of borrowing carried out by households? Gross income is a common standard in this instance. For younger borrowers, without substantial assets to serve as collect for a loan, a cosigner may be sought whose assets and financial standing represent more adequate security. The duration of employment of the borrower is often a cortical factor, and many institutions will deny a loan request if the customer has been employed at his or her present job for less than a year.
The past payment record of a customer usually is the key indicator of character and the likelihood that the loan will be repaid in timely fashion. Many lenders refuse to make loans to those consumers who evidence "pyramiding of debt"-that is, borrowing from one financial institution to pay another. Evidence of sloppy money handling, such as unusually large balances carried on charge accounts or a heavy burden of installment payments, is regarded as a negative factor in the loan decision. Loan officers are particularly alert to evidence of a lack of credit integrity as reflected in frequent late payments or actual default on past loans. The character of the borrower is the single-most-important issue in the decision to grant or deny a consumer loan. Regardless of the strength of the borrower's financial position, if the customer lacks the willingness to repay his or her debt, then the lender has made a bad loan.
Most lenders feel that those who own valuable property such as land, buildings, or marketable securities are more reliable than those who do not own such property, especially if the property itself is pledged to secure the loan. For example, homeowners are usually considered to be better risks than those who rent. Moreover, borrowers´ chances of getting a loan usually are better if they do other business (such as maintain a deposit) with the lending institution. If more than one member of the family works, this is often viewed as a more-favorable factor than if the family depends upon one breadwinner who may become ill, die, or simply lose his or her job. Having a telephone at home is another positive factor in evaluating a loan application, since the telephone gives the lender an inexpensive way to contact the borrower. One way to lower the cost of a loan is for the consumer to pledge a bank deposit, marketable securities, or other liquid assets behind the loan. The disadvantage here is that such a pledge "ties up" the asset pledged as security until the loan is repaid.

Fair Housing and Home Mortgage Disclosure Acts

Two other important antidiscrimination laws are the Fair Housing Act, which forbids discrimination in lending for the purchase or renovation of residential property, and the Home Mortgage Discloser Act (HMDA). The latter requires financial institutions to disclose to the public the amount and location of their home mortgage and home improvement loans. HMDA was designed to eliminate "redlining," in which some lenders would mark out areas of a community as unsuitable for mortgage loans because of low income, high crime rates, or other negative factors. Not only was the low supposed to increase home mortgage loans to low- and moderate-income neighborhoods, but it was also intended to encourage the public to divert its funds away from those institutions practicing redlining. Unfortunately, this law reveals information about the supply of mortgage credit but not the demand. Also, nondeposit mortgage lenders are exempted from its provisions even though they are often significant factors in the local real estate market.
Both HMDA and the Fair Housing Act require nondiscriminatory advertising by lenders. No longer can a consumer lending institution direct its advertisements solely to high-income neighborhoods to the exclusion of other potential customers. When loans to purchase, construct, improve, repair, or maintain a dwelling are advertised, the lender must state that such loans will be made without regard to race, color, religion, sex, or national origin. On written advertising, an "equal housing" symbol must be attached. Clearly, then, in advertising the availability of credit, in accepting and evaluating loan applications, and in the actual granting of credit, the principles of civil rights and nondiscrimination apply. Lenders are free to choose who will receive credit, but that decision must be made within the framework of the nation's social goals.

Equal Credit Opportunity Act

The Equal Credit Opportunity Act of 1974 forbids discrimination against credit applicants on the basis of age, sex, marital statues, race, color, religion, national origin receipt of public assistance or good-faith exercise of rights under the federal consumer credit protection laws. Major beneficiaries of this law are women, who no longer can be denied credit solely on the basis of their sex, age, family plans, or the fact that they are not wage earners. Women may receive credit under their own signature, based on their own personal credit record and earnings, without having the husband's joint signature. Credit applications must be notified of the approval or denial of their loan request within 30 days of filling a completed application. The reasons for denial of a loan application must be set forth in writing, and the lender may not request information on the borrower's race, color, religion, national origin, or sex, except in the case of residential mortgage loans.

Community Reinvestment Act

one of the most important and controversial pieces of financial legislation in recent years is the Community Reinvestment Act, singed into law by President Jimmy Carter on October12,1977. Under its terms financial institutions are required to make an " affirmative effort" to meet the credit needs of low- and middle-income customers, including households, small businesses, farms, and ranches. Moreover, the regulatory authorities are required to consider the performance of lending institution in meeting these community credit needs when processing applications for merges, new branch offices, corporate charters, and holding company acquisitions by these same lending institutions.
Each commercial and savings banks must define its own local "trade territory" and describe the services that it offers or is planning to offer in that local area. Once a year each institution must prepare an updated map which delineates the trade territory served, without deliberately excluding low- or moderate-income neighborhoods. The lending institution's board of directors must adopt a CRA Statement, which specifies that lender's trade territory and lists the principal types of credit offered in that territory. A notice must be posted in the lobby, alerting customers to their rights and where the institution's CRA Statement may be found. Customers are entitled to make written comments concerning the lender's performance in meeting local credit needs. These comments must be retained on the premises for at least two years and be available for public inspection. The basic purpose of the Community Reinvestment Act is to avoid "gerrymandering" out low-income neighborhoods and other areas that the lender may consider undesirable.

Recent Trends in Original Maturities of Bonds

There is a trend today toward shorter original maturities for corporate bonds due to inflation, rapid changes in technology, and heavy borrowing demands from other sectors of the economy. During the 1950s and 60s corporations usually found a ready market for 20-to 30-year bonds. Such long-term debt contracts were extremely desirable from the borrowing company's standpoint because they locked in relatively low interest costs for many years and made financial planning much simpler. Today, with inflation and other factors frequently sending market interest rates soaring to records levels, bonds and notes with 3- to 15-year maturities are becoming commonplace.
Some financial analysts expect to see a substantial number of corporate bonds issued in the future whose interest rates are indexed to commodity prices (especially silver and gold) or to the price of energy. These commodity-indexed bonds are designed to provide the investor a hedge against inflation and, as result, carry substantially lower coupon rates than conventional bonds. Another recent innovation is the issuance of zero-coupon bonds which carry no fixed rate of return but offer the investor the prospect of significant capital gains. Those bonds still issued with fixed interest rates may carry "openers" which call for periodic adjustments in the principal amount of the loan as interest rates change. In brief, the trend in corporate bonds today is toward shorter maturities and more flexible rate of return for the investor.

Special drawing rights

Several nations peg their currency's exchange rate to a basket of currencies assembled by the international monetary fund, known as the special drawing right (SDR). The SDR is an official international monetary reserve unit designed to settle international claims arising from transactions between the IMF, governments of member nations, central banks, and various international agencies. SDRs are really "book entries" on the ledgers of the IMF and are sometimes referred to as "paper gold" periodically, that organization will issue new SDRs and credit them to the international reserve accounts of member nations. To spend its SDRs, a nation simply requests the IMF to transfer some amount of SDRs from its own reserve account to the reserve account of another nation, usually one whose currency is widely accepted in the international markets. In return, the country asking for the transfer gets deposit balances denominated in the currency of the nation receiving the SDRs. These deposit balances may then be used to make international payments.
The value of SDRs today is based upon a basket of currencies representing the five IMF member nations with the largest volume of exports during the 1975-79 periods. These five countries are the United Stated, The Federal Republic of Germany, France, Japan, and the United Kingdom. In determining the current value of SDRs the currency of each of these five nations is weighted according to the value of their exports and currency holdings. In 1981 the weights applied to these five currencies in the SDR basket were: U.S. dollars, 42 percent; German marks, 19 percent: French francs, 13 percent; Japanese yen, 13 percent; and British pound sterling, 13 percent. Countries that peg their currency's value to the value of SDR basket include Burma, Guinea, Kenya, Vietnam, Zaire, and Zambia.

State banking commissions

The regulatory powers of the federal banking agencies overlap with those of the state banking agencies, which rule upon charter applications in their respective states and regularly examine all state-chartered banks. The states also have rules prescribing the minimum amount of equity capital for individual banks and frequently place interest-rate ceilings on deposits and loans. Many states in recent years have imposed restrictions on the growth and formation of bank holding companies, requiring state approval before a holding company may be formed or, once formed, before it can acquire additional authorities, consider the new bank's prospects for earnings, the convenience and needs of the public in the area to be served, and the potential for damage to existing financial institutions if a new charter is granted.
One of the areas in which state banking law currently is supreme is that concerning branch banking. Since the McFadden Act of 1927, the federal government has allowed the states to determine whether commercial banks operating within their borders will be permitted to establish any branch offices and, if so, under what circumstances. Today, 15 states forbid full-services branch offices. These so-called unit-banking states are situated mainly in the Midwest and south and include taxes, Kansas, Nebraska, and Colorado. However, as we saw earlier, there is a definite trend toward greater use of branching and holding company activity in most pats of the United States. Recent examples include Florida, which until 1978 was a unit-banking state and now permits limited branching on a countywide basis. The state of New York converted to statewide branching in 1976 following an experiment with limited branching in designated regions. Most experts predict that in future years branch banking in one form or another will spread across the United States as needs for larger banking organizations and new financial services increase.

Federal deposit insurance corporations

Federal Deposit Insurance Corporations insures deposits of U.S. commercial banks which meet its regulations; the coverage provides up to $100,000 per depositor. Roughly 98 percent of all U.S. banks are insured, and approximately 62 percent of all commercial bank deposits are covered by the FDIC's insurance program. Each participating bank is assessed annually an amount equal to about 1\10 of 1 percent of its eligible deposits to build and maintain a national insurance fund.
One of the most important functions of the FDIC is to act as a check on the state banking commissions, because few banks today-even those with state charters-will open their doors without FDIC insurance. The FDIC reviews the adequacy of capital, earnings prospects, the character of management, and the public convenience and needs aspects of each application before granting deposit insurance. This agency is also charged with examining insured banks that are not members of the Federal Reserve System, and it must approve applications for branches, changes in location, or mergers involving federally insured banks. The FDIC is empowered to close a bank will be merged with or absorbed by a healthy one; FDIC often purchases some of the bankrupt institution's weaker assets to support such a merger.

The roles played by life insurance companies in the mortgage market

Life insurance companies make substantial investments in commercial as well as residential mortgage properties. Commercial mortgages make up more than 60 percent of mortgage obligations held by life insurance companies, with residential units accounting for between a third and a quarter of their mortgage total. These companies will search national and international markets for good mortgage investments instead of focusing upon only one or a few local areas.
In the past, life companies strongly preferred government-guaranteed mortgages. In recent years, however, the higher yields available on conventional mortgages have caused some shift of emphasis toward these more risky loans. Despite the greater flexibility of conventional home mortgages, life insurance companies have been gradually reducing their holdings of home mortgages and emphasizing commercial and apartment mortgages. Commercial and apartment loans often carry "equity kickers," which permit the lender to receive a portion of project earnings as well as a guaranteed interest rate.
At the end of 1980 life insurance companies held about 9 percent of total mortgages loans outstanding in the United States. This market share placed them third among private mortgage lenders, behind savings and loan associations and commercial banks. This high ranking is due in part to the fact that life insurers are the largest institutional holder of farm mortgages; stand second only to commercial banks in mortgage loans for commercial properties, and rank second to savings and loans in apartment loans. However, in making loans to finance one-to-four-family residential dwellings, life companies rank a distant fourth among all private lenders. For example, at year-end 1980 they held only $18 billion in one-to-four-family residential loans, compared to $65 billion for mutual savings banks, more than $160 billion reported by commercial banks, and nearly $420 billion held savings and loan associations.

Residential versus nonresidential mortgage loans

The mortgage market can be dividend into two major segments: (1) residential, which encompasses all loans secured by single-family homes and other dwelling units; (2) nonresidential, which includes loans against business and farm properties. Which of these two sectors is the most important? Loans to finance the building and purchase of homes, apartments, and other residential units dominate the American mortgage market. In 1980 residential mortgage loans on one-to-four-family properties and multifamily structures represented three fourths of all mortgage loans outstanding. Mortgages on commercial and farm properties accounted for the remaining one fourth of all mortgages issued.
In recent years the residential portion of the market has grown faster than nonresidential mortgages. The most-dramatic growth occurred in loans on one-to-four family properties, which rose from 61 percent of total mortgage debt outstanding in 1975 to 66 percent in 1980.this category of mortgages is dominated by singe-family home loans, which increased significantly due to the rapid growth of new family formations and the effects of inflation.
The 1970a also ushered in a speculative investment boom in the building of condominiums, duplexes, triplexes, and smaller residential structures by wealthy investors. Much of this speculative construction activity has been aimed at the rental housing market, designed especially to appeal to college students and low-to middle-income families. Unlike owner-occupied residences, rental properties can be depreciated so that both mortgage-loan costs and annual depreciation expenses are legitimate income tax deductions for investors in such properties. While one-to-four-family residential mortgages were capturing a larger share of the total market, both multifamily (apartment) and commercial mortgage loans were declining in relative importance.
Because residential mortgages dominate the market, it should not be surprising that households are the leading mortgage borrower. The next-largest group of borrowers-nonfinancial corporations- is a distant second. Moreover, the share of the market represented by household has risen in recent years due to an upward surge in the demand for housing, while other mortgage borrowers have declined in relative importance.

Reserve requirements and excess reserve

Money creation by banks is made possible because the public readily accepts claim on bank deposits (mainly checks) in payment for goods and services. In addition, the law requires individual banks to hold only a fraction of the amount of deposits received from the public in cash or near-cash reserve, thus freeing up a majority of incoming funds for the making of loans and the purchasing of securities. We need to look more closely at these so-called reserve requirements bank must meet, since they play a key role in the money-creation process.
Under current federal law, banks and other depository institutions must hold reserves in cash or in deposit form behind their transaction accounts and time and savings deposits. These reserve requirements are linked to the size of the depository institution and require that a specified percentage of all incoming deposits must be placed either in an account at the Federal Reserve Bank in the region or as cash in the bank's vault. Vault cash and deposits at the Fed constitute a bank's holdings of legal reserves- those assets acceptable for meeting reserve requirements behind the public's deposits. In 1980, following passage of the depository institutions deregulation and Monetary Control Act, all deposit-type financial institutions (including commercial banks, mutual savings banks, savings and loan associations, and credit unions) were required to hold legal reserves equal to 3 percent of that portion of their transaction accounts (principally checking and NOW accounts) below $25 million and 12 percent for that portion over $25 million.
Each bank's legal reserve may be divided into two categories- required reserves and excess reserves. Required reserves are equal to the legal reserve requirement ratio times the volume of deposits subject to reserve requirements. For example, if a bank holds $20 million in checking and other transaction accounts and $30 million in savings deposits and the law requires it to hold 3 percent of its transaction accounts and 3 percent of its savings deposits in legal reserve , then required reserves for this bank are $20 million ×3%+$30 million×3 %,or $1.5 million.
Excess reserve equal the difference between the total legal reserves actually held by a bank and the amount of its required reserves. For example, if a bank is required to hold legal reserves equal to $1.5 million but finds on a given date that it has $500,000 in cash on the premises and $1.5 million on deposit with the Federal Reserve Bank in its region, this bank clearly holds $500,000 in excess reserves. Since legal reserve assets earn little or no interest income, most commercial banks try to keep their holdings of excess reserve as close to zero as possible. Indeed, the larger banks frequently run deficits in their required reserve position and must borrow additional legal reserves from other banks or attract more funds from their customers to cover the deficit.

Pension fund assets

The particular assets held as investment by pension funds depend heavily upon whether the fund is government controlled or private. Private funds emphasize investments in corporate stock, which represented about three fifths of their assets at year-end 1979. Corporate bonds ranked a distant second, accounting for almost one fourth of all financial investments. With few liquidity needs, private pensions held relatively small amounts of cash, time deposits, or government securities.
Corporate stock is far less important in the portfolios of government pension funds. State and local government pension programs held almost $44 billion in corporate stock at year-end 1979, which represented about one quarter of their financial assets. However, stock investments were far outweighed by corporate bonds, which amounted to $86 billion-close to half the assets of public pensions.
Under the pressure of strict regulations and more-frequent benefit claims, public plans hold a larger proportion of cash and liquid government securities than do private plans. For example, investments in U.S. Treasury and federal agency securities, demand deposits, and currency represented a full 20 percent of total financial investments at year-end 1979. Government pensions also place moderate amounts of funds in state and local government securities-often IOUs issued by their own governmental unit.

The money market versus the capital market

The pool of funds represented by the financial markets may be divided into different segments, depending upon the characteristics of financial claims being traded and the needs of different groups. One of the most important divisions in the financial system is between the money market and the capital market.
The money market is designed for the making short-term loans where individuals and institutions with temporary surpluses of funds meet borrowers who have temporary cash shortages. By convention, a security evidencing a loan which matures within one year or less is considered to be a money market instrument. One of the principal functions of the money market is to finance the working-capital needs of corporations and to provide governments with short-term funds in lieu of tax collections. The money market also supplies funds for speculative buying of securities and commodities.
In contrast, the capital market is designed to finance long-term investments. Trading of funds in the capital market makes possible the construction of factories, office buildings, highways, bridges, schools, homes, and apartments. Financial instruments traded in the capital market have original maturities of more than one year.
Who are principal suppliers and demanders funds in the money market and the capital market? In the money market commercial banks are the most important institutional lender to both business firms and governments.
Nonfinancial business corporations with temporary cash surpluses also provide substantial short-term funds to commercial banks, securities dealers, and other corporations in the money market. Finance companies supply large amounts of working capital to major corporate borrowers, as do money market mutual funds which specialize in short-term, high-grade government and corporate securities.
On the demand-for-funds side the largest borrower in the American money market is the U.S Treasury, which borrowers several billion dollars weekly. The largest and best-known U.S. corporations are also active borrowers in the money market through their offerings of short-term notes. Major securities dealers require huge amounts of borrowed funds daily to carry billions of dollars in securities held in their trading portfolio to meet customer demand. Finally, the Federal Reserve System, which is charged by Congress with responsibility for regulating the flow of money and credit in U.S. financial system, operates on both sides of the money market. Through its open market operations the Fed both buys and sells securities to maintain credit conditions at levels deemed satisfactory to meet the nation's economic goals. Due to the large size and strong financial standing of these well-known money market borrowers and lenders, money market credit instrument are considered to be highly-quality, "near money" IOUs.
The principal suppliers and demanders of funds in the capital market are more varied than in the money market. An institution must be large and well known with an excellent credit rating to gain access to the money market. The capital market for long-term funds, in contrast, encompasses both well-established and lesser-known individuals and institutions. Families and individuals, for example, tap the capital market when they borrow to finance a new home or new automobile. State and local governments rely upon the capital market for funds to build schools, highways, and public buildings and to provide essential services to the public. The U.S. Treasury draws upon the capital market in issuing new notes and bonds to pay for federal government programs. The most important borrowers in the nation's capital market are businesses of all sizes, which issue bonds, notes, and other long-term IOUs to cover the purchase of equipment and the construction of new plants and other facilities.
Ranged against these many borrowers in the capital market are financial institutions which supply the bulk of long-term funds. Prominent here are life and property-casualty insurance companies, pension funds, savings and loan associations, mutual savings banks, finance companies, and commercial banks. Each of these institutions tends to specialize in a few different kinds of loans consistent with it own cash-flow needs and regulatory restrictions.
For example, life insurance companies are major buyers of corporate bonds and commercial mortgages. Property-casualty insurers stay heavily invested in state and local government (municipal) bonds, corporate stock, and corporate bonds. Pension funds are major buyers of both corporate equities and bonds, while savings and loan associations are principally home mortgage lenders. Mutual savings banks emphasize investments in mortgages and corporate bonds. Finance companies and commercial banks provide large amounts of capital funds to both individuals and businesses through direct loans and financing. Commercial banks are probably the most diversified of all lenders in the capital market since they provide long-term funds to all major groups in the economy.

Open versus negotiated markets

Another distinction within the financial system which is sometimes useful is that between open markets and negotiated markets. For example, some corporate bonds are sold in the open market to the highest bidder and bought and sold any number of times before they mature. In contrast, in the negotiated market for corporate bonds, securities generally are sold to one or a few buyers under private contract and held maturity.
An individual who goes to his or her local banker to secure a loan for a new car enters the negotiated market for auto loan. However, a broker instructed to buy a few shares of GM stock will attempt to fill the order by contacting a seller in the open market. Most state and local government securities are sold in the open market. But a growing number are sold under a privately negotiated "treaty" with one or a few buyers. In the market for corporate stocks there are over-the-counter (OTC) sales and the major stock exchanges, which represent the open market. Operating at the same time, however, is the negotiated market for stock, in which a corporation may sell its entire equity issue to a large insurance company or pension funds.

Preferred stock

The other major form of stock issued today is preferred stock. Each share of preferred carries a stated annual dividend expressed as a percent of the stock's par value. For example, if preferred shares carry a $100 par value with an 8 percent dividend rate, then each preferred shareholder is entitled to dividends of $8 per year on each share owned, provided the company declares a dividend. Common stockholders would receive whatever dividends remain after the preferred shareholders receive their stated annual dividend.
Preferred stock occupies the middle group between debt and equity securities, including advantages and disadvantages of both forms of raising long-term funds. Preferred stockholders have a prior claim over the firm's assets and earnings relative to the claim of common stockholders. However, bondholders and other creditors of the firm must be paid before either preferred or common stockholders receive anything. Unlike creditors of the firm, preferred stockholders cannot press for bankruptcy proceedings against a company which fails to pay them dividends. Nevertheless, preferred stock is part of a firm's equity capital and strengthens a firm's net worth account allowing is to issue more debt in the future. It also is a more flexible financing arrangement than debt since dividends may be passed if earnings are inadequate or uncertain and there is no fixed maturity date.
Generally, preferred stockholders have no voice or vote in the selection of management unless the corporation "passes" dividends (i.e., fails to pay dividends at the agreed-upon time). A frequent provision in corporate charters gives preferred stockholders the right to elect some members of the board of directors if dividends are passed for a full year. Dividends on proffered stock, like those paid on common stock are not a tax-deductible expense. This makes preferred shares nearly twice as expensive to issue as debt for companies in the top-earning bracket. However, IRS regulations specify that 85 percent of the dividends on preferred stock received by a corporate investor are not taxable. This tax-exemption feature makes preferred stock especially attractive to companies seeking to acquire ownership shares in other firms and sometimes allows preferred stock to be issued at a lower net interest cost than debt securities. In fact, corporations themselves are the principal buyers of preferred stock issues.
Most preferred stock is cumulative, which means that the passing of dividends results in an arrearage which must be paid in full before the common stockholders receive anything. A few preferred shares are participating, allowing the holder to share in the residual earnings normally accruing entirely to the common stockholders. To illustrate how the participating feature might work, assume that an investor holds 8-percents participating preferred stock with a $100 par value. After the issuing company's board of director's votes to pay preferred shareholders their stated annual dividend of $8 per share, the board also declares a $20-a-share common stock dividend. If the formula for dividend participation calls for common and preferred shareholders to share equally in any net earnings, then each preferred shares will earn an additional $12 to bring its total dividend to $20 per share as well. Not all participating formulas are this generous, however, and most preferred issues are nonparticipating since the participation feature is detrimental to the interests of the common stockholders.
Most corporations plan to retire their preferred stock, even though it carries no stated maturity. In fact, the bulk of preferred shares issued today have call provisions. When interest rates decline, the issuing company may exercise the call privilege at the price (which usually includes a premium over par) stated in the formal agreement between the firm and its shareholders. A few preferred issues are convertible into shares of common stock at the investor's option. The company retires all converted proffered shares and may force conversion by simply exercising the stock's call privilege. New preferred issues today are often accompanied by a sinking fund provision whereby funds are gradually accumulated and set aside for eventual retirement of preferred shares. A trustee is appointed (usually a bank trust department) who collects sinking fund payments from the company and periodically calls in preferred shares or occasionally purchases them in the open market. While sinking fund provisions allow the issuing firm to sell preferred stock with lower dividend rates, payments into the fund drain earnings and reduce dividend payments flowing to common stockholders.
From the standpoint of the investor, preferred stock represents an intermediate investment between bonds and common stock. Preferred shares often provide more income than bonds but also carry greater risk. Preferred shares prices fluctuate more widely than bond prices for the same change in interest rates. Compared to common stock, preferred shares generally provide less total income (considering both capital gains and dividend income) but are, in turn, less risky. They appeal to the investor who is looking for a favorable, but moderate rate of return.
Among major corporations preferred stock experienced a resurgence of interest during the 1970s due to high debt financing cost, the greater flexibility of preferred stock financing over bonds, and pressure on many firms (especially public utilities) to rebuild their equity positions. The numbers of issues of preferred stock listed on the New York stock exchange reached a low of 373 in 1965 and then rose to record highs during the 1970s. Many of these new preferred stock issues proved to be extremely popular with investors because of their high dividend yields, which, in several recent periods, have averaged about twice as large as the dividends yield on listed common stock.

Common stock

The most important from of corporate stock is common stock. Like all forms of equity, common stock represents a residual claim against the assets of the issuing firm, entitling the owner to a share in the net earnings of the firm when it is profitable and to a share in the net market value (after all debts are paid) of the company's assets if it is liquidated. By owning common stock the investor is subject to the full risks of ownership, which means that the business may fail or its earnings may fall risks of ownership, which means that the business may fail or its earning may fall to unacceptable levels, however, the risks of equity ownership are limited since the stockholder is liable only for the amount of his or her investment of funds.
If a corporation with out standing shares of common stock is liquidated, the debts of the firm must be paid first from any assets available. The preferred stockholders then receive their contractual share of any remaining funds. The residual, whatever is left, accrues to common stockholders on a pro rate basis. Unlike many debt securities, common stock is generally a registered instrument with the holder's name recorded on the issuing company's books.
The volume of stock that a corporation may issue is limited by the terms of its charter of incorporation. Additional shares beyond those authorized by the company's charter may be issued only by amending the charter with the approval of the current stockholders. Some companies have issued large numbers of corporate shares, reflecting not only their need for large amounts of equity capital, but also a desire to broaden their ownership base across millions of shareholders. For example, American Telephone and Telegraph (AT&T) have more than 700 million shares of common stock listed on the New York stock exchange. International business machines (IBM) lists more than 580 million shares.
The par value of common sock is an arbitrarily assigned value printed on each stock certificate. Par is usually set low relative to the stock's current market value. In fact, today some stock is issued without any par value. Originally, par value supposed to represent the owners´ original investment per share in the firm. The only real significant of par today is that the firm cannot pay any dividends to stockholders which would reduce the company ´s net worth per share below the par value of its stock . In addition, in the event of liquidation or bankruptcy, the common stockholders may be liable under some circumstances to creditors of the firm for the difference between par value and the subscription price of the stock.
Common stockholders are granted a number of rights when they buy a share of equity in a business corporation stock. Stock ownership permits them to elect the company's board of directors which, in turn, chooses the firm's officers responsible for day-to-day management of the company. Most companies grant a preemptive right when stock is purchased (unless specifically denied by the firm's charter ) which gives the individual shareholder the right to purchase any new voting stock, convertible bonds, or preferred stock issued by the firm in order to maintain his pro rate share of ownership. For example, if a stockholder holds 5 percent of all shares outstanding and 500 new shares are issued, this stockholder has the right to subscribe to 25 new shares.
While most common stock grants each shareholder one vote per share, nonvoting common is also issued occasionally. Some companies issue class a common which as voting rights and class B common which has a prior claim on earnings but no voting power. Te major stock exchanges do not encourage publicly held firms to issue classified common stock, but classified shares are used extensively by privately held firms.
A right granted to all common stockholders is the right of access to the minutes of stockholder meetings and to lists of existing shareholders. This gives the stockholders some power to reorganize the company if existing management or the board of directors is performing poorly. Common stockholders may vote on all matters which affect the firm's property as a whole, such as a merger, liquidation, or the issuance of additional equity shares. This vote may be cast in person or by revocable proxy (which is a temporary assignment of voting power and an instruction on how to vote) granted to a trustee.

The channels through which central banks work

Later on, we will examine in some detail how the Federal Reserve System affects domestic and international economic conditions. It is useful at this point, however, to give a brief overview of the channels through which modern central banks influence conditions in the economy and financial system. Central bank policy affects the economy as a whole by making:
1-Changes in the cost and availability of credit to businesses, consumers, and governments.
2-Changes in the volume and rate of growth of the nation's money supply.
3-Changes in the wealth of investors as reflected in the market value of their security holdings.
The central bank has a number of policy tools at its command which it can use to influence interest rates, the prices of securities, and the level and growth of reserve in the banking system. In the United States the principal policy tools used by the central bank are open market operations, changes in required reserves held by depository institutions, and changes in the discount rate on central bank loans. In turn, changes in interest rates, security prices, and bank reserves influence the cost and availability of credit. If borrowers find that credit is less available and more expensive to obtain, they are likely to restrain their borrowing and reduce spending for both capital and consumer goods. This results in a slowing in the economy's rate of growth and perhaps a reduction in inflationary pressures. Second, if the central bank can reduce the rate of growth of the nation's money supply, this policy will eventually slow the growth of income and production in the economy due to a reduction in the demand for goads and services. Finally, if the central bank raises interest rates and therefore lowers security prices, this will tend to reduce the market value of the public's holdings of stocks, bonds, and other securities. The result is a decline in the value of investors´ wealth, altering borrowings and spending plans and ultimately influencing employment, prices, and the economy's rate of growth.

The goals and channels of central banking

Central banking is goal oriented. Since World War II the United States and several other industrialized nations have accepted the premise that government is responsible to its citizens for maintaining high levels of employment, combating inflation, and supporting sustained economic growth. This is a relatively new idea since, in earlier periods, governments were assigned a much smaller role in the economic system and much less was expected of them by their citizens. It was felt that "automatic" mechanisms operated within t economy to provide stability and high employment in the long run. One of the bitter lessons of the Great Depression of the 1930s was that these mechanisms can break down and that innovative and skillfully managed government policies may be needed to restore the economy's stability and growth.
Central banking in the United States and in most other nations is directed toward four major goals:
1- Full employment of resources.
2- Reasonable stability in the general price level of all goods and services.
3- Sustained economic growth.
4- A stable balance of payments positions for the nation vis-à-vis the rest of the world.
Through its influence over interest rates and the growth of the nation's money supply, the central bank is able to influence the economy's progress toward each of these goals. Achievement of all these goals simultaneously as proven to be exceedingly difficult, however, as the recent track record of the economy demonstrates. One reason is that the goals often conflict. Pursuit of price stability and an improved balances of payments position, for example, may require higher interest rates and restricted credit availability- policies which tend to increase unemployment and slow investment spending and growth. Central bank policy making is a matter of accepting trade-off (compromises) among multiple goals. For example, the central bank can pursue policies leading to lower rate of inflation and a stronger dollar but probably at the price of some additional unemployment and slower economic growth in the short run.
Central banking in most Western nations, including the United States, operates principally through the marketplace. Modern central banks operate as a balance wheel in promoting and stabilizing the flow of savings from surplus-spending units to deficit-spending units. They try to assure a smooth and orderly flow of funds through the money and capital markets so that adequate financing is available for worthwhile investment projects. This means, among other things, avoiding panic in the market due to sudden shortages of available credit or sharp declines in security prices. However, most of the actions taken by the central bank to promote a smooth flow of funds are carried out through the marketplace rather than by government order. For example, the central bank may encourage interest rates to rise in order to reduce borrowing and spending and combat inflation, but it does not usually allocate credit to particular borrowers. The private sector, working through demand and supply forces in the marketplace, is left to make its own decisions about how much borrowing and spending will take place at the current level of interest rates and who is to receive credit.

The role of central banks in the economy

Control of the money supply
Central banks, including the Federal Reserve System, perform several important functions in a modern economy. The first and most important of their functions is control of the nation's money supply.
What is money? Money is anything which serves as a medium of exchange in the purchase of goods and services. Money as another important function, however-serving as a store of value, for money is a financial asset that may be used to store purchasing power until it is needed by the owner. If we define money exclusively as a medium of exchange , then the sum of all currency and coin held by the public plus the value of all publicly held checking accounts and other deposits against which drafts may be issued (such as NOW accounts) would constitute the nation's money supply. If we define money as a store of value, on the other hand, then time and savings accounts at commercial banks and other nonbank financial intermediaries, such as credit unions and savings banks, would also be considered important components of the money supply. However we define money, the power to regulate its quantity and value was delegated by Congress early in this century to the Federal Reserve System. The Fed has become, not only the principal source of currency and coin (pocket money) used by public, but also the principal government agency responsible for stabilizing the value of the dollar and protecting its integrity in the international financial markets. Why is control of the nation's money supply so important? One reason is that changes in the money supply are closely linked to the changes in economic activity. A number of studies in recent years have found a statistically significant relationship between current and lagged changes in the money supply and movements in the nation's gross national product (GNP). The essential implication of these studies is that, if the central bank carefully controls the rate of growth of money, then it can influence the growth rate of the economy as a whole.
Another important reason for controlling the money supply is that, in the absence of effective controls, money in the form of paper notes or bank deposits could expand virtually without limit. The marginal cost of creating additional units of money is close to zero. Therefore, the banking system, the government, or both are capable of increasing the money supply well beyond the economy's capacity to produce goods and services. Because this action would bring on severe inflation, disrupt the nation's payments mechanism, and eventually bring business activity to a halt, it is not surprising that modern governments have come to rely so heavily upon centrals banks as guardians of the quantity and value of their currencies. The Federal Reserve System operates almost daily in the financial markets in an attempt to control domestic price inflation in order to protect the purchasing power of the dollar at home, while occasionally intervening in foreign currency markets to protect the dollar abroad.
Stabilizing the money and capital markets
A second function of central banking is stabilization of the money and capital markets. The financial system must transmit savings to those who require funds for investment so that the economy can grow. If the system of money and capital markets is to work efficiently, however, the public must have confidence in financial institutions and be willing to commit its savings to tem. If the financial markets are unruly, with extremely volatile fluctuations in interest rates and security prices, or if financial institutions are prone to frequent collapse, the public´ confidence in the financial system might well be lost. The flow of capital funds would dry up, resulting in a drastic slowing in the nation's rate of economic growth and a rise in unemployment. All central banks play a vital role in fostering the mature development of financial markets and in ensuring a stable flow of funds through those markets.
Pursuing this objective, the Federal Reserve System will, from time to time, provide funds to major securities dealers when they have difficulty financing their portfolios so that buyers and sellers may easily acquire or sell securities. When interest rates rise or fall more rapidly than seems consistent with the nation's economic goals, the Fed will again intervene in the financial markets. The central bank may changes the rates it charges banks on direct loans or engage in securities trading in an attempt to moderate rate movements.
Lender of last resort
Another essential function of central banks is to serve as a lender of last resort. This means providing liquid funds to those financial institutions in need, especially when alternative sources of funds have dried up. For example, the Federal Reserve through its discount window will provide funds to selected deposit-type financial institutions, upon their request, to cover short-term cash deficiencies. As we will soon see, before the Fed was created, one of the weaknesses in the early financial system of the United States was the absence of a lender of last resort to aid to aid financial institutions squeezed by severe liquidity pressures.
Maintaining the payments mechanism
Finally, central banks have a role to play in maintaining and improving a nation´ payments mechanism. This involves the clearing checks, providing an adequate supply of currency and coin, and preserving confidence in the value of the fundamental monetary unit. A smoothly functioning and efficient payments mechanism is vital for carrying on business and commerce. If checks cannot be cleared in timely fashion or the public cannot get the currency and coin that it needs to carry out transactions, business activity will be severely curtailed. The result might well be large-scale unemployment and a decline in both capital investment and the nation's rate of economic growth.

Types of Hedging In The Financial Futures Market

There are basically three types of hedges used in the financial futures market today: (1) the long hedge, (2) the short hedge, and (3) the cross hedge. Cross hedges, as we will see, may be either long or short. Each types of hedge meets the unique trading needs of a particular group of investors. All three types have become increasingly popular as interest rates and security prices have become more volatile in recent years.
The long (or buying) Hedge
A long hedge involves the purchase of futures contracts today, before the investor must buy the actual securities desired at a later date. The purpose of the long hedge is to guarantee ("lock in") a desired yield in case interest rates decline before securities are actually purchased in the cash market.
As an example of a typical long-hedge transaction, suppose that a commercial bank, Life Insurance Company, pension funds, or other institutional investor anticipates receiving $ 1 million 90 days from today. Assume that today is April 1 and the funds are expected on July 2. The current yield to maturity on securities the investor hopes to purchase in July is 12.26 percent. We might imagine that these securities are long-term U.S. Treasury bonds, which appeal to this investor because of their high liquidity and zero default risk. Suppose, however, that interest rates are expected to decline over the next three months due to a recession. If the investor waits until the $1 million in cash is available 90 days from now, the yield on Treasury bonds may well be lower than 12.26 percent. Is there a way to lock in the yield available now even though funds will not be available for another three months?
Yes, if a suitable long hedge can be negotiated with another investor or trader. In this case the investor can purchase ("go long") 10 September Treasury bond futures contracts at their current market price. (Recall that Treasury bond futures are sold in $100,000 denominations.) Cash payment on these contracts will not be due until September. Suppose their price currently is 68-10, or $68,312.50 on a $100,000 face-value contract. Assume too that, as expected, bond prices rise and interest rates fall. At some later point the investor may be able sell the bond futures contracts at a profit, since prices on these contracts tend to rise along with rising bond prices in the cash market. Selling the bond futures contracts at a profit will help this investor offset the lower yields on Treasury bonds that will prevail in the cash market once the 1 million actually becomes available on July 2.
We note that on July 2 the investor goes into the spot market and buys $1 million in 8 percent, 20-year U.S. Treasury bonds at a price of 82-13. At the same time, the investor sells 10 September Treasury bonds futures contracts at 80-07. Due to higher bond prices (lower yields) in July, the investor loses $139,687.50, because the market price of treasury bonds has risen from 68-14 to 82-13. This represents an opportunity loss because the $1 million in investable funds was not available in April when interest rates were high and bond prices low. However, this loss is at least partially offset by a given in the futures market of $119,062.50, because the 10 September bond futures purchased on April 1st were sold at a profit on July 2. Over this period, bond futures contracts rose in price from 68-10 to 80-07. In effect, the investor will pay only $705,000 for treasury bonds bought in the cash market on July2. The market price of these bonds will be $824,062.50 (or 82-13) per bond, but the investor's net cost is lower by $119,062.25 due to a gain in the futures market.
The short (or selling) hedge
A financial device of growing popularity is the short hedge. This hedge involves the immediate sale of financial futures contracts until the actual securities must be sold in the cash market at some later point. Short hedges are especially useful to investors who may hold a large portfolio of securities which they plan to sell in the future but, in the meantime, must be protected against the risk of declining security prices. We examine a typical situation where a securities dealer might employ the short hedge.
Suppose the dealer holds $1 million in U.S. Treasury bonds, carrying an 8¾percent coupon and a maturity of 20 years. The current price of these bonds is 94-26 (or $948.125 per $1,000 par value), which amounts to a yield of 9.25 percent. However, the dealer is concerned because higher interest rates appear to be in the offing. Any upward climb in rates would bring about lower bond prices and therefore reduce the value of the dealer's portfolio. A possible remedy in this case is simply to sell bond futures contracts in order to counteract the anticipated decline in bond prices. For example, suppose the dealer decides to sell 10 Treasury bond futures contracts at 86-28, and 30 days later is able to sell $1 million of 20-year, 8¾ percent Treasury bonds at a price of 86-16 for yield of 10.29 percent. At the same time the dealer goes into the futures market and buys 10 Treasury bond futures contracts at 79-26 to offset the previous forward sale of bond futures.
The financial consequences of these combined trades in the spot and futures markets are offsetting. The dealer as lost $83,125 in the cash market due to the price decline in the bonds held. However, a gain of about $70,625 (fewer fees, commissions, and any tax liability) has resulted from the gain in the futures price. This dealer has helped to insulate the value of the portfolio from the risk of price fluctuations through a short hedge.
Cross hedging
Another approach to minimizing risk is the cross hedge- a combined transaction between the spot market and the futures market using different types of securities in each market. This device rests upon the assumption that the prices of most financial instruments tend to move in the same direction and by the same direction and by roughly the same proportion. Because this is only approximately true is any real-world situation, cross hedging does not usually result in forming a perfect hedge. Profits or losses in the cash market will not exactly offset losses or profits in the futures market. Nevertheless, if the investor's goal is to minimum risk, cross hedging is often preferable to a completely unhedged position.
As an example, consider the case of a commercial bank which holds good-quality corporate bonds carrying a face value of $5 million with an average maturity of 20 years. The bank's portfolio manager anticipates a rise in interest rates, which will reduce the value of the corporate bonds. Unfortunately, there is no futures market for corporate bonds, and therefore the portfolio manager cannot construct a prefect hedge involving these securities. However, futures contracts can be negotiated in U.S. Treasury bonds or even in Ginnie Mae passthroughs , providing either a long or a short hedge to offset the risk of a decline in the value of the corporate bonds.
To illustrate how such a cross-hedge transaction might take place, suppose that on January 2 the market value of the bank's corporate bonds is $3,673,437.50. This means that each $1,000 par value bond currently carries a market price of $734.6875 (or 73-15 on a $100 basis).the portfolio manager decides to 50 sell Treasury bond futures contracts at 81-20 (or $816.25 per $1,000 face value). About two and half months later, on March 14, interest rates have risen significantly. The value of each corporate bond has fallen to 64-13 (or $644.0625 per $1000 bond). At this point the Bank's portfolio manager decides to sell the bonds, receiving $3,220,312.50 from the buyer. This represents a loss on the bonds of $453,125.00. At the same time, however, the portfolio manager buys back 50 U.S. Treasury bond futures contracts at 69-20. The result is a gain from futures trading of 600,000. In this particular transaction the gain from futures trading more than offsets the loss in the cash market. Of course, this example of a cross hedge and the preceding example of long and short hedges are simplified considerably to make the fundamental principal of futures trading easier to understand. In the real world the placing and removal of hedges is an exercise requiring detailed study of the futures market and, in most cases, a substantial amount of trading experience.

Social consequences of the futures market

Not all observers agree that the futures market results in a net gain for society by helping financial institutions reduce risk and use scare resources more efficiently. Some analysts believe that the futures markets are largely speculative and not really geared for the hedging of risks per se. they see these markets as aimed principally at providing wealthy investors with a speculative outlet for their funds, and resulting in unnecessary risks due to excessive speculation. Some have argued that the futures markets increase the price volatility of those securities whose contracts are actively traded. If this is true, it would tend to make the impact of government economic policy, aimed at promoting high employment and low inflation, more difficult to predict. There is evidence from the commodities field that trading in futures tends to smooth out seasonal fluctuations, but only limited evidence exists to date as to the overall impact on the securities markets of contracts trading.
Certainly the more existence of the futures market and its continuing growth creates additional problems for regulatory authorities, especially those concerned with the regulation of financial institutions. Another market must be supervised and additional regulations prepared to cover new forms of risk and new fiduciary relationships. Some observers have expressed the fear that the futures markets substitute "gambling" with securities for "investing" in securities. If this view correct, it suggests a withdrawal of some risk-taking activity from the traditional securities markets and a redirection of this activity towards the futures market. To the extent that risk taking by securities investors is curtailed, this limits the flow of funds into venture capital and decreases the aggregate volume of investment in the economy. Other things equal, the economy's rate of growth is reduced.
On balance, the financial futures market probably has resulted in a modest net benefit to the financial system and to the economy. Those who support the development of this market have certainly overdramatized its positive features, alleging, for example, that interest rates tend to be lower and less volatile with a well-functioning futures market. There is little evidence that this is, in fact, the case. Regardless, it seems clear that the futures market has separated the risk of changing security prices and interest rates from the lending of funds, at least for those institutions actively participating in this market. The risk of price and yield changes is transferred to investors quite willing to assume such risks. The futures market has helped to reduce search costs and expand the flow of information on market opportunities for those who seek risk reduction through hedging. In this sense, the market tends to promote greater efficiency in the use of scare financial resources. Moreover, this developing institution has tended to unify many local markets into a national forward market, overcoming geographic and institutional rigities which tend to separate one market from another.
It should not be forgotten that futures trading is not without its own special risks. While the risk of price and yield fluctuations is reduced through negotiating a futures contract, the investor faces the risk of changing interest rates and security prices between the futures and spot markets. It is rare that gains and losses from simultaneous trading in spot and futures markets will exactly offset each other, resulting in a perfect hedge. Moreover, there are substantial brokerage fees for executing futures contracts, and required minimum deposits for margin accounts. To the extent that the futures market encourages speculation, does not fully offset all prices and interest-rates risks, and is characterized by substantial transactions costs, its net benefits to society will remain both limited and a subject of continuing controversy and close regulatory security.

Traders Active in The Future Market

A wide of financial institutions and individuals are active in futures trading today. The principal traders in financial futures are individuals and commodity pools. Commodity pools are like mutual funds, offering shares to the individual investor who regularly purchases futures contracts. Commodity pools offer the advantage of diversifying risk by trading in many contracts with varied maturities; in addition, they are professionally managed. the majority of commodity pools try to limit losses to the investor‘s original investment. Liquidating investor holdings rather than issuing margin calls. Combined, individuals and commodity pools held close to half of total open contract positions in 1979, and their share as been growing over time.
Firms and individual traders representing the future industry run a close second to individual investors and commodity pools, with open positions ranging from a fifth to about 35 percent of contracts outstanding, depending on the instrument being traded. many of these industry personal speculate on interest-rate movements or arbitrage between spot and futures markets, purchasing one contract and selling another in the expectation that interest rates on purchased contracts will decline more than (or rise less than) rates on contract sold. Alternatively, futures firms and industry traders will buy or sell futures contracts simultaneously with a sell or buy move in the spot market.
Financial institutions also play a prominent role in future trading, led by securities dealers, commercial banks, mortgages bankers, and savings and loans associations. Securities dealers appear to be less interested in risk reduction through hedging and more interested in profitable traders arising from correctly guessing the future course of interest rates and contract prices. Savings and loan associations and mortgage bankers, not surprisingly, are most involved in futures trading of GNMA mortgage-backed instruments. Rapid increases in long-term mortgage rates and volatile swings in the demand for new housing over the past two decades have brought substantial risk to the mortgage lending business. Under pressure from rising interest costs and deposit withdrawals, many savings and loan associations today have been forced to deeply discount and sell their old, low-yielding mortgage loans in the secondary market in order to raise funds. Losses incurred in the sale of old mortgages can be at least partially offset by trades executed in GNMA futures contracts. For their part, mortgages bankers frequently sell GNMA futures to hedge against interest-rate changes that may occur between the time mortgage loans are taken into their portfolios and the time they are sold in package to other investors.
The participation of savings and loan associations in futures trading was been a substantial boost in July 1981. The federal home loan bank broad (FHLBB), the industry ´s chief regulator, loosened the old rules, which limited the total volume of futures contracts an S&L could have outstanding at any one time to no more than the association's net worth position (normally about 5 percent of total assets). The new rules permit a savings and loan to hedge all of its assets if it so chooses. Trading may be carried out in any securities which a savings associations is legally entitled to hold. Many savings and loans sell GNMA futures to hedge the fixed-rate mortgages they hold on single-family homes. However, the new rules for futures trading set by the FHLBB allow savings associations to hedge on both the asset and liability side of the balance sheet and especially to offset the rapidly rising cost of deposits and nondeposit borrowings.
Participation by commercial banks in futures trading has been quite limited to date. Banks accounted for no more than 4 percent of all positions in the three most-active futures markets, according to a survey taken in March 1979. the survey, conducted by the Commodity Futures Trading Commission, found that only 24 banks held open positions in Treasury bill futures and only 14 carried positions in bond futures at that time. One major factor limiting commercial bank participation in the futures market is uncertainly over the attitude of the regulatory authorities, especially the Federal Reserve System and the Comptroller of the Currency. Another problem centers on the required accounting treatment of gains and losses from futures trading. Losses must be recognized immediately for tax purposes, while gains can be deferred. The result is volatile fluctuations in reported income for those banks active in futures trading. However, it is anticipated that bank participation in the futures market will expand significantly as the regulatory community becomes more comfortable with the hedging concept.

the future market for U.S. Treasury bonds and notes

the future market for U.S. Treasury bonds and notes is one of the most active markets for the forward delivery of an asset to be found anywhere in the world. Treasury bonds and notes are a popular investment medium for individuals and financial institutions because of their safety and liquidity. Nevertheless, there is substantial market risk involved with longer-term Treasury bonds and notes due to their lengthy maturities and relatively thin market. For example, Treasury bonds, which have original maturities stretching beyond 10 years, totaled only about $85 billion at year-end 1980, less than 10 percent of the total public debt of the United States and much less than half the volume of Treasury bills outstanding. Because the market for Treasury bonds is thinner than for bills, their price is more volatile, creating greater uncertainty for investors. Not surprisingly, then, Treasury bonds were among the first financial instruments for which a future market developed to hedge against the risk of price fluctuations.
Only those Treasury bonds which either have maturities of at least 15 years or cannot be called for at least 15 to 20 years from their date of delivery (depending on the exchange selected) are eligible for futures contracts. Moreover, all Treasury bonds delivered under futures contracts. Moreover, all Treasury bonds delivered under a futures contract must come from the same issue. The basic trading unit is $100,000(measured at par) with a coupon rate of 8 percent. Bonds with coupon rates above or below 8 percent are delivered at a premium or discount from their par values. Delivery of Treasury bonds is accomplished by look entry, and accrued interest is prorated. Price quotes in the market are expressed as a percentage of par values. The minimum price change which is recorded on published lists or in dealer quotations is one thirty-second of a point, or $31.25 per futures contract.
Contracts for U.S. Treasury notes and non-callable bonds with maturities of four to six years also are traded today. Like Treasury bond contracts, T-note contracts are priced as a percentage of their par (or face) value, based on an 8 percent coupon rate. The basic trading unit is $100,000 face value. Trading in Treasury note futures began at the Chicago Board of trade in June 1979, while Treasury bond contracts were first traded in August 1977

the informal over-the-counter market

The large maturity of securities bought and sold in the United States, especially debt securities are traded over-the-counter (OTC) and not on organized exchanges. The customer places a buy or sell order with a bank, broker, or dealer which is ten relayed via telephone, by wire, or by computer terminal to the particular dealer or broker with securities to sell or an order to buy. Each broker or dealer seeks the best possible price on behalf of himself or his customer, and the resulting competition to find the "best deal" brings together traders located hundreds or thousands of miles apart. The prices of actively traded securities respond almost instantly to the changing forces of demand and supply so that security prices constantly hover at or near competitive, market-determined levels.
All money market instruments are traded in the over-the-counter markets as are the large majority of government (federal, state, and local) bonds and corporate bonds. While most common stocks are traded on the exchanges, an estimated one quarter to one third of all stocks are traded OTC. The OTC Market is generally preferred by financial institutions, especially commercial banks, bank holding companies, mutual funds, and insurance companies, because in many cases their shares are not actively traded and OTC trading and disclosure rules are less restrictive. The presence of financial institutions tends to give the OTC market a more conservative tone than the exchanges.
Many dealers in the OTC market act as principal instead of brokers as on the organized exchanges. That is, they take "positions of risk" by buying securities outright for their own portfolios as well as for retail customers. Several dealers will handle the same stock so the customer can shop around. All prices are determined by negotiation with dealers acquiring securities at a bid price and selling them at an asked price. The OTC market is regulated by a code of ethics established by National Association of security Dealers, a private organization which encourages ethical behavior among its members. Trading firms or their employees who break NASD‘S regulations may be fined, suspended, or thrown out of the organization.
One of the most important contributions of NASD in recent years has been the development of NASDAQ-the National Association of security Dealers Automated Quotations System. Launched in 1971, NASDAQ displays bid and asked prices for thousands of OTC-traded securities on video screens connected electronically to a central computer system. All NASD-member firms trading in a particular stock report their bid-ask price quotations immediately to NASDAQ. This nation-wide communications network allows dealers, brokers, and their customers to determine instantly the terms currently offered by major securities dealers.

Limitations of the Liquidity preference Theory

Still, liquidity theory has important limitations. It is only a short-run approach to interest-rate determination because it assumes that income levels remain constant. In the longer run, interest rates are affected by changes in the level of income. Indeed, it is impossible to have a stable-equilibrium interest rate without also reaching an equilibrium level of income, savings, and investment. Then, too, liquidity preference considers only the supply and demand for money, whereas business, consumer, and government demands for credit clearly have an impact upon the cost of credit to these borrowers. A more comprehensive view of interest rates is needed which considers the important roles played by all actors in the financial system-businesses, households, and governments.

Securities Dealers Transactions

Trading among securities dealers and between dealers and their customers' amounts to billions of dollars a day. Average daily transactions in the U.S. government securities market were in excess of $13.1 billion in 1979. Indeed, so large is the government securities market that the volume of trading usually exceeds by four or five times the total volume of trading on the major U.S. stock exchange. The majority of traders by far are in treasury bills. It is also clear that government securities dealers trade heavily among themselves, usually trough brokers. Government security brokers do not take investment positions themselves but try to match bids and offers placed with them by dealers and other investors.
Dealerships are a cutthroat business where each dealer firm is out to maximize its returns from trading even if gains must be made at the expense of competing dealers, indeed, market analysts housed within each dealer firm study the daily price quotations of their competitors. If one dealer temporarily under prices some securities (I.e., offers excessively generous yields), other dealers are likely to rush in for a "hit" before the offering firm has a chance to correct its mistake. It is a business with little room for the inexperienced or slow-moving trader. Yet, as we have seen, the government securities dealers are essential to the smooth functioning of the financial markets and to the successful placement of billions of dollars in new U.S. government securities issued each year.

sources of Dealer financing

Where government security dealers do derives most of their funds to purchase and carry securities? Commercial banks are the largest single source of dealer funds, year in and year out. Indeed, half A dozen of the largest dealers are really dealer departments housed in some of the nation‘s largest banks. However, non-financial business corporations are the most rapidly growing source of funds for major securities dealers. Many industrial corporations. Today find the dealer loan market a convenient and safe way to dispose of temporarily idle monies. With wire transfer of funds between banks readily available, a company can lend a dealer millions of dollars in idle cash and recover those funds in a matter of hours if a cash emergency rears its head.

Dealer Positions in Securities

Dealer holdings of U.S. government and other securities are both huge and subject to erratic fluctuations. For example, during 1979, the roughly three dozen U.S. government security dealers held average daily positions of $3.2 billion in U.S. government securities and nearly $1.5 billion in the IOUs of various federal agencies. Three years earlier, in 1976, however, average daily dealer positions in U.S. government securities were more than double the average at almost $7.6 billion.
Why was there such a tremendous difference in the size of dealer portfolios during those years? Interest rates fell in 1976, creating ample opportunities for sizable dealer profits on securities held in long positions as market prices rose. In 1979, however, interest rates increased sharply, sending security prices downward. Fearing substantial losses, the dealers shifted out of long positions, especially in longer-term notes and bonds, and held mostly Treasury bills, whose prices are relatively stable. In fact, the dealers actually went short on 1-to-5-year and under-1-year government securities and held only nominal amounts of maturities exceeding 10 years

The Liquidity Premium View of The Yield Curve

the strong assumption underlying the unbiased expectations theory coupled with the real-world behavior of investors have caused many financial analysts to question the theory‘s veracity. securities dealers and analysts who trade actively in the financial markets frequently argue that other factors decides rate expectations also exert a significant impact on the character of the yield curve.
For example, in recent years most yield curves have sloped upward. Is there a built-in bias toward positively sloped yield curves due to factors other than interest-rate expectations? The liquidity premium view of the yield curve suggests that such a bias exists.
Longer-term securities tend to have more volatile market prices tan short-term securities. Therefore, the investor faces greater risk of capital loss when buying long-term financial instruments. To overcome this risk, it is argued, investors must be paid an extra return in the form of an interest-rate premium to encourage them to purchase long-term securities. This rate premium for the surrender of liquidity on longer-term issues, if it exists, would tend to give yield curves a bias toward an upward slope.
Why then do some yield curves slope downward? In such instances, expectations of declining interest rates plus other factors simply overcome the liquidity premium effect. The liquidity premium view does not preclude the important role of interest-rate expectations in influencing the shape of the yield curve. Even though expectations may be the dominant factor influencing the yield curve, however, other factors such as liquidity play an important role as well.
Moreover, the liquidity argument may help explain why yield curves tend to "flatten out" at the longest maturities. There are obvious differences in liquidity between a 1-year and 10-year bond, but it is not clear that major differences in liquidity exist between a 10-year bond and a 20-year bond, for example. Therefore, the size of the required liquidity premium paid to long-term investors may decrease for securities of the longest maturities

policy Implications of the expectations hypothesis

The expectations hypothesis has important implications for public policy. The theory clearly implies that changes in the relative amounts available of long-term versus short-term securities do not influence the shape of the yield curve unless investor expectations also are affected. For example, suppose the U.S. Treasury decided to refinance $100 billion of its maturing short-term IOUs by issuing $100 billion in long-term bonds. Would this government action affect the shape of the yield curve? Certainly, the supply of long-term bonds would be significant increased, while the supply of short-term securities would be sharply reduced. However, according to the expectations theory, the yield curve itself would be unchanged unless investors altered their expectations about the future course of short-term interest rates.
To cite one more example, the Federal Reserve System buys and sells U.S. government and federal agency securities almost daily in the money and capital markets in order to promote the nation‘s economic goals. Can the Fed influence the shape of the yield curve by buying one maturity of securities and selling another? Once again, the answer is no, unless the Federal Reserve can influence the interest-rate expectations of investors. Why? The reason lies in the underlying assumption of the unbiased expectations hypothesis: investors regard all securities, whatever their maturity, as perfect substitutes. Therefore, the relative amounts of long-term bonds versus short-term securities simply should not matter to investors

Bank Loans to Business

Commercial banks are direct competitors with the corporate note and bond markets in making both long-and short-term loans to business. At year-end 1980 total commercial and industrial loans extended by banks reached $330 billion, accounting for 35 percent of all loans granted by commercial banks operating in the United States. Business loans are the single largest asset item at most banks, regardless of their size. Moreover, commercial banks grant their loans to a wide variety of firms covering all major sectors of the business community.
In recent years the Federal Reserve Board as carried out surveys of business lending practices by banks across the United States. The Federal Reserve Survey indicates that bank loans to business firms tend to be short-term or medium-term maturity. For example, short-term commercial and industrial loans averaged just less than four years. Moreover, the short-term loans-which are used principally to purchase inventories, pay wages and salaries, and meet other current expenses-average considerably larger at most banks than long-term business loans, which are taken out mainly to purchase equipment and expand physical facilities.
The Federal Reserve survey suggests that longer-term business loans tend to carry higher average interest rates than shorter-term businesses loans. this is due, in part, to the greater risk associated with long-term credit, Moreover, yield curves have usually sloped upward in recent years, calling for higher average rates on long-term loans. especially interesting is the high proportion of business loans today which carry floating rather than fixed interest rates, the larger and longer-term a business loan is, the more likely its rate will float with market conditions. For example, just 35 percent of the sort-term business loans included in the August 1980 Federal Reserve Survey of U.S. banks carried floating interest rates, while almost twice as many of the long-term business loans-68percent-had floating rates. Clearly, banks become more determined to protect themselves against unexpected inflation and other adverse development through floating interest rates as the maturity and average size of a business loan increases.

Moody's Investor Service

Beginning in 1909, John Moody developed and published a simple system of letter grades which indicated the relative investment quality of corporate bonds. Today, Moody‘s Investor service rates thousands of issues of corporate and municipal bonds, commercial paper, short-term municipal notes, and preferred stock. these security ratings are reported in Moody‘s Bond Record, which is published monthly. In addition to assigning issue ratings, Moody‘s also notes for its subscribers the essential terms on each security issue; dates when interest, principal, or dividend payments are due; call provisions (if any); regulation status; bid and asked price quotations; yield to maturity; tax status; coverage; and amount of securities outstanding.

Factors Affecting Assigned Ratings

each rating assigned to a security issue is a reflection of at least three factors:(1) the character and terms of the particular security being issued;(2) the probability that the issuer will default on the security and the ability and willingness of the issuer to make timely payments as specified in the indenture (contract) accompanying the security; and (3) the degree of protection afforded investors if the security issuer is liquidated, reorganized, and\or declares bankruptcy. As a matter of practice, the investment agencies focus principally upon: (1) the past and probable future cash flows of the security issuer as an indication of the institution‘s ability to service its debt; (2) the volume and composition of outstanding debt; and (3) the stability of the issuer‘s cash flows over time. Other factors influencing quality ratings are the value of assets pledged as controlled for a security and the Security‘s priority of claim against the issuing firm‘s assets. Quality analysts also place heavy emphasis upon interest-coverage ratios and liquidity of the issuing firm.
The rating agencies stress that their evaluations of individual security issues are not recommendations to buy or sell or an indication of the suitability of any particular security for the investor. The agencies do not act as financial advisers to the businesses or units of government whose securities they rate, which helps to promote objectivity in assigning quality ratings. Both domestic and foreign securities are rated using the same criteria

What are Credit Ratings?

Corporate and municipal debt securities sold in the financial markets today generally must carry a credit rating assigned by one or more rating agencies. the two widely respected credit-rating agencies in the U.S. are Moody‘s Investor Service and Standard and Poor‘s Corporation, both headquartered in New York City. The ratings assigned by these private companies are generally regarded in the investment community as an objective evaluation of the probability that a borrower will default on a given security issue.
Default occurs whenever a security issuer is late in making one or more payments that it is legally obligated to make. In the case of a bond, when any interest or principal payment falls due and is not made on time, the bond is legally in default. While many defaulted bonds ultimately resume the payment of principal and interest, others never do, and the issuing company winds up in bankruptcy proceedings. In most instances, holders of bonds issued by a bankrupt company receive only pennies on each dollar invested, once the company‘s assets are sold at auction. Thus, the investor who holds title to bankrupt bonds typically loses both principal and interest. It is no wonder, then, that security ratings are so closely followed by investors. in fact, many investors accept the ratings assigned by credit agencies as a substitute for their own investigation of a security‘s investment quality.

Money Market Indicators

while control of the money supply and reserves are now the principal focus of central bank policy-making in the U.S., the Fed also keeps close watch on conditions in the nation‘s financial markets, especially the cost and availability of credit in the money market. Indeed, there is evidence that the Federal Open Market Committee also sets target levels or ranges for the interest rate on federal funds loans. One reason is tat the Fed is charged with the responsibility for stabilizing conditions in the financial markets to assure a smooth flow of funds from savers to investors. In addition, it must ensure that the government securities market functions smoothly so that adequate supplies of credit are available to dealers and the federal government can market its billions of dollars in debt securities without serious difficulty. This is a burdensome responsibility because the Treasury is in the market every week refunding and offering new bills, and both the Treasury and several federal agencies sell billions of dollars worth of notes and bonds each quarter of the year.

The Federal Reserve Statement

One of the most widely followed indicators of what the Federal Reserve System is doing to influence conditions in the financial markets and the economy is known as the Federal Reserve Statement. It is published each week in the financial pres and lists the factors which supply reserve to depository institutions and those which absorb reserves. The total amount of reserves held by depository institutions at any time equals the difference between the factors supplying reserves and the factors absorbing reserves. The Federal Reserve Statement shows levels of each reserve-supplying or reserve-absorbing factor for the current and previous month or week and any changes between the two time periods. It is the changes in each reserve factor that analysts concentrate upon in attempting to understand what the Federal Reserve is trying to accomplish in the financial marketplace.

the limitations of monetary policy

In additions to conflicts among the nation‘s economic goals, the Federal Reserve finds that it cannot completely control financial or the money supply. Changes in the economy itself feed back upon the money supply. It becomes exceedingly difficult, especially on a weekly or monthly basis, to sort out the effects of monetary policy from the impact of broad economic forces.
Moreover, until recently the Fed has received little cooperation from Congress in the pursuit of effective taxing and spending programs. Most economists agree that fiscal policy- the taxing and spending activities of the federal government-can have a potent impact upon economic conditions. Unfortunately, changes in tax rates and federal spending programs require the cooperation of the both the executive and legislative branches of the government. This kind of cooperation between Congress and the president has only just begun to surface. with the exception of recent tax and spending cuts by the Reagan administration, the Federal Reserve System as been forced to carry the burden of anti-inflation policy almost totally alone. Under these circumstances, we should not be too surprised that the Fed‘s past tract record leaves much to be desired.