Money banking and the financial system 1e by hubbard and OBrien chapter 11

Investment Banks, Mutual Funds, Hedge Funds, and the ShadowExplain how investment banks operate Distinguish between mutual funds and hedge funds and describe their roles in the financial

System

Investment Banks, Mutual Funds, Hedge Funds, and the Shadow

Explain how investment banks operate Distinguish between mutual funds and hedge funds and describe their roles in the financial system

Explain the roles that pension funds and insurance companies play in the financial system

systemic risk

WHEN IS A BANK NOT A BANK? WHEN IT’S A SHADOW BANK!

•During the financial crisis of 2007–2009, a variety of “nonbank” financial institutions were acquiring funds that had previously been deposited in

banks, and they were using these funds to provide credit that banks had previously provided The newly developed securities they were creating were not fully understood

•A key issue for policymakers in dealing with the crisis was the role the Fed should play in dealing with a financial crisis that involved many nonbank financial firms

•An Inside Look at Policy on page 338 discusses whether a panic in the shadow banking system caused the financial crisis

C H A P T E R 11 Investment Banks, Mutual Funds,

Hedge Funds, and the Shadow Banking System

Key Issue and Question

Issue: During the 1990s and 2000s, the flow of funds from lenders to

borrowers outside of the banking system increased

Question: What role did the shadow banking system play in the

financial crisis of 2007–2009?

11.1 Learning Objective

Explain how investment banks operate

Investment banking Financial activities that involve underwriting new security

issues and providing advice on mergers and acquisitions

Investment bankers are involved in the following activities:

1 Providing advice on new security issues

2 Underwriting new security issues

3 Providing advice and financing for mergers and acquisitions

4 Financial engineering, including risk management

5 Research

6 Proprietary trading

What Is an Investment Bank?

Providing Advice on New Security Issues

Underwriting An activity in which an investment bank guarantees to the

issuing corporation the price of a new security and then resells the security for

a profit, or spread.

Initial public offering (IPO) The first time a firm sells stock to the public

• Firms turn to investment banks for advice on how to raise funds by issuing

stock or bonds or by taking out loans

• An investment bank typically earns 2% to 4% of the dollar amount raised in a

secondary offering (or seasoned offering).

• In return for the spread, the investment bank takes on the risk that it cannot

profitably resell the securities being underwritten

Underwriting New Security Issues

Syndicate A group of investment banks that jointly underwrite a security issue.

• In a syndicated sale, a lead investment bank keeps part of the spread, and

the remainder is divided among the syndicate members

• Once a firm has chosen the investment bank that will underwrite its

securities, the bank carries out a due diligence process, during which it

researches the firm’s value The investment bank then prepares a

prospectus, which the Securities and Exchange Commission (SEC) requires

of every firm before allowing it to sell securities to the public

• During the financial crisis of 2007–2009, investor confidence about the ability

of investment banks to gather information was shaken when investment

banks underwrote mortgage-backed securities that turned out to be very

poor investments

Providing Advice and Financing for Mergers and Acquisitions

• Investment banks are very active in mergers and acquisitions (M&A) They

advise both buyers—the “buy side mandate”—and sellers—the “sell side

mandate.”

• When advising a firm seeking to be acquired, investment banks attempt to

find an acquiring firm willing to pay significantly more than the book value of

the firm

• Advising on M&A is particularly profitable for investment banks because the

bank does not have to invest its own capital Its only significant costs are the salaries of the bankers involved in the deal

Financial Engineering, Including Risk Management

• Financial engineering involves developing new financial securities or

investment strategies using sophisticated mathematical models

• Derivative securities, used by firms to hedge, are the result of financial

engineering

• Investment banks supply knowledge of financial markets to properly assess

the best way to raise funds by selling stocks and bonds, and construct risk

management strategies for firms in return for a fee

• During the financial crisis, investment bank managers greatly

underestimated the risk that the prices of these derivatives might fall if

housing prices declined and people began to default on their mortgages

• Investment banks assign research analysts to particular firms or industries,

to gather research notes used to advice investors on mergers and

acquisitions

• Research analysts also advice investors to “buy,” “sell,” or “hold” particular

stocks Overweight is a term used for a stock they recommend and

underweight for a stock they do not.

• The opinions of senior analysts at large investment banks can have a

significant impact on the market

• They also provide useful information for the investment bank’s trading desks,

where traders buy and sell securities

• Analysts also engage in economic research, writing reports on economic

trends and providing forecasts of macroeconomic variables

Proprietary Trading

• Beginning in the 1990s, proprietary trading, or buying and selling securities

for the bank’s own account rather than for clients, became a major part of

operations and an important source of profits for investment banks

• Proprietary trading exposes banks to both interest-rate risk and credit risk

During the financial crisis, it became clear that credit risk was the most

significant risk that investment banks faced Credit risk is the risk that

borrowers might default on their loans

• The problems investment banks faced during the financial crisis were made

worse because they had used large amounts of borrowed funds to finance

their proprietary trading Using borrowed funds increases leverage, which

increases risk

“Repo Financing” and Rising Leverage in Investment Banking

• Among the sources of funds for investment banks are the bank’s capital—

funds from shareholders and retained profits—and short-term borrowing

• During the 1990s and 2000s, most large investment banks converted from

partnerships to publicly traded corporations, and proprietary trading became

a more important source of profits

• Financing investments by borrowing rather than by using capital, or equity,

increases leverage.

• As we saw in chapter 10, the ratio of a bank’s assets to its capital is its

leverage ratio Because a bank’s return on equity (ROE) equals its return on

assets (ROA) multiplied by its leverage ratio, the higher the leverage ratio,

the greater the ROE for a given ROA But the relationship holds whether the ROA is positive or negative

Solved Problem 11.1

The Perils of Leverage

Suppose that an investment bank is buying $10 million in long-term mortgage-backed

securities Consider three possible ways that the bank might finance its investment:

1 The bank finances the investment entirely out of its equity.

2 The bank finances the investment by borrowing $7.5 million and using $2.5 million of

b For each of these ways of financing the investment, calculate the return on its equity

investment that the bank receives, assuming that:

after they are purchased.

after they are purchased.

Solved Problem

Step 2

Answer question (a) by

calculating the leverage ratio for each way of financing the investment.

Solving the Problem

Step 1 Review the chapter material.

Step 3

Answer the first part of

question (b) by calculating the bank’s return on its equity investment for each of the three ways of financing the investment.

Step 4

Answer the second part of

question (b) by calculating the return for each of the three ways of financing the investment.

Solved Problem 11.1

The Perils of Leverage

“Repo Financing” and Rising Leverage in Investment Banking

• Federal banking regulations put limits on the size of a commercial bank’s

leverage ratio But these regulations did not apply to investment banking

• Investment banks increasingly relied on borrowed funds to finance their

investments and, as a group, became much more highly leveraged than

commercial banks

• The process of reducing leverage is called deleveraging.

• Investment banks borrowed primarily by either issuing commercial paper or

by using repurchase agreements (short-term loans backed by collateral).

• If the funds raised are used to invest in mortgage-backed securities or to

make long-term loans to, for instance, commercial real estate developers,

investment banks face a maturity mismatch.

Figure 11.1

Leverage in Investment Banks

Panel (a) shows that at the start of the financial crisis in 2007, large investment banks were more highly leveraged than were large commercial banks.

Panel (b) shows that during 2008 and 2009, Goldman Sachs and Merrill Lynch reduced their leverage ratios, or deleveraged.

Making the Connection

Did Moral Hazard Derail Investment Banks?

• By the time of the financial crisis, all the large investment banks had become publicly traded corporations

• With corporations, there is a separation of ownership from control The moral hazard involved can result in a principal–agent problem, as top managers

may take actions that are not in the best interest of the shareholders

• Underwriting complex financial securities, such as CDOs and CDS contracts, are activities that shareholders and boards of directors do not understand

and therefore cannot effectively monitor

• Some commentators argue, however, that since top managers also suffered

significant losses during the crisis, the moral hazard problem could not have

been so severe

The Investment Banking Industry

• The Glass-Steagall Act in 1933 separated investment banking from

commercial banking after the great stock market crash of October 1929

resulted in heavy losses from underwriting

• Years later, economists argued that the act had protected the investment

banking industry from competition, which enabled it to earn larger profits

than the commercial banking industry

• In 1999, the Gramm-Leach-Bliley (or Financial Services Modernization) Act

repealed the Glass-Steagall Act

• The Gramm-Leach-Bliley Act also authorized new financial holding

companies that would allow securities and insurance firms to own

commercial banks, and allowed commercial banks to participate in

securities, insurance, and real estate activities Large investment banks,

known as “bulge bracket” banks were separated from standalone investment banks, and smaller, or “boutique,” banks

Where Did All the Investment Banks Go?

The effect of the financial crisis of 2007-2009 was labeled “The End of Wall

Street” because the investment banks that ran into difficulties had long been

seen as the most important financial firms in the stock and bond markets

Making the Connection

So, You Want to Be an Investment Banker?

• Over the past 20 years, investment banking has been one of the most richly

rewarded professions in the world

• The pay of top executives has been controversial Some argue that not only

is their pay out of line with their economic contributions, but also that they

may have helped bring on the crisis by promoting mortgage-backed

securities

• New college graduates are hired as analysts who spend 80 hours per week

or more researching industries, helping in the due diligence process, and

with mergers and acquisitions

• After two to four years, the bank either promotes an analyst to the position of associate or asks him or her to leave the firm MBA graduates are

sometimes hired directly as associates

11.2 Learning Objective

Distinguish between mutual funds and hedge funds and describe their roles in

the financial system

Investment institution A financial firm, such as a mutual fund or a hedge

fund, that raises funds to invest in loans and securities

• In addition to investment banks, investment institutions are financial firms

that raise funds to invest in loans and securities

• The most important investment institutions are mutual funds, hedge funds,

and finance companies

• Mutual funds help to reduce transaction costs, provide risk-sharing benefits,

and gather information about different investments

• The mutual fund industry in the United States dates back to 1924, with the

creation of the Massachusetts Investors Trust, State Street Investment

Corporation, and Putnam Management Company, which remain major

players today

Mutual Funds

Mutual fund A financial intermediary that raises funds by selling shares to

individual savers and invests the funds in a portfolio of stocks, bonds,

mortgages, and money market securities

• In closed-end mutual funds, a fixed number of nonredeemable shares is

issued, with the price of a share fluctuating with the market value of the assets

—called the net asset value, or NAV

• In more common open-end mutual funds, investors can redeem shares after

the markets close for a price tied to the value of the assets in the fund

• Exchange-traded funds (ETFs), like closed-end mutual funds, trade continually

throughout the day With ETFs, market prices track the prices of the assets

• Large institutional investors who purchase above a certain number of shares of

an ETF—called a creation unit aggregation—have the right to redeem those

shares for the assets in the fund

• Mutual funds that do not charge a commission, or “load,” are called no-load

funds Load funds charge buyers a commission to both buy and sell shares.

• An index fund consists of a fixed-market basket of securities, such as the

stocks in the S&P 500 stock index

Types of Mutual Funds

• Most money market mutual funds allow savers to write checks above a

specified amount against their accounts

• They are popular with small savers as an alternative to commercial bank

checking and savings accounts, which typically pay lower rates of interest

• Money market mutual funds brought additional competition for commercial

banks Rather than taking out loans from banks, firms sold commercial

paper to the funds The interest rates the firms paid on the paper was lower

than banks charged on loans

Money Market Mutual Funds

Money market mutual fund A mutual fund that invests exclusively in

short-term assets, such as Treasury bills, negotiable certificates of deposit, and

commercial paper

Hedge fund Financial firms organized as a partnership of wealthy investors that make relatively high-risk, speculative investments.

• Hedge funds are typically organized as partnerships of 99 investors or fewer, all of whom are either wealthy individuals or institutional investors, such as

pension funds They are largely unregulated and free to make risky

investments

• Modern hedge funds typically make investments that involve speculating,

rather than hedging, so their name is no longer an accurate description of

their strategies

• Although reliable statistics on hedge funds are difficult to obtain, in 2010,

there were as many as 10,000 operating in the United States, managing

more than $1 trillion in assets

Hedge Funds