Intersection of Wall Street and Main Street

The Third Way has produced a document that purports to explain the importance of capital markets. The importance of these markets lies in the link between the Streets: Wall and Main. The purpose of this post is to provide a competitive but much shorter essay on this important topic. In a nutshell, firms need injections of funds for various purposes: to build plant and buy equipment, to undertake research and development (R&D) as well as marketing campaigns, and so on. At the same time, individuals with funds need a way to place those funds . . . to put those funds to work.

Investors

The individuals who are called investors hope to make a return from placing their funds with firms. They place their funds through intermediaries such as a retirement fund or a mutual fund and of course brokers who all inhabit Wall Street. The individuals either buy equities or bonds (or derivative securities which we will explore later). An equity position represents ownership in the firm. A bond is a debt that the firm has. Equities and bonds have different rights to or claims on the income and the assets of the firm. In the first place, a bond has a claim on a stream of interest payments that are usually well-defined as well as a principal payment or payments. If the firm fails, the bond represents a claim on whatever remains of the firm’s assets that is of higher priority than the claims of the owners. In contrast, the owners have a claim on the residual income or what is left over after paying the bond holders and the other creditors. As a result, it is often thought that the equity holders hold riskier positions than bondholders and therefore receive a greater expected return called the equity premium. One contrary thought is that the bond holders often face greater inflation risk or interest rate risk. That is, when inflation increases and interest rates rise, the value of most bonds decline. This kind of risk requires compensation too.

Firms

The firms called corporations sell equities, called stock or shares, through IPOs (Initial Public Offerings) or Seasoned Offerings. Firms buy equities by entering the market and simply buying their own equities back. Similarly, firms may sell bonds or float a bond issue and they may enter the bond market to buy their own bonds back. Just as individuals employ specialist intermediaries to operate in the market for firm ownership and debt, firms also use intermediaries such as investment bankers who also inhabit Wall Street.

Wall Street

Wall Street is the place where the people who live on Main Street and the firms that produce on Main Street meet, through their intermediaries, to do some very important things. They decide together in markets just how much of a firm will be represented by equity and how much will be debt. They also decide together what the prices are. That is, interest rates for bonds are determined in this marketplace. Dividend policies are set in this environment too, where dividends are the periodic payments to the owners of the firm.

Markets for Existing Bonds and Stocks

One might ask, “Why do we need a market for stocks or bonds that are already created?” Well, you can’t just leave the investors high and dry, can you? As time passes, investors will want to change their portfolios because of changes in their lives and because of expectations about changes in the lives of the firms in which they invest. This need gives rise to markets in which existing stocks and bonds are bought and sold, or “traded.”

The Meaning of Prices

The prices of stocks and bonds that emerge in these markets reflect the investors expectations for these firms as well as their expectations for the general economic environment. More specifically, the market for existing stocks produces prices based on their dividends now and their growth or prospects for dividends in the future. Stock prices are enhanced by good news regarding the prospects for a firm such as a new market opening up for their products. Stock prices are suppressed by bad news such as an increase in corporate income taxes, with the US having the highest corporate tax rates in the developed world. Investors are continually looking out for stocks whose prices do not embody all the relevant information. Of course, if they find such a stock, their buying and selling efforts should eliminate the problem of under or over pricing.

Stock prices, in turn, become signals for firms. For example, if the price of a firm’s stock is rising, the managers are likely to conclude that they might well expand, because they can easily finance the expansion through the sale of more stock. The causation could well go the other way, however. That is, the price of the stock may be rising because of coherent expansion plans that the management has projected. Similarly, a reduction in interest rates might suggest to management that they may want to emphasize debt financing over stock offerings. The bottom line is that the prices that one observes on Wall Street have consequences for the people and firms on Main Street.

There are a number of financial instruments that are based on debt and equity instruments. Futures markets allow people to take positions that can potentially protect their portfolios from losses. Alternatively, futures provide a way to speculate about price movements up or down. Derivative securities allow financial engineers to deconstruct rather mundane collections of securities, like mortgages, into parts that behave rather differently than the original securities, like different risk groupings or tranches. These new derivative securities are extremely useful. For example, they provided a mechanism for the country to work out from under the effects of the S&L crisis. Those same derivatives have been incorrectly blamed for the implosion of real estate finance in 2008. Instead, the problem lay with the incredibly poor quality of the underlying mortgages, especially the high loan to value ratios.

Wall Street and Main Street Divergence

So far, it sounds like Wall Street and Main Street are joined at the hip: if firms’ profits increase on Main Street, their stock prices increase proportionately on Wall Street and vice versa. But is this true? In fact, it is not necessarily true. For example, if something in the economic environment changes to lower the rate of return, then people will have to pay more for stocks to get a given income from stocks. So what could lower the rate of return in the economy? Well, an increase in corporate taxes could do this. What happens then? Holding corporate income constant, stock price . . . curiously . . . might rise. This point may very well address current market activities. That is, the current stock market highs could be a symptom of bad news on Main Street. People in this country, and in other countries, are casting about trying to find reasonable investments. In doing so, they are bidding up the prices on Wall Street without affecting the incomes of corporate entities. They are lowering the rate of return.