Securities Operations

1. 25 Securities Operations

2. Chapter Objectives • Review and evaluate the key functions of investment banking firms • Describe the services provided by investment banking firms when they assist in issuing new stock issues • Analyze the risks of securities firms • Evaluate the key functions of brokerage firms • Evaluate the key factors impacting the value of securities firms

3. Investment Banking Services • Investment banking firms (IBFs) assist in raising capital for corporations and state and municipal governments • IBF’s serve both financing entities and investors: • Serve as an intermediary buying securities (promise to pay) from issuing companies and selling them (securities) to investors • Generate fees for services rather than interest income • Sell investing services to institutional and other investors • Advise companies on mergers and acquisitions • Value companies for sale or purchase • In recent years, loaned funds for mergers and acquisitions

4. Investment Banking Services Distribution Origination Investment Banking Services Advising Underwriting

5. How IBFs Facilitate New Stock Issues • Origination • Company wishes to issue additional stock or issue stock for the first time contacts IBF • Gets advice on the amount to issue • Helps determine stock price for first-time issues • IBF assists with SEC filings • Registration statement • Prospectus—summary of registration statement given to prospective investors

6. How IBFs Facilitate New Stock Issues • Underwriting stock • Issuer and investment bank negotiate the underwriting spread • The difference between the net price given the company and the selling price to investors • Incentive to under-price IPO’s • The lead investment bank usually forms an underwriting syndicate • Other IBFs underwrite a part of the security offering • Helps spread the underwriting risk among IBFs

7. How IBFs Facilitate New Stock Issues • Distribution of stock • Full underwriting vs. best efforts • IBFs in the syndicate have retail brokerage operations • Other IBF added as part of selling group • Corporation incurs flotation costs • Underwriting spread • Direct issuance costs—accounting, legal fees, etc.

8. How IBFs Facilitate New Stock Issues • Advising • The IBF acts as an advisor throughout the process • Corporations do not have the in-house expertise • Includes advice on: • Timing • Amount • Terms • Type of financing

9. How IBFs Facilitate New Bond Issues • Origination • IBF may suggest a maximum amount of bonds that should be issued based on firm characteristics • Decisions on coupon rate, maturity • Benchmark with market prices of bonds of similar risk • Credit rating • Bond issuers must register with the SEC • Registration Statement • Prospectus

10. How IBFs Facilitate New Bond Issues • Underwriting bonds • Public utilities often use competitive bids to select an IBF, versus….. • Corporations typically select an IBF based on reputation and prior working experience • The underwriting spread on bonds is lower than that for stocks • Can place large blocks with institutional investors • Less market risk

11. How IBFs Facilitate New Bond Issues • Distribution of bonds • Prospectus • Advertisements to public • Flotation costs are typically in the range of 0.5 percent to 3 percent of face value

12. How IBFs Facilitate New Bond Issues • Private placement of bonds • Avoids underwriting and SEC registration expenses • Potential purchaser may buy the entire issue • Insurance companies • mutual funds • commercial banks • pension funds • Demand may not be as strong, so price may be less, resulting in a higher cost for issuing firm • Investment banks may be involved to provide advice and find potential purchasers

13. How IBFs Facilitate Leveraged Buyouts • IBFs facilitate LBOs in three ways: • They assess the market value of the LBO firm • They arrange financing • Purchase outstanding stock held by public • Often invest in the deal themselves • Provide advice

14. How IBFs Facilitate Arbitrage • Arbitrage = purchasing of undervalued shares and reselling the shares at a higher price • IBFs work with arbitrage firms to search for undervalued firms • Asset stripping • A firm is acquired, and then its individual divisions are sold off • Sum of the parts is greater than the whole • Kohlberg, Kravis, and Roberts

15. How IBFs Facilitate Arbitrage • IBFs generate fee income from advising arbitrage firms as well as a commission on the bonds issued to support arbitrage activity • IBFs also provide bridge loans • When fund raising is not expected to be complete when the acquisition is initiated • IBFs provide advice on takeover defense maneuvers

16. How IBFs Facilitate Arbitrage • History of arbitrage activity • Greenmail is when a target company buys back stock from arbitrage firm at a premium over market price • Arbitrage activity has been criticized • Results in excessive financial leverage and risk for corporations • Restructuring sometimes results in layoffs • Arbitrage helps remove managerial inefficiencies • Target shareholders can benefit from higher share prices

17. Brokerage Services • Full-service versus discount brokerage services • Full-service firms provide investment advice as well as executing transactions • Discount brokerage firms only execute security transactions upon request • Online brokerage firms

18. Allocation of Revenue Sources • Importance of brokerage commissions has declined in recent years • Largest source of revenue has been trading and investment profits • Underwriting and margin interest also make up a significant portion of revenue • Revenue from fees earned on advising and executing acquisitions has increased over time

19. Regulation of Securities Firms • Regulated by the National Association of Securities Dealers (NASD) and securities exchanges • The SEC regulates the issuance of securities and specifies disclosure rules for issuers • Also regulates exchanges and brokerage firms • SEC establishes general guidelines, while the NASD provides day-to-day self-regulatory duties

20. Regulation of Securities Firms • The Federal Reserve determines the credit limits (margin requirements) on securities purchased • The Securities Investor Protection Corporation (SIPC) offers insurance on brokerage accounts • Insured up to $500,000 • Brokers pay premiums to SIPC to maintain the fund • Boosts investor confidence, increasing economic efficiency

21. Regulation of Securities Firms • Financial Services Modernization Act of 1999 • Permitted banking, securities activities, and insurance to be offered by a single firm • Varied financial services organized as subsidiaries under special holding company • Financial holding companies regulated by the Federal Reserve

22. Risks of Securities Firms Interest Rate Risk Market Risk Exchange Rate Risk Credit Risk

23. Risks of Securities Firms • Market risk • Securities firms’ activities are linked to stock market conditions • When stock prices are rising: • Greater volume of stock offerings • Increased secondary market transactions • More mutual fund activity • Securities firms take equity positions which are bolstered when prices rise

24. Risks of Securities Firms • Interest rate risk • Performance of securities firms can be sensitive to interest rate movements because: • Market values of bonds held as investments increase as interest rates fall • Lower rates can encourage investors to withdraw money from banks and invest in stocks • Exchange rate risk • Operations in foreign countries • Investments in securities denominated in foreign currency

25. Valuation of Securities Firms • Value of a securities firm depends on its expected cash flows and required rate of return V = f [E(CF),k] + Where: V= Change in value of the securities firm E(CF) = Change in expected cash flows k = Change in required rate or return

26. Valuation of Securities Firms • Factors that affect cash flows E(CF)= f (ECON, Rf , INDUS, MANAB) + ? + Where: E(CF)= Expected cash flow ECON= Economic growth Rf = Risk free interest rate INDUS = Prevailing industry conditions MANAB = The ability of the security firm’s management

27. Valuation of Securities Firms • Investors required rate of return k= f(Rf , RP) + + Where: Rf = Risk free interest rate RP= Risk premium

28. Interaction With Other Financial Institutions • Offer investment advice and execute security transactions for financial institutions that maintain security portfolios • Compete against financial institutions that have brokerage subsidiaries • Glass-Steagall Act of 1933 separated the functions of commercial banks and investment banking firms • Financial Services Modernization Act of 1999 • Effectively repealed Glass-Steagall • Commercial banks, securities firms, and insurance companies will increasingly offer similar services

29. Globalization of Securities Firms • Securities firms have increased their presence in foreign countries • Merrill Lynch has more than 500 offices spread across the world • Allows them to place securities in various markets for corporations or governments • International M&A • Ability to handle transactions with foreign securities

30. Globalization of Securities Firms • Growth in international securities transactions • Created more business for large securities firms • International stock offerings • Increased liquidity for issuing firm, avoiding downward price pressure • Growth in Latin America • Increased business due to NAFTA • Growth in Japan • Some barriers to foreign securities firms still exist