Lecture 15: Investment Banking and Secondary Markets

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Lecture 15 Investment Banking and Secondary
Markets
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Glass-Steagall Act 1933

• The modern concept of Investment Bank was
  created in the Glass-Steagall act (Banking Act of
  1933). Glass Steagall separated commercial banks,
  investment banks, and insurance companies.
• Carter Glass, Senator from Virginia, believed
  that commercial banks securities operations had
  contributed to the crash of 1929, that banks
  failed because of their securities operations,
  and that commercial banks used their knowledge as
  lenders to do insider trading of securities.

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Investment Banks

• Bulge bracket firms First Boston, Goldman Sachs,
  Merrill Lynch, Morgan Stanley, Salomon Brothers,
  Lehman Brothers.
• Traditionally were often partnerships, but
  partnership form is disappearing.

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Controversy over Glass Steagall

• Prof. George Benston showed that unregulated
  banks have lower failure rate.
• Other countries (Germany, Switzerland) have
  always allowed universal banking
• In 1990s, regulators nibbled away at Glass
  Steagall by allowing commercial banks to engage
  in certain securities operations

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Graham-Leach Act 1999

• President Clinton November 1999 signs
  Graham-Leach Bill which rescinded the
  Glass-Steagall Act of 1933.
• Consumer groups fought repeal of Glass-Steagall
  saying it would reduce privacy. Graham-Leach
  calls for a study of the issues of financial
  privacy

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Mergers among Commercial Banks, Investment Banks
Insurance Companies

• Travelers Group (insurance) and Citicorp
  (commercial bank) 1998 to produce Citigroup, on
  anticipation that Glass-Steagall would be
  rescinded. Brokerage Smith Barney
• Chase Manhattan Bank (commercial bank) acquires
  JP Morgan (investment bank) (2000) for 34.5
  billion
• UBS Switzerland buys Paine Webber (brokerage)
  2000
• Credit Suisse buys Donaldson Lufkin Jenrette
  (investment bank) 2000

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Underwriting of Securities

• Issuance of shares and corporate debt
• Seasoned issue versus IPO
• Underwriter provides advice for issuer,
  distribution of securities, sharing of risks of
  issue, and stabilization of aftermarket.
• Underwriter also certifies the issue by putting
  its reputation behind the issue.

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Moral Hazard Problem Mitigated by Investment
Banks

• Firms have incentive to issue shares when they
  know their earnings are only temporarily high.
• This problem can be solved by resorting to bank
  loans instead of new equity
• Problem can also be solved by issuing security
  with an investment bank that has a reputation to
  protect.
• Studies show that investment banks that
  repeatedly underprice or overprice issues suffer
  a market share loss afterwards.

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Two Basic Kinds of Offerings

• Bought deal (synonym Firm commitment offering)
  The underwriter agrees to buy all shares that are
  not sold
• Best efforts the underwriter says that if the
  issue is not sold, deal collapses.

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The Underwriting Process I

• Prefiling period
• Advise issuers about their choices
• Agreement among underwriters, designates manager,
  fees
• Filing of registration statement with SEC, begins
  cooling-off period
• Cooling off period distribute preliminary
  prospectus (red herring), nothing else

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The Underwriting Process II

• Call prospective clients for indication of
  interest
• Due diligence meeting between underwriter and
  corporation
• Decide on offering price,
• underwriting agreement, which underwriter sells
  what
• Dealer agreement, dealers purchase from
  underwriters at a discount from public price
• Effective date
• Support the price in the aftermarket

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Stabilization

• A form of market manipulation by the underwriter
  near the time of the issue that is permitted by
  the SEC
• Underwriting syndicate legally allowed to
  conspire to fix prices in market until entire
  issue is sold out

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From a 1929 Textbook on Investment Banking

• In floating any new issues of securities,
  therefore, the seller desires to have conditions
  so shaped that the price of the issue will remain
  stable, or perhaps it will rise slightly, during
  the period in which the securities are being
  absorbed by the market. . .establishing a
  favorable psychological attitude of investors. .
  The term manipulated market is not altogether a
  misnomer.

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The Tombstone

• Newspaper announcements of securities issues,
  listing underwriting syndicate
• Why called tombstones? Origin of term forgotten.
  Resemblance?
• The only kind of ad allowed during cooling-off
  period
• Cross between birth announcement and obituary.
  Tombstones appear after the securities have
  already been sold, but of course they are now on
  the market.
• Investment bankers love to read them

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Variations on the Usual Underwriting Process

• Auction Process (competitive bidding
  underwriting) various syndicates bid on the issue
• Preemptive rights offering existing shareholders
  have rights to buy issue below market value
• Directly Public Offering (DPO) Company itself
  sells its securities directly to public, usually
  over the web. Small firms. Example Internet
  Ventures, a web service provider, raised 3.8
  million in 1998 by advertising the securities to
  its customers on the web.

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Private Placement

• Sold only to sophisticated investors, exempt
  from SEC registration.
• Regulation D Private issues cannot be
  advertised, defines sophisticated investors
• SEC has provided that privately placed securities
  cannot be sold for two years after purchase.
• SEC Rule 144a April 1990 eliminates two-year
  holding period for institutions with over 100
  million in the security

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Initial Public Offerings

• Price tends to jump up immediately after an IPO
  is issued.
• Apparently leave money upon the table

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Poor Long-Run Performance of IPOs

• Jay Ritter, Journal of Finance, 1991
• Although average IPO earns a 16 return on the
  first day, this return tends to be offset over
  the next three years.

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Why This Performance of IPOs?

• Impressario Hypothesis analogy to sellers of
  tickets to concerts

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Survey of IPO Investors

• Do you think that investors expect reputable
  underwriters to take some account of true
  investment value in deciding the offering price
  in an IPO, rather than just the price the market
  will bear on the day of the offering?
• 84 agree

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Survey of IPO Investors

• Have you done any calculations of what the true
  fundamental value of a share in the company was,
  and compared the price of a share with this
  value?
• 80 no.