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

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Figure 5-1 Cash Flows Between Sectors

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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 $

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Savings and Investment

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

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Figure 5- 2 Flows Between Sectors

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The Term “Invest”

Individuals invest by putting savings into financial assets: stocks, bonds, etc.This makes funds available for business investmentHence: SAVINGS = INVESTMENT (Consumer) Savings = (Business) Investment

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Raising and Spending Money in Business

Firms spend two kinds of money– Day-to-day funds– Large sums needed for major projects

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Raising and Spending Money in Business

Firms to raise money by: Borrowing money: Debt Financing Selling stock: Equity Financing

Term

The length of time between now and the end (or termination) of something– Long-term projects

last over 5-10 yearsfinanced with debt (bonds) and equity (earnings/stocks)

– Short-term projects last less than 1 yearfinanced with short-term funds (bank loans)

– Process is known as maturity matching

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Financial Markets

Capital 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

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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

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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

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Direct and Indirect Transfers, Financial Intermediaries

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

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Primary market transactions can occur

Figure 5-3 Transfer of Funds

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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 fundsPension fundsInsurance companiesBanks

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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

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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

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Figure 5-4 Schematic Representation of a Stock Market Transaction

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Exchanges

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

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Stock Market and Exchanges

Stock Market refers to the entire interconnected set of places, organizations and processes involved in trading stocksRegulation– Securities Act of 1933

Required companies to disclose certain information

– Securities Exchange Act of 1934Set up Securities and Exchange Commission (SEC)

– Securities law is primarily aimed at disclosure

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Private, Public, and Listed Companies, and the OTCBB Market

Privately Held CompaniesCan’t sell securities to the general public – Sale of securities is

strictly regulated

Publicly Traded CompaniesReceived 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 CompaniesUse an investment banking firm to “go public”Prospectus—provides detailed information about companySEC reviews prospectus

– Red Herring - an unapproved, or preliminary, prospectus

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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

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The OTCBB Market

After a company goes public, its shares can trade in the over-the-counter (OTC) marketFirms not listed on an exchange trade through the OTCBB overseen by the NASDEventually a firm may list on an exchange

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Figure 5-7 Stock Market Quotation for Microsoft Corp.

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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 priceThe stock market bids prices up and downCurrent financial performance is the best indication of future performance

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Concept Connection Example 5-1 Executive Stock Options

Harry Johnson, CEOSalary $2,500,000Bonus 1,500,000

$4,000,000Plus: 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

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Moral Hazard

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

Concept Connection Example 5-1Moral 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

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Holding Performance Up

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

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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

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Events of the 1990s

Stock prices skyrocketedTop management was willing to bend rules– Some accountants partnered with unethical

executives in deceiving the publicEnron

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Public Accounting ReformRegulation

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

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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.

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Executives Profit While Others Go Broke

Executives often received huge incentive compensation while the stock tanked and investors/employees lost everythingSOX (§304) requires CEOs & CFOs to repay such gains to corporation

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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 recommendationsTheir compensation is not linked to specific recommendations

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The Financial Crisis of 2008

Home Ownership, Mortgages, and Risk Securitization Subprime marketsCredit Default Swap (CDS)

Home Ownership, Mortgages, and Risk

Loans are secured by a HouseFailure to make payment leads to Foreclosure

Securitization

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

Subprime Mortgage Market

Institutions borrowed at short-term rates to invest in CDOsNeeded money to investBanks ran out of qualified borrowers

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

In 2004 - 2006Concern about inflation Federal reserve raised ratesResulting in mortgage rates going up and an end to rising real estate prices

Effect on CDO Market and CDO Owners

CDO market froze2008 staggering losses and equity reductions by financial institutionsBailouts 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 2010Designed to fix the problem through legislationGoverns 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 issuerThere are MANY interest rates in debt markets– Depend on term and risk– Rates tend to move

together

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The Relationship Between Interest and the Stock Market

Stock returns and interest on debt instruments are related– Stocks and bonds compete for investor’s

dollarsStocks offer higher returns but have more riskInvestors prefer debt if the expected return is equal

Interest rates and security prices move in opposite directions

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Interest and the Economy

Interest rates have a significant effect on the economy– Lower interest rates stimulate business and

economic activityDebt financed projects cost less if rates are low

– More projects are undertaken

Consumers purchase more houses, cars, etc. when rates are low

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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

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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 curvesSets market price and quantity

– Changing conditions shift supply and demand curves for a new equilibrium

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

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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

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

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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

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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

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The Components of an Interest Rate

Interest rates include base rates and risk premiumsInterest rate represented by the letter k– k = base rate + risk premium

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The Components of an Interest Rate

Components of the Base Rate– Base rate = kPR + INFL– The pure interest rate plus expected

inflationRate 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

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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

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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

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Different Kinds of Lending Risk

Bond lending losses can be associated with price fluctuations and the failure of borrowers to repay loansThree sources of risk, each with its own risk premium:– Default risk– Liquidity risk– Maturity risk

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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

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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

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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

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Putting the Pieces Together:The Interest Rate Model

k = kPR + INFL + DR + LR + MRk is the nominal or quoted interest rate

Model tells what theoretically should be in an interest rateSetting Interest Rates– set by supply and demand– No one uses the model to set rates

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Federal Government Securities, the Risk Free Rate

Federal Government Securities– 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

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The Risk-Free Rate

Very short term federal securities, Treasury Bills, pay the risk free rateThe risk-free rate is approximately the yield on short-term Treasury billsDenoted as kRF Conceptual floor for interest rates

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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 negativeThe Real Risk-Free Rate implies that both the inflation adjustment and the risk premium is zero

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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). a. 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 = 3.8The 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.

Sunshine’s risk premium from assumptions

Yield Curves—The Term Structure of Interest Rates

A graphic relation between interest rates termThe normal yield curve– Short-term rates are usually lower than long-term

rates – curve slopes upThe inverted yield curve – Long-term rates are lower than short-term rates –

curve slopes downA sustained inverted curve usually signals an economic downturn is ahead

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Inverted Yield Curve- An Economic Predictor

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

Figure 5-10 Yield Curves

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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 TheoryInvestors prefer shorter term securities and must be induced to make longer loans

– Market Segmentation TheoryLoan terms define independent segments of the debt market which set separate rates

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