The Role of Financial Markets and Institutions Explained

Book: Financial Markets and Institutions, 11th Edition Author: Jeff Madura Publisher: Cengage Learning, 2015 ISBN: 978-1-133-94788-2

This is Part 1 of a chapter-by-chapter review of Financial Markets and Institutions by Jeff Madura. Chapter 1 sets the stage for the entire book by explaining what financial markets are, what gets traded in them, and why financial institutions exist.

Surplus Units and Deficit Units

The most basic concept in this chapter is the flow of funds. Some people and organizations have more money than they spend. Madura calls these surplus units. Others spend more than they receive. These are deficit units.

Financial markets exist to transfer money from surplus units to deficit units.

Here is a simple example from the book. A college student borrows money for tuition. They are a deficit unit. After graduation, they earn more than they spend and start saving. Now they are a surplus unit. A few years later, they buy a house with a mortgage. Deficit unit again. At this point they might be saving in a bank account while also making mortgage payments. They are both at the same time.

This back-and-forth is happening constantly, across millions of people and businesses.

Primary and Secondary Markets

Financial markets split into two types. Primary markets are where new securities get issued for the first time. When a company sells stock to the public for the first time (an IPO) or issues new bonds, that is the primary market.

Secondary markets are where existing securities get traded between investors. When you buy shares of Apple on the stock exchange, you are buying from another investor, not from Apple. The company does not get any money from that trade. Secondary markets matter because they provide liquidity. If you could not sell a security after buying it, far fewer people would invest in the first place.

Types of Securities

The book groups securities into three categories.

Money market securities are short-term debt with maturities of one year or less. These include Treasury bills, commercial paper (issued by corporations), and certificates of deposit. They tend to have low risk and low returns.

Capital market securities are long-term. This includes bonds (10-20 year maturities typically), mortgages, mortgage-backed securities, and stocks. Bonds pay interest periodically and return the principal at maturity. Stocks represent ownership in a company and have no maturity date.

Derivative securities are financial contracts whose values come from underlying assets like stocks or bonds. They serve two main purposes: speculation and risk management. You can use derivatives to bet on price movements or to protect yourself against them.

How Securities Are Valued

Every security generates a stream of cash flows. The value of a security is the present value of those expected future cash flows, discounted at a rate that reflects how uncertain those cash flows are.

Debt securities are easier to value because the payments (interest and principal) are specified in advance. Stocks are harder because future dividends and stock prices are uncertain.

When new information comes out that changes expectations about a company’s cash flows, the price adjusts. Positive news pushes prices up. Negative news pulls them down. This is the basic idea behind efficient markets.

The book mentions behavioral finance too. Sometimes prices deviate from fundamentals because of investor psychology. The Facebook IPO in 2012 is used as an example. The stock was priced high on hype, then dropped about 50% in a few months once reality set in.

Financial Institutions

Here is the thing about financial markets. They are imperfect. Individual investors do not have the time, expertise, or information to evaluate every borrower. That is why financial institutions exist.

Depository institutions include commercial banks, savings institutions, and credit unions. They take deposits from surplus units and lend to deficit units. Commercial banks are the biggest players, holding about $12 trillion in assets at the time of writing.

Nondepository institutions include:

• Finance companies that borrow by issuing securities and lend to individuals and small businesses
• Mutual funds that pool money from investors and buy diversified portfolios of securities
• Securities firms that act as brokers, dealers, and underwriters
• Insurance companies that invest premium income in stocks and bonds
• Pension funds that manage retirement savings by investing in securities

All together, these institutions held about $45 trillion in assets.

Financial Conglomerates

Over the past couple decades, barriers between different types of financial services have dropped. Banks merged with securities firms, insurance companies, and mortgage lenders. Wells Fargo is the textbook example. It started as a commercial bank and expanded into mortgages, brokerage, investment banking, insurance, and more.

This consolidation created financial conglomerates that offer one-stop shopping for financial services. It also created new risks, as we saw during the credit crisis.

The Credit Crisis

The last section of the chapter covers the 2008 credit crisis, and it is probably the most eye-opening part.

During 2004-2006, home prices kept climbing. Financial institutions rushed to originate mortgages, often with very loose standards. They did not always verify income, job status, or credit history. They figured that even if borrowers defaulted, rising home values would cover the losses.

They were wrong.

When mortgage defaults surged in 2007-2009, home prices collapsed. The collateral backing millions of mortgages was suddenly worth less than the loan amounts. By January 2009, at least 10% of American homeowners were behind on payments or had defaulted.

The damage spread far beyond the banks that originated the mortgages. Many institutions had purchased mortgage-backed securities. Others like Bear Stearns and Lehman Brothers relied on short-term debt and used mortgage-backed securities as collateral. When those securities tanked, they could not refinance.

This is what the book calls systemic risk: financial problems spreading from institution to institution and across markets, potentially collapsing the whole system.

The government responded with the Emergency Economic Stabilization Act ($700 billion bailout), Federal Reserve emergency lending, and eventually the Financial Reform Act of 2010. That act required lenders to actually verify borrower income and credit history before approving mortgages, created the Consumer Financial Protection Bureau, and established the Financial Stability Oversight Council.

My Take

Chapter 1 is a lot of ground to cover, but Madura keeps it organized. The surplus/deficit unit framework is simple but powerful. Once you see the financial system through that lens, everything else clicks.

The credit crisis section hit differently reading it years later. The mistakes seem so obvious in hindsight. Banks lending to people who could not repay, investors buying securities they did not understand, rating agencies giving high grades to risky debt. But the incentive structures at the time made each individual decision seem rational. That is the scary part.

This chapter is a strong foundation for the rest of the book.

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