1. © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Securities Firms and Investment Banks Chapter 4 K. R. Stanton

2. McGraw-Hill/Irwin -2 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 4-2 © 2006 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

3. McGraw-Hill/Irwin -3 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 4-3 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Securities Firms &Investment Banks  Nature of business: Underwrite securities. Market making. Advising (example: M&A, restructurings).

4. McGraw-Hill/Irwin -4 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 4-4 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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) $525 billion 2003 ($535 trillion worldwide)

5. McGraw-Hill/Irwin -5 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 4-5 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Largest M&A Transactions

6. McGraw-Hill/Irwin -6 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 4-6 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Size, Structure and Composition  Dramatic increase in number of firms from 1980 to 1987. Decline of 31% following the 1987 crash, to year 2003.  1987: Salomon Brothers held $3.21 billion in capital.  2003: Merrill Lynch held capital of $24.8 billion.  Many recent inter-industry mergers (i.e., insurance companies and investment banks). Role of Financial Services Modernization Act, 1999

7. McGraw-Hill/Irwin -7 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 4-7 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

8. McGraw-Hill/Irwin -8 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 4-8 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Top U.S.Underwriters, 2003

9. McGraw-Hill/Irwin -9 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 4-9 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Key Activities  Investing  Investment banking Activities related to underwriting and distributing new issues of debt and equity.  Market making Increasing importance of online trading  Trading Position trading, pure arbitrage, risk arbitrage, program trading

10. McGraw-Hill/Irwin -10 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 4-10 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Key Activities (continued) Cash management Assisting with M&A Back-office and service functions.

11. McGraw-Hill/Irwin -11 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 4-11 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Trends  Decline in trading volume and brokerage commissions particularly since crash of 1987, although some recovery since 1992. Record volumes 1995- 2000.  Declines in market values--and commission income 2001-2002  Resurgence in market values and commissions 2003-2004.

12. McGraw-Hill/Irwin -12 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 4-12 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Trends (continued)  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 $22.5 billion.  Continuing concerns over conflicts of interest and other ethical concerns Soft dollars Analysts’ recommendations to buy or hold collapsing technology stocks

13. McGraw-Hill/Irwin -13 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 4-13 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

14. McGraw-Hill/Irwin -14 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 4-14 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

15. McGraw-Hill/Irwin -15 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 4-15 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

16. McGraw-Hill/Irwin -16 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 4-16 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

17. McGraw-Hill/Irwin -17 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 4-17 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

18. McGraw-Hill/Irwin -18 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 4-18 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Web Resources  For details of regulation of securities firms and investment banks, visit: SEC: www.sec.govwww.sec.gov NYSE: www.nyse.comwww.nyse.com NASD: www.nasd.comwww.nasd.com SIPC: www.sipc.orgwww.sipc.org

19. McGraw-Hill/Irwin -19 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 4-19 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Global Issues  Global nature of securities firms Demonstrated by recent mergers such as Deutsche Bank/Bankers Trust Dominance of UBS in U.S. mortgage backed securities markets  Growth in securities trading and underwriting is a global event

20. McGraw-Hill/Irwin -20 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin 4-20 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Pertinent Websites Federal Reserve: www.federalreserve.govwww.federalreserve.gov NASD: www.nasd.comwww.nasd.com NYSE: www.nyse.comwww.nyse.com SEC: www.sec.govwww.sec.gov Securities Industry Association: www.sia.comwww.sia.com SIPC: www.sipc.orgwww.sipc.org The Banker: www.thebanker.comwww.thebanker.com Thompson Fin. Securities Data: www.tfibcm.comwww.tfibcm.com Wall Street Journal www.wsj.comwww.wsj.com