Securities

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25

• Securities
• Operations

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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
• IBFs 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

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Investment Banking Services
Distribution
Origination
Investment Banking Services
Advising
Underwriting
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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
• Prospectussummary of registration statement
  given to prospective investors

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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 IPOs
• 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

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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 costsaccounting, legal fees, etc.

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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Risks of Securities Firms
Interest Rate Risk
Market Risk

Exchange Rate Risk
Credit Risk
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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

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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

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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
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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 firms
management
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Valuation of Securities Firms

• Investors required rate of return

?k f(?Rf , ?RP)


Where
Rf Risk free interest rate
RP Risk premium
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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

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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 MA
• Ability to handle transactions with foreign
  securities

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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