Securities Firms and Investment Banks

8-1McGraw-Hill/IrwinChapter SixteenSecurities Firms and Investment Banks16-2McGraw-Hill/IrwinSecurities Firms and Investment Banks (IBs)Investment banks (IBs) help corporations and governments raise capital through debt and equity security issues in the primary marketunderwriting is assisting in the issue of new securitiesIBs also advise on mergers and acquisitions (M&As) and corporate restructuringSecurities firms assist in the trading of securities in secondary marketsbroker-dealers assist in the trading of existing securities16-3McGraw-Hill/IrwinSecurities Firms and Investment Banks (IBs)The size of the industry is usually measured by the equity capital of firms rather than total asset sizethe largest firm in 1987 had $3.2 billion in total capitalthe largest firm in 2007 had $114.2 billion in total capitalThe number of firms in the industry usually follows the overall condition of the economy5,248 firms in 19809,515 firms in 19875,808 firms in 2007As with commercial banks, consolidation has occurred through mergers and acquisitions16-4McGraw-Hill/IrwinSecurities Firms and Investment Banks (IBs)The largest firms in the industry are diversified financial service firms or national full-service IBsservice both retail and wholesale customers by acting as broker-dealersservice corporate customers by underwriting security issuesThe second largest group of firms are full-service firms that specialize in corporate finance or primary market activity (i.e., focus less on secondary market activities)16-5McGraw-Hill/IrwinSecurities Firms and Investment Banks (IBs)A third group of firms includes the rest of the industry and is further divided into five subgroupsIB subsidiaries of commercial banks (i.e., Section 20 subsidiaries)discount brokersregional securities firmsspecialized electronic trading firmsventure capital firms16-6McGraw-Hill/IrwinSecurities Firms and Investment Banks (IBs)Investment bankingfirst time debt and equity issues occur through initial public offerings (IPOs)new issues from a firm whose debt or equity is already traded are called seasoned equity offerings (SEOs)a private placement is a securities issue that is placed with one or a few large institutional investorspublic offerings are offered to the public at largeIBs act only as an agent in best efforts underwritingIBs act as principals in firm commitments16-7McGraw-Hill/IrwinSecurities Firms and Investment Banks (IBs)Market making involves the creation of secondary markets for an issue of securitiesagency transactions are two-way transactions on behalf of customerswith principal transactions market makers seek to profit for their own accountsTrading involves taking an active net position in an assetposition trading involves relatively long-term positions in assets16-8McGraw-Hill/IrwinSecurities Firms and Investment Banks (IBs)pure arbitrage involves attempts to profit from price discrepanciesrisk arbitrage involves attempts to profit by forecasting information releasesprogram trading is the simultaneous buying and selling of at least 15 different stocks valued at $1 million or morestock brokerage involves trading on behalf of customerselectronic brokerage offers customers direct access, via the internet, to the trading floor16-9McGraw-Hill/IrwinSecurities Firms and Investment Banks (IBs)Investing involves managing pools of assets such as closed- and open-end mutual fundsas agentsas principalsCash management involves deposit-like accounts such as money market mutual funds (MMMFs) that offer check writing privilegesMerger and acquisition (M&A) assistance16-10McGraw-Hill/IrwinSecurities Firms and Investment Banks (IBs)Venture capital (VC) is a professionally managed pool of money used to finance new (i.e., start-up) and often high-risk firmsVC usually purchases an equity stake in the start-upusually become active in management of the start-upinstitutional venture capital firms find and fund the most promising new firmsventure capital limited partnershipsfinancial venture capital firmscorporate venture capital firms16-11McGraw-Hill/IrwinSecurities Firms and Investment Banks (IBs)Industry trends depend heavily on the state of the stock marketcommission income declined markedly after the 1987 stock market crash and the 2001-2 stock market declineimprovements in the U.S. economy in the mid-2000s led to increases in commission incomeincome fell with the stock market in 2006-8 because of rising oil prices and the subprime mortgage collapse16-12McGraw-Hill/IrwinBalance Sheets of Securities Firms and Investment Banks (IBs) (2007)Long positions in securities and commodities represent 24.1% of assetsSecurities purchased under agreement to resell represent 21.6% of total assetsSecurities sold under agreement to repurchase represent 41.5% of total liabilities and equityEquity capital amounted to 3.0% of total liabilities and equitycompares to 10.1% for commercial banksSEC requires minimum net worth to assets of 2%16-13McGraw-Hill/IrwinRegulation of Securities Firms and Investment Banks (IBs)The Securities and Exchange Commission (SEC) is the primary regulator of the securities industryThe National Securities Markets Improvement Act (NSMIA) of 1996 reaffirmed federal (over state) authorityeven so, state attorneys general intervene through securities-related investigations that have led to many highly publicized criminal cases16-14McGraw-Hill/IrwinRegulation of Securities Firms and Investment Banks (IBs)The Sarbanes-Oxley Act (SOX) of 2002created an independent auditing oversight board under the SECincreased penalties for corporate wrongdoersforced faster and more extensive financial disclosurecreated avenues of recourse for aggrieved shareholders16-15McGraw-Hill/IrwinRegulation of Securities Firms and Investment Banks (IBs)The SEC sets rules governing underwriting and trading activitySEC Rule 144A defines boundaries between public offerings and private placementsSEC Rule 415 allows shelf registrationallows firms that plan to offer multiple issues of stock over a two-year period to submit one registration statement summarizing the firm’s financing plans for the period16-16McGraw-Hill/IrwinRegulation of Securities Firms and Investment Banks (IBs)Two self-regulatory organizations oversee the day-to-day regulation of trading practicesthe New York Stock Exchange (NYSE)the National Association of Securities Dealers (NASD)The U.S.A. Patriot Act became effective in 2003firms must verify identities of customersfirms must maintain records of identities of customersfirms must verify customers are not on suspected terrorist lists16-17McGraw-Hill/IrwinRegulation of Securities Firms and Investment Banks (IBs)Industry is protected by the Securities Investor Protection Corporation (SIPC)protects investors against losses of up to $500,000 due to securities firm failures (but not against poor investment decisions)created following passage of the Securities Investor Protection Act in 197016-18McGraw-Hill/IrwinGlobal IssuesSecurities firms and investment banks are by far the most global of any group of financial institutionsU.S. firms are increasingly looking to expand their business abroad—particularly into China an India