FAST MONEY
By Melvin J. Howard
Not many people understand the financial system including sometimes your
local bank manager surprised? Don’t be a lot of the retail bankers have limited knowledge of what happens upstairs in the corner office of
their institution. The real action goes on behind the scenes on the bank’s
trading floor these group of individuals are type A personalities and very
creative. With a couple of key strokes billions
of dollars fly around the world in minutes if they can package it they will
trade it.
The first goal of the financial system is to facilitate the flow
of funds from savers (entities with a surplus of funds) to investors (entities
with a deficit of funds). What is the distinction between real assets and
financial assets.
A real asset is an entity that generates a flow of goods or
services over time. Examples include land, people, factories, inventions,
business plans, goodwill with consumers, reputation. Anything that generates a
flow of goods or services counts real assets need not be tangible.
A financial asset is a piece of paper, or, in the modern world, an
account on a computer, that gives the owner of that piece of paper or account a
claim to flow of goods or services generated by a real asset. Examples include
currency ($), stocks, bonds, bank deposit, bank loans, options, futures, etc. Ultimate
investors sell financial assets to savers; they use the proceeds to buy real
assets (buying real assets is the same thing as investment). Sometimes people
sell financial assets to finance consumption too.
Given this first role, the financial system is the place where
savers (or, more generally, economic agents with a surplus of funds relative to
their immediate need for those funds) meet investors (or, more generally,
economic agents with a deficit of funds relative to their immediate need for
those funds). The financial system channels funds from savers to investors. In
equilibrium, savings = investment.
Important to note the term “investors” is often used loosely. When
a firm builds a factory or when a person buys a house that is investment. When
a person buys stock, that is, strictly speaking, savings. However, the purchase
of a share of stock is commonly called investment, and stockholders are called
investors. Agents can invest using their own money, using indirect finance,
or using direct finance. When agents invest out of their own funds (i.e. by
spending past accumulated savings), they bypass the financial system entirely.
When agents use indirect finance, funds come from a financial
intermediary, which are then invested (or spent on consumption goods). A
financial intermediary is a firm that pools the savings of many agents and then
passes those funds through to agents that want to spend them. The intermediary
is the middleman, not the ultimate source of funds. When an agent uses direct
finance, funds are provided to the investors directly, without the use of an
intermediary. For example, firms sometimes sell share of stock directly to the
public in an IPO.
Flow of funds through the
financial system
Indirect Finance
Financial Intermediaries
The line between direct and indirect finance has become
increasingly blurry as banks and other financial intermediaries have begun to
securitize their assets. Securitization involves removing an asset (or often a
pool of assets) from the balance sheet of an intermediary by selling the asset
to a “conduit” firm, known as a Special-Purpose Vehicle (SPV), that in turn
pays for these assets by issuing securities (bonds) into the capital market.
The SPV typically issues senior and subordinated bonds. The most junior bonds
absorb all of the losses on the assets (or pool of assets); if there are more
losses than can be absorbed by the most junior loans, then the next most junior
bonds begin to absorb losses, etc.
The six steps toward securitization:
1. Set up a legally separate trust (SPV) to serve as a conduit for
cash flows;
2. Sell designated loan or pool of loans to the trust (SPV);
3. Have the trust (SPV) issue securities that represent claims to
the cash flows generated from the pool of loans, and sell those securities to
the public;
4. Contract with a servicing organization to collect the loan
payments and forward those to securities owner (this outsourcing feature is
optional);
5. To improve the price received for the securities, two
approaches can be taken:
a). arrange for credit enhancement by the bank or another
reputable third party so that the securities can be highly rated;
b). strip and reassemble the cash flows from the loan pool based
on either timing (as in mortgage-backed securities), or seniority (as in
collateralized loan obligations).
6. Make sure a liquid secondary market exists for the securities,
or convey to the purchaser the right the put (re-sell) the securities back to
the bank on good terms.
Typically, the bank that originated the assets continues to
service those assets (i.e. collect payments, effect workouts if the borrower
defaults). In some cases, such as securitization of loans to businesses, a bank
will purchase the lowest rated bonds issued by the SPV. Now how do
all of the funds get transferred into my account if you ever had a bank or
brokerage account chances are SWIFT was involved.
WHAT IS S.W.I.F.T.
S.W.I.F.T. (the Society for Worldwide Interbank Financial
Telecommunication) provides financial data communication and processing
services to support the business activities of worldwide financial institutions
for securities, payments, foreign exchange and money markets, as well as trade
finance. As of January 2010, over
9,700 institutions use S.W.I.F.T. to communicate with each other 24 hours a
day. S.W.I.F.T. operates in 209 countries. When brokers were admitted in 1987,
the members created and began using the Category 5 (CAT 5) message standards to
structure settlement instructions, confirmations and safekeeping information
for securities transactions. Owned by nearly 4,000 of its user banks,
S.W.I.F.T. also connects other categories of non-bank financial institutions
engaged in the securities industry, including:
· Securities broker/dealers
· Investment managers
· Securities exchanges
· Central domestic securities depositories and clearing
organizations
· Central cross-border securities depositories and clearing
organizations such as Cedel and Euroclear
· Trust Companies and Fiduciary Service Providers
· Custody and Nominee Services Providers
· Registrars
· Transfer Agents
· Investment managers were granted full participant privileges in
June 1992, S.W.I.F. As participants, investment managers have the right to use
the S.W.I.F.T. standards, access the S.W.I.F.T. network, and indirectly
participate in setting the future direction of S.W.I.F.T.
