Solutions for End-of-Chapter Questions and Problems: Chapter Three 1.
What is the primary function of finance companies? How do finance companies differ from depository institutions?
The primary function of finance companies is to make loans to individuals and corporations. Finance companies differ from depository institutions in that they do not accept deposits, but borrow short- and long-term debt, such as commercial paper and bonds, to finance the loans. The heavy reliance on borrowed money has caused finance companies to generally hold more equity than depository institutions for the purpose of signaling solvency to potential creditors. Finally, finance companies are less regulated than depository institutions, in part because they do not rely on deposits as a source of funds. 2.
What are the three major types of finance companies? To which market segments do each of these types of companies provide service?
The three types of finance companies are (1) sales finance institutions, (2) personal credit institutions, and (3) business credit institutions. Sales finance companies specialize in making loans to customers of a particular retailer or manufacturer. An example is Ford Motor Credit. Personal credit institutions specialize in making installment loans to consumers. An example is HSBC Finance. Business credit institutions provide specialty financing, such as equipment leasing and factoring, to corporations. Factoring involves the purchasing of accounts receivable at a discount from corporate customers and assuming the responsibility of collection. An example is U.S. Bancorp Equipment Finance. 3.
What have been the major changes in the accounts receivable balances of finance companies over the 38-year period from 1977 to 2015?
The biggest change in the accounts receivable balances of finance companies over the last 38 years is that the amount of consumer and business loans has decreased from 95.1 percent of assets to 71.2 percent of assets. Real estate loans have replaced some of the consumer and business loans and are now 7.3 percent of assets. 4.
What are the major types of consumer loans? Why are the rates charged by consumer finance companies typically higher than those charged by commercial banks?
Consumer loans include motor vehicle loans and leases, other consumer loans, and securitized loans, with motor vehicles loans and leases taking the largest share. Other consumer loans include loans for mobile homes, appliances, furniture, etc. The rates charged by finance companies typically are higher than the rates charged by banks because the customers are considered to be riskier. Customers who seek individual (or business) loans from finance companies are often those judged too risky to obtain loans from commercial banks. 5.
Why have home equity loans become popular? What are securitized mortgage assets? 1 © 2022
Since the enactment of the Tax Reform Act of 1986 only loans secured by an individual’s home offer tax-deductible interest for the borrower. Thus, these loans are more popular than loans without a tax deduction, and finance companies as well as banks, credit unions, and savings institutions have been attracted to this loan market. Securitization of mortgages involves the pooling of a group of mortgages with similar characteristics, the removal of these mortgages from the balance sheet, and the subsequent sale of interests in the pool to secondary market investors. Securitization of mortgages results in the creation of mortgage-backed securities (e.g., government agency securities, collateralized mortgage obligations), which can be traded in secondary mortgage markets. While removed from its balance sheet, the finance company that originates the mortgage may still service the mortgage portfolio for a fee. 6.
What advantages do finance companies have over commercial banks in offering services to small business customers? What are the major subcategories of business loans? Which category is largest?
Finance companies have advantages in the following ways: (1) finance companies are not subject to regulations that restrict the types of products and services they can offer; (2) because they do not accept deposits, they do not have the extensive regulatory monitoring; (3) they are likely to have more product expertise because they generally are subsidiaries of industrial companies; (4) finance companies are more willing to take on riskier customers; and (5) finance companies typically have lower overhead than commercial banks. The four categories of business loans are (1) retail and wholesale motor vehicle loans and leases, (2) equipment loans, (3) other business assets, and (4) securitized business assets. Equipment loans constitute over 40 percent of the business loans. 7.
What have been the primary sources of financing for finance companies?
Finance companies have relied primarily on short-term commercial paper and long-term notes and bonds. Over 60 percent of finance company funding comes from debt due to parents and debt not elsewhere classified. Unlike banks and thrifts, finance companies cannot issue deposits. Rather, to finance assets, finance companies rely heavily on short-term commercial paper, with many having direct sale programs in which commercial paper is sold directly to mutual funds and other institutional investors on a continuous day-by-day basis. Indeed, finance companies are now the largest issuers in the short-term commercial paper market. Most commercial paper issues have maturities of 30 days or less, although they can be issued with maturities of up to 270 days. 8.
How do finance companies make money? What risks does this process entail? How do these risks differ for a finance company versus a commercial bank?
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Finance companies make a profit by borrowing money at a rate lower than the rate at which they lend. This is similar to a commercial bank, with the primary difference being the source of funds, principally deposits for a bank and money and capital market borrowing for a finance company. The principal risk in relying heavily on public debt as a source of financing involves the continued depth of the commercial paper and other debt markets. As experienced during the financial crisis of 2008-2009, economic recessions can affect these markets more severely than the effect on deposit drains in the commercial banking sector. In addition, the riskier asset customers may have a greater impact on the finance companies. 9.
Compare Tables 3-1 and 2-5. Which firms have higher ratios of capital to total assets: finance companies or commercial banks? What does this comparison indicate about the relative strengths of these two types of firms?
Table 3-1 indicates that finance companies had a ratio of capital to total assets of 12.8 percent in 2015. Commercial banks (Table 2-5) have 11.3 percent of total capital to total assets. The difference may be partially due to the fact that the commercial banks have FDIC insured deposits. This insurance makes the debt safer from the depositors’ and stockholders’ perspective. As a result, commercial banks can take on more debt than the uninsured finance companies. The higher amount of capital for finance companies serves as a cushion for their own solvency and as a possible signal to the market place regarding their ability to borrow funds. 10.
Why do finance companies face less regulation than do commercial banks? How does this advantage translate into performance advantages? What is the major performance disadvantage?
By not accepting deposits, the need is eliminated for regulators to evaluate the potentially adverse safety and soundness effects of a finance company failure on the economy. The performance advantage involves the avoidance of dealing with the heavy regulatory burden, but the disadvantage is the loss of the use of a relatively cheaper source of deposit funds. However, because of the impact that non-bank FIs, including finance companies, had on the U.S. economy during the financial crisis and as a result of the need for the Federal Reserve to rescue several non-bank FIs, regulators proposed that non-bank FIs receive more oversight.
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Solutions for End-of-Chapter Questions and Problems: Chapter Four 1.
Explain how securities firms differ from investment banks. In what ways are they financial intermediaries?
Securities firms specialize primarily in the purchase, sale, and brokerage of securities, while investment banks primarily engage in originating, underwriting, and distributing issues of securities. In recent years, investment banks have undertaken increased corporate finance activities such as advising on mergers, acquisitions, and corporate restructuring. In both cases, these firms act as financial intermediaries in that they bring together economic units who need money with those units who wish to invest money. Both segments have undergone substantial structural changes in recent years. Some of the most recent consolidations include the acquisition of Bears Stearns by J.P. Morgan Chase, the bankruptcy of Lehman Brothers and the acquisition of Merrill Lynch by Bank of America. Indeed, as discussed later in the chapter, the investment banking industry has seen the failure or acquisition of all but two of its major firms (Goldman Sachs and Morgan Stanley) and these two firms converted to commercial bank holding companies in 2008. 2.
In what ways have changes in the investment banking industry mirrored changes in the commercial banking industry?
First, both industries have seen a concentration of business among the larger firms. This concentration has occurred primarily through the merger and acquisition activities of several of the largest firms. Second, firms in both industries tend to be divided along product line services provided to customers. Some national full-line firms provide service to both retail customers, in the form of brokerage services, and corporate customers, in the form of new issue underwriting. Other national full-line firms specialize in corporate finance and security trading activities. Third, the remaining firms specialize in more limited activities such as discount brokerage, regional full service retail activities, etc. This business line division is not dissimilar to that of the banking industry with money center banks, regional banks, and community banks. Clearly product line overlap occurs between the different firm divisions in each industry. 3.
What are the different types of firms in the securities industry and how does each type differ from the others?
Firms in the industry can be divided along a number of dimensions. The largest firms, the socalled national full-line firms, service both retail customers (especially in acting as broker– dealers, thus assisting in the trading of existing securities) and corporate customers (such as underwriting, thus assisting in the issue of new securities). With the changes in the past few years, national full-line firms now fall into three subgroups. First are the commercial bank holding companies that are the largest of the full service investment banks. They have extensive domestic and international operations and offer advice, underwriting, brokerage, trading, and asset management services. The largest of these firms include Bank of America (through their acquisition of Merrill Lynch), Morgan Stanley, and J.P. Morgan Chase (through its many 1 © 2022
acquisitions, including that of Bear Stearns, for $240 million in 2008). Second are the national full-line firms that specialize more in corporate business with customers and are highly active in trading securities. Examples are Goldman Sachs and Salomon Brothers/Smith Barney, the investment banking arm of Citigroup (created from the merger of Travelers and Citicorp in 1998). Third are the large investment banks. These firms maintain more limited branch networks concentrated in major cities operating with predominantly institutional client bases. These firms include Lazard Ltd. and Greenhill & Co. The rest of the industry is comprised of firms that perform a mix of primary and secondary market services for a particular segment of the financial markets: 1. Regional securities firms that are often subdivided into large, medium, and small categories and concentrate on servicing customers in a particular region, e.g., New York or California (such as Raymond James Financial). 2. Specialized discount brokers that effect trades for customers on- or offline without offering investment advice or tips (such as Charles Schwab). 3. Specialized electronic trading securities firms (such as E*trade) that provide a platform for customers to trade without the use of a broker. Rather, trades are enacted on a computer via the Internet. 4. Venture capital firms that pool money from individual investors and other FIs (e.g., hedge funds, pension funds, and insurance companies) to fund relatively small and new businesses (e.g., in biotechnology). 5. Other firms in this industry include research boutiques, floor specialists, companies with large clearing operations, and other firms that do not fit into one of the preceding categories. This would include firms such as Knight Capital Group (a leading firm in off-exchange trading of U.S. equities) and floor specialist LaBranche & Co. 4.
What are the key activity areas for investment banks and securities firms? How does each activity area assist in the generation of profits and what are the major risks for each area?
The seven major activity areas of security firms are: a) Investment Banking: Investment banks specialize in underwriting and distributing both debt and equity issues in the corporate market. New issues can be placed either privately or publicly and can represent either a first issued (IPO) or a secondary issue. Secondary issues of seasoned firms typically will generate lower fees than an IPO. Securities underwritings can be undertaken through either public offerings or private offerings. In a private offering the investment bank receives a fee for acting as the agent in the transaction. In best-efforts public offerings, the firm acts as the agent and receives a fee based on the success of the offering. The firm serves as a principal by actually takes ownership of the securities in a firm commitment underwriting. Thus, the risk of loss is higher. Finally, the firm may perform similar functions in the government markets and the asset-backed derivative markets. In all cases, the investment bank receives fees related to the difficulty and risk in placing the issue. 2 © 2022
b) Venture Capital: A difficulty for new and small firms in obtaining debt financing from commercial banks is that CBs are generally not willing or able to make loans to new companies with no assets and business history. In this case, new and small firms often turn to investment banks (and other firms) that make venture capital investments to get capital financing as well as advice. Venture capital is a professionally managed pool of money used to finance new and often high-risk firms. Venture capital is generally provided to back an untried company and its managers in return for an equity investment in the firm. Venture capital firms do not make outright loans. Rather, they purchase an equity interest in the firm that gives them the same rights and privileges associated with an equity investment made by the firm’s other owners. c) Market Making: Security firms assist in the market-making function by acting as brokers to assist customers in the purchase or sale of an asset. Market making can involve either agency or principal transactions. Agency transactions are two-way transactions on behalf of customers, for example, acting as a stockbroker or dealer for a fee or commission. In principal transactions, the market maker seeks to profit on the price movements of securities and takes either long or short inventory positions for its own account. (Or an inventory position may be taken to stabilize the market in the securities.) These principal positions can be profitable if prices increase, but they can also create downside risk in volatile markets. d) Trading: Trading activities can be conducted on behalf of a customer or the firm. The activities usually involve position trading, pure arbitrage, risk arbitrage, program trading, stock brokerage, and electronic brokerage. Position trading involves the purchase of large blocks of stock to facilitate the smooth functioning of the market. Pure arbitrage involves the purchase and simultaneous sale of an asset in different markets because of different prices in the two markets. Risk arbitrage involves establishing positions prior to some anticipated information release or event. Program trading involves positioning with the aid of computers and futures contracts to benefit from small market movements. In each case, the potential risk involves the movements of the asset prices, and the benefits are aided by the lack of most transaction costs and the immediate information that is available to investment banks. Stock brokerage involves the trading of securities on behalf of individuals who want to transact in the money or capital markets. Electronic brokerage, offered by major brokers, involves direct access, via the Internet, to the trading floor, therefore bypassing traditional brokers. e) Investing: Securities firms act as agents for individuals with funds to invest by establishing and managing mutual funds and by managing pension funds. The securities firms generate fees that affect directly the revenue stream of the companies. f) Cash Management: Cash management accounts are checking accounts that earn interest and may be covered by FDIC insurance. The accounts have been beneficial in providing full-service financial products to customers, especially at the retail level. 3 © 2022
g) Mergers and Acquisitions: Most investment banks provide advice to corporate clients who are involved in mergers and acquisitions. This activity has been extremely beneficial from a fee standpoint during the 1990s and 2000s. h) Back-Office and Other Service Functions: Security firms offer clearing and settlement services, research and information services, and other brokerage services on a fee basis. 5.
What is the difference between an IPO and a secondary issue?
An IPO is the first time issue of a company’s securities, whereas a secondary offering is a new issue of a security that is already offered. 6.
What is the difference between a private placement and a public offering?
A public offering represents the sale of a security to the public at large. A private placement involves the sale of securities to one or several large investors such as an insurance company or a pension fund. 7.
What are the risk implications to an investment bank from underwriting on a best-efforts basis versus a firm commitment basis? If you operated a company issuing stock for the first time, which type of underwriting would you prefer? Why? What factors may cause you to choose the alternative?
In a best efforts underwriting, the investment bank acts as an agent of the company issuing the security and receives a fee based on the number of securities sold. With a firm commitment underwriting, the investment bank purchases the securities from the company at a negotiated price and sells them to the investing public at what it hopes will be a higher price. Thus, the investment bank has greater risk with the firm commitment underwriting, since the investment bank will absorb any adverse price movements in the security before the entire issue is sold. Factors causing preference to the issuing firm include general volatility in the market, stability and maturity of the financial health of the issuing firm, and the perceived appetite for new issues in the market place. The investment bank will also consider these factors when negotiating the fees and/or pricing spread in making its decision regarding the offering process. 8.
An investment bank agrees to underwrite an issue of 15 million shares of stock for Looney Landscaping Corp. a. If the investment bank underwrites the stock on a firm commitment basis, it agrees to pay $12.50 per share to Looney Landscaping Corp. for the 15 million shares of stock. It can then sell those shares to the public for $13.25 per share. How much money does Looney Landscaping Corp. receive? What is the profit to the investment bank? If the investment bank can sell the shares for only $11.95, how much money does Looney Landscaping Corp. receive? What is the profit to the investment bank? 4 © 2022
If the investment bank sells the stock for $13.25 per share, Looney Landscaping Corp. receives $12.50 x 15,000,000 shares = $187,500,000. The profit to the investment bank is ($13.25 $12.50) x 15,000,000 shares = $11,250,000. The stock price of Looney Landscaping Corp. is $13.25 since that is what the public agrees to pay. From the perspective of Looney Landscaping Corp., the $11.25 million represents the commission that it must pay to issue the stock. If the investment bank sells the stock for $11.95 per share, Looney Landscaping Corp. still receives $12.50 x 15,000,000 shares = $187,500,000. The profit to the investment bank is ($11.95 - $12.50) x 15,000,000 shares = -$8,250,000. The stock price of Looney Landscaping Corp. is $11.95 since that is what the public agrees to pay. From the perspective of the investment bank, the -$8.25 million represents a loss for the firm commitment it made to Looney Landscaping Corp. to issue the stock. b. Suppose, instead, that the investment bank agrees to underwrite the 15 million shares on a best-efforts basis. The investment bank is able to sell 13.6 million shares for $12.50 per share, and it charges Looney Landscaping Corp. $0.275 per share sold. How much money does Looney Landscaping Corp. receive? What is the profit to the investment bank? If the investment bank can sell the shares for only $11.95, how much money does Looney Landscaping Corp. receive? What is the profit to the investment bank? If the investment bank sells the stock for $12.50 per share, Looney Landscaping Corp. receives ($12.50 - $0.275) x 13,600,000 shares = $166,260,000, the investment bank’s profit is $0.275 x 13,600,000 shares = $3,740,000, and the stock price is $12.50 per share since that is what the public pays. If the investment bank sells the stock for $11.95 per share, Looney Landscaping Corp. receives ($11.95 - $0.275) x 13,600,000 shares = $158,780,000, the investment bank’s profit is still $0.275 - 13,600,000 shares = $3,740,000, and the stock price is $11.95 per share since that is what the public pays. 9.
An investment bank agrees to underwrite a $500 million, 10-year, 8 percent semiannual bond issue for KDO Corporation on a firm commitment basis. The investment bank pays KDO on Thursday and plans to begin a public sale on Friday. What type of interest rate movement does the investment bank fear while holding these securities? If interest rates rise 0.05 percent, or five basis points, overnight, what will be the impact on the profits of the investment bank? What if the market interest rate falls five basis points?
An increase in interest rates will cause the value of the bonds to fall. If rates increase 5 basis points over night, the bonds will lose $1,695,036.32 in value. The investment bank will absorb the decrease in market value, since the issuing firm has already received its payment for the bonds. If market rates decrease by 5 basis points, the investment bank will benefit by the $1,702,557.67 increase in market value of the bonds. These two changes in price can be found with the following two equations respectively: 5 © 2022
− $1,695,036.32 = $20,000,000PVAi=4.025%,n=20 + $500,000,000PVi=4.025%,n=20 − $500,000,000 $1,702,557.67 = $20,000,000PVAi=3.975%,n=20 + $500,000,000PVi=3.975%,n=20 − $500,000,000 10.
An investment bank pays $23.50 per share for 4 million shares of JCN Company. It then sells those shares to the public for $25 per share. How much money does JCN receive? What is the profit to the investment bank? What is the stock price of JCN?
JCN receives $23.50 x 4,000,000 shares = $94,000,000. The profit to the investment bank is ($25.00 - $23.50) x 4,000,000 shares = $6,000,000. The stock price of JCN is $25.00 since that is what the public must pay. From the perspective of JCN, the $6,000,000 represents the commission that it must pay to issue the stock. 11.
XYZ, Inc., has issued 10 million new shares of stock. An investment bank agrees to underwrite these shares on a best-efforts basis. The investment bank is able to sell 8.4 million shares for $27 per share, and it charges XYZ $0.675 per share sold. How much money does XYZ receive? What is the profit to the investment bank? What is the stock price of XYZ?
XYZ receives ($27.00 - $0.675) x 8,400,000 shares = $221,130,000, the investment bank’s profit is $0.675 x 8,400,000 shares = $5,670,000, and the stock price is $27 per share since that is what the public pays. 12. What is venture capital? Venture capital is a professionally managed pool of money used to finance new and often highrisk firms. Venture capital is generally provided by investment institutions or private individuals willing to back an untried company and its managers in return for an equity investment in the firm. Venture capital firms do not make outright loans. Rather, they purchase an equity interest in the firm that gives them the same rights and privileges associated with an equity investment made by the firm’s other owners. As equity holders, venture capital firms are not generally passive investors. Rather, they provide valuable expertise to the firm’s managers and sometimes even help in recruiting senior managers for the firm. They also generally expect to be fully informed about the firm’s operations, any problems, and whether the joint goals of all of the firm’s owners are being met. 13. What are the different types of venture capital firms? How do institutional venture capital firms differ from angel venture capital firms? Institutional venture capital firms are business entities whose sole purpose is to find and fund the most promising new firms. Private-sector institutional venture capital firms include venture capital limited partnerships (that are established by professional venture capital firms, acting as general partners in the firm: organizing and managing the firm and eventually liquidating their 6 © 2022
equity investment), financial venture capital firms (subsidiaries of investment or commercial banks), and corporate venture capital firms (subsidiaries of nonfinancial corporations which generally specialize in making start-up investments in high-tech firms). Limited partner venture capital firms dominate the industry. In addition to these private sector institutional venture capital firms, the federal government, through the SBA, operates Small Business Investment Companies (SBICs). SBICs are privately organized venture capital firms licensed by the SBA that make equity investments (as well as loans) to entrepreneurs for start-up activities and expansions. As federally sponsored entities, SBICs have relied on their unique opportunity to obtain investment funds from the U.S. Treasury at very low rates relative to private-sector institutional venture capital firms. In contrast to institutional venture capital firms angel venture capitalists (or angels) are wealthy individuals who make equity investments. Angel venture capitalists have invested much more in new and small firms than institutional venture capital firms. 14. What are the advantages and disadvantages to a new or small firm of getting capital funding from a venture capital firm? A difficulty for new and small firms in obtaining debt financing from banks is that banks are generally not willing or able to make loans to new companies with no assets and business history. In this case, new and small firms often turn to venture capital firms to get capital financing as well as advice. As equity holders, venture capital firms are not generally passive investors. Rather, they provide valuable expertise to the firm’s managers and sometimes even help in recruiting senior managers for the firm. They also generally expect to be fully informed about the firm’s operations, any problems, and whether the joint goals of all of the firm’s owners are being met. Venture capital firms look for two things in making their decisions to invest in a firm. The first is a high return. Venture capital firms are willing to invest in high-risk new and small firms. However, they require high levels of returns (sometimes as high as 700 percent within five to seven years) to take on these risks. The second is an easy exit. Venture capital firms realize a profit on their investments by eventually selling their interests in the firm. They want a quick and easy exit opportunity when it comes time to sell. Basically, venture capital firms provide equity funds to new, unproven, and young firms. This separates venture capital firms from commercial banks and investment firms, which prefer to invest in existing, financially secure businesses. 15.
How do agency transactions differ from principal transactions for market makers?
Agency transactions are done on behalf of a customer. Thus, the investment bank is acting as a stockbroker, and the company earns a fee or commission. In a principal transaction, the investment bank is trading on its own account. In this case, the profit is made from the difference in the price that the company pays for the security and the price at which it is sold. In the first case the company bears no risk, but in the second case the company is risking its own capital. 16.
One of the major activity areas of securities firms is trading. 7 © 2022
a. What is the difference between pure arbitrage and risk arbitrage? Pure arbitrage involves the buying and selling of similar assets trading at different prices. Pure arbitrage has a lock or assurance of the profits that are available in the market. This profit position usually occurs with no equity investment, the use of only very short-term borrowed funds, and reduced transaction costs for securities firms. Risk arbitrage also is based on the principle of buying low and selling high a similar asset (or an asset with the same payoff). The difference between risk arbitrage and pure arbitrage is that the prices are not locked in, leaving open a certain speculative component that could result in real economic losses. b. What is the difference between position trading and program trading? Position trading involves the purchase of large blocks of stock for the purpose of providing consistency and continuity to the secondary markets. In most cases, these trades are held in inventory for a period of time, either after or prior to the trade. Program trading involves the ability to buy or sell entire portfolios of stocks quickly and often times simultaneously in an effort to capture differences between the actual futures price of a stock index and the theoretically correct price. The program trading process is useful when conducting index arbitrage. If the futures price is too high, an arbitrager would short futures contract and buy the stocks in the underlying index. The program trading process in effect is a coordinated trading program that allows for this arbitrage process to be accomplished. 17.
If an investor observes that the price of a stock trading in one exchange is different from the price in another exchange, what form of arbitrage is applicable, and how can the investor participate in that arbitrage?
The investor should short sell the more expensive asset and use the proceeds to purchase the cheaper stock to lock in a given spread. This transaction would be an example of a pure arbitrage rather than risk arbitrage. The actual spread realized would be affected by the amount of transaction costs involved in executing the transactions. 18.
An investor notices that an ounce of gold is priced at $1,018 in London and $1,025 in New York. a. What action could the investor take to try to profit from the price discrepancy?
An investor would try to buy gold in London at $1,018 and sell it in New York for $1,025 yielding a riskless profit of $7 per ounce. b. Under which of the four trading activities would this action be classified? This transaction is an example of pure arbitrage. 8 © 2022