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Chapter 4 Securities Firms and Investment Banks McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Overview In this segment ... Securities Firms and Investment Banks: Activities of securities firms and investment banks Size, structure and composition Balance sheets and recent trends Regulation of securities firms and investment banks Global issues 4-2 -2 Securities Firms &Investment Banks 4-3 -3 Nature of business: Underwrite securities. Market making. Advising (example: M&A, restructurings). Securities Firms &Investment Banks Growth in domestic M&A: Less than $200 billion in 1990. $1.83 trillion in 2000 In US: bottomed out at $458 billion in 2002 ($1.2 trillion worldwide) $1.3 trillion 2006 ($2.9 trillion worldwide) 4-4 -4 Mergers and acquisitions 1990-2006 4-5 -5 The Largest M&A Transactions Deal Price (billions) Year Citicorp/Travelers $83.0 1998 BOA/Fleet Boston 49.3 2003 J.P. Morgan/Bank One 60.0 2004 Chase/J.P. Morgan 35.0 2000 BOA/MBNA 35.0 2005 Wachovia/Golden West 25.5 2006 4-6 -6 Size, Structure and Composition 4-7 -7 Dramatic increase in number of firms from 1980 to 1987. Decline of 37% following the 1987 crash, to year 2006. 1987: Salomon Brothers held $3.21 billion in capital. 2006: Merrill Lynch held capital of $35.5 billion. Many recent inter-industry mergers (i.e., insurance companies and investment banks). Role of Financial Services Modernization Act, 1999 Types and Relative Sizes of Firms National full-line firms are largest. Merrill Lynch, Morgan Stanley National full-line firms specializing in corporate finance are second in size. 4-8 -8 Goldman Sachs, Salomon Brothers/Smith Barney Remainder of industry: Specialized investment subsidiaries of BHCs. Discount brokers. Regional securities firms (subdivided into large, medium and small). Specialized electronic trading securities firms Top U.S.Underwriters, 2006 Manager Market Share SSB Amount (Billions) $668.8 J.P. Morgan 506.1 6.6 Deutsche Bank 475.0 6.2 Morgan Stanley 454.6 6.0 Lehman Bros. 446.5 5.8 8.7% 4-9 -9 Key Activities 4-10 -10 Investing Investment banking Activities related to underwriting and distributing new issues of debt and equity. Market making Increasing importance of online trading Technology risk Decimalization Trading Position trading, pure arbitrage, risk arbitrage, program trading Key Activities (continued) Cash management Assisting with M&A Back-office and service functions. 4-11 -11 Trends 4-12 -12 Decline in trading volume and brokerage commissions particularly since crash of 1987, although some recovery since 1992. Record volumes 19952000. Declines in market values--and commission income 2001-2002 Resurgence in market values and commissions during mid-2000s. Trends (continued) 4-13 -13 Pretax net income over $9 billion per year 1997-2000 Pretax profits soared to $21.0 billion in 2000 curtailed by economic slowdown and September 11 attacks 2001. 2003 record pre-tax profits of $24.1 billion. Continuing worries over investor confidence Balance Sheet Key assets: Long positions in securities and commodities. Reverse repurchase agreements. Key liabilities: 4-14 -14 Repurchase agreements major source of funds. Securities and commodities sold short. Broker call loans from banks Capital levels much lower than levels in banks Regulation Primary regulator: SEC Reiterated by National Securities Markets Improvement Act (NSMIA) of 1996. Prior to NSMIA, regulated by SEC and states. Regulate trading activities such as shelf registration 4-15 -15 Regulation Early 2000s erosion of SEC dominance 4-16 -16 Increased vigilance by State Attorneys General Spring 2003, $1.4 billion in penalties over investor abuses. Sarbanes-Oxley Act of 2002 Independent auditing oversight board under SEC Instigated by Enron, Global Crossings, Tyco, WorldCom Regulation (continued) 4-17 -17 Day-to-day regulation: NYSE, NASD October 2003 implementation of provisions of Patriot Act to combat money laundering Scrutiny of individual identities and affiliations with terrorists Investor Protection & Other Monitoring Securities Investors Protection Corporation (SIPC). 4-18 -18 Protection level of $500,000 Federal Reserve also has role in overseeing securities firms and investment banks Vulnerability of the financial system Issue of timely settlement raised by Greenspan Web Resources For details of regulation of securities firms and investment banks, visit: SEC: www.sec.gov NYSE: www.nyse.com NASD: www.nasd.com SIPC: www.sipc.org 4-19 -19 Global Issues Global nature of securities firms Demonstrated by recent mergers such as Deutsche Bank/Bankers Trust Dominance of Royal Bank of Scotland in U.S. mortgage backed securities markets Growth in securities trading and underwriting is a global event US accounting standards issues Depreciation of the dollar against the yen and the euro 4-20 -20 Pertinent Websites 4-21 -21 Federal Reserve: www.federalreserve.gov NASD: www.nasd.com NYSE: www.nyse.com SEC: www.sec.gov Securities Industry Association: www.sia.com SIPC: www.sipc.org The Banker: www.thebanker.com Thompson Fin. Securities Data: www.thomson.com Wall Street Journal www.wsj.com