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THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 342

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310

PA R T I I I

Financial Institutions

needed. This largesse did not come for free.
The federal government in effect took over
these companies by putting them into conservatorship, requiring that their CEOs step
down, and by having their regulator, the
Federal Housing Finance Agency, oversee the
companies day-to-day operations. In addition the U.S. government received around
US$1 billion of senior preferred stock and the
right to purchase 80% of the common stock if
the companies recovered. After the bailout,
the prices of both companies common stocks
was less than 2% of what they had been
worth only a year earlier.

It is not yet clear how much the government bailout of Fannie and Freddie will cost
the American taxpayer. The ultimate fate of
these two companies is also unclear. The sad
saga of Fannie Mae and Freddie Mac illustrates how dangerous it was for the U.S. government to set up GSEs that were exposed to
a classic conflict-of-interest problem: They
were supposed to serve two masters. As publicly traded corporations, they were expected
to maximize profits for their shareholders,
but as government agencies, they were
obliged to work in the interests of the public.
In the end, neither the public nor the shareholders were well served.

*Quoted in Nile Stephen Campbell, Fannie Mae Officials Try to Assuage Worried Investors, Real Estate Finance


Today, May 10, 1999.

S U M M A RY
1. Insurance providers, which are regulated by the
OSFI and the provinces, acquire funds by selling
policies that pay out benefits if catastrophic events
occur. Property and casualty insurance companies
hold more liquid assets than life insurance companies because of greater uncertainty regarding the
benefits they will have to pay out. All insurers face
moral hazard and adverse selection problems that
explain the use of insurance management tools,
such as information collection and screening of
potential policyholders, risk-based premiums,
restrictive provisions, prevention of fraud, cancellation of insurance, deductibles, coinsurance, and limits on the amount of insurance.
2. Pension plans provide income payments to people
when they retire after contributing to the plans for
many years. Pension funds have experienced very
rapid growth as a result of encouragement by federal
tax policy and now play an important role in the
stock market. Many pension plans are underfunded,
which means that in future years they will have to
pay out higher benefits than the value of their contributions and earnings. The problem of underfunding is especially acute for public pension plans such
as the CPP.

3. Finance companies raise funds by issuing commercial
paper and stocks and bonds and use the proceeds to
make loans that are particularly suited to consumer
and business needs. Virtually unregulated in comparison to chartered banks and near banks, finance companies have been able to tailor their loans to customer
needs very quickly and have grown rapidly.
4. Investment bankers assist in the initial sale of securities in primary markets, whereas securities brokers

and dealers assist in the trading of securities in the
secondary markets, some of which are organized
into exchanges. The provinces and the federal government regulate the financial institutions in the
securities markets and ensure that adequate information reaches prospective investors.
5. Mutual funds sell shares and use the proceeds to buy
securities. Open-end funds issue shares that can be
redeemed at any time at a price tied to the asset value
of the firm. Closed-end funds issue nonredeemable
shares, which are traded like common stock. They are
less popular than open-end funds because their
shares are not as liquid. Money market mutual funds
hold only short-term, high-quality securities, allowing
shares to be redeemed at a fixed value.



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