Chapter 24

Securities Operations

Financial Markets and Institutions, 7e, Jeff Madura Copyright 2006 by South-Western, a division of Thomson Learning. All rights reserved.

Chapter Outline

Investment banking services Brokerage services Sources of income Regulation of securities firms Risks of securities firms Valuation of a securities firm Interaction with other financial institutions Participation in financial markets Globalization of securities firms
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Investment Banking Services

One of the main functions of investment banking firms (IBFs) is raising capital for corporations
IBFs

originate, structure, and place securities in the capital markets They serve as an intermediary rather than a lender or investor Their compensation is typically in the form of fees

Investment Banking Services (contd)

How IBFs facilitate new stock offerings

An

IBF acts as an intermediary between a corporation and investors Origination

IBFs recommend the appropriate amount of stock to issue IBFs evaluate the corporations financial condition to determine the appropriate stock price

Investment Banking Services (contd)

How IBFs facilitate new stock offerings (contd)

Origination

(contd)

The issuing corporation registers with the SEC

The registration statement is intended to ensure that accurate information is disclosed by the issuing corporation Included in the registration information is the prospectus, disclosing relevant financial data on the firm and provision applicable to the security

The IBF and the issuing firm may engage in a road show to meet with institutional investors

Investment Banking Services (contd)

How IBFs facilitate new stock offerings (contd)

Underwriting The IBF may form an underwriting syndicate and ask other IBFs to underwrite a portion of the stock In a best-efforts agreement, the IBF does not guarantee a price to the issuing corporation During IPOs:

IBFs want to set the price high so that the issuing corporation receives higher proceeds IBFs do not want to set the price too high in order to place the entire issue IBFs tend to underprice IPOs

Investment Banking Services (contd)

How IBFs facilitate new stock offerings (contd)

Distribution

of stock

The prospectus is distributed to all potential purchasers of the stock The issue is advertised to the public Some IBFs have brokerage subsidiaries that can sell stock on a retail level The corporation incurs two types of flotation costs:

Fees paid to the underwriters Issue costs, including printing, legal, registration, and accounting expenses
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Investment Banking Services (contd)

How IBFs facilitate new stock offerings (contd)

Advising

The IBF acts as an adviser during the origination stage and may provide advice after the stock is issued

Private

placement of stocks

IBFs may be able to place an entire offering with a small set of institutional investors Rule 144A allows firms to engage in private placement without the registration statement An underwriting syndicate may not be necessary The issuing firms costs are lower
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Investment Banking Services (contd)

How IBFs facilitate new bond offerings

Origination

The IBF may suggest a maximum amount of bonds based on existing debt levels The coupon rate, maturity, and other provisions are decided The asking price on the bonds will be determined by evaluating market prices of existing bonds Issuers of bonds must register with the SEC and a registration statement must be filed

Investment Banking Services (contd)

How IBFs facilitate new bond offerings (contd)

Underwriting bonds

Some issuers may solicit competitive bids on the price of bonds from various IBFs IBFs provide several services to the issuer Underwriting spreads on newly issued bonds are normally lower than on newly issued stock The IBF may organize an underwriting syndicate to participate in placing the bonds

Distribution of bonds

A prospectus is distributed to all potential purchasers The issue is advertised to the public The asking price is normally set to ensure a sale of the entire issue Flotation costs range from 0.5 to 3 percent of the value of the bonds
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Investment Banking Services (contd)

How IBFs facilitate new bond offerings (contd)

Advising

IBFs may serve as advisers even after the placement is completed

Private

placement of bonds

In a private placement, the issuing corporation sells the issue to a purchaser of the entire issue

Avoids underwriting fees

Private placements are more common for bonds than for stocks
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Investment Banking Services (contd)

How IBFs facilitate leveraged buyouts

IBFs assess the market value of the firm IBFs arrange financing, which involves raising funds and purchasing any common stock outstanding that is held by the public IBFs may be retained in an advisory capacity IBFs may purchase a portion of the firms assets to provide financial support

Exposes the IBF to a high degree of risk Purchase junk bonds of firms that went private Provides bridge loans that offer temporary financing to firms until junk bonds can be issued
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Merrill Lynch has designed a mutual fund that finances LBOs

Investment Banking Services (contd)

How IBFs facilitate arbitrage

Arbitrage

activity involves the purchasing of undervalued shares and the resale of those shares for a higher profit Arbitrage firms search for undervalued firms and IBFs raise funds for these firms Asset stripping involves acquiring the firm and selling its individual divisions off

The sum of the parts is greater than the whole

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Investment Banking Services (contd)

How IBFs facilitate arbitrage (contd)

IBFs generate fee income from advising arbitrage firms and receive a commission on the bonds issued to support the arbitrage activity IBFs receive fees from divestitures of divisions IBFs may provide bridge loans if additional financing is needed IBFs may provide advise on defense takeover tactics and finance takeovers Some arbitrage firms take positions in hostile takeover targets to benefit from the expected takeover by another group

Some attempts at arbitrage fail because target firms are successful at defending against a takeover
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Investment Banking Services (contd)

How IBFs facilitate arbitrage (contd)

History

of arbitrage activity

Sometimes arbitrage firms have accumulated shares of targets with the expectation that targets will buy back the shares at a premium

Greenmail

Some IBFs helped to finance greenmail Arbitrage activity has been criticized because:

It often results in excessive financial leverage and risk for corporations The restructuring of divisions after acquisitions results in layoffs
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Investment Banking Services (contd)

How IBFs facilitate corporate restructuring

IBFs

provide advice on corporate restructuring

IBFs assess potential synergies that might result from the combination of two businesses

The sum of the whole is greater than the sum of the parts

IBFs may suggest a carve-out in which the firm sells a unit of the firm to new shareholders through an IPO by the unit

The sum of the parts is greater than the sum of the whole The unit may also be spun off, where new shares of the unit are created and distributed to existing shareholders

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Investment Banking Services (contd)

How IBFs facilitate corporate restructuring (contd)

IBFs

provide advice on mergers and acquisitions

IBFs are critical in the valuation of the business IBFs have loaned out their funds to companies involved in mergers and acquisitions or even provided equity financing The IBF can help finance an acquisition by:

Providing loans to the acquirer Underwriting bonds or stock for the acquirer Investing their own equity in the acquirers purchase of the target
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Brokerage Services

Market orders are requests by customers to purchase or sell securities at the market price existing when the order reaches the exchange floor Limit orders are requests by customers to purchase or sell securities at a specified price or better

Specialists monitor limit orders and execute transactions in accordance with the limits specified If investors order a sale of securities when the price reaches a specified minimum, it is a stop-loss order

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Brokerage Services (contd)

Short selling involves the sale of securities investors do not own

Used to speculate on expectations of a decline in securities prices Short sellers are required to reimburse the owners of the stock for any missed dividends Full-service brokerage firms provide information and advice as well as executing transactions Discount brokerage firms only execute transactions upon requests and do not provide advice

Full-service versus discount brokerage services

The required minimum opening balance is typically between $1000 and $3,000 Most discount brokers offer some degree of research on a website
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Brokerage Services (contd)

Online orders
The

implementation of an online order system has reduced costs of brokerage firms Online trading has become very competitive

Prices charged are low, typically $25 or less for 100 shares of stock

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Sources of Income
Investment Banking Services
Underwriting
Advising

Fees from underwriting stock or bond offerings

Fees for advice to firms about identifying potential targets, valuing targets, identifying potential acquirers, protecting against takeover Fees for facilitating mergers, divestitures, carveouts, spin-offs Fees for managing securities portfolios Fees for executing trades securities requested by individual or firms in the secondary market

Restructuring

Brokerage services
Management fees Trading commissions

Margin interest

Interest charged to investors who buy securities on margin

Investing its own funds

Investing Profits from investing in securities
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Sources of Income (contd)

Income allocation among securities firms

The proportion of income derived from each source varies among securities firms in any particular year

e.g., when IPOs are hot, income from underwriting fees will be high

Some securities firms emphasize investment banking and therefore generate a high proportion of income from underwriting and advising fees

e.g., Goldman Sachs

Some firms emphasize brokerage and generate a higher proportion of income from trading commissions

e.g., Charles Schwab

Many securities firms attempt to diversify their services so that they can capitalize on economies of scope
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Sources of Income (contd)

Impact of the September 11 Crisis on revenue sources

Trading

profits declined because stock prices declined The attack led to more uncertainty and reduced the number of IPOs and secondary offerings The volume of acquisitions declined

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Regulation of Securities Firms

Securities firms are subject to a variety of regulations The SEC attempts to ensure that investors have access to financial information The SEC has power to ensure that publiclytraded companies provide sufficient financial information to existing or prospective investors The SEC tends to establish general guidelines that can affect trading on security exchanges
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Regulation of Securities Firms (contd)

Stock exchanges and the Nasdaq are expected to prevent unfair or illegal practices, ensure orderly trading, and address customer complaints Stock exchanges are responsible for the day-to-day regulation of exchange trading

Stock exchanges have regulatory divisions The Nasdaq market is regulated by the NASD Surveillance departments monitor trading patterns and behavior by specialists or market makers and floor traders Enforcement divisions investigate possible violations and can enforce disciplinary actions
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Regulation of Securities Firms (contd)

The Fed determines margin requirements The Securities Investor Protection Corporation (SIPC) offers insurance on cash and securities deposited at brokerage firms and can liquidate failing brokerage firms
All

brokers registered with the SEC are assessed premiums by the SIPC

The insurance limit is $500,000, including $100,000 against claims on cash The SIPC has a $500 million revolving line of credit and can borrow up to $1 billion from the SEC
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Regulation of Securities Firms (contd)

Financial Services Modernization Act

The

Act allowed banking, securities activities, and insurance to be consolidated in a financial holding company The Act resulted in the creation of more financial conglomerates that included securities firms

A primary benefit to securities firms is cross-listing The bundling of financial services can generate more business for each type of financial institution that is part of the conglomerate

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Regulation of Securities Firms (contd)

Regulation FD:
Was

enacted in October 2000 by the SEC Requires that firms disclose any significant information simultaneously to all market participants Was partially intended to prevent a firm from leaking information to analysts Prevented analysts working for securities firms to have a competitive information advantage Benefited analysts who relied on their own analysis
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Regulation of Securities Firms (contd)

Rules regarding analyst compensation and ratings

When

firms need underwriting or advisory services, they are more likely to hire a securities firm whose analyst would rate the stock highly The compensation of some analysts in the 2001 2002 period was sometimes aligned with the new business they brought in Analysts were tempted to inflate the ratings of stocks and investors were misled
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Regulation of Securities Firms (contd)

Rules regarding analyst compensation and ratings (contd)

In

2002, the SEC implemented new rules:

If a securities firm underwrites an IPO, it cannot use its analysts to promote the stock for the first 40 days after the IPO Analyst compensation cannot be directly aligned with the amount of business that the analyst bring to the securities firm Analysts cannot be supervised by the investment banking department within the securities firm An analyst rating must divulge any recent investment banking business provided by the securities firm that assigned the rating

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Regulation of Securities Firms (contd)

Rules preventing abuse in the IPO market

In

the 20012003 period various abuses occurred:

Some securities firms that served as underwriters allocated shares to corporate executives who were considering an IPO for their firm (spinning) Some securities firms that served as underwriters encouraged institutional investors to place bids for the shares on the first day that are above the offer price in order to be allowed to participate in the next IPO

The

SEC investigated cases of abuse and imposed fines The SEC enacted rules to prevent such abuses from occurring in the future
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Regulation of Securities Firms (contd)

Repeal of the trade-through rule

Specialists were sometimes able to jump ahead of other orders (called penny-jumping)

Prevented other investors from having their orders executed

In 2004, the SEC ruled that investors could circumvent the trade-through rule to avoid penny-jumping by specialists In 2003, some funds were allowing their large clients to buy or sell shares after the 4 p.m. closing but at the 4 p.m. prices (late trading at stale prices)

Mutual fund disclosure

Violates 1968 SEC laws The SEC imposed heavy fines on those mutual funds and is working on laws requiring more disclosure of the fees that mutual funds charge and better governance
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Risks of Securities Firms

Market risk

When stock prices are rising there is a greater volume of stock offerings and secondary market transactions Securities firms benefit from a bullish stock market

Some take equity positions in the stocks they underwrite Some take a partial equity interest in target firms Acquisitions tend to be more common in bullish markets

Interest rate risk

The market values of bonds held as investment by securities firms increase as interest rates decline Lower interest rates can encourage investors to withdraw deposits from banks and invest in the stock market
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Risks of Securities Firms (contd)

Credit risk

Securities firms offer bridge loans and other types of credit to corporations Default risk increases during periods when economic conditions deteriorate Many securities firms have operations in foreign countries Earnings remitted by foreign subsidiaries are reduced when the foreign currencies weaken against the parent firms home currency Market values of foreign investments decline as the currencies weaken against the parent firms home currency
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Exchange rate risk

Valuation of a Securities Firm

The value of a securities firm is the present value of its future cash flows
The

value should change in response to changes in expected cash flows and the required rate of return:
V f E(CF ), k -

Factors that affect cash flows:

E(CF ) f ( ECON , Rf , INDUS, MANAB ) ?
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Valuation of a Securities Firm (contd)

Economic growth

Economic growth increases the level of income of firms and households and can increase the demand for the firms services

The volume of brokerage activity increases Business expansion increases Debt securities are less likely to default Equity securities should perform well

Change in the risk-free interest rate

The valuation of a securities firm is inversely related to interest rate movements

Assets are adversely affected by rising interest rates

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Valuation of a Securities Firm (contd)

Change in industry conditions

Affected by regulations, technology, and competition Reduced regulations may increase expected cash flows Increased competition from reduced regulations may reduce expected cash flows Managers can attempt to make decisions that will capitalize on external forces the firm cannot control Securities firms need skillful management to create new financial services that may complement the brokerage services they already offer
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Change in management abilities

Valuation of a Securities Firm (contd)

Factors that affect the required rate of return by investors: k f ( R , RP )

f

The risk-free rate is positively related to inflation, economic growth, and the budget deficit level, but inversely related to money supply growth The risk premium is inversely related to economic growth and the companys management skills Regulatory constraints may discourage firms from taking excessive risk Loosening of regulatory barriers to entry may increase the risk of securities firms
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Interaction with Other Financial Institutions

Type of Financial Institution
Commercial banks and SIs

Interaction with Securities Firm

Compete with commercial banks and SIs for brokerage services Compete with commercial banks offering advice on M&As and underwriting commercial paper

Mutual funds

Execute trades for mutual funds Some mutual funds are organized by securities firms Mutual funds purchase newly issued securities
Advise portfolio managers of insurance companies on trades Execute securities transactions for insurance companies Advise portfolio managers on hedging interest rate and market risk Underwrite stocks and bonds purchased by insurance companies Compete with insurance companies in the sales of mutual funds Obtain financing on LBOs from insurance companies Have acquired or merged with insurance companies
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Insurance companies

Interaction with Other Financial Institutions (contd)

Type of Financial Institution
Pension funds

Interaction with Securities Firm

Advise pension fund portfolio managers in trades Execute securities transactions for pension funds Advise pension fund portfolio managers on hedging interest rate and market risk Pension funds purchase newly issued securities

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Participation in Financial Markets

Type of Financial Market
Money markets Bond markets

Participation by Securities Firms

Some firms have created money market mutual funds Underwrite commercial paper and purchase short-term securities Underwrite bonds, advise clients on bonds to purchase or sell, serve as brokers for secondary market transactions Some bond mutual funds have been created by securities firms Facilitate mergers, acquisitions, and LBOs Purchase bonds for their own investment portfolios Place securities backed by mortgages for financial institutions Underwrite stocks, advise clients on what stocks to purchase or sell, serve as brokers for secondary market transactions Purchase stocks for their investment portfolios

Mortgage markets Stock markets

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Participation in Financial Markets (contd)

Type of Financial Market
Futures markets

Participation by Securities Firms

Advise large financial institutions on how to hedge their portfolios with futures Serve as brokers for financial futures transactions

Options markets
Swap markets

Advise large financial institutions on how to hedge portfolio with options Serve as brokers for options transactions
Engage in interest rate swaps to reduce their exposure to interest rate risk Serve a financial intermediaries in swap markets

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Participation in Financial Markets (contd)

Competition between securities firms and commercial banks

Commercial

banks can offer discount brokerage services at lower fees than full-service fees
Commercial banks compete with discount brokers Commercial banks must either establish a brokerage subsidiary or acquire a brokerage firm

Recently,

some securities firms have provided loans to businesses

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Globalization of Securities Firms

In 1986, the Big Bang allowed for deregulation in the U.K.

Many securities firms have increased their presence in foreign countries Commercial banks from the U.S. have established investment banking subsidiaries overseas Allows firms to place securities in various countries Allows firms to benefit from international M&As Institutional investors investing in foreign securities prefer firms that can easily handle such transactions

Advantages of becoming internationalized

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Globalization of Securities Firms (contd)

Growth in international joint ventures

Securities firms have expanded internationally by engaging in joint ventures

Allows foreign market penetration with a limited stake

Securities firms facilitate privatizations of firms in foreign markets such as Latin America and Europe The growth in international securities transactions has created more business for the larger securities firms

Growth in international securities transactions

Growth in Latin America Growth in Japan

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