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Chapter 16 - Securities Firms and Investment Banks
6th Edition
1. Recent Trends and Balance Sheets
a. Recent Trends
As goes the stock market, so goes securities firms’ profitability. Industry profits are
strongly cyclical. Extended bull markets are good for profits, employment and growth;
crashes and downturns hurt trading volume and hence commission income (a mainstay of
revenue at most firms). Fewer firms seek to issue new equity during a bear market, and
debt issuance drops off as coverage ratios decline so underwriting income is also cyclical.
Both underwriting and brokerage income recovered dramatically in the 1990s after
dropping off precipitously subsequent to the 1987 crash. Profitability remained strong
with the bull market of the 1990s. Industry profits were at a record high $21 billion in
2000, but fell 50% in 2001. Reasons for the profit problems included the weak stock
market, the September 11, 2001 attacks, the drop in M&A activity, and the loss of
confidence by investors due to the many ethical violations by some corporations, bankers
and auditors. Profitability remained poor in 2002 at $6.9 billion, but increased in 2003,
hitting a record $22.5 billion and remained high at $19.5 billion in 2004 on large
increases in underwriting activity and hefty cuts in interest and operating expenses. ROE
for 2004 was 13.04%. Domestic underwriting activity was $3,358.3 billion in 2006.
Profits would have been up in 2005 but interest expense on financing securities
inventories increased as interest rates rose. Interest expense rose from $43 billion in
2003 to $136 billion in 2005 to almost $216 billion in 2006. Pre-tax profits fell to $17.6
billion in 2005 but recovered to $33.1 billion in 2006 due to additional revenue growth.
The year 2007 was as bad a year for these firms as it was for most of the financial
services industry due to the subprime crisis. UBS wrote down $10 billion of subprime
related assets in 2007. Likewise, Morgan Stanley wrote down $9.4 billion, Merrill Lynch
wrote down $5 billion. Two hedge funds of Bear Stearns collapsed and went bankrupt
due to their subprime holdings as well. This was the setup to the Federal Reserve assisted
bailout of Bear in March 2008 where J.P. Morgan Chase agreed to purchase Bear for $2 a
share or $236 million.1 J.P. Morgan Chase also received guarantees on parts of Bear’s
mortgage portfolio.
In 2008 the industry reported net losses of $34.1 billion as revenues fell 38.7%.
Expenses fell as well particularly because with the lower interest rates, interest expense
declined. Trading and investment account losses for the industry were $65 billion. As a
result employment in the industry fell from 869,000 to 840,800. Employment kept
falling to 779,800 in September 2009. Profits rebounded sharply in 2009 reaching a
record $61.4 billion. Commissions, fee income and trading profits all rebounded and
interest expense remained very low as the Fed kept interest rates down. High profits
helped in rebuilding capital and efforts to raise external equity.
The years 2010 through 2012 brought many new challenges. The threat of a ‘fiscal cliff’
as U.S. government debt levels grew rapidly while Congress could not decide whether to
increase the debt ceilings, the problems in the Euro area, increasing regulations and
generally weak U.S. economic growth limited profitability for many firms. In May
2010 the ‘flash crash’ brought more scrutiny to trading activities as did the collapse in
1 The sale price was subsequently raised when shareholders complained.
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Chapter 16 - Securities Firms and Investment Banks
6th Edition
October 2011 of MF Global along with the trading glitch at Knight Capital in August
2012. Pretax profits fell from 2010 levels of $34.8 billion to $10.6 billion in 2011 and
$12.4 billion in 2012. The fiscal cliff problem was resolved in January 2013 and after the
European Central Bank pumped about $1 trillion into euro area banks the euro crisis
subsided. In 2013, trading activity, and municipal bond and equity underwriting began to
grow once more and profitability improved.
b. The Balance Sheets
Selected major assets include: (2012)
Receivables from other broker-dealers 26.19%
Long positions in securities and commodities 24.38%
Reverse repurchase agreements 34.21%
Selected major liabilities and equity include: (2012)
Payables to other broker-dealers 14.23%
Payables to customers 15.35%
Short positions in securities and commodities 7.74%
Repurchase agreements 45.83%
Other nonsubordinated liabilities 7.56%
Equity 4.68%
Securities firms finance much of their securities inventory used in market making with
repos. Notice the high levels of repurchase agreement liabilities. This is one reason why
the Fed reacted quickly to ensure liquidity to securities firms when the repo market
briefly ceased functioning on collateral worries during the subprime crisis. These firms
can hold lower capital than banks because they are subject to lower capital requirements
and because their assets are more liquid than banks. Nevertheless, securities firms’
balance sheets are subject to high levels of both market and interest rate risk.
Non-commercial bank firms in this industry must maintain a minimum 2% capital ratio.
This level is probably too low for the risks they take. Indeed Bear-Stearns probably
failed because of its excessive leverage. During the crisis, these firms employed leverage
ratios greater than 30 to 1. This means if the firm loses 3% of the value of their assets,
they are bankrupt. Rumors of large losses at Bear in relation to their capital base led
investors to stop lending and forced a liquidity crisis and a lack of confidence that led to
the firm’s demise. J.P. Morgan Chase purchased the firm for $236 million even though
Bear’s offices in New York were valued at over $2 billion.
2. Regulation
The Securities Investor Protection Corporation (SIPC) insures losses of funds
deposited with securities firms up to $500,000 per investor in the event of the failure of a
securities firm. Losses to security values due to adverse market moves are not insured.
The daily activities of the securities industry are primarily regulated via the New York
Stock Exchange and the Financial Industry Regulatory Authority (FINRA). Thus, to a
large extent these firms are self-regulated according to rules promulgated by the SEC.
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Chapter 16 - Securities Firms and Investment Banks
6th Edition
The Federal Reserve regulates margin requirements on stocks and occasionally suggests
rules changes involving securities trading and underwriting. Recently the Fed suggested
shortening securities settlement from the current three days to one day because securities
are often used as collateral for bank loans.
Since the passage of the National Securities Markets Improvement Act of 1996 removed
state oversight of securities firms, the SEC has the primary jurisdiction over securities
firms and sets standards for their activities. The SEC regulates underwriting and trading
activities and promulgates a series of rules such as Rule 144A regulating private
placements, Rule 415 allowing shelf registrations,2 etc. Under Rule 144A security
issuers may avoid the registration process (and the considerable expense) if they are sold
to a few qualified buyers. The buyers are typically institutional investors but certain high
net worth individuals can qualify. These securities may now be re-traded among the
qualified investors but may not be sold to the public.
Teaching Tip: Very few equities are privately issued; the private market is mostly for
debt. Privately placed debt issues will have lower flotation costs but often carry higher
interest rates.
In the early 2000s certain states began to take a much more active role in regulations of
the markets. Former New York State General Attorney Spitzer led in this process. These
prosecutions led to SEC rules changes to help ensure fewer conflicts of interests between
analysts and investment bankers and better methods of allocating IPO shares.
Investment bankers paid large fines as a result (fines totaled $1.4 billion, see Chapter 8).
In particular, analysts have been barred from attending/participating in the ‘road shows’
and may not receive compensation based on the amount of underwriting business the firm
generates. Within days of the settlement however, Bear Stearns allegedly violated the
new rules. Morgan Stanley allegedly withheld emails pertinent to hundreds of arbitration
cases, falsely claiming the email were lost in the September 11, 2001 terrorist attacks
when they were not.
Teaching Tip:
Interestingly, Bear Stearns (and I am sure the rest) had a very explicit code of ethics
requiring employees to treat customers fairly and to report all ethical violations. The
corporate culture on Wall Street, including compensation schemes, needs an overhaul.
Moreover, these violations matter. They impede growth by raising the cost of funds to
everyone. How much value was destroyed by unethical behavior of managers at Enron,
WorldCom, HealthSouth, Tyco, Parmalat, etc.? How much spillover to other firms’ stock
prices occurred as a result of the loss of confidence in management? What did this do to
our cost of funds, or reliance on foreign funds if you prefer. What has/will this cost us in
the future in terms of costly contracting? Already a class action lawsuit against bankers
2To help speed up the process issuers sometimes pre-register securities using a procedure
termed a shelf registration. After the registration is approved the issuer may then market
the issue at any time within the subsequent two years after filing a short form with the
SEC that is normally approved within a day or two.
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that underwrote WorldCom debt has resulted in payments of $6 billion by bankers (with
the largest payment of $2.85 billion by Citigroup). Citigroup also paid $2 billion to settle
a class action suit over Enron and $75 million to settle a similar suit over its involvement
with Global Crossing. Citi has now instituted mandatory ethics training for all
employees.3 The long jail sentences that Ebbers (WorldCom CEO), Rigas (Adelphia
CEO), Dennis Kozlowski and others received should also help deter some of the more
egregious fraud schemes. I believe that at some point increased sentences may be needed
to rein in unethical investment banking practices as well.
The markets themselves have not been immune to scandal. In 1996 the SEC charged the
NASD (the regulatory body of the NASDAQ stock market) with ignoring evidence of
price fixing by NASDAQ market makers or dealers. The dealers were allegedly
colluding to keep bid-ask spreads artificially high by refusing to quote odd eighths and
blackballing dealers who did not comply (at that time many stock prices traded in
minimum increments of one eighth). The NASD agreed to spend $100 million to
improve rules enforcement. Subsequently, 30 brokerage firms agreed to pay $900 million
to settle a civil suit alleging they engaged in price fixing of NASDAQ securities.
In 2003 the NYSE fined a trader of Fleet Specialist Inc $25,000 for front running. Front
running occurs when a specialist executes orders for their own account ahead of public
orders. The trader sold GM stock from the specialist’s own account on rumors of
accounting problems at GM ahead of a public sell order.
In July 2002, Congress passed the Sarbanes-Oxley Act seeking to improve corporate
governance and accounting oversight. This bill created an independent auditing oversight
board run by the SEC, increased penalties for corporate malfeasance, and gave
disgruntled shareholders more options to pursue lawsuits. The law restricts accounting
firms’ ability to provide non-audit services to audit clients and no longer allow the AICPA
to set accounting and auditing standards. These will be set by the Public Company
Accounting Oversight Board. The act requires that the CEO and CFO prepare and sign a
statement certifying the reasonableness of the firm’s financial statements. The NYSE and
the NASD have also changed their listing requirements with respect to corporate
governance. Details may be obtained from their websites (see the list of websites at the
end and in Chapter 8).
Anti-money laundering activities:
The USA Patriot Act added three new requirements to securities firms as of October
2003. The new rules included:
1. Firms must verify the identity of any person seeking to open an account.
2. Firms must keep records of the information used to verify the client’s identity.
3. Firm must determine whether the client appears on any lists of known or
suspected terrorists or terrorist organizations.
The industry is subject to Congressional oversight, but this usually takes the form of
3 Citgroup data from “Evening Wrap Up, Citi Settles,” Mark Congoloff, The Wall Street
Journal Online, June 10, 2005.
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ex-post investigations after problems have emerged. For instance, Goldman Sachs (GS)
was investigated by a congressional panel in 2010 concerning GS’ creation of mortgage
backed CDOs which they had shorted to limit their risk. GS was accused of knowingly
creating and selling risky mortgage investments after they knew they were likely to be
riskier than the rating indicated and put themselves in a position to profit from a decline
in the securities’ values. This is an obvious conflict of interest. Under the Dodd Frank
Act, the Financial Services Oversight Council (FSOC) has oversight of systemic risk of
the industry. More investment advisors will have to be registered with either the SEC or
state advisors. Securitization markets should now have more oversight and originators
will have to retain a greater interest in loans that will be resold. More derivatives
regulation over time can be expected as well. FINRA is increasing oversight and
reporting requirements for dark pools and for flash trading. As of this writing no formal
limits have been proposed on these activities but they are suspected to increase volatility
and of being used in market manipulation strategies.
The government can also mandate higher capital requirements for larger and for
interconnected firms. Government oversight of industry practices has increased as a
result of the bill. Executive compensation restrictions were also promulgated by the
Obama administration which tried to strengthen the independence of the compensation
committee from senior management. Shareholders now also have a non-binding vote on
executive compensation packages and Obama’s pay czar, Kenneth Feinberg, has a say on
executive pay for firms that accepted bailout money.
Teaching Tip:
Ask students whether limits on executive pay are appropriate or not. What would be the
pros and cons? The industry argues that they will be unable to attract top talent without
large performance type bonuses. Executive pay would seem to be very high however and
it is higher than is typical in much of the rest of the world. Many in the public would
argue that executives in firms that took taxpayer dollars have no business receiving any
performance bonuses. AIG executives received bonuses even as the firm was on the
verge of bankruptcy.
The Scandals Continue
Date Firm/Principal Acvity
Selement
Payment
January 2011 Primary Global
Research LLC, Bob
Nguyen
Solicing informaon for inside
trading
June 2012 Barclays Bank LIBOR manipulaon $450 million
July 2012 Peregrine Financial,
Russell Wassendorf ,
Misallocang and misreporng
usage of $215 million in client funds
December
2012
Goldman Sachs trader
Mahew Taylor
Concealed $8.3 billion futures
posion
$1.5 million
December
2012
Morgan Stanley
Senior banker in6uenced analyst and
share allocaon of Facebook IPO
December
2012 UBS LIBOR manipulaon $1.5 billion
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December
2012 HSBC Money laundering $1.9 billion
February
2013
Royal Bank of
Scotland LIBOR manipulaon $610 million
October 2013 J. P. Morgan Bad mortgage pracces originaon
and sale $13 billion
October 2013 J. P. Morgan Trade error in London cost ;rm $6
billion $920 million
October 2013 J. P. Morgan Excessive credit card charges $ 80 million
October 2013 J. P. Morgan Manipulang energy markets $410 million
December
2013 Deutsche Bank Euribor manipulaon $981 million
February
2014 Morgan Stanley Bad mortgage pracces originaon
and sale $1.25 billion
July 2014 Cigroup Bad mortgage pracces originaon
and sale $7.00 billion
July 2014 Lloyds Banking Group LIBOR manipulaon $370 million
Sources: Text, Wall Street Journal and Bloomberg, various dates
This list is not complete. Charges of the same banks as involved in LIBOR fixing of
manipulating ISDAfix, a rate used for swaps, are also emerging as of July 2014. Also as
of this writing, evidence is emerging of allegations that the Bank of England, the British
central bank, knew of manipulations of currency rate quotes for as long as eight years
without taking action. The currency markets involve over $5.3 trillion in daily trading
volume.4 The SEC is investigating whether traders distorted prices for currency options
and exchange traded funds. Reports are emerging that traders shared information about
client orders in order to manipulate prices. As of June 2014 about 20 traders at the top
three banks (Deutsche, Citi and Barclays) involved in currency trading had been fired.
Teaching Tip:
These firms are regulated but we continue to have ethical problems. Ask students
whether regulations are sufficient to prevent these problems. If not, then what else
should be done? As of January 1, 2013 Dutch bankers are required by law to swear an
oath to act ethically, details can be found at:
http://www.nibc.com/investor-relations/dutch-banking-code.html. Should the U.S. do
something similar?
3. Global Issues
Investment banking activities are highly globalized. For instance, in 2012 Deutsche Bank
was the number one underwriter of convertible debt and mortgage debt. Foreign
transactions in U.S. stocks increased from $211.2 billion in 1991 to $12,037.9 billion in
4 Carney Faces Grilling as Currency Scandal Snares BOE. Bloomberg, By Scott
Hamilton and Suzi Ring Mar 10, 2014 8:37 AM MT,
http://www.bloomberg.com/news/2014-03-10/carney-faces-leadership-test-as-currency-sc
andal-snares-boe.html.
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Chapter 16 - Securities Firms and Investment Banks
6th Edition
2008. This represents a compound average annual growth rate of 26.85%. U.S.
transactions in foreign stocks increased from $152.6 billion in 1991 to $5,410.9; an
annual compound growth rate of over 23%. The financial crisis deterred the rate of
growth. In 2013 foreign transactions in U.S. stocks were $7,571.68 billion and U.S.
trading in foreign stocks was $3,969.5 billion. International offerings have also grown
rapidly, but recent scandals, the U.S. stock market weakness, disclosure requirements and
the decline in the value of the dollar has probably deterred foreign investors and foreign
issuers from participating in the U.S. markets. U.S. firms are seeking a greater presence
in fast growing markets such as China and India.
The financial crisis has increased the need for capital at banks. Many firms are now
engaging in strategic alliances with foreign partners. For instance, Morgan Stanley sold a
21% stake of its firm to Mitsubishi UFJ in 2008. Citigroup took a different tact and sold
some of its foreign businesses such as Nikko Asset Management and Nikko Citi Trust to
increase capital. The industry continues to restructure as a result of the crisis.
Teaching Tip: Investment bankers can help U.S. institutions gain exposure to
international markets. Banks have created structured derivative debt products that allow
an institution to earn higher overseas interest rates while limiting exchange rate risk.
Bankers can also sometime help improve the marketability of foreign bonds that are
difficult to sell because they are denominated in a foreign currency. Many U.S. financial
institutions are limited as to how much currency risk they can incur. Bankers have at
times securitized these foreign currency denominated bonds by placing them in a trust
and issuing dollar denominated claims to U.S. buyers.5 Hedge funds engage in risk
arbitrage strategies on a global basis. The most famous of these (or infamous), Long
Term Capital Management, engaged in risk arbitrage on an unprecedented global scale.
1.1.1.1
1.1.1.2 VI. Web Links
http://www.federalreserve.gov/ Website of the Board of Governors of the Federal
Reserve
http://www.wsj.com/ Website of the Wall Street Journal Interactive
edition. The web version of the well known
financial newspaper can be personalized to meet
your own needs. The Wall Street Journal Online
‘Scandal Scorecard’ provides readers with a fast
way to keep track of the large number of scandals
and what has happened to the players.
http://www.sifma.com/ The Securities Industry Association website.
Industry information, the SIA Factbook (other than
the current annual version) and discussions on key
industry issues may be found here.
5 These claims are usually overcollateralized to help limit exchange rate risk.
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Chapter 16 - Securities Firms and Investment Banks
6th Edition
http://www.sec.gov/ The Securities Exchange Commission
http://www.nyt.com/ The New York Times, from time to times the NYT
has excellent articles on financial topics.
http://www.tfibcm.com/ Thompson Reuters website. This site has the latest
updates on U.S. and global underwriting volume
and M&A activity.
http://www.nyse.com/ The website of the NYSE, exchange rules are
online.
http://www.nasdaq.com/ The National Association of Securities Dealers
website.
http://www.sipc.org/ The Securities Investor Protection Corporation
website.
1.1.1.2.1.1
1.1.1.2.1.2 VII. Student Learning Activities
1. Go to the website of the SIPC and summarize the answers to the ‘7 most
asked questions about the SIPC.’
2. At the NASD’s website, read the study outline for the Series 7 exam. What is
the purpose of the Series 7 exam? What are the seven critical functions of a registered
representative?
3. Go to the SIFMA website and read about the complexity of the new Dodd
Frank law. How many new regulations are proposed? Will this law help or hurt the
industry? Defend your answer.
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