Professional Documents
Culture Documents
Financial Markets
Two Types:
Money Market
Capital Market
Money Market
Money Market
Liquidity - Speed with which an asset can be converted to cash without loss of value
Short Term: All money market securities have maturity less than 270 days (except for Treasuries T-Bills 1 Year).
Reason: Federal securities laws require securities with maturities greater than 270 days to be registered.
Registration is costly Sell at a Discount: Way money market securities pay interest. Ex: Security with $100,000 face value but sells for $98,000. The $2,000 difference in the interest.
Treasuries
Negotiable Certificates of Deposit Bankers Acceptances Commercial Paper Federal Funds
Eurodollar Loans
Repurchase Agreements
Federal Funds
Sale of bank reserves that are held at Federal Reserve
Expansionary Monetary Policy - Buy securities from banks (Treasury deal Fed buys securities from banks and credits their reserve accts Bank reserves increase - Federal Funds rate declines
Quantitative Easing
A more extreme form of expansionary monetary policy Used by central bank to expand the economy when interest rates are at or close to zero When the central bank purchases assets, Treasuries & corporate bonds, using money the central bank simply created Used by Japan in early 2000s Used by US & UK in 2008-2009 subprime crisis and recession that followed
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6%
4%
2%
0% 1/1/2001
1/1/2002
1/1/2003
1/1/2004
1/1/2005
1/1/2006
1/1/2007
1/1/2008
1/1/2009
1/1/2010
1/1/2011
8%
6%
4%
2%
0% 1/1/2001
1/1/2002
1/1/2003
1/1/2004
1/1/2005
1/1/2006
1/1/2007
1/1/2008
1/1/2009
1/1/2010
1/1/2011
Discount Rate
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11
Source: Krugman/Wells
Treasury Bills
Maturities: 90 days, 180 days & 365 days - 365 days is exception - Treasury not have to worry about registration Purpose: Help Fed. Govt. close gap between expenditures and receipts Sold at a Discount: Pay less than face value to buy Secondary Market - very active Minimum Unit: used to be $10,000 but now is $1,000 Frequency of Sale: Auction every Monday for 91 days & 180 days - Treasury announces winning bids Monday afternoon & pay Thursday - 9 mo & 12 mo auction every month
Sold at a discount - ie investors bid $9,700 for a Treasury bill that matures at $10,000 in 1 year
What is the return in that period? Pay $ 9,700 Get $10,000 Difference: $10,000 - $9,700 = $300 Rate of Return: $300/$9,700 = 3.1%
Note: Higher the bid price - lower the return Lower the bid price - higher the return
3.
Repurchase Agreements
Called Repos Used by government securities dealers to help finance their inventories
Govt securities dealers may buy more securities than have cash for
Use broker to find investors (corporations) that want to invest cash short term - say 1 - 4 days
Repurchase Agreements: way securities dealer or banks can borrow from corpora Process: Dealer sells securities to investors and agrees to buy them back later. Term: usually overnight Term Repos: 30 days or longer Banks: active in repo market - way corporations can lend $ to banks Ex: GM has idle $1 mil in bank GM uses $ to buy T-bills from bank & bank agrees to buy them back later In effect, GM lends $ to bank
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Commercial Paper
Short term promissory notes issued by credit worthy corporations Maturities: 5-270 days
Source:WSJ 9/4/08 B1
All Rights Reserved. May not be reproduced , copied, or otherwise used without the express, written permission of Dr. Patrick Gaughan
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CP Rate vs. Treasuries: CP risk greater than Treasuries CP rate greater than Treasuries
Bankers Acceptances
Short term credit instrument created by a non-financial firms but guaranteed by a bank Used in importing & exporting and as a money market investment Int'l Trade: most frequent use
- Physical Nature of Security: letter of credit from importer's bank to exporters bank
The amount is accepted & guaranteed by a bank and payment will be drawn from a specific account of the banks customer Holder of the draft can sell it at a discount to an investor who is will to wait for the payment The market for these sales in the BA market Waiting period: typically 6 months
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Capital Market
Capital Market
Bond Market
- Government Bonds
- Corporate Bonds Mortgage Market Stock Market
Percentage
50
40
30
20
10
Year
-6
-8 -10 -12
Two factors affect the return on fixed income securities like Treasuries:
1. Inflation: increase causes value to decline
Municipal Bonds
Bonds of Cities, States and Counties and Authorities Tax Benefits: interest income exempt from federal taxation (not capital gains)
General Obligation Municipal Bonds - also called full faith and credit bonds - not backed up by specific assets or revenue streams
Limited Obligations Municipal Bonds - obligation is tied to some assets or revenue stream - ie. tolls revenues from building bridge Insuring Companies: lowers risk for investors MBIA - Municipals Bonds Insurance Assn AMBAC: American Municipal Bonds Assurance Corp.
These firms has been hurt by the subprime crisis
These firms are under much financial pressure due to their insuring sub-prime mortgage securities S&P Ratings: S&P agrees to give highest ratings to municipalities that get this insurance
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Municipal Bonds
More on Tax Exemption
They were promised by firms that sold them that they would be very low risk and highly liquid Sellers of these securities were paid unusually high commissions - auction rate commissions: 0.25% of securities value Merrill Lynch sometimes offered as high as 1% - Treasury securities commission: 0.05%
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30 25 20 15 10 5 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Mortgages are pooled together and pieces of them are sold to the public - all the mortgages in a given pool have the same interest rate
Ginnie Maes are a conduit through which the mortgage payments and principals payments flow through to the buyers of the Ginnie Maes Investors receive monthly payments The loans they buy are mortgage loans backed by the federal govt
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2008 both were placed in conservatorship by the Federal Housing Finance Agen - As of 2008 they owned or guaranteed of $12 trillion mortgage market
Benefit of Market: provides liquidity to secondary mortgages - helps increase mortgage availability - pooling lowers risk - helps eliminate regional differences in mortgage markets
1977 Congress and Carter passed the Community Investment Act 1999 Clinton administration put pressure on Fannie Mae to increase lending to low and middle income people Fannie Mae lowered loan requirements for mortgage loans it was willing to purchase This helped banks and mortgage brokers make big money Brokers issued many teaser rates loans with reset mechanisms Also gave more business for Fannie Mae and its shareholders made more money
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2005 Federal Housing Regulatory Reform Act (sponsored by Senators Chuck Hegel & John McCain)
Never got to have a full senate vote
Was designed to try to rein in the Fannie Mae and Freddie Mac Was designed to try to correct abuses and bad accounting Fannie Mae and Freddie Mac engaged in great lobbying efforts to control regulators
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Securities issued by Fannie Mae & Freddie Mac were not officially guaranteed by the Federal government However, the market believed that the government would not let them fail This increased the demand for these securities It also enabled them to raise capital at a lower rate
Real estate market fell sharply in 2006-2007 Economy slowed Many mortgages aggressively sold to those whose credit was weak The strong value of real estate as collateral was the basis for many of these loans and the lax lending policies When real estate and the economy slowed defaults rose dramatically This led to defaults of these securities
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Cost to taxpayers expected to be $200 billion Shareholders were be wiped out Bondholders, many of them foreign governments, will have investments saved Federal Housing Finance Agency took control of both Fannie Mae and Freddie Mac
This is the regulator of both
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Housing Market
Had been showing signs of an impeding decline for a while leading up to the end of 2008
Corporate Bonds
Indenture Contract - legal agreement between bondholders and corporation Trustee: usually a bank, makes sure issuer lives up to contract Coupon Rate: interest paid on bond Yield: Effective rate of return when take into account both capital gains and interest payments Bond selling at a Discount: Yield greater than interest rate Bond Selling at a Premium: Yield less than interest rate Size of Corp. Bond Market: About 1/2 size stock market
Corporate Bonds #2
Maturities:
Short Term: Less than 5 years Medium Term: 5 - 10 years Long Term: 10 - 20 years
Note: Medium and Long Term are usually backed by some security
Reason for Call: Interest rates decline - corporation refinances Sinking Fund: name describing repayment method - company sets aside monies, paid into fund, to retire bonds - bonds are period called at random and retired - way of lowering risk
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Corporate Bonds #3
Collateral Trust Bonds: - security that is pledged are stocks or bonds Unsecured Bonds - Also called Debentures No specific assets pledged All assets not already pledged can have claims against them Subordinated Debentures: debentures made subordinate to other creditors Junior Subordinated Debentures - subordinate to subordinated debentures
Prior Lien Bonds: bonds placed ahead of first mortgage bonds - ie in Chapter 11
Three Types of Mortgage Bonds Open End: Can issue more bonds on same mortgage contract Limited Open End: Only issue limited amt more bonds Closed End Mortgage: No additional borrowing using same assets After Acquired Property Clause: All additional property acquired will also be pledged
Bond Ratings
Corporate bonds are rated by major rating companies Standard & Poors (S&P) Moodys Will discuss this more when covering bond valuation These companies are also under fire for the high ratings they gave some mortgage securities They were given AAA ratings (never defaulted before)
- could do so 2 yrs after issue and again every six months have that opportunity
Convertible Securities
Securities that offer right to convert into other securities
Callable Usually
Conversion Ratio: Rate of exchange, i.e. 20 shares for each bond
Convertible Bonds
Bonds that can be converted into common stock
Investor has the option to convert the bonds into a specific number of shares over a certain time period.
Ex: Time Warner 8 1/4% bonds that mature in the year 2015 may be converted into 20.95 shares of Time Warner common stock. Market price is also influenced by the price of the stock - if the stock price is high the bonds will be worth more
Investors can get both the protection of bonds but also the opportunity for capital gains with stock
Income Bond
Bonds whose income is paid only if the company makes money
This makes them more risky so they are not issued that often.
Ex) Disney bonds that pay 13.5% interest annually if a package of 20 Disney movies gross over $800 million Similar to the revenue bonds issued by municipalities
Bowie Bonds
This is a unique example of a type of income bond or an asset backed security First sold in 1997 Raised $55 million for David Bowie Gave bondholders a right to the future album earnings of David Bowie Other artists followed such as James Brown, Ashford & Simpson and the Isley Brothers
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Mortgage Bonds
Bonds backed up by specific assets especially equipment (not just real estate)
Frequently used by utilities to build power plants Resale value may be uncertain
Reset Bonds: Bonds whose rate is periodically reset Extendible Bonds: Bonds whose maturity date may be extended into the future by the issuer The investor who buys such bonds does not know exactly when the bonds will mature
Two Types: those denominated in the local currency and those in dollars
Serial Bonds a bond issue where certain bonds in the issue mature in one year and others mature at other times - often used to finance equipment such as railroad cars - few companies issue serial bonds
Preferred Stock # 1
Stock and Equity: = Mean the same thing
Preferred Stock: a class of stock that pays a fixed dividend that is not guaranteed but which has a preference over common stock in both dividend payments and in bankruptcy/liquidation. Preferred Dividends: Expressed as a dollar amount of a percent of par value.
Ex) Virginia Electric $5.00 preferred
- the par value is $100 and the stock pays $5 per year in dividends
Preferred Stock # 2
Order of Return: Common Stock > Preferred Stock > Bonds
Preemptive Rights:
Dividends: usually fixed stated amount Cumulative Dividends: - Unpaid dividends accumulate until past ones are paid - may not pay dividends to common shareholders until preferred fully paid
Preferred Stock # 3
Call Features: Firm may have right to redeem shares
Default: If the company does not pay the interest payments on the bonds it is in default but that is not the case if it misses preferred dividend payments.
Explain bankruptcy process in US vs other nations Tax Effects Affecting Purchasers of Preferred Stock vs. Bonds - Dividends paid by one corporation to another receive favorable tax treatment ie holdings companies only 30% of the dividends received by a corporation are subject to taxation. (70% excluded)
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- This may cause corporations, such as insurance companies to buy preferred stock instead of bonds
- Note: this just looks at the tax effects for buyers of securities rather than issuers. For issuers the effects are the opposite.
Tax Effects for Issuers: Bond interest payments are tax deductible but preferred dividends are not deductible - this gives an incentive for firms to issue bonds and borrow rather than issuing stock
Common Stock
First security to be issued, last Security to be retired Earnings potential unlimited
Ex) Class A: may be non-voting dividend paying stock Class B: may be voting, but non-dividend paying stock
Ex) Call E shares of GM old EDS, & Class H shares the old Hughes Electronics - both have been sold off and are not part of GM anymore - sometimes used to be used as an anti-takeover device
Stock Dividends: dividends paid in corporate stock Stock Split: name given when get 25% or more of a share for each share
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a)
Interest Rates: Higher rates the less likely firms will raise debt capital
Ex) From 1981 to 1982 interest rates rose and the percent raised externally declined from 39.4% to 25.4% b) Corporate Profitability Two effects: - Good profits will generate higher cash flows and this may reduce the need for need for externally financing - Greater future profitability may increase financing needs and this can increase the demand for financing. - If the firm has limited past profitability and cash flows, then the higher anticipated profitability may cause the firm to look outside for financing.
Reason:
Interest payments are tax deductible and dividend payments are not.
$ 8.6
7/09/99
Financial Institutions
Investment Bankers
Glass Steagal Act of 1933:
- Investment banking and commercial bankers
functions were separated. - Example was Morgan Bank which was separated into Morgan Stanley and Morgan Guaranty. - This law has been slowly taken apart. - Now securities firms and banks are diversified - Many have undone this diversification - Law has been phased out - in 2010 there has been call to bring the law back
1. 2. 3. 4. 5. 6. 7. 8. 9. 10.
Merrill Lynch Salomon Smith Barney Morgan Stanley Dean Witter Goldman Sachs Credit Suisse First Boston Chase Manhattan Lehman Brothers Bank of America Securities J.P. Morgan Deutsche Bank
208.3 180.8 135.0 129.7 125.3 91.5 89.7 71.0 64.2 53.3
1,978 1,127 1,638 555 770 730 536 584 307 262
15.1 13.1 9.8 9.4 9.1 6.6 6.5 5.1 4.6 3.9
The large US independent investment bank no longer exists Bear Stearns acquired by Citibank Merrill Lynch acquired by BOA Lehman Brothers bankrupt Salomon Smith Barney part of Morgan Stanley Morgan Stanley and Goldman Sachs received commercial bank status
Allows them to borrow from Fed Really Fed would have allowed them anyway
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Goldman Sachs
quarterly profit/ loss
$6 $5 $4 in billions $ $3 $2 $1
$0
-$1 -$2 -$3 2008 Q1 2008 Q2 2008 Q3 2008 Q4 2009 Q1 2009 Q2 2009 Q3 2009 Q4
1. Goldman Sachs 2. Morgan Stanley Dean Witter 3. Merrill Lynch 4. Salomon Smith Barney 5. Credit Suisse First Boston 6. UBS Warburg 7. Wasserstein Perella Group 8. Donaldson, Lufkin & Jenrette 9. Chase Manhattan 10.J.P. Morgan
* Market shares exceed 100 percent because adviser to acquirer and target are given credit on each deal.
Source: Thomson Financial Securities Data
Private Placements
Institutional Investors Major buyers in private placements.
a) Life Insurance Companies b) State & Local Government Pension Funds c) Private Pension Funds
PIPEs
PIPE = private investments in public equity Public companies can sell shares in a private transaction to specific investors
Good for smaller or medium sized companies that are less well known
Ex: 2006 90% of all PIPE deals involved companies with market capitalization < $250 million
For them access to capital markets may not be as readily available
Agency Problem
Owners of Firm: - Shareholders Agents of Owners - Management Board of Directors - elected by shareholders to oversee their interests - Board selects management Inside Board vs. Outside Board Interlocking boards (explain) Agency Problem: agents (management) may have different agenda Agent's Agenda: a) maximize their salaries b) more perks c) make firm bigger - more prestige
Partnerships (cont)
- Master Limited Partnerships - popular in 1980s Partnership units may trade in organized exchanges
Often used by firm to spin off assets whose profits flow directly to partners
LLCs
Limited Liability Companies business organizations that have limited liability and are available for proprietorships and partnerships
(C in LLC stands for company not corporation)
When they apply for Federal tax ID they can elect to be taxed as C corp, partnership or S corp. Can decide to be member managed or manager managed One member LLCs may be disregarded (unlike Corporations with one shareholders) Professional Groups: accountants, law firms form PLLCs International: other countries starting to recognize similar type entities:
UK 2002 Limited Liability Partnership
Japan 2006 Godo Kaisha similar to US LLC
LLCs (cont)
Advantages:
Earnings flow through to the owners & are taxed at the individual level Simpler than C Corp
LLCs (cont)
Disadvantages:
Taxes: a) some states levy franchise tax on them this tax may be tied to revenues - may offset the elimination of double taxation b) more difficult to raise capital - IPOs easier with regular C corp
Corporations
- Separate legal entity - Incorporated in particular state - Governed by State Law - More Corporations Incorporated in Delaware Tax benefits - Very developed corporate law & court system - Limited Liability for Owner - stockholders - limit is investment - Continuity of Business - exist after specific owners die
S Corporations
S Corporations
If have fewer than 75 shareholders May allow shareholders to not be taxed twice corporate level & individual level May or may not be fully recognized by states in their taxation Ex: NJ taxes S Corps at lower rate