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
rage e
xpen
se
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
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