Wall Street

When you mention the word "investment" most people think of Wall Street and the stock market, not capital investment in new plant and equipment by firms. These are two distinct uses of the same word. When someone buys 100 shares of Nike Corporation they are making a financial investment. When Nike Corp. builds a new factory or warehouse, it is making a capital investment.

We need to be careful not to confuse financial investment by savers with capital investment by firms, although the two kinds of investment are closely related. Both of these “investments” are part of the process of turning household savings into the production and purchase of new capital goods. Both involve taking a risk now in the hopes of earning a larger return later. To develop the concepts of financial investment, let's continue our example of Blue Skies' purchase of a new Boeing 777.

Instead of borrowing from a financial intermediary, Blue Skies could instead raise the money to buy that 777 by selling additional shares in the company. The ownership of a corporation is divided up into equal parts called shares, rather like pieces of a pie. Each share has one vote in the election of the directors who govern the corporation and hire its management. The collective term for shares is "stock." The value of a corporation's shares is established in the stock market which has its center on Wall Street in New York City.

The New York Stock Exchange (NYSE) is located in a very large room, known as the floor of the stock exchange, where the shares of major corporations are traded. The purchase or sale of stock is handled through brokerage firms which act as agents for buyers and sellers.

When Jane Johnson places an order with her stock broker to buy 100 shares of Blue Skies, it is transmitted to the broker's representative on the floor of the NYSE. That person takes it to the “specialist” whose responsibility is to make an orderly market in that stock. The specialist tries to match her buy order with a corresponding sell order. The price is where the supply of shares just equals the demand. Each trade is recorded and displayed on the “ticker tape” which is displayed on the wall and on computer monitors and television sets around the world.

This “transparency” of the exchange give investors confidence in the integrity of the trading process and the validity of prices. Tourists can watch the action on the floor from the visitors’ gallery. A visit to the NYSE is highly recommended; watching brokers and clerks dashing around the floor in seeming chaos is an experience you will not likely forget. In spite of the apparent disorder, many billions of dollars worth of stock change ownership every day without a hitch.

Shares of smaller corporations have long been traded “over the counter” among brokers in an informal market of “unlisted” stocks. This became what we now call NASDAQ, an electronic market in which offers to buy or sell are displayed on monitors on brokers’ desks, with trades being relayed at light speed over the network. Prices are collected and trades are displayed in ticket tape fashion on screens around the world.

Some of the largest corporations do not list on the NYSE, preferring to have their shares traded on NSDAQ. Examples include Intel, Microsoft, and Apple Computer. With the rapid development of electronic communication, the trading in this market has become highly efficient and transparent. Indeed, electronic trading has started to replace the face-to-face trading of the NYSE and smaller transactions are now largely automated.

Financial markets in the U.S. are regulated by the Securities and Exchange Commission, an agency of the federal government which is much in the news these days. The SEC was established during the Great Depression of the 1930’s to curb abuses that many felt contributed to the stock market crash of 1929, practices such as trading by insiders on the basis of privileged information. The Securities Act of 1933 requires that any corporation planning to issue stocks or bonds in interstate commerce file detailed statements with the SEC, which become a matter of public record, and publish a prospectus. Issuers of securities are then required to furnish periodic reports to the SEC and their shareholders disclosing financial results. The guiding principal of SEC regulation is “full disclosure.” It is not up to the SEC to guarantee that investments will turn out well, only to insure that investors receive full and accurate information that enables them to assess risks and opportunities. Failure is not a crime, nor is getting rich a crime. But it is a crime to lie to the investing public and it is the responsibility of the SEC to ensure that people do not get by with it.

We are hearing a lot about the SEC these days in the wake of the collapse of major financial institutions in 2008. It seems clear that a wide-ranging review of the powers and effectiveness of the SEC will be forthcoming from Congress, and we may well see the first major overhaul of Wall Street regulation since the 1930s.

Investment Banking

If shares in Blue Skies are trading at $10 per share on the New York Stock Exchange, then Blue Skies could expect to raise $125 million by selling another 12,500,000 shares. The new shares would be sold through an investment bank which will contract with Blue Skies to purchase all of the new shares at a negotiated price. The investment bank, which is sometimes called an underwriter, will in turn sell those shares to perhaps thousands of different investors, some of whom will be individual households and some of whom will be financial intermediaries. Not surprisingly, the investment bank is often also a brokerage firm since brokers have n established relationships with potential buyers of stock.

Under the Glass-Steagall Act of 1933 commercial banks, those that take in deposits and make loans, were prohibited from engaging in investment banking in the U.S. The separation of underwriting from

ordinary banking was intended to insulate banks, many of which failed during the Depression that followed the stock market crash of 1929, from riskier investment activities. In the 1990’s banks were allowed to enter areas of the investment business previously closed to them, as regulators loosened interpretation of the law. Finally Congress, perhaps swept up in the stock market euphoria at the end of the 1990’s, repealed Glass-Steagall. With large brokerage firms offering checking to their clients, and banks selling mutual funds in their lobbies, the gulf between banks and investment banking has almost entirely disappeared.

The evolution of investment banking took a dramatic turn in 2008 with the failure of two of the largest investment banks when they were unable to cope with effects of the end of the long-running boom in housing. As the market value of houses fell, the value of collateral underlying mortgages became questionable and investments of these firms became illiquid. Surviving investment banks underwent conversion to commercial banks in order to get access to government funding. This ends the era of independent and free-wheeling investment banking, at least for the foreseeable future.

What Does the Shareholder Get?

What does the buyer of Blue Skies stock get for that $10 per share? The investor gets the legal right to cast one vote per share in the election of directors, and each share participates equally in the future profits of the firm. Stocks offer savers a way of participating in both the rewards and risks of the ownership of firms. If Blue Skies prospers with the help of its new more efficient aircraft, then its profits will soar and the directors will declare a higher dividend payment to shareholders. But if Blue Skies does not prosper for whatever reason, the shareholders may receive smaller dividends, or none at all.

Stocks are quite liquid, since you can sell your shares in Blue Skies at any time for the market price and get your cash in a several days. However, they are risky because the market price can fluctuate. The market price is determined in the stock market and will reflect what investors, as a group, think the future of the firm is worth. When new information is disclosed that affects the firm, the market will react by adjusting the share price up or down accordingly. For example, if you buy Blue Skies stock today and next week the price of jet fuel doubles because of political upheaval in the Middle East, those shares will fall in value because investors fear that higher fuel costs mean smaller profits and therefore smaller dividends in the future.

By owning shares in many types of companies across different industries an investor can mitigate risk through diversification. For example, an oil company would benefit from higher fuel prices, so an investor in Blue Skies can hedge the risk of higher fuel prices by also holding shares of an oil producer. However, the cost of getting information on many different stocks and the broker's fees on small amounts of stock mean that diversification is costly for small investors.

Mutual Funds

As explained in our discussion of financial intermediaries, a mutual fund is a firm that owns the stocks and bonds of other firms. A fund which invests almost entirely in stocks is sometimes called a “stock fund” or “equity fund.” Other mutual funds invest primarily in corporate bonds or government bonds (“bond funds”), or a blend of stocks and bonds (“balanced funds”), depending on a fund’s stated investment policy. But stock fund is what most people have in mind when they talk about mutual funds. Each share of a fund owns a small fraction of all the stocks that the fund has invested in, thus providing diversification. If the fund holds many stocks across many industries, the degree of diversification may be to the point where buying the fund is like “buying the market.”

Mutual funds are an excellent way for new investors to get started in the stock market, but it is important to understand that there is risk not present in a bank deposit which is an obligation of the bank. In contrast, a mutual fund makes no promise of a specific interest payment or of gains from owning stocks or bonds. The price of the shares is “marked to market” at the close of trading every day, and as the market value of the stocks or bonds it holds fluctuates, any gains or losses are immediately reflected in the value of the fund shares. Thus, shareholders in a mutual fund are fully exposed to all the risk of stock market fluctuations.

Hedge Funds

The last two decades has seen the emergence of a new class of investment firms which are in the eye of the financial storm overtaking Wall Street in 2008. These are hedge funds which are investment partnerships not subject to the same rules as mutual funds. By limiting participation to a small number of investors both means and experience, they are exempt from regulations designed to protect the small investor.

This allows hedge funds to employ investment strategies that mutual funds are not allowed to use, such as borrowing to achieve ‘leverage’ and selling borrowed stock in a ‘short sale’ to benefit from a subsequent decline in its price, as well as the use of ‘derivatives’ such as options that pay if a stock or other asset moves in price in one direction or the other.

They can bet on moves in commodities such as oil and since they are not required to mark-to-market or redeem shares on a daily basis they can hold illiquid assets such as real estate. In short, they can do pretty much anything an individual can do with their own money, but they do so with a pool of funds drawn from a group of wealthy investors. These ‘investors’ can be institutions such as college endowments and charities. Indeed, participation in hedge funds was credited with much of the growth in endowments at the wealthiest private universities in the last decade.

In 2008 many hedge funds closed their doors as bets on the direction of stocks and bonds and faith in continued rise in house prices undermined strategies based on investing in ‘subprime’ mortgages. Leverage has proved to be a two-edged sword, causing catastrophic loss when loans must be repaid from a shrunken pool of capital. Hedge funds are likely to undergo scrutiny, not only for the losses suffered by their investors but also because of the suspicion that they contributed to the heavy losses by imprudent risk-taking.

Exercises 3.2

A. Economics.com, an internet company providing forecasts of the economy, has just ‘invested’ in a new server, while at the same time you have just ‘invested’ in 100 shares of the company. Discuss how these two investments are different and how they are related.

B. What do we mean by transparency in financial markets? How has the development of the internet made stock trading more transparent?

C. What used to prevent your bank from selling you 100 shares of Apple Computer, and what has changed? Why did this restriction exist? Was it a good idea, in your opinion, to allow banks to become stock brokers?

D. For most of its history Microsoft Corp. never paid a dividend to its shareholders, yet the total market value of its stock was ultimately greater than that of any other corporation on earth. What motivation do people have for buying this stock if it pays no dividends?

E. Identify a story in the news about a major corporation and then check the stock market table to see how the price of the stock reacted to the news. Discuss briefly whether the response of the stock market to this news makes sense. In thinking about your answer, try to determine whether this piece of news had been widely anticipated or came as a surprise.

F. There are far more mutual funds than there are individual stocks in those funds! Can you guess at why this is the case?