1 u.s. financial regulation online economic seminars last update: october 7, 2009

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U.S. Financial RegulationU.S. Financial Regulation

Online Economic SeminarsOnline Economic Seminars

www.econseminars.comwww.econseminars.com

Last Update: October 7, 2009Last Update: October 7, 2009

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Part 1Part 1

Depository Financial Depository Financial Institutions:Institutions:

Commercial BanksCommercial Banks

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Overview of Banking Regulation

¶ Regulatory Goals and Tools

“Reserve Requirements” To ensure sufficient liquidity to convert notes (now deposits) into Specie (now notes), thereby avoiding bank runs

”Capital Requirements” To ensure sufficient capital to allow banks to survive declines in asset prices

”Interbank Relations Rules” To ensure competition among banks and between banks and other institutions • Rules on Mergers and New Bank Formation • Rules on Deposit Interest Rates

”Interindustry Relations Rules” to ensure that combinations between bank and non-bank companies do not weaken banks

”Asset Allocation Rules” To ensure diversification

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Fractional Reserve Banking

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First Bank of the United States (1791 – 1811)

¶ Formation

Private Bank Formed By Congress With 20 Year Term

Advocated By Alexander Hamilton, First Treasury Secretary And Leading Federalist (Democrat) Under Washington Opposed By Jefferson, Madison And Most Republicans

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First Bank of the United States (1791 – 1811)

¶ Functions

Manage State War Debts Recently Assumed By New Federal Government

Establish The Public Credit Of The U.S.

Provide Strong Central Currency As Alternative To State Banks Act As Federal Fiscal And Monetary Agent • Receive Federal Tax Deposits And Make Payments • Manage U.S. Mint’s Minting of Coin And Purchase/Sale of Specie

Act As Private Bank • Make Loans (Excluding Loans to Federal Government) • Issue Bank Notes Convertible Into Specie and Legal Tender For Federal Tax Payment

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First Bank of the United States (1791 – 1811)

¶ Financing The Bank

$10 Million Capitalization

• $2 Million From U.S. Treasury - 100% Borrowed From Bank

• $8 Million From Private Sources - 25% ($2M) Payable In Specie - 75% ($6M) Payable In Treasury Bonds and Scrip ¶ Revenue Sources

Investment And Loan Portfolio Customs Excise Taxes Tax On Whiskey Sales

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First Bank of the United States

¶ Opposition To First Bank, Primarily In The South

Agricultural States Viewed The Bank As • A Tool Of Northern Commercial Interests • A Source Of Weakened Southern Banks • A Source Of Tighter Farm Credit • An Infringement On States’ Rights

South Objected To The Excise Tax On Alcohol Used To Finance The Bank’s Interest Payments On States’ Debts • Whiskey Was “A Necessity of Southern Life” • Controversy Led To Shay’s Rebellion (“The Whiskey Rebellion”) in 1794

¶ Charter Allowed To Expire In 1811 (Under Madison)

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Second Bank of the United States (1816 – 1836)

¶ Formation

Private Bank Formed By Congress With 20 Year Term Advocated By The Democrats (Federalists) With Madison, A Republican, As President ¶ Functions Manage War Of 1812 Debts Provide Strong Central Currency As Alternative To State Banks Act As Federal Fiscal And Monetary Agent • Receive Federal Tax Deposits And Make Payments • Manage U.S. Mint’s Minting of Coin And Purchase/Sale of Specie Act As Private Bank • Make Loans Including Loans to Federal Government • Issue Bank Notes Convertible Into Specie and Legal Tender For Federal Tax Payment

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Second Bank of the United States

¶ Opposition To Bank Was Primarily In The South

Agricultural States Viewed The Bank As

• A Tool Of Northern Commercial Interests • A Source Of Weakened Southern Banks • A Source Of Tighter Farm Credit • An Infringement On States’ Rights

In Early Years Bank Was Haunted By Corruption

• Loans To Political Supporters • Nicholas Biddle Became President In 1822 And Ended Corrupt Practices

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Second Bank of the United States

¶ Andrew Jackson Was Strong Opponent

Objected To Elite Central Institution Not Responsible To “The People”

Attempted To End Bank In 1832 By Transferring Federal Deposits To State Banks; Congress Over-Ruled

Bank Became Pawn In Jackson-Clay Presidential Campaign

Bank Charter Allowed To Expire n 1836

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The “Free Banking” Era (1836 – 1863)

¶ State Banking

All Banks Chartered And Supervised By States

State Supervision Focused On • Capital Requirements • Bank Note Reserve Requirements (Usually Specie Plus Eligible Paper)

¶ Era Of Frequent Bank Failures

General Relaxation Of Capital And Reserve Requirements

Banks Chose To Charter In Easy States

Southern Agricultural Banks Most “At Risk” • Agricultural PricesVolatility and Weak Supervision

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The National Banking Act Of 1863 (Dual Banking)

¶ Established Federally-Chartered Banks

Civil War Took Southern Opponents To “National” Banking Out Of Congress

Office Of The Comptroller Was Created To Supervise National Banks

Federally-Chartered Banks Tended To Have Weak Capital Requirements But Strong Reserve Requirements To Maintain Convertibility

• Reserve Requirements Could Be Satisfied By Holding Treasury Securities, Thereby Enhancing War Finance

• National Banks Were Required To Accept Each Others ‘ Notes At Par

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The National Banking Act Of 1863 ¶ Congress Actively Favored National Banks

Levied A 10% Tax On Notes Of State Banks, Effectively Driving State Bank Note Issuance Out Of Existence

• State Banks Responded By Shifting Issuance From Notes To Deposits

The Act Prohibited Interstate Banking

• State Banks Could No Longer Shop For Favorable Charters

• State Banks Declined Significantly In Importance

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The National Banking Act Of 1863 ¶ The Act Did Not Prevent Bank Failures

The Panic Of 1873

• Agricultural Prices Collapsed • “The Crime Of 1873”

The Panics Of the 1890s

• International Gold Flows • The Silver Purchase Act Of 1890

The Panic Of 1907

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The Federal Reserve Act Of 1913

¶ Background

Crop Cycles And The “Inelastic Currency”

• During Harvest Season Demand For Money And Credit Increased But No Source Of Increased Supply

• Severe Seasonal Credit Crunches Occurred

• Only Moderating Factors Were Inflows Of Foreign Credit And Lending By Clearing Houses

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The Federal Reserve Act Of 1913

¶ Background

The Panic Of 1907

• Weakening Economy Coincided With Financial Scandal And Harvest Time

• Trust Company Failures In NYC Led To Major Credit Lockup

• Problem Spread To Interior Banks As NY Correspondents Failed

• Resolved By J.P. Morgan And Intervention By Clearing Houses, Treasury, And Strong Banks/Trust Companies

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The Federal Reserve Act Of 1913

¶ Federal Reserve System Structure

Managed By 7-Member “Board Of Governors” In DC

Created 12 “Branches,” Called Federal Reserve Districts

Federal Reserve Bank Of New York Was Major District Bank Federal Open Market Committee Formed In 1930s

• Function Was To Conduct Monetary Policy

• 12 Members--7 BOG Members Plus 5 Regional Bank Presidents In Rotation

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The Federal Reserve Act Of 1913

¶ Federal Reserve System Functions

Lend To Member Banks At Discount Window

• Loans Made On “Real Bills” At “Discount Rate”

• Loans For “Need,” Not “Profit”

Supervise Member Banks

Provide Services To Member Banks

• Check Clearing

• Coin Sorting

Establish Reserve Requirements For Member Banks

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The Banking Act Of 1933 (Glass-Steagall Act) ¶ Main Features

Prohibited Commercial Bank Ownership Of Investment Banks And Insurance Companies

Prohibited Payment Of Interest On Demand Deposits

Established The FDIC To Insure Bank Deposits Authorized Fed To Supervise Member Banks

• Establish Capital Requirements For Member Banks

Authorized Fed To Issue Federal Reserve Notes, Limited To 4 times Gold Stock Held

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The Banking Act Of 1933 (Glass-Steagall Act) ¶ Main Features

Expanded Authority Of The Federal Reserve System

• Fed Could Set Ceilings On Rates Paid On “Time And Saving Deposits”

• Fed Could Set Limits On Margin Loans By Banks And Others

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Federal Reserve System Responses To 1933 Act

¶ Subsequent Developments

Implemented Authority To Restrict “Margin Loans”

• Established Regulation “T” For Security Lending By Broker- Dealers (1934)

• Established Regulation “U” Controlling Security Lending By Banks (1936)

• Established Regulation “G” Controlling Security Lending By Non-Bank Domestic Lenders (1968)

• Established Regulation “X” Controlling Security Lending By Foreign Lenders (1968)

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Federal Reserve System Responses To 1933 Act

¶ Subsequent Developments Implemented Regulation “Q” Setting Ceilings On Interest Rates Paid On Bank Time And Saving Deposits (1933) Implemented Regulation “D” Creating Uniform Reserve Requirements For Member Bank Deposits

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The Bank Holding Company Act Of 1956

¶ Prohibited Banks From Buying Or Being Owned By Non-Bank Non-Financial Entities (e.g., Industrial Corporations)

Concern That Industrial Companies Would Borrow From Banks At Advantageous Terms, Thereby Weakening Banks

Concern That BHCs Were Being Used To Circumvent Prohibition Of Interstate Branching via “Chain Banking”

Excluded One-Bank Holding Companies

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Bank Holding Company Act Amendments Of 1970

¶ Extended To One-Bank Holding Companies The BHCA Limitations On Mergers With Non-Banking Companies

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The Community Reinvestment Act Of 1977 (CRA) ¶ Introduced Social Criteria Into Bank Lending

Initiated By Concerns About “Redlning”

FDIC-Insured anks Evaluated On Basis Of Lending Within Deposit-Generating Communities

• Focuses On Limiting Deposit Drains To Outside Areas

• CRA Does Not Require Making Loans With High Default Prospects

Federal Reserve System Was Charged With Evaluating CRA Compliance

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The Community Reinvestment Act Of 1977 (CRA) ¶ Government Sponsored Entities (FNMA, FHLMC) Also Required To Meet Social Criteria

Monitored By HUD

HUD Introduced “Special Affordable Loan” Requirement

• GSEs Must Have A Minimum Share Of New Loans To Borrowers With Incomes Below 60% Of Community Median

• GSEs SAL Minimum Started at 12% of New Mortgages In 1996, Rose to 28% in 2008

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The Depository Institutions Deregulation And Monetary Control Act of 1980 (DIDMCA) ¶ Initiated Removal Of Glass-Steagall Restrictions

Established Uniform Reserve Requirements For Banks and Thrift Institutions

Phased Out Requlation Q, Allowing Unlimited Interest Payments on Time And Saving Deposits

Allowed Interest Payments On Substitutes For Demand Deposits (NOW Accounts)

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The Depository Institutions Deregulation And Monetary Control Act of 1980 (DIDMCA) ¶ Other Actions

Liberalized Investment Authority of Thrift Institutions

• S&Ls Could Invest Up To 20% In Non-Mortgage Assets

• MSBs Coukd Invest Up To 5% In Non-Mortgage

Increased FDIC Deposit Insurance To $100K from $40K

Required Federal Reserve System To Price Its Services (Check Clearing, Coin Sorting, FedWire, ACH, etc.)

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The Financial Industry Modernization Act of 1999 [Called Gramm-Leach-Bliley Act, Or GLB Act]

¶ Continued Dismantling Of Glass-Steagall Act

In 1994 CitiBank Bought Travelers Insurance And Salomon Brothers’ Smith-Barney Brokerage To Form CtiGroup

• CitiGroup Formation Illegal Under Glass-Steagall

• CitiBank Received Waiver To Allow Merger

GLB Act Formalized Approval Of CitiGroup By Allowing Any Commercial Bank To Undertake Cross-Industry Mergers

• Chase Bank Buys JPMorgan to Create JPMorganChase

Cross-Industry Merger Approval Conditioned On “Satisfactory” CRA Rating In Most Recent Evaluation

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Part 1.2Part 1.2

Bank Supervisory Bank Supervisory

AgenciesAgencies

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Supervisory Agency Structure

Comptroller of the CurrencyComptroller of the Currency 18631863 National Chartered BanksNational Chartered Banks

Federal Reserve SystemFederal Reserve System 19131913 State Chartered FRB State Chartered FRB MembersMembers

Federal Deposit Insurance Federal Deposit Insurance CorpCorp

19331933 National Chartered BanksNational Chartered Banks

State Chartered BanksState Chartered Banks

Savings BanksSavings Banks

State Banking CommissionsState Banking Commissions VariousVarious State Chartered BanksState Chartered Banks

Office of Thrift Supervision, Office of Thrift Supervision, FDIC,FDIC,

And State Banking And State Banking CommisionsCommisions

VariousVarious Savings and Loan Savings and Loan AssociationsAssociations

Savings BanksSavings Banks

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Supervisory Agency Ratings

¶ The CAMELS System (1978)

CAMELS Criteria • Capital Adequacy • Asset Quality • Management Ability • Earnings Performance • Liquidity • Sensitivity To Market Risk

The CAMELS Ratings

• Rating Based On Call Reports, Field Visits - Scored From 1 (Poor) To 5 (Excellent) - Results Are Not Public

• Rating Assigned By Lead Supervisory Agency

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The Basle Accords

¶ Basle I (1988)

Established International Standards For Bank Supervision

Defined “Capital”

• Tier 1 Capital = Common Equity Paid In + Cumulative Retained Earnings + Noncumulative Preferred Stock

• Tier 2 Capital = Hybrid Debt + Subordinated Debt + Loan Loss Reserves + Contingency Reserves

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The Basle Accords

¶ Basle I (1988)

Established Capital Composition Standards

• At Least 50% Of Capital Had To Be Tier 1

• No More Than 50% Of Tier 2 Capital In Subordinated Debt

Set “Risk-Based” Capital Requirements (Credit Risk Only)

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The Basle Accords

¶ Basle II (2004)

Extended Types Of Risk Evaluated

• Credit Risk • Operational Risk • Market Risk

Credit Risk Requirements • Standard Method—e.g. 8% of Average Risk-Adjusted Assets • Internal Risk-Based Analysis (Option For Large Banks)

Market Risk

• Basle II Recommends “Value At Risk” (VaR)

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Basle II: Measuring Market Risk By VaR

Example of VaR Analysis of Capital Required(Cumulative Probability Distribution Of Gain or

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Low Volatility (s=0.20) high volatility (s=0.40)

5% Critical Probability

Capital Required for 5% Wipeout and 40% Volatility= 67% of Net Assets

Capital Required for 5% Wipeout and 20% Volatility= 33.5% of Net Assets

Expected Net Asset Increasein Next Year = 0.0%

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Problems With VaR

¶ Non-Normality In Distribution Of Returns

Above-Normal Probability Of Large Asset Price Declines

• Fat Tails And • “Black Swans”

¶ Use Of Historical Data Historical Measurement Of Correlations Between Asset Returns Dramatic Changes In Correlations In Crisis Periodx Failure To Incorporate Connections Between Markets

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What Went Wrong With Commercial Banks In 2008?

¶ Off Balance Sheet Investments

Structured Investment Vehicles

• Independent Entities Created By Banks

- Sold To Investors (Hedge Funds, High-Wealth)

- Investors Financed Purchase Wiyj Short-Term Loans (Commercial Paper)

- Banks Had No Explicit Obligation To Redeem

- Bank’s Did Provide Letters of Credit (Commitments To Replace Short-Term Loans If Normal Lenders Withdrew)

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What Went Wrong With Commercial Banks In 2008?

¶ Off Balance Sheet Investments

The Collapse Of SIVs

• During Credit Freeze In Fall, Banks Forced To Make Loans To SIVs, Selling Assets And Restricting Bank Loans • Banks Faced Implicit Commitents To Repurchase SIV Assets (”Reputational Put)

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What Went Wrong With Commercial Banks In 2008?

¶ Changes In Supervisory Philosophy

The Shift To Internal Risk Assessment (Basle II)

• Applied To Large Banks

• Rested On Poor Assumptions

- Quantitative Risk Management Methods (VaR) Were Suitable

- Management Incentives Were Aligned With Shareholders

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Part 2Part 2

Depository Financial Institutions:Depository Financial Institutions:

Thrift InstitutionsThrift Institutions

Savings And Loan Associations Savings And Loan Associations

And And

Mutual Savings BanksMutual Savings Banks

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Thrift InstitutionsThrift Institutions

¶ Designed To Collect Savings Deposits And

Invest In Residential Mortgages

¶ S&L Deposits Insured By Federal Savings And Loan

Insurance Corporation (FSLIC)L Institutions; MSB

Deposits Insured By State Insurance Funds

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Thrift InstitutionsThrift Institutions

¶ Fatal Flaws

Borrowed Short-Term (Deposits) And Made Long-Term Loans (Mortgages)

• Viability Required Upward-Sloping Yield Curve And Stable Interest Rates

Undiversified Assets--Entirely In Residential Mortgages

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Important LegislationImportant Legislation

¶¶ Federal Home Loan Bank Act of 1932 Federal Home Loan Bank Act of 1932

Created FHLB SystemCreated FHLB System

Modeled After Federal Reserve System Modeled After Federal Reserve System

• • Twelve Regional Banks Twelve Regional Banks

•• Authority To Lend To S&Ls On MortgageAuthority To Lend To S&Ls On Mortgage CollateralCollateral

Allowed Federally Chartered S&LsAllowed Federally Chartered S&Ls

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Important LegislationImportant Legislation

¶ Federal Savings And Loan Insurance Act Of 1934

Created FSLIC

• Modeled After FDIC

• Supervised By FHLB Board

• Insured S&L Deposits

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Important LegislationImportant Legislation

¶ Formation Of Government Sponsored Entities Federal National Mortgage Association (1938)

• Purchased FHA/VA-Insured Mortgages • Financed By Bonds And “Pass-Thru” Securities • “Privatized” In 1968

Government National Mortgage Association (1968)

• Supervised By HUD • Purchased Conventional And FHA/VA

Mortgages

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Important LegislationImportant Legislation

¶ Formation Of Government Sponsored Entities

Federal Home Loan Mortgage Corp (1970)

• Supervised By FHLB Board

• Purchased Conventional Mortgages

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Important LegislationImportant Legislation

¶ Interest Rate Control Act of 1966

Subjected S&L Deposits to Regulation Q Ceiling

Plus +.25%

Goals:

• Protect Income Of Thrift Institutions

• Allow Thrifts A Small Deposit Rate Advantage

Over Commercial Banks

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Important LegislationImportant Legislation

¶ DIDMCA of 1980

Liberalized Investment Authority of Thrift Institutions

• S&Ls Could Invest Up To 20% In Non-Mortgage Assets

• MSBs Could Invest Up To 5% In Non-Mortgage Assets

Eliminated Interest Rate Ceilings On Deposits (Reg Q)

Required Federal Reserve To Price Services To Banks

(Check Clearing, Coin Sorting, Currency Replacement)

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Important Legislation

¶ Depository Institutions Act Of 1982 (Garn-St. Germain)

Broadened Powers of S&Ls

•• Allowed Investment of Up To 40% In Commercial Mortgages And 10% In Commercial Loans

• • Allowed S&Ls To Borrow An Unlimited Amount In Non-Deposit Loans

• • Shifted Risk Management Responsibility From Regulators To Bank/S&L Management

•• Allowed Any Depository Institution To Borrow From FDIC Or FSLIC To Replenish Capital

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Other Important Events

¶ Advent Of Junk Bonds

Michael Milken Sees That Below-Investment-Grade Bonds Earn More Than High-Rated Bonds After Adjusting For Defaults

Drexel, Burnham, Lambert Creates A Market For Junk Bonds

• • Junk Bonds Allowed Smaller Companies To Get Access To Long-Term Financing

•• S&Ls Bought Junk Bonds On A Large Scale As A Way To Diversify Beyond Mortgages and Get High Returns

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What Went Wrong With Thrifts?

¶ Interest Rates Rose, Especially Short Rates

Long-Term Rate Increases Created Losses In Value Of Mortgage Assets, Wiping Out Capital

Yield Curve Tilt Created Losses On Income Account, Threatening Liquidity

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What Went Wrong With Thrifts?

¶ S&Ls Invested Heavily In Bad Loans

Oil Prices and Home Prices Broke In The Mid-1980s

Lack of Familiarity With New Lending Opportunities

Scandalous Abuses In S&L Investing: The Keating Episode

Mortgage Foreclosures Increased And S&Ls Began Failing, First in The South Then Elsewhere

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Resolution: The Financial Institution Reform, Recovery, And Enforcement Act Of 1989 (FIRREA)

¶ Forced Insolvent S&Ls to Fail Or Be Bought By Stronger Institutions

¶ FSLIC Paid Off Depositors of Failed S&Ls And Acquired S&L Assets For Resale

¶ Resolution Trust Company (RTC) Was Formed to Sell Foreclosed Homes And Other Assets Acquired From S&Ls

RTC Dissolves in 1993 After Cost To Taxpayer Of $150-$300 Billion

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The Financial Institution Reform, Recovery, And Enforcement Act Of 1989 (FIRREA)

¶ Regulatory Restructuring

The FHLBB Was Dissolved

The Office Of Thrift Supervision (OTS) Was Formed To Regulate All Thrift-Type Institutions (S&Ls And Mutual Savings Banks)

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Part 3Part 3

Security MarketsSecurity Markets

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Important Legislation

¶ Securities Act Of 1933

Required Registration Of Issued Securities With The SEC With Some Exceptions:

• • Securities Issued By Banks And S&Ls

• • Securities Issued By Religious And Charitable Organizations

• • Life Insurance And Pension Policy Liabilities

• • Notes With Less Than 270-Day Maturity (Commercial Paper)

• • Private Placements

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Important Legislation

¶ Securities Act Of 1933

Registration Statements Must Specify:

• • Risk Factors

• • Any Material Information

Civil Penalties Levied For Failure To Register Or To Properly Disclose Relevant Information

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Important Legislation

¶ Securities Exchange Act Of 1934

Created Extensive Regulation Of Companies Issuing Securities, Of Security Broker-Dealers, And Of Security Exchanges Periodic Reporting To SEC By Companies With Publicly-Traded Securities • • Form Annual 10-K And Quarterly 10Ql Reports • • Form 8-K Reorts Of Unusual Events • • Reports Of Insider Transaction •• Reports Of Acquistions Of Over 5% Of Any Security Class

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Important Legislation

¶ Securities Exchange Act Of 1934

Broker-Dealer Regulation

• • Segregation Of Accounts (Except net free credit)

• • Net Capital Rule: $100K Or 2% Of Debit Balances (50:1 Leverage)

• • Duty To Act In Clients’ Interest

- Churning and Excessive Fees

- Conflicts Of Interest In Proprietary Trading (Front Running)

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Important Legislation

¶ Securities Exchange Act Of 1934

Prohibition Of “Market Manipulation” And Of Preferential Treatment Of Customers

•• Stock Gunning

•• Links Between Underwriting And Trading Desks

•• IPO Flipping And IPO Allocation Preferences

•• Insider Trading On Private Information

• • Disproportional Allocation Of Gains/Losses

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Important Legislation

¶ Securities Exchange Act Of 1934

SEC Regulation Of Security Exchanges

• • Authority To Set Margin Requirements For Member Firms (Delegated To Fed)

• • Authority To Regulate Exchange-Traded Options (Delegated tp CBOE And Other SROs)

• • Authority To Regulate Futures Markets (Delegated tp CFTC)

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Important Legislation

¶ Investment Company Act Of 1940

Regulates Investment Companies • • Unit Trusts: Fixed Asset Composition •• Management Companies: Variable Portfolio - Open-End Investment Companies (Mutual Funds) • • Shares Sold And Redeemed By Company • • Shares Continuously Distributed • • Shares Priced Daily At Net Asset Value (NAV) - Closed-End Investment Companies • • Shares Sold At IPO And Traded On Exchanges • • Shares Priced Continuously At Market • • Share Price Can Be At Premium Or Discount To NAV

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Important Legislation

¶ Investment Company Act Of 1940

Aspects Of Investment Companies Act • • Requires Registration With SEC •• All Securities Must Be Held In Trust Account

• • Must Pay Out At Least 90% Of Income To Avoid Being Taxed At Trust Level

• • Prohibited From Borrowing Except From Banks For Temporary Purposes (Redemptions)--No “Margin”

• • Prohibited From Issuing “Senior Securities” - Debt Or Preferred Stock, Short Sales

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Important Legislation

¶ Investment Company Act Of 1940

Mutual Fund Shennanigans (“Spitzerisms”)

• • Market Timing - Use Of After-Hours Info To Place Fund Orders

- Example: Int’l Securities Close At 10AM USEST Or Later So Price Info Not Embedded In 4PM Closing NAV On Prior Day

•• Late Trading - Placing Orders After 4PM To Be Executed At 4PM NAV

• • Cherry-Picking Asset Sales To Meet Redemptions - Selling Most Marketable Assets to Pay Out Cash

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Important Legislation

¶ Investment Advisors Act Of 1940

Requires Registration With SEC Of Any Investment Advisor Who Uses The Mail Or Any Form Of Interstate Commerce In The Conduct Of Business •• Exceptions -- Advisors Whose Clients All Reside Within The State Of The Advisor’s Office And Who Do Not Advise On Securities Traded On Listed Exchanges -- Advisors Whose Only Clients Are Insurance Companies -- Advisors Who Have Fewer Than 15 Clients And Who Do Not Represent Themselves To The Public -- Advisors Who Are Charitable Organizations Or The Employees Of, Or Volunteers To, Such Entities

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Important Legislation

¶ Securities Investors Protection Act (SIPA) Of 1970

Establishes SIPC

• • SIPC Authorized To Borrow $1 Billion From Treasury

• • All Registered Broker-Dealers Must Be Members

• • Members Pay Flat Insurance Premium

- 1/2 Of 1% Of Gross Revenues

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Important Legislation

¶ Securities Investors Protection Act (SIPA) Of 1970

Insures Broker-Dealer Accounts Up To $500K

• • Coverage

- Direct Client Accounts (“Feeder” Is Insured Entity)

- All Fully Paid Securities In Cash Accounts

- “Free Cash Balances” In Margin Accounts

- Cash Covered Up To $100K

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What Went Wrong In Securities Markets In 2008?

¶ Mutual Funds: Collateral Damage

Redemptions In Excess Of Cash Balances

• • Withdrawal Of Bank Letters Of Credit

• • Forced Sales Of Securities

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What Went Wrong In Securities Markets In 2008?

¶ Stock Markets: Collateral Damage

Breach Of Maintenance Margin Requirements

•• Forced Sales Of Securities By Customers

Breach Of Broker-Dealer Collateral Requirements

• • Banks Call Loans To Brokers’ Trading Departments

•• Forced Sales Of Securities By Broker-Dealers

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Part 4Part 4

Commodities FuturesCommodities Futures

And And

Derivative SecuritiesDerivative Securities

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Commodities FuturesCommodities Futures

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Essentials Of Commodity Trading

¶ Occurs Primarily Through Futures Contracts

Contract To Deliver Or Take Delivery Of A Commodity At A Specific Date And Place And At A Specific Price

Parties To Contract

• • Hedgers - Short Hedgers: Hold Or Expect To Have Commodity Units At A Future Date (e.g., Fuel Oil Producer) - Long Hedgers: Committed To Sell Commodity at Future Date (e.g., Fuel Oil Company)

• • Speculators - Short Speculators: Sell In Expectation Of Price Decline - Long Speculators: Buy In Expectation Of Price Increase

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Essentials Of Commodity Trading

¶ Economic Functions Of Futures Contracts

Price Discovery

• • Provide Current Economic Agents With Information About Future Prices

- Example: Farmers Can Plan Crop Amounts More Efficiently--Plant Less When Prices Are Expected To Fall, More When Prices Expected To Rise

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Essentials Of Commodity Trading

¶ Economic Functions Of Futures Contracts

Create Efficient Intertemporal Allocation Of Supply

• • If Prices Expected To Rise, Producers Will Store Product Now And Sell In Future--Thereby Aiding Consumers By Providing More Supply In Scarcer Times

• • If Prices Expected To Fall, Producers Will Reduce Stockpiles Now And Restore In Future At Lower Prices-- Thereby Aiding Consumers By Shifting Supply From Low-Price Future To High-Price PresentStore Product Now And Sell In Future--Thereby Aiding Consumers By Providing More Supply In Scarcer Times

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Essentials Of Commodity Trading

¶ Characteristics Of Commodity Prices

Determined In Auction Market (Pit) By Open Outcry •• Clearing Price Is That For Which Long Hedges+Long Specs = Short Hedges+Short Specs

•• Storeable Commdities Typically Are In “Contango” (Futures Price Exceeds Spot Price by Cost Of Carry)

•• Perishable Commodities (Onions) Have No Normal Future vs. Spot Relationship

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Essentials Of Commodity Trading

¶ Role Of Exchange Clearing House

Guarantee Completion Of Payments (Counterparty Risk)

Establish Characteristics Of Standardised Contract

Maintain Records On Contracts Traded And Contracting Parties

Mark Accounts To Market Daily, And Transfer Losses To Gaining Accounts

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Federal Regulation Of Commodities Futures

¶ Early Acts

Grain Futures Act (1922)

Commodity Exchange Act (1936) •• Supplanted Grain Futures Act •• Established Commodities Exchange Commission • • Prohibited Market Manipulations And Fraudulent and Abusive Behavior • • Regulation Applied Only To Agricultural Futures Contracts •• Required All Futures Contracts To Be Traded On Exchanges Onion Futures Act (1958) •• Prohibited Trading Of Onion Futures

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Federal Regulation Of Futures Contracts

¶ Commodity Futures Trading Commission (1974)

Amended 1936 Act To Extend Regulation To “All Amended 1936 Act To Extend Regulation To “All Futures Futures Contracts” Traded On ExchangesContracts” Traded On Exchanges

Response To Rise Of Non-Agricultural Futures Response To Rise Of Non-Agricultural Futures (Financials And Currencies)(Financials And Currencies) Excluded Forward Contracts And OTC Contracts Excluded Forward Contracts And OTC Contracts BetweenBetween “ “Sophisticated Parties.” Sophisticated Parties.”

Left Status Of Swap Agreements Uncertain, Left Status Of Swap Agreements Uncertain, ExcludingExcluding Them By CFTC Action Rather Than CongressionalThem By CFTC Action Rather Than Congressional MandateMandate

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Federal Regulation Of Futures Contracts

¶ Commodity Futures Modernization Act (2000)

Clarified Legal Status Of OTC Contracts

Excluded OTC Instruments

•• Forward Contracts Between Private Parties

•• Swap Agreements (Financial, Currency and Credit Default Swaps)

Authorized Trading Of Single Stock Futures (Prior Authorization Had Been Only For Index Futures)

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Financial DerivativesFinancial Derivatives

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Futures Contracts For Common Stocks

¶ Stock Index Futures

Trading Began In 1983 With Value Line Index

•• Same Principles As Physical Commodities

•• Most Traded On NYSE/AMEX

•• Index Arbitrage: Establishes Relationship Between Futures And Spot Prices

- Futures Price Equals Expected Spot Price Discounted @(1+r) - Changes In Futures Price Affect Spot Price

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Futures Contracts For Common Stocks

¶ Single Stock Futures Contract

Illegal Prior To Commodities Exchange Modernization Act (2000)

First Single Stock Futures Contracts Traded in 2002

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Options On Common Stocks ¶ Types Of Options

Call Option

•• Option, But Not Obligation, To Buy Stock At A Fixed Price (The Strike Price) On Or Before A Specified Date

•• Holder Profits If Price At Exercise Exceeds Strike Price

Put Option

•• Option, But Not Obligation, To Sell Stock At A Fixed Price (The Strike Price) On Or Before A Specified Date

•• Holder Profits If Price At Exercise Is Less Than The Spot Price

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Options On Common Stocks ¶ Option Trading

OTC Prior To 1973

CBOE Created In 1973

•• Standardized Contracts: Expiration Dates, Strike Prices

•• Clearing House (OCC) To Bear Counterparty Risk And Monitor Trading In Options

CBOE And NYSE/AMEX (NYSE/EuroNext) Are The Major Exchanges

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Options On Common Stocks ¶ Option Regulation

SEC - CFTC Turf Disputes

SEC Is Primary Regulator Of Options On Stocks And Stock Indexes

CFTC Is Primary Regulator Of Options On Futures Contracts

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Credit Default Swaps ¶ Characteristics

Created As Unregulated OTC Contracts

Significant Counterparty Risk

•• No Clearing House

•• Buyer Requires Collateral From Seller

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Credit Default Swaps ¶ Payment Triggered By “Credit Events” Specified In Particular Contracts

• • Buyer Pays Premium Based On Risk (Standard is 5% Of Protected Value)

•• Seller Pays Net Loss

- Can Buy Securities At Face Value Or Pay Net Loss

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What Went Wrong In 2008?

¶ The OTC Swap Market--Particularly CDSs--Had Created Extreme Interconnectedness Among Financial Institutions

¶ Trouble In One Market Was Rapidly Transmitted To Other Instruments And Markets Bank Loans To SIVs To Replace Commercial Paper Created Short-Term Credit Squeeze Credit Freeze Arising From Bank SIVs Resulted In High Libor Rates Used In Financial Swap Agreements Trading Departments At Investment Banks Faced Collateral Calls From Counterparties, Forcing Asset Sales Failure Of Lehman And AIG Triggered An Escalation In Counterparty Risk