(OTC) market - does not have a physical location. Instead, dealers and brokers are
connected together by telephones and computers. Either new or small firms are likely to be
traded in the over-the-counter market. The largest OTC market is the National Association
of Securities Dealers' Automated Quotation, otherwise known as NASDAQ. NASDAQ is very
popular, because many new high-tech firms started in this market, such as Microsoft.
Investment institutions are made up of:
Mutual funds - pool together
funds from many people into a fund, and invest the money in a variety of stocks. This
method allows the diversification of stocks, and lowers investors' risk.
For example, you started your own mutual fund and
offer investors a chance to invest in this fund. You take the money and buy 30 different
corporate stock. The Coca-Cola stock may go up one day, while the value of my IBM stock
goes down. Overall the average of the fund's 30 stock will probably earn a return to your
fund and to the fund investors. If you bought only one type of corporate stock, like Apple
Computers, you will loose your investment if this company bankrupts.
The most well-known mutual fund companies
are Fidelity, Vanguard, and Dreyfres. Mutual fund companies have different strategies and
characteristics. The mutual fund companies may only buy stock in certain industries, large
companies, or foreign company stock.
Closed-end mutual funds - the
mutual fund company may issue a fixed number of shares to the fund. Then, investors may
buy and sell these shares in over-the-counter markets, just like stock. The mutual fund
company does not buy shares back for closed-end mutual funds.
Open-ended mutual funds - the
mutual fund company will buy back shares to the fund and the price of the shares is tied
to the value of the stock in the fund.
Mutual fund managers are paid in two ways.
No-load funds - the managers
of the fund charge management fees, which are usually 0.5% of assets.
Load funds - the fund
managers charge a commission for selling or purchasing of shares.
Money market mutual funds are
very similar to mutual funds. However, the fund manager buys only money market financial
instruments and does not buy corporate stock. The theory behind money market mutual funds
are simple. If you have five friends with $2,000 each who want to buy a Treasury bill and
the minimum face value of a Treasury bill is $10,000, then your friends can pool their
money together and buy one T-bill. When the T-bill matures, your friends split the
interest among them.
Money market mutual funds are very
popular, because these funds offer check writing privileges. The value of the fund does
not change much, when interest rates changes. In 1998, money market mutual funds had
assets of $1,154 billion. There is another financial instrument that is exactly identical
to money market mutual funds. They are called money market deposit accounts
and are offered by commercial banks. The only difference between these two fund are money
market deposit accounts are insured by the federal government, while money market mutual
funds are not insured. If your bank bankrupts and you invested in money market deposit
accounts, you will get your money back from the federal government.
Finance companies - raise
money by selling stock, bonds, and commercial paper. Commercial paper is short-term loans
issued by well-known banks and corporations for a maximum maturity of 270 days. Commercial
paper is a form of direct finance and has no collateral. Finance companies make loans to
consumers, so they can buy furniture, appliances, cars, home improvement loans, or the
loan can be to a small business. Some corporations have started their own finance
companies that help consumers buy their product. For example, General Motors Acceptance
Corporation lends money to people, so they can buy cars from General Motors.
Contractual saving institutions
are the third type of financial institutions and include:
Insurance companies - provide
protection for people who buy insurance policies. The insurance policy prevents financial
hardship that results from a medical emergency, car accident, or the death of a family
member. Insurance companies are financial intermediaries, because they link the funds from
the policy holders to the financial markets. The policy holders will make periodical
payments to the insurance company called premiums. The insurance company
will invest the premiums in the financial markets. For the insurance company to earn a
profit, the amount of interest earned in the financial markets plus the total amount of
premiums have to be greater than the amount paid for claims. The largest insurance
companies are Allstate, Aetna, and Prudential. Most states established commissions that
regulate insurance companies. The commissions may limit premiums, minimize fraud, and
prevent the insurance companies from investing in risky securities.
Law of large numbers - insure
a large number of people. On average, statisticians can accurately predict how much the
insurance company will pay out in claims, because on average the death, illness, injury,
and property damage can be accurately predicted. Statisticians do not know which specific
individuals will experience hardship, but they can predict how often it occurs.
Adverse selection - is a
problem for insurance companies. It occurs when the person buying insurance has more
information than the insurance company. For example, a person knows he has a heart problem
and decides to buy a very large life insurance policy. T
Moral hazard - is another
problem. It occurs when the person buying insurance becomes more careless. For
example, a person buys theft insurance for his home and this person stops locking his
windows and doors when he leaves, increasing the risk that his home will be
Insurance companies lower these problems by:
Risk-based premium - gather
information about the policy holders, such as driving records, medical records, and credit
histories. The insurance company will charge a higher premium to a person who is more
likely to make claim.
Deductible - when a person
makes a claim, this person is responsible for the first $500. This passes some of the
responsibility to the person holding the insurance policy.
Life insurance companies -
tend to purchase long-term corporate bonds and commercial mortgages, because they can
predict with high accuracy future payments. Insurance companies are organized in two ways.
Mutual company - are owned by
the insurance policy holders. The insurance policy functions as corporate stock.
Stock company - these
companies issue stock. The insurance policy holders do not own these companies, the
shareholders do. The stock company is more popular, because the company can raise more
funding. They receive funding from stockholders by selling stock and receive funding from
selling insurance policies.
Most polices issued are called term life policies. The person buying the life
insurance has to pay the premium for the rest of his life. These policies are popular,
because the policyholder can borrow against the value of the life insurance policy, when
he retires. This is called annuities. Annuities pay a retired person a
specific amount of money each year.
Property and casualty insurance
companies - can be organized as a stock or mutual companies and insure
against theft, illness, fire, earthquakes, and car accidents. These companies tend to
purchase highly liquid, short-term assets, because these companies cannot accurately
predict the amount of future claims. The premiums that are charged correspond to the
chance of the event occurring. For example, a homeowner in California will pay a higher
premium for earthquake insurance than a homeowner in the Midwest of the United State,
because California has more earthquakes.
Pension funds - pension funds
are the most important form of saving for people. People save for retirement in two ways:
Pension funds sponsored by employers or through personal savings accounts.
Pension funds are managed by financial companies and the pension funds are invested in the
financial market. The pension fund managers can accurately predict when people will retire
and usually invest in long-term securities, such as stocks, bonds, and mortgages. A person
can only receive benefits from the pension fund if the person is vested.
Vesting is the time period required for a person to receive participate in the pension
plan. The time period varies for the pension fund. Some city governments require a person
to be employed by the city for 10 years before this person is 100% vested in the city's
pension plan. Employers prefer to offer pension plans to employees for three reasons.
Pension fund managers can more efficiently
manage the fund, lowering the pension funds' transaction costs.
The pension funds may offer benefits such
as life annuities. Life annuities could be more expensive if the retire person bought them
The pension fund is not taxed. If the
employer offered higher wages and no pension plan to the employees, these wages are taxed.
Defined contribution plan -
the employees own the value of the funds in the pension plan. If the pension fund is
profitable, retired employees will receive higher pension income. If the pension fund is
not profitable, then the retired employees will receive a low pension income. Companies
that have a defined contribution plan like to invest the pension funds into the companies'
own stock. That way, employees have an incentive to be more productive, because the value
of their pension plan depends on their company's profitability.
Defined benefit plan - the
most common type of plan and an employee is promised a specific amount of benefits based
on the employee's earnings and years of service to the company. If this pension fund is
profitable, the company pays the promised benefits and keeps the remaining funds from the
pension plan that is not paid to the employee. If the pension fund is unprofitable, the
company has to pay the promised benefit out of its own pocket.
401(k) plans - a
recent trend in pension funds allows the employees to manage their own pension plans.
(401(k) is a section of law in the Internal Revenue Service's regulations). The benefit of
this pension plan is the employee can take his pension plan with him when he finds a new
job. There is one risk. The amount of money a person has at retirement depends how much
money he invested in the plan and how well the investments have done.
The pension funds are regulated by federal
and state governments. The regulations require the managers of the pension funds to
disclose all investment. That way, employees know which securities the pension fund is
invested in. The regulations prevent fraud and mismanagement. Many pension funds will
bankrupt, when the companies where the employees work bankrupt. Congress created the
Pension Benefit Guaranty Corporation, which insures pension fund benefits up to a limit if
the company cannot meet its obligations. Some economists believe a pension fund disaster
Depository institutions are intermediaries and link savers to borrowers.
Commercial banks - accept
deposits from the public. Many depositors prefer to put their savings in a bank than
directly into the financial markets, because of three reasons: Liquidity, lower
investment risk, and bank collects information about borrowers more efficiently.
Many borrowers seek bank loans, because it
costs too much to issue stock or bonds. To issue stock and bonds, the company has to
follow SEC regulations and pay commissions to the investment bankers. For a small loan of
$500,00 and less, these fees can average 20% of the loan.
Savings institutions -
originally, these institutions would take deposits and only would lend for home mortgages.
These institutions provided low-cost financing for home buyers. During the 1980s and
1990s, many savings institutions experienced financial crisis, because of higher interest
rates. For example, if you borrowed $10,000 at 5% interest rate and loaned it out at 10%,
you can earn a profit. If you borrowed $10,000 at 10% interest rate and loaned it out at
5%, you will earn a loss. This is what happened to the saving institutions. During the
1980s, the interest rates rose, so the savings institutions had to pay a greater interest
rate to the depositors than what these institutions were earning on the mortgages.
Mortgages are usually 30-year loans and these loans were locked into low interest rates
from the 1960s.
Credit unions - are very
similar to commercial banks except membership is restricted. Membership is only extended
to people who share a common interest, usually the people work for a particular company or
industry. For example, many states have credit unions for school teachers. These
institutions will only allow school teachers to open accounts. Originally credit unions
offered savings deposits and made consumer loans for cars and boats. Now, credit unions
are very similar to banks and offer the same services, such as checking accounts and
mortgages. There is conflict between commercial banks and credit unions, because a credit
union's profit is not subjected to income taxes. The commercial banks want credit unions
on equal grounds.
Government Financial Institutions
The U.S. government can lend funds to the public in two ways.
- the U.S. government sells bonds and commercial paper to investors in the financial
markets. The U.S. government will take the investors' money and lend to borrowers
Farm Credit System - a U.S. government
agency, lends to farmers. The loans can be for crops, equipment, or mortgage loans.
Sallie Mae - the U.S. government lends
money to students who are pursuing an education. The agency is the Student Loan Market
Association, otherwise known as "Sallie Mae." This agency may lend directly to
students or buy their student loans from banks.
Loan guarantees -
this is really a form of insurance. For example, a bank can lend to a student for an
education and the Department of Education will guarantee the loan. If the student
defaults, the U.S. Department of Education pays for the loan.
- some people do question the federal government's role in financing. When the federal
government directly grants loans, the government is squeezing the financial institutions
out of the loan market. Also, federal government loan guarantees may increase the problem
of moral hazard. The financial institutions receiving the loan guarantees may not screen
borrowers as much, granting loans to borrowers with high risk of default. In the 1990s,
the loan guarantees were about $100 billion. If many borrowers started defaulting on their
loans, the federal government will have large losses.