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BUFN 722. ch-4 Securities Firms & Investment Banks. Overview . In this segment ... Securities Firms and Investment Banks: Activities of securities firms and investment banks Size, structure and composition Balance sheets and recent trends

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BUFN 722

ch-4

Securities Firms &

Investment Banks

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Overview

  • In this segment ... Securities Firms and Investment Banks:

    • Activities of securities firms and investment banks

    • Size, structure and composition

    • Balance sheets and recent trends

    • Regulation of securities firms and investment banks

    • Global issues

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Services Offered by Securities Firms versus Investment Banks

  • Investment Banks

    • raise the debt and equity securities for corporations or governments including the origination, underwriting, and placement of securities in money and capital markets

  • Securities Firms

    • services involve assistance in the trading of securities in the secondary markets (brokerage services or market making)

  • The largest companies in the industry perform multiple services (e.g., underwriting and brokerage) and are generally called investment banks

    • advise corporations on mergers and acquisitions as well as advising on the restructuring of existing corporations

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Securities Firms and Investment Banks

  • Nature of business:

    • Underwrite securities.

    • Market making.

    • Advising (example: M&A, restructurings).

  • Growth in mergers and acquisitions:

    • Less than $200 billion in 1990.

    • $1.83 trillion in 2000

    • Decline in 2001

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Investment Banking Firms

  • highly leveraged - use very little own capital

    • borrow short term to finance inventory of securities - repurchase agreements - use securities as collateral to finance portfolio

  • revenue generated from:

    • commissions

    • fee income

    • Bid/ask spread

    • principal activities

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underwriting (“u/w”) securities

  • primary market - direct placement of sec. IPO

  • advise issuer on terms & timing of offering- may design structure desirable to investors

  • buy securities from issuer &

  • distribute issue to public firm commitment vs. best efforts

  • fee = gross spread or underwriter discount = difference between price paid to issuer & price at which re-offers securities to public

  • syndicate - to share the capital risk of u/w

  • selling group = syndicate + other firms

    • they buy securities at concession price (price < the reoffering price)

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The Largest M&A Transactions

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Size, Structure and Composition

  • Dramatic increase in number of firms from 1980 to 1987. Decline of 24% following the 1987 crash, to 2000.

  • 1987: Salomon Brothers held $3.21 billion in capital.

  • 2000: Merrill Lynch held capital of $19.3 billion.

  • Many recent inter-industry mergers (i.e., insurance companies and investment banks).

    • Role of Financial Services Modernization Act, 1999

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Types and Relative Sizes of Firms

  • National full-line firms are largest. (e.g., Merrill Lynch)

  • National full-line firms specializing in corporate finance are second in size. (e.g., Goldman Sachs)

  • Remainder of industry:

    • Specialized investment subsidiaries of BHCs.

    • Discount brokers.

    • Regional securities firms (subdivided into large, medium and small).

    • Specialized electronic trading securities firms

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Top U.S.Underwriters, 2000

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Key Activities

  • Investing

  • Investment banking

    • Activities related to underwriting and distributing new issues of debt and equity.

    • Private Placements – rule 144A

    • Securitization

  • Market making

  • Trading

    • Position trading, pure arbitrage, risk arbitrage, program trading

  • Cash Management

  • Assisting with Mergers and Acquisitions

  • Back Office & Other Service Functions

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Investing

  • Involves managing pools of assets such as mutual funds

  • Compete with commercial banks, life insurance companies, and pension funds

  • Manage funds either as agents for other investors or as principals

  • Objective is to select asset portfolios to beat some return-risk performance benchmark such as the S&P 500

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Investment Banking

  • Refers to activities related to underwriting and distributing new issues of debt and equity securities

  • Industry is dominated by a small number of underwriting firms

  • Securities underwriting can be undertaken through either public or private offerings

    • Private placement - securities issue placed with one of a few large institutional investors

    • Public placement - may be underwritten on a best efforts or firm commitment basis and offered to the public

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Market Making

  • Involves the creation of a secondary market in an asset by a securities firm or investment bank

  • Either agency or principal transactions

    • Agency transactions - two-way transactions on behalf of customers

    • Principal transactions - the market maker seeks to profit on the price movements of securities and takes long or short inventory positions for its own account

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Trading

  • Closely related to market-making activities

  • Six types of trading

    • Position trading - purchases of large blocks on expectation of favorable price move

    • Pure Arbitrage - buying an asset in one market and selling it immediately in another market at a higher price

    • Risk Arbitrage - buying securities in anticipation of some information release

    • Program Trading - simultaneous buying and selling using a computer program to initiate such trades

    • Stock Brokerage - trading of securities on behalf of individuals

    • Electronic Brokerage - offered by major brokers, direct access via internet to trading floor

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Cash Management

  • Securities firms and investment banks offer bank deposit-like cash management accounts(CMAs) to individual investors

    • money market mutual fund sold by investment banks that offer check-writing privileges

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Mergers and Acquisitions

  • Frequently provide advice on, and assistance in, mergers and acquisitions

    • assist in finding merger partners

    • underwrite any new securities

    • assess the value of target firms

    • recommend terms of the merger agreement

    • assist target firms in preventing a merger

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Other Service Functions

  • Custody and escrow services

  • Clearance and settlement services

  • Research and advisory services

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Trends

  • Decline in trading volume and brokerage commissions

    • particularly since crash of 1987, although some recovery since 1992. Record volumes 1995-2000.

  • Decline in underwriting activities over 1987-90.

  • Resurgence in activity and profitability 1991-2000.

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Trends (continued)

  • Increases in holdings of fixed-income trading

    • greater interest rate and sovereign risk exposure

  • Pretax profits soared to $21.0 billion in 2000

    • curtailed by economic slowdown and September 11 attacks

  • 1987: Federal Reserve allowed BHCs to expand securities underwriting.

    • Had been Prohibited since 1933 under Glass-Steagall Act.

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Balance Sheet

  • Key assets:

    • Long positions in securities and commodities.

    • Reverse repurchase agreements.

  • Key liabilities:

    • Repurchase agreements major source of funds.

    • Securities and commodities sold short.

    • Broker call loans from banks

  • Capital levels much lower than levels in banks

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Balance Sheet Assets

Assets

Cash $ 27,780.4 1.26%

Receivable from other broker-dealers 766,399.7 34.72

Receivable from customers 135,723.3 6.15

Receivables from noncustomers 19,296.1 0.87

Long positions in securities/commodities 514,949.9 23.33

Securities and investments not marketed 8,833.8 0.40

Securities purchased w/resell agreement 647,360.8 29.33

Exchange membership 933.0 0.04

Other assets 85,964.03.90

Total assets $2,111,191.2 100.00

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Balance Sheet Liabilities

Liabilities

Bank loans payable $ 47,363.2 2.15%

Payables to other broker-dealers 361,774.7 16.39

Payables to noncustomers 39,604.9 1.79

Payables to customers 239,797.3 10.86

Short positions in securities/commodities 263,219.8 11.93

Securities sold w/repurchase agreements 933,214.3 42.28

Other nonsubordinated liabilities 170,715.5 7.73

Subordinated liabilities 55,501.52.52

Total liabilities $2,111,191.2 95.65

Capital

Equity capital 96,049.8 4.35

Number of firms 7,785

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Regulation

  • Primary regulator: SEC (established 1934)

    • Reiterated by National Securities Markets Improvement Act (NSMIA) of 1996.

    • Prior to NSMIA, regulated by SEC and states.

    • Regulate trading activities such as shelf registration -- allows firms that plan to offer multiple issues of stock over a two-year period to submit one registration statement summarizing the firm’s financing plans for the period

  • Day-to-day trading practices regulated by the NYSE and NASD.

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Investor Protection & Other Monitoring

  • Securities Investors Protection Corporation (SIPC).

    • Protection level of $500,000 against losses due to securities firm’s failure

  • Federal Reserve also has role in overseeing securities firms and investment banks

    • Vulnerability of the financial system

    • Issue of timely settlement

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Global Issues

  • Growth in securities trading and underwriting is a global event

  • Other countries were not encumbered by regulations such as Glass-Steagall Act

    • Foreign banks operating in the U.S. compete with U.S. commercial and investment banks

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Globalization of Securities Firms

  • Securities firms have increased their presence in foreign countries

    • E.g.: Merrill Lynch has more than 500 offices spread across the world

      • Advantages:

        • Allows them to place securities in various markets for corporations or governments

        • International M&A

        • Ability to handle transactions with foreign securities

  • Growth in international securities transactions

    • Created more business for large securities firms

      • International stock offerings

        • Increased liquidity for issuing firm, avoiding downward price pressure

    • Growth in Latin America

      • Increased business due to NAFTA

    • Growth in Japan

      • Some barriers to foreign securities firms still exist


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  • The Investment Banking Industry

  • I. A Brief Historical Perspective

    • Prior to the 1930s, securities underwriting and distribution were performed by both investment and commercial banks.

    • The Great Depression brought allegations that banks had underwritten new securities in order to raise funds which were then paid to them. This was viewed as defrauding the investor in order to shore up the bank’s financial position.

    • The government attempted to rectify this perceived conflict ofinterest with:

      • The Banking Act of 1933 (Glass-Steagall)

      • The Securities Act of 1933

      • The Securities Exchange Act of 1934

    • More recently, it is thought that perhaps these acts may have been overkill.

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  • II. The Investment Banking Function

    • A. Advising Function

      • The investment bank first assesses the clients funding needs. It will then suggest a funding mechanism and structure.

    • B. Administration Function

      • Given a financing strategy, an investment bank then takes on myriad of details associated with a new issue.

      • Administration can range from the tedium of record keeping to navigation thru the morass of regulation.

    • C. Underwriting Function

      • An investment firm undertakes the underwriting function when it agrees to bring an issue to market.

      • Proper setting of the guaranteed price is difficult and is often delayed until the end of the registration period.

      • Over or under-pricing of a security flotation not only can hurt an underwriter’s profitability, it can diminish its reputation.

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  • The underwriter likes the offering to sellout quickly at a price slightly above the guaranteed price. In this way, profits and goodwill are maintained.

  • The investment bank may choose not to be the underwriter. The client’s offering is then said to be distributed on a best-efforts-basis.

  • D. Distribution Function

    • A good investment bank is able to share its risk by the addition of other banks to the underwriting syndicate.

    • The underwriter is able to further reduce its risk by the establishment of a good selling group.

    • Syndicate members are expected to incur the further risk of stabilizing the offering’s price during initial stages.

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    • III. Investment Banking Structure price slightly above the guaranteed price. In this way, profits and goodwill are maintained.

      • A. Boutique vs. Full-Service Banks

        • Firms that limit their activity to a small portion of the securities industry are said to be a boutique.

        • Limitation may range from restriction to underwriting to further specialization in a small subset of the market.Limitation can lead to greater expertise but lessened diversification.To improve diversification, other firms have levered their expertise into activities such as: mergers and acquisitions, asset management, security sales and trading, and merchant banking.But diversification can lead to conflicts of interest between differing areas.Investment banks sometimes segment their business into divisions to address these potential conflicts. These are called “Chinese Walls”.

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    • B. Investment Management Activity price slightly above the guaranteed price. In this way, profits and goodwill are maintained.

      • Private client investment management .

      • Wholesale fund management.

      • Mutual fund investment management.

    • C. Mergers, Acquisitions, and Other Activities

      • Corporate restructuring.

      • Facilitation of acquisition or defensive measures.

    • D. Full Service: Good or Bad?

      • Niche players versus full-service firms.

    • E. The Major Players

      • The largest full-line firms in the U.S. include: Merrill Lynch, Goldman Sachs, Salomon Smith Barney, Morgan Stanley Dean Witter, and Credit Suisse-First Boston.

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    • There are also specialized investment bank subsidiaries such as J.P. Morgan, Chase Manhattan, discount brokers, and regional securities firms.

    • The banks that underwrite the bulk of U.S. corporate securities are collectively known as the “bulge bracket” firms. Exhibits provide various rankings for the underwriting market.

    • Numerous sources also rank firms in various subcategories. Rankings vary by category and over time.

  • F. The Cyclicality Nature of Profits

    • There are many cycles that affect the profitability of financial corporations: interest rates, exchange rates, commodity prices, and equity prices.

    • During high points of the cycle, profits can be astronomical as can losses during low points.

    • Many firms have reduced this cyclicality by diversifying. An additional survival method has been increased capital.

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    Valuation of a Securities Firm as J.P. Morgan, Chase Manhattan, discount brokers, and regional securities firms.

    • Value of a securities firm depends on its expected cash flows and required rate of return

    V = f [ E(CF),  k]

    k= f(Rf , RP)

    +

    +

    • Factors that affect cash flows

    +

    E(CF)= f (ECON, Rf , INDUS, MANAB)

    + – ? +

    Where:

    V= Change in value of the institution

     E(CF) = Change in expected cash flows

     k = Change in required rate or return

    Rf = Risk free interest rate; RP = risk premium

    ECON =Economic growth

    MANAB = The ability of the institution’s management

    INDUS =Prevailing industry conditions for the institution

    E(CF) =Expected cash flow


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    Interaction With Other Financial Institutions as J.P. Morgan, Chase Manhattan, discount brokers, and regional securities firms.

    • Offer investment advice and execute security transactions for financial institutions that maintain security portfolios

    • Compete against financial institutions that have brokerage subsidiaries

    • Glass-Steagall Act of 1933 separated the functions of commercial banks and investment banking firms

    • Financial Services Modernization Act of 1999

      • Commercial banks, securities firms, and insurance companies will increasingly offer similar services

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    Pertinent Websites as J.P. Morgan, Chase Manhattan, discount brokers, and regional securities firms.

    Federal Reserve: www.federalreserve.gov

    NASD: www.nasd.com

    NYSE: www.nyse.com

    SEC: www.sec.gov

    Securities Industry Association: www.sia.com

    SIPC: www.sipc.org

    The Banker: www.thebanker.com

    Thompson Fin. Securities Data: www.tfsd.com

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