Chapter Sixteen

1. Chapter Sixteen Securities Firms and Investment Banks

2. Services Offered by Securities Firms versus Investment Banks • Investment Banks • Service entities who wish to raise funds through sales of debt and equity securities, including corporations or governments; services include originating, underwriting, and placing 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

3. Size, Structure, and Composition of the Industry • Size of the industry is measured by the equity capital of the firms in the industry ($144.5 bn. in 2001) • Three major types of firms • national full-line investment banks that service retail and corporate customers (e.g., Merrill Lynch) • national full-line firms that specialize in corporate finance (e.g., Goldman Sachs) • the remainder of the industry and includes five subclasses • specialized investment bank subsidiaries of commercial banks • specialized discount brokers • regional securities firms • specialized electronic trading securities firms • venture capital firms

4. Securities Firm and Investment Bank Activity Areas • Securities firms and investment banks engage in as many as seven key activity areas • Investing • Investment Banking • Market Making • Trading • Cash Management • Mergers and Acquisitions • Other Service Functions

5. 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

6. 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

7. 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

8. 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 securities on behalf of individuals • Electronic Brokerage - offered by major brokers, direct access via internet to trading floor

9. 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

10. Mergers and Acquisitions • Frequently provide advice on, and assistance in, mergers and acquisitions • assist in finding merger partners • underwrite any new securities • asses the value of target firms • recommend terms of the merger agreement • assist target firms in preventing a merger

11. Other Service Functions • Custody and escrow services • Clearance and settlement services • Research and advisory services

12. Balance Sheet Assets Assets Cash $ 50,982.3 1.51% Receivable from other broker-dealers 1,204,448.8 35.72 Receivable from customers 177,945.9 5.28 Receivables from noncustomers 15,757.7 0.47 Long positions in securities/commodities 838,254.9 24.86 Securities and investments not marketed 10,550.0 0.31 Securities purchased w/resell agreement 856,043.4 25.39 Exchange membership 1,034.2 0.03 Other assets 216,,624.56.43 Total assets $3,371,641.7 100.00

13. Balance Sheet Liabilities Liabilities Bank loans payable $ 76,191.9 2.26% Payables to other broker-dealers 629,858.6 18.68 Payables to noncustomers 59,910.5 1.78 Payables to customers 391,543.1 11.61 Short positions in securities/commodities 409,342.3 12.14 Securities sold w/repurchase agreements 1,282,870.8 38.05 Other nonsubordinated liabilities 302,757.3 9.16 Subordinated liabilities 68,710.42.04 Total liabilities $3,227,184.9 95.72 Capital Equity capital 144,456.7 4.28 Number of firms 7,029

14. Regulation • The primary regulator of the securities industry is the Securities and Exchange Commission (SEC) established in 1934 • SEC sets rules governing securities firms’ underwriting and trading activities • Shelf registration – allows qualifying firms that plan to offer multiple issues of stock over two years to submit one registration statement summarizing the firm’s financing plans for the period • The Securities Investor Protection Corporation (SIPC) protects investors against losses of up to $500,000 on securities firm failures