CHAPTER 4 Financial Services: Securities Brokerage and Investment Banking Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.McGraw-Hill/Irwin

4-2 Overview  This chapter discusses securities brokerage firms and investment banks –Activities of securities firms and investment banks –Size, structure, and composition –Balance sheets and recent trends –Regulation of securities firms and investment banks –Global issues

4-3 Securities Firms & Investment Banks  Nature of business –Underwrite securities –Market making –Advising (example: M&A, restructurings)

4-4 Securities Firms & Investment Banks  Growth in domestic M&A: –Less than $200 billion in 1990 –$1.83 trillion in 2000 –In US: bottomed out at $458 billion in 2002 ($1.2 trillion worldwide) –Topped $1.7 trillion 2007 ($4.5 trillion worldwide) –Effects of financial crisis: fell to $808 billion in 2009 ($1.7 trillion worldwide)  Worst financial crisis since 1930s, but M&A activity still greater than early 2000s

4-5 Mergers and Acquisitions,

4-6 Structural Changes in Recent Years  Acquisition of Bear Stearns by J.P. Morgan Chase  Bankruptcy of Lehman Brothers  Acquisition of Merrill Lynch by Bank of America  Only two remaining major firms: –Goldman Sachs and Morgan Stanley  Converted to commercial bank holding companies in 2008

4-7 Largest M&A Transactions

4-8 Size, Structure & Composition  Dramatic increase in number of firms from 1980 to 1987; Decline of 37% following the 1987 crash, to year 2006  1987: Salomon Brothers held $3.21 billion in capital  2006: Merrill Lynch held capital of $35.5 billion

4-9 Size, Structure & Composition  Many recent inter-industry mergers (i.e., insurance companies and investment banks) –Role of Financial Services Modernization Act, 1999  Lehman Brothers, Bear Stearns, Merrill Lynch, Goldman Sachs, and Morgan Stanley gone by end of 2008

4-10 Types & Relative Sizes of Firms  National full-line firms are largest –BOA (via acquisition of Merrill Lynch) Morgan Stanley  National full-line firms specializing in corporate finance are second in size –Goldman Sachs, Salomon Brothers/Smith Barney (Citigroup)

4-11  Remainder of industry: –Large investment banks (Lazard Ltd. And Greenhill & Co.) –Regional securities firms (subdivided into large, medium and small) –Specialized discount brokers, electronic trading firms, venture capital firms, and other firms Types & Relative Sizes of Firms

4-12 Top Bank Holding Companies 2009 (by brokerage fee income)

4-13 Key Activities  Investing  Investment banking –Activities related to underwriting and distributing new (IPOs) and secondary (seasoned) issues of debt and equity  Public offerings & private placements  Market making –Increasing importance of online trading  Technology risk –Decimalization

4-14 Activities (continued)  Trading –Position trading, pure arbitrage, risk arbitrage, program trading  Cash management  Assisting with M&A  Back-office and service functions

4-15 Recent Trends  Decline in trading volume and brokerage commissions –Particularly since crash of 1987, although some recovery since 1992; Record volumes  Declines in market values--and commission income  Resurgence in market values and commissions during mid-2000s  New lows in 2008

4-16 Trends (continued)  Pretax net income over $9 billion per year  Pretax profits soared to $21.0 billion in 2000 –Curtailed by economic slowdown and September 11 attacks 2001  Worries over securities law violations and investor confidence  Financial crisis, 2008  Profits recovered, 2009

4-17 Securities Industry Pretax Profits,

4-18 Balance Sheet  Key assets: –Long positions in securities and commodities –Reverse repurchase agreements –Implications: Market, interest rate & F/X risks  Key liabilities: –Repurchase agreements major source of funds –Securities and commodities sold short –Broker call loans from banks  Capital levels much lower than in banks

4-19 Regulation  Primary regulator: SEC –Reiterated by National Securities Markets Improvement Act (NSMIA) of 1996 –Prior to NSMIA, regulated by SEC and states

4-20 Regulation  Early 2000s erosion of SEC dominance –Increased vigilance by State Attorneys General  Criminal cases brought mainly by states against securities law violators ∙ New York State vs. Merrill Lynch  Spring 2003, $1.4 billion in penalties over investor abuses  New rules brought by SEC for greater disclosure by analysts of potential conflicts of interest

4-21 Regulation (continued)  Sarbanes-Oxley Act of 2002 –Independent auditing oversight board under SEC –Instigated by Enron, Global Crossings, Tyco, WorldCom

4-22 Regulation (continued)  SEC sets regulatory standards –Day-to-day regulation: Financial Industry Regulatory Authority (FINRA)  Example: Floor trader at Fleet specialist fined $25,000 for mishandling customer orders (10,000 shares of GM sold from Fleet’s account on rumors of problems at GM)

4-23 Extension of Oversight  Additional oversight from US Congress –Hearings focused on role of investment banks in the financial crisis  Goldman Sachs bundling of toxic assets

4-24 Extension of Oversight  2010 Financial Services Regulatory Overhaul Bill –Financial Services Oversight Council –New authority for Federal Reserve to oversee payment, clearing, and settlement systems  Executive compensation in the financial crisis culminated in “pay czar” (Feinberg)

4-25 Investor Protection & Other Monitoring  Securities Investors Protection Corporation (SIPC) –Protection level of $500,000  October 2003 implementation of provisions of Patriot Act to combat money laundering –Scrutiny of individual identities and affiliations with terrorists

4-26 Web Resources  For details of regulation of securities firms and investment banks, visit: SEC NYSE NASD SIPC

4-27 Global Issues  Global nature of securities firms –Competition between US and European firms –Foreign investors’ transactions in US securities and US investors’ transactions in foreign securities exchanges increased –Global concern about capital, liquidity and leverage following the financial crisis  Implications for global competitiveness ∙ Strategic alliances ∙ Exits from foreign markets

4-28 Pertinent Websites Federal Reserve NASD NYSE SEC Securities Industry Association SIPC