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

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

2. 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 flowof money

3. Figure 5-1 Cash Flows Between Sectors

4. 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 $

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

6. Figure 5- 2 Flows Between Sectors

7. 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

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

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

10. Term • 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

11. 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

12. 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

13. 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

14. 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 Primary market transactions can occur

15. Figure 5-3 Transfer of Funds

16. 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

17. 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

18. 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

19. Figure 5-4 Schematic Representation of a Stock Market Transaction

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

21. 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

22. 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’

23. 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

24. 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

25. 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

26. Figure 5-7 Stock Market Quotation for Microsoft Corp.

27. 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

28. 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

29. 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

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

31. 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

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

33. 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

34. 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

35. 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

36. 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.

37. 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

38. 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

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

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

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

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

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

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

45. The Trigger- Interest Rates Rise In 2004 - 2006 • Concern about inflation • Federal reserve raised rates • Resulting in mortgage rates going up and an end to rising real estate prices

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

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

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

49. 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

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