BUFN722-ch04.ppt

BUFN722- Financial Institutions ch4 - 1

BUFN 722

ch-4

Securities Firms &

Investment Banks


Overview

• In this segment ... Securities Firms and Investment Banks:Activities of securities firms and investment

banksSize, structure and compositionBalance sheets and recent trendsRegulation of securities firms and investment

banksGlobal issues


Services Offered by Securities Firms versus Investment Banks

• Investment Banksraise the debt and equity securities for corporations or

governments including the origination, underwriting, and placement of securities in money and capital markets

• Securities Firmsservices 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 banksadvise corporations on mergers and acquisitions as well as

advising on the restructuring of existing corporations

• Investment Banksraise the debt and equity securities for corporations or

governments including the origination, underwriting, and placement of securities in money and capital markets

• Securities Firmsservices 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 banksadvise corporations on mergers and acquisitions as well as

advising on the restructuring of existing corporations


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 2000Decline in 2001


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:commissionsfee incomeBid/ask spreadprincipal activities


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)


The Largest M&A Transactions

Deal Price (billions) Year

Citicorp/Travelers $83.0 1998

Chase/J.P. Morgan 35.0 2000

CSFB/DLJ 12.0 2000

Dean Witter/MorganStanley

11.5 2000

Travelers/Solomon 10.2 1997


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


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


Top U.S.Underwriters, 2000

Manager Amount(Billions)

Market Share

Merrill Lynch $289.9 14.8%

SSB 251.7 12.9

CSFB 211.1 10.8

J.P. Morgan 207.2 10.6

Morgan Stanley 194.7 9.9


Key ActivitiesInvestingInvestment banking

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

• Private Placements – rule 144A• Securitization

Market makingTrading

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

Cash ManagementAssisting with Mergers and AcquisitionsBack Office & Other Service Functions


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

• 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


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 offeringsPrivate placement - securities issue placed with one of a

few large institutional investorsPublic placement - may be underwritten on a best

efforts or firm commitment basis and offered to the public

• 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 offeringsPrivate placement - securities issue placed with one of a

few large institutional investorsPublic placement - may be underwritten on a best

efforts or firm commitment basis and offered to the public


Market Making

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

• Either agency or principal transactionsAgency transactions - two-way transactions on behalf

of customersPrincipal transactions - the market maker seeks to profit

on the price movements of securities and takes long or short inventory positions for its own account

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

• Either agency or principal transactionsAgency transactions - two-way transactions on behalf

of customersPrincipal transactions - the market maker seeks to profit

on the price movements of securities and takes long or short inventory positions for its own account


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

• 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


Cash Management

• Securities firms and investment banks offer bank deposit-like cash management accounts (CMAs) to individual investorsmoney market mutual fund sold by investment

banks that offer check-writing privileges

• Securities firms and investment banks offer bank deposit-like cash management accounts (CMAs) to individual investorsmoney market mutual fund sold by investment

banks that offer check-writing privileges


Mergers and Acquisitions

• Frequently provide advice on, and assistance in, mergers and acquisitionsassist in finding merger partnersunderwrite any new securitiesassess the value of target firmsrecommend terms of the merger agreementassist target firms in preventing a merger

• Frequently provide advice on, and assistance in, mergers and acquisitionsassist in finding merger partnersunderwrite any new securitiesassess the value of target firmsrecommend terms of the merger agreementassist target firms in preventing a merger


Other Service Functions

• Custody and escrow services

• Clearance and settlement services

• Research and advisory services

• Custody and escrow services

• Clearance and settlement services

• Research and advisory services


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.


Trends (continued)

• Increases in holdings of fixed-income tradinggreater interest rate and sovereign risk exposure

• Pretax profits soared to $21.0 billion in 2000curtailed 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.


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


Balance Sheet Assets

Assets

Cash $ 27,780.4 1.26%Receivable from other broker-dealers 766,399.7 34.72Receivable from customers 135,723.3 6.15Receivables from noncustomers 19,296.1 0.87Long positions in securities/commodities 514,949.9 23.33Securities and investments not marketed 8,833.8 0.40Securities purchased w/resell agreement 647,360.8 29.33Exchange membership 933.0 0.04Other assets 85,964.0 3.90Total assets $2,111,191.2 100.00

Assets

Cash $ 27,780.4 1.26%Receivable from other broker-dealers 766,399.7 34.72Receivable from customers 135,723.3 6.15Receivables from noncustomers 19,296.1 0.87Long positions in securities/commodities 514,949.9 23.33Securities and investments not marketed 8,833.8 0.40Securities purchased w/resell agreement 647,360.8 29.33Exchange membership 933.0 0.04Other assets 85,964.0 3.90Total assets $2,111,191.2 100.00


Balance Sheet Liabilities

LiabilitiesBank loans payable $ 47,363.2 2.15%Payables to other broker-dealers 361,774.7 16.39Payables to noncustomers 39,604.9 1.79Payables to customers 239,797.3 10.86Short positions in securities/commodities 263,219.8 11.93Securities sold w/repurchase agreements 933,214.3 42.28Other nonsubordinated liabilities 170,715.5 7.73Subordinated liabilities 55,501.5 2.52Total liabilities $2,111,191.2 95.65

CapitalEquity capital 96,049.8 4.35Number of firms 7,785

LiabilitiesBank loans payable $ 47,363.2 2.15%Payables to other broker-dealers 361,774.7 16.39Payables to noncustomers 39,604.9 1.79Payables to customers 239,797.3 10.86Short positions in securities/commodities 263,219.8 11.93Securities sold w/repurchase agreements 933,214.3 42.28Other nonsubordinated liabilities 170,715.5 7.73Subordinated liabilities 55,501.5 2.52Total liabilities $2,111,191.2 95.65

CapitalEquity capital 96,049.8 4.35Number of firms 7,785


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.


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 banksVulnerability of the financial systemIssue of timely settlement


Global Issues

• Growth in securities trading and underwriting is a global event

• Other countries were not encumbered by regulations such as Glass-Steagall ActForeign banks operating in the U.S. compete

with U.S. commercial and investment banks

ch4 - 27

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 transactionsCreated more business for large securities firms

• International stock offerings– Increased liquidity for issuing firm, avoiding downward price

pressureGrowth in Latin America

• Increased business due to NAFTAGrowth in Japan

• Some barriers to foreign securities firms still exist


• 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 of interest 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.

•


• 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.


• 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.


• III. Investment Banking Structure

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”.


B. Investment Management Activity• 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.


• 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.

ch4 - 34

Valuation of a Securities Firm

Value of a securities firm depends on its expected cash flows and required rate of returnV = f [ E(CF), k]

V = Change in value of the institution

k = Change in required rate or return

Where:

E(CF) = Change in expected cash flows

+Factors that affect cash flowsE(CF)= f (ECON, Rf , INDUS, MANAB)

+ – ? +

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

k = f(Rf , RP)+ +


Interaction With Other Financial Institutions

• 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 1999Commercial banks, securities firms, and insurance

companies will increasingly offer similar services


Pertinent Websites

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

http://www.federalreserve.gov/

http://www.nasd.com/

http://www.nyse.com/

http://www.sec.gov/

http://www.sia.com/

http://www.sipc.org/

http://www.thebanker.com/

http://www.tfsd.com/

BUFN722-ch04.ppt

Documents

trading of securities

activities of securities

placement of securities

regional securities

inventory of securities

price movements of securities

investment banking firms

equity securities industry