1. 1. Security Underwriting 2. Trading 1. Client related trading 2. Proprietary trading Financings and Trading 1 L10: Financing and Trading of Investment Banking

2. Capital Markets Financing A capital markets financing is a long-term funding obtained through the issuance of a security in a regulated market or through a private placement The security can be debt (bonds, debentures, or notes), equity (common stock) or a hybrid (both debt-like and equity-like characteristics, such as preferred shares or convertibles) A capital markets financing is underwritten by investment banks (the banks take on risk when purchasing securities from an issuer and then reselling those securities to investors) or distributed by banks as a private placement on an agency or principal basis In the US, a securities offering must either be registered with the Securities and Exchange Commission (SEC) through a registration statement ( a portion of which is called a “prospectus”) or sold as a private placement pursuant to an exemption from this registration requirement 2 L10: Financing and Trading of Investment Banking

3. Underwriting and League Tables A group, or “syndicate” of investment banks underwrites a securities offering The issuer must decide which banks in the syndicate will act as the “lead bookrunners” of the transaction These banks determine the marketing method and pricing for the transaction and, therefore, receive the highest underwriting allocation and a proportionately higher percentage of the gross spread The investment banking industry keeps track of underwriting participations by all banks and this becomes a basis for comparing banks’ underwriting capabilities This underwriting record is called a “league table”: every different type of security (and geographic region) has its own league table See exhibit 3.2 (page 43) 3 L10: Financing and Trading of Investment Banking

4. Financing Considerations Bankers focus on liquidity (cash balances, marketable securities, and available lines of credit), cash flow multiples, debt/earnings multiples, cost of capital and rating agency considerations before recommending whether a client should raise financing and, if so, whether it should be in the form of debt, equity or a hybrid security like convertibles Bankers analyze liquidity as a percentage of market capitalization, total debt, annual interest payment obligations and other balance sheet and income statement metrics These metrics are then compared with results from other companies in the same industry to determine whether the client has relatively more or less liquidity than its competitors 4 L10: Financing and Trading of Investment Banking

5. Equity Offerings When a company sells stock to the public for the first time in an SEC-registered offering, this is an Initial Public Offering (IPO) Subsequent sales of stock to the public by the company are called “follow-on” offerings Selling shareholders can sell shares using the company’s registration statement, which is called a “selling shareholders” or “secondary” offering, with proceeds received by the shareholder and not the company The difference between the purchase and sale price of a securities offering is called the “gross spread” and represents compensation for the bank for undertaking a distribution effort and certain legal risks 5 L10: Financing and Trading of Investment Banking

6. Types of Equity Underwritings 6 L10: Financing and Trading of Investment Banking

7. Benefits and Disadvantages of an IPO Benefits include: access to public market funding, enhanced profile and marketing benefits, creation of an acquisition currency and compensation vehicle and liquidity for shareholders Disadvantages include: SEC reporting requirements, costs associated with on-going reporting (including Sarbanes- Oxley), disclosure of sensitive information and short term focus by management to meet investor expectations in quarterly reports 7 L10: Financing and Trading of Investment Banking

8. IPO Pricing An investment bank determines the expected value of the company based on comparisons with publicly traded comparable companies or values derived through other methods (including DCF analyses) This is an imperfect process that requires analysis of both historical operating earnings and revenues and forecasts of future earnings and revenues In order to encourage investor interest in an IPO company that does not have a track record as a public company, typically, bankers will set an IPO price at a discount to the determined value 8 L10: Financing and Trading of Investment Banking

9. Green Shoe Option (Overallotment Option) Allows an investment bank to sell short securities that are equal to 15% of the securities sold in a public offering For example, bank sells 100 shares for a company @ $100/share = $10,000 Bank simultaneously sells short 15 company shares @ $100/share = $1,500 If company’s share price increases after the offering, the bank buys 15 shares from the company @ $100/share and delivers these shares to the short buyers The company therefore sells 115 shares and receives proceeds of $11,500 If company’s share price decreases after the offering, the bank buys 15 shares from the market at, say, $99/share and delivers these share to the short buyers These market purchases mitigate further downside price movement in the stock If share price increases, the bank earns $11,500 x 2% gross spread = $230 If share price decreases, the bank earns $10,000 x 2% gross spread = $200 plus trading profits of $100-$99 = $1 for each share sold short, so earnings of $215 9 L10: Financing and Trading of Investment Banking

10. SEC Registration Process When a company files a registration statement with the SEC, this starts a “quiet period”, which ends when the SEC declares the registration “effective”, meaning that all required information is provided (which could take several days to several months, depending on the company) The securities are priced and sold immediately following effectiveness During the quiet period, the lead bank may conduct a roadshow for the company to discuss the prospective offering with investors and an internal presentation to sales professionals to get them ready to sell the offering The company and bank are only allowed to discuss information provided in the prospectus with prospective investors in order to avoid the discussion being deemed an “offer to sell” securities, which is a “gun jumping” violation For Well-Known Seasoned Issuers (WKIS filers), a registration statement may become immediately effective and usable for offerings, without SEC review, allowing the issuer, through the bank, to immediately make offers to sell after filing, which avoids the potential gun jumping problem 10 L10: Financing and Trading of Investment Banking

11. IPO Timetable 11 L10: Financing and Trading of Investment Banking

12. Types of Bond Underwritings 12 L10: Financing and Trading of Investment Banking

13. Investment Grade and Below Investment Grade (High Yield or Junk) Bonds 13 L10: Financing and Trading of Investment Banking

14. Bonds vs Loans A bond is debt in the form of a security, issued as a long- term obligation of a borrower with a specific maturity and coupon 14 L10: Financing and Trading of Investment Banking

15. Client Related Trading Traders basically buy and sell securities to make profits, but client-related traders also have the additional objective of helping investing clients trade profitably If a client can’t trade profitably with an investment bank, the client may eventually stop trading with that bank As a result, sometimes traders decide to accept lower trading margins (and occasional losses) to accommodate client investment objectives and to facilitate greater trading volume Traders divide their focus into two principal areas: supporting primary market transactions, which involves purchasing securities directly from a corporate or government issuer, reselling those securities at a profit, and standing ready to repurchase securities at any time participating in the secondary market by buying and selling previously issued securities at a profit In order to provide this “market-making” service, a bank keeps an inventory of securities and makes “bid” and “offer” prices on these securities based on their risk and liquidity 15 L10: Financing and Trading of Investment Banking

16. Research To gain insights into the securities that they trade Trading-desk-based research that they initiate (proprietary data) Public available data Research can focus on specific securities, industries, and financial products, or on general economy, political, or regulatory topics L10: Financing and Trading of Investment Banking 16

17. Sales Sales professionals cover individual and institutional investing clients Their role is to bring to clients value-added investing or hedging ideas, as well as pricing from traders Sales teams have the dual objective of helping both traders and investing clients create profits, but sometimes it is difficult to meet the objectives of both sides In addition to providing pricing information, sales professionals provide investment ideas developed from research and analysis 17 L10: Financing and Trading of Investment Banking

18. Prime Brokerage The Prime Brokerage business is housed in the Trading Division and focuses principally on hedge funds and other clients who borrow securities and cash to support their investment business In addition to lending, other services provided to investing clients include trade clearing, custody and settlement, real estate and computer assistance, performance measurement and performance reporting These products and services bring in fees that can be several billion dollars per year at some banks. Hedge funds sometimes borrow securities to enable them to sell the securities short (selling a borrowed security, with the obligation to return it after repurchasing it in the market in the future) Depending on a hedge fund’s strategy, shorting is used to create downside security price protection (a hedge) or to generate a potential gain based on speculation that a security’s price will drop Hedge fund cash borrowings from investment banks (called “margin loans”) require the use of securities as collateral If the value of the collateral drops over time, banks will exercise margin calls to receive repayment of a portion of the loan 18 L10: Financing and Trading of Investment Banking

19. Securities Lending Many large institutional investors own sizeable blocks of stock that they expect to hold for an extended period of time These investors are often willing to lend their shares to investment banks, who re-lend to other parties for a fee (which is split between the lenders and the bank) Lenders receive cash collateral when they lend shares, and the collateral is adjusted daily, based on a mark-to-market value of the shares lent. Usually the required collateral is 2% to 5% greater than the value of the shares The lenders will pay interest on the cash collateral at a rate close to or considerably less than the market rate, depending on demand and supply conditions for lending of different stocks The rate of interest paid by lenders to share borrowers is called “rebate”. It depends on market demand of the security 19 L10: Financing and Trading of Investment Banking

20. Securities Lending -- Example If an investor lent 4,000 shares of IBM stock when the stock traded at $100 (valued at $400,000), the borrower might be required to post $416,000 in cash collateral with the stock lender when the stock was borrowed If the loan was for one month, the market interest earned on the $416,000 cash collateral at 4% p.a. would be $1,387 Because IBM shares are fairly easy to borrow, the stock lender might pay a rebate to the stock borrower at a rate of 3.5% p.a., or $1,213 (the lower the rebate, the higher the effective cost for the borrower in creating a short position) The 50 basis point spread, or $174 difference between market rate and the rebate rate paid to the stock borrower mostly kept by the stock lender, a portion to the investment bank that facilitated the transaction 20 L10: Financing and Trading of Investment Banking

21. More on Securities Lending Shares are difficult to borrow when Demand exceeds supply Large portion of the stock is held by insiders who are restricted from lending Investors who might normally lend shares decide they want to sell the shares the next day Investors owning the shares are concerned about potential negative share price consequence if there is excessive shorting in the stock When shares are loaned, title to the shares is transferred to the party that the borrower sells stock short to This means that the short buyer receives dividends if title is held on a “record date” and is able to vote if a shareholder election is held In most cases, the stock loan agreement provides that whenever short buyers receive dividends, the borrower (and short seller) must pay to the lender a cash amount that is equal to the dividends received 21 L10: Financing and Trading of Investment Banking

22. Still on Securities Lending Sometimes shares are sold short without taking steps to borrow the shares, which is called “naked” shorting If this shorting activity is done to avoid settlement failure, this is considered legal naked shorting For example, if an investor agrees to sell stock, but fails to deliver shares to a buyer on the settlement date, the buyer may need to sell stock short to avoid settlement failure (and associated costs and penalties) if the buyer has already resold the stock that should have been received in the original settlement There has been considerable regulatory analysis of legal naked shorting and non-legal naked shorting (selling stock short without taking steps to borrow it and without legitimate settlement concerns) 22 L10: Financing and Trading of Investment Banking

23. FICC Trading Interest rate products – foreign exchange, government bond trading and interest rate derivatives Credit products – corporate bonds (investment grade, high yield and distressed debt securities), mortgage-backed securities, asset-backed securities (credit card receivables, automobile loans, computer leases, trade receivables, equipment leases, etc.), structured credit and credit derivatives Commodities – Contracts on commodities are traded in the energy (electricity, natural gas, and oil) and metals (precious metals and base metals) sectors 23 L10: Financing and Trading of Investment Banking

24. Structured Credit Products The Structured Credit business is primarily focused on collateralized debt obligations (CDOs) that are linked to bonds (collateralized bond obligations, or “CBO”) and loans (collateralized loan obligations, or “CLO”) A CDO is a debt security underwritten by an investment bank that is backed by a pool of non-investment grade bonds or loans. Because the pool includes a broadly diversified group of assets, credit rating agencies have given an investment grade rating to certain tranches in many of these CDOs In a CDO, a special purpose trust is formed to purchase non-investment grade bonds and then the trust issues three or more tranches of bonds (each with a different credit rating) to investors who purchase these securities as a means to receive slightly higher coupons than similarly rated straight bonds 24 L10: Financing and Trading of Investment Banking

25. CDO 25 L10: Financing and Trading of Investment Banking

26. CDO (cont.) 26 L10: Financing and Trading of Investment Banking

27. Credit Default Swaps A credit default swap (CDS) is a contract between two counterparties whereby one party makes periodic payments in return for receiving a payoff if an underlying security or loan defaults For example, if an investor purchased $10 million of a five-year $100 million bond issued by Company ABC and then decided to protect their investment risk by entering into a CDS on a $10 million notional amount of the Company ABC bond, they might pay 2% of $10 million annually for five years in exchange for the right to deliver defaulted bonds in exchange for $10 million if Company ABC defaults The party that receives an annual fee is a credit protection seller; the fee payer is a credit protection buyer 27 L10: Financing and Trading of Investment Banking

28. Credit Default Swaps (cont.) None of the cash flows from the CDS directly involves Company ABC, but it is their bond that is the subject of the CDS contract. A CDS is essentially an insurance policy to hedge against default Because there is no requirement to own the actual underlying security or loan when entering into this type of contract, many CDS credit protection buyers engage in this transaction purely for speculative purposes The CDS market came under regulatory scrutiny because of its massive size, lack of regulation and potential to permit insider-trading activity 28 L10: Financing and Trading of Investment Banking

29. Credit Default Swaps (cont.) The cost of CDS sometimes increases considerably in the weeks prior to the announcement of a corporate takeover by a private equity fund Upon completion of a leveraged buyout, the target company’s credit rating generally deteriorates because the buyout is financed in large part by leveraging the target’s balance sheet. Because this increases the riskiness of the company’s outstanding bonds, the result is an increase in CDS pricing relative to these bonds During 2007 and 2008, prior to announcement of a number of acquisitions by private equity funds, CDS pricing for the target company increased substantially, suggesting that CDS credit protection buyers became aware of the acquisition before it was publicly announced Speculators evidently purchased CDS on private equity target companies before the announcement and then sold CDS after the announcement, creating a substantial profit 29 L10: Financing and Trading of Investment Banking

30. Proprietary Trading Proprietary traders are non-client related traders who trade solely for the benefit of their firm They have no responsibility to balance their profitability interests with the interests of clients of the firm, and therefore can be considered competitors to these clients At some investment banks, they are covered by sales professionals within the same firm and are considered one of the most important clients of the sales team At other firms, internal sales contacts are limited. Even when proprietary traders are allowed to trade with their own firm, they always trade with others as well, including competitor firms, and will execute transactions with whichever firm best enables them to achieve profits and mitigate risks 30 L10: Financing and Trading of Investment Banking

31. Proprietary Trading (cont.) Proprietary traders take positions in interest rate and credit products, mortgage-related securities and loan products, and multiple kinds of asset-backed securities They also take positions in commodities and currencies, as well as in the derivatives of all of these products In the equity world, they take positions in all forms of equity and equity-related products, including derivatives Their positions can be long or short and, in many cases, are leveraged by borrowing, using their positions as collateral 31 L10: Financing and Trading of Investment Banking

32. Proprietary Trading (cont.) Proprietary traders do their own research and rely on the research of others as well They build models that track credit markets, regulatory and legal developments, accounting and tax developments, market anomalies and economic events Their models attempt to predict mean reversion or a collapse in historical relationships, among other phenomena Basically, the proprietary trading business is similar to the business conducted by hedge funds 32 L10: Financing and Trading of Investment Banking

33. Proprietary Trading (cont.) Proprietary trading desks at investment banks have become significant competitors to hedge funds, who are the most important clients of the bank’s client-related trading business This sometimes creates conflict and some hedge funds have, as a result, limited their trading activity with those investment banks that have the largest proprietary trading businesses Although Goldman Sachs does not break out revenue for client- related trading and proprietary trading, it is possible that proprietary trading represented larger revenue and earnings than were achieved during 2007 by Och-Ziff, the largest publicly reporting hedge fund in the U.S. and one of the largest hedge funds in the world 33 L10: Financing and Trading of Investment Banking

34. Comparison of Goldman Sachs and Och-Ziff