MUJTABA ZEESHAN 11387

INVESTMENT BANKS: A MAJOR PLAYER IN FINANCIAL CRISIS OF 2008

OBEJECTIVES…

• What is an Investment Bank

• Historical perspective

• Organizational structure

• Functions

• Role of Investment banks in Financial crisis of 2008 (using a research paper ‘Causes of The financial Crisis’ by Viral V. Acharya and Matthew Richardson)

WHAT IS AN INVESTMENT BANK

BANK INVESTMENT

• Place where deposits are being piled up

• under financial management these are institutions that accumulate deposits of money and acts as an intermediary between borrowers and lenders.

An act whereby an investor puts up his money to acquire an asset or an item, holding it for a certain period, in the hope that it will generate income, or appreciate in future

• Investment Bank is an institution that is meant for creation of capital for corporations with the help of issuing securities (equity and debt capital), a process known as underwriting (discussed later).

What is an Investment Bank

TOP 10 INVESTMENT BANKS OF THE WORLDRANK BANK NAME FOUNDED HEADQUARTERS REVENUE(in

Billion) 2012PRODUCTS

1 JP Morgan Chase 2000 270 Park Avenue, Manhattan, New York, New York, U.S.

USD 97.03 Commodities, consumer banking, corporate banking, credit cards, finance and insurance, foreign currency exchange, global banking, mortgage loans, risk management, treasury services, underwriting

2 Bank of America Merill Lynch

2009 Bank of America Tower, New York City, United States

USD 25.14 Investment banking

3 Goldman Sachs 1869 200 West Street, New York, New York, U.S.

USD 41.664 Asset management, commercial banking, commodities, investment banking, investment management, mutual funds, prime brokerage

4 Citigroup 1812 399 Park Avenue, Manhattan, New York City, New York,U.S.

USD 70.17 Credit cards, consumer banking, corporate banking, investment banking, global wealth management, financial analysis, private equity

5 Morgan Stanley 1935 Morgan Stanley Building, New York City, New York, U.S.

USD 32.03 Investment banking, asset management, commercial banking, prime brokerage, investment management,retail brokerage, commodities

6 Deutsche Bank 1870 Deutsche Bank Twin Towers, Taunusanlage 12 Frankfurt Hesse, Germany

EUR 33.70 consumer banking, corporate banking, finance and insurance, investment banking, mortgage loans, private banking, private equity, savings, Securities, asset management, wealth management, Credit cards

7 Barclays 1690 Canary Wharf, London, United Kingdom

EUR 24.691 Retail bankingCommercial bankingInvestment bankingInvestment management

8 Credit Suisse 1856 Paradeplatz 8 Zurich, Switzerland

CHF 23.97 Investment and private banking, asset management

9 UBS 1854 Bahnhofstrasse 45 Zürich, Switzerland

CHF 25.443  Investment Banking, Investment Management, Wealth Management, Private Banking, Corporate Banking, Private Equity, Finance and Insurance, Consumer Banking, Mortgages, Credit Cards

10 Wells Fargo 1852 San Francisco, California, U.S.

USD 86.08 Consumer banking, corporate banking, credit cards, finance and insurance, foreign currency exchange, investment banking, mortgage loans, private banking, private equity, wealth management

HISTORCIAL PERSPECTIVE

1896-1929

• Investment banking was in its golden era before the Great Depression

• JP Morgan and National City Bank were the market leaders

• JP Morgan is personally credited with saving the country from a calamitous panic in 1907 when the New York Stock Exchange fell almost 50% from its peak the previous year

• After World War I stock markets showed a booming trend during 1920s

• Excessive trading of stocks on margin

• Excess market speculation, especially by banks using Federal Reserve loans, resulted in the market crash of 1929, sparking the great depression.

1929-1970

• During the Great Depression, the nation’s banking system was at the brink, with 40% of banks either failing or forced to merge

• The Glass-Steagall Act enacted in 1933, isolated the activities of insurance companies, securities companies and Investment banks to avoid the conflict of interest between the desire to win investment banking business and duty to provide fair and objective brokerage services.

• Most large banks split into separate entities e.g JP Morgan split into three entities: JP Morgan continued to operate as a commercial bank, Morgan Stanley was formed to operate as an investment bank, and Morgan Grenfell operated as a British merchant bank

1970-1980

• Trend of an integrated investment bank, providing sales, trading, research, and investment banking under one roof began to take root

• In the late 70’s and early 80’s saw the rise of a number of financial products such as derivatives, high yield an structured products, which provided lucrative returns for investment banks

1980-2007

• In the 1980s, investment bankers had shed their dominating image. In its place was a reputation for power, which was enhanced by a rush of mega-deals during wildly prosperous times.

• An IPO boom dominated the perception of investment bankers.

• In 1999, 548 IPO deals were done with most going public in the internet sector.

• Gramm-Leach-Bliley Act enacted in November 1999 repealing Glass-Steagal Act, hence removing the separation that previously existed between Wall Street investment banks and depository banks

ORGANIZATIONAL STRUCTUREFRONT OFFICE MIDDLE OFFICE BACK OFFICE

1. Investment banking: • Helping customers

raise funds in capital markets • giving advice on mergers and

acquisitions (M&A)

1. Risk Management: analyzing different types of risk associated with the bank especially credit risk and market risk

1. Operations

2. Sales and Trading:• Buying and selling products

(stocks & bonds)• Market making

2. Financial Control: tracks and analyzes the capital flows of the firm, the global risk exposure and the profitability and structure of the firm's various businesses

2. Technology

3. Research:• reviews companies and writes

reports about their prospects, often with buy/sell ratings.

• covers credit research, fixed income research, macroeconomic research, and quantitative analysis, all of which are used internally and externally to advise clients

3. Corporate treasury: responsible for an investment bank's funding, capital structure management, and liquidity risk monitoring

FUNCTIONS OF INVESMENT BANKS

1. Investigation:

• A company that desires to raise money will approach an investment banking firm for its assistance. From that point on, that investment banking firm is known as the manager or lead investment bank in the process. The manager will provide two investigations, or type of analyses, for its client:

a) Legal analysis

b) Market Analysis

The manager will begin preparing a prospectus i.e., a financial disclosure brochure used to help sell the issue

2. Underwriting:

• Purchasing an issue of securities from a firm and selling it in the secondary market

• “Assuming the risk of loss”, the eligibility of a customer to receive their products

• The investment banker assumes this risk by underwriting the securities offering. In a typical underwriting, the investment banker underwrites the issue by buying the securities at a discounted price from the company.

• The investment bank will then mark-up the securities to the full retail price and try to sell the securities to the investing public

• Underwriting spread is the earning of investment bank

CONTINUED…• Investment banks place their own capital at risk by using their own money to buy the

issue. Plus frequently borrow money from commercial banks to raise part of the funds necessary for the purchase

• Even then though, the investment bank may not have enough money to bad the entire issue or, perhaps, the bank may not want to assume this much risk. If stock prices fall during the period of sale, the investment bank will be making a loss on the transaction.

• So the investment bank may reduce its risk by inviting other investment banks (i.e. a Syndicate of banks) to participate in the underwriting called Underwriting syndicate.

• If they are not able to find enough investors, they will have to hold some securities themselves

• The services of an underwriter are typically used during a Public Offering

• Initial public offering (IPO) is one type of public offering

• Most public offerings are in the primary market, that is, the issuing company itself is the offerer of securities to the public.

3. Selling:

• Each of the investment banks will likely have its own sales force. However, additional brokerage firms may be invited to help sell the issue in return for a commission on the sale.

• These brokerage firms are known as the selling group.

THE THREE FUNCTIONS CAN BE SHOWN AS LAYERS, AS IN THE FOLLOWING DIAGRAM

ROLE OF INVESTMENT BANKS IN GLOBAL FINANCIAL CRISIS 2008

BRIEF OVERVIEW OF THE CRISIS…

• The 9/11 terrorist attacks on World Trade center caused US economy to plunge

• People lost confidence in stocks and switched to property investment

• Alan Greenspan Chairman of FED lowered interest rate to 1% which was a drawback for investors but essential for borrowers

• High investment in property gave an idea to the Wall Street, Connecting Investors and Home owners through MORTGAGES

• Traditionally when a home owner made mortgage payment, it went to the lender

• In the new system, lenders sell the mortgages to Investment banks

• Investment banks combine all sorts of mortgages and loans to create complex derivatives called CDOs

• Investment banks sold the CDOs to investors

• Which meant that the payment from home owners was going to the Investors

• Investment banks paid the Rating Agencies to evaluate the CDOs, majority getting a AAA rating

• Lenders were not interested if the borrowers defaulted so they started to make Riskier loans: SUBPRIME MORTGAGES

• Neither the Investment banks were interested, the higher CDOs they sold, higher profits they made

• Rating Agencies were paid by the Investment banks, they had no liabilities if their ratings of CDOs proved wrong

• The investment banks preferred Subprime loans because they had high interest rate

• Which resulted in PREDATORY LENDING that is borrowers were needlessly placed in expensive subprime loans and many were given to people who could not repay

• SEC removed leverage limits on borrowing of Investment banks and was not regulating the activities of investment banks

SOMETHING UNETHICAL…

• Betting against the securities they sold, CDOs telling the customers that they were high quality investments

• Plus insuring the very security they were speculating on, through the organization called American International Group(AIG) by purchasing a derivative called Credit Default Swap (CDS)

• An investor who purchased a CDS from AIG paid a quarterly premium to them

• If the CDO went bad, AIG promised to pay the Investors the losses

• Speculators could also buy CDS from AIG betting against CDOs they didn’t own

• Lehman reported losses of $2.8 billion and forced to sell off $6 billion in asset

• Lehman stock lost 73% of its value as the credit market continued to tighten

• Lehman reported that it had been in talks with Bank of America and Barclays for the company's possible sale

• According to Bloomberg, JPMorgan Chase & Co. provided Lehman Brothers with a total of $138 billion in "Federal Reserve-backed advances."

• The cash-advances by JPMorgan Chase were repaid by the Federal Reserve Bank of New York for $87 billion on September 15 and $51 billion on September 16.

RESEARCH PAPER • ‘Causes of The financial Crisis’ by Viral V. Acharya and Matthew Richardson)

• Identified 2 major reasons:

1. Placing assets under off-balance sheet so that there is no need of capital buffer against them

2. Regulations allowed banks to reduce capital required to hold against assets, if they were AAA or Fannie/Freddie securities.

ONE MIGHT WONDER WHY THE BANKS WOULD CREATE AND THEN RETAIN THE RISKS OF ASSETS SUCH AS SUBPRIME MORTGAGES!

• CDOs were divided into tranches of AAA, BBB and so on

• Taking AAA had both ways:

1. Reduced their capital requirements, and they (or other investors) earned the higher premium commanded by the risky nature of subprime assets.

2. Losses would only occur if a large number of subprime mortgages got hit at once, so that even the AAA tranche of a CDO got hit. This would in fact bring the financial system to its knees. (Banks were betting that this would not happen, but eventually it did!)

CONCLUSION

• The failure of the likes of Bear Stearns and Lehman Brothers, which invested in the securities created out of these mortgages, led to severe counterparty risk concerns that paralyzed capital markets and thus caused the worldwide recession.

• Standing behind the collapse of the investment banks was the systemic failure of securitization market, which had been triggered by the popping of the overall housing bubble, which in turn had been fueled by the ability of these firms, as well as commercial banks, to finance so much housing stock in the first place

THANK YOU!