Chapter Five:Mutual Funds

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Overview Overview In this segment ... Mutual Funds:

◦Activities of mutual funds◦Size, structure and composition◦Balance sheets and recent trends◦Regulation of mutual funds◦Global issues◦Hedge funds*

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Mutual FundsMutual FundsOpen-endedClosed-endEnd of 2003:

◦More than 7,100 stock and bond mutual companies.

◦Total assets of $5.36 trillion.◦8,200 firms and $7.41 trillion if money

market mutual funds includedSlower rate of growth in the

industry in early 2000s than in 1990s

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Size, structure and Size, structure and compositioncomposition

◦First mutual fund: Boston, 1924.◦Slow growth, initially.◦Advent of money market mutual

funds, 1972. Regulation Q.

◦Total assets in stock and bond mutual funds: 1940: $0.4 billion. 1990: $1,065.2 billion 2003: $7,414.1 billion.

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Size, Structure and Size, Structure and CompositionComposition

◦By asset size, mutual fund industry second most important FI group.

◦Recent inroads by commercial banks and insurance companies Mellon purchase of Dreyfus State Farm (9,000 agents) As of 2004, insurance companies managed

approximately 14% of mutual fund assets

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Types of Mutual FundsTypes of Mutual FundsLong-term funds

◦74.3% of assets, 1999◦2002, long-term funds dropped to

62.1% of assets, losing ground to MMMFs

Types of Long-term Funds:◦Bond and income funds.◦Equity funds.◦Hybrid.

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Types of Mutual FundsTypes of Mutual Funds

Short-term funds ◦25.7% of assets, 1999. ◦30.2% of assets, 2002.◦Taxable and tax-exempt MMMFs◦Generally higher returns than bank

deposits but uninsured.Impact of low interest rates

during early 2000s

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Number of Mutual FundsNumber of Mutual Funds

Year

Equity

Hybrid

Bond

Taxable

MM

Tax-exempt

MM 1980 288 N/A 170 96 10

1990 1,099 193 1,046 506 235

2003 4,601 509 2,043 661 312

Overview of Mutual FundsOverview of Mutual Funds◦Objectives (and adherence to stated

objectives), rates of return and risk characteristics vary.

Examples:◦Capital appreciation funds◦Growth funds◦High-yield bond◦World equity◦Corporate bond

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Returns to Mutual FundsReturns to Mutual Funds◦Income and dividends of underlying

portfolio.◦Capital gains on trades by mutual

fund management.◦Capital appreciation in values of

assets held in the portfolio. Marked-to-market. Net-asset value (NAV).

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Web ResourcesWeb ResourcesFor information on the

performance of mutual funds, visit:Morningstar www.morningstar.com

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Types of FundsTypes of Funds◦Open-ended funds: contrast with

most corporate securities traded on stock exchanges.

◦Closed-end investment companies:◦Fixed number of shares

Example: REITs. May trade at premium or discount.

◦Load versus no-load funds.

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Mutual Fund CostsMutual Fund CostsTwo types of fees:

◦Sales loads Generally, negative effect on

performance outweighs benefits

◦Fund operating expenses Management fee 12b-1 fees

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Mutual Fund Share QuotesMutual Fund Share QuotesQuotes include:

◦Fund NAV, Fund name, Objective, one-month through ten-year return and rating (A through E), Maximum initial charges, and Annual expenses.

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Balance Sheet and TrendsBalance Sheet and Trends

Money Market Funds◦Key assets are short-term securities

(consistent with deposit-like nature) 2003: $1,395.9 billion (69.2% of total assets)

◦Many have share values fixed at $1 and adjust number of shares owned by the investor.

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Balance Sheet and TrendsBalance Sheet and TrendsLong-term Funds

◦Stocks comprised over 65.6 % of asset portfolios in 2000.

◦Credit market instruments 32.3% of asset portfolios

◦Shift to U.S. Treasuries, municipal bonds etc. when equity markets not performing as well.

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RegulationRegulation◦One of the most closely regulated

among non-depository FIs.◦Primary regulator: SEC

Emphasis on full disclosure and anti-fraud measures to protect small investors.

NASD supervises mutual fund share distributions.

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Regulatory ChangesRegulatory Changes

Prosecutions in light of trading abuses in early 2000s. ◦Market timing◦Late trading◦Directed brokerage◦Improper fee assessments

Changes include: SEC requirements for independent board members; reporting and disclosure requirements

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LegislationLegislation◦Securities Act 1933, 1934◦Investment Advisers Act, 1940.◦Insider Trading and Securities Fraud

Enforcement Act of 1988.◦Market Reform Act of 1990

Allows SEC to halt trading and introduce circuit breakers.

◦National Securities Markets Improvement Act of 1996. Exempts mutual fund sellers from state

securities regulatory oversight.

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Pertinent Websites Pertinent Websites American Banker

www.americanbanker.com American Funds www.americanfunds.comFederal Reserve www.federalreserve.gov Fidelity Investments www.fidelity.comInvestment Company Institute www.ici.orgMorningstar, Inc. www.morningstar.com SEC: www.sec.govNASD: www.nasd.comVanguard www.vanguard.comWall Street Journal www.wsj.com

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Global IssuesGlobal IssuesWorldwide growth in mutual fund

investment not as great as in the U.S.◦$1.626 trillion in 1992 to $6.543 trillion in

2003 Over 300% growth compared to 350% in U.S.

◦Larger returns in U.S.stock markets◦Greatest development in countries with

most developed markets◦Opportunities from declining Japanese

markets◦Efforts to reduce barriers for U.S. mutual

fund sponsors China and other Asian countries

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Hedge Funds*Hedge Funds*Not technically mutual funds

◦Not subject to SEC regulation◦Organized as limited partnership

Small number of sophisticated investors

◦Common feature is use of leverageHigh returns in 1990s

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Hedge Funds* Hedge Funds*

Near collapse of Long-Term Capital Management◦$3.6 billion bailout◦2003 SEC scrutiny of hedge funds ◦Scandals such as Canary Capital

Partners involving trades with mutual funds

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Chapter Six:◦Finance Companies

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OverviewOverview

In this segment we discuss Finance Companies:◦Activities of finance companies◦Competitive environment◦Size, structure and composition◦Regulation ◦Global issues

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Historical PerspectiveHistorical PerspectiveFinance companies originated during

the depression.◦Installment credit◦General Electric Capital Corporation.◦Competition from banks increased during

1950s.Expansion of product lines

◦GMACCM is largest commercial mortgage lender in U.S.

Industry is highly concentrated◦Largest 20 firms account for more than

75% of assets.04/12/23 04:34 26

Finance CompaniesFinance CompaniesActivities similar to banks, but no

depository function. May specialize in installment loans

(e.g. automobile loans) or may be diversified, providing consumer loans and financing to corporations, especially through factoring.

Commercial paper is key source of funds.

Captive Finance Companies: e.g. GMAC

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Major Types of Finance Major Types of Finance CompaniesCompanies

Sales finance institutions◦Ford Motor Credit and Sears Roebuck

Acceptance Corp.Personal credit institutions

◦Household International Corp. and AIG American General.

Business credit institutions◦CIT Group and Fleet Boston Financial.◦Equipment leasing and factoring.

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Web ResourcesWeb ResourcesFor information on finance

companies, visit:www.ge.comwww.gmacfs.comwww.fordcredit.comwww.household.comwww.americangeneral.comwww.citgroup.com

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Largest Finance CompaniesLargest Finance CompaniesCompany Name Total Assets

(Millions)

General Electric Capital Services

$233,086

Ford Motor Credit Company 202,528

Citigroup 130,400

Household International, Inc. 107,496

MBNA Corp. 107,258

Balance Sheet and TrendsBalance Sheet and TrendsBusiness and consumer loans are

the major assets ◦51.9% of total assets, 2003. ◦Reduced from 95.1% in 1977.

Increases in real estate loans and other assets.

Growth in leasing (largely due to tax incentives of 1981 Economic Recovery Act).

Finance companies face credit risk, interest rate risk and liquidity risk.

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Balance Sheet and TrendsBalance Sheet and TrendsConsumer loans

◦Primarily motor vehicle loans and leases.

◦Recent low auto finance company rates are anomalous—partly due to 9/11 effects. Attempts to boost new vehicle sales via

0.0% loans lasted into 2004. By 2003, rates 3.5% lower than banks on

new vehicle rates

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Consumer loans Consumer loans (continued)(continued)Generally riskier customers than

banks serve.◦Subprime mortgage lenders ◦Jayhawk Acceptance Corp.

From auto loans to tummy tucks and nose jobs

Increase in “loan shark” firms with rates as high as 30% or more.

Other consumer loans about 24.7% of consumer loan portfolio, 2003.

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Balance Sheet and TrendsBalance Sheet and TrendsMortgages

◦Recent addition to finance company assets

◦Smaller regulatory burden than banks◦May be direct mortgages, or as

securitized mortgage assets.◦Growth in home equity loans since

passage of Tax Reform Act of 1986. Tax deductibility issue. Conversion of credit card debt 2003 average home equity loan

$69,513

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Web ResourcesWeb ResourcesFor information on home equity

loans, visit the Consumer Bankers Association at:

www.cbanet.org

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Business LoansBusiness LoansBusiness loans comprise largest

portion of finance company loans.Advantages over commercial banks:

◦Fewer regulatory impediments to types of products and services.

◦Not depository institutions hence less regulatory scrutiny and lower overheads.

◦Often have substantial expertise and greater willingness to accept riskier clients.

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Business LoansBusiness LoansMajor subcategories:

◦Retail and wholesale motor vehicle loans and leases

◦Equipment loans tax issues associated when finance

company leases the equipment directly to the customer

◦Other business loans and securitized business assets

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LiabilitiesLiabilitiesMajor liabilities: commercial paper

and other debt (longer-term notes and bonds).

Finance firms are largest issuers of commercial paper (frequently through direct sale programs).◦Commercial paper maturities up to 270

days.Consequently, management of

liquidity risk differs from commercial banks relying on deposits

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Industry PerformanceIndustry PerformanceStrong loan demandStrong profits for the largest firms

◦e.g. Household International, Associates First Capital, Beneficial

◦Effects of low interest ratesMost successful have become

takeover targets◦Citigroup/Associates First Capital, ◦Household International/HSBC

Holdings04/12/23 04:34 39

Industry PerformanceIndustry PerformanceHigh risk has a downside:

◦Subprime lending: Jayhawk Acceptance Corporation

◦Cityscape Financial Corp., Aames Financial Corp., Advanta, FirstPlus Financial Group, The Money Store, Associates First Capital

◦FTC scrutiny of subprime lending practices violating Truth in Lending Act, Fair Credit Reporting Act, Equal Opportunity Act

◦2002, Citigroup $200 million settlement for predatory lending via Associates First Capital

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Electronic LendingElectronic LendingMainly mortgages completed

over the Internet◦E-Loan◦Suffered with the dot-com downturn

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Web ResourcesWeb ResourcesFor additional information, visit:www.household.comwww.firstunion.comwww.citigroup.comwww.ftc.gov

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Regulation of Finance Regulation of Finance CompaniesCompanies

Federal Reserve definition of Finance Company◦Firm, other than depository institution,

whose primary assets are loans to individuals and businesses.

Subject to state-imposed usury ceilings.

Much lower regulatory burden than depository institutions.◦Not subject to Community Reinvestment

Act.◦Lack the banks’ regulatory safety-net

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RegulationRegulationWith less regulatory scrutiny, finance

companies must signal safety and soundness to capital markets in order to obtain funds.

Lower leverage than banks (15.1% capital-assets versus 9.1% for commercial banks).

Captive finance companies may employ default protection guarantees from parent company or other protection such as letters of credit.

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Global IssuesGlobal IssuesIn foreign countries, Finance

companies are generally subsidiaries of commercial banks or industrials

In Japan, ownership of finance companies by banks created opportunities when banks hit by increase in nonperforming loans◦GE Capital/Japan Leasing Corporation

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Pertinent WebsitesPertinent WebsitesAames Financial Corp. www.aames.netAdvanta www.advanta.comAmerican General www.aigag.comFederal Reserve www.federalreserve.govCIT Group www.citgroup.comCitigroup www.citigroup.comConsumer Bankers Association

www.cbanet.orgFederal Trade Commission www.ftc.govFirst Union Bank www.firstunion.com

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Pertinent WebsitesPertinent WebsitesFord Motor Credit www.fordcredit.comGE Capital Corp. www.ge.comGMAC www.gmacfs.comHousehold International

www.household.comThe Wall Street Journal www.wsj.com

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Team Names for Paper & Team Names for Paper & Presentation?Presentation?Names are due NEXT CLASS.

The Finished Paper is due February 28th,

at the Start of Class.

Your Presentations will be done March 4th & 6th

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