Chapter 24
Securities Operations
Outline
Services Provided by Securities Firms
Facilitating Stock Offerings
Facilitating Bond Offerings
Securitizing Mortgages
Advising Corporations on Restructuring
Regulation of Securities Firms
Valuation of a Securities Firm
Exposure of Securities Firms to Risk
Market Risk
Interest Rate Risk
Impact of Financial Leverage on Exposure to Risk
Impact of the Credit Crisis on Securities Firms
Impact of the Crisis on Bear Stearns
Chapter 24: Securities Operations ❖ 2
Key Concepts
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.
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
firm.
Questions
1. Regulation of Securities Activities. Explain the role of the SEC, FINRA, and the stock exchanges in
regulating the securities industry.
Chapter 24: Securities Operations ❖ 3
2. SIPC. What is the purpose of the SIPC?
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
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
5. Underwriting Function. Describe the underwriting function of a securities firm.
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,
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
8. Direct Placement. Describe a direct placement of bonds. What is an advantage of a private
placement? What is a disadvantage?
Chapter 24: Securities Operations ❖ 4
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
10. Proprietary Trading. Explain the process of proprietary trading by securities firms. How was it
affected by the Volcker Rule?
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
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. How does such leverage affect their expected return and their risk?
ANSWER: Securities firms use a high level of financial leverage because it can enhance their return
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
Chapter 24: Securities Operations ❖ 5
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
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
16. Conversion to BHC Structure. Explain how the credit crisis of 2008-2009 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 this 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
17. 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
18. 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
Chapter 24: Securities Operations ❖ 6
CRITICAL THINKING QUESTION
Regulation of Security Firms. Should large securities firms be allowed to be independent and insulated
from bank regulation, or should they be required to register as bank holding companies, and subject to
bank regulations? Write a short essay that supports your opinion.
ANSWER
Large securities firms engage in very similar operations as large commercial banks, and therefore should
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
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
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
Managing in Financial Markets
As a consultant for a securities firm, you are assessing the operations of a securities firm.
a. This securities firm relies heavily on full-service brokerage commissions. Do you think that
heavy reliance on these brokerage commissions is risky? Explain.
Chapter 24: Securities Operations ❖ 7
Brokerage commissions are dependent on the volume of transactions executed, which can change
b. If this firm attempts to enter the underwriting business, would it be an easy transition?
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 index funds or exchange-traded funds rather than in individual stocks. How would this
affect the securities firm?
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 also serve other clients
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
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
Chapter 24: Securities Operations ❖ 8
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 higher
than 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
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