Securities Firms and Investment Banks Chapter 4 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin

-24-2 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

-34-3 Securities Firms &Investment Banks  Nature of business: Underwrite securities. Market making. Advising (example: M&A, restructurings).

-44-4 Securities Firms &Investment Banks  Growth in domestic M&A: Less than $200 billion in $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)

-54-5 Mergers and acquisitions

-64-6 The Largest M&A Transactions

-74-7 Size, Structure and Composition  Dramatic increase in number of firms from 1980 to Decline of 37% following the 1987 crash, to year  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

-84-8 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. 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

-94-9 Top U.S.Underwriters, 2006

Key Activities  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.

Trends  Decline in trading volume and brokerage commissions particularly since crash of 1987, although some recovery since Record volumes  Declines in market values--and commission income  Resurgence in market values and commissions during mid-2000s.

Trends (continued)  Pretax net income over $9 billion per year  Pretax profits soared to $21.0 billion in 2000 curtailed by economic slowdown and September 11 attacks  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: 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 Prior to NSMIA, regulated by SEC and states. Regulate trading activities such as shelf registration

Regulation  Early 2000s erosion of SEC dominance 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)  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). 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: NYSE: NASD: SIPC:

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

Pertinent Websites Federal Reserve: NASD: NYSE: SEC: Securities Industry Association: SIPC: The Banker: Thompson Fin. Securities Data: Wall Street Journal