Securities Firms and Investment Banks January 25th, 2010 The Industry Investment banking involves origination, underwriting, and placement of securities in financial markets for corporate and government issuers. In addition, these firms often provide advisory services such as Mergers & Acquisitions (M&A) and corporate finance. Securities services relate to the trading of securities in the secondary market. Full service firms who do both securities trading and investment banking are referred to as “Investment Banks”. Otherwise an investment bank who only does the traditional investment banking business is still called an Investment Bank and a firm that just does securities services a Securities Firm. The Industry The number of firms in the industry fluctuates with financial shocks causing a rapid weeding out or merger of firms. Recent trend had been towards larger players. However, with lack of funding the ability of investment banks to operate independently appears doubtful. Many small boutique firms who are highly specialized – often begun by successful industry executives and traders who leave the big firms to start out on their own. The Industry (continued) The major national full-line firms have huge retail business (broker-dealer activities) as well as corporate (securities trading, underwriting and advising) e.g. Merrill Lynch (now owned by BofA) and Morgan Stanley. The national full-line firms who do less of the retail and more of the corporate finance, securities trading, and underwriting e.g. Goldman Sachs and Salomon Bros./Smith Barney (Citigroup) Section 20 subsidiaries of Commercial Bank Holding Companies Others such as discount brokers who offer no advice, regional firms, electronic firms, and venture capital firms. Activities: Investing Investing: Investment Banks and Securities Firms manage pools of assets from closed end to open end funds They also manage pension funds (in direct competition now with Life Insurers). Activities: Investment Banking Underwriting and distributing new issues of debt and equity. Primary (IPO’s –initial public offerings) vs Secondary issues (new issues of securities that are already in the market). Private vs. Public offerings. (Commercial banks can do 144A’s aka private placements) Mechanics of Underwriting Best Efforts vs. Firm Commitment Best Efforts means there is no financial risk to the underwriter. If the IB cannot sell the issue, it is the customer’s problem. Firm Commitment means that the underwriter effectively purchases the bonds or equity from the issuer at an agreed upon price. If the IB cannot sell them at or above that price then the IB stands to lose money. Customer receives the price the IB commits to e.g. if the underwriter commits to GM to underwrite $100 MM in bonds at par. GM will receive $100 MM. If the underwriter finds that the market appetite for these bonds changes before it can sell them and now, it will only get 99 instead of par (100), too bad – it will lose $1 MM. Given the risks involved in committing to underwrite deals, investment banks take large fees from their customer. So in the case of GM, the underwriting fee may have been 2% or $2 MM. This fee reduces the risk that the bank will lose money or better put it is getting compensated for the risk it is undertaking. Activities: Market Making This activity involves making a secondary market in a security. This is done by always offering to purchase a security at a price (the “Bid”) or sell the security at a higher price (the “Offer” or “Ask”). The seriousness or competitiveness of a market maker is determined by the narrowness of the bid-ask spread. In turn, the narrower the spread, the more liquid the security (and usually less risky). Market Making (continued) Usually, underwriters of securities are expected to make a market in those instruments they bring to market to give the instrument liquidity. Securities firms who do not participate in the underwriting process may choose to make a market as well in the instrument. Activities: Trading Obviously anybody in the market making business is also in the trading business since both require expertise on the security and the market place. Position Trading: Involves the purchase or short-sale of large blocks of instruments generally with the view that the trader has a better idea of what the true price should be. Pure Arbitrage: Involves the simultaneous buying in one market and selling in another to take advantage of price differentials. It may also involve similar instruments from the same issuer. Activities: Trading (continued) Risk Arbitrage: Involves the purchase or short-sale of securities in anticipation of some new information that will cause the price to go in a predicted direction. E.g. Traders may feel that there is an over reaction to a lawsuit by investors, and that once more information comes out about the lawsuit the investors will be less concerned. Program Trading: NYSE definition of 15 or more different stocks valued at $1 million or more using computer programs to initiate trades (form of risk arbitrage) Activities: Cash Management Investment banks are now offering bank-deposit like cash management accounts i.e. they invest cash at competitive rates. This is an area where we are seeing the convergence between investment and commercial banking. However, commercial banks have huge branch and correspondent bank networks which allow them to collect funds and pool them in ways that investment banks cannot. An example would be Canon who sells 1000’s of retailers and businesses throughout the US – they have lots of accounts in lots of different banks where their customers make payments – large cash management banks like JPM, Citi, and BofA can pool funds in the morning from 100’s of their own branches as well as other banks and post the funds to the Canon’s account by the close of business and then invest them the next day. This reduces Canon’s need for working capital loans while earning them more interest. Activities: Mergers and Acquisitions Advising and or assisting in the merger of two companies or the acquisition of one company by another. This involves suggesting strategic mergers and acquisitions, finding the partners, valuing the firms, recommending the terms of the merger or acquisition, issuing the new securities and or arranging the financing package, to the opposite preventing acquisitions through “poison pills” Highly lucrative activity with Goldman Sachs as king but with several others increasing the competition. Activities: Administrative and Custodial Services Because trading houses are in large need of back office functions for their own activities, they often perform these functions for others and receive a fee. Therefore, e.g. they keep track of who owns IBM stock. They often need to borrow stocks and bonds to put short positions in place so are “happy” to hold a company’s stock for safe-keeping. Principal vs. Agent In a number of the different activities the term principal vs agent comes up. The distinction is very important in terms of risk since as principal you own the security while as agent you are simply managing the security on behalf of someone else. Not making this clear in any business transaction can lead to enormous problems. Profitability Investment Banking and Securities Trading is highly cyclical and is generally driven by stock market cycles. M&A activity and government intervention/deregulation have their impact as do volatile foreign exchange markets. Balance Sheet Securities Firms buy and sell securities in large volume so always have a number of transactions waiting to be settled (Receivables/Payables from/to brokers and customers). Repo and Reverse Repo transactions come from inventories of usually highly liquid, low volatility securities that are sold or purchased with a simultaneous agreement to repurchase or resell at a fixed price in the future. These are done at a discount which is equivalent to prevailing market lending rates for a secured transaction. Repo Example (1) Bank A owns a US Government Bond worth $10 MM. (2) It sells that bond to B Bank who pays them just slightly less than $10 MM dollars e.g. $9.9 MM and with the agreement that bank A repurchases the bond 30 days later at $10 MM. (3) Bank A receives the cash (something less than $10 MM and can now invest it somewhere else (liquidity). (4) At the end of the 30 days, Bank A “repurchases” the bond for $10 MM. The $100K difference between the initial “sale” price and the “repurchase” price constitutes the interest for what is effectively a secured loan. Secured transaction Bank B’s side of the transaction is the “reverse repo” where it is “investing” funds for 30 days. These transactions are done at low rates of interest because they are secured by collateral (the bond itself) i.e. a US government bond should not fluctuate too much in price over a short period of time. In effect, Bank A is still the legal holder of the bond unless it fails to repurchase on day 30. In which case, the Bank B can sell the bond a collect the proceeds. If the proceeds are insufficient then they still have a legal claim against Bank A for the remainder of the funds. “Haircuts” As we know longer term maturities such as 30 year bonds are highly interest rate sensitive. Therefore, in some repo transactions a “haircut” may be specified. This means that in addition to discounting the bond as part of the means of charging interest, B Bank may insist that Bank A give more than the $10 MM in bonds e.g.$10.5 MM. B Bank calls this a “haircut” whereby they are only giving approximately 95% value to the bonds to cover the risk that the bonds may fall in value. This does not affect the discounted interest rate they charge i.e. B Bank still pays $9.9 MM day 1 and receives $10.0 MM day 30 when Bank A repurchases the bonds.