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  1. 1. Chapter Sixteen Securities Firms and Investment Banks
  2. 2. Chapter Outline <ul><li>Types of Firms </li></ul><ul><li>Activity Areas </li></ul><ul><li>Balance Sheet </li></ul><ul><li>Regulation </li></ul>
  3. 3. 1. Investment Banks vs. Securities Firms <ul><li>Investment Banks </li></ul><ul><ul><li>raise the debt and equity securities for corporations or governments including the origination, underwriting, and placement of securities in money and capital markets </li></ul></ul><ul><li>Securities Firms </li></ul><ul><ul><li>services involve assistance in the trading of securities in the secondary markets (brokerage services or market making) </li></ul></ul><ul><li>The largest companies in the industry perform multiple services (e.g., underwriting and brokerage) and are generally called investment banks </li></ul>
  4. 4. Size of the Industry <ul><li>Size of the industry is measured by the equity capital of the firms participating in the industry rather than by “asset size” </li></ul><ul><li>At the end of 2004, equity capital in this industry amounted to $168.0 billion, supporting total assets of $5.11 trillion </li></ul>
  5. 5. Industry Composition <ul><li>Three major types of firms </li></ul><ul><ul><li>national full-line investment banks that service retail and corporate customers (e.g., Merrill Lynch) </li></ul></ul><ul><ul><li>national full-line firms that specialize in corporate finance (e.g., Goldman Sachs) </li></ul></ul><ul><ul><li>the remainder of the industry </li></ul></ul><ul><ul><ul><li>specialized investment bank subsidiaries of commercial banks </li></ul></ul></ul><ul><ul><ul><li>specialized discount brokers </li></ul></ul></ul><ul><ul><ul><li>regional securities firms </li></ul></ul></ul><ul><ul><ul><li>specialized electronic trading securities firms </li></ul></ul></ul><ul><ul><ul><li>venture capital firms </li></ul></ul></ul>
  6. 6. 2. Activity Areas <ul><li>Securities firms and investment banks engage in as many as seven key activity areas </li></ul><ul><ul><li>Investing </li></ul></ul><ul><ul><li>Investment Banking </li></ul></ul><ul><ul><li>Market Making </li></ul></ul><ul><ul><li>Trading </li></ul></ul><ul><ul><li>Cash Management </li></ul></ul><ul><ul><li>Mergers and Acquisitions </li></ul></ul><ul><ul><li>Other Service Functions </li></ul></ul>
  7. 7. 2.1 Investing <ul><li>Involves managing pools of assets such as mutual funds </li></ul><ul><li>Compete with commercial banks, life insurance companies, and pension funds </li></ul><ul><li>Manage funds either as agents for other investors or as principals </li></ul><ul><li>Objective is to select asset portfolios to beat some return-risk performance benchmark such as the S&P 500 </li></ul>
  8. 8. 2.2 Investment Banking <ul><li>Refers to activities related to underwriting and distributing new issues of debt and equity securities </li></ul><ul><li>Industry is dominated by a small number of underwriting firms; top 5 underwriters represented 36.6% of the industry total </li></ul><ul><li>Securities underwriting can be undertaken through either public or private offerings </li></ul><ul><ul><li>Private placement - securities issue placed with one of a few large institutional investors </li></ul></ul><ul><ul><li>Public placement - may be underwritten on a best efforts or firm commitment basis and offered to the public </li></ul></ul>
  9. 9. Public Placement <ul><li>Best efforts </li></ul><ul><ul><li>Investment banker acts as an agent on a fee basis </li></ul></ul><ul><li>Firm commitment </li></ul><ul><ul><li>Dominant form of underwriting in the US </li></ul></ul><ul><ul><li>Investment banker acts as principal, purchasing the securities from the issuer at one price and seeking to place them with public investors at a slightly higher price </li></ul></ul>
  10. 10. 2.3 Market Making <ul><li>Involves the creation of a secondary market in an asset by a securities firm or investment bank </li></ul><ul><li>Either agency or principal transactions </li></ul><ul><ul><li>Agency transactions - two-way transactions on behalf of customers </li></ul></ul><ul><ul><li>Principal transactions - the market maker seeks to profit on the price movements of securities and takes long or short inventory positions for its own account </li></ul></ul>
  11. 11. 2.4 Trading <ul><li>Six types of trading </li></ul><ul><ul><li>Position trading - purchases of large blocks on expectation of favorable price move </li></ul></ul><ul><ul><li>Pure Arbitrage - buying an asset in one market and selling it immediately in another market at a higher price </li></ul></ul><ul><ul><li>Risk Arbitrage - buying securities in anticipation of some information release </li></ul></ul><ul><ul><li>Program Trading - simultaneous buying and selling using a computer program to initiate such trades; at least 15 stocks of value more than $ 1 million </li></ul></ul><ul><ul><li>Stock Brokerage - trading securities on behalf of individuals </li></ul></ul><ul><ul><li>Electronic Brokerage - offered by major brokers, direct access via internet to trading floor; an estimated 5 million people used the facilities in early 2000s </li></ul></ul>
  12. 12. 2.5 Cash Management <ul><li>Securities firms and investment banks offer bank deposit-like cash management accounts (CMAs) to individual investors </li></ul><ul><ul><li>money market mutual fund sold by investment banks that offer check-writing privileges </li></ul></ul>
  13. 13. 2.6 Mergers and Acquisitions <ul><li>Frequently provide advice on, and assistance in, mergers and acquisitions </li></ul><ul><ul><li>assist in finding merger partners </li></ul></ul><ul><ul><li>underwrite any new securities </li></ul></ul><ul><ul><li>asses the value of target firms </li></ul></ul><ul><ul><li>recommend terms of the merger agreement </li></ul></ul><ul><ul><li>assist target firms in preventing a merger </li></ul></ul>
  14. 14. 2.7 Other Service Functions <ul><li>Custody and escrow services </li></ul><ul><li>Clearance and settlement services </li></ul><ul><li>Research and advisory services </li></ul>
  15. 15. Balance Sheet Assets, 2004 Assets Cash $ 50,744.0 1.28% Receivable from other broker-dealers 1,530,227.0 38.44 Receivable from customers 163,159.2 4.10 Receivables from noncustomers 18,345.8 0.46 Long positions in securities/commodities 1,075,696.7 27.02 Securities and investments not marketed 11,753.1 0.30 Securities purchased w/resell agreement 967,008.0 24.29 Exchange membership 1,086.6 0.03 Other assets 162,346.1 4.08 Total assets $3,980,375.4 100.00
  16. 16. Balance Sheet Liabilities, 2004 Liabilities Bank loans payable $ 75,548.8 1.90% Payables to other broker-dealers 842,983.0 21.18 Payables to noncustomers 66,995.6 1.68 Payables to customers 407,432.6 10.23 Short positions in securities/commodities 510,513.0 12.82 Securities sold w/repurchase agreements 1,565,003.7 39.32 Other nonsubordinated liabilities 286,459.8 7.20 Subordinated liabilities 75,921.7 1.91 Total liabilities $3,830,858.1 96.24 Capital Equity capital 149,517.3 3.76 Number of firms 6,549
  17. 17. 4. Regulation <ul><li>The primary regulator of the securities industry is the Securities and Exchange Commission (SEC) established in 1934 </li></ul><ul><li>SEC sets rules governing securities firms’ underwriting and trading activities </li></ul><ul><li>Shelf registration – allows qualifying firms that plan to offer multiple issues of stock over two years to submit one registration statement summarizing the firm’s financing plans for the period </li></ul><ul><li>The Securities Investor Protection Corporation (SIPC) protects investors against losses of up to $500,000 on securities firm failures </li></ul>
  18. 18. Self-Regulation <ul><li>Two self-regulatory organizations are involved in the day-to-day regulation of trading practices </li></ul><ul><ul><li>NYSE </li></ul></ul><ul><ul><li>NASD </li></ul></ul><ul><li>Monitor trading abuses, such as insider trading </li></ul><ul><li>Solvency positions, requiring a minimum of 2% net worth to assets ratio </li></ul>

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