Securities Firms & Investment Banks

1. Class 3, Chap 4 Securities Firms & Investment Banks

2. Lecture outline • Securities Firms & Investment Banks • Introduction • Basic definitions • Industry concentration & trends • Types of firms and business lines • Conflicts of interest • Balance sheet trends • Regulation

3. Financial Services Definitions • 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

4. Financial Services Firms • 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

5. Financial Services Firms • Securities Firms: • Firms that specialize in trading i.e. the purchase, sale, brokerage and market making services.

6. Financial Service Firms • Full-Line Firms: • Large investment banks that provide both investment banking and securities services

7. Size and Composition of the Industry

8. Industry Size • 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

9. Industry Composition/Concentration What caused the large growth in the number of securities firms and Investment banks?

10. Industry Composition/Concentration • 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

11. Industry Composition/Concentration What happened in 1987?

12. Industry Composition/Concentration • 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.

13. Industry Composition/Concentration • Aftermath of the crash • Consolidation within and across industries left investment banking and brokerage services concentrated with a small group of small firms.

14. Industry Composition/Concentration

15. Industry Composition/Concentration • 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

16. Industry Composition/Concentration 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 represented a structural shift in the financial industries

17. Industry Composition/Concentration • 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 Bankrupt “Acquired” Acquired Why? Requested and were granted commercial bank holding company status

18. Types of Firms and Business Activities

19. Types of Firms • National Full-Line Firms • Other firms

20. National Full-Line Firms • 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

21. National Full-Line Firms • 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) • Large investment bank (Money Center Banks) • Concentrated in major cities, limited branch networks • Client-base is predominantly intuitional investors • Examples: Lazard ltd; Greenhill & co.

22. Other Firms • The remaining firms in the industry can be split up into 5 categories • Regional securities firms • Often subdivided into small medium and large • Concentrate on servicing firms in a particular region • Special discount brokers • Execute trades for investors • on-line or off-line • Do not offer investment advice

23. Other Firms • Specialized electronic trading securities firms • Provide a platform for customers to trade online without the use of a broker • 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 • 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

24. Business Lines • Investment banks and securities firms engage in at least seven key activities • 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

25. Business Lines • 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

26. Underwriting Underwriting Concentration • The top 5 firms makeup 36% of the total activity • The top 10 firms makeup 60% of the total activity

27. Underwriting types • Private • Public • Best-efforts • Firm Commitment • Government offerings

28. Private Placement • 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

29. Public offerings • 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

30. Public offerings • 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

31. Government offerings • Investment banks acts as the primary dealer for: • Government bonds • Municipal bonds • Asset backed securities

32. 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: • $16.35 per share • $14.75 per share

33. 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: • $16.35 per share • $14.75 per share

34. Best Efforts vs. Firm Commitment Best Efforts: • 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: • 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

35. Business lines • 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

36. Business lines • 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

37. Business lines • Program trading: • buying and selling a portfolio of at least 15 different stocks/bonds valued at more than $1 million using computer programmed transactions • 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

38. Business lines • 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

39. Business lines • 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

40. Conflicts of interest Brokerage Service Soft Dollars Soft Dollars Brokerage expense Commissions Other costs: Research Marketing Administrative Soft Dollars Soft dollars are the fraction of commissions dedicated to pay for these costs

41. Conflicts of interest Investment Bank 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) Transaction fees Commissions Other costs: Research Marketing Administrative

42. Conflicts of interest 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

43. Balance sheet / Profitability

44. Securities industry 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

45. Revenue from broker commissions Commission income as a percent of total revenue What happened to commissions? What do you notice about commissions after 1990?

46. Revenue from broker commissions • 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

47. Profitability after 1990 Securities industry pre-tax profitability What caused the drop in profits Why did profits fall? Where are the increased profits coming from? If commissions are less important then why are profits growing? Really?

48. Profitability after 1990 Securities industry pre-tax profitability Underwriting activity

49. Profitability after 1990 Securities industry pre-tax profitability S&P 500 Index

50. Profitability after 1990 Securities industry pre-tax profitability Underwriting activity