So, what is underwriting of securities? Is issuance of shares and corporate debt. I might add, they're kind of like a consulting firm. A consulting firm, is a firm that a company will go to for advice. They have researchers there. But the difference, in investment bank, you go to for advice to, but an investment bank is like a consulting firm with an army. And I shouldn't say army. With resources. They know where the money is and they can get it for you. And so, they'll give you advice. And it may share some of the risks of the offering. But the really important thing that investment banks do is put their reputation behind the issue. They check you out, due diligence. You're a company, you want to issue a new share because you need money. They have to figure out why do you need money. Is this legit, or is some scheme here? And then, they will certify the issue. So, the issuer is behind. This deals with a moral hazard problem. You could kind of take over an existing company. You rise in the ranks of the company. And then, raise money through issuing debt or securities. You look kind of sleazy, but the investors out there may not know that. And then, you just kind of steal the money. You tunnel it out to yourself. So, investment bankers are like bankers. But the public doesn't want to be the loser who makes them bad investment. So commercial bankers which make loans, are members of a community and they follow what's going on, and they look at the moral integrity of organizations, and they won't deal with sleazy ones. The same thing is true for investment bankers. So, this is a moral hazard, as I was just saying. One kind of crime, you may call it a crime, that the managers of companies do is, when they see that their earnings are unusually high, and they think, "Well, it's not going to last. We're going to drop in value". They have an incentive to issue shares when the public looking at those earnings, thinks they're worth a lot more than they really are. The public is necessarily skeptical about new share issues. Especially, after a burst of earnings, they wonder if it's real or fake. The problem can be solved by borrowing instead of issuing to the public. Then, when you're borrowing from a local branch of a big bank, the people at the branch really know business in your community, and they're not going to be fooled as easily. But it's also the same with investment banks. Studies have shown that investment banks that miss price issues, suffer a market share loss. Afterwards, people either if they price them too low, in other words, the company says I want to issue new shares and the investment bank says, I think we should issue them at such a price, and it's too low, then the company is not happy. They didn't get enough for their shares. If it's too high, then the investors are not happy. So, they have to find the right price. And that's how they are. There's two basic kinds of offerings that investment banks do. A bought deal. So imagine you're issuing shares of a company. You are a company. And you don't know what to do. You go to an investment bank. The investment bank says, "We'll buy those shares from you. But we're only a short term investor, we'll flip them almost immediately. But we just want you to know that we can get this price for you". And then, the investment bank hopes to make a profit on reselling the shares. Another kind of deal is called, best efforts. And that's a case where the underwriter says, "I'll try to sell your shares at such a price, and if it's not sold then we'll just try again. It's over. We tried, we couldn't sell them at that price". So, it starts at the processes defined by law and tradition. There's a pre-filing period. Imagine that you are a company needing to raise money. You first approach an investment bank. And then, there's so called pre-filing period when you get advice from the investment bank, about choices. Then, suppose you decide to go ahead, the underwriter forms a syndicate. It's an agreement among underwriters. Typically, if it's a big offering, it's more than one underwriter can handle. So, they go to their competitors. Well, there are other companies that also do underwriting. And they form a syndicate to issue your shares. And they designate a manager of the offering. The reason they do that, is that it's all about trust and connections. The reason you don't just issue your own shares is because nobody trusts you, and nobody knows you, and you could be anybody. So, you need contacts. So, the investment bankers are among the most decorous of people, impressive of people. If you want a job as an investment banker, it helps if you are impressive and ethically, if you have had look about you, that looks ethical and sincere. So, investment bankers like to go to the symphony to be seen as among the upper crust people. Because that's their business. They have to sell these things so, they have to look right. And they have to have their connections that they maintain. So, one underwriter can't handle a big issue. They've got to farm it out to all the salespeople. You can call them salespeople. Then they file a registration statement with the Securities and Exchange period Commission. And then, there's a so-called, cooling off period, before the issue in which they distribute what's called a preliminary prospectus, which describes the offering. On the Wall Street, that's called, nicknamed, The Red Herring. Meaning, well, I don't know why you got that meaning but it's just a document that tells about all of the risks that an investor will take by buying this security. And that document is regulated by the SEC. So, it has to be forthcoming about risks. Now, most people never read the prospectus who buy into the issue. I did a survey once about that and found that indeed they don't. That's because they trust that their broker read the prospectus. And they trust their broker. Everything is built on trust. Not many people read these things. Maybe it'd be a good idea to read it sometime. You can have that experience someday. So, then the underwriting process takes the members of the syndicate, call their connections among investors, and ask them,"What do you think? Would do with this interest you?" They'll say, "We think it's a solid investment at some price, but we're trying to find what the prices". And at that point, they do due diligence. There's a due diligence meeting between underwriter and the issuing corporation. They decide on an offering price. They write an underwriting agreement. They'll say how the underwriting is split up among members of the syndicate. >> An underwriting syndicate is a band of investment banks and broker dealers who come together to sell new offerings of equity or debt securities of a firm to investors when the issue is too large for a single firm to handle. The syndicate takes on inventory risk by committing to purchase the full issue upfront, and selling it afterwards to investors in the market. It is compensated by the underwriting spread, which is the difference between the price paid to the issuer, and the price received from investors. >> They have a dealer agreement. Dealers purchase from underwriters at a discount. There's an effective date when it goes on the market. And then, after the whole thing is done, when they've sold the issue, let's say it's new shares, the underwriter typically supports the price in the so-called aftermarket. The issuing market is the price initially. Everyone gets the same price in the initial offering. After that, then it's open to the market. Supply and demand. But then, they typically support the price. That means, suppose the price starts dropping days after the issue. The underwriter thinks that's a reputation concern. Because if people bought into it, and they lose 20% of their money in three days, they get annoyed and then they start thinking badly of the underwriter. So, the underwriter will typically go in and buy to support the price of the underwrite. That's called, stabilization. Now some people thought it was unethical for an underwriter to do that because the stabilization seems like a market manipulation. They're not doing it because they want to buy it. They're doing it to prevent a panic or anger. But the SEC has decided that this stabilization is a good thing. And so, they're legally allowed to conspire to fix prices in market, at least until the entire issue is sold out. I think maybe it is a good thing. You want stable markets. And if the underwriter is willing to buy it, they're taking a risk. Anyway, we need somehow supply capital to business. And the fundamental problem is that nobody in the real world, most people don't know the business. They can't figure out whether they're being tricked or not. So, this kind of fixing looks okay to the SEC, and so it's done widely. I found a 1929 textbook on Investment Banking, and it says, "The seller desires to have conditions so shaped that the price of the issue will remain stable, or even better, it will rise slightly". That'll be good news. So in fact, there's some tendency to under-price the new issue. So, that as price rises in the immediate after market. If you just bought 10,000 shares of some company, it might even be a new company, you watch the news every day for a few days after, and you're really attentive for a while. So, there is a tendency for underwriters to under-price them a little bit in the market to establish a favorable psychological attitude of investors. The term manipulated market is not altogether a misnomer.
