Chapter 16 - Securities Firms and Investment Banks
Chapter Sixteen
Securities Firms and Investment Banks
I. Chapter Outline
1. Services Offered by Securities Firms versus Investment Banks: Chapter Overview
. Si!e" Structure" and C#mp#siti#n #f the Industry
$. Securities Firm and Investment Bank %ctivity %reas
a. Investment Bankin&
b. 'enture Capita(
c. )arket )akin&
d. *radin&
e. Cash )ana&ement
f. )er&ers and %c+uisiti#ns
&. Other Service Functi#ns
,. -ecent *rends and Ba(ance Sheets
a. -ecent *rends
b. *he Ba(ance Sheet
.. -e&u(ati#n
6. /(#ba( Issues
II. Learning Goals
1. 0n#w the different types #f securities firms and investment banks.
. 1nderstand the ma2#r activity areas in which securities firms and investment banks
en&a&e.
$. 3ifferentiate am#n& the ma2#r assets and (iabi(ities he(d by securities firms.
,. 0n#w the main re&u(at#rs #f securities firms and investment banks.
III. Chapter in Perspective
Investment bankers assist b#rr#wers in raisin& capita( in debt and e+uity markets and
pr#vide advice ab#ut mer&ers and ac+uisiti#ns" c#rp#rate restructurin& and &enera(
assistance in finance. Bankers a(s# pr#vide many creative #ver the c#unter derivative
pr#ducts. Securities firms pr#vide br#kera&e and market makin& services. *he
investment bankin& and securities industries are c#mp(ementary and many firms pr#vide
a br#ad ran&e #f services. S#me specia(i!ed entities with advanta&es in certain market
niches remain (ess diversified. *he industry underwent tremend#us c#ns#(idati#n in the
(ast decade due t# increasin& sca(e and sc#pe ec#n#mies and the need f#r &reater capita(.
*he face #f the industry was chan&ed f#rever durin& the financia( crisis #f 445-446
with f#rced buy#uts #f )erri((-7ynch and Bear-Stearns" fai(ure #f 7ehman Br#thers and
/#(dman-Sachs and )#r&an Stan(ey bec#min& c#mmercia( banks. 8everthe(ess" w#rkin&
f#r many #f these firms is #ften c#nsidered the penu(timate finance career" with presti&e
and remunerati#n t# match. 9ith industry pr#fits d#wn" firms #n the Street are havin& a
difficu(t time maintainin& their (ar&e sa(aries and b#nuses. % very si&nificant p#rti#n #f
pr#fits are paid #ut in the f#rm #f remunerati#n t# e:ecutives. *he chapter presents an
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Chapter 16 - Securities Firms and Investment Banks
#verview #f the si!e #f the industry and the &enera( strate&ies #f the participants" ma2#r
activities" primary assets and (iabi(ities #n the ba(ance sheet" recent in the news events
c#ncernin& breaches #f ethics and the trend t#ward &(#ba(i!ati#n. *here is s#me #ver(ap
with Chapter 6" *he St#ck )arket.
IV. e! Concepts and "e#initions to Communicate to Students
Br#kers and dea(ers Best eff#rts underwritin&
1nderwritin& Firm c#mmitment #fferin&
3isc#unt br#ker Cash mana&ement acc#unt
;rivate p(acement She(f re&istrati#n
'enture capita( B(#ck #r ;#siti#n *radin&
;ure arbitra&e -isk arbitra&e
;r#&ram tradin& Cash mana&ement acc#unts
)er&ers < %c+uisiti#ns SI;C
Sarbanes-O:(ey =thica( pr#b(ems #n 9a(( Street
*#mbst#ne ad )arket makin&
Fr#nt runnin& ;rice fi:in&
V. $eaching notes
%. Services O##ered &! Securities Firms versus Investment Banks' Chapter
Overvie(
Investment bankin& inv#(ves market ana(ysis" advisin&" securities pricin&" underwritin&"
distributi#n #f new(y created securities and venture capita(. Investment banks #ften
create f#rma( #r inf#rma( syndicates t# assist in sharin& risk and e:pertise. S#me bankers
are str#n&er in distributi#n" such as Bank #f %merica >via f#rmer )erri(( 7ynch?" s#me
are str#n&er in c#rp#rate ne&#tiati#ns" such as )#r&an Stan(ey" and s#me are str#n&er in
certain industries #r in certain aspects #f restructurin&s such as /#(dman Sachs.
C#rp#rate finance activities such as spin-#ffs" divestitures" mer&ers and ac+uisiti#ns"
tender #ffers" and #ther financia( restructurin&s are #ften undertaken with the advice and
assistance #f investment bankers. Securities firms pr#vide br#kera&e" research and
advisin& services and trade securities f#r their #wn acc#unt. Fu(( (ine firms pr#vide b#th
investment bankin& and br#kera&e services. Specia(i!ed firms may c#ncentrate #n firms
in a &iven re&i#n" f#cus #n a tradin& meth#d" such as #ver the Internet" #r specia(i!e in a
particu(ar type #f financin& such as pr#vidin& capita( f#r startups and sma(( firms >venture
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Chapter 16 - Securities Firms and Investment Banks
capita(?.
). Si*e+ Structure and Composition o# the Industr!
*#ta( assets in 414 c#mprised @,.$. tri((i#n. =+uity capita(" the m#re traditi#na(
measure f#r this industry" was @1,.. bi((i#n.
1
*he industry underwent shake#uts in the
1A54s after B)ay 3ayC and a&ain after the 1A65 crash.
*he number #f firms fe(( fr#m
A".1. in 1A65 t# ."46$ in 414. =ver (ar&er firms have a(s# been created via intra and
inter industry mer&ers. *he am#unt #f capita( firms emp(#y has a(s# &r#wn dramatica((y
and pr#bab(y n#w represents a va(id entry barrier.
*he industry can be br#ken d#wn int# three ma2#r subdivisi#ns and a &r#up #f sma((er
specia(i!ed firms:
Commercial &ank holding companies that operate diversi#ied national #ull line
#irms that serve b#th retai( and c#rp#rate cust#mers such as Bank #f %merica and D.;.
)#r&an Chase. *hese firmsE inc#me c#mes primari(y fr#m br#kera&e" (endin&" and
underwritin& and tradin& activities.
,ational #ull line #irms specia(i!in& in c#rp#rate finance such as /#(dman Sachs.
*heir inc#me is primari(y fr#m underwritin&" p(acement" mer&ers and ac+uisiti#ns
#ther c#nsu(tin& services and tradin& inc#me.
Large investment &anks such as 7a!ard 7td and /reenhi(( and C#mpany
Speciali*ed #irms such as
re&i#na( investment bankers >3.%. 3avids#n" -aym#nd Dames?" >s#metimes
(abe(ed F&outi-uesE?
disc#unt br#kers >Schwab?"
Internet br#kers >=-*rade?"
venture capita( firms >8ew =nterprise? <
e:chan&e f(##r specia(ists >7aBranche < C#.?
dea(ers in #ff e:chan&e tradin& >0ni&ht Capita( /r#up?
.. Securities Firm and Investment Bank /ctivit! /reas
a. Investment Banking
Investment bankin& is underwritin& and distributin& new issues #f debt and e+uity. *he
t#p . underwriters are (isted in *e:t *ab(e 16-$. *he t#p firms represented ab#ut $$.6G
#f the t#ta( underwritin& v#(ume. % key fact#r #f success in the investment bankin&
industry is reputati#n and bankers &uard their firmEs name 2ea(#us(y.
*eachin& *ip: One can see the peckin& #rder in the bankin& industry in a tom&stone ad.
*he (ead #r mana&in& underwriter>s?E names wi(( appear at the t#p #f the (ist #f bankers
1
*he si!e #f investment bankin& and securities tradin& is n#t pr#per(y measured by industry assets
because" un(ike (#ans #r insurance p#(icies" investment bankers and securities firms need n#t permanent(y
h#(d securities. *heir purp#se is t# turn them #ver +uick(y. =+uity capita( measures a firmEs abi(ity t#
turn#ver (ar&e issues since firms wi(( #n(y risk (imited am#unts #f their capita( at #ne time. 1nderwritin&
v#(ume is a(s# used t# measure activity.
In )ay #f 1A5. br#kera&e c#mmissi#n rates were dere&u(ated (eadin& t# reduced c#mmissi#n revenue.
7#wer c#mmissi#n revenue trans(ated int# (#wer pr#fitabi(ity and caused a ma2#r industry shake#ut #f
(ess c#mpetitive firms.
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Chapter 16 - Securities Firms and Investment Banks
inv#(ved in the issue. 9here the bankersE name appears in this (ist is very imp#rtant t#
the bankerEs reputati#n.
1.S. c#rp#rate underwritin& activity f#r debt issues is a(m#st a(ways many times (ar&er
than the v#(ume #f e+uity underwritin& th#u&h e+uity dea(s usua((y d#minate the
head(ines. Investment bankin& strate&y e(ements can be discussed with the he(p #f *e:t
*ab(e 16-$ which c#ntains the t#p underwriters f#r different security types. In 414
)#r&an Stan(ey was t#ps f#r I;Os and /#(dman Sachs f#r e+uity" Bank #f %merica f#r
syndicated (#ans and Barc(ays f#r &(#ba( debt. %fter dec(inin& precipit#us(y durin& the
financia( crisis" @6.,. tri((i#n #f debt and e+uity was underwritten in 44A and @,.,1
tri((i#n in the first nine m#nths #f 414. *he (ar&est e+uity dea( #f 414 was /)Es I;O
#f @16"1,4 mi((i#n" f#((#wed by Citi&r#upEs #fferin& #f @14".1..5 mi((i#n.
;(acement meth#ds:
Firm commitment: In a firm c#mmitment the underwriter buys the issue fr#m
the issuer at a set price ca((ed the bid price and then attempts t# se(( the issue t#
the fina( buyers at a s(i&ht(y hi&her am#unt ca((ed the #ffer price. *he banker acts
as a princip(e in this transacti#n and the banker bears the risk #f a fai(ed issue if it
d#es n#t se((. *he banker may n#t raise the #ffer price durin& the #ffer peri#d
#nce it is ann#unced. In this sense the banker has a pr#fit pr#fi(e simi(ar t# a
written put #pti#n with (imited upside &ains and un(imited d#wnside (#ss
p#tentia(. Bankers s(i&ht(y underprice issues and charge #ees t# #ffset the risk #f
underwritin&. % si&nificant am#unt #f pre-se((in& activity #ccurs >the s# ca((ed
Broad sho(C? t# (imit the investment bankerEs risk #f se((in& the issue. %n
e:ce((ent interactive C3--O) #n the mechanics #f &#in& pub(ic >and sec#ndary
market mechanics? is avai(ab(e fr#m 8%S3%H >f#r free? tit(ed Market
Mechanics
SM
which y#u can #rder fr#m academicInasda+.c#m.
Best e##orts: *he investment banker a&rees t# market and distribute the issue and
use their Fbest eff#rtsE t# se(( the issue t# the pub(ic" but the banker d#es n#t buy
the issue #utri&ht and is n#t at risk if buyers d# n#t want the securities #ffered.
Private placements: Issues s#(d t# a few (ar&e primari(y instituti#na( invest#rs
are termed private p(acements and are e:empt fr#m S=C re&istrati#n
re+uirements. ;rivate p(acements can n#w be traded am#n& instituti#na( and hi&h
net w#rth invest#rs.
&. Venture Capital
It can be difficu(t f#r sma(( firms t# #btain sufficient capita( t# &r#w. )any banks are n#t
wi((in& t# (end t# sma(( firms wh# d# n#t have a sufficient rec#rd #f pr#fitabi(ity and may
n#t have sufficient c#((atera(. %n a(ternative s#urce #f financin& is thr#u&h venture
capital >'C? #r angel investors. 'enture capita(ists are typica((y (imited partnership
#r&ani!ati#ns that specia(i!e in financin& and assistin& in the mana&ement #f sma((
startup entities. 'C invest#rs purchase an e+uity stake in the enterprise and usua((y are
active(y inv#(ved in the business mana&ement #f the firm in which they invest. *he 'C
firm wi(( have a we(( defined e:it strate&y and an e:it time(ine. *he e:it strate&y is
usua((y t# take the firm pub(ic #r t# find a buyer f#r the firm" usua((y within 14 years.
'C firms usua((y invest m#ney in sta&es t# (imit their capita( at risk. 'C capita( is n#t
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Chapter 16 - Securities Firms and Investment Banks
unif#rm(y distributed am#n& different industries. % 'C invest#r is (##kin& f#r the Fne:t
bi& ideaE and is #ften c#ncentrated in whatever industry is Fh#tE at the time" #ften in
techn#(#&y and bi#en&ineerin& firms. *he typica( 'C invest#r is (##kin& f#r a 4G t#
$4G annua(i!ed return #n invested capita(.
)any sma(( invest#rs #btain fundin& fr#m an&e( invest#rs. %n&e( invest#rs can ran&e
fr#m wea(thy individua(s wh# are wi((in& t# put up capita( with#ut re+uirin& such a hi&h
return #n investment n#r pr#vidin& active mana&ement t# pr#fessi#na( investment firms
that specia(i!e in sma((er dea(s than 'C firms.
;rivate e+uity >;=? differs fr#m 'C in funds s#urces and in types #f investments. ;=
firms raise funds by se((in& securities rather than c#mmin&(in& private funds as many 'C
firms d#. Sec#nd" ;= firms #ften ac+uire estab(ished e:istin& firms rather than purchase
start ups. 3urin& and after the crisis h#wever there have been fewer pr#misin& startups
s# 'C firms have be&un en&a&in& in ;= type investments.
*he federa( &#vernment pr#vides fundin& thr#u&h the Sma(( Business %dministrati#n
>SB%? t# assist in venture financin&. *he SB% (icenses private(y #r&ani!ed Sma((
Business Investment C#mpanies >SBICs? t# he(p finance entrepreneurs. SBICs can
#btain funds fr#m the *reasury s# they have a c#st advanta&e #ver private 'C firms.
S#me banks #perate 'C firms >#inancial VCs? and s#me c#rp#rati#ns such as Inte(
#perate 'C firms as we((.
c. 0arket 0aking
0arket making is creatin& a sec#ndary market f#r securities #r c#ntracts. *hese inv#(ve
b#th a&ency >&rokerage? and princip(e >dealer? functi#ns. Br#kera&e is typica((y
remunerated with c#mmissi#ns and dea(ers pr#fit fr#m the bid-ask spread. 3ea(ers buy at
the &id >(#w? and se(( at the ask >hi&h?. 3ea(ers incur the risk #f price chan&es #n the
st#ck since they must maintain an invent#ry and bear invent#ry financin& c#sts. On the
8JS=" specia(ists are desi&nated market makers that have an affirmative #b(i&ati#n t#
ensure #n&#in& market li-uidit! and price continuit!. If the ma2#rity #f invest#rs wish
t# se(( the st#ck" the specia(ist is char&ed with buyin& in #rder t# pr#vide market (i+uidity.
In the event #f a (ar&e market m#ve the e:chan&eEs circuit breakers may ha(t tradin&"
re(ievin& specia(ists #f their #b(i&ati#n. In additi#n specia(ists may petiti#n the e:chan&e
t# ha(t tradin& in a &iven security.
*eachin& *ip: *he si!e #f the spread is determined by the securityEs v#(ati(ity" invent#ry
financin& c#sts" the am#unt #f tradin& and c#mpetiti#n between n#n-c#((udin& dea(ers
and re&u(ati#ns. 3ecima(i!ati#n reduced the minimum st#ck spread fr#m ab#ut 6 cents
>1K16? t# 1 cent. *# the e:tent that reduced spreads enc#ura&e m#re tradin& v#(ume"
specia(ists and #ther br#kers c#u(d see an increase in c#mmissi#n revenue. Increased
c#mpetiti#n fr#m =C8s and #ther markets have (ed t# an er#si#n #f specia(ist pr#fits
h#wever.
Investment banks mana&e @66 tri((i#n in derivatives securities in 414. *his is a ma2#r
s#urce #f inc#me f#r banks and why they d#nEt (ike the new restricti#ns in the 3#dd-
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Chapter 16 - Securities Firms and Investment Banks
Frank bi((. 7#sses fr#m subprimes and derivatives were #ver @1 tri((i#n in 44A s# these
are risky investments.
d. $rading
*radin& activities inc(ude:
Position trading: L#(in& a p#siti#n f#r weeks #r m#nths
Pure ar&itrageM arbitra&e is takin& advanta&e #f a mispricin& between tw#
markets by simu(tane#us(y buyin& and se((in& the same c#mm#dity. Sp#t futures
arbitra&e is a c#mm#n e:amp(e.
1isk ar&itrageM takin& advanta&e #f a rea( #r perceived mispricin& based #n s#me
inf#rmati#n the trader p#ssesses with#ut perfect(y c#verin& #r e(iminatin& a(( the
risk.
Program tradingM defined as simu(tane#us buyin& and se((in& #f a p#rtf#(i# #f at
(east 1. different st#cks va(ued at m#re than @1 mi((i#n in t#ta( usin& a c#mputer
pr#&ram t# initiate the trade. S#me f#rms #f pr#&ram tradin& are either pure #r
risk arbitra&e" such as st#ck inde: futures arbitra&e trades. Port#olio insurance is
an#ther f#rm #f pr#&ram tradin&.
Stock &rokerageM pr#cessin& buy and se(( #rders fr#m the pub(ic. )any firms
either buy #r (ease seats #n the 8JS= andK#r are 8%S3%H members.
*eachin& *ip: Full service &rokers #ffer research and advice ab#ut which st#cks t# buy"
discount &rokers pr#cess pub(ic #rders f#r a reduced fee.
=(ectr#nic br#kera&e #ffers invest#rs direct access t# the tradin& f(##r" bypassin&
n#rma( br#kers and #fferin& even (#wer fees than disc#unt br#kers. =:amp(es
inc(ude =-*rade and %meritrade. )#st (ar&e firms n#w #ffer c(ients a ch#ice #f
fu(( service br#kera&e #r reduced c#st e(ectr#nic tradin&.
e. Cash 0anagement
Securities firms have (#n& #ffered acc#unts ca((ed Cash 0anagement /ccounts >C)%s?
that were simi(ar t# bank checkin& acc#unts. %s #f 1AAA securities firms were a((#wed t#
#ffer federa((y insured dep#sits. *hese acc#unts have n#rma((y been checkin& acc#unts
written #n mutua( fund investments. )any #f these acc#unts n#w #ffer %*) and debit
card services. C)%s make it easier and cheaper f#r br#kers t# pr#cess payments f#r
security buy and se(( #rders. 8#te that since the FS)% securities firms can a(s# #ffer
(#ans" credit cards and #ther bankin& type services t# cust#mers and banks can #ffer
traditi#na( br#kera&e services.
#. 0ergers and /c-uisitions 203/4
Investment bankers he(p find mer&er partners" underwrite new securities t# be issued as a
resu(t #f a restructurin& #r ac+uisiti#n" assess the va(ue #f a p#tentia( tar&et" rec#mmend
take#ver terms" #r assist in fi&htin& #ff a h#sti(e take#ver.
1.S. and &(#ba( )<% activity b##med in the (ate 1AA4s and thr#u&h 444 t#ppin& #ut at
@1.6$ tri((i#n in 444" but activity dec(ined substantia((y after that. In 441 1.S. )<%
activity t#ta(ed @61A bi((i#n" d#wn .$G fr#m the pri#r year" and dec(ined a&ain in 44 t#
@,.6 bi((i#n. )<% activity picked up s(i&ht(y in 44$ t# @,6. bi((i#n" but &rew rapid(y
16-6
Chapter 16 - Securities Firms and Investment Banks
a&ain in 44, when the t#ta( va(ue hit @5,6 bi((i#n" (ed by mer&ers #f financia(
instituti#ns. )<% activity in 445 was @1..A tri((i#n. 9hi(e )<% activity brin&s (ar&e
fees t# bankers" this type #f business remains very cyc(ica( and it dec(ined durin& the
financia( crisis. See be(#w:
)<% activity by year
1S /(#ba(
446 @A, bi((i#n @.6. tri((i#n
44A 51$ 1.54
414N ,. 1.6
N First nine m#nths
*eachin& *ip: %cc#rdin& t# a very interestin& piece by )ichae( Densen" B%&ency C#sts
#f Overva(ued =+uity"C ). Densen" Sprin& 44." Financial Management" pp" .-1A" many
if n#t m#st #f the (ar&e number #f ac+uisiti#ns in the (ate 1AA4s destr#yed shareh#(der
va(ue. Le ar&ues that #verpriced e+uity (ed t# t## (#w c#st #f capita( and enc#ura&ed
mana&ers t# en&a&e in p##r investments such as ac+uisiti#ns in #rder t# meet ana(ystsE
earnin&s e:pectati#ns. /iven that a hi&h ;K= rati# predicts rapid earnin&s &r#wth andK#r
(#w risk" t## hi&h a st#ck price then predicts an imp#ssib(y hi&h &r#wth rate >andK#r an
unrea(istica((y (#w (eve( #f risk?. *he mana&er" e:pected t# hit ever &r#win& earnin&s
tar&ets" faces an imp#ssib(e task" because with #verva(ued e+uity mana&ement cann#t
de(iver the e:pected (eve( #f perf#rmance e:cept by chance. Lence firms (##k f#r ways
t# keep the ficti#n #f impr#vin& perf#rmance a(ive" even res#rtin& t# i((e&a( acc#untin&
practices and p##r ac+uisiti#ns. *his is a very interestin& ar&ument. It he(ps e:p(ain why
there have been s# many scanda(s (ate(y. It is n#t that mana&ers sudden(y decided t# F(ie"
cheat and stea(.E *he pressure t# perf#rm has been very hi&h" and br#u&ht ab#ut in part
by t## c(#se a tie between 9a(( Street ana(ysts and c#rp#rate e:ecutives" a c#nf(ict #f
interest. 9ith #verva(ued e+uity" st#ck price si&na(s are fau(ty and cann#t be re(ied up#n
as indicat#rs #f (#n& term va(ue #f the firm. *ryin& t# d# s# when th#se si&na(s are
wr#n& must (ead t# sub#ptima( decisi#ns f#r (#n& term shareh#(der wea(th. Severa( firms
en(isted their pr#fessi#na( c#nsu(tants in acc#untin& and finance t# he(p them find ways
t# hit perf#rmance tar&ets" which #f c#urse c#u(d n#t c#ntinue t# #ccur with#ut s#me
f#rm #f Fcheatin&E such as acc#untin& manipu(ati#ns. *his ar&ument d#es n#t e:cuse
mana&ers. *hey sh#u(d have kn#wn better. 9e have seen a ma2#r breakd#wn #f
c#rp#rate &#vernance at the b#ard (eve(. *## many mana&ers had ethica( fai(ures even
th#u&h they were hi&h(y paid t# act in shareh#(ders interests.
g. Other Service Functions
In additi#n t# the ab#ve functi#ns" investment bankers and securities firms a(s# pr#vide
security cust#dian services" c(earance and sett(ement services" escr#w services" research
and advice #n divestitures and asset sa(es. Fees f#r these services are #ften bund(ed
t#ðer and a((#cated f#r different activities. S#me #f these Fso#t dollarE a((#cati#ns
have c#me under scrutiny as a((e&ed c#nf(icts #f interest have arisen between the
underwritin& and security se((in& functi#ns #f investment bankers >see the ethics
discussi#n be(#w?.
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Chapter 16 - Securities Firms and Investment Banks
5. 1ecent $rends and Balance Sheets
a. 1ecent $rends
%s &#es the st#ck market" s# &#es securities firmsE pr#fitabi(ity. Industry pr#fits are
str#n&(y cyc(ica(. =:tended bu(( markets are &##d f#r pr#fits" emp(#yment and &r#wthM
crashes and d#wnturns hurt tradin& v#(ume and hence c#mmissi#n inc#me >a mainstay #f
revenue at m#st firms?. Fewer firms seek t# issue new e+uity durin& a bear market" and
debt issuance dr#ps #ff as c#vera&e rati#s dec(ine s# underwritin& inc#me is a(s# cyc(ica(.
B#th underwritin& and br#kera&e inc#me rec#vered dramatica((y in the 1AA4s after
dr#ppin& #ff precipit#us(y subse+uent t# the 1A65 crash. ;r#fitabi(ity remained str#n&
with the bu(( market #f the 1AA4s. Industry pr#fits were at a rec#rd hi&h @1 bi((i#n in
444" but fe(( .4G in 441. -eas#ns f#r the pr#fit pr#b(ems inc(uded the weak st#ck
market" the September 11" 441 attacks" the dr#p in )<% activity" and the (#ss #f
c#nfidence by invest#rs due t# the many ethica( vi#(ati#ns by s#me c#rp#rati#ns" bankers
and audit#rs. ;r#fitabi(ity remained p##r in 44 at @6.A bi((i#n" but increased in 44$"
hittin& a rec#rd @.. bi((i#n and remained hi&h at @1A.. bi((i#n in 44, #n (ar&e
increases in underwritin& activity and hefty cuts in interest and #peratin& e:penses. -O=
f#r 44, was 1$.4,G. 3#mestic underwritin& activity was @$"$.6.$ bi((i#n in 446.
;r#fits w#u(d have been up in 44. but interest e:pense #n financin& securities
invent#ries increased as interest rates r#se. Interest e:pense r#se fr#m @,$ bi((i#n in
44$ t# @1$6 bi((i#n in 44. t# a(m#st @16 bi((i#n in 446. ;re-ta: pr#fits fe(( t# @15.6
bi((i#n in 44. but rec#vered t# @$$.1 bi((i#n in 446 due t# additi#na( revenue &r#wth.
*he year 445 was as bad a year f#r these firms as it was f#r m#st #f the financia(
services industry due t# the subprime crisis. 1BS wr#te d#wn @14 bi((i#n #f subprime
re(ated assets in 445. 7ikewise" )#r&an Stan(ey wr#te d#wn @A., bi((i#n" )erri(( 7ynch
wr#te d#wn @. bi((i#n. *w# hed&e funds #f Bear Stearns c#((apsed and went bankrupt
due t# their subprime h#(din&s as we((. *his was the setup t# the Federa( -eserve assisted
bai(#ut #f Bear in )arch 446 where D.;. )#r&an Chase a&reed t# purchase Bear f#r @ a
share #r @$6 mi((i#n.
$
D.;. )#r&an Chase a(s# received &uarantees #n parts #f BearEs
m#rt&a&e p#rtf#(i#.
In 446 the industry rep#rted net (#sses #f @$,.1 bi((i#n as revenues fe(( $6.5G.
=:penses fe(( as we(( particu(ar(y because with the (#wer interest rates" interest e:pense
dec(ined. *radin& and investment acc#unt (#sses f#r the industry were @6. bi((i#n. %s a
resu(t emp(#yment in the industry fe(( fr#m 66A"444 t# 6,4"644. =mp(#yment kept
fa((in& t# 55A"644 in September 44A. ;r#fits reb#unded sharp(y in 44A reachin& a
rec#rd @61., bi((i#n. C#mmissi#ns" fee inc#me and tradin& pr#fits a(( reb#unded and
interest e:pense remained very (#w as the Fed kept interest rates d#wn. Li&h pr#fits
he(ped in rebui(din& capita( and eff#rts t# raise e:terna( e+uity.
&. $he Balance Sheets
Se(ected ma2#r assets inc(ude: >414?
-eceivab(es fr#m #ther br#ker-dea(ers $$.5AG
7#n& p#siti#ns in securities and c#mm#dities 6..,G
-everse repurchase a&reements 6.,4G
$
*he sa(e price was subse+uent(y raised when shareh#(ders c#mp(ained.
16-6
Chapter 16 - Securities Firms and Investment Banks
Se(ected ma2#r (iabi(ities and e+uity inc(ude: >414?
;ayab(es t# #ther br#ker-dea(ers 1,..G
;ayab(es t# cust#mers 1$.$.G
Sh#rt p#siti#ns in securities and c#mm#dities 14.AG
-epurchase a&reements ,4.6G
Other n#nsub#rdinated (iabi(ities A.64G
=+uity ,.A,G
Securities firms finance much #f their securities invent#ry used in market makin& with
rep#s. 8#tice the hi&h (eve(s #f repurchase a&reement (iabi(ities. *his is #ne reas#n why
the Fed reacted +uick(y t# ensure (i+uidity t# securities firms when the rep# market
brief(y ceased functi#nin& #n c#((atera( w#rries durin& the subprime crisis. *hese firms
can h#(d (#wer capita( than banks because they are sub2ect t# (#wer capita( re+uirements
and because their assets are m#re (i+uid than banks. 8everthe(ess" securities firmsE
ba(ance sheets are sub2ect t# hi&h (eve(s #f b#th market and interest rate risk.
8#n-c#mmercia( bank firms in this industry must maintain a minimum G capita( rati#.
*his (eve( is pr#bab(y t## (#w f#r the risks they take. Indeed Bear-Stearns pr#bab(y
fai(ed because #f its e:cessive (evera&e. *hese banks emp(#yed (evera&e rati#s &reater
than $4 t# 1. *his means if the firm (#ses $G #f the va(ue #f their assets" they are
bankrupt. -um#rs #f (ar&e (#sses at Bear in re(ati#n t# their capita( base (ed invest#rs t#
st#p (endin& and f#rced a (i+uidity crisis and a (ack #f c#nfidence that (ed t# the firmEs
demise. D.;. )#r&an Chase purchased the firm f#r @$6 mi((i#n even th#u&h BearEs
#ffices in 8ew J#rk were va(ued at #ver @ bi((i#n.
6. 1egulation
*he Securities Investor Protection Corporation >SI;C? insures (#sses #f funds
dep#sited with securities firms up t# @.44"444 per invest#r in the event #f the fai(ure #f a
securities firm. 7#sses t# security va(ues due t# adverse market m#ves are n#t insured.
*he dai(y activities #f the securities industry are primari(y re&u(ated via the 8ew J#rk
St#ck =:chan&e and the Financia( Industry -e&u(at#ry %uth#rity >FI8-%?. *hus" t# a
(ar&e e:tent these firms are sel#7regulated acc#rdin& t# ru(es pr#mu(&ated by the S=C.
*he Federa( -eserve re&u(ates mar&in re+uirements #n st#cks and #ccasi#na((y su&&ests
ru(es chan&es inv#(vin& securities tradin& and underwritin&. -ecent(y the Fed su&&ested
sh#rtenin& securities sett(ement fr#m the current three days t# #ne day because securities
are #ften used as c#((atera( f#r bank (#ans.
Since the passa&e #f the 8ati#na( Securities )arkets Impr#vement %ct #f 1AA6 rem#ved
state #versi&ht #f securities firms" the S=C has the primary 2urisdicti#n #ver securities
firms and sets standards f#r their activities. *he S=C re&u(ates underwritin& and tradin&
activities and pr#mu(&ates a series #f ru(es such as 1ule %55/ re&u(atin& private
16-A
Chapter 16 - Securities Firms and Investment Banks
p(acements" 1ule 5%6 a((#win& shel# registrations"
,
etc. 1nder -u(e 1,,% security
issuers may av#id the re&istrati#n pr#cess >and the c#nsiderab(e e:pense? if they are s#(d
t# a few +ua(ified buyers. *he buyers are typica((y instituti#na( invest#rs but certain hi&h
net w#rth individua(s can +ua(ify. *hese securities may n#w be re-traded am#n& the
+ua(ified invest#rs but may n#t be s#(d t# the pub(ic.
*eachin& *ip: 'ery few e+uities are private(y issuedM the private market is m#st(y f#r
debt. ;rivate(y p(aced debt issues wi(( have (#wer f(#tati#n c#sts but #ften carry hi&her
interest rates.
In the ear(y 444s certain states be&an t# take a much m#re active r#(e in re&u(ati#ns #f
the markets. F#rmer 8ew J#rk State /enera( %tt#rney Spit!er (ed in this pr#cess. *hese
pr#secuti#ns (ed t# S=C ru(es chan&es t# he(p ensure fewer c#nf(icts #f interests between
ana(ysts and investment bankers and better meth#ds #f a((#catin& I;O shares.
Investment bankers paid (ar&e fines as a resu(t >fines t#ta(ed @1., bi((i#n" see Chapter 6?.
In particu(ar" ana(ysts have been barred fr#m attendin&Kparticipatin& in the Fr#ad sh#wsE
and may n#t receive c#mpensati#n based #n the am#unt #f underwritin& business the firm
&enerates. 9ithin days #f the sett(ement h#wever" Bear Stearns a((e&ed(y vi#(ated the
new ru(es. *e:t *ab(e 16-6 >repr#duced be(#w? c#ntains the firms that were pena(i!ed
and the am#unts they paid.
*e:t *ab(e 16-6 Securities Firm ;ena(ties %ssessed f#r *radin& %buses
Firm ;ena(ty >)i((i#ns @?
Citi&r#up @,44
Credit Suisse First B#st#n 44
)erri(( 7ynch 44
)#r&an Stan(ey 1.
/#(dman Sachs 114
Bear Stearns 64
D.;. )#r&an Chase 64
7ehman Br#s. 64
1BS 9arbur& 64
;iper Daffray $..
)#r&an Stan(ey a((e&ed(y withhe(d emai(s pertinent t# hundreds #f arbitrati#n cases"
fa(se(y c(aimin& the emai( were (#st in the September 11" 441 terr#rist attacks when they
were n#t.
*eachin& *ip:
Interestin&(y" Bear Stearns >and I am sure the rest? had a very e:p(icit c#de #f ethics
re+uirin& emp(#yees t# treat cust#mers fair(y and t# rep#rt a(( ethica( vi#(ati#ns. *he
c#rp#rate cu(ture #n 9a(( Street" inc(udin& c#mpensati#n schemes" needs an #verhau(.
,
*# he(p speed up the pr#cess issuers s#metimes pre-re&ister securities usin& a pr#cedure termed a shel#
registration. %fter the re&istrati#n is appr#ved the issuer may then market the issue at any time within
the subse+uent tw# years after fi(in& a sh#rt f#rm with the S=C that is n#rma((y appr#ved within a day #r
tw#.
16-14
Chapter 16 - Securities Firms and Investment Banks
)#re#ver" these vi#(ati#ns matter. *hey impede &r#wth by raisin& the c#st #f funds t#
every#ne. L#w much va(ue was destr#yed by unethica( behavi#r #f mana&ers at =nr#n"
9#r(dC#m" Lea(thS#uth" *yc#" ;arma(at" etc.O L#w much spi((#ver t# #ther firmsE st#ck
prices #ccurred as a resu(t #f the (#ss #f c#nfidence in mana&ementO 9hat did this d# t#
#ur c#st #f funds" #r re(iance #n f#rei&n funds if y#u prefer. 9hat hasKwi(( this c#st us in
the future in terms #f c#st(y c#ntractin&O %(ready a c(ass acti#n (awsuit a&ainst bankers
that underwr#te 9#r(dC#m debt has resu(ted in payments #f @6 bi((i#n by bankers >with
the (ar&est payment #f @.6. bi((i#n by Citi&r#up?. Citi&r#up a(s# paid @ bi((i#n t# sett(e
a c(ass acti#n suit #ver =nr#n and @5. mi((i#n t# sett(e a simi(ar suit #ver its inv#(vement
with /(#ba( Cr#ssin&. Citi has n#w instituted mandat#ry ethics trainin& f#r a((
emp(#yees.
.
*he (#n& 2ai( sentences that =bbers >9#r(dC#m C=O?" -i&as >%de(phia
C=O?" 3ennis 0#!(#wski and #thers received sh#u(d a(s# he(p deter s#me #f the m#re
e&re&i#us fraud schemes. I be(ieve that at s#me p#int increased sentences may be needed
t# rein in unethica( investment bankin& practices as we((.
*he markets themse(ves have n#t been immune t# scanda(. In 1AA6 the S=C char&ed the
8%S3 >the re&u(at#ry b#dy #f the 8%S3%H st#ck market? with i&n#rin& evidence #f
price fi:in& by 8%S3%H market makers #r dea(ers. *he dea(ers were a((e&ed(y
c#((udin& t# keep bid-ask spreads artificia((y hi&h by refusin& t# +u#te #dd ei&hths and
b(ackba((in& dea(ers wh# did n#t c#mp(y >at that time many st#ck prices traded in
minimum increments #f #ne ei&hth?. *he 8%S3 a&reed t# spend @144 mi((i#n t#
impr#ve ru(es enf#rcement. Subse+uent(y" $4 br#kera&e firms a&reed t# pay @A44 mi((i#n
t# sett(e a civi( suit a((e&in& they en&a&ed in price fi:in& #f 8%S3%H securities.
In 44$ the 8JS= fined a trader #f F(eet Specia(ist Inc @."444 f#r #ront running. Fr#nt
runnin& #ccurs when a specia(ist e:ecutes #rders f#r their #wn acc#unt ahead #f pub(ic
#rders. *he trader s#(d /) st#ck fr#m the specia(istEs #wn acc#unt #n rum#rs #f
acc#untin& pr#b(ems at /) ahead #f a pub(ic se(( #rder.
In Du(y 44" C#n&ress passed the Sar&anes7Oxle! /ct seekin& t# impr#ve c#rp#rate
&#vernance and acc#untin& #versi&ht. *his bi(( created an independent auditin& #versi&ht
b#ard run by the S=C" increased pena(ties f#r c#rp#rate ma(feasance" and &ave
dis&runt(ed shareh#(ders m#re #pti#ns t# pursue (awsuits. *he (aw restricts acc#untin&
firmsE abi(ity t# pr#vide n#n-audit services t# audit c(ients and n# (#n&er a((#w the %IC;%
t# set acc#untin& and auditin& standards. *hese wi(( be set by the ;ub(ic C#mpany
%cc#untin& Oversi&ht B#ard. *he act re+uires that the C=O and CFO prepare and si&n a
statement certifyin& the reas#nab(eness #f the firmEs financia( statements. *he 8JS= and
the 8%S3 have a(s# chan&ed their (istin& re+uirements with respect t# c#rp#rate
&#vernance. 3etai(s may be #btained fr#m their websites >see the (ist #f websites at the
end and in Chapter 6?.
%nti-m#ney (aunderin& activities:
*he 1S% ;atri#t %ct added three new re+uirements t# securities firms as #f Oct#ber
44$. *he new ru(es inc(uded:
1. Firms must verify the identity #f any pers#n seekin& t# #pen an acc#unt.
.
Cit&r#up data fr#m B=venin& 9rap 1p" Citi Sett(es"C )ark C#n&#(#ff" The Wall Street Journal
Online" Dune 14" 44..
16-11
Chapter 16 - Securities Firms and Investment Banks
. Firms must keep rec#rds #f the inf#rmati#n used t# verify the c(ientEs identity.
$. Firm must determine whether the c(ient appears #n any (ists #f kn#wn #r
suspected terr#rists #r terr#rist #r&ani!ati#ns.
*he industry is sub2ect t# C#n&ressi#na( #versi&ht" but this usua((y takes the f#rm #f e:-
p#st investi&ati#ns after pr#b(ems have emer&ed. F#r instance" /#(dman Sachs >/S? was
investi&ated by a c#n&ressi#na( pane( in 414 c#ncernin& /SE creati#n #f m#rt&a&e
backed C3Os which they had sh#rted t# (imit their risk. /S was accused #f kn#win&(y
creatin& and se((in& risky m#rt&a&e investments after they knew they were (ike(y t# be
riskier than the ratin& indicated and put themse(ves in a p#siti#n t# pr#fit fr#m a dec(ine
in the securitiesE va(ues. *his is an #bvi#us c#nf(ict #f interest. 1nder the 3#dd Frank
%ct" the Financia( Services Oversi&ht C#unci( >FSOC? has #versi&ht #f systemic risk #f
the industry. )#re investment advis#rs wi(( have t# be re&istered with either the S=C #r
state advis#rs. Securiti!ati#n markets sh#u(d n#w have m#re #versi&ht and #ri&inat#rs
wi(( have t# retain a &reater interest in (#ans that wi(( be res#(d. )#re derivatives
re&u(ati#n is e:pected as we((. *he &#vernment can a(s# mandate hi&her capita(
re+uirements f#r (ar&er and f#r interc#nnected firms. /#vernment #versi&ht #f industry
practices has increased as a resu(t #f the bi((. =:ecutive c#mpensati#n restricti#ns were
a(s# pr#mu(&ated by the Obama administrati#n which tried t# stren&then the
independence #f the c#mpensati#n c#mmittee fr#m seni#r mana&ement. Shareh#(ders
n#w a(s# have a n#n-bindin& v#te #n e:ecutive c#mpensati#n packa&es and ObamaEs pay
c!ar" 0enneth Feinber&" has a say #n e:ecutive pay f#r firms that accepted bai(#ut m#ney.
*eachin& *ip:
%sk students whether (imits #n e:ecutive pay are appr#priate #r n#t. 9hat w#u(d be the
pr#s and c#nsO *he industry ar&ues that they wi(( be unab(e t# attract t#p ta(ent with#ut
(ar&e perf#rmance type b#nuses. =:ecutive pay w#u(d seem t# be very hi&h h#wever and
it is hi&her than is typica( in much #f the rest #f the w#r(d. )any in the pub(ic w#u(d
ar&ue that e:ecutives in firms that t##k ta:payer d#((ars have n# business receivin& any
perf#rmance b#nuses. %I/ e:ecutives received b#nuses even as the firm was #n the
ver&e #f bankruptcy.
8. Glo&al Issues
Investment bankin& activities are hi&h(y &(#ba(i!ed. F#r instance" the Swiss bank 1BS is
the number #ne underwriter #f &(#ba( I;Os. F#rei&n transacti#ns in 1.S. st#cks increased
fr#m @11. bi((i#n in 1AA1 t# @11"AA4 in 446. *his represents a compound average
annual gro(th rate o# )8.9:. 1.S. transacti#ns in f#rei&n st#cks increased fr#m @1..6
bi((i#n in 1AA1 t# @.",14.AM an annual compound gro(th rate o# over ).:.
Internati#na( #fferin&s have a(s# &r#wn rapid(y" but recent scanda(s" the 1.S. st#ck
market weakness" disc(#sure re+uirements and the dec(ine in the va(ue #f the d#((ar has
pr#bab(y deterred f#rei&n invest#rs and f#rei&n issuers fr#m participatin& in the 1.S.
markets. 1.S. firms are seekin& a &reater presence in fast &r#win& markets such as China
and India. *he financia( crisis has increased the need f#r capita( at banks. )any firms
are n#w en&a&in& in strate&ic a((iances with f#rei&n partners. F#r instance" )#r&an
Stan(ey s#(d a 1G stake #f its firm t# )itsubishi 1FD in 446. Citi&r#up t##k a different
16-1
Chapter 16 - Securities Firms and Investment Banks
tact and s#(d s#me #f its f#rei&n businesses such as 8ikk# %sset )ana&ement and 8ikk#
Citi *rust t# increase capita(. *he industry c#ntinues t# restructure as a resu(t #f the
crisis.
*eachin& *ip: Investment bankers can he(p 1.S. instituti#ns &ain e:p#sure t#
internati#na( markets. Banks have created structured derivative debt pr#ducts that a((#w
an instituti#n t# earn hi&her #verseas interest rates whi(e (imitin& e:chan&e rate risk.
Bankers can a(s# s#metime he(p impr#ve the marketabi(ity #f f#rei&n b#nds that are
difficu(t t# se(( because they are den#minated in a f#rei&n currency. )any 1.S. financia(
instituti#ns are (imited as t# h#w much currency risk they can incur. Bankers have at
times securiti!ed these f#rei&n currency den#minated b#nds by p(acin& them in a trust
and issuin& d#((ar den#minated c(aims t# 1.S. buyers.
6
Led&e funds en&a&e in risk
arbitra&e strate&ies #n a &(#ba( basis. *he m#st fam#us #f these >#r infam#us?" 7#n&
*erm Capita( )ana&ement" en&a&ed in risk arbitra&e #n an unprecedented &(#ba( sca(e.
VI. ;e& Links
http:KKwww.federa(reserve.&#vK 9ebsite #f the B#ard #f /#vern#rs #f the Federa(
-eserve
http:KKwww.ws2.c#mK 9ebsite #f the 9a(( Street D#urna( Interactive
editi#n. *he web versi#n #f the we(( kn#wn
financia( newspaper can be pers#na(i!ed t# meet
y#ur #wn needs. *he 9a(( Street D#urna( On(ine
<Scandal Scorecard= pr#vides readers with a fast
way t# keep track #f the (ar&e number #f scanda(s
and what has happened t# the p(ayers.
http:KKwww.sifma.c#mK *he Securities Industry %ss#ciati#n website.
Industry inf#rmati#n" the SI% Factb##k >#ther than
the current annua( versi#n? and discussi#ns #n key
industry issues may be f#und here.
http:KKwww.sec.&#vK *he Securities =:chan&e C#mmissi#n
http:KKwww.nyt.c#mK *he 8ew J#rk *imes" fr#m time t# times the 8J*
has e:ce((ent artic(es #n financia( t#pics.
http:KKwww.tfibcm.c#mK *h#mps#n -euters website. *his site has the (atest
updates #n 1.S. and &(#ba( underwritin& v#(ume
and )<% activity.
http:KKwww.nyse.c#mK *he website #f the 8JS=" e:chan&e ru(es are
#n(ine.
6
*hese c(aims are usua((y #verc#((atera(i!ed t# he(p (imit e:chan&e rate risk.
16-1$
Chapter 16 - Securities Firms and Investment Banks
http:KKwww.nasda+.c#mK *he 8ati#na( %ss#ciati#n #f Securities 3ea(ers
website.
http:KKwww.sipc.#r&K *he Securities Invest#r ;r#tecti#n C#rp#rati#n
website.
VII. Student Learning /ctivities
1. /# t# the website #f the SI;C and summari!e the answers t# the F5 m#st
asked +uesti#ns ab#ut the SI;C.E
. %t the 8%S3Es website" read the study #ut(ine f#r the Series 5 e:am. 9hat is
the purp#se #f the Series 5 e:amO 9hat are the seven critica( functi#ns #f a re&istered
representativeO
$. /# t# the SIF)% website and read ab#ut the c#mp(e:ity #f the new 3#dd
Frank (aw. L#w many new re&u(ati#ns are pr#p#sedO 9i(( this (aw he(p #r hurt the
industryO 3efend y#ur answer.
16-1,
