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Financial Markets

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Financial Markets

Two Types:
Money Market

Capital Market

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Money Market

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Money Market

Securities have little or no Risk Centered mainly in New York

Helps establish equilibrium interest rates

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Money Market Securities


Money Market securities - very liquid, short term debts

Liquidity - Speed with which an asset can be converted to cash without loss of value
Short Term: All money market securities have maturity less than 270 days (except for Treasuries T-Bills 1 Year).

Reason: Federal securities laws require securities with maturities greater than 270 days to be registered.
Registration is costly Sell at a Discount: Way money market securities pay interest. Ex: Security with $100,000 face value but sells for $98,000. The $2,000 difference in the interest.

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Type of Money Market Securities

Treasuries
Negotiable Certificates of Deposit Bankers Acceptances Commercial Paper Federal Funds

Eurodollar Loans
Repurchase Agreements

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Federal Funds
Sale of bank reserves that are held at Federal Reserve

Very Short Term - usually overnight or a week


Average Daily Volume - $20 billion p/day Business Trading Unit - $1 million Highly Volatile - rates fluctuate - even hourly Obtained By Banks Calling each Other or Through Brokers

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Federal Funds Market & Monetary Policy


Federal Funds Rate - price of federal funds Used as a gauge of federal reserve policy How Federal Reserve Has Impact on Federal Funds Market:

Concretionary Monetary Policy - Sell securities to banks (really Treasury d


Fed deducts reserves from bank's accts with Fed Bank reserves decline - Federal Funds rate increases

Expansionary Monetary Policy - Buy securities from banks (Treasury deal Fed buys securities from banks and credits their reserve accts Bank reserves increase - Federal Funds rate declines

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Quantitative Easing
A more extreme form of expansionary monetary policy Used by central bank to expand the economy when interest rates are at or close to zero When the central bank purchases assets, Treasuries & corporate bonds, using money the central bank simply created Used by Japan in early 2000s Used by US & UK in 2008-2009 subprime crisis and recession that followed
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Federal Funds Rate January 2001- January 2011


Federal Funds Rate
8%

6%

4%

2%

0% 1/1/2001

1/1/2002

1/1/2003

1/1/2004

1/1/2005

1/1/2006

1/1/2007

1/1/2008

1/1/2009

1/1/2010

1/1/2011

Federal Funds Rate v. Discount Rate January 2001- January 2011

8%

6%

4%

2%

0% 1/1/2001

1/1/2002

1/1/2003

1/1/2004

1/1/2005

1/1/2006

1/1/2007

1/1/2008

1/1/2009

1/1/2010

1/1/2011

Federal Funds Rate

Discount Rate

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0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

30 Year Fixed Mortgage Rate January 2001- January 2011

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Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11

Interest Rates and the U.S. Housing Boom

Source: Krugman/Wells

Treasury Bills
Maturities: 90 days, 180 days & 365 days - 365 days is exception - Treasury not have to worry about registration Purpose: Help Fed. Govt. close gap between expenditures and receipts Sold at a Discount: Pay less than face value to buy Secondary Market - very active Minimum Unit: used to be $10,000 but now is $1,000 Frequency of Sale: Auction every Monday for 91 days & 180 days - Treasury announces winning bids Monday afternoon & pay Thursday - 9 mo & 12 mo auction every month

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Treasury Bills (Contd)


1. Sold in denominations of between $10,000 - $1,000,000 (some as low as $1,000)

Sold at a discount - ie investors bid $9,700 for a Treasury bill that matures at $10,000 in 1 year
What is the return in that period? Pay $ 9,700 Get $10,000 Difference: $10,000 - $9,700 = $300 Rate of Return: $300/$9,700 = 3.1%

Note: Higher the bid price - lower the return Lower the bid price - higher the return

3.

Treasury bills have an active secondary market


- bought by brokerage firms, commercial banks and the Federal Reserve banks

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Repurchase Agreements
Called Repos Used by government securities dealers to help finance their inventories

Govt securities dealers may buy more securities than have cash for
Use broker to find investors (corporations) that want to invest cash short term - say 1 - 4 days

Repurchase Agreements: way securities dealer or banks can borrow from corpora Process: Dealer sells securities to investors and agrees to buy them back later. Term: usually overnight Term Repos: 30 days or longer Banks: active in repo market - way corporations can lend $ to banks Ex: GM has idle $1 mil in bank GM uses $ to buy T-bills from bank & bank agrees to buy them back later In effect, GM lends $ to bank
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Repurchase Agreements as Monetary Policy Tool


Expand Money Supply - Fed buys securities from non-bank government securities dealers The Fed payment is deposited in commercial banks of the dealers Bank reserves increase

Banks may increase loans (hopefully)


Money Supply increases Decrease Money Supply - opposite process

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Commercial Paper
Short term promissory notes issued by credit worthy corporations Maturities: 5-270 days

Denominations: $100,000 or more


Backing: General credit worthiness of corp + bank line of credit Reason Corp Issue CP: quicker, easier & cheaper than bank loans

Cost: usually less than bank loans


Liquidity: promissory note is negotiable Purchasers: institutions: ie. insurance co, pension funds bank trusts

Ratings: S&P, Moodys & Fitch rate commercial paper

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Defaults of Commercial Paper


Rare Penn Central - early 1970s, a famous default Lehman Brothers 2008 largest bankruptcy in history
Rocked the commercial paper market

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Volume of Commercial Paper Before & During Subprime Crisis

Source:WSJ 9/4/08 B1
All Rights Reserved. May not be reproduced , copied, or otherwise used without the express, written permission of Dr. Patrick Gaughan
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Commercial Paper (Contd)

CP Rate vs. Treasuries: CP risk greater than Treasuries CP rate greater than Treasuries

Finance Companies : ie. GMAC - big issuer of CP


Subprime crisis has made this more difficult and costly
Bankruptcy of Lehman Bros severely hurt this market in 2008

Used by corporations to help finance short term needs


Examples: financing of inventories or accounts receivables

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Eurodollar Market & Eurodollar Loans


Not under the control of the Federal Reserve Size deposit: Large sums - usually $1 mil or more Who Makes Deposits: 1. Large corps, U.S. banks & wealthy individuals Length of Transaction: Usually less than 6 months Borrowers From Market: U.S. or foreign banks or corporations - important source of borrowing for U.S. banks Eurodollar Dealers: get together suppliers & demanders 90% Eurodollar deposits are time deposits Advantage of Eurodollar Deposits: a) may pay higher rates than U.S. b) not subject to U.S. regulation Center of Eurodollar Market: London Other Eurocurrencies: EuroYen - ie. EuroYen Yen outside Japan
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Eurodollars: Deposits denominated in US dollars in foreign banks or U.S. branch bank

Birth of Eurodollar Market


One of Finance's Great Ironies - Fathered by Russia

Early 1950s - Height of Cold War


Russia had accumulated large deposits in U.S. banks Russia feared U.S. would freeze Russian deposits in U.S. Russia moved its dollar deposits to Europe Freeze Fear: not unjustified in light of freeze on Iranian Assets in 1973 Russia need to keep assets in dollars to settle int'l trade transactions

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Negotiable Certificates of Deposit


1961: Citibank started this market Size: $100,000 or more


$1 million or more not unusual

Liquidity: negotiable active secondary market

Sold at a Discount to its Par Value


FDIC Insurance - up to $250,000 Risk: Low because of FDIC
Remember though only $250,000 FDIC insured

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Negotiable CDs (cont)


Most often sold to large institutional investors They use them as a low risk but low return investment Maturity: can be few weeks but not more then a year Negotiable CD vs Regular CD Regular CD: you deposit money and cant withdraw until come due without penalty Negotiable CD: still cant withdraw without penalty but can easily sell
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Bankers Acceptances
Short term credit instrument created by a non-financial firms but guaranteed by a bank Used in importing & exporting and as a money market investment Int'l Trade: most frequent use

- Physical Nature of Security: letter of credit from importer's bank to exporters bank

- Allows trade between 2 companies in 2 nations that do not know

Allows company to substitute the banks credit worthiness for


its own credit worthiness
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Bankers Acceptances (cont)


Also referred to as a time draft
like post-dated check

The amount is accepted & guaranteed by a bank and payment will be drawn from a specific account of the banks customer Holder of the draft can sell it at a discount to an investor who is will to wait for the payment The market for these sales in the BA market Waiting period: typically 6 months
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Bankers Acceptances (cont)


Amount: typically $100,000 or more Amounts < $100,000 referred to as odd lots

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Bankers Acceptances History


Can be traced to 12th Century 1700s and 1800s an active market for these acceptances developed in London When the Federal Reserve was first formed in 1913 one of the things it was supposed to do was to help facilitate the developed of a US bankers acceptances market to rival London and help US trade The Fed would buy certain bankers acceptances from certain banks to help the market develop Today the Fed does not but them but mainly buys Treasuries to conduct monetary policy
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Capital Market

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Capital Market
Bond Market

- Government Bonds
- Corporate Bonds Mortgage Market Stock Market

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U.S. Government Bonds


Non-Marketable: 40% of government debt Series EE Bonds - rates fluctuate - usually set at 85% of current market yield on 5 Year Treasuries issued on that date - minimum yield of 7.5% - early redemption possible but a lower yield penalty Marketable: 60% of total government debt Different Types: a) Treasury Bills Certificate of Indebtedness - not issued by Treasury much - maturities 1 year - interest paid semi-annually - called coupon rate b) Treasury Notes: 1-10 year maturities Intermediate Term Treasuries
c) Treasury Bonds: 10-30 year maturities - some issues are callable

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Treasury Notes and Bonds


Treasury Notes: Intermediate Term Treasury debt
- Mature in 1 - 10 years - Sold in denominations of $10,000 to greater than $100,000 - interest paid semi-annually

Treasury Bonds: Long term Treasury debt


- Mature in more than 10 years: 10 - 30 years Both are purchased by brokerage firms, pension funds Active secondary market for both (notes & bonds) Safe Investments: a) Free of default risk b) Not free of interest rate risk

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U.S. Treasury Bonds 30 Year Bonds


Late 2001 the U.S. Treasury stopped issuing 30 year bonds
Reason was to save taxpayers money lower rates on bonds of shorter maturity Treasury has started issuing again now that US is running large budget deficits again US Fiscal stimulus program of 2008-2009 is dramatically increasing the budget deficits UK also issues 30 year government bonds

In 2005 UK & France issued 50 year bonds


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Sales of Treasuries to Foreigners


Significant percent of US Treasury debt is held by foreigners Such sales have been rising in recent years

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Share of Treasury Securities Held by Foreigners


70 60

Percentage

50

40

30

20

10

Year

Source: U.S Department of Treasury

Federal budget balance as a percentage of GDP


4
2 0 -2 -4

-6
-8 -10 -12

Source: WSJ and CBO

Inflation & Interest Rate Risk


Inflation & Interest Rate Risk:
Treasuries are fixed income investment
- when inflation rises it erodes the value of the fixed payments received

Two factors affect the return on fixed income securities like Treasuries:
1. Inflation: increase causes value to decline

2. Interest Rates: increases cause values to decline

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Municipal Bonds
Bonds of Cities, States and Counties and Authorities Tax Benefits: interest income exempt from federal taxation (not capital gains)

General Obligation Municipal Bonds - also called full faith and credit bonds - not backed up by specific assets or revenue streams
Limited Obligations Municipal Bonds - obligation is tied to some assets or revenue stream - ie. tolls revenues from building bridge Insuring Companies: lowers risk for investors MBIA - Municipals Bonds Insurance Assn AMBAC: American Municipal Bonds Assurance Corp.
These firms has been hurt by the subprime crisis

These firms are under much financial pressure due to their insuring sub-prime mortgage securities S&P Ratings: S&P agrees to give highest ratings to municipalities that get this insurance
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Bond Insurance Companies


Nov 2010 AMBAC missed bond payment and will be filing for prepackaged bankruptcy Expanded it business to insure CDOs and mortgage backed securities
Lost significant monies on these policies

MBIA still around but not issuing new insurance

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Municipal Bonds
More on Tax Exemption

Municipals exempt from federal taxation by the Doctrine of Reciprocal Immunity


This doctrine states that federal and state governments shall not tax under personal income taxes the interest payments on the others debt instruments This was upheld by the U.S. Supreme Court in 1895

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Municipal Bonds (cont)


Widely held by individuals Tax advantage enables them to offer relatively higher after-tax returns compared to other fixed income securities

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Municipal Securities (contd)


Revenue Bonds: limited obligation bond

- interest is tied to a particular project (i.e. toll road or bridge)


- this can be more risky i.e. Chesapeake Bay Bridge & Tunnel did not generate enough toll revenue to repay the bonds so the bonds defaulted - lenders could not foreclose on the bridge so they had to wait a few years until the bridge generated enough income to start making interest payments again.

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Municipal Securities (contd)


Usual minimum value: $5,000 Risks: a) default b) liquidity - secondary market may be thin, - especially for lesser known municipalities c) interest rate risk General Obligation Bonds - thought to be safer than revenue bonds as the municipal government is supposed to use its full taxing authority to make sure the bonds are repaid.

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Auction Rate Securities


Long term securities whose rates are regularly reset in an auction process They are long term variable rate bonds Late 2008 2009 most of these auctions have failed Many of the securities firms that issued them have agreed to buy them back

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Auction Rate (cont)


Main issuers are municipals, hospitals, charities and student loan organizations Were a way that these entities could try to borrow for long term needs using short term capital which has lower costs The rates reset through periodic auctions Market was created in the mid-1980s More then $330 billion were sold to > 100,000 investors

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Auction Rate Securities


Auctions rates are reset in weekly or monthly auctions Prior to 2007 the securities were quite liquid as there was heavy demand At the auction the holders of the securities can hold them or sell them Investors can then sell their securities to new demanders of them
The ability to sell at each auction made long term securities seem short-term-like

The new investors get the new rate


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Auction Rate Securities


Typical investors: were corporations, funds, family trusts and individuals
Many of these individuals were smaller investors

They were promised by firms that sold them that they would be very low risk and highly liquid Sellers of these securities were paid unusually high commissions - auction rate commissions: 0.25% of securities value Merrill Lynch sometimes offered as high as 1% - Treasury securities commission: 0.05%
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Auction Rate Securities


Failure of the auction does not necessarily mean default If the auction fails the issuer must pay a higher fail rate If this creates problems for the issuer then it might have to default Investors get the fail rate but their cash is frozen until the next auction (rate higher but not liquid) This was an issue for many investors as they were told by brokers that they could sell their securities at regular intervals (auctions) so they were liquid
Auctions such as every 7, 28 or 35 days
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Annual Issuance of Auction-Rate Municipal Bonds


50 45 40 35
$ billion

30 25 20 15 10 5 0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Source: Thompson Financial

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Ginnie Mae Securities


Securities issued by the Government National Mortgage Assn Division of Housing and Urban Development (HUD) Created in 1968 Ginnie Maes Monies raised through the sale of the securities are used to purchase mortgages issued by private lenders (ie S&Ls)

Mortgages are pooled together and pieces of them are sold to the public - all the mortgages in a given pool have the same interest rate
Ginnie Maes are a conduit through which the mortgage payments and principals payments flow through to the buyers of the Ginnie Maes Investors receive monthly payments The loans they buy are mortgage loans backed by the federal govt
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Other Government Agency Securities


Federal National Mortgage Association (Fannie Mae) 1938 Created after Great Depression 1968 turned into private shareholder corporation 1970 Federal Home Loan Mortgage Corporation (Freddie Mac) - formed to compete with Fannie Mae and make mortgage market
stronger
Also a stockholder owned corporation Fannie was bigger

2008 both were placed in conservatorship by the Federal Housing Finance Agen - As of 2008 they owned or guaranteed of $12 trillion mortgage market

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Government Sponsored Entities (cont)


Mortgage Secondary Market - mortgages purchased
These are called conforming mortgages Securitization Process: they are placed in pools and

Pieces (securities) of them are resold

Benefit of Market: provides liquidity to secondary mortgages - helps increase mortgage availability - pooling lowers risk - helps eliminate regional differences in mortgage markets

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Legal Developments & Growth of the Mortgage Market

1977 Congress and Carter passed the Community Investment Act 1999 Clinton administration put pressure on Fannie Mae to increase lending to low and middle income people Fannie Mae lowered loan requirements for mortgage loans it was willing to purchase This helped banks and mortgage brokers make big money Brokers issued many teaser rates loans with reset mechanisms Also gave more business for Fannie Mae and its shareholders made more money
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Legal Changes & Subprime Meltdown (cont)


2002 President Bush signed Single Family Affordable Housing Tax Credit Act
gave $2.4 billion in tax credits over 5 years to companies that develop single family housing in low income areas December 2003 President Bush sign American Dream Down Payments Act
Provided $200 million p/yr for help with down payments and closing costs But what if buyers cant make mortgage payments? What do they do after the down payments?
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Legal Changes & Subprime Meltdown (cont)

2005 Federal Housing Regulatory Reform Act (sponsored by Senators Chuck Hegel & John McCain)
Never got to have a full senate vote

Was designed to try to rein in the Fannie Mae and Freddie Mac Was designed to try to correct abuses and bad accounting Fannie Mae and Freddie Mac engaged in great lobbying efforts to control regulators
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Implied Guarantee from Federal Government

Securities issued by Fannie Mae & Freddie Mac were not officially guaranteed by the Federal government However, the market believed that the government would not let them fail This increased the demand for these securities It also enabled them to raise capital at a lower rate

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Mortgage Market Meltdown of 20072008

Real estate market fell sharply in 2006-2007 Economy slowed Many mortgages aggressively sold to those whose credit was weak The strong value of real estate as collateral was the basis for many of these loans and the lax lending policies When real estate and the economy slowed defaults rose dramatically This led to defaults of these securities
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SubPrime Meltdown (cont)


The mortgage industry aggressively issued mortgages to many weak borrowers called sub-prime borrowers in the 2000s These loans were securitized (explain) Many of these securities defaulted and caused many major investment banks to incur huge losses in 2007-2008

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Bailout of Fannie Mae & Freddie Mac


Sept 2008 US Government announced bailout of Fannie Mae & Freddie Mac
US Treasury received $1 billion in senior preferred stock in each company & warrants to purchase 79.9% of each companys common stock (common for nominal sum)

Cost to taxpayers expected to be $200 billion Shareholders were be wiped out Bondholders, many of them foreign governments, will have investments saved Federal Housing Finance Agency took control of both Fannie Mae and Freddie Mac
This is the regulator of both
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Housing Market
Had been showing signs of an impeding decline for a while leading up to the end of 2008

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Corporate Bonds
Indenture Contract - legal agreement between bondholders and corporation Trustee: usually a bank, makes sure issuer lives up to contract Coupon Rate: interest paid on bond Yield: Effective rate of return when take into account both capital gains and interest payments Bond selling at a Discount: Yield greater than interest rate Bond Selling at a Premium: Yield less than interest rate Size of Corp. Bond Market: About 1/2 size stock market

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Corporate Bonds #2
Maturities:

Short Term: Less than 5 years Medium Term: 5 - 10 years Long Term: 10 - 20 years
Note: Medium and Long Term are usually backed by some security

Call Provision: Allows debtor to redeem issue at some call price


Call Price > Par Value Call Premium: Call Price - Par Value

Reason for Call: Interest rates decline - corporation refinances Sinking Fund: name describing repayment method - company sets aside monies, paid into fund, to retire bonds - bonds are period called at random and retired - way of lowering risk
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Corporate Bonds #3
Collateral Trust Bonds: - security that is pledged are stocks or bonds Unsecured Bonds - Also called Debentures No specific assets pledged All assets not already pledged can have claims against them Subordinated Debentures: debentures made subordinate to other creditors Junior Subordinated Debentures - subordinate to subordinated debentures

Convertible Debentures - convertible into another asset - ie stock


Divisional Bond: backed up by assets of specific division

Prior Lien Bonds: bonds placed ahead of first mortgage bonds - ie in Chapter 11

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Secured Corporate Bonds


Secured Bonds: bonds secured by some asset - if bond defaults can sell asset to repay

Mortgage Bonds: bonds secured by mortgage on some real property


Blanket Mortgage - all firm's asset pledged

Three Types of Mortgage Bonds Open End: Can issue more bonds on same mortgage contract Limited Open End: Only issue limited amt more bonds Closed End Mortgage: No additional borrowing using same assets After Acquired Property Clause: All additional property acquired will also be pledged

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Bond Ratings
Corporate bonds are rated by major rating companies Standard & Poors (S&P) Moodys Will discuss this more when covering bond valuation These companies are also under fire for the high ratings they gave some mortgage securities They were given AAA ratings (never defaulted before)

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High Yield or Junk Bonds


Bonds that get an S&P rating of BB or worse

pay a higher return to compensate for greater risk

Original Issue vs. Fallen Angels

Michael Milken and Drexel Burnham Lambert


Market boomed in the 1980s Collapsed in the late 1980s and early 1990s but came back in the mid 1990s Remains a very important part of corporate finance

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Zero Coupon Bonds


Bonds whose interest is paid at maturity They are sold at a discount 1981 - J.C. Penny issued the first zero coupon bond bonds sold for $330 and matured at $1,000 after 8 years (1989) The return really depends on the ability of the issuer to retire the debt - if the firm goes bankrupt then investor may get a zero return Tax Disadvantage: IRS taxes you on the imputed interest that you accrue each year even though you do not get any interest until the bonds mature.

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Variable Interest Rate Bonds


Long term bonds whose interest rate varies with short term interest rates
Citicorp was the first company to issue such bonds - the variable rate was tied to the T-bill rate - The interest rate was set 1% above the T-bill rate - holders had the right to redeem them at face value

- could do so 2 yrs after issue and again every six months have that opportunity

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Convertible Securities
Securities that offer right to convert into other securities

Callable Usually
Conversion Ratio: Rate of exchange, i.e. 20 shares for each bond

Conversion Value: What convertible security is worth


Market price of stock X Number of shares you get Dilution: adverse effect on shareholder wealth Advantages: Issuer pay lower interest rate

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Convertible Bonds
Bonds that can be converted into common stock

Investor has the option to convert the bonds into a specific number of shares over a certain time period.
Ex: Time Warner 8 1/4% bonds that mature in the year 2015 may be converted into 20.95 shares of Time Warner common stock. Market price is also influenced by the price of the stock - if the stock price is high the bonds will be worth more

Investors can get both the protection of bonds but also the opportunity for capital gains with stock

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Equipment Trust Certificates


Bonds backed up by specific pieces of equipment
Unlike mortgage bonds the resale value of collateral may be more accurately measured Reason: Can better measure the value of a plane than a power plant Frequently used by airlines and railroads to finance planes and trains Remember just because you can better measure the value does not mean you cant lose money i.e. bankruptcies of Midway, Eastern and PanAm, Continental, Delta - Some of these airlines dumped planes on the market when the used plane market was already saturated and weak

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Income Bond
Bonds whose income is paid only if the company makes money

This makes them more risky so they are not issued that often.
Ex) Disney bonds that pay 13.5% interest annually if a package of 20 Disney movies gross over $800 million Similar to the revenue bonds issued by municipalities

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Bowie Bonds
This is a unique example of a type of income bond or an asset backed security First sold in 1997 Raised $55 million for David Bowie Gave bondholders a right to the future album earnings of David Bowie Other artists followed such as James Brown, Ashford & Simpson and the Isley Brothers
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Bowie Bonds (cont)


Market for them slid down in 2001 Free downloading of music hurt them 2004 Moodys downgraded Bowie Bonds to junk status

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Mortgage Bonds
Bonds backed up by specific assets especially equipment (not just real estate)

Frequently used by utilities to build power plants Resale value may be uncertain

Major Famous Default: WPPSS default

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Other Types of Securities


Payment in Kind (PIK) Securities: Bonds or preferred stock whose payment of interest is in additional bonds or shares The PIK feature may apply to the initial years in the life of the securities Issuer may not have the cash flow to pay cash interest initially

Reset Bonds: Bonds whose rate is periodically reset Extendible Bonds: Bonds whose maturity date may be extended into the future by the issuer The investor who buys such bonds does not know exactly when the bonds will mature

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Other Types of Securities


Euro-Bonds :where U.S. firms issued bonds outside the U.S. such as in Europe

Two Types: those denominated in the local currency and those in dollars
Serial Bonds a bond issue where certain bonds in the issue mature in one year and others mature at other times - often used to finance equipment such as railroad cars - few companies issue serial bonds

- more often used by state and local governments

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Preferred Stock # 1
Stock and Equity: = Mean the same thing

Preferred Stock: a class of stock that pays a fixed dividend that is not guaranteed but which has a preference over common stock in both dividend payments and in bankruptcy/liquidation. Preferred Dividends: Expressed as a dollar amount of a percent of par value.
Ex) Virginia Electric $5.00 preferred

- the par value is $100 and the stock pays $5 per year in dividends

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Preferred Stock # 2
Order of Return: Common Stock > Preferred Stock > Bonds

Order of Risk: Common Stock > Preferred Stock > Bonds


Voting Rights: Preferred shares often do not have voting rights.

Preemptive Rights:

- may or may not have - depends on state incorporated in

Dividends: usually fixed stated amount Cumulative Dividends: - Unpaid dividends accumulate until past ones are paid - may not pay dividends to common shareholders until preferred fully paid

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Cumulative vs. Non-Cumulative Dividends


Most preferred shares are cumulative
Arrearage = the total amount of preferred dividends that have not been paid Example: Unisys - Suspended payment of preferred dividends in 1991 but resumed them in 1993. The 1993 dividend payments were $5.625 p/share which consisted of $3.75 for the current year (1993) and $1.875 towards the arrearage. Note: Unisys was formed in the merger between Burroughs and Sperry

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Preferred Stock # 3
Call Features: Firm may have right to redeem shares

Maturity: Preferred stock usually does not have maturity date


Sinking fund: - Some issues may have this - usually set up to call in the preferred shares Difference between Bond & Preferred Sinking Funds: If firm cant make payments to bonds sinking fund issuer is in default, but not with preferred stock. Participating Preferred Stock: Earnings rise Dividends rise Adjustable Rate Preferred Stock: - started in 1982 - protection against interest rate risk - rate tied to T-Bill rate Convertible Preferred: convertible into common stock

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Preferred Stock & Bonds Contrasted


Risk: Preferred Stock Riskier than Bonds.

Default: If the company does not pay the interest payments on the bonds it is in default but that is not the case if it misses preferred dividend payments.
Explain bankruptcy process in US vs other nations Tax Effects Affecting Purchasers of Preferred Stock vs. Bonds - Dividends paid by one corporation to another receive favorable tax treatment ie holdings companies only 30% of the dividends received by a corporation are subject to taxation. (70% excluded)
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Preferred Stock & Bonds Contrasted (Contd)


Tax Effects Affecting Purchasers of Preferred Stock vs. Bonds (Contd)

- This may cause corporations, such as insurance companies to buy preferred stock instead of bonds
- Note: this just looks at the tax effects for buyers of securities rather than issuers. For issuers the effects are the opposite.

Tax Effects for Issuers: Bond interest payments are tax deductible but preferred dividends are not deductible - this gives an incentive for firms to issue bonds and borrow rather than issuing stock

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Common Stock
First security to be issued, last Security to be retired Earnings potential unlimited

Bankruptcy: Last claim usually nothing


Cumulative Voting: 1 share 1 vote - if have this, can pool votes Preemptive Rights: allows shareholders to have first right to purchase shares helps maintain ownership percentage Par Value: face value or minimum value of stock - used to give idea of stock value in bankruptcy - little relationship to true value of stock Book Value: (Assets Liabilities)/ # of shares - not good measure of value of a corporation - assets at book values: may be very different from market values

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Common Stock (Contd)


Classes of Stock: Dual Capitalization Sometimes called alphabet stock

Ex) Class A: may be non-voting dividend paying stock Class B: may be voting, but non-dividend paying stock
Ex) Call E shares of GM old EDS, & Class H shares the old Hughes Electronics - both have been sold off and are not part of GM anymore - sometimes used to be used as an anti-takeover device

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Classes of Stock (cont)


Ford Motor Company has 2 classes of stock: Class A and Class B shares Class B shares have higher voting rights (16.561 votes p/share) This gives the Class B shareholders 40% control family members

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Stock Rate of Return


Dividends: one of two ways make money from stock Rate of Return on Stock:
[(Pt+1 Pt) + (d t+1)] / Pt

Stock Dividends: dividends paid in corporate stock Stock Split: name given when get 25% or more of a share for each share
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Common Stock and the Corporate Form of Business


Common Stock - security representing ownership interest in the corporation State Laws: companies are incorporated in states and the company is then governed by that states laws. Certificate of Incorporation: document creating the corporation. - indicates the name of the corporation, its location of principal office, purpose and the # of shares of stock authorized to be issued. Corporate Charter: specifies the relationship between the corporation and the laws of that state. Charters By Laws: then established by the shareholders at the first meeting and then may be amended by shareholders ie (at annual meetings) - these are the rules by which the corporation is governed.

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Rights of Common Shareholders


Rights to vote their shares for directors and on certain major issues ie control issues. Cumulative Voting: voluntary in many states - some states require it: CA, IL and MI - where shareholders can pool votes for specific director

Preemptive Rights: rights of certain shareholders to maintain their ownership share.


- some states require them but most do not - here shareholders get right to maintain their share of ownership by getting a certain # of rights to buy a certain # of shares - if not exercised the rights can be sold

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Sources of Financing for Corporations


Majority Comes from Internal Funds : Percentage varies Factors That Influence Percentage

a)

Interest Rates: Higher rates the less likely firms will raise debt capital

Ex) From 1981 to 1982 interest rates rose and the percent raised externally declined from 39.4% to 25.4% b) Corporate Profitability Two effects: - Good profits will generate higher cash flows and this may reduce the need for need for externally financing - Greater future profitability may increase financing needs and this can increase the demand for financing. - If the firm has limited past profitability and cash flows, then the higher anticipated profitability may cause the firm to look outside for financing.

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Mix of Securities Sold in Capital Markets


Majority are Bonds not Equities Most often used is Debt, then Common Stock followed by Preferred Stock Typical Average: Bonds - Common Stock - Preferred Stock 75.6% 20.2% 4.2%

Reason:

Interest payments are tax deductible and dividend payments are not.

- This lower the after-tax costs of debt financing

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Largest Bond Offerings of All Time


Issuer Duetsche Telekom Ford Motor Credit Tecnost Intl Finance AT & T World Com Wal-Mart Amount ($ bn) $ 14.5 Date 6/20/00 Investment Banks Deutsche Bank, Goldman S. Morgan Stanley Bear Stearns Merrill Lynch. Salomon Smith B. Lehman Brothers Chase DLJ Merrill Lynch Salomon Smith B. Salomon Smith B. Lehman Brothers

$ 8.6

7/09/99

$ 8.3 $ 8.0 $ 6.1 $ 5.8

6/3/99 5/23/99 8/6/98 8/4/98

Sources: WSJ 6/29/2000, CommScan, DebtDesk

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Financial Institutions

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Investment Bankers
Glass Steagal Act of 1933:
- Investment banking and commercial bankers
functions were separated. - Example was Morgan Bank which was separated into Morgan Stanley and Morgan Guaranty. - This law has been slowly taken apart. - Now securities firms and banks are diversified - Many have undone this diversification - Law has been phased out - in 2010 there has been call to bring the law back

Definition of an Investment Banker:


- An intermediary involved in the merchandising of securities. - Investment bankers facilitates the flow of savings from those with capital to invest and those who need such capital.
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Investment Bankers (Contd)


Underwriting:
Term borrowed by finance from the insurance industry - It means assuming a risk. - The investment bank assumes the risk that the issue will not sell at prices high enough to guarantee a profit for the investment bank. investment bank uses to sell the issue Today many investment banks are so big they may not need a syndicate - The syndicate will use a network of dealers to sell an issue. It is not unusual for larger issues to have 300-400 dealers.

Syndicate: Group of investment banks that the lead

Advisory Services: Investment banks advise their clients


of capital markets and the best methods to raise capital - They also advise on mergers and acquisitions. - Lazard does mainly just M&A advising
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Leading Underwriters of U.S. Corporate Securities in Early 2000s*


Rank Manager Issue Value ($ bn) # of Issues Mkt. Share (%)

1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

Merrill Lynch Salomon Smith Barney Morgan Stanley Dean Witter Goldman Sachs Credit Suisse First Boston Chase Manhattan Lehman Brothers Bank of America Securities J.P. Morgan Deutsche Bank

208.3 180.8 135.0 129.7 125.3 91.5 89.7 71.0 64.2 53.3

1,978 1,127 1,638 555 770 730 536 584 307 262

15.1 13.1 9.8 9.4 9.1 6.6 6.5 5.1 4.6 3.9

*The lead manager is given credit for the entire issue.

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Subprime Crisis Impact of Large Independent Investment Banks

The large US independent investment bank no longer exists Bear Stearns acquired by Citibank Merrill Lynch acquired by BOA Lehman Brothers bankrupt Salomon Smith Barney part of Morgan Stanley Morgan Stanley and Goldman Sachs received commercial bank status
Allows them to borrow from Fed Really Fed would have allowed them anyway
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Impact of the Demise of Big Investment Banks Such as Lehman


Was a boon for Goldman Sachs Business that would have gone to Lehman is now going to Goldman Goldman is Poulsons former employer Goldman had its most profitable year in 2009 the year of the Great Recession

Goldman Sachs
quarterly profit/ loss
$6 $5 $4 in billions $ $3 $2 $1

$0
-$1 -$2 -$3 2008 Q1 2008 Q2 2008 Q3 2008 Q4 2009 Q1 2009 Q2 2009 Q3 2009 Q4

Source: Goldman Sachs

Leading Advisers on Worldwide Mergers and Acquisitions in Early 2000s*


Rank Manager Size of Deals ($ bn) 928.6 919.6 554.0 540.7 503.0 312.3 272.6 243.0 242.6 170.6 # of Deals 273 299 204 280 262 161 32 223 210 172 Mkt. Share (%) 36.8 36.4 21.9 21.4 19.9 12.4 10.8 9.6 9.6 6.8

1. Goldman Sachs 2. Morgan Stanley Dean Witter 3. Merrill Lynch 4. Salomon Smith Barney 5. Credit Suisse First Boston 6. UBS Warburg 7. Wasserstein Perella Group 8. Donaldson, Lufkin & Jenrette 9. Chase Manhattan 10.J.P. Morgan

* Market shares exceed 100 percent because adviser to acquirer and target are given credit on each deal.
Source: Thomson Financial Securities Data

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Private Placements
Institutional Investors Major buyers in private placements.
a) Life Insurance Companies b) State & Local Government Pension Funds c) Private Pension Funds

Advantages of a Private Placement


a) Speed not need SEC filing b) Lower flotation costs SEC filing not needed and investment banker distribution costs lower or zero. c) Flexibility firm may get to deal face-to-face with investors

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Private Placements (Contd)


Disadvantages of a Private Placement
a) Interest costs tend to be higher. This may outweigh the lower flotation costs b) Investors in a better position to require specific additional restrictive covenants c) Liquidity if not registered less liquid d) SEC registration may come in the future then this is only a temporary savings

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PIPEs
PIPE = private investments in public equity Public companies can sell shares in a private transaction to specific investors
Good for smaller or medium sized companies that are less well known
Ex: 2006 90% of all PIPE deals involved companies with market capitalization < $250 million
For them access to capital markets may not be as readily available

Market for PIPEs


1980s and early 1990s market for PIPEs used to be high net worth investors and hedge funds Mid-1990s 2010 market now also includes pension funds, mutual funds, private equity and venture capital funds

Goal of the Firm


Owners of Company - Shareholders

Goal of the Firm - Maximization of Shareholder Wealth


Other Goals or Constituencies or Stakeholders: Employees Community Retirees

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Agency Problem
Owners of Firm: - Shareholders Agents of Owners - Management Board of Directors - elected by shareholders to oversee their interests - Board selects management Inside Board vs. Outside Board Interlocking boards (explain) Agency Problem: agents (management) may have different agenda Agent's Agenda: a) maximize their salaries b) more perks c) make firm bigger - more prestige

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Corporate Governance Issues


Should All Shareholders Have Equal Rights? China: 2005 Chinese Securities Regulatory Commission reluctant to allow foreign shareholders should to have the same voting rights as Chinese shareholders Long Term vs. Short Term
Acquisition Rights - Prior shareholders may have more rights State Laws - govern corporations

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Forms of Business Organization

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Forms of Business Organization


Sole Proprietorship - business owned by a single individual No legal requirement to set up - just start business

May have to register name if want exclusive rights top it.


Termination occurs with owner's death Full Liability

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Forms of Business Organization (cont)


Partnerships: Two Types a) General Partnerships - general partners fully liable for all liabilities of the partnership b) Limited Partnerships - certain partners are allowed to have limited liability

- Must meet certain conditions:


a. There must be at least 1 general partner b. Names of limited partners may not appear on name of firm c. Limited partners may not participate in management

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Partnerships (cont)
- Master Limited Partnerships - popular in 1980s Partnership units may trade in organized exchanges

Often used by firm to spin off assets whose profits flow directly to partners

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LLCs
Limited Liability Companies business organizations that have limited liability and are available for proprietorships and partnerships
(C in LLC stands for company not corporation)

When they apply for Federal tax ID they can elect to be taxed as C corp, partnership or S corp. Can decide to be member managed or manager managed One member LLCs may be disregarded (unlike Corporations with one shareholders) Professional Groups: accountants, law firms form PLLCs International: other countries starting to recognize similar type entities:
UK 2002 Limited Liability Partnership
Japan 2006 Godo Kaisha similar to US LLC

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LLCs (cont)
Advantages:
Earnings flow through to the owners & are taxed at the individual level Simpler than C Corp

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LLCs (cont)
Disadvantages:
Taxes: a) some states levy franchise tax on them this tax may be tied to revenues - may offset the elimination of double taxation b) more difficult to raise capital - IPOs easier with regular C corp

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Forms of Business Organization (cont - 2)

Corporations
- Separate legal entity - Incorporated in particular state - Governed by State Law - More Corporations Incorporated in Delaware Tax benefits - Very developed corporate law & court system - Limited Liability for Owner - stockholders - limit is investment - Continuity of Business - exist after specific owners die

- Transferability - easier - sell stock


- Easier to Raise Capital - Double Taxation (in US not necessarily in other countries ie India)
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S Corporations
S Corporations
If have fewer than 75 shareholders May allow shareholders to not be taxed twice corporate level & individual level May or may not be fully recognized by states in their taxation Ex: NJ taxes S Corps at lower rate

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