Chapter 5 – The Financial System, Corporate Governance, and Interest

The Financial System The economy is divided into sectors Consumption Production (includes government) Services, products, and money flow between the sectors every day Producers pay wages Workers spend incomes Producers spend revenues Creates a cyclical flow of money

Figure 5-1 Cash Flows Between Sectors

Diagram Omits Two Things Consumption sector Most people do not consume all of their income—they deposit savings and earn a return Production sector Companies need to raise money to finance large, infrequent projects Economy has a need for and a source of $

Savings and Investment Financial markets channel consumer savings to companies through the sale of financial assets Companies issue securities Consumers purchase securities

Figure 5- 2 Flows Between Sectors

This makes funds available for business investment The Term “Invest” Individuals invest by putting savings into financial assets: stocks, bonds, etc. This makes funds available for business investment Hence: SAVINGS = INVESTMENT (Consumer) Savings = (Business) Investment

Raising and Spending Money in Business Firms spend two kinds of money Day-to-day funds Large sums needed for major projects

Raising and Spending Money in Business Firms to raise money by: Borrowing money: Debt Financing Selling stock: Equity Financing

Term Long-term projects The length of time between now and the end (or termination) of something Long-term projects last over 5-10 years financed with debt (bonds) and equity (earnings/stocks) Short-term projects last less than 1 year financed with short-term funds (bank loans) Process is known as maturity matching

Financial Markets Capital Markets Money Markets Trade in stocks and long-term debt Money Markets Trade in short term debt securities Federal government issues a great deal of short-term debt

Financial Markets: Primary and Secondary Markets Primary Market: Initial sale of a security Proceeds go to the issuer Secondary Market: Subsequent sales of the security Between investors Company not involved

Primary and Secondary Markets Corporations care about a stock’s price in the secondary market Influences how much money can be raised in future stock issues Senior management’s compensation is usually tied to stock price

Direct and Indirect Transfers, Financial Intermediaries Primary market transactions can occur Directly Issuer sells directly to buyers or through an investment bank Investment bank lines up investors and functions as a broker Indirectly Financial intermediary sells shares in itself and invests the funds collectively on behalf of investors Mutual fund is an example Portfolio is collectively owned

Figure 5-3 Transfer of Funds

Direct and Indirect Transfers, Financial Intermediaries Institutional investors play a major role in today’s financial markets Own ¼ of all stocks, make over ¾ of all trades Examples include: Mutual funds Pension funds Insurance companies Banks

The Stock Market and Stock Exchanges Stock market—a network of exchanges and brokers Exchange—a marketplace such as NYSE, AMEX, NASDAQ, & regional exchanges Brokerage houses employ licensed brokers to make securities transactions for investors

Trading—The Role of Brokers What brokers do… An investor opens an account with a broker and place trades via phone or online Local broker forwards order to floor broker on the exchange trading floor Trade confirmation is forwarded to local broker and investor

Figure 5-4 Schematic Representation of a Stock Market Transaction

Exchanges New York Stock Exchange (NYSE) NYSE MKT (Previously AMEX) (NASDAQ) Regional stock exchanges (Philadelphia, Chicago, San Francisco, etc.) Exchanges are linked electronically

Stock Market and Exchanges Stock Market refers to the entire interconnected set of places, organizations and processes involved in trading stocks Regulation Securities Act of 1933 Required companies to disclose certain information Securities Exchange Act of 1934 Set up Securities and Exchange Commission (SEC) Securities law is primarily aimed at disclosure

Private, Public, and Listed Companies, and the OTCBB Market Privately Held Companies Can’t sell securities to the general public Sale of securities is strictly regulated Publicly Traded Companies Received approval from SEC to offer securities to the general public Process of obtaining approval and registration is known as ‘going public’

Private, Public, and Listed Companies, and the NASDAQ Market Public Companies Use an investment banking firm to “go public” Prospectus—provides detailed information about company SEC reviews prospectus Red Herring - an unapproved, or preliminary, prospectus

Private, Public, and Listed Companies, and the OTC Market The IPO Initial public offering (IPO) is the initial sale Investment banks usually line up institutional buyers prior to the actual securities sale IPO occurs in primary market, then trading begins in the secondary market IPOs are discussed in detail in Chapter 8

The OTCBB Market After a company goes public, its shares can trade in the over-the-counter (OTC) market Firms not listed on an exchange trade through the OTCBB overseen by the NASD Eventually a firm may list on an exchange

Figure 5-7 Stock Market Quotation for Microsoft Corp.

Corporate Governance Corporate governance refers to the relationships, rules and procedures under which businesses are organized and run. Focused on ethics and legality of financial relationships between top managers and the corporations they serve. The idea is connected to the agency problem, which refers to a conflict of interest between executives and stockholders Two major financial crises thus far in the 21st century Stock market crash of 2000 caused by financial reporting fraud Financial crisis of 2008 caused by the subprime mortgage market

Corporate Governance: Executive Compensation The personal wealth of corporate executives is closely tied to stock price The stock market bids prices up and down Current financial performance is the best indication of future performance

Concept Connection Example 5-1 Executive Stock Options Harry Johnson, CEO Salary $2,500,000 Bonus 1,500,000 $4,000,000 Plus: Stock option: 200,000 shares @ $20, Market Price now $48.65 Option Value: 200,000 x ($48.65 - $20.00) = $5,730,000 Total comp = $9,730,000; 59% from options

Moral Hazard A situation that tempts people to act in immoral or unethical ways

Concept Connection Example 5-1 Moral Hazard of Stock Based Compensation What if Harry can’t exercise his option for another six months? AND some disturbing financial information comes up that will cause the stock’s price to drop by $10. If released, that info will cost Harry $2,000,000 Harry is motivated to hold stock price up at any cost until he can exercise his option. Usually means suppressing the damaging information while ordinary investors buy in at inflated price

Holding Performance Up Company financial statements - Income Statement and Balance Sheet are actually easy to manipulate by “bending” accounting rules

Responsibility for Financial Statements Responsibility for the contents of financial statements primarily falls to top management Top execs have the power to enhance their own wealth by cheating on financial reporting

Stock prices skyrocketed Top management was willing to bend rules Events of the 1990s Stock prices skyrocketed Top management was willing to bend rules Some accountants partnered with unethical executives in deceiving the public Enron

Public Accounting Reform Regulation SOX (§§101-109) creates the Public Accounting Oversight Board (PCAOB) to oversee and regulate the accounting industry Accounting will never be self-regulated again Requires firms to register Sets standards of performance & compliance Inspections and disciplinary procedures

Resulted in the Sarbanes-Oxley (SOX)Act: Events of the 1990s Resulted in the Sarbanes-Oxley (SOX)Act: Title I: Oversight of the Public Accounting Industry. Title II: Auditor Independence. Title III: Corporate Responsibility. Title IV: Enhanced Financial Disclosure. Title V: Wall Street Reforms—Securities Analyst Conflicts of Interest.

Executives Profit While Others Go Broke Executives often received huge incentive compensation while the stock tanked and investors/employees lost everything SOX (§304) requires CEOs & CFOs to repay such gains to corporation

Stock Analyst Conflicts SOX (§501) directs the SEC to issue rules insulating analysts from investment banking pressure SEC adopted Regulation Analyst Certification (Reg AC): Analysts must certify: They actually believe in their recommendations Their compensation is not linked to specific recommendations

The Financial Crisis of 2008 Home Ownership, Mortgages, and Risk Securitization Subprime markets Credit Default Swap (CDS)

Home Ownership, Mortgages, and Risk Loans are secured by a House Failure to make payment leads to Foreclosure

Securitization Bundle of Loans and Securitization Collateralized debt obligations (CDO) CDO tranche Flaw in Risk Allocation Method

Subprime Mortgage Market Institutions borrowed at short-term rates to invest in CDOs Needed money to invest Banks ran out of qualified borrowers

Loans made to unqualified borrowers Types of loans Subprime Loans Loans made to unqualified borrowers Types of loans Zero down Adjustable Rate Mortgages (ARM) Negative Amortization (NegAm) Alt-A loans

Credit Default Swaps (CDS) Contract between buyer and seller in which the seller agrees to repay losses the buyer suffers

The Trigger- Interest Rates Rise Concern about inflation Federal reserve raised rates Resulting in mortgage rates going up and an end to rising real estate prices

Effect on CDO Market and CDO Owners CDO market froze 2008 staggering losses and equity reductions by financial institutions Bailouts arrived

Federal Government Actions in 2008 Intervention Government takeover Officials brokered merger of at risk institutions Bail outs by the federal government

Federal Government Actions in 2008 Two actions were particularly important to the financial crisis Bear- Stearns Lehman Brothers

The Crisis is a Governance Issue The financial system created an incentive for dishonesty Make loans regardless of ability to pay The “too big to fail” concept creates a Moral Hazard in banking Executives are rewarded if high risk projects go well But government (taxpayers) pay for failures

The Dodd-Frank Act Signed in 2010 Designed to fix the problem through legislation Governs conduct on more than 240 issues

Interest Interest is the return on debt Primary vehicle is the bond Investor lends money to the bond’s issuer There are MANY interest rates in debt markets Depend on term and risk Rates tend to move together

The Relationship Between Interest and the Stock Market Stock returns and interest on debt instruments are related Stocks and bonds compete for investor’s dollars Stocks offer higher returns but have more risk Investors prefer debt if the expected return is equal Interest rates and security prices move in opposite directions

Interest and the Economy Interest rates have a significant effect on the economy Lower interest rates stimulate business and economic activity Debt financed projects cost less if rates are low More projects are undertaken Consumers purchase more houses, cars, etc. when rates are low

Debt Markets: Supply and Demand A Brief Review Interest rates are set by supply and demand Demand curve relates price and quantity of a product that consumers will buy Reflects desires and abilities of buyers at a particular time Usually slopes downward to the right since people buy more when the price of a product is low

Debt Markets: Supply and Demand A Brief Review A supply curve relates prices with quantities supplied by producers Generally upward sloping to the right since firms will to produce more at higher prices Equilibrium – intersection of supply and demand curves Sets market price and quantity Changing conditions shift supply and demand curves for a new equilibrium

Figure 5-8 Supply & Demand Curves for a Product or Service

Supply and Demand for Money In the debt market Lenders represent supply Borrowers represent demand The price represents the interest rate Debt securities are bills, notes and bonds

Figure 5-9 Supply and Demand Curves for Money (Debt)

The Determinants of Supply and Demand Demand for borrowed funds depends on: Opportunities available to use the funds Attitudes of people and businesses about using credit

The Determinants of Supply and Demand Supply of loanable funds depends on the time preference for consumption of individuals A decrease in the preference for consumption will lead to an increase in loanable funds Constant changes shift supply and demand curves

The Components of an Interest Rate Interest rates include base rates and risk premiums Interest rate represented by the letter k k = base rate + risk premium

The Components of an Interest Rate Components of the Base Rate Base rate = kPR + INFL The pure interest rate plus expected inflation Rate people lend money when no risk is involved Pure interest rate (kPR) = earning power of money Would exist in the real world if no inflation

The Components of an Interest Rate The Inflation Adjustment (INFL) Inflation refers to a general increase in prices If prices rise, $100 at the beginning of the year will not buy as much at the end of the year If you loaned someone $100 at the beginning of the year, you need to be compensated for what you expect inflation to be during the year

Risk Premiums Risk in loans is the chance that the lender will not receive the full amount of principal and interest payments Lenders demand risk premiums of extra interest for risky loans

Different Kinds of Lending Risk Bond lending losses can be associated with price fluctuations and the failure of borrowers to repay loans Three sources of risk, each with its own risk premium: Default risk Liquidity risk Maturity risk

Different Kinds of Lending Risk Default Risk (DR) The chance the lender won't pay principal or interest Losses can be as much as the entire amount Investors demand a default risk premium based on the their perception of the borrower’s creditworthiness Considers firm's financial condition and credit record

Different Kinds of Lending Risk Liquidity Risk (LR) Associated with being unable to sell the bond of an little known issuer Debt of small, hard to market firms is “illiquid” Liquidity risk premium is the extra interest demanded by lenders as compensation for bearing liquidity risk

Different Kinds of Lending Risk Maturity Risk (MR) Bond prices and interest rates move in opposite directions Long-term bond prices change more with interest rate swings than short-term bond prices

Putting the Pieces Together: The Interest Rate Model k = kPR + INFL + DR + LR + MR k is the nominal or quoted interest rate Model tells what theoretically should be in an interest rate Setting Interest Rates set by supply and demand No one uses the model to set rates

Federal Government Securities, the Risk Free Rate The Federal government issues long-term bonds as well as shorter-term securities Risk in Federal Government Debt No default risk: Can print money to pay off its debt No liquidity risk: It’s easy to sell federal securities Federal debt does have maturity risk

The Risk-Free Rate Very short term federal securities, Treasury Bills, pay the risk free rate The risk-free rate is approximately the yield on short-term Treasury bills Denoted as kRF Conceptual floor for interest rates

The Real Rate of Interest The Real Rate of Interest implies the effects of inflation removed Tells investors whether or not they are getting ahead There are periods during which the real rate has been negative The Real Risk-Free Rate implies that both the inflation adjustment and the risk premium is zero

Concept Connection Example 5-3 Using the Interest Rate Model Using the Interest Rate Model, Sunshine Inc. is planning to borrow by issuing three year bonds (notes). The following information is available. 1. The pure interest rate is 2.0%. 2. Inflation will be 3% next year and 4% thereafter. 3. Sunshine’s debt carries a default risk premium of 1.5%. 4. The firm carries a liquidity risk premium of .5%. 5. Maturity risk premiums on three-year debt are 1.0%. a. Estimate the interest rate Sunshine will have to offer. b. Moonlight Ltd. recently issued three-year debt paying 11%. What does the interest rate model imply about Moonlight’s risk relative to Sunshine’s?

Concept Connection Example 5-3 Using the Interest Rate Model SOLUTION: To estimate the interest rate Sunshine will have to offer to sell the bonds (ks). Calculate INFL, the average inflation rate over the life of the loan. INFL = (3 + 4 + 4)/3 = 11/3 = 3.67 = 3.7 3 + 4 +4 are the inflation rates for the three years, or the life of this project. Add them together The 3 is the number of years, or life of the project Then write the interest rate model and substitute for kS. kS = kPR + INFL + DR + LR + MR = 2.0 + 3.7 + 1.5 + .5 + 1.0 = 8.7%

Concept Connection Example 5-3 Using the Interest Rate Model b. Write the interest rate model for Moonlight treating DR as an unknown, then substitute, and solve for DR. kM = kPR + INFL + DR + LR + MR 11.0 = 2.0 + 3.7 + DR + .5 + 1.0 DR = 3.8 Sunshine’s risk premium from assumptions The debt market seems to be assigning Moonlight a default risk premium of 3.8%, which is (3.8/1.5 ) = 2.5 times as large as Sunshine’s. This implies more risk.

Yield Curves—The Term Structure of Interest Rates A graphic relation between interest rates term The normal yield curve Short-term rates are usually lower than long-term rates – curve slopes up The inverted yield curve Long-term rates are lower than short-term rates – curve slopes down A sustained inverted curve usually signals an economic downturn is ahead

Inverted Yield Curve- An Economic Predictor Inversion Period Recession Date July 2000 - January 2001 March 2001 May 1989 - August 1989 July 1990 October 1980 - September 1981 July 1981 November 1978 - May 1980 January 1980 June 1973 - November 1974 November 1973 December 1968 - February 1970 December 1969

Figure 5-10 Yield Curves

Yield Curves—The Term Structure of Interest Rates Theories attempt to explain the term structure of interest rates Expectations Theory Today's rates rise or fall with term as future rates are expected to rise or fall Liquidity Preference Theory Investors prefer shorter term securities and must be induced to make longer loans Market Segmentation Theory Loan terms define independent segments of the debt market which set separate rates