Financial Markets and Institutions (2-downloads)

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Investment Banks

Investment bankers were called “Masters of the Universe” in Tom Wolfe’s The Bonfire

of the Vanities. They are the elite on Wall Street. They have earned this reputa-

tion from the types of financial services they provide. Investment banks are best

known as intermediaries that help corporations raise funds. However, this defini-

tion is far too narrow to accurately explain the many valuable and sophisticated ser-

vices these companies provide. (Despite its name, an investment bank is not a bank

in the ordinary sense; that is, it is not a financial intermediary that takes in deposits

and then lends them out.) In addition to underwriting the initial sale of stocks, bonds,

and commercial paper, investment banks also play a pivotal role as deal makers

in the mergers and acquisitions area, as intermediaries in the buying and selling of

companies, and as private brokers to the very wealthy. Some well-known invest-

ment banking firms are Morgan Stanley, Bank of America, Merrill Lynch, Credit

Suisse, and Goldman Sachs.

One feature of investment banks that distinguishes them from stockbrokers and

dealers is that they usually earn their income from fees charged to clients rather than

from commissions on stock trades. These fees are often set as a fixed percentage

of the dollar size of the deal being worked. Because the deals frequently involve huge

sums of money, the fees can be substantial. The percentage fee will be smaller for

large deals, in the neighborhood of 3%, and much larger for smaller deals, sometimes

exceeding 10%.

Background

In the early 1800s, most American securities had to be sold in Europe. As a result,

most securities firms developed from merchants who operated a securities busi-

ness as a sideline to their primary business. For example, the Morgans built their

initial fortune with the railroads. To help raise the money to finance railroad expan-

sion, J. P. Morgan’s father resided in London and sold Morgan railroad securities to

European investors. Over time, the profitability of the securities businesses became

evident and the securities industry expanded.

Prior to the Great Depression, many large, money center banks in New York

sold securities and simultaneously conducted conventional banking activities. During

the Depression, about 10,000 banks failed (about 40% of all commercial banks). This

led to the passage of the Glass-Steagall Act, which separated commercial bank-

ing from investment banking.

The Glass-Steagall Act made it illegal for a commercial bank to buy or sell secu-

rities on behalf of its customers. The original reasoning behind this legislation was

to insulate commercial banks from the greater risk inherent in the securities business.

There were also concerns that conflicts of interest might arise that would subject com-

mercial banks to increased risk. For example, suppose that an investment banker

working at a commercial bank makes a mistake pricing a new stock offering. After

promising the customer that he can sell the stock for $20, no sales materialize. The

investment banker might be tempted to go down the hall to the commercial bank’s

investment department and talk them into bailing him out. This would subject depos-

itors to the risk that the bank could lose money on poor investments.

Regulators thought another problem existed. Suppose the investment banker still

cannot sell all of that $20 stock issue. He could call up bank customers and offer to

loan them 100% of the funds needed to buy a portion of the stock issue. This would

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not cause a problem if the stock price rose in the future, but if it fell, the value of

the securities would be less than the amount of the loan and the customer might

not feel a great obligation to repay the loan. Many industry observers felt that this

practice was partially to blame for some of the bank failures that occurred during the

Depression. However, bank lobbyists argue that although only large banks were

involved in issuing securities, most banks that actually failed were small.

When the Glass-Steagall Act separated commercial banking from investment

banking, new securities firms were created, many of which offered both investment

banking services (selling new securities to the public) as well as brokerage services

(selling existing securities to the public).

The legal barriers between commercial and investment banks have been decay-

ing rapidly since the 1980s. One significant trend has been the acquisition of invest-

ment banks by commercial banks. For example, in 1997, Bankers Trust acquired

Alex Brown, the oldest investment bank in the nation. Bankers Trust was subse-

quently acquired by Deutsche Banks, which has been spending enormous amounts

of money establishing its own investment banking arm. Bank of America bought

Robertson Stephens & Co., while NationsBank acquired Montgomery Securities.

During the financial crisis in 2009 Bank of America acquired Merrill Lynch, J.P.

Morgan acquired Bear Stearns, and Barclays acquired some of the remaining assets

of Lehman Brothers.

Underwriting Stocks and Bonds

When a corporation wants to borrow or raise funds, it may decide to issue long-term

debt or equity instruments. It then usually hires an investment bank to facilitate the

issuance and subsequent sale of the securities. The investment bank may underwrite

the issue. The process of underwriting a stock or bond issue requires that the secu-

rities firm purchase the entire issue at a predetermined price and then resell it in

the market. There are a number of services provided in the process of underwriting.

Giving Advice

Most firms do not issue capital market securities very frequently.

Over 80% of all corporate expansion is financed using profits retained from prior-

period earnings. As a result, the financial managers at most firms are not familiar with

how to proceed with a new security offering. Investment bankers, since they par-

ticipate in this market daily, can provide advice to firms contemplating a sale. For

instance, a firm may not know if it should raise capital by selling stocks or by sell-

ing bonds. The investment bankers may be able to help by pointing out, for exam-

ple, that the market is currently paying high prices for stocks in the firm’s industry

(historically high PE ratios), while bonds are currently carrying relatively high inter-

est rates (and therefore low prices).

Firms may also need advice as to when securities should be offered. If, for exam-

ple, competitors have recently released earnings reports that show poor profits, it

may be better to wait before attempting a sale: Firms want to time the market to

sell stock when it will obtain the highest possible price. Again, because of daily inter-

action with the securities markets, investment bankers should be able to advise firms

on the timing of their offerings.

Possibly the most difficult advice an investment banker must give a customer

concerns at what price the security should be sold. Here the investment banker

and the issuing firm have somewhat differing motives. First, consider that the firm

wants to sell the stock for the highest price possible. Suppose you started a firm

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and ran it well for 20 years. You now wish to sell it to the public and retire to Tahiti.

If 500,000 shares are to be offered and sold at $10 each, you will receive $5 million

for your company. If you can sell the stock for $12, you will receive $6 million.

Investment bankers, however, do not want to overprice the stock because in most

underwriting agreements, they will buy the entire issue at the agreed price and then

resell it through their brokerage houses. They earn a profit by selling the stock at a

slightly higher price than they paid the issuing firm. If the issue is priced too high,

the investment bank will not be able to resell, and it will suffer a loss.

Pricing securities is not too hard if the firm has prior issues currently selling in

the market, called seasoned issues. When a firm issues stock for the first time, called

an initial public offering (IPO), it is much more difficult to determine what the

correct price should be. All of the skill and expertise of the investment banking firm

will be used to determine the most appropriate price. If the issuing firm and the

investment banking firm can come to agreement on a price, the investment banker

can assist with the next stage, filing the required documents.

Filing Documents

In addition to advising companies, investment bankers will

assist with making the required Securities and Exchange Commission (SEC)

filings. The activities of investment banks and the operation of primary markets are

heavily regulated by the SEC, which was created by the Securities and Exchange

Acts of 1933 and 1934 to ensure that adequate information reaches prospective

investors. Issuers of new securities to the general public (for amounts greater

than $1.5 million in a year and with a maturity longer than 270 days) must file a