Transcript Slide 1

Class 3, Chap 4

Securities Firms & Investment Banks

Introduction
 Basic definitions
 Industry concentration & trends

Types of firms and business lines

Conflicts of interest

Balance sheet trends

Regulation
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Investment Banking:
 Raising capital through debt and equity issues which
involves: origination, underwriting and placement of
securities in money and capital markets for corporate
and government issuers
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Securities Firms:
 Involves assisting clients in the trading of securities.
 Brokerage services – take and execute client orders
 Market making – take the offsetting side of a trade
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Investment Banks:
 Firms that specialize in originating, underwriting and distributing new
security issues
 Also investment banks usually have some corporate finance services
▪ Mergers and acquisitions
▪ Advising on Restructuring
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Securities Firms:
 Firms that specialize in trading i.e. the purchase, sale, brokerage and
market making services.
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Full-Line Firms:
 Large investment banks that provide both investment banking and
securities services
Size and Composition of the
Industry
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The size of the industry is usually measured by the equity
capital of firms rather than total asset size
 the largest firm in 1987 had $3.2 billion in total capital
 the largest firm in 2007 had $114.2 billion in total capital
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Why?
Investment banks usually hold a piece of any new issue for a
short period of time during the underwriting process. Therefore
total asset values can vary widely as investment banks sell
vested assets
Number of Securities Firms and Investment Banks
10,000
9,000
8,000
7,000
6,000
5,000
9,515
4,000
3,000
6,016
5,248
4,800
2,000
1,000
0
1980
10/19/1987
What caused the large growth in the
number of securities firms and
Investment banks?
2006
2009
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1980 – 1987: Growth in the industry
 Hint: on May 1, 1975 the SEC eliminated fixed brokerage
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commissions – brokers could set commission on trades
Increased competition among dealers (Charles Schwab)
Decreased the cost of trading
Created a new sector of retail traders
Increased the demand for stock
Increased the number of IPOs
Deficit spending in the 1980 grew the economy
Number of Securities Firms and Investment Banks
10,000
9,000
8,000
7,000
6,000
5,000
9,515
4,000
3,000
6,016
5,248
4,800
2,000
1,000
0
1980
10/19/1987
What happened in 1987?
2006
2009
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Black Monday – October 19, 1987
 News clip
 The crash
▪ Started in Hong Kong and spread to Europe and finally hit the US –
the Dow lost 508 points on the day
 Potential Causes:
▪ program trading, overvaluation, illiquidity, and market psychology.
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Aftermath of the crash
 Consolidation within and across industries left investment banking and
brokerage services concentrated with a small group of small firms.
Acquirer
Citicorp
JP Morgan
Bank of America
Bank of America
Chase
Bank of America
Wachovia
Wachovia
UBS
Credit Suiss First Boston
Dean Witter
Deutche Bank
Region's Financial
CME Group
Goldman Sachs
Target
Travelers (Smith Barney and Salomon)
bank one
Fleet Boston
Merrill Lynch
JP Morgan
MBNA
Golden West Financial
Southtrust
Paine Webber Group
Donaldson Lufkin Jenrette
Morgan Stanley
Bankers Trust
AmSouth
NYMEX Holdings
Spear, Leeds & Kellogg
Price (billions)
83.00
60.00
49.30
47.10
35.00
35.00
25.50
14.30
12.00
11.50
10.20
10.10
10.00
9.50
6.50
Year
1998
2004
2003
2008
2000
2005
2006
2004
2000
2000
1997
1998
2006
2008
2000
Number of Securities Firms and Investment Banks
10000
9000
8000
7000
6000
5000
9515
4000
3000
6016
5248
4800
2000
1000
0
1980
10/19/1987
2006
2009
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What caused the merger wave?
 Financial Services Modernization Act 1999
 Removed barriers between investment banks, commercial
banks, and insurance companies that prohibited any one
company to act as a combination of the three
 The act made it legal for investment banks, commercial
banks and insurance companies to consolidate under a bank
holding company
Number of Securities Firms and Investment Banks
10000
9000
8000
7000
6000
5000
9515
4000
3000
6016
5248
4800
2000
1000
0
1980
10/19/1987
2006
Decline in the number of investment banks and
securities firms is mainly because of the merger
wave but many banks also failed around this time
2009
2008 represented a structural shift
in the financial industries
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2008: the largest 5 investment banks were gone by the end of
the year
 Lehman Brothers – Bankrupt
 Bear Stearns – “Acquired”
Why?
 Merrill Lynch – Acquired
 Goldman Sachs –
 Morgan Stanley –
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Requested and were granted commercial
bank holding company status
2009: consolidations and bank failures left the number of
investment banks and securities firms at 4800
Types of Firms and Business
Activities
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National Full-Line Firms
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Other firms
1. Commercial Bank Holding Companies
▪ Largest of the full line firms
▪ Extensive domestic and international operations
▪ Offer underwriting brokerage and asset management
advising service
▪ Examples:
JP Morgan Chase – through many acquisitions
Morgan Stanley
Bank of America – through its acquisition of Merrill Lynch
2. National Full Line Firms – with corporate specialty
▪ Specialize more in corporate activities with customers
who are highly active in securities trading
▪ Example: Goldman Sachs and Salomon Brothers / Smith
Barney (Investment banking arm of Citigroup)
3. Large investment bank (Money Center Banks)
▪ Concentrated in major cities, limited branch networks
▪ Client-base is predominantly intuitional investors
▪ Examples: Lazard ltd; Greenhill & co.
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The remaining firms in the industry can be split up
into 5 categories
1. Regional securities firms
▪
▪
Often subdivided into small medium and large
Concentrate on servicing firms in a particular region
2. Special discount brokers
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▪
▪
Execute trades for investors
on-line or off-line
Do not offer investment advice
3. Specialized electronic trading securities firms
▪
Provide a platform for customers to trade online
without the use of a broker
4. Venture capital firms
▪
▪
Pool money from individual investors and other FIs
(Hedge Funds, Pension Funds and insurance
companies)
Use the money to finance new small businesses
5. Other firms
▪
▪
▪
▪
Research Boutiques
off-exchange trading specialist
Floor specialists
Companies with large clearing operations
Other firms that do not fit into other categories Floor specialist, acquired by
Crown group
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Investment banks and securities firms engage in at
least seven key activities
1. Investing:
▪ Object – chose some asset allocation to beat some performance
benchmark such as the S&P 500
▪ Managing pools of money such as:
▪ Closed/open ended mutual funds
▪ Pension funds
▪ The firm’s own account
▪ Investment advising generates fees based on the size of the pool
making it a more stable source of income than Investment Banking
2. Investment Banking
▪ Refers to activities related to underwriting and distribution
of corporate securities
▪ Underwriting: the process by which investment banks raise
capital for themselves or their clients by issuing securities
The term refers to the location of signatures on the contract – below
the risk assessment
▪ New issues can be either
▪ Primary – IPO
▪ Secondary – secondary offering, new debt issues
9
Total Debt & Equity Underwriting (Trill)
8
7
6
5
4
7.84
7.51
3
6.45
4.95
2
1
Underwriting Concentration
• The top 5 firms makeup
36% of the total activity
0
2006
2007
2008
2009
• The top 10 firms makeup
60% of the total activity
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Private
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Public
 Best-efforts
 Firm Commitment
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Government offerings
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The investment bank acts as a private placement
agent for a fee
 They shop the securities around to one or more private
parties to try to find one or multiple buyers
 These are usually large institutional investors such as
pension funds or insurance companies
 Private placements are issued under rule 144a of the
securities law – it is called a 144a issue
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Best-Efforts underwriting
 This is an agreement between the issuer and the underwriter
(investment bank)
 The underwriter agrees to sell as much of the offering as
possible at the agreed upon price to investors
 The investment bank is not responsible for any of the
unsold offering but it can purchase the remaining
shares/debt if it chooses to
 Example: Ford offers a $10 million bond issue the
investment bank sells 9.5 mill of the issue. The remaining .5
mill remains unsold or is purchased by the underwriter
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Firm commitment underwriting
 An agreement between the issuer and underwriter
 The underwriter agrees to purchase the issue at the agreed
upon price
 The underwriter then tries to sell the issue to public investors
at a higher price
 The underwriter is responsible for the unsold portion
 Example: Ford offers a $10 million bond issue. The IB
purchases the issue and sells 9.5 million of the issue. The
investment bank is responsible for the remaining .5 million
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Investment banks acts as the primary dealer for:
 Government bonds
 Municipal bonds
 Asset backed securities
An investment bank agrees to underwrite an issue of 20 mill shares of stock for CCL Inc. on a firm
commitment basis. The IB purchases the offering from CCL for $15.50 per share. How much will CCL and
the investment bank make if the shares sell for:
a) $16.35 per share
b) $14.75 per share
An investment bank agrees to underwrite an issue of 20 mill shares of stock for CCL Inc. on a best efforts
basis. The IB charges CCL for $0.375 per share issued. How much will CCL and the investment bank make
if it can sell 18.4 mill of the issue for:
a) $16.35 per share
b) $14.75 per share
Best Efforts:
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Less risky for the IB – gets paid a flat fee
More risky for the issuer – uncertain about proceeds of issue
Less costly for the issuer
Less profitable for the investment bank (limited upside)
Firm Commitment:
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More risky for the IB – profit depends on proceeds from sale (bears the
risk of selling securities in the market)
Less risky for issuer – paid upfront by the IB
More costly for the issuer – IB will likely charge a higher fee
Potentially more profit for the IB
3. Market Making
▪ Market making involves creating a secondary market in
an asset (stock, bond).
▪ The firm agrees to be a dedicated buyer/seller of a
security – they provide liquidity
▪ Example:
▪
▪
▪
▪
A securities firm may have a market maker on the NYSE for IBM
The market maker sets buy and sell prices. They may agree to
buy IBM at $78 per share and immediately sell for $79 per share
The difference between the buy and sell price is called the bidask spread
They also trade on their own accounts
4. Trading
▪ Position trading:
▪ Purchase a large block of securities in anticipation of a favorable
price move
▪ Pure arbitrage:
▪ A strategy to exploit mispricing of an asset across different markets
▪ Buy the under priced asset and immediately sell it in the
overpriced market – no risk!
▪ Risk Arbitrage:
▪ buying a block of securities in anticipation of an information
release such as a merger or interest rate change
▪ Program trading:
▪ buying and selling a portfolio of at least 15 different stocks/bonds
valued at more than $1 million using computer programmed
transactions
5. Cash Management:
▪ Cash management accounts (CMA) allows customers to write
checks against some type of mutual fund account – covered by
FDIC insurance if issued by commercial banks or thrifts
▪ Makes it easier for brokers to buy/sell securities – the account is
debited for purchases and credited for sales
6. Mergers & Acquisitions:
▪ Assist in finding merger partners
▪ Underwriting new securities
▪ Assessing the value of the target firm
▪ Recommend terms for the merger agreement
▪ Help target firms prevent a merger – poison pill
7. Back office and other service functions
▪ Custody and escrow services
▪ Clearance and settlement
▪ Research and advising
▪ Small business loans – new
▪ These are fee-based services
Soft Dollars
Soft Dollars
Brokerage
Service
Commissions
Soft Dollars
Other costs:
Research
Marketing
Administrative
Soft dollars are the fraction of
commissions dedicated to pay
for these costs
Investment Bank
Soft Dollars
Commissions
Transaction
fees
Other costs:
Research
Marketing
Administrative
Conflict
 Banks are allowed to set commissions that include fees for services they
purchase from themselves
 Soft dollars began to include all types of expenses computers, bribes to tipsters
from other investment firms (WSJ: Insider Case Has Soft-Dollar Focus)
Analyst Recommendations:
 Investment banks provide research but also compete for corporate
finance business – underwriting.
 In the 2000’s corrective action was taken against several investment
banks for biasing analysts recommendations to boost their underwriting
business
Washington Post - Aug 1, 2001
Analysts Sold Stock They Pushed, SEC Says; Profits Ranged Up to $3.5
Million, Agency Finds in Probe for Conflicts
Balance sheet / Profitability
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The profitability in the securities industry is highly dependant
on economic conditions especially the stock market
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Revenue: from two main business activities
 Investment banking
 Brokerage services
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Expenses:
 Mainly interest expense
Commission income as a percent of total revenue
What happened to
commissions?
What do you notice about
commissions after 1990?
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Pre-1990:
 Fixed brokerage fees were eliminated in 1975 (investors
would pay the same price for any size trade at any financial
institution)
 Competition (mainly from Charles Schwab) drove the
brokerage fees down
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Post-1990
 Brokerage fees are no longer a large source of revenue for
the securities industry
Securities industry pre-tax profitability
What caused the
drop in profits
If commissions are less important
then why are profits growing?
Why did profits
fall?
Where are the increased
profits coming from?
Really?
Securities industry pre-tax profitability
Underwriting activity
3500
3000
2500
2000
1500
1000
500
0
Securities industry pre-tax profitability
S&P 500 Index
1600
1400
1200
1000
800
600
400
200
0
Securities industry pre-tax profitability
Underwriting activity
3500
3000
2500
2000
1500
1000
500
0
Securities industry pre-tax profitability
Bailout
Subprime
crisis
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Pre-1990: profits suffered from lower commissions and a decrease in IPO
activity
1990 – 2000: profits driven by increased underwriting (IPOs and debt)
internet bubble fuelled demand for IPOs
2000-2002: slowing economy along with terrorist attacks caused profits to
fall
2002 – 2006: increased underwriting and low interest rates increased
profits in the securities industry
2006-2008: profits plummeted due to the subprime crisis
2009: tax payer bailouts increased profits to an all-time high
Profits are highly dependant on economic conditions, IPO and
M&A activity as well as investor confidence
Regulation
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Securities and exchange commission (SEC)
 Administration of securities law
 Review and evaluation of new security offerings – through the
registration process
 Review and evaluation of semiannual reports
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Financial Industry Regulatory Authority (FINRA)
 Involved in day-to-day regulation and trading practices – monitor:
▪ Trading abuses – insider trading
▪ Trading rule violations
▪ Securities firms capital positions
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Congress:
 Can hold hearings and propose new regulation
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Securities exchange act of 1934
 Sweeping regulation that regulated financial markets and their
participants in the United States
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National Securities Market Improvement Act (1996)
 States were no longer allowed to require federally registered securities
firms to register at the state level
 Gave the SEC exclusive regulatory jurisdiction over securities firms
 However, states could still bring suit in civil court
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Sarbanes-Oxley (SOX) (2001)
 In response to the accounting scandals (Enron Worldcom) SOX:
▪
▪
▪
▪
Created an independent auditing oversight board under the SEC
Increased penalties for corporate wrongdoers
Forced faster and more extensive financial disclosure
Created avenues of recourse for share holders
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2010 Financial Services and regulatory overhaul bill
 Created the financial services oversight council – identify systemic risk
 Gave new authority to the Federal Reserve to supervise firms that pose
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a systemic threat to financial stability
Imposed stronger capital and other prudential standards
Called for stronger regulation on securities markets and credit rating
agencies
Required issuers and originators to retain a financial interest in
securitized loans
Regulation of OTC derivatives
New authority to the Federal Reserve to oversee payment, clearing, and
settlement systems
Gave special power to the government to resolve non-bank FIs whose
failure could have serious systemic effects
Revised federal reserve emergency lending to improve accountability
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The Patriot Act
 Firms must identify individuals seeking to open accounts
 Firms must keep records of the information used to identify individuals
identity
 Must verify that the name of an individual opening an account does not
appear on a list of known or suspected terrorists

Securities Firms & Investment Banks

Introduction
 Basic definitions
 Industry concentration & trends

Types of firms and business lines
 Best efforts vs. firm commitment underwriting

Conflicts of interest

Balance sheet trends

Regulation