Securities Firms
by
Charles Lamson
Securities firms aid in the smooth functioning of the financial system. There are two main functions of securities firms: investment banking and the buying and selling of previously issued securities. Investment banking deals with the marketing of newly issued securities in the primary market. Brokers and dealers assist in the marketing of previously issued securities in the secondary market. Some security firms provide both functions, while others provide only one or the other.
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Investment Banks: The Primary Market
Investment banks are financial institutions that design, market, and underwrite new issuances of securities---stocks or bonds---in the primary market. Merrill Lynch, Salomon Smith Barney, Morgan Stanley, Dean Witter, and Goldman Sachs are some of the better-known investment banks. Their main offices tend to be in New York City, but they are electronically-linked to branch offices in other major cities in the United States and around the world.
The design function of the investment bank is important because a corporation may need assistance in pricing the new financial instruments that it will issue in the open market. The corporation looks to the investment bank to provide advice about the design of the new offering. In return for their services, the investment bank is paid a fee. Many investment banks, in addition to their primary market activity, are also brokers and dealers in the secondary markets.
Responsibilities for New Offerings
There are two types of new offerings. When a company has not previously sold financial stocks or bonds to the public, the offering is an initial public offering (IPO). The investment bank will try to establish an appropriate price by looking at stock prices of other firms in the industry with comparable characteristics. Because there are no previously issued securities being publicly traded, it is usually much more difficult to determine the price at which securities in an IPO should be offered. In the case of bonds, investment banks look to the market prices of existing bonds with comparable maturity, risk, and liquidity. The existing degree of leverage (reliance or borrowed funds) of the issuer is also a determinant of how much can be raised and at what price in the bond market.
When stocks or bonds have been previously issued, the offering is called a seasoned issuance. The price of the new issue should be the same as the market price of the outstanding shares. However, the investment bank must still anticipate how the new issue will affect the market price of the outstanding shares. Likewise, with a seasoned issuance of bonds, the investment bank must anticipate how the greater degree of leverage will affect the price at which the new bonds can be sold.
Timing. Timing is one of the most important factors affecting the selling price of new securities. For example, it may be a good time to sell if the corporation's outstanding stock is trading at relatively high prices, if favorable earnings reports have recently been issued, and if the economy is particularly strong. A relatively larger amount of funds can be raised by issuing fewer shares at a higher price than if the stock was trading at a lower price. Likewise, if long-term interest rates are relatively low and profit expectations are high, it may be a good time to issue bonds.
The Role of the Securities and Exchange Commission. Once the amount, type, and pricing of securities has been established, the investment bank assists the corporation in filling out and filing the necessary documents with the Securities and Exchange Commission (SEC). The SEC is a government regulatory agency that was created in 1934 to regulate the securities industry. Primary areas of regulation include "disclosure" requirements for new securities issues and the monitoring of illegal and fraudulent behavior in securities markets.
The SEC maintains active supervision of investment banks, particularly with regard to information that must be disclosed to potential investors. A registration statement must be filed with the SEC before the offering can be issued. This statement contains information about the offering, the company and other disclosure information, including relevant information about management that the funds will be used for, and the financial help of the corporation. Once the registration statement has been filed, the SEC has 20 days to respond. If the SEC does not object during the 20-day period, then the securities can be sold to the public. The lack of an objection by the SEC in no way means that the new securities are of high quality or that the price is appropriate. It simply means that it appears that the proper information has been disclosed to potential investors. The prospectus. which is a subpart of the registration statement, must be given to investors before they purchase the securities. It contains all of the disclosures and pertinent information about the offering that the SEC requires.
Credit Rating. Investment banks also assist in obtaining a credit rating for the new issuance from Standard & Poor's or Moody's Investors Services. A trustee is selected that will monitor whether or not the corporation fulfills the terms of the offering as outlined in the bonds indenture. The terms of the offering, along with many other provisions, are spelled out in the bond indenture before the bonds are issued. Investment banks may also assist in arranging that the issuance of new stock is listed (traded) on an exchange and/or in the over-the-counter market.
Underwriting and Marketing. Once the necessary steps to issue the new securities have been taken, the investment bank takes on the responsibility of underwriting and marketing the securities. In underwriting the security, the investment bank purchases the entire issuance at an agreed-upon price. It then assumes responsibility for marketing the newly issued securities. If the price at which the bank sells the securities is greater than the price they paid, the bank will earn a profit on the spread. If the securities sell for less than the agreed upon price, the investment bank accepts the loss.
Sometimes one investment bank may be reluctant to take full responsibility for a new issuance. In this case, the bank may form a syndicate by asking other investment banks to underwrite part of the new offering. The syndicate is merely a group of investment banks, each of which underwrites a portion of a new securities offering. In a syndicate, each participating investment bank earns the profit---or assumes the loss---on the portion of the new offering it underwrites.
Private Placement
Investment banks also handle private placement. This is an alternative for a corporation issuing new securities that bypasses the process described previously and places the new securities offering privately. In a private placement, new securities are sold to a limited number of investors. Because the number of investors is small, they are of necessity very large investors as commercial banks, insurance companies, pension plans, or mutual funds. Private placements occur more frequently with bonds than with stocks.
Recap
Investment banks design, market, and underwrite the issuance of new securities (stocks and bonds) in the primary market. The securities may be an IPO or a seasoned offering. In addition to advising the issuer about market conditions and prospective prices, the investment bank also assists in filing the necessary forms with the SEC so that the new securities can be publicly sold. A registration statement must be filed with the SEC. Part of the registration statement is the prospectus that contains information and disclosures about the issuance. The formation is disclosed to the public and approval by the SEC to sell the securities is in no way an endorsement of their quality or that the price is proper. Private placement of securities to a limited number of investors is an alternative to going through the underwriting process.
*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 351-354*
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