Chapter 5 Investment Banks Mutual Funds Hedge Funds and the Shadow Banking System Overview of Commercial Banks for comparison Basic operations take in deposits from individuals small firms make loans mainly mortgages and small firms Government regulations o Limited to what they can invest in o Limits on size of leverage ratio FDIC insurance stopped liquidity problems ended bank runs o If cash is greater than what bank can supply Overview of this chapter During financial crisis of 2007 2009 commercial banks no longer played the dominant role in routing funds from lenders to borrowers o non bank financial institutions using newly developed financial securities Shadow Banking System Financial crisis of 2007 2009 first time in U S History that a major financial crisis had not originated in the commercial banking system Key issue for policy makers what role the Fed could should play in dealing with a financial crisis that involved many nonbank financial firms o Since it was originally set up to stabilize and regulate the commercial banking system Investment Banking Providing advice on new security issues o Firms turn to investment banks for advice on how to raise funds by issuing stock or bonds or by taking out loans o Investment banks have information about the current willingness of investors to buy different types of securities and on the price the investors are likely to require Underwriting new security issues o Investment banks typically guarantee a price to the issuing firm sell the issue in financial markets or directly to investors at a higher price and keep the difference the spread o Initial Public Offering Investment banks typically earn 6 8 of the total dollar amt raised First time a firm sells stock to the public o Seasoned Secondary Offering they earn 2 4 of the total dollar amt raised Security sales by a firm that has sold securities previously o Syndicates groups of investment banks which underwrite large issues one investment bank is the manager and the rest are under it firm decides second step due diligence process to research firm s value third step bank prepares a prospectus required by SEC fourth step bank conducts a road show fifth step bank seta a price for the stock o lowers information costs reputation of investment bank is behind the firms they underwrite Providing advice and financing for mergers and acquisitions o They advise both buyers the buy side mandate and sellers the sell side mandate o Investment banks take the initiative in contacting firms o Investment banks attempt to find an acquiring firm willing to pay significantly more than the book value of the firm Assets Liabilities o Investment bank does not have to invest its own capital Financial engineering including risk management o Financial engineering designing new securities o Derivative securities are the result of financial engineering o Mortgage Backed Securities when housing prices declined and people began to default on their mortgages o Collateralized Debt Obligations assets to back debt obligations o MBS and CDOs lacked transparency because they were complex Did rating companies fail to understand Conflict of interest Company puts together these derivative products that pays rating agencies for ratings rated based on probability of defaulting a little higher rating will bring more business if rated lower Last time they will come Research Proprietary trading o Banks assign research analysts to individual large firms or to industries o They gather publicly available information on firms and sometimes interview o These opinions can have a large impact on the market o Privately owned publicly owned owned by shareholders o Buying and selling securities for the bank s own account rather than for clients o Exposes banks to interest rate risk and credit risk Interest rate risk If they hold long term securities banks are exposed to the risk of an increase in market interest rates that will cause the prices of their long term securities to decline Credit risk most significant Borrowers might default on their loans The credit risk on mortgage backed securities was much higher than expected Result was significant losses for investment banks and eventually a reorganization of the industry since market prices for MBS declined and were difficult to sell Government Regulations o No FDIC o No leverage limits o No minimum asset requirements Leverage Source of funds short term borrowing Financing investments by borrowing increases a bank s leverage Borrowed to finance their investments in securities and their direct loans to firms Profits from the investment are increased but so are losses ROE ROA x leverage ratio the higher the leverage ratio the higher the ROE for a given ROA Leverage ratio ratio of a bank s assets to its capital Commercial Paper Short term loan o Unsecured Sale of issue means of borrowing demands Firm with reputation as high quality o Maturity of 270 days or less SEC registration not required Reduces transaction costs Repo Financing Investment banks borrowed primarily by either issuing commercial paper or by using repurchase agreements short term loans backed by collateral i e investment bank might borrow money by selling Treasury bills to another bank or a pension fund and at the same time the investment bank would agree to buy the treasury bills back at a slightly higher price either the next day or within a few days o The difference between the price of the Treasury bills when sold and repurchased would represent the interest on the loan Both commercial paper and Repo financing represent short term loans Investment banks face a maturity mismatch when the maturity of their liabilities the commercial paper or repos is shorter than the maturity of their assets the mortgage backed securities or loans Commercial banks usually face a maturity mismatch when they use short term deposits to make long term loans o This leave commercial banks vulnerable to bank runs in which depositors want to withdraw their money but can t because banks have invested most of the money in illiquid loans Lenders who buy the commercial paper of investment banks or engage in repo financing with them have no federal guarantees o If an investment bank fails lenders can suffer heavy losses unless the loans are collateralized with assets that do not decline in value This counterparty risk played an important role in the financial crisis of 2007 2009 As investment banks suffered heavy losses on MBS lenders refused
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