In marketing securities, three groups of institutions are suc cessively engaged: The securities are purchased by one group, are underwritten by another, and are distributed among ultimate buyers by a third. These functions overlap, it is true, and in some instances one house may perform all three of them, and the bond house may operate in any or all of these ways.
i. Purchasing Securities. The houses which buy first hand the largest blocks of securities are relatively few in number and strong financially, with central offices in New York, Philadelphia, Boston, or Chicago. There are, of course, in these and other cities many houses which are competent to handle somewhat smaller blocks of securities. Institutions which buy securities on a large scale must command large resources, occupy a position of finan cial influence, and have a record of successes which will assure the company issuing the securities of the success of the flotation. Such houses determine the direction of industrial and commercial development and the selection of the personnel of business enter prises worthy of financial support. They may act either inde pendently or in conjunction with others.
The promoter brings his proposition to one of the financial houses at a time; if his negotiations fail he approaches another; but he will not find the financial houses actively competing with one another, nor do they actively bid for his proposition. Ac tive competition by bond houses might result in reckless extensions of credit and overfinancing; the bankers prefer to act in a more professional capacity and to select their clients with an eye to an intimate, confident, and permanent relationship.
A few years ago the cry arose that the financial houses constituted a "money, trust," denying financial assistance to warrantable business undertakings mainly because the latter in terfered or competed with the vested interests. The extensive investigations of the Pujo Committee failed to make out a con clusive case for these allegations.
In purchasing a block of municipal securities a preliminary investigation, unless it is the issue of a well-known municipality, is made by an agent who inquires into the physical and financial condition of the city to determine its ability and willingness to meet its present and prospective obligations.
The securities issued by business corporations are usually submitted to the bond houses by a representative of the company or by a promoter. The bond houses, except under very favorable
conditions, refuse to handle securities of a business with which they are unfamiliar. They reject issues in excess of the physical value of the mortgaged property and they likewise refuse securi ties of corporations with narrow margins of net earnings above fixed charges, and of corporations owned or operated by men of low business morality.
If a favorable price can be agreed upon, accountants, engineers, and investigators are sent to make a thorough examination of the conditions, and after the proposition is finally accepted the bond house may insist upon having representation upon the board of directors until the securities are disposed of. Some houses finally handle only securities of well-established earning power. This insistence upon high quality reacts favorably upon corporate finance in general.
2. Underwriting. A bond house which has bought a big block of securities endangers itself by the high concentration of risk; this risk is usually distributed by having the issue underwritten by a group of banks through what is known as a "syndicate agree ment." There are four basic types of syndicate agreements, with several variations. It will suffice to illustrate but one type: Sup pose that a bond house takes over the bond issue of a corpora tion at 97.5 and that a syndicate is formed, the members of which are offered and agree to take parts of the issue at 98.29 in case the public does not take them at 99.04. The bond house might be successful in closing out the issue directly to purchasers at 99.04, but rather than run the risks attendant on underwriting so large a block, it is content to make a smaller margin of profit through offering the securities to the underwriting syndicate. If the public absorbs the securities at 99.04, the underwriters make per cent for having assumed the risk; but if the market offers only 96 the underwriters take them over at 98.29, and thus tie up their funds indefinitely or until the market rises. The members of the underwriting syndicate co-operate to establish and maintain the market for the issue. Bond houses like to participate in syndi cates so as to diversify their security offerings and be able to offer such a variety of investments as will be sure to attract and retain customers.