Module 2 Study Guide and Deliverables Shareholder Activism Assignment

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We've seen a significant increase in shareholder activism in recent years, particularly from large institutional shareholders. One of these areas is that shareholders may now voice opinions on senior management compensation (though not a binding voice). However such activism extends much further to include proposed mergers, acquisitions or spinoffs. Provide some recent examples where shareholder activism has affected a company’s performance or actions, and discuss the consequences of this.

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2019/3/26 Module 2 Compiled Module 2 - Compiled Content The following are all pages from the module linked as a single file suitable for printing or saving for offline viewing. Please note that this compilation will not include popup pages, and some animations or images may not work. Module 2 Study Guide and Deliverables Lecture Mortgage Markets Topics: Equity Markets Readings: Madura: Ch. 9, 10, 11, 12 and HBS#1 Discussions: 2: Shareholder Activism Initial post due by Wednesday, March 27 at 11:59 PM ET Reply posts due by Sunday, March 31 at 11:59 PM ET Activities: Homework Exercise 03 – Mortgage Amortization due by Sunday, March 31 at 11:59 PM ET Homework Exercise 04 – Equity Pricing due by Sunday, March 31 at 11:59 PM ET Short Summary of Term Paper Topic due by Sunday, March 31 at 11:59 PM ET Week 2 Introduction msm_ad712_13_su2_bchambers_w02 is displayed here Download Mortgage Characteristics What Are Mortgages? A form of debt used to finance/purchase investment in property Involves periodic payment > bond-like Debt secured by the purchased property > collateralized debt https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Print… 1/77 2019/3/26 Module 2 Compiled Value paid for property – Down payment = mortgage Types of property single-family: house, apartment, condo multi-family farm commercial: malls, office buildings Borrowers: individuals, farmers, corporations Lenders: commercial banks, savings & loans, mortgage companies Further sub-classification into Residential, Commercial, Farm Different government agency assistance / subsidy / support Different risk characteristics , attracts different investors Different cash flow We begin our coverage of mortgages and the mortgage market by going over some basic characteristics of this security. As with bonds, mortgage securities are considered as a form of debt security since they involve periodic payment of interest and repayment of the principal amount of the debt. The exception here is that a mortgage security is always collateralized by the underlying property from the loan. This can be a lien on a residential property, a house or a condominium, a parcel of land, or a commercial building. The principles are all the same. Residential mortgages generally refer to single residences (including condos), duplexes, triplexes (like Boston's infamous triple deckers) and often small apartment buildings of up to 4 units. Larger apartment complexes are regarded as commercial properties. Mortgage market securities are typically classified as residential (and in residential mortgage backed securities or RMBS), commercial (commercial mortgage backed securities or CMBS), or farm properties. As we will see later, these distinctions are necessary from the viewpoint of governmental housing programs as well as the preferences of investor participation in a particular class of property. Car loans are not mortgages, since they are not collateralized by property. The cash flow from a mortgage security is often a type of annuity. This is particularly true if the mortgage is a fixed-rate mortgage, that is, a fixed amount of mortgage payment per month. Other mortgages have a fixed payment of interest each month with one single "balloon" payment at the end of the mortgage term to repay the principal. One encouraging fact about the size of the mortgage market, in particular the North American mortgage market, is its steady growth over the years. The interruption of this growth in 2007-2009 due to the problems of the sub-prime mortgage market and the recession constitute a real change from historical patterns and most likely will be seen as a notable anomaly when more normal conditions return. I analogize the growing mortgage market to that of an expanding universe. Its rate of growth is driven by certain critical factors. To begin with, the North American demographic is sizeable. New family units are constantly being created. The desire and need for home ownership (the US, for example, has the highest rate of home ownership in the world), and hence a mortgage, is also supported by government's role in making housing loans widely available to qualified home buyers. One mystery that I will let students chew on for the moment is this: Where are resources of fund to maintain the growth? An often asked question is, "Where are the deep pockets?" At times it seems bottomless. We will revisit this mystery in a later topic called securitization. At more than $9 trillion, with one to four family dwellings as the overwhelming proportion of the total, this is no small mortgage market. It is almost the size of the North American Gross Domestic Product. Let's introduce the term "originate". This is used a lot in mortgage-speak. Although this is not a word unique to this financial market, it refers to the initial issuance of mortgage contracts by lenders to home buyers. Playing the role of mortgage originators are mostly commercial banks, savings and loans, and mortgage companies. But there are also https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Print… 2/77 2019/3/26 Module 2 Compiled independent mortgage originators who just act as agents or middlemen, not lending their own money but that of other lenders, in return for a fee or commission. As an aside, it appears that many of the subprime and so called "Alt-A" mortgages that have gone into default were initiated by independent mortgage originators who were much more interested in the volume of mortgages underwritten (enhance their fee income) than in the quality of the underwriting. From a prior Principles of Finance course, one of the properties of a mortgage's cash flow is the composition of principle and interest. The notion of amortization is also associated to mortgage payments since the principal of most residential mortgages is gradually reduced or amortized over its life, leaving a zero balance at maturity. The chart above illustrates the ever-changing principal to interest proportion within each payment of a fixed-payment mortgage. Of note is that most of the payments at the beginning of the loan are made up of interest payments. Mortgages can be a very, very good business to the lenders. It tends to be very stable with few defaults and generally appreciating collateral should a loan default (2007 through 2009 excepted). For students who have constructed an actual 30-year amortization table, the sum of interests over the life of the mortgage is typically a few multiples of the original size of the loan. For example, the 30 year fixed rate mortgage bearing a 6% loan rate will make fixed monthly payments of $599.55 for every $100,000 of principal, meaning total payments over the 30 year period of $215,838 or total interest payments equal to 116% of the principal amount. There's also an FYI section on amortization and its table towards the end of this week's lecture. https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Print… 3/77 2019/3/26 Module 2 Compiled This is an amortization graph of the same mortgage, but with maturity of 15 years instead of 30 years. Note the drastic shift away from the sizable proportion of interest at the beginning of the loan. Just a little bit of advice, if you can afford a 15 year mortgage, do it. However, the periodic payments are significantly higher. That is, more pain, but for a much shorter period of time. Note also that other factors, such as tax considerations and investment opportunities will also drive your choice of maturity of a mortgage since in the US interest on a first residential mortgage interest is a deductible expense for income tax purposes. One final word about the principal and interest components of a mortgage's cash flow. As we will see later, mortgage securities can be re-packaged and may have the two components of cash flow (the principal portion and the interest portion) directed to different classes of investors. We will cover in detail this financial innovation in the mortgage-backed securities segment of this topic. Residential Mortgages – Characteristics, Data Source, ARMs Residential Mortgages Characteristics Loan Categories Conforming – loan amount less than $417,000 Jumbo – above $417,000 FHA – government-backed loan supported by the Federal Housing Authority and the Department of Housing and Urban Development (HUD) VA – government-backed loan for enlisted personnel, qualified veterans and active duty military personnel; Veterans Administration Less-than-perfect-credit – designed to help borrowers get a mortgage, plus improve their credit grade for later financing Mortgage Loan Amortization monthly payment (pmt) consist of principal and interest https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Print… 4/77 2019/3/26 Module 2 Compiled during early years of mortgage, bulk of payment is interest over time, interest proportion of pmt decreases, principal portion increases principal eventually whittled down to zero when mortgage ends Let's turn our attention to residential mortgages – the largest proportion of all mortgage debt outstanding. Residential loans can be categorized by the amount that a home-buyer is borrowing. If the amount is less than $417,000, then its amount "conforms" to various government housing agencies requirement in the mortgage market. (Note: The ceiling for a "confirming" mortgage was temporarily raised to $729,750 under the economic stimulus legislation in 2009). Otherwise, it is called a "jumbo" loan. Loans can also be categorized by the level of assistance from government housing agencies. Finally, there's a risky category for home-buyers that have poorer credit profiles. These loans are termed "sub-prime" and tend to be much riskier than "prime" loans. There is also an in between category termed "Alt-A" mortgages. In some ways, sub-prime mortgages are analogous to the junk category in the bond market. As is the case, the mortgage rate will be higher than all other categories. P.S. I just can't help but put this stretch limo pig on this slide. Some of you might have seen this pop up on some websites. It points to the competitive environment of the mortgage market. It didn't take long after the shock of the mortgage crisis for these ads to start reappearing. It is extremely easy and convenient to apply online for a mortgage. Note the various range of mortgage rates being offered. They correspond to a wide choice in terms of loan size, maturity, as well as risk categories. A few more characteristics about residential mortgages. "Points" is a mortgage practice that is unique to the American mortgage market. It refers to up-front money that the borrower can pay in order to acquire a mortgage that has a slightly lower stated interest rate and is analogous to issuing bonds at a discount. Part of this buy-down incentive benefits the lenders as well. They manage to generate up-front cash upon origination, and could use these funds to originate proportionally more mortgages. Another recent trend that highlights the competitiveness among mortgage originators, is the practice of offering mortgage rates with 0% down payment on the purchase price of the property. Again this would make the loan "non-conforming" as the maximum loan-to-value (LTV) rate for conforming loans is 90%. (which some would say is already pretty high). This practice, by the way, places more risk on the lender in the event the borrower defaults. We will discuss FICO scores in detail later. It is standardized way of measuring a borrower's credit strength, based on the borrower's credit history. The most common original maturities for mortgages are a 15-, 20-, or 30-year mortgage. One recent trend is the introduction of 10-year mortgages. The shorter maturity gained some popularity during the early 2000s when the general level of mortgage rates was at a multi-decade low. If you do the calculation, when mortgage rates rise above 6%, the monthly payment of $300,000 to $500,000 mortgage practically makes it unaffordable for most average-income families. Balloon payment mortgages are like time bombs. During the early years payments, which are interest only, are much lower and affordable. However, once this honeymoon period is over, borrowers of this form of mortgage will have to face the music. https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Print… 5/77 2019/3/26 Module 2 Compiled Although mortgages are always collaterized with the loan's property, there's still a chance that the borrower might default, something that has been all too evident in recent years. This situation is made worse when the seized property no longer retains its mortgage value during depressed property market conditions. The chances of this are, of course, exacerbated when the original LTV ratio was quite high and/or when a high general level of defaults or recessionary conditions put a lot more properties on the market, further reducing the property's market value. Therefore, an insurance scheme to insure against such event can add a lot of additional protection to lenders. One form of insurance is those that are backed by various government housing agencies, like the Federal Housing Administration (FHA). Its mission is to make housing loans affordable to low- and mid-income families, as well as first-time home-buyers. Conventional mortgages on the other hand, are arrangements with private insurance companies. One implication of these two schemes of mortgage insurance is that investors of federally insured mortgages require a lower rate of return than those of conventionals. Recall during last week's topic on bond markets, no entity has a better credit quality than the full faith and trustworthiness of the United States government. And therefore, by extension, its governmental agencies. Private insurers, in contrast, have a very small but not zero chance of default, hence the larger margin. Fixed-rate mortgages and adjustable-rate mortgages are the two common forms of mortgage rates. Fixed rate payments throughout the life of the loan certainly has its appeal to some borrowers. If the general level of future interest rates is expected to increase, then a fixed-rate mortgage should be higher than the adjustable-rate mortgage. We will discuss more about interest rate expectations and their theories during the third week of the course. Adjustable rate mortgages (ARMs), also called variable rate, however, set the loan rate at a margin over some index, like LIBOR or the Treasury rate. The actual mortgage rate is then re-set periodically (annually is common) to reflect increases or decreases in the index rate. When general interest rates are low, ARMs can look very attractive. The pinch comes when the index rate increases and the homeowner gets surprised by a sometimes huge increase in the interest rate and the required monthly payment. The popularity of ARMs from the mid 1990s onwards and the increase in interest rates from 2004 through 2006 certainly contributed to the increased rate of defaults in the following years. Creative Mortgage Financing – too many choices! FRMs: Fixed-Rate Mortgages ARMs: Adjustable-Rate Mortgages GPMs: Graduated-Payment Mortgages initial payments start low, rises, then levels off tailored to borrower's income: expected to rise and keep pace with rising payments SAMs: Shared-Appreciation Mortgages "discounted" mortgage, i.e. below market rate lender shares in future appreciation of property Equity Participation Mortgages like SAMs but outside investor participant instead of lender Second Mortgages secured by the same real estate, but junior to 1st mortgage in case of default often has a shorter maturity than first mortgage has higher interest rate than the first mortgage due to increased default risk RAMs: Reverse Annuity Mortgages < owner/retiree of property gets paid https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Print… 6/77 2019/3/26 Module 2 Compiled Beyond fixed- and adjustable-rate mortgages, we also have a wide range of new mortgage products developed during the housing boom in 2002-2006. Such a wide variety of choices to a borrower attests to the depth and competitiveness of the mortgage market. For sure, it was a borrower's market. This market power, from the borrower's perspective, is unavailable in other countries. Try asking for a GPM (Graduated-Payment Mortgage) in Singapore, and the originators will give you a puzzled look. The market saw some questionable mortgage practices like zero down payments, artificially low "teaser" interest rates for the first year or two of a mortgage (which huge escalation of the interest rate and payment once the teaser rate had expired), negative amortization loans or loans where the size of the monthly payment was optional (and anything less than the normally scheduled payment was simply added on to the principal of the loan), and "no documentation" loans where the lender never even checked whether the borrower had the income needed to make the monthly payment or even had a job. With such "great" innovations was there any question that a mortgage crisis would occur at some point? Let me also point out reverse annuity mortgages, or RAMs. This has received some attention in the media and promoted by individual financial planners for retirees. In this mortgage, the roles of the borrower and the lender for a particular property are reversed. A retiree home-owner while still occupying the property, receives periodic payments from a bank. To the retiree, cash flows from the RAM are thus used to supplement those from retirement funds. The loan is then repaid when the retiree dies and the house is sold. The "lock" feature in a mortgage is useful to potential borrowers. Because mortgage rates fluctuate based on market and economic conditions, as well as actions from the Fed, a lock is a lender's guarantee of a particular rate to potential borrowers over a certain period of time. Locks serve the borrowers in two ways. First, the legal paperwork may take more than a few days to process. Second, even if a potential homebuyer has already identified his dream home, it may take weeks and even months for the transaction to actually close. Even a slight change in mortgage rate during this period could derail a home-buyer's affordability on that property. Again, locks exist as a result of competition among mortgage companies. https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Print… 7/77 2019/3/26 Module 2 Compiled Let's talk about ARMs. Each different colored segment in the table below represents variance of adjustable-rate mortgages. For example, N-year arms refer to how frequently mortgage rates get adjusted. The N here refers to the number of years. The N-1 ARMs – those highlighted in blue – refers to an initial period of fixed mortgage rate. It is then followed by annual interest rate adjustments for the rest of the loan. Students are not required to memorize all these variants, as well as those in the blue box below, but having the basic principles and the direction of influences set in your mind will be useful. This box below describes the mechanism used by ARMs in adjusting the mortgage rate. That is, how often is it being adjusted, by how much per adjustment, and what is the total maximum amount of adjustment during the life of the loan. The basic principle is that adjustments are typically linked to some benchmark rate, such as a T-bill, the 10-year Tnote, or LIBOR. If the interest rate of this securities changes, so do the ARMs. At ARMs Length The period between one rate change and the next is called an adjustment period ARM interest rate changes to changes in an index rate Index rate may be based on: 1-, 3-, or 5-year Treasury securities National or regional average costs of funds to S&L associations Some lenders use their cost of finds as an index Borrowers should ask what index will be used and how often it changes To determine the interest rate on an ARM, lenders add to the index rate a few percentage points, called the margin ARM interest rate = index rate + margin < "lik e credit card's Prime + 10%" https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Print… 8/77 2019/3/26 Module 2 Compiled Margin may differ from one lender to another, but is usually constant over life of loan In comparing ARMs, look at both the index rate and the margin for each program Interest rate caps places a limit on the amount an ARM can increase: Periodic caps – limit rate increases from one adjustment period to the next Overall caps – limit rate increases over the life of the loan < required by law With some ARMs, rate may increase even if the index rate stays the same or declines. How? By how much are rates adjusted? Typically based on the movement of the U.S. 1-year Treasury Bill Lender has no control over this number Safe to assume periodic adjustment(s) will be fairly determined Which ARM is best for me? Depends on your current income and growth rate of future income Depends on how long you will be staying in the property Depends on your expectations of future interest rate changes (direction, magnitude, rate of change) Why n-year ARM? Rate gets adjusted every n years (e.g. 1-year, 2-year, 3-year ARMs) In declining interest rate environment, rate consistently adjusted downwards Quite risky because payments can change significantly from year to year Initial rate is significantly lower than fixed-rate mortgages - affordable starting rate for low income, or to qualify for largest loan possible based on current income As income rises in the future, able to keep up with large monthly payments Typically a 2% limit adjustment; max 6% adjustment over life of loan Why n/1 ARM? First n years at fixed rate, then becomes a 1-year ARM (e.g. 3/1. 5/1, 7/1, 10/1 ARMs) Offers certainty in payment amount the first n years, then assumes for interest rate risk later Why n/(30-n) Balloon? First n years adjustable; then pay off the remaining principal thereafter (e.g. 5/25, 7/23 Balloon) Suitable for temporarily relocated workers Suitable if you plan to sell your property before n years Suitable if you plan to refinance before balloon payment date Unlike the 5-year, 5/1, 5/25 Two-Step, which fixes the rate for the first 5 years, a 5/25 Balloon starts off with a lower rate Why n/(30-n) Two-Step? Fixed rate during n years; then adjusted to another fixed rate for remaining life of loan e.g. 5/23, 7/23 Two-Step i.e. a two-step fixed rate mortgage Consider this loan if you expect to remain in the home for n years, but with a possibility of remaining longer that that Why 2/28 or 3/27 ARM? First 2 or 3 years at fixe rate; then adjusted every 6 months https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Print… 9/77 2019/3/26 Module 2 Compiled For consumers with less-than-perfect credit Allows consumers 2 or 3 years to improve their credit rating, at which point they may refinance at a better rate The "Other" MBA: Mortgage Bankers Association 1/3 Securitization of Mortgage Securities In this section we introduce a very important and innovative concept in financial markets. Namely the process of securitization. The whole area of securitization has received a huge amount of attention over the last several years. It has been blamed, in some cases deservedly so, for the mortgage and housing crisis. There is little question that many of the day key participants made some huge errors in the market euphoria in the 1990s and 2000s. It is also true that regulators did little to control the huge bubble in the marketplace which almost inevitably leads to the bursting of the bubble. That being said, there is a lot to be said for the process of securitization, whether for mortgages or other financial receivables, in that it provided a much larger, steadier and lower cost source of funding for these sectors. https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 10/77 2019/3/26 Module 2 Compiled In the context of mortgages, the securitization process takes very illiquid loans that are typically long-term, 15 to 30 years, and transform them into liquid securities that are easily traded in the secondary market. The outcome is a new market, as well as an additional investment vehicle for investors. The diagram above illustrates all the moving parts. Home-buyers, financial institutions, investors, and government housing agencies, all play key roles of creating and growing the mortgage market. But before we dive into the details, let's take a look at the problem at hand. As a starting point, the key challenge in the mortgage market is a strong demand for funds from home-buyers. As we have seen in the introductory segment, the total amount of mortgage debt outstanding is truly huge. Historically, mortgage lenders would fund mortgage loans from retail savings deposits. That tended to work reasonably well except that it also constrained the amount of mortgage money available, particularly in high growth areas. Mortgage originators – commercial banks, savings and loans, and mortgage companies, combined – do not have such deep pockets to meet this aggregate demand for mortgage funds. The second problem, even if mortgage originators have the fund to meet this demand, they face a problem of holding illiquid assets in the form of the properties as collateral. Although they will be receiving monthly mortgage payments from home-buyers, their capital can be tied up for 15 to 30 years. To some financial institutions, this is a slow way to make a return on capital, and constitutes a huge liquidity risk if short term deposits are withdrawn and the only asset the institution has is a long-term, illiquid mortgage portfolio. This was the underlying problem of the savings and loan crisis (See the Case Study). As you will see later in the commercial banking segment, one of the trends in banking is to move away from traditional banking, which earn a living by interest-related activities (essentially the same as a "buy-and-hold" investment strategy) of borrowing at a low rate (e.g. retail deposits) and lending at a higher rate, and into a mode of "originating and selling" where lenders are providing financial services and charging a fee for doing so. Let's move on and look at solutions to this illiquid mortgage market. https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 11/77 2019/3/26 Module 2 Compiled Solution 1/4 The top half of the image above (illustrated in red), alludes to the illiquid mortgage market. This is essentially a primary market, since the mortgages are originated by banks and mortgage companies with long-term funds transferred to the home-owners. Thus banks and mortgage companies hold a portfolio of illiquid mortgages. The solution lies in the creation of a liquid secondary mortgage market. Solution A. Mortgage originators sell their portfolio of mortgages to government housing agencies, such as Fannie Mae and Freddie Mac, and recoup their capital promptly. Originators are now essentially acting as a mortgage agent or broker between the home-owners and the government housing agencies. Solution B. Originators can take their portfolio of illiquid mortgages, package them, and then sell them as mortgagebacked securities. For the moment, note this, individual mortgage originators may lack the economies of scale to securitize mortgages. A few hundred million dollars, or even a few billion dollars, in a mortgage portfolio won't do the trick. As you will see later, various government housing agencies have the capacities to securitize mortgages, as do some of the larger investment banks which purchase the mortgage portfolios from originating institutions. Let's take a look at the various government housing agencies. As mentioned in the prior segment, these agencies cater to certain segment of home buyers. The biggest are FHA, which acts primarily as an insurance provider and as a lender for public housing or subsidized housing, Fannie Mae, Freddie Mac and Ginnie Mae (all are almost always referred to by their acronyms) which act primarily as wholesale mortgage lenders. Over the years, their roles have overlapped somewhat, but collectively they provide liquidity to the primary mortgage market. Their participation has grown this to a multi-trillion-dollar market. Note that this is not the end of the solution. Historically, Fannie, Freddie and Ginnie would issue bonds under their own names as a source of funding for the mortgages which they purchased. Although these government agencies have much deeper pockets than mortgage originators, they are nowhere near the size necessary to support the entire market. Second, even if they do, these government agencies have now inherited the liquidity problem from the mortgage originators. Solution B is actually an extension to Solution A. That is, government agencies solve the liquidity problem by securitizing these portfolios of mortgages. msm_ad712_wk2_pg5_diagram is displayed here https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 12/77 2019/3/26 Module 2 Compiled Download msm_ad712_wk2_pg5_table is displayed here Download Added comment for Slide 2 above: But, as noted earlier, the originate-and-sell model also gives the originators less incentive to underwrite good, safe loans and more incentive to just originate the highest volume possible, regardless of quality, as long as the mortgages can be sold to someone else (and are thus that other investor's problem). It's a bit like playing hot potato. The concept of securitization is extremely important and can be replicated with other forms of underlying security. During the process of securitization the pooling action also brings in the benefits of risk diversification. For example, an investor in a mortgage backed security may actively be purchasing exposure to mortgages in Wisconsin, Florida, California, Colorado, and Massachusetts simultaneously. This is akin to the concept of portfolio diversification that you will explore in more depth in another course called Investment Analysis and Portfolio Management. We conclude this segment and briefly introduce some of the trouble at Freddie Mac. During the early 2000s, this government agency strayed from its government-mandated mission. This scandal, along with that of Fannie Mae's, is covered in detail in a later segment in mortgage markets. Despite these problems, these government housing agencies still have a lot of potential to do very positive things. The government's social role in promoting home ownership is still a valuable one. It's just that government agencies, just like publicly traded stocks, need proper and sometimes close supervision. Nowhere else around the world will you find a $9-trillion mortgage market that is this liquid. Over the past few decades these government housing agencies have served the people well. Try getting a mortgage in many other countries, and you will see what I mean. Mortgage-Backed Securities We continue in this segment with mortgage-backed securities, or MBS. Recall from the previous segment the process of securitizing pools of mortgages. As it turns out, this is a generic technique that can be applied to all sorts of securities that have a cash flow associated with it. In this slide we see other forms of asset-backed securities (ABS) with the most common forms marked with an X. Mortgage-Backed Securities (MBS) Definition: securities backed by mortgage loans MBS is just one form of the broad class of securities that are labeled "X"-backed securities, where "X" can be: https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 13/77 2019/3/26 Module 2 Compiled CMBS – Commercial Mortgage-backed securities ABS – Asset-backed Securities, where "Asset" can be: Aircraft leases Auto loans and leases Credit card receivables Equipment loans and leases and many more ABS is a very rich class of securities Reminder: The concept of securitization is very powerful. Its generic technique can be replicated with all sorts of assets or cash flows. Note the variety of assets that can be used in the securitization process. They differ in the frequency of cash flow, the maturity of the loans used to back the security (e.g. 3 year automobile loans vs. 30 year mortgages) and in some cases the risk/uncertainty of the amount of such cash flows during each period (e.g. credit card customers may repay the full balance outstanding or make the minimum payment each month). Returning to mortgage-backed securities, let's look at variants of MBS. They mostly have to do with the way cash flows from the underlying asset– in this case pools of mortgages – are to be distributed to investors of MBS. Recall from the previous section, the numerical illustration of the process of securitization. That illustration is essentially a mortgage pass-through security. All the cash flows from the pool of mortgages were collected by the servicing agent. These cash flows, whether it is principal component or the interest component, is lumped together and then distributed to investors on a pro-rata basis. That is, proportionate amount of each share of the MBS. Thus, all investors in a pass-through are treated equally in the receipt of any cash flows from the pools of mortgages. Hence, each investor is exposed to the same level of risk, whether it is interest-rate risk, pre-payment risk, defaults, and etc. We will discuss more in detail all these forms of risk. The second form of mortgage-backed securities collateralize mortgage obligations, or CMO's, make the receipt of the mortgage cash flows a lot more interesting, complex, flexible, and, in some cases, riskier. Its complexity lies in the way it redistributes the cash flow to various classes of investors. One of the earliest forms used was to divide the total cash receipts into interest payments and principal payments. One group of investors would receive only the interest portion of the payments, so-called IOs for "interest only", while the second group received only the principal portion, so called POs for "principal only". This has a similar risk profile to that of Treasury strips that we covered in the bond market section of the lecture. IO investors would receive an immediate large regular payment, but took the risk that if the mortgage was repaid early, future interest payments would be decreased. PO Investors would receive minimal payments early, but significantly larger payments later on and always be assured that the principal amount of the loan would be repaid. If the mortgage were repaid early the PO investor would get his money back but quicker than expected. However, if the mortgage defaulted he could receive little or none of his investment back. This is akin to various classes of bond-holders, for example, senior, subordinated, debentures, etc. We can also add several other dimensions. For example, the packager may break the total amount of mortgage backed securities into several different tranches or subgroups. Tranche A security holders get the first call on any cash flows, so they are most are shored of getting repaid, and thus will accept a lower rate of return on their investment. Tranche B holders will get paid only after the holders of Tranche A. Thus they are taking more risk and will demand a higher rate of return. The size of the different tranches and the rates they pay can be adjusted so that even a portfolio, of highly risky assets can be packaged so that the Tranche A https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 14/77 2019/3/26 Module 2 Compiled investors are very well protected. Thus the Tranche A Bonds could receive a very high rating from the debt rating agencies. This box below describes the three main government housing agencies and the way they choose to securitize the mortgage pools. Note also that each may cater to certain segment of the borrower. They can also differ in provisions and insurance, and certainly have different terminology for the shares that were securitized. It is truly a fascinating subject but I think I've beaten this securitization idea to death. Government Housing Agencies (MBS) 1. Ginnie Mae MBS guarantees time payment of principal and interest to investors in FHA or VA mortgages all mortgages pooled together must have the same interest rate interest rate received by purchasers is about 50 basis points less 2. Fannie Mae MBS issues MBS and uses the funds to purchase mortgages channels funds from investors to financial institutions that desire to sell their mortgages receives a fee for guaranteeing timely payments of principal and interest to the holders of the MBS some MBS are stripped into POs and IOs 3. Freddie Mac MBS called Participation Certificates (PCs) sells (PCs) and uses the proceeds to finance the origination of conventional mortgages from financial institutions The MBS market is truly complex with a lot of moving parts. The underwriting standards, the geographic location of the mortgages, the mortgage term and yield, the delinquency and default rates on the mortgages, recovery values on defaulted mortgages, prepayment rates (mortgages getting repaid before the stated maturity), etc. etc. all vary considerably. https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 15/77 2019/3/26 Module 2 Compiled This is a market snapshot of mortgage-backed securities during a particular trading day. On the second column you have the coupon rate of the mortgage-backed security. On the fifth column it lists the average life of the mortgage, since not all mortgages in a pool need to be of the same maturity. On the eighth column a term that is specific to mortgagebacked securities, called PSA. This is an average measure of the rate of pre-payment of the underlying pool of mortgage of the security. And finally, on the right edge of this slide, we have the CMO's. Students will have opportunity to read more about MBS and CMO's in an assigned reading of a Harvard Business School case. Miscellaneous: Institutional Use, Risks from Investing in Mortgages, Globalization We conclude mortgage markets by looking at a number of miscellaneous topics and loose ends. First let's look at institutional use and participation in the mortgage markets. Note that mega-financial institutions, such as CitiGroup and Bank of America, have the financial resources to securitize as well as originate loans. Also, mortgage companies, commercial banks, savings and loans, play the typical roles of originating mortgages, and may, in turn, sell those to one of the larger "packagers" of MBS. Just as important is the division of mortgage activities into three distinct areas: The origination in the primary market, the servicing of mortgage collection, and finally, investment activities in the secondary mortgage-backed security market. Such division makes it possible for financial institutions to participate in any combination of these activities. For example, a small bank might originate loans, sell them in turn, an investment bank which will package them into MBS, but retain the right (along with the fees) for servicing the mortgage. The individual borrower may have no idea that her loan was sold to eight different institutions and incorporated into a MBS. Brokerage firms also play supporting roles in the secondary market. And finally, investment banks offer the expertise in interest rate-management to institutional investors that have significant holdings in mortgage-backed securities. https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 16/77 2019/3/26 Module 2 Compiled The pie chart above shows the proportion of holdings in mortgage securities by various financial institutions. The bar graph shows the holdings by property type. Three trends in holdings are apparent here. First, commercial banks are major holders across all property types. This has to do with the collective size of the assets. Second, the preference of life insurance companies in multi-family and commercial properties. And finally, savings and loans prefer holdings in family dwellings, both one- to four-family as well as multi-family. As we'll see in the lecture on banking, savings institutions are chartered by the government to primarily provide traditional banking and mortgage services to the general public. The next four boxes describe the various risks an investor faces when holding mortgage-backed securities. Recall from the lecture on bonds all debt securities have an inverse price-yield relationship. Individual mortgages or MBS, which are forms of a debt security, are no exception, and hence, faced with the same effects of interest-rate risks as bonds. If general interest rates increase, the market value of the mortgage or MBS will decrease correspondingly. Interest Rate Risk mortgages commonly financed by financial institutions with short-term deposits (thus mismatch between asset and liability) ↑interest rate > ↓mortgage security ↓interest rate > ↑mortgage security > high returns (but gains are limited because borrowers tend to refinance Limiting exposure to Interest Rate Risk (lenders) financial institutions can: Maintain adjustable-rate residential mortgages Invest in a fixed-rate mortgage with a short time remaining to maturity Become a broker Originate mortgages... ...then turnaround and sell mortgages https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 17/77 2019/3/26 Module 2 Compiled get money back...and repeat originating process, each time earning a fee or spread In pre-payment risk home-owners behave in the same manner as corporate bond issuers, that is, they refinance their mortgages when mortgage rates decline. When this event occurs, investors, in this case, holders of mortgage-backed securities will now be faced with reinvestment risk in a climate of lower interest rate. Terms for prepayment vary considerably. In some states (e.g. Massachusetts) and the movement is in this direction, a homeowner can prepay a mortgage at any time. In others, the mortgage terms may set a maximum amount that may be prepaid annually (e.g. 10%) without incurring a pre-payment penalty (which, where they are levied, may be quite substantial). Prepayment Risk ↓interest rate > borrower pay off entire mortgage by refinancing it with new lower mortgage rates investor receives payment now has to reinvest at the lower interest rate < Reinvestment Risk Note: because mortgage market is so competitive, prepayment penalty that used to be imposed on borrowers, no longer exist Limiting exposure to Prepayment Risk – (lenders) financial institutions can: Become a broker Invest in adjustable-rate mortgages Extension risk is the opposite of pre-payment risk. Depending on the variety of mortgage-backed securities, investors may find that their actual periodic receipt of cash flows diminished. Extension Risk ↑interest rate > borrower with ARM may have problems paying higher payment Borrower paying a smaller than usual amount Principal outstanding actually increases life of mortgage actually lengthens take longer for investors to recoup investments As in bonds, credit risk is also present in mortgages. That is, the event of late payments from home-owners (delinquency), as well as the chance of default, is ever-present. Beginning in 2006 lenders began to see the delinquency and default rates for mortgages, especially the sub-prime and subsequently the Alt-A, begin to increase dramatically. Ultimately this carried over into the prime mortgage market as well. This can be tied to several key factors. Increases in interest rates had increased mortgage payments for ARMs as the rates were re-set; home price appreciation began to wane, reducing the ability of homeowners to sell their homes at a profit if they were unable to meet the mortgage payments the combination of these two factors also reduced the ability of homeowners to refinance their mortgages and, https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 18/77 2019/3/26 Module 2 Compiled finally, higher unemployment rates reduced incomes for the primary or secondary income earner or both. The resultant increase in delinquency and default rates were the highest experienced since the Great Depression. Credit Risk possibility that borrowers will make late payments or even default probability of default influenced by: economic conditions: e.g. recession > layoffs, high unemployment rate level of equity invested by borrower borrower's income level borrower's credit history borrower using ARM borrowing "too much" Limiting exposure to Credit Risk – (lenders) financial institutions can: purchase insurance maintain the mortgages they originate The following are typical measures that are taken in managing and reducing risk of mortgage defaults. We will look at FICO scores next. Managing Risk of Mortgage Default Insured Mortgages Guaranteed by government agencies like FHA, VA Conventional Mortgages Not guaranteed Typically requires Private Mortgage Insurance (PMI) 5%, 10%, 15%, 20% down payment Down Payments 5%, 10%, 15% down payment PMI may be waived with a 20% down payment Credit check and pre-qualification Income level Net Worth Outstanding credit card balances Consumer credit history FICO Scores Recall in the bond market topic, impartial agencies such as Moody's and Standard's and Poor's, perform credit ratings on all borrowers in the bond market. These ratings typically cover MBS, but not individual mortgages. However, in the https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 19/77 2019/3/26 Module 2 Compiled problems of 2007 and beyond, it became pretty clear that the agencies had underestimated the risk of these securities, most especially in the delinquency and default stress tests that they had included in their models. FICO Scores www.myfico.com Consumer credit rating system Developed by Fair Isaac & Co., since 1950s < FTC approved Credit scores from 300 ∼ 850 Calculated by using scoring models and mathematical tables Assigns points for different pieces of credit information Median FICO score is 736 (4/2015) Three credit bureaus compile FICO Scores (for a fee) Transunion Experian Equifax Each of them may come up with a different score for the same consumer Mortgage companies may use one of these scores; others use the middle score Some states allow one free set of FICO scores per year Compiling FICO sores History of late payments Amount of time credit has been established Amount of credit use vs. the amount of credit available Length of time at present residence Employment history Negative credit information such as bankruptcies, charge-offs, collections, etc. Improving one's FICO Score Pay bills on time. Late payments and collections can have a serious impact on score Do not apply for credit frequently. Having a large number of inquiries on your credit report can worsen your score Reduce your credit-card balances. If your are "maxed" out on your credit cards, this will affect your credit score negatively Obtain additional credit (if you have limited credit). Not having sufficient credit can negatively impact your score Correcting errors in your credit report Call those credit bureaus (warning: may be an exercise in bureaucracy) Some mortgage companies may be able to help Higher FICO Scores reduces a borrowers mortgage rate https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 20/77 2019/3/26 Module 2 Compiled FICO scores is the equivalent at the personal level. Individuals or joint borrowers in the household are rated based on the consumer's credit history. That is, how many credit cards one has, the average balance outstanding on all credit cards, patterns of late payments, employment history, etc. This credit history is aggregated into a FICO score with high numbers referring to better consumer-credit quality. Each range of FICO scores correspond to varying grades of credit quality, which in turn translates to a level of mortgage rate to the home-buyer. Note that the range of mortgage rates that corresponds to the range of FICO scores has to float up and down, and be relatively aligned to other yields in the debt market. For students who plan on applying a mortgage in the future, some common tips on improving your FICO scores are also listed. By doing so, a consumer is practicing responsible and diligent credit behavior. This is no different from safe-driver points being rewarded with lower premiums in the auto-insurance industry. There are several independent consumer credit scoring agencies which produce these scores and some of the individual consumer lenders have developed their own FICO scoring systems by altering the weights of various factors. The commercial agencies are required to reveal to consumers what information they keep in their files and the resulting FICO scores. FYI – Amortized Loans and Table Amortized Loan An amortized loan is a loan whereby periodic (fixed) payments of the loan is made up of two components: 1. The Interest component is the interest payment based on the beginning-of the-period principal balance 2. The Principal component of each monthly payment gradually reduces the remaining principal balance of the loan. Thus, periodic PMT + Principal + Interest Examples of amortized loans: car loans, mortgages. Thus, by the end of the loan, the principal balance will be reduced to zero, i.e. fully amortized. This segment contains FYI material on the concept of amortization in mortgages. It should be material that is familiar to all from a prior principles of finance course. https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 21/77 2019/3/26 Module 2 Compiled The two components of a fully-amortizing loan are principal and interest. Note that the proportion of these two components, relative to the payment, constantly changes over term of the mortgage. In particular, the earlier payments contain a much larger proportion of interest (since the principal balance is high at this point) and a corresponding small proportion of the payment goes to reduce the principal. Towards the end of the mortgage term, the relative proportions are reversed. Since by this time the principal balance has been reduced, the proportion of each payment going for interest is much smaller which as bigger share of the payment goes to reduce the principal balance even more. The slides below preview the steps in constructing an amortization table. It is now very common to use spreadsheet software like Excel to construct long-maturity mortgages. For example, a 30-year mortgage with monthly payments has a total of 360 payments. Constructing an Amortization Table 1/7 https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 22/77 2019/3/26 Module 2 Compiled At the end of the loan the ending balance of the principal amount should be amortized to zero. For short-term amortized loans the total sum of interest payments is not that bad. For longer-term amortized loans the sum of interest payment can be multiples of the original size of the loan. FYI – Trouble at Freddie Mac and Fannie Mae This segment contains FYI material regarding recent accounting scandals at Freddie Mac and at Fannie Mae. Recall that both are government-sponsored agencies (sometimes the acronym GSE is used for government sponsored entities). They were formed to promote home-ownership in the United States. These entities play a critical role in developing the mortgage market. First, they provide liquidity to mortgage originators that lend money to home-buyers. Second, Freddie and Fannie create a secondary mortgage market by securitizing the mortgages that they buy from the originators into mortgage-backed securities. This role brings in capital from institutional investors, both domestic and foreign. The Freddie Mac Accounting Scandal Since 2000, Freddie Mac invested in non-mortgage related assets: corporate bonds strip malls hotels This is a deviation from their mission The company used irregular accounting techniques to stabilize earnings hide its increased risk Freddie Mac was required to restate its earnings (2000-2002) and replace its CEO and other senior managers A timeline of Freddie Mac's and Fannie Mae's troubles and how it affected the agencies' stock price highlights some of the key issues as seen in the image below. Note that in addition to securitizing the mortgages, Freddie also issues stock, to further capitalize their enterprise. It is difficult, if not impossible, to exactly match the terms and maturities of the mortgages which the agency buys and the bonds which is sells to finance these. As a result, to try to bring the two closer together, the agency also buys and sells interest rate forwards and futures and other derivatives. https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 23/77 2019/3/26 Module 2 Compiled How did Freddie Mac and Fannie stray from their Congressional charter? Recall that generally bonds and mortgages held to maturity as shown in the company's balance sheet at historical prices. However, financial derivatives are marked-to-market, meaning that the values will vary as interest rates rise and fall, in some cases quite significantly. If these changes in derivative values are passed through the income statement, they can result in great volatility in the company's earnings. Freddie and Fannie used improper accounting to smooth out their periodic accounting results. In the stock market the appearance of consistent growth of earnings is an attribute that attracts share-holders. This is because consistency is synonymous to low volatility and hence less risk in holding the stock. Two other improper behaviors also occurred: First, they started trading mortgages in the same market, where their main role is to maintain liquidity. Even worse, trading in bonds, a security that is unrelated to mortgages, unless it was used in hedging (which they did not). Second, they used improper accounting for its derivatives. Derivatives are a form of security that can be used to manage financial risk. In Freddie's case, interest rate risks arise from the mortgages that they hold. Their use of derivatives was legitimate to smooth this out, however, one has to question if the amount of derivatives used was appropriate. Look at the years 2001 and 2002, the green-colored bars on the graph. The value of the derivatives far exceed the value of their mortgage portfolio, indicating that Freddie had gone from using the derivatives as a riskmanagement tool, to using it as a speculative tool in the derivative market to try to outguess the market regarding interest rate movements. That is, switching from defense to offense in the management of their portfolio. https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 24/77 2019/3/26 Module 2 Compiled OFHEO, the Office of Federal Housing Enterprise and Oversight, is the government agency that supervises all government housing agencies. In the case of Fannie Mae's improper behavior, here are OFHEO's findings. Part of the accounting scandals and Fannie's actions to smooth earnings was the attempt to beat certain earnings-performance measures that were tied to compensation packages of senior management. Fannie Mae's Accounting Problems OFHEO's charges: derivative transactions and hedging did no comply with GAAP use of cookie jar reserves to smooth earnings < delay income or expense recognition internal control deficiencies maintaining a corporate culture that emphasized stable earnings a the expense of accurate financial disclosures $50 million on advertising to promote Fannie's mission One of the biggest corporate lobbyists in the country Earnings manipulation to meet target bonus: In 1998, inappropriately deferred $200 million of expenses > allowed the company to record EPS of $3.23, exactly the minimum level needed to trigger the biggest possible bonus for executives. More aggressive compensation rules – "The EPS Challenge Option Grants" bonuses of executives and employees tied to EPS need to double EPS from 1998 ($3.23/share) to Dec. 2003 ($4.46/share) reported $7.29 EPS in 2003 Fannie's prior complaint: "...we have unfairly suffered collateral damage from the accounting crisis at Freddie Mac..." Fannie Mae's stock price also took a hit as a result of OFHEO's findings. See the trading volume and the sharp drop in stock price during September, 2004. https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 25/77 2019/3/26 Module 2 Compiled A comparison of this agency's stock price, dividend yield, and earnings per share shows the progression of the scandal is seen below. Prior to this scandal, both the stocks are highly sought-after by institutional investors and foreign government and institutions. https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 26/77 2019/3/26 Module 2 Compiled Fannie Mae's earnings looked too smooth. Look at the top-right chart in the image below. Before the uncovering of the scandal, look at her earnings prior to 2000. In hindsight they look highly suspicious. Life just isn't that stable. The bottom chart shows Freddie's restated earnings. As is expected, earnings should fluctuate somewhat in response to market condition and the uncertainties of interest rate-related market dynamics. Again, a side-by-side comparison of Fannie Mae and Freddie Mac (below) highlights both similarities and differences. By measures of total assets and market capitalization Fannie is often referred to as the big sister, while Freddie the little brother. Both have sustained too-big-to-fail status in the mortgage market, their role is so crucial to the existence of the https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 27/77 2019/3/26 Module 2 Compiled mortgage market. In mid 2008 both were effectively taken over by the government. While the companies did not enter bankruptcy, the government became the administrator for both agencies, pledged a formal support for their debt (there had previously been an implied rather than explicit guarantees), and it will be surprising if the shareholders will be able to realize any substantial value for their shares. If these agencies hiccup, or even worse, were to collapse, it will bring about hardship and chaos to all participants in the housing industry. Hence, they receive special treatment from the government and sometimes in the form of tacit support against systemic failures. As you will see when we proceed to the banking topic, certain of the mega-banks of American origin have also achieved seemingly too-big-to-fail status. Stock Characteristics Most people have some basic working knowledge of stock markets. The following is a checklist for students who feel reasonably well acquainted with this topic. For specific questions, feel free to post and discuss them in the discussion board. https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 28/77 2019/3/26 Module 2 Compiled There are a number of textbook chapters on equity markets. Some material is deferred to in the next course on investment analysis and portfolio management. The main seekers-of-funds in the stock market are corporations in need of capital to expand their businesses. The definition of primary market and secondary market is no different of those of other securities. In the primary market the company is selling stock to investors and directly receiving the proceeds. But note the term IPO. There is sometimes a point of contention about whether an IPO is a primary market or a pre-primary market activity. This confusion has to do with the pre-IPO process and the role of private investors and investment banks. That is, whether the offering is made directly to the public or whether it may have changed hands prior to the first day of trading in the secondary market. More will be said in the next segment on the IPO process. But for now, it is a primary market activity, that is, stocks are newly minted and are being offered for sale for the first time. Equity = Stocks Definition: a certificate representing partial ownership in a corporation = equity Borrower: issued by companies to obtain long-term funds is owned by shareholders indefinitely < "ongoing concern" obligated, but not required to distribute earnings to shareholders < unlike bond coupon payments Lender: individuals, financial institutions. Earns a return by, potential rise of stock price over time dividends (cash or stock) from company Types of stock market transaction Primary Market New issue of stock > company gets to keep capital raised from sale https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 29/77 2019/3/26 Module 2 Compiled Initial Public Offering (IPO): "going public"; brand new, very first time Secondary Market Stock that was issued is re-sold/traded (e.g. New York Stock Exchange) Has nothing to do with the company > no additional capital raised by company Secondary Offering Firm issues additional stock after IPO Companies may also participate in the primary market by making secondary offerings of stock, which may be sold directly a selected investors (a "private" sale) or more widely to the general investor community. However the vast majority of stock trading is between individual investors in the secondary market. While the issuing companies are not directly involved in these transactions, they are very interested in what is happening to the stock price and whether some particular investors are accumulating a bigger ownership stake (such as take-over candidates) or are selling down their positions (a sign of lack of confidence in the company). Stocks that are differentiated by voting rights and claim on the company's cash flow. On a balance sheet preferred shares are placed between that of company's debt and common equity. In some ways preferreds behave more like a debt security. Two Types of Stocks 1. Common Stock < common equity right to vote receive dividends 2. Preferred Stock Typically no voting rights receives dividends before common dividends are paid out "guaranteed", and if deferred, cumulative in nature receive periodic fixed dividend (and no more) behaves like a perpetuity... ...more bond-like than stock-like less desirable source of funds than bonds because: dividends are not tax deductible dividends may be omitted, do not legally have to be paid Most stock certificates are held in custody in electronic form with brokers, instead of the traditional paper stock certificate. There are a few specialized financial institutions who serve as trustees for these holdings. In some countries all stocks are maintained electronically in a central depository. Stock transactions are then credited and debited accordingly from this depository. https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 30/77 2019/3/26 Module 2 Compiled Market capitalization refers to the market value of all common shares outstanding. This is the product of the number of shares time its current stock prices. It is one form of measure of the size of a publicly traded company. Whether it is $15 trillion or $25 trillion, this value moves up and down, pending market and economic conditions. Note that under the household category there may be some double-counting, since stores of wealth in the form of stocks may include direct purchases of mutual funds. Who Owns Stocks? Stocks in addition to debt securities are the two main forms of capital market instruments. Hence, the usual suspects, or rather market participants, in the stock market. All financial institutions are visibly represented in stock markets. Institutional Use and Participants in Stock Markets Stock Issuance: IPO Process, Secondary Offerings Let's take a look at the IPO process – a primary activity. This is a process whereby shares of a soon-to-be-publicly listed company are offered for sale to investors. Keep in mind that not all companies are equally attractive in raising capital in the stock market. Generally, only companies that have a reasonable history and strong future revenue outlook can do this. Thus most companies typically go through a venture capital phase where private money is used to fund the https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 31/77 2019/3/26 Module 2 Compiled company's R&D and expenses, prior to the IPO process and to develop a track record that they can show to potential investors. There are, of course, exceptions. During the dot-com boom of the 1990s, companies with little history or even revenues, let alone profits, were able to access stock markets in record numbers. The results of this speak for themselves a disaster for both many of the companies and their investors. Initial Public Offerings (IPOs) First-time offering of shares by a firm to the public Typical capital-raising timeline: private firm with potential growth opportunity obtains private equity funding (i.e. private funding) from venture capital company(s) VCs own most of company Investment banks help company IPO... ...VCs sell their portion of shares after IPO (6-24 months later) ...recoups money, and move on Note: private firms can IPO through investment banks without VC funding common path for non-high tech companies No matter how big the private company is, and no matter how capable the Chief Financial Officer is, the IPO process always involves an investment bank, since they are the institutions with the best established contacts with the investment community. Google was one very unusual exception is "went public" via an internet sale of their shares (for what is seen in retrospect as a ridiculously low share price). Larger issues of an IPO might involve a group of investment banks – call it syndication. Investment banks play a key role in the IPO process. They act as intermediary in the primary market, performing legal filings with the SEC, preparing promotional material, and looking for potential investors on road shows. The prospectus, in layperson's term, is a catalogue of the product – in this case, the company, its business, and the financial outlook of the company. The Pre-IPO Process 1. Use of Investment Bank underwrites the IPO large IPOs may be syndicated > multiple underwriters with a lead underwriter experts in doing and filing legal paperwork Has the connections & wholesale ability to sell in volume... ...placement of shares to interested buyers 2. Develop a Prospectus: file with the SEC < "SEC Filing" detailed information about the firm: financial statements discussion of risks < fair warning to potential investors, whether to invest in firm requires SEC approval https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 32/77 2019/3/26 Module 2 Compiled upon approval, prospectus used as promotional material sent to institutional investors 3. IPO Roadshow: promote IPOs in institutional investors how hard underwriters and managers work depends on how "hot" the IPO issue is some hot IPOs require "only a few phone calls" to the right institutions... ...while others require even overseas road shows also depends on the size of the IPO 4. Pricing the IPO decided by lead underwrites driven by supply and demand during roadshows & phone calls... ...bookbuilding: number of shares demanded and at what price may use an auction process to set prices (e.g. Google) 5. Transaction Cost: aka this is a very very good business ranges from 4% - 11% of the value of the IPO average about 7% IBs fight over hot and large IPOs may syndicate... ...and share the spoils of war also benefits from division of labor e.g. global roadshows to different parts of the world 6. Pre-IPO Allotments < is there such a thing as a fair process? most are offered to institutional investors < "individuals don't stand a chance" about 2% offered to brokerage firms Pricing an IPO is not a simple task. It begins with the book-building process, the exercise of taking orders from prospective investors and getting a sense for what price they might be willing to pay for the shares. Note that there is also an incentive for the underwriter to get the highest possible price for an IPO, since its compensation is based on a percentage of the total proceeds of the IPO. But the investment bank also wants the IPO to be seen as a success which is often measured by how the stock performs on its first day of trading. If the stock price rises, success is declared. But if the stock price falls or even worse the entire allotment of stock is not sold to ultimate investors, the IPO might be viewed as a failure. So there is also some incentive for the investment bank to underprice the IPO to assure its "success". However, such underpricing merely shifts profits from the companies issuing the stock to those who are able to purchase the stock at its artificially-low IPO price. A conundrum. Pre-IPO allotments have received a lot of attention in the last few years. Sometimes, this falls under the gray areas of fair dealing in the markets. The problem is understandable, however. In a popular IPO demand far exceeds supply, especially in optimistic periods such as the later 1990s. Seemingly disproportionate allotments sometime go to the institutions that are in the best position to transfer the security to the secondary market. At question is that these institutions are greatly enriched during this process. The fair but impractical way to solve this is to pro-rate the allotments based on the number of interested parties. But by doing so it is an inefficient way to generate liquidity in the market. There are no easy solutions to this dilemma. https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 33/77 2019/3/26 Module 2 Compiled There is often a venture capital stock certificate (Image 1 below) in the pre-IPO process. It has a clause that permits the venture capital company to convert its advances to the company  to common shares as the process moves closer to an IPO event. The subsequent conversion to common shares upon IPO is seen in Image 2 below. Note that the conversion does not have to be one-for-one. In this particular example, there was a 100% dilution. That is, going from 33,000 shares to 16,000 shares. The process allows the VC to effectively cash out of the company, if it so desires, at the point of an IPO or to realize the potential appreciation of the shares following the IPO. With many IPOs it is quite common to see price volatility during the initial days of trading in the secondary stock market as both new investors pour in to get a stake in the company and some existing holders and those that bought stock at the (artificially low) IPO price seek to cash out. Also, the best time to initiate an IPO is typically in an economic upturn, https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 34/77 2019/3/26 Module 2 Compiled during the bull market cycle when investors are generally in an optimistic mood to take on more stock investments. So we saw huge IPO activity during the late-1990s boom, and virtually no IPO activity once the bubble burst in 2001-2002. Some common forms of misbehavior in the IPO market. There have been many instances with these very popular IPOs of the underwriting investment banks giving out-sized allocations to executives of firms that are potential future customers of the investment bank. Is this bribery or just a case of "I'll scratch your back if you scratch mine?" Abuses in the IPO Market 2003: regulators attempted to impose new guidelines 1. Spinning: "you scratch my back, I'll scratch yours" investment bank allocates IPOs to executives... ...in future, executives return favor by enlisting IB services 2. Laddering of hot IPOs: demand > supply during the 1st day of IPO... ...brokers charging investors above IPO price 3. Excessive Commissions: it is still a seller's (i.e. broker) market in hot IPOs Secondary offerings have nothing to do with a second helping of dessert in a buffet. Instead it refers to a second series of stock issuance by the company. This is only possible for firms that continue to receive strong investment reception from market participants. Note that this can be detrimental to the first set of shareholders, since it dilutes their claim on company's assets. The only exception is that if the secondary offering puts the company in a stronger position to boost their earnings, then it is not a problem. We also saw many financial institutions issue new common and preferred stock in 2008-2009 as they attempted to restore their equity positions after huge financial losses. Secondary Stock Offerings A secondary stock offering is: firm issues additional stocks after prior IPO e.g. raise more equity to expand operations usually facilitated by a securities firm Late 1990s Internet, dot.com era volume increased substantially 2000-2002 economic downturn & post 9-11 volume declined Existing shareholders often have the preemptive right to purchase newlyissued stock Shelf-registration pre-registration with the SEC up to two years before issuance allows firms quick access to funds, when ready to do it https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 35/77 2019/3/26 Module 2 Compiled potential purchasers must realize that information disclosed in the registration is not continually updated Shelf-registration is a pre-emptive security filing that prepares a publicly registered firm for future issuance of a security, which can be either debt or equity. The shelf registration documentation contains a lot of the basic information contained in a prospectus and permits the company to move quickly to issue stock if they see a favorable window open in the market. Normally, absent the shelf registration, the stock issuance process can take a long time from start to finish, this precluding the chance to take advantage of specific, short-term opportunities. Forms of Exchanges: ECNs, Program Trading In this segment, we will talk about the organization of the secondary stock market that is how do buyers and sellers interact to trade stocks. Going back in time some of the first stock exchanges were informal gatherings in taverns and coffee houses. "I'll have a double latte (or a pint of ale) and 10 shares of XYZ company." Gradually they took on a more formal structure. Today we see both physical and electronic exchanges. The first form is the physical market, the most famous of which is the New York Stock Exchange. Its roots date back to 1792, when 24 brokers and merchants gathered and trade under a tree in Lower Manhattan. Until as recently as 2003, the NYSE was a privately run exchange owned by its members, but nonetheless regulated by the Securities Exchange Commission. A "seat" on the Exchange represented part ownership of this Exchange that permits the holder or its representative, to trade on the Floor. In 2004, the New York Stock Exchange initiated a series of dramatic transformation. First, it went public, and then it acquired Archipelago, an electronic trading network, and as of May, 2006, subsequently acquired Euronext, a European exchange that handled the trades of a number of country-specific exchanges. In late 2013, the NYSE was acquired by the Intercontinental Exchange (“ICE”). The actions of NYSE points to a trend in financial markets that is an electronic trading platform, global exchanges, and the trading of more than one class of securities extending not just to stocks and bonds, but derivatives, futures, commodities, etc. We've witnessed a lot of jockeying in the market – acquisition of one exchange by another, partnerships and working agreements, all aimed at creating a dominant position in the market. The NYSE remains the major league of stock trading in a physical market. In order for a company stock to be listed, that is being traded, it has to meet the broad financial definition of a company with sizeable assets, revenues, earnings, and so forth. Some corporations from developing nations chose to list at New York Stock Exchange for a number of reasons. First, an NYSE listing is a stamp of approval that legitimizes the company's existence as a corporation that has met all the stringent entry requirements and financial scrutiny, so there is a great element of prestige attached. Second, the NYSE has a large trading volume, so a listing helps the company assure that there will be a lot of potential buyers and sellers available, aiding in the stock's liquidity. These are two of the attributes that we discussed in our opening lecture on features of a successful market. https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 36/77 2019/3/26 Module 2 Compiled The second form of stock exchange actually has no physical form. It is called an "over the counter" market. It uses a network of computers and telecommunications equipment to route, match, and process buy/sell transactions. Essentially it is a network of brokers who, when one has shares to sell on behalf of a client, calling other brokers who have customers interested in buying the shares. NASDAQ is by far the largest stock exchange in terms of volume and value, in this form of exchange. This form of exchange makes it possible to integrate trading activities across the globe. This virtual setting is an extremely important attribute that is driving the current trend of cross country and cross market consolidation of exchanges. While the NYSE historically has carried the "prestige" label, many "new economy" companies, especially firms in the tech sectors like Google, now Alphabet, and Facebook are listed solely on the NASDAQ. Increasingly, the over the counter electronic market is becoming an automated, computerized telecommunications network. Here, we see various buy and sell orders of Cisco, a maker of networking equipment, at different prices of market participants. The prices are always quoted from the perspective of the broker, the dealer or the market maker. The quoted "bid" price is the amount at which the broker of a security is willing to buy the stock. The quoted "ask price of the broker of a security is the amount at which it is willing to sell the stock. In this example, if you are trading as a customer, your best purchase price for a share of Cisco stock would be $25.42. Conversely, if you are selling your shares of Cisco, your best selling price would be $25.41. The "asking" price is always higher than the "bid" price. Your best selling and buying prices as a customer correspond to the top row of these prices. Part of the electronic system is this auction process that arranges bid and ask prices in ascending order. The difference in price between the top most bid/ask, called a "spread", represent the market clearing price of a security for market orders. Spreads are how brokers, acting as intermediaries in the market, make a living. Take the spread and multiply it by the trading volume of a particular stock, and you will have the revenue earned from this activity. The electronic efficiency of trading, its volume and competition in the market, has narrowed the spreads and eroded the profit levels of brokers. The size of the spread is also indicative of the liquidity of the stock (lower spreads = higher liquidity) and general market sentiment. Penny stocks and Pink Sheets are other trading activities of less reputable stocks in the OTC or electronic market. Their listing requirements and financial transparency are far from idea, so trade at your own risk. You never know, there may be a diamond in the rough. Historically penny stocks have been viewed suspiciously as highly speculative investments. Over-the-Counter (OTC) Markets OTC Bulletin Board penny stocks: lists stocks that have price < $1 per share fail to meet NASDQ listing requirements 3,500+ stocks listed less liquid mostly traded by individual investors, day traders, speculators https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 37/77 2019/3/26 Module 2 Compiled Pink Sheets even worse than OTCBB penny stocks 20,000+ stocks lack financial data families and officers of the firms commonly control much of the stock One of the limitations of a physical market is that at some point in time, traders and operators need to go home. Extended trading hours, whether before or after the market closes, allows a select group of participants to transact beyond normal trading hours. In the latter part of this segment, we will discuss electronic communication networks, or ECNs. In theory, it is possible to have 24-hour trading, that is the market never sleeps, just like the internet activities of Amazon and eBay, or a 24-hour convenience store. At question is always the trading volume. Low liquidity at odd hours may turn away market participants, since the flip side of low liquidity is potentially large, volatile moves in stock prices. Extended Trading Sessions Normal trading hours: e.g. NYSE: 9:30 a.m. to 4:30 pm NYSE and NASDQ have extended trading hours Early trading buy/sell before market opens e.g. NYSE: 8:00 am - 9:30 am Late trading buy/sell after market closes e.g. NYSE: 4:15 pm - 8:00 pm common for individual online trader to have such extended hours low volume: < 5% normal-hour volume ECNs also allow for trading at any time < institutional traders An example of a stock quote and some typical market data associated with the company. Markets in the electronic age, has little room for traditional newspaper quotes. https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 38/77 2019/3/26 Module 2 Compiled The biggest exchanges – NYSE and NASDAQ – are located in New York but note the continued decline in stock listings in North America. This recent trend is attributed to two reasons. First, the economic growth and consolidation of exchanges in Europe and Asia have supported this growth and, as well, some developing countries have made significant steps to develop a liquid domestic stock markets. Companies from these regions were able to raise the needed capital without going to the US market. Second, the Sarbanes-Oxley Act and other measures requiring more stringent and costly financial reporting is turning away some potential listings. This includes companies that are American as well as foreign in origin. Most of these listings ended up in the European Stock Exchanges. https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 39/77 2019/3/26 Module 2 Compiled Here is a quick comparison of the two major American exchanges. Every exchange establishes listing requirements to permit a company's stock to be traded on the on the exchange. These can be viewed as entry requirements are similar to that of an exclusive country club. Part of the requirements has to do with volume, and liquidity of the listed security. If there are no buyers and consumers of broccoli (a company's stock), a storekeeper (the exchange) might as well not sell them in its market. Shelf space and market overhead are best used on other popular items. You see, stock markets are no different from that of a grocery or farmers market. Want to be listed on the NYSE? You will need at least: 400 stockholders, each owning at least 100 shares A minimum of 1.1 million shares traded publicly Pretax earnings of $10 million for the previous three years at the time of listing Price per share no lower than $4.00 A total of $40 million in market value of publicly traded shares Let's move on to an equally important topic about the emerging structure of the stock market, that of electronic communications network or ECN. In technical terms, this is the backbone or infrastructure of the stock market, whether a physical or an electronic market. In some ways, they are analogous to the internet servers and routers, and use similar https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 40/77 2019/3/26 Module 2 Compiled technology for the purpose of facilitating communication and trading among and across different markets. The phrase that stands out in ECNs is that they are the interconnected electronic islands of stock markets. These are the equivalent of Amazon, eBay and Google, all rolled up into one. Amazon-like because ECNs provide the listings, the features of products for sale, eBay-like because ECNs have auction features, and finally, Google-like because ECNs have the search capability match buyers to sellers across the network of markets. Perhaps the most interesting thing about ECNs, beyond their reach, is that the computers actually do the job of matching sellers and buyers and setting the market-clearing price. This has replaced the "open-outcry" system of the NYSE or Chicago Board of Trade, with groups of traders screaming at each "pit" to conduct trades which newscasters love to feature on their shows. It's just not as sexy to show electrons dashing about. In addition to other benefits, the speed and unbiased accuracy of computer networks to set appropriate prices and complete transactions has created a very different environment in capital markets of all types. Electronic Communication Networks (ECNs) History Created in mid-1990s to publicly display stock orders (buy and sell) Later adapted to facilitate the execution of orders Served only institutional investors 1997: NASDQ book order info visible to all market participants ECNs Today Automated system's appeal doing away with traders acting as middleman fast execution of orders Google-like: able to match orders beyond one's ECN neighborhood ECNs are now interconnected islands of automated electronic trading/auction system "Amazon + EBay +Google of the financial stock market" Accounts for 30% of NASDQ total trading volume Execute a small proportion of NYSE transactions Implication: NYSE acquired Archipelago NYSE moving promptly to attempt acquisition of EuroNext or LSE NYSE transformed to hybrid: physical + OTC Stock Indexes: Price- and Value-Weighted, Dow and NASDAQ In this segment, we will discuss the two main ways of constructing a stock index. Almost everyone is familiar with the Dow Jones Industrial Average or the S&P 500 Index, but the range of various indices and what they truly indicate demands more attention. A stock index is simply a number that captures the performance of a set of stocks it includes. What differs from index to index then is which stocks are included in the particular index and how the prices of individual securities are incorporated (weighted) in the index. https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 41/77 2019/3/26 Module 2 Compiled Let's start with the price-weighted stock indexes (example in above image), the most famous of which is the Dow Jones Industrial Average. The index is calculated as the average price of the stocks that make up the index. In this two stock example, the average price changes from $62.50 to $62.00. Thus, this price-weighted two stock index decreased by 4 % during a specified trading period. Two criticisms about this form of index are apparent from this example. First, the price of the stock ABC rose by a sizeable 20 percent, while XYZ declined by 10 percent. This method does not reflect the percentage change in price of its index components. Second, stock ABC, by a market capitalization, is a much bigger company than XYZ, yet its stock's price movement is not proportionately represented, since a price weighted index ignores the number of shares outstanding. One final criticism that is not apparent here is the event of a stock split. For example, a two for one stock split, and when the market opens the next trading day at half its prior day price, then a price-weighted index could change dramatically and leave a discontinuity in stock index that has nothing to do with the change in market conditions of the underlying stock that made up the index. To correct for this, most price weighted indexes create a "divisor" which prevents a stock split from affecting the index but reduces further the transparency of the index – what changes in the index really mean. The market value weighted index is a second form of index. The S&P 500 and the NASDAQ indices are the best known of this variety. A market value weighted (or just "market weighted") index is a compilation that overcomes the stock split and the market value criticism of the price-weighted index. It uses a change in total market value of the stocks in the index. Thus, this index favors and are proportionately influenced by stocks with a larger market capitalization. A marketvalue index adds together the market value (price times number of shares outstanding) for all the companies in the index and then divides by the number of companies. This index is more transparent and does away with the need for the https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 42/77 2019/3/26 Module 2 Compiled "divisor" adjustment. Most analysts believe that a market-weighted index is superior to other forms of weighting, but there are some strong dissenters. Let's move on and take a look at some high profile stock indexes that use either of these two methods of compilation. As in any stock indexes, each is intended to capture the price movement of a particular set of stocks. For example, the Dow Jones Industrial Average, (DJIA or simply "the Dow"), is an index of 30 of the largest American companies. Periodically the stocks are changed, due to a company merging with another, entering bankruptcy or simply declining in relative importance (such as the removal of Citi Group in 2009). Standards & Poor's 500, similar intent to the Dow, is a broader based index of about 500 companies, chosen from the largest American companies (i.e. it is not necessarily "the" 500 largest). The S&P, however, is a market value weighted index. Sector indexes, as the name suggests, are intended to capture the market performance of certain sectors of the industry, so, for example, the Dow Jones Transportation Index and Dow Jones Utility Index take firms from just these industrial sectors. Let's take a look at the DJIA. This is the longest serving market indicator of its kind. The purpose of this stock index is twofold. First, it represents all major sectors of American industry and hence, the health of the American economy in general. Thus, large companies which are considered leaders in their respective industry are components of the Dow. JP Morgan Chase, and American Express in the financial services sector. Pfizer, Merck, and Johnson & Johnson, in the pharmaceutical and consumer health sector, Dupont in chemicals, Microsoft, McDonalds, and so on. The Dow components are periodically updated to continue to be the leading bellwether of the American economy. Some notable companies, such as Citigroup and General Motors were removed in 2009 reflecting their on-going financial troubles, and replaced by others. Physical Markets "Blue-chip" stocks: established, long history, leaders of respective sector of economy Started in 1896 by Charles Dow with and arithmetic average of 12 stocks Expanded to 30-stock average in 10/1/1928 Now no longer simple average; still price-weighted with a "0.12493117 divisor" Critics: DJIA not broad-based and favors higher-priced stocks. Also Dow 5, 10, 20 Compare this to S&P 500, Wilshire 5000 Most from NYSE; only Intel, Apple, Cisco, and Microsoft from NASDQ! Go to CNN Money to find: 30 Stocks in the Dow Jones Industrial Average Each stock that is listed and traded in an exchange has a ticker symbol. Note that all NASDAQ ticker symbols are four lettered symbols, while those in the New York Stock Exchange can be one, two or three letters. Single lettered ticker symbol is highly sought after in the New York Stock Exchange and generally these are old-line, well known firms like https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 43/77 2019/3/26 Module 2 Compiled CitiGroup (C) and ATT (T). Most are tied to the company's name like General Electric (GE), Dow Chemical (DOW) and IBM (IBM), but a few have adopted cutesy names or ones tied to the company's major products like Harley Davidson (HOG). Despite the prestige, it is unlikely that Microsoft (MSFT), Apple (AAPL), and Intel (INTC) will defect from the NASDAQ market and start listing in the New York Stock Exchange. A walk down memory lane for the Dow. Not only did the number of components increase to the present day 30, its components also changed as the American economy transitioned from manufacturing and heavy industries to financial services and technology related businesses. It is expected to change again as the U.S. economy moves forward to newer sectors. Who knows? Biotechnology, nanotechnology, new energy sources, et cetera. Dow continues to reflect & capture current industry & economy First issue of Wall Street Journal (WSJ) was published on 7/8/1889 The DJIA or Dow refers to the index first published on WSJ on 10/7/1896 Prior to this date, Charles Dow had been compiling industry indexes: In 1894, 9 railroad stocks, and 2 industrial stocks The first Dow-12 in WSJ: from railroad > agriculture > manufacturing In 1916, Dow-20 In 1920, 5 major industries represented: oil, rubber, locomotives, container, communications In 1928, Dow-30 aeronautical, automobiles, radio, phonograph, food, steel, chemicals, electrical From 1959 - 1976: industrial-based economy to service economy More recently—Emergence of information, finance and service industries Only one stock has been in the Dow since 1928: General Electric The most recent changing of the guard in Dow components, the new economy (Microsoft, Apple, Intel); more financial services ( Bank of America, JP Morgan Chase and American Express) , more pharmaceuticals (Merck, Pfizer and Johnson & Johnson) and more wireless (Verizon). Also recall, that the price-weighted method of calculating the Dow, whereby higher priced stock has a stronger influence on the index. As a result of these factors, the movement of Dow is altered henceforth. First, the influence of existing components on the Dow is somewhat altered with the replacement of this one higher priced stock for the lower priced one. Second, the potential increase in volatility of the Dow as a result of the addition of these three new components. It has relatively higher and larger price swings than the replaced components. The Dow recently celebrated its 119th year as the longest serving market indicator of the U.S. economy. In particular, the continuity of a stock index over time is extremely useful in putting stock prices and their performance in a broader time https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Prin… 44/77 2019/3/26 Module 2 Compiled perspective. The accompanying FYI segment towards the end of this lecture, offers a nice summary of political and market events, superimposed on the change in the Dow index. The good and bad days of the market for sure, the circuit breaker in the stock exchange was tripped on these bad days. The S&P 500, which is a broader based, large market capitalization index, is somewhat between the Dow and the NASDAQ in terms of its index movement. S&P also has other indexes which address the medium sized companies (mid-cap) in the S&P 400 Index and smaller ones (small cap) in the S&P 600 Index, as well as a comprehensive allmarket index which combines the three into one super index (S&P 1500 Index). There are a range of other indices as well. The NYSE Index covers all companies listed on the exchange, and the Wilshire 5000 Index covers a very broad range of US stocks, about as close as is possible to an "all market" index. Market Dynamics: Equilibrium and Efficiency Concepts In finance we generally assume that the market is generally in balance (or close to equilibrium) most of the time. I've intentionally put all those qualifiers in the sentence. The idea behind this is a simple one of demand and supply. If investors perceive a stock as undervalued they will jump in and buy it (i.e. added demand) which will drive the price up until it reaches that perceived value. In contrast, if the stock (or other asset) is viewed as overvalued, investors will sell the stock and its price will fall until it reaches the perceived value. Few would debate that general tendency. The question is how strong is this tendency; how quickly the market will adjust to these divergences; and, when making a correction, does the market tend to overshoot the target. This is the basis for the efficient market hypothesis in its various forms – weak, semi-strong and strong. What Is Market Equilibrium? From a mathematical standpoint , the market is seen in equilibrium when the expected rate of return that investors receive from a particular investment is just equal to the required rate of return. Let's break these down into two pieces: The expected rate of return is ...
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Running Head: SHAREHOLDER ACTIVISM

Shareholder Activism
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SHAREHOLDER ACTIVISM

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Activism involves bringing about lasting change. Shareholders become activists when
they think the executive is not helping an organization realize its full potential (Chen, 2018). A
recent case of an activist shareholder who was fairly influential involved the Coca-Cola company
in 2014 when Wintergreen Advisors was publicly (and highly) critical of the equity plan
proposal by Coca-Cola and the implications brought abo...


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