The smooth functioning of securities markets, in which bonds and stocks are traded, involves several financial institutions, including securities brokers and dealers, investment banks, and organized exchanges. None of these institutions were included in our list of financial intermediaries in Chapter 2, because they do not perform the intermediation function of acquiring funds by issuing liabilities and then using the funds to acquire financial assets. Nonetheless, they are important in the process of channeling funds from savers to spenders and can be thought of as "financial facilitators."

First, however, we must recall the distinction between primary and secondary securities markets discussed in Chapter 2. In a primary market, new issues of a security are sold to buyers by the corporation or government agency borrowing the funds. A secondary market then trades the securities that have been sold in the primary market (and so are secondhand). Investment banks assist in the initial sale of securities in the primary market; securities brokers and dealers assist in the trading of securities in the secondary markets, some of which are organized into exchanges.

Investment Banking

When a corporation wishes to borrow (raise) funds, it normally hires the services of an investment banker to help sell its securities. (Despite its name, an investment bank is not a bank in the ordinary sense; that is, it is not engaged in financial intermediation that takes in deposits and then lends them out.) Some of the well-known U.S. investment banking firms are Merrill Lynch, Salomon Smith Barney, Morgan Stanley Dean Witter, Goldman Sachs, Lehman Brothers, and Credit Suisse First Boston, which have been very successful not only in the United States but outside it as well.

Investment bankers assist in the sale of securities as follows. First, they advise the corporation on whether it should issue bonds or stock. If they suggest that the corporation issue bonds, investment bankers give advice on what the maturity and interest payments on the bonds should be. If they suggest that the corporation should sell stock, they give advice on what the price should be. This is fairly easy to do if the firm has prior issues currently selling in the market, called seasoned issues. However, when a firm issues stock for the first time in an initial public offering (IPO),it is more difficult to determine what the correct price should be. All the skills and expertise of the investment banking firm then need to be brought to bear to determine the most appropriate price. IPOs have become very important in the U.S. economy, because they are a major source of financing for Internet companies, which became all the rage on Wall Street in the late 1990s. Not only have IPOs helped these companies to acquire capital to substantially expand their operations, but they have also made the original owners of these firms very rich. Many a nerdy 20- to 30-year-old became an instant millionaire when his stake in his Internet company was given a high valuation after the initial public offering of shares in the company. However, with the bursting of the tech bubble in 2000, many of them lost much of their wealth when the value of their shares came tumbling down to earth.

When the corporation decides which kind of financial instrument it will issue, it offers the issue to underwriters—investment bankers that guarantee the corporation a price on the securities and then sell them to the public. If the issue is small, only one investment banking firm underwrites it (usually the original investment banking firm hired to provide advice on the issue). If the issue is large, several investment banking firms form a syndicate to underwrite the issue jointly, thus limiting the risk that any one investment bank must take. The underwriters sell the securities to the general public by contacting potential buyers, such as banks and insurance companies, directly.

The activities of investment bankers and the operation of primary markets are heavily regulated by the Securities and Exchange Commission (SEC), which was created by the Securities and Exchange Acts of 1933 and 1934 to ensure that adequate information reaches prospective investors. Issuers of new securities to the general public (for amounts greater than $1.5 million in a year with a maturity longer than 270 days) must file a registration statement with the SEC and must provide to potential investors a prospectus containing all relevant information on the securities. The issuer must then wait 20 days after the registration statement is filed with the SEC before it can sell any of the securities. If the SEC does not object during the 20-day waiting period, the securities can be sold.

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