CHAPTER 16
Securities Firms, Mutual Funds, and Financial
Conglomerates
Learning Objectives





What
What
What
What
What
securities firms are and what financial services they provide
the various types of mutual funds are
hedge funds and real estate investment trusts (R EITs) are
the role of government-sponsored enterprises (GSEs) is
financial conglomerates are and why they have grown so much in recent years
Chapter Outline
I.
II.
III.
IV.
V.
VI.
VII.
VIII.
The Boiler Room
Securities Firms
A.
Investment Banks: The Primary Market
B.
Private Placement
Brokers and Dealers: The Secondary Market
A.
Types of Orders
B.
Margin Loans
C.
Brokerage Fees
Investment Companies
A.
Open-End and Closed-End Companies
B.
Load and No-Load Companies
C.
Growth of Investment Funds
Hedge Funds
Real Estate Investment Trusts (REITs)
Government-Sponsored Enterprises
A.
The GSE Housing Market
B.
The GSE Farm Loan Market
The Growth of Financial Conglomerates
Answers to Review Questions
What are the functions of investment banks? Do they engage in primary or secondary
market activity? What is a syndicate?
Investment banking deals with the marketing of newly issued securities in the primary market.
Investment bankers design, market and underwrite the issuances of new securities such as
stocks and bonds. The design function includes helping to establish the price and other
features of the new offering. The investment banker helps in establishing the appropriate time
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to issue the offering; assists in completing the necessary paper work including the registration
statement that must be filed with the SEC; and assists in obtaining a credit rating from a credit
rating service. The investment bank underwrites or purchases the entire issuance at the agreed upon price and assumes the responsibility for marketing the newly issued securities. The
investment bank is paid a fee for its services and may earn a profit if the price at which it sells
the securities is greater than the agreed-upon price that it paid.
A syndicate is a group of investment banks, each of which underwrites a proportion of a new
securities offering. In this way, the risk to one investment bank of underwriting an entire
issuance is reduced.
What is a prospectus? What are the differences between a prospectus, a registration
statement, and a bond indenture?
A prospectus is a subpart of the registration statement that must be given to investors before
they purchase the securities. The prospectus contains a description of the securities and other
disclosures. A registration statement is a statement that must be filed with the SEC b efore a
new securities offering can be issued. The registration statement contains information about
the offering, the company, and other relevant disclosure information in addition to the
prospectus. A bond indenture is a document that outlines the term s of a bond issuance and that
is interpreted and monitored for compliance by the trustee.
What is the difference between a securities broker and a securities dealer? What role do
brokers and dealers play in the financial system?
A securities broker merely arranges a trade for a brokerage fee or commission. For example,
they arrange for an investor to buy or sell stocks or bonds. The securities dealer not only
arranges trades, but also stands ready to be a principal in a transaction (buyer or seller) and
may maintain an inventory of securities. Dealers may purchase and hold previously issued
securities sold by investors. Dealers are market makers.
Brokers and dealers facilitate the flow of funds among SSUs and DSUs in the financial system.
They facilitate the smooth and orderly functioning of secondary financial markets.
How does a hedge fund differ from a traditional mutual fund? What are the two types of
hedge funds and how are their requirements for participation different? What is the
difference between a mutual fund and a money market mutual fund?
A hedge fund is a nontraditional type of mutual fund formed as a partnership of up to 99
wealthy investors with large minimum investments. Hedge funds attempt to earn maximum
returns regardless of whether financial prices are rising or falling. Hedge funds often engage
in risky investment strategies. Hedge funds are not regulated by the SEC.
One type of hedge fund has up to 99 “accredited investors who have at least $1 million in
investable assets. Another type of hedge fund can have up to 499 “qualified” investors, where a
qualified investor has a minimum net worth of $5 million or is an institution such as a pension
fund or mutual fund with at least $25 million in capital.
A traditional mutual fund is a financial intermediary that pools funds from many small
investors by selling shares. The funds that are raised by the mutual funds are used to purchase
financial securities. The income and capital gains from the securities are passed through to
investors. Mutual funds are closely regulated by the SEC.
Securities Firms, Mutual Funds, and Financial Conglomerates
89
A money market mutual fund invests in money market instruments —securities with an original
maturity of one year or less. Mutual funds invest in capital market instruments such as stocks
and bonds.
Are investment banks financial intermediaries? Explain why or why not.
Investment banks are not financial intermediaries. Financial intermediaries borrow for the
purpose of relending and give off their own liability. Investment banks merely underwrite
security issuances or offerings.
The spread between the bid and asked price widens. What does this mean about the
securities?
If the spread between the bid and asked price widens, then the quality (breath and depth) of the
secondary market in the securities has deteriorated.
What is the difference between a load and no-load mutual fund? Could a no-load fund
ever result in higher total sales commissions and costs?
A load is a sales commission that some investment companies require investors pay in order to
buy into a fund. By law, the load cannot exceed 8.5 percent of the investment. “No -load” funds
are purchased directly from the mutual fund company without a broker or a sales commission
up front.
Both load and no-load companies deduct a percentage from t he net asset value each year to
administer the funds. The fees are usually in the range of 0.2 to 1.5 percent. A fund may also
deduct a fee called 12b-1 (named for the SEC regulation that authorizes the fee) for marketing
and advertising expenses. There can be a redemption fee, called a “back-end” load, to sell the
investment company shares. The back-end load and other fees on a no-load fund may result in
a no-load fund actually having a higher total cost or commissions than a load fund.
Miguel expects a stock’s price to rise. Should he short-sell the stock? Explain.
A short sell instructs the broker or dealer to borrow shares of stocks and sell them today with
the guarantee that the borrowed stocks will be replaced by a particular date in the future. The
investor engages in a short sell if he or she believes that the stock’s price is going to fall in the
future and that the borrowed shares will be paid back with shares purchased in the future at the
lower price. Therefore, if Miguel expects a stock’s p rice to rise, he should not short sell the
stock. If the volume of short sells is very high, this is an indication that investors believe the
stock’s price is going to fall. If the price does not fall, the buyer of the short sell must
purchase the shares at a higher price and thus loses money. If many buyers of short sells are in
this position, the market price is pushed even higher.
What is the different between a market order and a limit order? What are the two types
of limit orders?
A market order by an investor directs a broker or dealer to purchase or sell securities at the
present market price.
One type of limit order by an investor instructs a broker or dealer to purchase securities at the
market price up to a certain maximum amount, if possible . Another type of limit order
instructs a broker or dealer to sell securities at the market price if it is above a certain
minimum amount.
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What type of securities do GSEs sell? What is the purpose of GSEs? Does the federal
government guarantee the securities of GSEs? Who owns the GSEs?
GSEs are corporations that are sponsored or chartered by Congress. GSEs issue short -term
securities that sell at a discount, and long-term bonds that pay semi-annual coupon payments.
The majority of the issuances are long term. The proceeds are used to assist in some aspect of
lending that the federal government has deemed desirable. The major areas that GSEs operate
in are housing and farm credit, and student loans. The securities that GSEs issue are called
government agency securities and are considered government securities for SEC purposes.
In most instances, the federal government has no legal obligation to guarantee the timely
payment of interest and principal of GSE securities. Many market participants assume that the
government does “de facto” guarantee the payments. The yield spread between government
agency securities and U.S. government securities is due to differences in liquidity and risk. The
yield spread can be significant because secondary markets do not have the breadth and depth of
Treasuries. If market participants question the “de facto” government guarantee, the spread can
also widen.
Despite their federal charter, most GSEs are privately owned and privately managed. Some
GSEs have issued shares of stock that are publicly held like shares in other corporations and
the stocks of these GSEs are traded on organized exchanges.
What are some of the factors for the growth of mutual funds in recent years?
Mutual funds have experienced incredible growt h since the late 1980s. One reason for this
trend is that recent legislation gives individuals control over where their pension funds are
invested, and many have chosen mutual funds. In 1999, nearly half of all U.S. households (48.4
million households) owned mutual funds. Increases in mutual funds in each year in the late
1990s often exceeded the total amount outstanding prior to 1990. This was due not only to
additional funds flowing into mutual funds, but also to increases in market valuations due to
the booming stock market. As market valuations fell in the early 2000s, mutual funds also fell
in value.
List some reasons why Henry should consider purchasing a fund of funds? Are there any
reasons he should not?
A “fund of funds” invests in several mutual funds. For example, Vanguard’s STAR fund
invests in nine different Vanguard funds. In general, 60 to 70 percent of investments are held
in stock funds, 20 to 30 percent in bond funds, and 10 to 20 percent in money market mutual
funds. The advantages of investing in a fund of funds to Henry is that he achieves much greater
diversification than if he invested in only one mutual fund. He also saves the time and effort
of investing in several different mutual funds on his own. A disadvantage is that costs c an be
high because both the individual funds and the “fund of funds” charge fees. If Henry picked
different funds on his own, he could avoid the “fund of funds” fees.
How do REITs differ from other mutual funds? Are all REITs pretty much the same?
What are their differences?
Real Estate Investment Trusts (REITs) are a special type of mutual fund that pool the funds of
many small investors and use them to make investments. Unlike other mutual funds that invest
only in financial instruments, REITs may invest in real property as well. The funds of REITs
are used to buy or build income property or to make or purchase mortgage loans. Another
difference between REITs and other mutual funds is that to some extent REITs also raise funds
by taking out bank loans or issuing debt. REITs are pass-through enterprises in that rents from
Securities Firms, Mutual Funds, and Financial Conglomerates
91
income property and/or interest income from the mortgages are passed through to shareholders.
Shareholders are also entitled to any capital gains from the properties that the REITs own .
At least 75 percent of the assets of REITs must be either real property (generally commercial
or industrial real estate) or mortgages. The majority of REITs invest in real property such as
shopping malls, apartment complexes, hotels, golf courses, and other commercial buildings for
income. REITs may either buy or provide the funding to build income property. The income
from property provides a steady, dependable stream of income for investors. Some REITs
either make or purchase mortgage loans on comm ercial property, and some do both.
Individual REITs have different characteristics and may be highly specialized, depending on
the investment strategy and management style of the fund’s manager. They are virtually
diversified holdings of real estate investments that are professionally managed.
By law, REITs must return 95 percent of their earnings to shareholders each year. Therefore, if
they want to expand they must issue new equity or debt or take out bank loans.
Shares of REITs are traded on organized exchanges like shares of stock. Thus , they are liquid
investments even though their equity is in real property and long term mortgages. In recent
years, the spreads between the bid and asked prices have narrowed significantly, signaling that
the secondary markets are becoming more highly developed. Prices of REITs are determined
by supply and demand. In this sense, they are like closed -end investment companies because
the price can deviate from the underlying value of the assets owned.
What is a financial conglomerate? Discuss the factors that contribute to the formation of
financial conglomerates.
A financial conglomerate is a firm that owns and operates several different types of financial
intermediaries and financial institutions. As a rule, it operates on a global basis. A financial
conglomerate usually results from the mergers of several firms. For example, a financial
conglomerate may own a commercial bank, a savings institution, a mutual fund, a pension
fund, a securities firm, and an insurance company. The factors that contribute to a financial
conglomerate include taking advantage of economies of scale (gains of bigness), economies of
scope, and diversification.
How does diversification reduce the risk that a financial conglomerate wi ll fail? What is
the difference between economies of scale and economies of scope?
Diversification refers to the branching out of the financial conglomerate into several product
lines. Diversification reduces the dependence of the financial conglomerate on one service.
This in turn reduces the risk of failure for the financial conglomerate. If one division is
performing poorly, the conglomerate can still be earning a profit if other divisions pick up the
slack. For example, if the credit card division is losing money, it can be subsidized by the
insurance division for a while. If credit cards were the dominant product line of a financial
services institution, then losses in this area could affect the solvency of the institution. This is
not so in the case of a financial conglomerate.
Economies of scale, which are gains from large size, may result when separate firms owned by
a conglomerate and offering the same product are able to streamline management and eliminate
duplication of effort. The conglomerate may have fewer Boards of Directors than if there were
many separate firms. They may also share a common technology infrastructure.
Economies of scope refer to the advantages of conglomerate’s ability to offer several financial
services under one roof. This one-stop shopping is supposedly an advantage to financial
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services customers and hence gives financial conglomerates advantages over several separate
firms providing the same set of services. In addition, the subsidiaries can share information
about customers and seek new customers from other subsidiaries.
Answers to Analytical Questions
A mutual fund owns stocks with a market value of $1 billion and has liabilities of $1
million. What is the net asset value? If there are 2 million shares of stock
outstanding, what is the net asset value per share?
The net asset value is the difference between the market value of the shares of stock that the
mutual fund owns and the liabilities of the mutual fund. In this case, the net asset value is
$999 million ($1 billion  $1 million). Since there are 2 million shares outstanding, the net
asset value per share is $499.50 ($999 million/2 million).
What are some of the factors that determine the spread between the bid and asked price?
If the bid-asked spread narrows, what does this mean?
The spread between the bid and asked price is determined by the breadth and depth of the
secondary market. If the bid-asked spread narrows, this means secondary markets are
becoming more developed and the volume of trading is increasing.
What are the factors that determine the spread between agency securities and Treasuries?
The yield spread between government agency securities and U.S. government securities is due
to differences in liquidity and risk. If market participant s assume a “de facto” guarantee, then
the yield spread is due to differences in liquidity only. The yield spread due to differences in
liquidity can be significant because secondary markets do not have the breadth and depth of
Treasuries. If market participants question the “de facto” government guarantee, the spread can
also widen.
Make a chart listing the similarities and differences among the following institutions:
money market mutual funds, mutual funds, hedge funds, GSEs, and REITs.
Participants
Investment Size Investment
or Type
Term
Regulation Other
MMMFs
pools the funds
of many
investors
hundreds or
thousands of short
term money market
instruments
original
maturity of
one year or
less
SEC
began in the mid1970s to offer small
investors an
alternative to bank
deposits
Mutual
Funds
pools the funds
of many
investors
capital market
instruments,
including stocks and
bonds
original
maturity of
more than one
year
SEC
may offer greater
safety and more
diversification than
one or a few stocks;
have experienced
tremendous growth
in recent years
Hedge
nontraditional
large minimum
not regulated
One type of hedge
Securities Firms, Mutual Funds, and Financial Conglomerates
Funds
type of mutual
fund formed as
a partnership of
wealthy
investors
investments; attempt
to earn maximum
returns regardless of
whether financial
prices are rising or
falling; often engage
in risky investment
strategies
GSEs
corporations
sponsored or
chartered by
Congress;
despite the
federal charter,
most GSEs are
privately owned
and privately
managed
some GSEs issue
shares of stock that
are publicly held like
shares in other
corporations, and are
traded on organized
exchanges
REITs
pools the funds
of many small
investors
investments in
financial instruments
and real property;
pass-through in that
rents from income
property and/or
interest income from
mortgages are passed
through to
shareholders
issue shortterm securities
that sell at a
discount, and
long-term
bonds that pay
semi-annual
coupon
payments; the
majority of
the issuances
are long term
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by the SEC
fund has up to 99
“accredited”
investors who have
at least $1 million in
assets to invest;
another can have up
to 499 “qualified”
investors, where a
qualified investor
has a minimum net
worth of $5 million
or is an institution
such as a pension
fund or mutual fund
with at least $25
million in capital.
considered
government
securities for
SEC
purposes, but
not regulated
by SEC
proceeds are used to
assist in some aspect
of federal lending,
such as housing and
farm credit, and
student loans. The
securities that GSEs
issue are called
government agency
securities
regulated by
state charters,
Internal
Revenue
Codes, and
by the SEC
only if
publicly
traded
funds are used to
buy or build income
property or to make
or purchase
mortgage loans,
unlike those of
traditional mutual
funds; funds can be
raised by taking out
bank loans or
issuing debt;
Shareholders are
also entitled to any
capital gains from
the properties that
the REITs own.
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Chapter 16
Jessie has bought a share of stock for $100. She has borrowed $50 from her broker.
There is a 25 percent maintenance margin requirement. The price of the stock falls to
$80. Will her broker put in a margin call to her asking her to put up more funds? If
so, how much? What if the price falls to $50? In each case, if so, how much more
funds will she need?
The maintenance margin requirement is the minimum amount of equity the investor needs in
his account relative to the market value of his stock. The maintenance requirement comes into
play if the stock has been purchased using borrowed funds and if the stock’s value falls so that
the investor has less equity than the amount required by the maintenance margin. If the price of
a stock falls to $80, then Jessie must have $20 equity in her account ($80  .25). If Jessie
bought a share of stock for $100 and has bor rowed $50 from her broker, then she has $50 of
equity in her account and a margin call will not be placed. If the price of the stock falls to
$50, she will have no equity in her account. A margin call will be placed for $12.50 ($50  .25
= $12.50).
Comment on the following: Frank calls his broker to complain that the stock the broker
sold him has fallen in value and Frank has lost a lot of money. The broker says:
“Look, I made money and the brokerage firm made money on the deal. Two out of
three is not bad!”
This comment points out an interesting fact. Brokers and brokerage firms make money based
on the volume of trades. They make money regardless of whether investors are selling stocks
at a loss or profit.