Security Firms (Investment Banks)

1. Security Firms (Investment Banks) 24

2. Commercial vs. investment banks • Commercial banks (e.g. Baker Boyer Bank) provide business and consumer loans. Their funds mostly come from customer deposits. Traditionally, the Fed only made credit available to commercial banks and thrifts. • Investment banks help firms raise capital (debt or equity) in the primary markets and also work as brokers/dealers in the secondary market. Traditionally, funding sources did not include deposits but relied heavily on debt and shareholders. • The Banking Act of 1933 (Glass-Steagall Act) separated commercial from investment banks, (but it did allow commercial banks to underwrite gov’t securities in limited situations). The separation between commercial and investment banking was unique to the U.S. and Japan from 1933 until 1999. • During the 1990s, commercial banks sought permission to do investment banking; and they succeeded with the Financial Services Modernization Act of 1999. • In the financial crisis of 2008-2009, most surviving investment banks converted to bank holding company status, which subjected them to greater regulation, but also gave them access to Federal Reserve discount window, and to TARP money. • Because most major investment banks are now regulated as bank holding companies, they cannot take as many risks as they used to. Consequently, their high profitability and high salaries will be tame compared to the past.

3. Changing Landscape • Traditionally, investment banking promised new MBA grades a six-figure income right out of school. Few careers offered the same lucrative prestige. However, the cost was high stress and very long hours. • The landscape changed within the last decade. Investment banks (especially Merrill Lynch) got a black eye in 2002 for knowingly promoting bad stocks, simply because they were also the underwriters and coveted the underwriting fee. • The biggest black eye came from the 2008-2009 financial crisis, where most elite investment banks either failed or changed their status to bank holding companies. • Today, tens of thousands of jobs in investment banking have been eliminated and salaries have declined substantially. In 2009-2013, for example, average pay for Goldman’s 33k employees fell substantially from pre-crisis levels. Also, cash bonuses were capped. Must be rough. But things are starting to pick up again in 2014.

4. Where have all the investment banks gone? Today, security firms either operate independently or within a conglomerate. (1) Independent Investment Banks – M&A advisors/underwriters not affiliated with commercial banks: e.g. Oppenheimer, Piper Jaffray, Raymond James (2) Investment Banks operated by Financial Conglomerates (illegal in US until 1999): Examples:Bank of America (Merrill Lynch 9/08)Barclays (Barclays Capital, purchased Lehman’s leftover No. American assets 9/08)Citigroup (purchased Salomon Smith Barney in 1999)Credit Suisse (used to be Credit Suisse First Boston)JP Morgan Chase (JP Morgan Securities, purchased Bear Stearns 3/08)UBS AG (originally Union Bank of Switzerland) Recent Activity:Bear Stearns – purchased by JP Morgan 3/08Goldman Sachs – became bank holding co. (9/08) to gain access to Fed creditLehman Bros – N. America sold to Barclays and Asia/Euro to Nomura Holdings (9/08)Merrill Lynch – sold to Bank of America (9/08) to gain access to Fed creditMorgan Stanley – became bank holding co. (9/08) to gain access to Fed credit

5. The Big Ones (Bulge Bracket)

7. The Big Ones (Bulge Bracket)

8. Revenue Sources of Securities Firms

9. Allocation of Revenue Sources • The proportion of income derived from each source varies among securities firms in any particular year • e.g. when IPOs are hot, income from underwriting fees will be high • Some securities firms emphasize investment banking and therefore generate a high proportion of income from underwriting and advising fees • e.g. Goldman Sachs • Some firms emphasize brokerage and generate a higher proportion of income from trading commissions • e.g. Charles Schwab • Many securities firms attempt to diversify their services so that they can capitalize on economies of scope

10. Allocation of Revenue Sources of SFs • Importance of brokerage commissions has declined in recent years • Largest source of revenue has been trading and investment profits (called proprietary trading) • Underwriting and margin interest also make up a significant portion of revenue • Revenue from fees earned on advising and executing acquisitions has increased over time

11. Interaction between Securities Firms and Other Financial Institutions

12. Functions of Securities Firms Facilitating Security Offerings – A securities firm acts as an intermediary between a corporation issuing securities and investors by providing the following services (all covered in Ch. 10): • Origination • Underwriting • Distribution of stock • Advising • Assist with private placement

13. Stock Origination • Origination • Company wanting IPO contacts investment bank • Gets advice on the amount to issue • Helps determine stock price for first-time issues • Investment bank assists with SEC filings • Registration statement • Prospectus—given to prospective investors (often called Red Herring) to disclose relevant data about the firm • Firms have attempted to unethically promote an IPO simply because they also were the underwriter (e.g. Merrill Lynch, student’s dad, a surgeon)

14. Stock Underwriting • Underwriting stock • The lead investment bank usually forms an underwriting syndicate • Other IBFs underwrite a part of the security offering • Helps spread the underwriting risk among investment banks • Best efforts approach is the most common, where the price of the stock is not guaranteed by the investment bank - the corporation bears the risk • Full underwriting approach may be used but is rare (investment bank guarantees price of stock, bears risk) • Often the IPO is underpriced on purpose to provide a big return to insiders and institutional investors

15. Stock Distribution • Distribution of stock • Floatation Costs: (1) underwriting spread & (2) issue costs • 1 - IBF negotiates the underwriting spread (the difference between the net price given the company and the selling price to investors) • 2 - Floatation costs also include issue costs (accounting, legal, printing, registration, etc.) • Floatation costs much higher for stock (5-15%) than bonds (0.5-8%)

16. Floatation Costs

17. Advising • Advising • Investment bank acts as an advisor throughout the process • Most corporations do not have the in-house expertise • Includes advice on: • Timing • Amount • Terms and legal issues • Type of financing

18. New Bond Issues • Origination • IBF may suggest a maximum amount of bonds that should be issued based on firm characteristics • Decisions on coupon rate, maturity • Benchmark with market prices of bonds of similar risk • Credit rating • Bond issuers must register with the SEC • Registration Statement • Prospectus

19. New Bond Issues • Underwriting bonds • Public utilities often use competitive bids to select an IBF. • Corporations typically select an IBF based on reputation and prior working experience • The underwriting spread on bonds is lower than that for stocks • Can place large blocks with institutional investors • Less market risk

20. New Bond Issues • Distribution of bonds • Prospectus • Advertisements to public • Flotation costs are typically in the range of 0.5 percent to 8 percent of face value, much less than for stocks

21. New Bond Issues • Private placement of bonds • ADV: Avoids underwriting and SEC registration expenses • Potential purchaser may buy the entire issue • insurance companies • mutual funds • commercial banks • pension funds • DISADV: Demand may not be as strong as in a public placement, so price may be less, resulting in a higher cost for issuing firm • Investment banks may be involved to provide advice and find potential purchasers

22. Revenue Sources of Securities Firms

23. Restructuring: Leveraged buyouts • Investment banks facilitate LBOs in three ways: • They assess the market value of the LBO firm • They arrange financing (junk bonds usually) • Purchase outstanding stock held by public • Often invest in the deal themselves • Provide advice

24. Restructuring: arbitrage • Arbitrage = purchasing undervalued shares and reselling them at a higher price • Investment banks work with arbitrage firms to search for undervalued firms • Asset stripping • A firm is acquired, and then its individual divisions are sold off (Pepsi, KFC, Taco Bell, Pizza Hut, etc.) • Sum of the parts is greater than the whole (reverse synergy)

25. Restructuring: arbitrage • IBs generate fee income from advising arbitrage firms as well as a commission on the bonds issued to support arbitrage activity • IBs also provide bridge loans • When fund raising is not expected to be complete at the time the acquisition is initiated • IBs provide advice on takeover defense maneuvers • Poison pills, golden parachutes, white knights, etc.

26. Restructuring: arbitrage • History of arbitrage activity • Greenmail is when a target company buys back stock from arbitrage firm at a premium over market price • E.g. Paul Steinberg & Disney, not fair to other owners • Arbitrage activity has been criticized • Results in excessive financial leverage and risk for corporations • Restructuring sometimes results in layoffs • But arbitrage helps remove managerial inefficiencies • And target shareholders can benefit from higher share prices

27. Revenue Sources of Securities Firms

28. Brokerage Services • Full-service versus discount brokerage services • Full-service firms provide investment advice as well as executing transactions • Discount brokerage firms only execute security transactions upon request • Online brokerage firms • Margin accounts

29. Revenue Sources of Securities Firms

30. Proprietary Trading • Securities firms commonly engage in proprietary (or “prop”) trading, in which they use their own funds to make investments for their own account. • They may have an “equity trading desk” that takes positions in equity securities. • They may have a “fixed income desk” that takes speculative positions in bonds and other debt securities. • They may have a “derivatives trading desk” that takes speculative positions in derivative securities.

31. Proprietary Trading Barings Bank • Established in 1763 and one of the most prominent financial institutions in England; financed the Louisiana purchase; where the Queen banked. • In 1995, Nick Leeson, a 28-year-old currency trader at the Singapore branch, circumvented trading restrictions and invested much more money than Barings realized. When he was winning, Leeson was a rock star in the firm. • Due partially to the effect on markets from the Kobe earthquake in Japan, Leeson suffered losses of more than $600 million, which wiped out Barings’ capitaland eventually the bank itself. • Better controls were needed to prevent individual traders from taking excessive risk. http://www.nickleeson.com

32. Proprietary Trading SociétéGénérale • In 2008, SociétéGénérale, a large French bank, incurred $7.2 billion in trading losses due to huge unauthorized trades by JérômeKerviel, one of its employees. • Kerviel’s assignment was to take positions in European stock indexes for the company. • During 2007, he circumvented the company’s computerized controls. His supervisors claim they were unaware of the size of his positions; however, Kerviel claims that they knew what was going on and supported it as long as he made money. JérômeKerviel with one of his lawyers.

33. Proprietary Trading Bear Stearns • In 2008, the Wall Street securities firm Bear Stearns suffered major losses from investing in mortgage-backed securities. • It had relied heavily on borrowed funds (financial leverage) in order to magnify its return on investment. Instead, the leverage magnified its losses. • Once creditors recognized Bear was in trouble, they cut off credit. Bear suffered liquidity problems. It was ultimately saved from bankruptcy by the U.S. government.

34. Proprietary Trading Lehman Brothers • Lehman Brothers also suffered financial problems due to bad investments in mortgage-backed securities and heavy reliance on borrowed funds. • It filed for bankruptcy in September 2008. • Proprietary Trading: An Underlying Cause Taking excessive risks to get big profits caused the problems at these four securities firms

35. Proprietary Trading JP Morgan Chase – 2012 London trader Bruno Iksil, nicknamed London Whale, traded in CDS positions as a supposed hedging activity, but he lost $6.2B instead in what many now call a speculative activity. The Volcker Rule, named after former Fed chair Paul Volcker, part of the Dodd-Frank Act, bans high-risk trading using depositor funds. The huge loss at JPMC hastened the implementation of this rule, which is complicated because of the difficulty of determining what is hedging and what is speculating.

36. Regulation of Securities Firms • Day-to-day trading policies & procedures are regulated by the National Association of Securities Dealers (NASD) and securities exchanges • The SEC regulates the issuance of securities and specifies disclosure rules for issuers • Also provides overall regulation of exchanges and brokerage firms

37. Regulation of Securities Firms • The Federal Reserve determines the credit limits (margin requirements) on securities purchased (initial margin 50%, maintenance margin 25%) • The Securities Investor Protection Corporation (SIPC) offers insurance on brokerage accounts • Insured up to $500,000, including $100,000 cash, for losses from brokers’ fraud (not from investment performance). • Brokers (which must be members) pay premiums to SIPC to maintain the fund • Boosts investor confidence, increasing economic efficiency • See www.sipc.org

38. Regulation of Securities Firms • Financial Services Modernization Act of 1999 • Permitted banking, securities activities, and insurance to be offered by a single firm (Citigroup SSB) • Varied financial services organized as subsidiaries under special holding company • Financial holding companies regulated by the Federal Reserve

39. Regulation • Regulation FD: • Was enacted in October 2000 by the SEC • Requires that firms disclose any significant information simultaneously to all market participants • Was partially intended to prevent a firm from leaking information to analysts • Prevented analysts working for securities firms to have a competitive information advantage • Benefited analysts who relied on their own analysis

40. Analysts Rating Scandal • In 2002-03, firms were unethically promoting an IPO simply because they also were the underwriter (to get the fee) • Analysts provided tainted research that showed IPOs in favorable light even though the researchers were privately saying the IPOs were a POS • e.g. Merrill Lynch ripped off student’s dad, a surgeon • See video “The Sherriff of Wall Street” http://www.cbsnews.com/video/watch/?id=4501767n • Firms and researchers were punished severely for their greed and ethical lapses • SEC has put in place regulations to prevent tainted research from occurring again (see next slide)

41. Regulation Rules regarding analyst compensation and ratings • In 2002, the SEC implemented new rules: • If a securities firm underwrites an IPO, it cannot use its analysts to promote the stock for the first 40 days after the IPO • Analyst compensation cannot be directly aligned with the amount of business that the analyst bring to the securities firm • Analysts cannot be supervised by the investment banking department within the securities firm • An analyst rating must divulge any recent investment banking business provided by the securities firm that assigned the rating

42. Risks of Securities Firms • Market risk • Securities firms’ activities are linked to stock market conditions • When stock prices are rising: • Greater volume of IPOs • Increased secondary market transactions • More mutual fund activity • Securities firms take equity positions which are bolstered when prices rise • When real estate pricing rising, firms invested heavily in mortgages; which they later regretted

43. Risks of Securities Firms • Interest rate risk • Performance of securities firms can be sensitive to interest rate movements because: • Market values of bonds held as investments increase as interest rates fall • Lower rates can encourage investors to withdraw money from banks and invest in stocks • Exchange rate risk • Operations in foreign countries • Investments in securities denominated in foreign currency

44. Illustration of How Level of Equity Affects Return on Equity Default Risk: Obviously, default risk has been proven to exist (e.g. Lehman), which is primarily caused by high leverage and illiquidity. The reasons that firms such as Bear Stearns and Lehman Bros. had such high leverage was that it magnified returns to stockholders.

45. 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 • Allows them to place securities in various markets for corporations or governments • Better assess international M&A • Give advice on foreign securities that their investors should purchase

46. Impact of the Credit Crisis on Securities Firms Summary of Frontline video of “Inside the Meltdown” http://www.pbs.org/wgbh/pages/frontline/meltdown/ • Sub-prime mortgages were originated by institutions who immediately sold them (they were securitized and sold around the world). And then they began to default and home prices tumbled. • Bear Stearns, the 5th largest investment house who was heavily invested in sub-prime mortgages, collapsed in Mar/08, and was bailed out at the last moment by the gov’t and sold to JPMC for fire sale price. • Lehman, 4th largest, was next to fail. Dick Fuld, CEO of Lehman, didn’t want to sell the firm because he didn’t think enough would be paid (he owned a big chunk of it, $1B!). But the stock was being shorted in huge volumes and it eventually collapsed. Fuld thought there’d be a bailout, like at Bear. But there wasn’t. • Lehman’s collapse caused a panic, and a run on ALL the banks occurred, not just Lehman. It even affected firms like GE and GMAC. Everyone knew there’d be a domino effect, but nobody knew what to do. • Credit dried up and panic occurred on Wall St (stock market crashed). Then panic moved to Main St. Firms like McDonalds were not able to get credit to meet payroll. • TARP was hurriedly created by the Bush Administration to inject liquidity and capital into the system and to calm the fears. And it worked!

47. Impact of the Credit Crisis on Securities Firms Bear Stearns • Bear owned two hedge funds that collapsed because of their heavy investment in subprime mortgage securities. In early 2007, Bear’s stock was worth $171. A year later, when its hedge funds collapsed, the stock was worth $2. • Some of the financial institutions that were providing loans to Bear were no longer willing to provide funding because they were doubtful that Bear would be able to repay. • On Thursday, March 13, 2008, Bear Stearns secretly notified the Federal Reserve that it was experiencing liquidity problems and would have to file for bankruptcy the next day if it could not obtain funds.

48. Impact of the Credit Crisis on Securities Firms Bear Stearns • Fed Intervention • On Friday, March 14, 2008, the government arranged for J.P. Morgan Chase (a commercial bank) to buy Bear Stearns for $2/share, with a Fed Res guarantee to cover any losses from Bear’s investments. Due to public outrage, JPMC eventually paid $10/share. • The Fed’s assistance to Bear Stearns offered only limited help to its stockholders, who lost out big time. • Potential Systemic Risk Due to the Bear Stearns Problems • The failure of Bear Stearns could have spread adverse effects throughout financial markets. • Its failure might have frozen or delayed many financial transactions, which could have resulted in a liquidity crisis for many individuals and firms.

49. Impact of the Credit Crisis on Securities Firms Government Assistance to Bear Stearns • Criticism of the Fed’s Assistance to Bear Stearns • Some critics have questioned the Fed’s role in aiding Bear Stearns, since Bear was a securities firm, not a commercial bank. • They suggest that providing assistance to a firm other than a commercial bank should be the responsibility of Congress and not the Fed. • A rescue can cause a moral hazard problem, meaning that financial institutions may pursue high-risk opportunities in order to achieve high returns with the assumption that they will be bailed out if their strategies fail.

50. Impact of the Credit Crisis on Securities Firms Failure of Lehman Brothers • Lehman Brothers specialized in the underwriting of fixed-income securities such as bonds and in asset management for companies and wealthy individuals. • By 2008, it had grown to become the fourth largest securities firm in the United States. • Lehman Brothers was using an accounting method that allowed its capital position to look stronger because capital was measured in proportion to total assets rather than risky assets. Thus, Lehman’s degree of financial leverage was even higher than what was reported on its balance sheet.