 Ask
Dr. Econ
December 1999
Why do investment banks syndicate a new securities issue? What is
ERISA and what does it do? And, what are its implications for the financial
markets? Why are life insurance companies major buyers of bonds?
Why do investment banks syndicate a new securities issue?
Investment banks play a key role in the issuance of new corporate and
state and local government securities. However they also face considerable
risks in doing so. Investment bankers typically provide one or more of
the following services for the entity issuing new securities:
- Advice on the timing, issue price, volume of securities offered, and
other terms,
- Purchase all or some of the securities from the issuer, and
- Resell the securities to the public.
The latter two activities, called underwriting, generate fees for the
investment bank. However, underwriting may involve substantial risks,
especially the risk that the investment bank underwriting the securities
may not be able to resell the securities at a profit. In cases where the
investment bank must sell the securities at a price below what it paid
to purchase them from the issuer, the investment bank will suffer a loss
of its own capital.
Since there is considerable uncertainty about the success or failure
of new securities offerings, investment banks typically share the potential
risks (and rewards) by forming a syndicate of investment banks. The number
of firms included in the syndicate may vary widely, depending on the size
and the risks associated with the securities. Establishment of a syndicate
thus limits the risk to any single investment bank from any single new
issue by spreading the risk across a number of investment banks.
What is ERISA and what does it do? And, what are its implications
for the financial markets?
The Employee Retirement Income Security Act of 1974 (ERISA) was designed
by Congress to comprehensively regulate pension plans. ERISA is a complex
piece of legislation that is administered by the Department of Labor and
the Internal Revenue Service. It includes the following important provisions:
- Sets funding standards for firm contributions that are sufficient
to cover projected benefit payouts,
- Establishes fiduciary standards (including the so-called "prudent
man" rule of investing) for pension fund trustees, managers, and/or
advisors,
- Sets minimum vesting standards for plan participants' rights to accumulated
benefits,
- Created the Pension Benefit Guarantee Corporation (PBGC), an insurance
fund for vested benefits, and
- Requires periodic reporting and public disclosure.
ERISA plays an important role in maintaining employee confidence in the
safety of their pension plans. Maintaining confidence in pension plans
is significant given the rapid expansion of pension plan holdings in the
financial system. In 1998, pension funds (not including Federal employees)
held over $6.7 trillion in assets, or over 28 percent of all financial
intermediary assets. Pension funds are now the largest category of financial
intermediary in the United States, with assets greater than either the
banking industry ($5.6 trillion) or the mutual fund industry ($5.1 trillion).
Why are life insurance companies major buyers of bonds?
At yearend 1998, the life insurance industry, with $2.8 billion in assets,
was a major holder of corporate bonds. The industry's $1.1 trillion in
corporate and foreign bonds in 1998 accounted for nearly 39 percent of
life insurance industry assets.
Life insurance companies play an important role, both in the corporate
bond market and the financial system. In 1998, they were the fourth largest
category of financial intermediary, accounting for nearly 12 percent of
U.S. financial intermediary assets.
Because life insurance companies enter into many long-term financial
contracts (insurance products, annuities) with customers, they have relatively
predictable long-term cash inflows that they can match to actuarially
expected payouts. These predictable long-term contractual flows allow
life insurance companies to invest a sizeable portion of their portfolio
in correspondingly long-term financial assets, like corporate bonds.
In contrast to the life insurance industry, the property and casualty
insurance industry typically has shorter-term contractual arrangements
and experiences potentially larger and less predictable losses (natural
disaster, for example). Thus, in 1998 the property and casualty insurance
industry requires relatively more short-term financial assets in their
portfolio. The property and casualty insurance industry held less than
18 percent of its assets in corporate and foreign bonds in 1998, less
than half the percent held by the life insurance industry.
References
Fabozzi, Frank J., Franco Modigliani, and Michael
G. Ferri. 1994. Foundations of Financial Markets and Institutions,
Chapters 7, 9, and 14. Englewood Cliffs, NJ: Prentice Hall Inc.
Rose, Peter S. 1994. Money and Capital Markets,
Chapter 6. Burr Ridge, Illinois: Irwin.
Saunders, Anthony. 1997. Financial Institutions
Management, Chapters 2, 3, and 18. Boston, MA: Irwin/McGraw-Hill.
Source of financial data: Flow of Funds Accounts
of the United States, Federal Reserve Statistical Release Z.1, Fourth
Quarter 1998. <http://www.federalreserve.gov/releases/Z1/>
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