Investment Banking services pertain to the origination, underwriting, and placement of securities in financial markets for government and corporate issuers. In addition these firms offer advisory services in areas such as mergers and acquisitions and corporate finance. Securities Services on the other hand relate to trading of securities in the secondary markets. In some cases, full service firms do both investment banking and securities trading. We call the firms that focus on investment banking only or both Investment Banking and Securities-Trading as Investment Banks. If they focus only on securities trading then we call them Securities Companies or Firms. Many Investment Banks and Securities Companies have retail outlets where the public can walk in, open accounts, get advice, place trades etc... Others deal directly with fund managers, other investment banks and securities companies, and corporations and don’t generally have a retail presence. With the acquisition of Merrill Lynch by Bank of America, the collapse of Lehman Brothers and Bear Sterns, the application by Morgan Stanley for a commercial banking license really leaves Goldman Sachs as one of the few true investment banks. This is largely due to the recent crisis which put into question investment banks' abilities to fund themselves in difficult market conditions which we will discuss later. Origination/Underwriting of Securities Let's start then by understanding the different functions of the two areas of investment banking and securities trading. Origination is a primary function of investment banks and helps distinguish them from commercial banks. Investment banks go out and find companies that want to sell directly securities to the general public. By securities, we basically mean stocks and bonds. Therefore, when Investment Banks originate stock or bonds for companies, they are actually creating new investment securities. For example, if a large family held business decides after years of growing the business that they either want to get out of the business or want to bring in investors with new capital to grow the company faster, then they use investment banks to help them sell their stock to the market which we refer to the Primary Market as opposed to the Secondary Market to be discussed later. The investment bank they choose needs to be very knowledgeable about the industry in which the company operates. The bank will work with company management - may even hire consultants and accountants to put together a prospectus in order to launch the company's stock. Remember the company typically only has private financial statements that were prepared on a GAAP basis which it will provide to its banks. There has been no scrutiny by the market - it has not been required to publish results or respond to the general public about the business (so no competitive comparisons). Therefore, they are basically an unknown entity. It is, therefore, key to both the company and the investors that the investment bank assess the true value of the company. If the investment banks description of the company overstates the value of the company then the investors will over pay and the private owners will get more money than they should. If on the other hand, the investment bank undervalues the company then the private owners will be cheated out of value. Obviously, it is difficult to get the valuation absolutely correct. So which way do you think the investment banks err? If you said on the side of the investor, you are right since if they err on the side of the owners they along with the owners risk being sued for fraud. Remember the owners are ultimately responsible for getting all the pertinent information to the investment bank so as to allow the investment bank to get the valuation right. I gave an example of stock which we actually call an IPO or an initial public offering. The Investment Bank can do the same with bonds i.e. issue bonds publicly where no bonds had previously existed. The company probably relied on bank financing prior to issuing the bonds. Therefore, the commercial bank, with its highly trained credit analysts, will have done all the loan analysis and made all of the risk assessments on the company. Given that is their line of business one would expect them to be good at it and know all the right questions to ask and insist on having all the complete information necessary to make their lending decision. Not surprisingly, the investment bank is there to again flush out all the relevant information and explain all the possible risks to the investor. The investment bank doesn't however have to value the company. It just needs to find a fair price so as to be able to sell the bonds to the public market. This is an example of an initial public bond offering as opposed to a stock offering – still an IPO because there are no “seasoned” issues of this company’s bonds in the market. Investment Banks also issue securities into the secondary market. This basically means that similar securities for that company exist. For example, if an investment bank wants to issue new stock for IBM, they have the benefit of IBM’s stock already being traded in the market. Now the current stock price is relevant for current market conditions and current supply. However, new stock is potentially dilutive (if the market doesn’t believe the capital is going to be well used and generate more earnings then the same earnings stream will be shared among more shareholders). Supply and demand is another factor. There may not be that many people interested in buying the new shares which could push down the price of the stock or there could be a glut of similar companies issuing stock (think of bank stocks over the past few months and what demand and supply might be there). Similarly, the IB may want to issue new bonds on behalf of IBM. In the case of bonds, there may be other IBM bonds of different maturities in the market but what the Investment Bank is underwriting is a bond with e.g. a new and longer tenor – let’s say 15 years. The challenge for the IB is to figure out what the demand in the market is for these bonds and at what price just as it would have to figure out with the stock. Again, if there is not a lot of depth in the market for the issue or a glut of similar issues from similar types of companies. In fact even the tenor could be a problem if there is lack of depth. The US treasury yield curve when adjusted for risk should dictate what longer tenors should sell at. However, if there aren’t investors who are willing or capable of understanding where the company and industry are going beyond let’s say 7 years then, the bond may be a difficult sell. Of course, if the company is willing to pay a higher premium than normal, that may be the incentive to get analysts to look at the issue. So how do Investment Banks make money underwriting stocks and bonds? Basically, they charge fees based on their level of commitment to the company for whom they are underwriting the issue. Remember risk return when we discuss this topic - the higher the risk the higher the fees. First option a company has is to issue new stock or bonds on a “best efforts” basis. The Investment Bank will charge a smaller fee for a best efforts underwriting because the risk will be lower to the Bank. By best efforts, the investment bank agrees to do its best to determine at what price the bond or stock should sell for in the market. The Bank then will try to sell the securities to its investor base. Now if the Bank is only able to sell half the issue at the recommended price, it is up to the company to decide whether they want to lower the selling price or just accept half the proceeds from the issue. In other words, the Investment Bank bears no risk in this situation. It just gets rewarded for its expertise and sales effort. On the other hand, if the Investment Bank offers to underwrite a bond on a “fully committed” basis, then it bears all the risk of the securities. What this means is that once the Bank has told the company it can issue e.g. $50 million worth of bonds at par (100% of face value) at say 5% p.a. and the Company agrees to that rate, the Company will get the $50 million in funds from the Bank and the Bank will get $50 million worth of bonds regardless of whether the Bank is able to sell them or not. The Bank will then go to the market and if they sell the bonds to yield 4.75% then the extra quarter percent benefit will go to the bank. If e.g. they sell the bonds at 5.25% then the extra quarter percent that the market requires will be at the cost of the Bank. Of course, the bond will trade either at a discount or a premium depending on what price the bonds actually “clear” the market. Therefore, there is a lot of risk here to the investment bank for which they may charge a fee in the neighborhood of 2 to 3% of face value to compensate them for the risk of under-pricing the bond. They of course could lose the entire fee and more if they under-price or they could gain more than that fee if they overprice. There are different types of bonds such as regular, subordinated, hybrid etc… that banks can issue along with different categories of equity such as common or preferred shares. Each type of bond or category of equity will have different risk parameters just due to the structure of the security. Add to that the different industries, the phase the company is in e.g. a start up or an established firm. Trading Securities We have just seen how Investment Banks create stocks and bonds. Now that they are created, they along with Securities Firms trade these bonds on what we call the Secondary Market as opposed to the primary market which is what we have previously discussed where there are only corporate issuers and underwriters. Primary Market issuers generally compete in this market too. In fact, they are typically what we call market makers in the stocks they underwrite. In other words, they guarantee to the corporate issuer as well as investors in the stock or bond that they will always be ready to quote a price for the stock or bond. By quoting we mean giving a “Bid” – the price at which they will purchase the security and an “Ask” – price at which they are willing to sell the stock. We call this the “bid-ask spread”. Now the underwriting bank is usually not the only Market Maker. Many Securities Companies and full line Investment Banks are market makers, which means they are heavily involved in trading securities. To be considered a true market maker, however, participants must quote narrow bid-ask spreads. In other words, a firm who claims to be a market maker in JPM Chase stock and quotes $40 on the bid side and $46 on the ask is not very serious. To be a legitimate market-maker, the firm would need to quote something like $43.01-$43.02. What this indicates is that the market-maker believes the true price is somewhere in between. The difference between that “true price” and the bid or the ask is the market makers commission. To make money trading firms need to buy and sell large volumes of the stock. As market makers there is the additional risk that if they get the price wrong in difficult market conditions they could get saddled with more stocks or bonds than they intended to hold or sell to other investors. Now back to trading itself. As mentioned, traders can make money on volume by simply matching up buyers and sellers and getting their commissions. They can also try to guess the direction of prices and purchase large volumes of securities to hold for short periods of time – we call this Spot Trading. For example, traders may feel that a jump in interest rates will be higher than expected by most of the market, so they start their day by selling bonds (going short), since they only have to deliver bonds at the end of the day for their purchasers, they can wait until the Fed announcement comes out. If the Fed says inflation in their view is going up and that they will have to raise rates more than the market expected, bond prices will fall. At that point, the traders who started the day by selling will swoop in and purchase bonds at a lower price than what they sold them at in the morning. They will have “arbitraged” the market to make a profit. If executed properly such a trading strategy requires very little capital since the traders in our example here didn’t need to actually pay cash for the bonds. They could simply deliver the bonds they agreed to purchase at the end of the day and receive the cash proceeds from the bonds that they sold at the start of the day. This cash is then used to conclude their purchase transaction. Obviously, such a trading strategy can go horribly wrong if some unexpected event happens. Therefore, those parties entering into trading arrangements with the traders, who are trying to arbitrage, will have decided how much if anything they will be willing to buy and sell from these traders. If they work for large credit worthy institutions, they shouldn’t be too concerned. Traders can also take a longer term (typically overnight to about 90 days) view of the markets which we call position trading. This may mean that they view stock price for example as being too high or too low. If they believe this true, they will start by purchasing the stock. They may not react to minor fluctuations in the stock with the expectation it will go up significantly in value over e.g. a 3 week period. They then may expect conditions either in the industry for this stock to improve or for this company to bring positive news to the market. They then will sell the stock at a profit. If on the other hand they purchase the stock and other unfavorable news hits and the stock falls below the purchase price by a significant amount (e.g. 5 to 10%) – the trader will usually have to sell the stock. The trigger here is called a “stop-loss-limit” which is required by the bank and the regulators to keep traders from causing enormous losses and potentially putting the solvency of the bank into question. Other Activities In addition to trading and investment banking activities, full line investment banks are offering cash management accounts – although not FDIC insured. This would be in direct competition with commercial banks. They do mutual fund and pension fund management which competes with life insurers. Other areas of expertise in Investment Banks include Mergers and Acquisitions where an Investment Bank advises banks or other corporations on with whom to merge or acquire and at what price. This is a very secretive as well as lucrative business because firms generally cannot go advertizing that they are for sale or would like to acquire certain businesses since to do this would cause the price of either the company for sale or the company for purchase to go up in price. Hence M&A specialists are always out meeting CEO’s and discussing strategy. They often will suggest mergers or acquisitions that CEO’s hadn’t even thought of. The king of the M&A market has in recent years been Goldman Sachs but others such as Morgan Stanley, Merrill Lynch (BofA), and JP Morgan have been increasing the competition. Finally, Investment Banks participate in custodial and administrative functions for other smaller banks and security houses – in other words in doing their back office work they create expertise and economies of scale that they can subcontract out for the likes of fund managers and so forth. Unlike a lot investment banking business which is highly volatile, it is steady if less spectacular in terms of total fees. Principal vs. Agent Function In Investment Banking, the concept of role of principal and agent come up frequently. Traders for example may trade on behalf of a client (as Agent) whereby they do exactly what the client asks for a small fee. However, the risk of the transaction is born by the client not the trader. For example, a client may ask a trader to sell a stock at that sells very infrequently at $40 when the market hits that price. Like a Best Efforts underwriting, the trader will do his/her best to get that price. If the market never hits $40 then stock is not sold. Therefore, the client still owns the stock. If the trader commits to getting the client a $40 price then the trader is acting as Principal on the transaction. In other words, the trader has basically purchased the stock (similar to a firm commitment on an underwriting). This becomes an issue when a trader approaches another bank and says: I am selling on behalf of XYZ client and he is offering $40 for the stock. The purchasing bank needs to understand that the transaction is really between itself and XYZ Client so if for some reason the XYZ Client doesn’t deliver the stock – the acquiring bank may have no recourse to the trader’s organization who is only acting as Agent. Balance Sheet Securities Firms and Investment Banks usually have lots of transactions that they are buying and selling (underwriting also in the case of Investment Banking). These transactions require funds to purchase while waiting for the proceeds from sales – most transactions take a day or two to settle e.g. you enter into an agreement to sell but the buyer has two days to come up with the cash. Some intraday purchases and sales as we have seen in a previous example can be offsetting. So there can be offsetting payables and receivables with little or no funds required. However, due to overnight position taking firms will have either receivables or payables that are not always offsetting. Therefore, they need to borrow funds to smooth out these activities. Typically they go to commercial banks for some of their lending. In other cases, they borrow by entering into Repurchase Agreements (Repos) and invest by entering into Reverse Repurchase Agreements (Reverse Repos). Repos are simply collateralized loans whereby the borrower takes a security from its balance sheet and “sells” it to a bank with agreement to “repurchase” it at a given date and price in the future – often the next day or after just a few days. The bank who acquires the security sees it as collateral so that if the seller fails to repurchase the security it can then sell the security and recover most if not all of its loan. As a result, the bank likes this arrangement (it is actually entering into the reverse repo) because if it lends the same amount of money without collateral it could lose a lot of money if the trading firm or investment bank failed all without warning. Therefore, the bank wants only the safest securities such as US government bonds or AAA rated corporate or other structures (AAA Subprime mortgage backed securities?!!!!). This way the bank doesn’t need to worry about analyzing and monitoring to a great degree the collateral. Since repos are loans with typically with AAA collateral the rates are low and the willingness of other parties to enter into the reverse repo had been very strong. Now just think of how a firm could buy a 30 year US Treasury bond yielding e.g. 4%, enter into a repo “borrowing” at 0.5% - not a bad spread if US Treasury bond yields do not go up. Of course they can then take the cash from the repo and buy another Treasury Bond and earn the same spread and then enter into another repo with the new Treasury Bond and acquire more cash to buy yet another Treasury bond ..... You get the picture – of course Treasury Bonds are not high risk over short periods of time. How about AAA Subprime mortgage backed securities?!!!