Instruments of the money market

The key instruments of the money market include treasury bills, tax-anticipation bills, treasury notes, federal agency issues, negotiable certificates of deposit, commercial paper, banker's acceptances, money market mutual funds, and repurchase agreements. These marketable securities will be described in next topic. It is important for you to a general understanding of the key characteristics of these instruments. One characteristic common to all is liquidity. The annual rate of return, or yield, on these securities reflects directly the "tightness' or "looseness" of money. Difference in return between various instruments result from the different degrees of risk associated with the issuers. Although the list of securities given above is not all-inclusive, it does contain the key money market instruments available to the corporate purchaser. The only instrument actually issued by a nonfinancial corporate business is commercial paper.

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.

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.

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.

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.

policy Implications of the segmented-markets theory

The segmented-markets theory, like the expectations theory, has significant implications for public policy. If markets along maturity spectrum are relatively isolated from each other due to investor preferences, government policy makers can alter the shape of the yield curve merely by influencing supply and demand conditions in one or more market segments.
For example, if a positively sloped yield curve were desired, with long-term interest rates higher than short-term rates, the Treasury and the central bank could flood the market with long-term bonds. Simultaneously, the government could purchase large quantities of short-term securities. The expanded supply of bonds would drive long-term rates higher, while purchases of short-term securities would push short-term down, other factors held equal. Therefore, government monetary and debt-management policies could alter the shape of the yield curve.

The Federal Reserve‘s Discount Rate

The discount rate is the interest rate charged by the Fed on loans of reserve secured by U.S. government securities or other acceptable collateral. In reality, there are four different discount rates. The cheapest rate applies to loans (advances) for short-term liquidity adjustment or seasonal needs secured by U.S. government securities or high-grade commercial ("eligible") paper. In the summer of 1981 this rate was 14 percent. A slightly higher interest rate is levied against discount window loans secured by collateral of lesser quality. In times of national emergency, the Fed may also extent credit to individuals, partnerships, and even nonfinancial corporations, but the interest rate is much higher on such loan.
An interesting development occurred in 1981 when the Fed imposed a penalty rate on borrowing by the nation‘s largest depository institutions. Effective May5,1981, a 4 percent surcharge was applied to short-term borrowings by financial institutions holding total deposits of 500$ million or more when these institutions attempted to borrow in successive weeks or in more than four weeks in a calendar quarter. Because the discount rate was we below interest rates on federal funds, CDs, and other popular sources of reserves, many large banks were using the window to support their lending operations, contributing (in the Federal Reserve‘s opinion) to inflationary pressures. The 4 percent surcharge brought the cost of Fed loans closer to open-market rates and encouraged larger banks to look elsewhere for funds.
The individual Federal Reserve banks often recommend that the discount rate be changed; however, a change in that rate must be approved by the Federal Reserve Board in Washington, D.C. In recent years the Fed has lived a higher interest rate for emergency borrowings when a bank is in serious financial trouble. Large, continuous borrowings over a prolonged period of time may be approved at a rate of 1 to 2 percent above the regular Federal Reserve discount rate.

Restrictions on Federal Reserve Credit

Large money-center banks are heaviest users of the discount window since they incur reserve deficits most frequently. However, less than 10 percent of all institutions eligible regularly borrow from the Federal Reserve System, despite the fact that it often the cheapest source of reserves. In part, this is due to an uneasy feeling experienced by most bankers about being in debt to a government regulatory agency. then too, the Fed‘s own regulations discourage heavy and frequent use of the window. for example, Federal Reserve officials stress that borrowing is a "privilege, not a right" and that no depository institution should come to rely upon Federal Reserve Credit. Borrowing institution are required to alternate between the window and other money market sources, especially Federal funds.

Mechanics of federal fund trading

The Mechanics of federal fund trading vary depending upon the locations of the buying (borrowing) and selling (lending) institutions. For example, suppose two commercial banks involved in a Federal funds transaction are located in the heart of the New York money market. These banks can simply exchange checks. The borrowing bank is given a check drawn on the lending bank‘s reserve account at the Federal Reserve Bank of New York or drawn on a correspondent balance held at some other bank in New York City. This check is payable immediately ("same day money"), and, therefore Fed funds are transferred to the borrower‘s reserve account before the close of business that same day. The lender, on the other hand, receives a check drawn on the borrower. This check is "one-day money" (i.e., payable the following day) because it must pass through the New York Clearing House for proper settlement. thus, funds flow instantly to the borrowing bank‘s reserve account and are automatically returned to the lending bank‘s reserve account the next day or whenever the loan agreement terminates.
Interest on the loan may be included when the funds are returned, paid by separate check, or settled by debiting and crediting correspondent balances. If the transacting institutions are not both located within the New York Federal Reserve District, the loan transaction proceeds in much the same way except that two Federal Reserve banks are involved. Once borrower and lender agree on the terms of a Federal funds loan, the lending institution will directly, or indirectly through a major correspondent bank, contact the Federal Reserve Bank in its district, requesting a wire transfer of funds. the Federal Reserve bank then merely transfer reserves trough the Fed‘s wire network to the Federal Reserve bank serving the region of the country where the borrowing institution is located. Funds travel the reverse route when the loan is terminated.

The Nature of Federal Funds

The name of federal funds came about because early in the development of the market principal source of immediately available money was the reserve balances which member banks keep at the Federal Reserve Banks. If one member bank needs to transfer funds to another, it need only contact the Federal Reserve Bank in its district, and money is transferred into the appropriate reserve account- a transaction accomplished in minutes or seconds by computer.
Today, however, the fed funds market is far broader in scope than just reserves on deposit with the Federal Reserve banks. For example, virtually all banks maintain deposits with large correspondent banks in the principal U.S. cities, and these deposits may be transferred readily by wire from the account of one bank to that of another. Savings and loan associations, credit unions, and mutual savings banks maintain deposits wit commercial banks that also are available for immediate transfer to a customer or to another financial institution. Because corporations and state and local governments can lend Federal fund by executing repurchase agreements with securities dealers, banks, or other funds traders. Securities dealers who have received payment for securities sold can turn around and make their funds immediately available to borrowers through the federal fund market. Borrowers of Federal funds include securities dealers, corporation, state and local governments, and nonbank financial intermediaries, such as savings and loan associations and insurance companies. Without question, however, the most important of all borrowers in the Fed funds market are commercial banks, which use this instrument as the principal way to adjust their legal reserve positions.

selective credit controls used by the Fed

The discount rate, reserve requirements, and open-market operations are often called general credit controls because each has an impact on the whole financial system. There is another set of policy tools available to the Federal Reserve; however that is more selective in its impact, focusing upon particular sectors of the economy. Nevertheless, use of these selective tools does contribute toward the overall objectives of the Fed to minimize unemployment, stabilize prices, sustain economic growth, and protect the nation‘s international payments position.

Money market maturities

Despite the fact that money market securities cover a narrow range of maturities-one year or less-there are maturities available within this range to meet just about every short-term cash and investment need. We must distinguish here between original maturity and actual maturity, however. The interval of time between the issue date of a security and the date on which the borrower promises to redeem it is the security‘s original maturity. Actual maturity, on the other hand, refers to the number of days, months, or years between today and the date the security is actually redeemed or retired.
Original maturities on money market instruments range from as short as one day on many federal funds transactions and loans to security dealers, out to a full year on some Eurodollar deposits, Banker‘s acceptances, bank certificates of deposit, and U.S. Treasury bills. Obviously, once a money market instrument is issued, it grows shorter in actual maturity every day. Because there are thousands of money market securities outstanding, some of which reach maturity each day, investors have a wide menu from which to select the precise number of days they need to invest cash.

Dealer Loans and Repurchase Agreements

The money market depends heavily upon the buying and selling activities of securities dealers to move funds from cash-rich units to those with cash shortages. About three dozen primary dealers in United States government securities trade today in both new and previously issued Treasury bills, bonds, and notes. Many of these dealers also buy and sell other money market instruments, such as commercial paper, CDs, and bankers‘acceptances. They are the principal points of contact with the money market for thousands of individual and institutional investors and are essential to the efficient functioning of that market.
While the dealers supply a huge volume of securities daily to the financial market, they also depend heavily upon the money market for borrowed funds. Most dealer houses invest little of their own equity in the business. The bulk of dealer operating capital is obtained through borrowings from commercial banks, nonfinancial corporations, and other institutions. A major dealer firm carries hundreds of million of dollars in securities in its trading portfolio, with 90 percent or more of that portfolio supported by short-term loans, some carrying only 24-hour maturities.
the two most heavily used sources of dealer funds are demand loans from the nation‘s largest banks and repurchase agreements (RPs) with banks and other lenders. Every day, the major New York banks post rates at which they are willing to make short-term loans to dealers. Generally, one rate is quoted on new loans and a second (lower) rate is posted for renewals of existing loans. A demand loan may be called in at any time if the banks need cash in a hurry. Such loans are virtually riskless, however, since they usually are collateralized by U.S. government securities, which may be transferred temporarily to the lending bank or its agent

Risk in the Money and Capital Markets (2)

Financial claims issued by demanders of funds also differ greatly in their degree of risk due to fluctuations in market price- money risk. For example, most short-term money market securities are quite stable in price, holding their value well even in periods of considerable economic turmoil and uncertainty. In contrast, long-term capital market securities frequently experience large price fluctuations due to changing economic conditions, political developments, and so on. Some securities are more easily marketed than others, and there are vast differences in maturity. For example, all U.S. Treasury bills mature within a year. In contrast, most home mortgages and many corporate bonds carry original maturities of 20 to 39 years. While, in theory at least, the financial markets are one vast pool of funds, quite clearly the financial system is divided into many segments, each with special features. .