1. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-1 McGraw-Hill/Irwin Chapter Sixteen Securities Firms and Investment Banks

2. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-2 McGraw-Hill/Irwin Services Offered by Securities Firms versus Investment Banks Investment Banks –originating, underwriting, and placing securities in money and capital markets Securities Firms –brokerage services or market making The largest companies in the industry perform multiple services (e.g., underwriting and brokerage) and are generally called investment banks Investment Banks –originating, underwriting, and placing securities in money and capital markets Securities Firms –brokerage services or market making The largest companies in the industry perform multiple services (e.g., underwriting and brokerage) and are generally called investment banks

3. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-3 McGraw-Hill/Irwin Size, Structure, and Composition of the Industry Three major types of firms –national full-line investment banks that service retail and corporate customers (e.g., Merrill Lynch) –national full-line firms that specialize in corporate finance (e.g., Goldman Sachs) –the remainder of the industry specialized investment bank subsidiaries of commercial banks specialized discount brokers ( execute no advice) regional securities firms specialized electronic trading securities firms venture capital firms Three major types of firms –national full-line investment banks that service retail and corporate customers (e.g., Merrill Lynch) –national full-line firms that specialize in corporate finance (e.g., Goldman Sachs) –the remainder of the industry specialized investment bank subsidiaries of commercial banks specialized discount brokers ( execute no advice) regional securities firms specialized electronic trading securities firms venture capital firms

4. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-4 McGraw-Hill/Irwin Diversified national full line firms that serve both retail and corporate customers such as Morgan Stanley. These firms’ income comes primarily from brokerage, lending, and underwriting, although trading activities are a growing component of income at all investment banks.

5. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-5 McGraw-Hill/Irwin National full line firms specializing in corporate finance such as Goldman Sachs. Their income is primarily from underwriting, placement, mergers and acquisitions and other consulting services.

6. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-6 McGraw-Hill/Irwin Specialized firms such as regional investment bankers (D.A. Davidson), discount brokers (Schwab), Internet brokers (E-Trade), venture capital firms (New Enterprise) & subsidiaries of commercial banks (J.P. Morgan Chase) Specialized firms such as regional investment bankers (D.A. Davidson), discount brokers (Schwab), Internet brokers (E-Trade), venture capital firms (New Enterprise) & subsidiaries of commercial banks (J.P. Morgan Chase)

7. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-7 McGraw-Hill/Irwin Securities Firm and Investment Bank Activity Areas Securities firms and investment banks engage in as many as seven key activity areas –Investing –Investment Banking –Market Making –Trading –Cash Management –Mergers and Acquisitions –Other Service Functions Securities firms and investment banks engage in as many as seven key activity areas –Investing –Investment Banking –Market Making –Trading –Cash Management –Mergers and Acquisitions –Other Service Functions

8. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-8 McGraw-Hill/Irwin 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 Fee based income from managing investments tends to be more stable than income from underwriting and trading which varies more with market cycles. 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 Fee based income from managing investments tends to be more stable than income from underwriting and trading which varies more with market cycles.

9. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-9 McGraw-Hill/Irwin Investment Banking Investment banking is underwriting and distributing new issues of debt and equity. The top 5 underwriters are listed in Text Table 16-2 The top firms represented about 37% of the total underwriting volume. Morgan Stanley is tops for IPOs and equity, J.P. Morgan for syndicated loans and Citigroup/Solomon, Smith-Barney (Citi/SSB) for straight debt. The old firm of Solomon Brothers traditionally dominated the debt markets for many years, and not surprisingly, a strong corporate bank, J.P. Morgan, dominates in syndicated loans. Investment banking is underwriting and distributing new issues of debt and equity. The top 5 underwriters are listed in Text Table 16-2 The top firms represented about 37% of the total underwriting volume. Morgan Stanley is tops for IPOs and equity, J.P. Morgan for syndicated loans and Citigroup/Solomon, Smith-Barney (Citi/SSB) for straight debt. The old firm of Solomon Brothers traditionally dominated the debt markets for many years, and not surprisingly, a strong corporate bank, J.P. Morgan, dominates in syndicated loans.

10. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-10 McGraw-Hill/Irwin A key factor of success in the investment banking industry is reputation and bankers guard their firm’s name jealously. Securities underwriting can be undertaken through either public or private offerings –Private placement –Public placement ( Firm commitment, best offer) U.S. corporate underwriting activity for debt issues is almost always many times larger than the volume of equity underwriting though equity deals usually dominate the headlines. A key factor of success in the investment banking industry is reputation and bankers guard their firm’s name jealously. Securities underwriting can be undertaken through either public or private offerings –Private placement –Public placement ( Firm commitment, best offer) U.S. corporate underwriting activity for debt issues is almost always many times larger than the volume of equity underwriting though equity deals usually dominate the headlines.

11. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-11 McGraw-Hill/Irwin Market Making Market making is creating a secondary market for securities or contracts. These involve both agency (brokerage) and principle (dealer) functions.( agency or principal transactions) Brokerage is typically paid with commissions and dealers profit from the bid-ask spread. Market making is creating a secondary market for securities or contracts. These involve both agency (brokerage) and principle (dealer) functions.( agency or principal transactions) Brokerage is typically paid with commissions and dealers profit from the bid-ask spread.

12. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-12 McGraw-Hill/Irwin Dealers buy at the bid (low) and sell at the ask (high). Dealers incur the risk of price changes on the stock since they must maintain an inventory and bear inventory financing costs. On the NYSE, specialists are designated market makers that have an affirmative obligation to ensure ongoing market liquidity and price continuity. Dealers buy at the bid (low) and sell at the ask (high). Dealers incur the risk of price changes on the stock since they must maintain an inventory and bear inventory financing costs. On the NYSE, specialists are designated market makers that have an affirmative obligation to ensure ongoing market liquidity and price continuity.

13. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-13 McGraw-Hill/Irwin Trading Closely related to market-making activities Six types of trading Position trading: Holing a position for weeks or months Pure arbitrage; arbitrage is taking advantage of a mispricing between two markets by simultaneously buying and selling the same commodity. Spot futures arbitrage is a common example. Risk arbitrage; taking advantage of a real or perceived mispricing based on some not happen information; the trader possesses( insider or so) without perfectly covering or eliminating all the risk. Closely related to market-making activities Six types of trading Position trading: Holing a position for weeks or months Pure arbitrage; arbitrage is taking advantage of a mispricing between two markets by simultaneously buying and selling the same commodity. Spot futures arbitrage is a common example. Risk arbitrage; taking advantage of a real or perceived mispricing based on some not happen information; the trader possesses( insider or so) without perfectly covering or eliminating all the risk.

14. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-14 McGraw-Hill/Irwin Program trading; defined as simultaneous buying and selling of a portfolio of at least 15 different stocks valued at more than $1 million in total using a computer program to initiate the trade. It is like risk arbitrage, find a gap between spot, cash, future. Stock brokerage; processing buy and sell orders from the public. Many firms either buy or lease seats on the NYSE and/or are NASDAQ members. (i.e Merrill Lynch) Program trading; defined as simultaneous buying and selling of a portfolio of at least 15 different stocks valued at more than $1 million in total using a computer program to initiate the trade. It is like risk arbitrage, find a gap between spot, cash, future. Stock brokerage; processing buy and sell orders from the public. Many firms either buy or lease seats on the NYSE and/or are NASDAQ members. (i.e Merrill Lynch)

15. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-15 McGraw-Hill/Irwin Tip: Full service brokers offer research and advice about which stocks to buy, discount brokers process public orders for a reduced fee.  Electronic brokerage offers investors direct access to the trading floor, bypassing normal brokers and offering even lower fees than discount brokers. Examples include E-Trade and Ameritrade. Most large firms now offer clients a choice of full service brokerage or reduced cost electronic trading. Tip: Full service brokers offer research and advice about which stocks to buy, discount brokers process public orders for a reduced fee.  Electronic brokerage offers investors direct access to the trading floor, bypassing normal brokers and offering even lower fees than discount brokers. Examples include E-Trade and Ameritrade. Most large firms now offer clients a choice of full service brokerage or reduced cost electronic trading.

16. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-16 McGraw-Hill/Irwin Cash Management cash management accounts (CMAs) –money market mutual fund sold by investment banks that offer check-writing privileges and FDIC some times cash management accounts (CMAs) –money market mutual fund sold by investment banks that offer check-writing privileges and FDIC some times

17. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-17 McGraw-Hill/Irwin Mergers and Acquisitions Frequently provide advice on, and assistance in, mergers and acquisitions –assist in finding merger partners –underwrite any new securities –asses the value of target firms –recommend terms of the merger agreement –assist target firms in preventing a merger Frequently provide advice on, and assistance in, mergers and acquisitions –assist in finding merger partners –underwrite any new securities –asses the value of target firms –recommend terms of the merger agreement –assist target firms in preventing a merger

18. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-18 McGraw-Hill/Irwin Michael Jensen, “Agency Costs of Overvalued Equity,” many if not most of the large number of acquisitions in the late 1990s destroyed shareholder value. He argues that overpriced equity led to too low cost of capital and encouraged managers to engage in poor investments such as acquisitions in order to meet analysts’ earnings expectations.

19. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-19 McGraw-Hill/Irwin Given that a high P/E ratio predicts rapid earnings growth; the manager, expected to hit ever growing earnings targets, faces an impossible task, because with overvalued equity management cannot deliver the expected level of performance except by chance

20. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-20 McGraw-Hill/Irwin Hence firms look for ways to keep the fiction of improving performance alive, even resorting to illegal accounting practices and poor acquisitions. This is a very interesting argument. It helps explain why there have been so many scandals lately. It is not that managers suddenly decided to ‘lie, cheat and steal.’ The pressure to perform has been very high, and brought about in part by too close a tie between Wall Street analysts and corporate executives, a conflict of interest.

21. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-21 McGraw-Hill/Irwin With overvalued equity, stock price signals are faulty and cannot be relied upon as indicators of long term value of the firm. Trying to do so when those signals are wrong must lead to suboptimal decisions for long term shareholder wealth. Several firms enlisted their professional consultants in accounting and finance to help them find ways to hit performance targets, which of course could not continue to occur without some form of ‘cheating’ such as accounting manipulations..

22. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-22 McGraw-Hill/Irwin This argument does not excuse managers. They should have known better. In particular what we have seen is a major breakdown of corporate governance at the board level and a failure of ethics and a breach of fiduciary duty and trust among too many managers who were very highly paid to look out for shareholders interests

23. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-23 McGraw-Hill/Irwin 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

24. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-24 McGraw-Hill/Irwin Balance Sheet Assets, 2004 Assets Cash $ 50,744.0 1.28% Receivable from other broker-dealers 1,530,227.0 38.44 Receivable from customers 163,159.2 4.10 Receivables from noncustomers 18,345.8 0.46 Long positions in securities/commodities 1,075,696.7 27.02 Securities and investments not marketed 11,753.1 0.30 Securities purchased w/resell agreement 967,008.0 24.29 Exchange membership 1,086.6 0.03 Other assets 162,346.1 4.08 Total assets $3,980,375.4 100.00 Assets Cash $ 50,744.0 1.28% Receivable from other broker-dealers 1,530,227.0 38.44 Receivable from customers 163,159.2 4.10 Receivables from noncustomers 18,345.8 0.46 Long positions in securities/commodities 1,075,696.7 27.02 Securities and investments not marketed 11,753.1 0.30 Securities purchased w/resell agreement 967,008.0 24.29 Exchange membership 1,086.6 0.03 Other assets 162,346.1 4.08 Total assets $3,980,375.4 100.00

25. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-25 McGraw-Hill/Irwin Balance Sheet Liabilities, 2004 Liabilities Bank loans payable $ 75,548.8 1.90% Payables to other broker-dealers 842,983.0 21.18 Payables to noncustomers 66,995.6 1.68 Payables to customers 407,432.6 10.23 Short positions in securities/commodities 510,513.0 12.82 Securities sold w/repurchase agreements 1,565,003.7 39.32 Other nonsubordinated liabilities 286,459.8 7.20 Subordinated liabilities 75,921.7 1.91 Total liabilities $3,830,858.1 96.24 Capital Equity capital 149,517.3 3.76 Number of firms 6,549 Liabilities Bank loans payable $ 75,548.8 1.90% Payables to other broker-dealers 842,983.0 21.18 Payables to noncustomers 66,995.6 1.68 Payables to customers 407,432.6 10.23 Short positions in securities/commodities 510,513.0 12.82 Securities sold w/repurchase agreements 1,565,003.7 39.32 Other nonsubordinated liabilities 286,459.8 7.20 Subordinated liabilities 75,921.7 1.91 Total liabilities $3,830,858.1 96.24 Capital Equity capital 149,517.3 3.76 Number of firms 6,549

26. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-26 McGraw-Hill/Irwin Regulation The primary regulator of the securities industry is the Securities and Exchange Commission (SEC) SEC sets rules governing securities firms’ underwriting and trading activities Shelf registration The Securities Investor Protection Corporation (SIPC) The primary regulator of the securities industry is the Securities and Exchange Commission (SEC) SEC sets rules governing securities firms’ underwriting and trading activities Shelf registration The Securities Investor Protection Corporation (SIPC)

27. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-27 McGraw-Hill/Irwin Recent Trends As goes the stock market, so goes securities firms’ profitability. Industry profits are strongly cyclical. Extended bull markets are good for profits, employment and growth; crashes and downturns hurt trading volume and hence commission income (a mainstay of revenue at most firms).

28. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-28 McGraw-Hill/Irwin Fewer firms seek to issue new equity during a bear market, and debt issuance drops off as coverage ratios decline so underwriting income is also cyclical. Both underwriting and brokerage income recovered dramatically in the 1990s after dropping off precipitously subsequent to the 1987 crash

29. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-29 McGraw-Hill/Irwin Profitability remained strong with the bull market of the 1990s. Industry profits were at a record high $21 billion in 2000, but fell 50% in 2001. Reasons for the profit problems included the weak stock market, the September 11 2001 attacks, the drop in M&A activity, and loss of confidence by investors due to the many ethical violations by some corporations, bankers and auditors. Profitability remained poor in 2002 at $6.9 billion, but picked up in 2003, hitting a record $22.5 billion and remained high at $19.5 billion in 2004 on large increases in underwriting activity and hefty cuts in interest and operating expenses. ROE for 2004 was 13.04%.

30. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-30 McGraw-Hill/Irwin Global Issues Investment banking activities are highly globalized. For instance, UBS, a Swiss bank, is the number one underwriter of municipal securities in the U.S. Foreign transactions in U.S. securities and U.S. transactions in foreign securities have been growing at a (compound) annual rate of 25.5% and 20.9% respectively. International offerings have also grown rapidly, but recent scandals and the U.S. stock market weakness has probably deterred foreign issuers from raising capital in the U.S. Investment banking activities are highly globalized. For instance, UBS, a Swiss bank, is the number one underwriter of municipal securities in the U.S. Foreign transactions in U.S. securities and U.S. transactions in foreign securities have been growing at a (compound) annual rate of 25.5% and 20.9% respectively. International offerings have also grown rapidly, but recent scandals and the U.S. stock market weakness has probably deterred foreign issuers from raising capital in the U.S.

31. ©2007, The McGraw-Hill Companies, All Rights Reserved 16-31 McGraw-Hill/Irwin Tip Investment bankers can help U.S. institutions gain exposure to international markets. Banks have created structured derivative debt products that allow an institution to earn higher overseas interest rates while limiting exchange rate risk. Bankers can also sometime help improve the marketability of foreign bonds that are difficult to sell because they are denominated in a foreign currency. Many U.S. financial institutions are limited as to how much currency risk they can incur. Bankers have at times securitized these foreign currency denominated bonds by placing them in a trust and issuing dollar denominated claims to U.S. buyers.] Hedge funds engage in risk arbitrage strategies on a global basis. The most famous of these (or infamous), Long Term Capital Management, engaged in risk arbitrage on an unprecedented global scale.] Investment bankers can help U.S. institutions gain exposure to international markets. Banks have created structured derivative debt products that allow an institution to earn higher overseas interest rates while limiting exchange rate risk. Bankers can also sometime help improve the marketability of foreign bonds that are difficult to sell because they are denominated in a foreign currency. Many U.S. financial institutions are limited as to how much currency risk they can incur. Bankers have at times securitized these foreign currency denominated bonds by placing them in a trust and issuing dollar denominated claims to U.S. buyers.] Hedge funds engage in risk arbitrage strategies on a global basis. The most famous of these (or infamous), Long Term Capital Management, engaged in risk arbitrage on an unprecedented global scale.]