1. McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Sixteen Securities Firms and Investment Banks

2. McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Outline 1.Types of Firms 2.Activity Areas 3.Balance Sheet 4.Regulation 1.Types of Firms 2.Activity Areas 3.Balance Sheet 4.Regulation

3. McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 1. Investment Banks vs. Securities Firms Investment Banks –raise the debt and equity securities for corporations or governments including the origination, underwriting, and placement of securities in money and capital markets Securities Firms –services involve assistance in the trading of securities in the secondary markets (brokerage services or market making) The largest companies in the industry perform multiple services (e.g., underwriting and brokerage) and are generally called investment banks Investment Banks –raise the debt and equity securities for corporations or governments including the origination, underwriting, and placement of securities in money and capital markets Securities Firms –services involve assistance in the trading of securities in the secondary markets (brokerage services or market making) The largest companies in the industry perform multiple services (e.g., underwriting and brokerage) and are generally called investment banks

4. McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Size of the Industry Size of the industry is measured by the equity capital of the firms participating in the industry rather than by “asset size” At the end of 2004, equity capital in this industry amounted to $168.0 billion, supporting total assets of $5.11 trillion Size of the industry is measured by the equity capital of the firms participating in the industry rather than by “asset size” At the end of 2004, equity capital in this industry amounted to $168.0 billion, supporting total assets of $5.11 trillion

5. McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Industry Composition Three major types of firms –national full-line investment banks that service retail and corporate customers (e.g., Merrill Lynch) –national full-line firms that specialize in corporate finance (e.g., Goldman Sachs) –the remainder of the industry specialized investment bank subsidiaries of commercial banks specialized discount brokers regional securities firms specialized electronic trading securities firms venture capital firms Three major types of firms –national full-line investment banks that service retail and corporate customers (e.g., Merrill Lynch) –national full-line firms that specialize in corporate finance (e.g., Goldman Sachs) –the remainder of the industry specialized investment bank subsidiaries of commercial banks specialized discount brokers regional securities firms specialized electronic trading securities firms venture capital firms

6. McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2. Activity Areas Securities firms and investment banks engage in as many as seven key activity areas 1.Investing 2.Investment Banking 3.Market Making 4.Trading 5.Cash Management 6.Mergers and Acquisitions 7.Other Service Functions Securities firms and investment banks engage in as many as seven key activity areas 1.Investing 2.Investment Banking 3.Market Making 4.Trading 5.Cash Management 6.Mergers and Acquisitions 7.Other Service Functions

7. McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2.1 Investing Involves managing pools of assets such as mutual funds Compete with commercial banks, life insurance companies, and pension funds Manage funds either as agents for other investors or as principals Objective is to select asset portfolios to beat some return-risk performance benchmark such as the S&P 500 Involves managing pools of assets such as mutual funds Compete with commercial banks, life insurance companies, and pension funds Manage funds either as agents for other investors or as principals Objective is to select asset portfolios to beat some return-risk performance benchmark such as the S&P 500

8. McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2.2 Investment Banking Refers to activities related to underwriting and distributing new issues of debt and equity securities Industry is dominated by a small number of underwriting firms; top 5 underwriters represented 36.6% of the industry total Securities underwriting can be undertaken through either public or private offerings –Private placement - securities issue placed with one of a few large institutional investors –Public placement - may be underwritten on a best efforts or firm commitment basis and offered to the public Refers to activities related to underwriting and distributing new issues of debt and equity securities Industry is dominated by a small number of underwriting firms; top 5 underwriters represented 36.6% of the industry total Securities underwriting can be undertaken through either public or private offerings –Private placement - securities issue placed with one of a few large institutional investors –Public placement - may be underwritten on a best efforts or firm commitment basis and offered to the public

9. McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Public Placement Best efforts –Investment banker acts as an agent on a fee basis Firm commitment –Dominant form of underwriting in the US –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 Best efforts –Investment banker acts as an agent on a fee basis Firm commitment –Dominant form of underwriting in the US –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

10. McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2.3 Market Making Involves the creation of a secondary market in an asset by a securities firm or investment bank Either agency or principal transactions –Agency transactions - two-way transactions on behalf of customers –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 Involves the creation of a secondary market in an asset by a securities firm or investment bank Either agency or principal transactions –Agency transactions - two-way transactions on behalf of customers –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

11. McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2.4 Trading Six types of trading –Position trading - purchases of large blocks on expectation of favorable price move –Pure Arbitrage - buying an asset in one market and selling it immediately in another market at a higher price –Risk Arbitrage - buying securities in anticipation of some information release –Program Trading - simultaneous buying and selling using a computer program to initiate such trades; at least 15 stocks of value more than $ 1 million –Stock Brokerage - trading securities on behalf of individuals –Electronic Brokerage - offered by major brokers, direct access via internet to trading floor; an estimated 5 million people used the facilities in early 2000s Six types of trading –Position trading - purchases of large blocks on expectation of favorable price move –Pure Arbitrage - buying an asset in one market and selling it immediately in another market at a higher price –Risk Arbitrage - buying securities in anticipation of some information release –Program Trading - simultaneous buying and selling using a computer program to initiate such trades; at least 15 stocks of value more than $ 1 million –Stock Brokerage - trading securities on behalf of individuals –Electronic Brokerage - offered by major brokers, direct access via internet to trading floor; an estimated 5 million people used the facilities in early 2000s

12. McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2.5 Cash Management Securities firms and investment banks offer bank deposit-like cash management accounts (CMAs) to individual investors –money market mutual fund sold by investment banks that offer check-writing privileges Securities firms and investment banks offer bank deposit-like cash management accounts (CMAs) to individual investors –money market mutual fund sold by investment banks that offer check-writing privileges

13. McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2.6 Mergers and Acquisitions Frequently provide advice on, and assistance in, mergers and acquisitions –assist in finding merger partners –underwrite any new securities –asses the value of target firms –recommend terms of the merger agreement –assist target firms in preventing a merger Frequently provide advice on, and assistance in, mergers and acquisitions –assist in finding merger partners –underwrite any new securities –asses the value of target firms –recommend terms of the merger agreement –assist target firms in preventing a merger

14. McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 2.7 Other Service Functions Custody and escrow services Clearance and settlement services Research and advisory services Custody and escrow services Clearance and settlement services Research and advisory services

15. McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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 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. McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 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 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. McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 4. Regulation The primary regulator of the securities industry is the Securities and Exchange Commission (SEC) established in 1934 SEC sets rules governing securities firms’ underwriting and trading activities 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 The Securities Investor Protection Corporation (SIPC) protects investors against losses of up to $500,000 on securities firm failures The primary regulator of the securities industry is the Securities and Exchange Commission (SEC) established in 1934 SEC sets rules governing securities firms’ underwriting and trading activities 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 The Securities Investor Protection Corporation (SIPC) protects investors against losses of up to $500,000 on securities firm failures

18. McGraw-Hill /Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. Self-Regulation Two self-regulatory organizations are involved in the day-to-day regulation of trading practices –NYSE –NASD Monitor trading abuses, such as insider trading Solvency positions, requiring a minimum of 2% net worth to assets ratio Two self-regulatory organizations are involved in the day-to-day regulation of trading practices –NYSE –NASD Monitor trading abuses, such as insider trading Solvency positions, requiring a minimum of 2% net worth to assets ratio