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

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

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

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

Securities Firms: Firms that specialize in trading i.e. the purchase, sale, brokerage and

market making services.

Full-Line Firms: Large investment banks that provide both investment banking and

securities services

Size and Composition of the Industry

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

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

What caused the large growth in the number of securities firms and

Investment banks?

1980 – 1987: Growth in the industry Hint: on May 1, 1975 the SEC eliminated fixed brokerage

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

What happened in 1987?

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.

Aftermath of the crash Consolidation within and across industries left investment banking and

brokerage services concentrated with a small group of small firms.

Acquirer Target Price (billions) Year

Citicorp Travelers (Smith Barney and Salomon) 83.00 1998

JP Morgan bank one 60.00 2004

Bank of America Fleet Boston 49.30 2003

Bank of America Merrill Lynch 47.10 2008

Chase JP Morgan 35.00 2000

Bank of America MBNA 35.00 2005

Wachovia Golden West Financial 25.50 2006

Wachovia Southtrust 14.30 2004

UBS Paine Webber Group 12.00 2000

Credit Suiss First Boston Donaldson Lufkin Jenrette 11.50 2000

Dean Witter Morgan Stanley 10.20 1997

Deutche Bank Bankers Trust 10.10 1998

Region's Financial AmSouth 10.00 2006

CME Group NYMEX Holdings 9.50 2008

Goldman Sachs Spear, Leeds & Kellogg 6.50 2000

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

2008 represented a structural shift in the financial industries

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

2008: the largest 5 investment banks were gone by the end of the year Lehman Brothers – Bear Stearns – Merrill Lynch – Goldman Sachs – Morgan Stanley –

2009: consolidations and bank failures left the number of investment banks and securities firms at 4800

“Acquired”Bankrupt

Acquired

Requested and were granted commercial bank holding company status

Why?

Types of Firms and Business Activities

National Full-Line Firms

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.

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▪ 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

▪ Floor specialists

▪ Companies with large clearing operations

▪ Other firms that do not fit into other categories

off-exchange trading specialist

Floor specialist, acquired by Crown group

Investment banks and securities firms engage in at least seven key activities1. 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

Underwriting Concentration• The top 5 firms makeup 36% of the total activity

• The top 10 firms makeup 60% of the total activity

Private

Public Best-efforts Firm Commitment

Government offerings

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

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

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

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:Less risky for the IB – gets paid a flat feeMore risky for the issuer – uncertain about proceeds of issueLess costly for the issuerLess profitable for the investment bank (limited upside)

Firm Commitment: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 IBMore 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 bid-ask 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

Commissions

Brokerage Service

Other costs:Research Marketing Administrative

Soft dollars are the fraction of commissions dedicated to pay

for these costs

Broke

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Soft Dollars

Soft Dollars

Soft Dollars

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)

Commissions

Transaction fees

Other costs:Research Marketing Administrative

Investment Bank

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

The profitability in the securities industry is highly dependant on economic conditions especially the stock market

Revenue: from two main business activities Investment banking Brokerage services

Expenses: Mainly interest expense

Commission income as a percent of total revenue

What happened to commissions?

What do you notice about commissions after 1990?

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

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

Where are the increased profits coming from?

If commissions are less important then why are profits growing?

Why did profits fall?

Really?

Underwriting activity

Securities industry pre-tax profitability

S&P 500 Index

Securities industry pre-tax profitability

Underwriting activity

Securities industry pre-tax profitability

Securities industry pre-tax profitability

Subprime crisis

Bailout

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

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

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

Congress: Can hold hearings and propose new regulation

Securities exchange act of 1934 Sweeping regulation that regulated financial markets and their

participants in the United States

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

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

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

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

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