Three large financial firms that were said to be at the heart of the financial crisis Chapter 5 1 Bear Stearns 2 Lehman Brothers 3 AIG Investment Banking Financial activities that involve underwriting new security issues and providing advice on mergers and acquisitions Ex JP Morgan Merrill Lynch Goldman Sachs Concerned with the following activities Providing advice on new security issues Underwriting new securities Providing advice for mergers and acquisitions Financial engineering i e risk management Research Proprietary trading MORE SPECIFICALLY Providing advice on new security issues Advice regarding how to raise funds by issuing stocks or bonds or by taking out loans This includes the current willingness of buyers in terms of the type of securities they are looking for as well as the price they are willing to pay Underwriting new securities Underwriting is the guarantee that the investment bank will issue the new security at a certain price and then resells the security for a profit spread In underwriting the investment bank takes on the risk that they will not be able to resell with a profit Typically this spread is about 6 8 for Initial Public Offerings IPO and 2 4 for Secondary Offerings Underwriting advantages lower information costs and increases consumer confidence because of the firm s reputation Syndicate A group of investment banks that jointly underwrite a security issue 1 2 3 Form a prospectus required by the SEC to contain all information that may be pertinent to the sale firms profitability net worth and any other risks involved Conduct a Road Show visit potential buyers hedge funds mutual funds and pension funds that might be interest in buying the security issue Set a price dependent on the current market demand Providing advice for mergers and acquisitions An investment bank advises both sides of the equation the buy side mandate and the sell side mandate Typically the investment bank takes the initiative in contacting firms about potential purchases sales or mergers When a firm is SEEKING to be acquired the investment bank attempts to find a firm that is willing to pay significantly more than the firm s BV Assets Liabilities Mergers and acquisitions are VERY profitable because the only real cost involved for the bank is the cost of the banker s salaries the bank does NOT have to invest its own capital Financial engineering i e risk management Financial Engineering process of designing new securities by using mathematical models Ex Derivative securities These mathematical models help reduce RISK During the financial crisis financial engineers with investment banks were criticized for not fully understanding therefore underestimating risk collateralized debt obligations and credit default swap contracts Research Investment banks employ analysts to gather publicly available information on firms and sometimes visit firm s to interview its managers Investment banks use the research of these analysts to identify mergers acquisitions and to convey advice to trading desks Analysts advice is highly noted amongst the community and can have a huge impact on the current price of stock Underweight stock they do not recommend Overweight stock they do recommend Analysts may also participate in writing reports on economic trends providing forecasts on macro variables inflation rates GDP and various interest rates Proprietary trading Buying or selling securities for the bank s own account rather than for clients Became a major source of profits for banks in the early 90 s and has continued to be Exposes banks to both interest rate risk and credit risk Interest Rate Risk Risk that increases in market interest rates prices of long term securities to decline loss Credit Risk Risk that borrowers might default on loans Ex Mortgage backed securities during the financial crisis The risk was much higher than investment banks expected significant losses How do investment banks finance their investments 1 Capital funds from shareholders profits the bank has retained over the years through underwriting and providing advice 2 Short term borrowing bad because it increases leverage increases profits losses so it is a double edged sword Investment banks used Repurchase Agreements short term loans backed by collateral in particular as their method for short term borrowing Because of this heavy losses during the financial crisis It is argued that the reason investment banks took on so much risk prior to the financial crisis is because the board of directors were not equipped to understand their new financial activities i e trading complex financial securities such as repos Glass Steagall Act in 1933 legally separated investment banking from commercial banking and also contained provisions for federal deposit insurance Congress saw investment as too risky for commercial banking The act was designed to protect people with deposits in commercial banks from risky banking activities In 1999 the Gramm Leach Bliley Act repealed the Glass Steagall Act Gramm Leach Bliley Act of 1999 The act permitted securities and insurance firms to own commercial banks It also allowed commercial banks to participate in risky activities such as securities insurance and real estate Some economists believe this act may have caused the financial crisis Where did all the investment banks go As the financial crisis deepened investment banks had a hard time borrowing money on a short term basis which forced them to sell assets at lower than BV The sale of assets at lower than BV liquidity problems bankruptcy Investment Institutions financial firms that raise funds to invest in loans and securities Ex Hedge funds mutual funds finance companies Mutual Funds Financial intermediary that raises funds by selling shares to individual savers and invests the funds in a portfolio of stocks bonds mortgages and money market securities Advantage reduce transaction costs Investors buy shares in mutual funds and become part owners with a widely diversified portfolio of securities Most investors are able to enjoy a much more diversified portfolio than they could have on their own In recent years it has become the largest financial intermediary in the world event ahead of banks Mutual funds appeal to investors at all income levels mainly those who lack the time commitment or knowledge to maintain their own portfolios No load funds mutual funds that do not charge buyers a commission to buy and sell shares but DO charge a management fee
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