Chapter 24 Securities Operations Outline Services Provided by Securities Firms Facilitating Stock Offerings Facilitating Bond Offerings Securitizing Mortgages Advising Corporations Financing Corporations Providing Brokerage Services Operating Mutual Funds Proprietary Trading Interaction with Other Financial Institutions Participation in Financial Markets Expanding Functions Internationally Regulation of Securities Firms Stock Exchange Regulations Regulatory Events that Affected Securities Firms Exposure of Securities Firms to Risk Market Risk Interest Rate Risk Credit Risk Exchange Rate Risk Impact of Financial Leverage on Exposure to Risk Valuation of a Securities Firm Factors That Affect Cash Flows Factors That Affect the Required Rate of Return by Investors Impact of the Credit Crisis on Securities Firms Government Assistance to Bear Stearns Failure of Lehman Brothers Impact of the Credit Crisis on Regulatory Reform Key Concepts 1. Describe the main functions of securities firms. 2. Explain how securities firms facilitate corporate acquisitions. 3. Explain how securities firms may be exposed to systemic risk, and discuss the pros and cons of the Federal Reserve rescuing Bear Stearns during the credit crisis. POINT/COUNTER-POINT: Should Analysts be Separated from Securities Firms to Ensure No Conflicts of Interest? POINT: No. Securities firms are known for their ability to analyze companies and value them. Investors may be more comfortable when analysts work within the securities firms, because they have access to substantial information. COUNTER-POINT: Yes. Analysts have a conflict of interests, because they may be unwilling to offer negative views about a company that is a client of their securities firm. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: Most students are well aware of the conflicts of interest, and therefore have some strong opinions about this issue. The conflicts of interest were highly publicized in 2002 and 2003. New regulations were imposed to prevent the conflict of interests in the future. For example, analysts have to report whether they have a personal investment in the company they are rating. However, there is some question as to whether the rules will change analyst behavior. Even if the analysts were separated from securities firms, consider the potential conflict of interests that would still occur. A securities firm may need to pay an analyst to conduct an analysis of a firm for it recently underwrote the initial public offering. The analyst knows that the securities firm is hoping for a very favorable assessment over time, as that assessment may create more demand for the stock and ensure that the stock price remains high. Thus, even if analysts are not employed by the securities firm, they still have an interest in offering an opinion that will please the securities firms, so that that they receive future business from the securities firm. Questions 1. Regulation of Securities Activities. Explain the role of the SEC, the NASD, and the stock exchanges in regulating the securities industry. ANSWER: The SEC regulates the issuance of securities and specifies disclosure rules for the issuers. Day-to-day regulating duties such as the prevention of illegal practices and the assurance of orderly trading are the responsibility of the exchange and the NASD. 2. SIPC. What is the purpose of the SIPC? ANSWER: The SIPC offers insurance on cash and securities deposited at brokerage firms. 3. Investment Banking Services. How do securities firms facilitate leveraged buyouts? Why are securities firms that are more capable of raising funds in the capital markets preferred by corporations that need advice on proposed acquisitions? ANSWER: Securities firms facilitate leveraged buyouts by: (1) assessing the appropriate market value of the firm, (2) arranging financing, and (3) offering additional advice when needed. Many acquisitions require outside financing. A securities firm that has more ability to raise funds can enhance the chances of a successful acquisition for the potential acquiring firm. 4. Origination Process. Describe the origination process for corporations that are about to issue new stock. ANSWER: A corporation about to issue new stock contacts an IBF, which recommends the amount of stock to issue along with the suggested price and other provisions. The corporation then registers with the SEC with a registration statement. 5. Underwriting Function. Describe the underwriting function of a securities firm. ANSWER: An IBF may be willing to underwrite the stock of an issuing corporation, which guarantees the price to be received by the corporation. The IBF assumes the risk that the securities could sell for a lower price than anticipated. 6. Best-Efforts Agreement. What is a best-efforts agreement? ANSWER: In a best-efforts agreement, the IBF does not guarantee a price to the issuing corporation, but only promises to offer its best efforts in selling the securities. Thus, the issuing corporation bears the risk that the securities may sell for a lower price than anticipated. 7. Failure of Lehman Brothers. Why did Lehman Brothers experience financial problems during the credit crisis? ANSWER: Lehman Brothers had much exposure to mortgage-backed securities. It had a relatively low level of cash, and its high degree of financial leverage created more pressure. For every dollar of equity, it had about $30 of debt. Furthermore, some of its debt was short-term and therefore could be cut off (not renewed) if creditors sensed that Lehman was experiencing potential financial problems. 8. Direct Placement. Describe a direct placement of bonds. What is an advantage of a private placement? What is a disadvantage? ANSWER: A direct placement involves the sale of securities directly to a specific investor (or investors) without offering securities to the general public. This is more likely for bonds than for stocks. A direct placement can avoid underwriting fees. However, the demand for securities that are directly placed may be low, since only a fraction of the market is targeted. 9. International Expansion. Explain why securities firms from the United States have expanded into foreign markets. ANSWER: U.S. securities have expanded overseas because: (1) their international presence allows them to place securities in various markets, (2) they can better assess potential international mergers for corporations, and (3) they can advise on foreign securities that their institutional investors should purchase. 10. Proprietary Trading. Explain the process of proprietary trading by securities firms. ANSWER: Securities firms can engage in proprietary trading, in which they use their own funds to make investments for their own account. They may invest in equity securities, bonds and other debt securities, or even in derivative securities. Their proprietary trading has often supplemented their income from other operations, but their investments expose them to risk, and have resulted in major losses in some cases. 11. Asset Stripping. What is asset stripping? ANSWER: Asset stripping is a form of arbitrage in which after a firm is acquired, some of its divisions are sold. 12. Securities Firm's Use of Financial Leverage. Explain why securities firms have used a high level of financial leverage in the past. Explain how the leverage affects their expected return and their risk. ANSWER: Securities firms use a high level of financial leverage because it can enhance their return on equity. For a given return on assets, the return on equity will be magnified if a higher level of financial leverage is used. However, a negative return on equity will convert into a more pronounced loss (as a percent of equity) if a higher level of financial leverage is used. 13. Systemic Risk. Why was the Federal Reserve concerned about systemic risk due to the financial problems of Bear Stearns? ANSWER: The failure of Bear Stearns could have spread adverse effects throughout financial markets. Since Bear Stearns was a major provider of clearing operations for many types of financial transactions, its failure might have frozen or delayed many financial transactions, which could have resulted in a liquidity crisis for many individuals and firms that were to receive cash as a result of the transactions. Bear Stearns also served as a counterparty to various types of financial agreements. If Bear had defaulted on all of its counterparty positions, this could have caused problems for the financial institutions on the other side of those agreements, which could have created chaos in financial markets. 14. Access to Inside Information. Why do securities firms typically have some inside information that could affect future stock prices of other firms? ANSWER: Securities firms are often aware of which firms are targets to other acquiring firms. They may even identify what they believe to be undervalued targets for their clients. Also, when a firm plans to acquire a target, it may ask a securities firm o facilitate the financing and other tasks of the acquisition. The stock prices of target firms typically rise substantially prior to an acquisition. 15. Sensitivity to Stock Market Conditions. Most securities firms experience poor profit performance after periods in which the stock market performs poorly. Given what you know about securities firms, offer some possible reasons for these reduced profits. ANSWER: Profits are reduced because of (1) less stock transactions by investors, resulting in less commissions; (2) less issuances of new stock by firms (since their stock prices are so low, they do not want to sell new stock at that price), resulting in less underwriting fees; and (3) some securities firms had made major investments in some targets with their own equity. The market value of these equity positions had declined substantially. 16. Conversion to BHC Structure. Explain how the credit crisis encouraged some securities firms to convert to a bank holding company (BHC) structure. Why might the expected return on equity be lower for securities firms that convert to a bank holding company structure? ANSWER: While securities firms were allowed to borrow short-term funds from the Federal Reserve during the credit crisis, their conversion to a bank holding company would give them permanent access to Federal Reserve funding. Also, the bank holding company structure results in a higher required capital and greater degree of regulatory oversight by the Federal Reserve. The securities firms may be viewed as safer because of their conversion to bank holding companies, and this may also allow for easier access to funding. Financial Services Modernization Act. How did the Financial Services Modernization Act affect securities firms? ANSWER: The Financial Services Modernization Act resulted in the creation of more financial conglomerates that include securities firms. One of the key benefits to securities firms in a financial conglomerate is cross-listing. When individuals use brokerage services of a securities firm, that firm may steer them to do their banking with the affiliated commercial bank or to obtain a mortgage with the affiliated savings institution. When firms use investment banking services of a securities firm, that firm may steer them to do their banking with the affiliated commercial bank. The other types of financial institutions that form the conglomerate can reciprocate by steering their customers toward the securities firm. Thus, the bundling of financial services can generate more business for each type of financial institution that is part of the financial conglomerate. Regulation FD. What impact has the SEC’s Regulation Fair Disclosure (FD) had on securities firms? ANSWER: As a result of Regulation FD, firms more frequently provide their information in the form of news releases or conference calls rather than leaking it to a few analysts. Those analysts who relied on inside information when providing their insight to clients have lost their competitive advantage, while analysts who relied on their own analysis rather than information leaks have gained a competitive edge. Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “The stock prices of most securities firms took a hit because of the recent increase in interest rates.” Some securities firms hold bonds, which decline in value when interest rates rise. Some securities firms may lose some underwriting business when interest rates rise, as corporations reduce their bond offerings. If the higher interest rates discourage investors from purchasing more stock, those securities firms that have large brokerage businesses will be adversely affected. b. “Now that commercial banks are allowed more freedom to offer securities services, there may be a shakeout in the underwriting arena.” If commercial banks are allowed more freedom to underwrite securities, this will create more competition in the underwriting business. The intensified competition will probably result in lower underwriting fees charged to clients, and some firms that cannot offer underwriting services efficiently will be pushed out of the market. c. “Chaos in the securities markets can be good for some securities firms.” Chaos may cause a substantial amount of trading in securities in the securities markets, if investors respond to the chaos instead of waiting it out. Those securities firms that generate much of their business from executing securities transactions can possibly benefit. Managing in Financial Markets As a consultant for a securities firm, you are assessing the operations of a securities firm. a. The securities firm relies heavily on full-service brokerage commissions. Do you think that heavy reliance on these brokerage commissions is risky? Explain. Brokerage commissions are dependent on the volume of transactions executed, which can change abruptly. Also, as new competitors enter the industry, the securities firm may lose market share. Therefore, the securities firm may benefit from diversifying its securities businesses. b. If this firm attempts to enter the underwriting business, would it be an easy transition? Full-service brokerage firms have some experience in valuing stocks, and therefore have some ability to advise corporations on what their stocks might be sold for if they issue stocks. However, the firm would need to hire additional employees at high salaries who would focus on the underwriting business. The transition may be logical, but may take time to become profitable. c. In recent years, the stock market volume increased substantially, and this securities firm performed very well. In the future, however, many institutional and individual investors may invest in indexes rather than in individual stocks. How would this affect the securities firm? Indexing would reduce the trading of stocks, and therefore could reduce brokerage commissions. Thus, this firm could be adversely affected if indexing becomes more popular. Flow of Funds Exercise How Investment Banking Facilitates the Flow of Funds Recall that Carson Company has periodically borrowed funds, but contemplates a stock or bond offering so that it can expand by acquiring some other businesses. It contacted Kelly Investment Company, an investment bank. a. Explain how Kelly Investment Company can serve Carson and how it will serve other clients as well when it serves Carson. Also explain how Carson Company can serve Kelly Investment Company. Kelly can underwrite stocks or bonds issued by Carson Company so that Carson can obtain funds to support its expansion. Kelly would place securities with investors who wanted to purchase stocks or bonds, so its underwriting function also serves investors. In addition, a secondary market for the securities is created, so that investors are able to sell these securities to other investors at a future point in time. Kelly can offer Carson advice about acquisitions, by conducting valuations of potential target companies and by negotiating with the companies in an effort to close a deal for Carson. Carson pays Kelly fees for any of the services offered here. Carson is unable to perform these specialized services on its own, so it relies on an investment bank to perform the services. b. In a securities offering Kelly Investment Company would like to do a good job for its clients, which include both the issuer and institutional investors. Explain the dilemma. Kelly wants to ensure that the securities are offered at a high enough price to satisfy the issuer and a low enough price to satisfy the investors. If the investors earn a very high return on the first day of a securities offering, this may imply that Kelly priced the offering too low, which results in less proceeds to the issuer. If the investors earn a negative return on the first day, it may suggest that Kelly priced the offering too high. Kelly’s goal should be to price the securities near a level that is consistent with what the market price becomes. In this way, it signals that it priced the securities at a level that properly anticipated the market supply and demand. c. The issuing firm in an IPO hopes that there will be a strong demand for its shares at the offer price, which will ensure that it receives a reasonable amount of proceeds from its offering. In some previous IPOs, the share price by the end of the first day was more than 80 percent above the offer price at the beginning of the day. This reflects a very strong demand relative to the price at the end of the day. In fact, it probably suggests that the IPO was fully subscribed at the offer price, and that some institutional investors who purchased the stock at the offer price flipped their shares near the end of the first day to individual investors who were willing to pay the market price. Do you think that the issuing firm would be pleased that its stock price increased by more than 80 percent on the first day? Explain. Who really benefits from the increase in price on the first day? If the price increases by 80 percent in one day, this may suggest that the underwriter used an offer price that was too low. Consequently, the issuer should have been paid more for the stock than it was paid. The major beneficiary is the institutional investor who purchased the stock and in one day earns a return of 80 percent. d. Continuing the previous question, assume that the stock price drifts back down to near the original offer price over the next three weeks (even though the general stock market conditions were stable over this period) and then moves in tandem with the market over the next several years. Based on this information, do you think the offer price was appropriate? If so, how can you explain the unusually high one-day return on the stock? Who benefited from this stock price behavior, and who was adversely affected? Given this information, it appears that the equilibrium stock price is near the offer price, which suggests that the offer price was a reasonable estimate of the equilibrium price. The high initial return is not due to major underpricing by the underwriter, but is due to the excessive demand for the shares on the first day in the secondary market. Some individual investors were willing to pay much more for the stock than was appropriate, and the stock price was driven up as a result. Over the next few weeks, some investors sold their shares as they recognized that the price was too high. Thus, the institutional investors who paid the offer price and sold within the first few weeks benefited from the stock price behavior. The investors who purchased the stock in the secondary market on the first day or within the first few weeks were adversely affected. Solution Manual for Financial Markets and Institutions Jeff Madura 9781133947875, 9781305257191, 9780538482172
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