Investment Banking and the Boundaries of Banking¶
Investment Banking: Connecting Fundraisers with Investors¶
We're talking today about investment banks and money managers. These are the people who manage investments. Investing used to be more of an individual thing. It still is for some people, but more increasingly, there's an intermediary between you and your investment. Of course, I'm talking not about commercial banks or regular bank, but investment banks, and other kinds of intermediary.
in intermediaries like mutual fund managers, ETFs, exchange-traded fund managers, etc. So this is the reality of the modern world, and I thought we need to talk about it for this course. So we'll start with investment banks. So what do investment banks do? They traditionally do not accept deposits. They're not members of the Federal Reserve System. There's no FDIC insuring them.
Well, they don't even have deposits. But what they do, instead of, and so commercial banks take deposits and make loans. Investment banks don't take deposits and don't make loans, but in fact they underwrite securities. What does it mean to underwrite a security? It means you're the guy that companies go to, or nonprofits or even governments, go to, when they want to raise money.
And they do it with you as like a broker intervening. So underwrite a security means to manage the process, of issuing new shares in companies, or issuing debt for companies, or, as I said, for other organizations. Now, just to give some names, the term bulge bracket, I looked it up on Ngrams. It only goes back to the 1980s, so it's not huge old. But the bulge bracket firms are the big firms.
So first Boston. But they're gone, they're mostly not, pure investment banks anymore. So first Boston. Actually, it was an outgrowth of the national, I think it's called the National Bank of Boston, but it became a investment bank in New York, big time. But it was acquired by a Swiss bank, Credit Swiss. Goldman Sachs was until the financial crisis of 2008 was a investment bank.
It was forced by regulation to become a bank holding company. And so now they're regulated as a bank, and they might as well accept deposits. So they are. In fact, there was news last year that Goldman Sachs had bought $16 billion of deposits from General Electric, the financial arm of General Electric. So they are now bank. You can deposit money in Goldman Sach.
I don't know if it's up and running yet, but they don't have corner offices. You know. or ATM machines. So they're not really in, you know, what you think of as a commercial bank. But they're not a pure investment bank either. So they have an investment banking division. I ask a question. Yes. Professor, you discussed a lot about how the business of investing are heavily based on people's trust.
And I used to be a investment banker. I totally echo that. I'm just wondering about your opinion on how, if this, How about the current stature of the U.S. and banks, I mean, after the financial crisis? And how do you think they can improve their public image? Well, I think investment bankers have a better public image than undertakers. Every occupation has its public attitude.
So, actually, I don't think people are overall extremely negative. Movies about investment bankers are usually very negative, right? They're usually criminals, practically. But if you have one living next door, you probably don't because he lives in the rich neighbor. But if you did, you'd probably think he's an okay guy. He or she is an okay person. So I think there's something about, the way I view it is that finance is an important technology.
Many people don't view it this way. It's not about shifting papers. around and making obscure deals that exclude someone else. It's about making things happen. But any good activity has to be financed. And when you get people together to do something important, they start worrying. They have risks that they're concerned about. And they're wondering, is this for me or not?
Or maybe I'm out of here. Maybe they'll do a cynical job as an employee. So you have to incentivize people. You have to protect them from risks. And that's, we are living in an age of financial capitalism. Now, it may create inequality and problems like that, but it also creates the tremendous growth, economic growth that we've been seeing around the world since, in the last half century, particularly, when there was greater appreciation of finance.
So I think that there is mistrust in hostility sometimes, but, and especially after, the financial crisis recently, but I think it's manageable. And one shouldn't not go into finance. I think maybe politicians are lower esteemed than finance people. And that's also an important thing for people to do, and you shouldn't stay away from that one either.
Securities Underwriting: Reputation, Due Diligence, and the Issuance Process¶
So what is underwriting of securities? It's issuance of shares and corporate debt. I might add, it's also, they're kind of like a consulting firm. is a firm that a company will go to for advice. They have researchers there. But the difference, an investment bank you go to for advice too, but an investment bank is like a consulting firm with an army, and I shouldn't say army, with resources.
They know where the money is, and they can get it for you, and so they'll give you advice. So, and it may share some of the risks of the offering. But the really important thing that investment banks do is put their reputation behind the issue. They check you out, due diligence. You're a company, you want to issue new shares because you need money. They have to figure, oh, why do you need money?
Is this legit or some scheme here? And then they would certify the issue. So the issuer is behind the, this deals with a moral hazard problem. Company, you know, you could kind of take over an existing company. You rise in the ranks of the company. And then raise money through issuing debt or securities. You look kind of sleazy, but the investors out there may not know that.
And then you just kind of. You kind of steal the money. You tunnel it out to yourself. So investment bankers are like bankers, but the public doesn't want to be the loser who makes some bad investment. So bankers are members of, commercial bankers, which make loans, are members of a community, and they follow what's going on. And they look at the moral integrity of organizations, and they won't deal with sleazy ones.
The same thing is true for investment bankers. So this is the moral hazard. as I was just saying, it's one kind of crime that, you may call it a crime, that managers of companies do, is when they see that their earnings are unusually high, and they think, well, you know, it's not going to last, we're going to drop in value. They have an incentive to issue shares when the public looking at those earnings.
thinks they're worth a lot more than they really are. So the public is necessarily skeptical about new share issues, especially after a burst of earnings, they wonder if it's real or fake. The problem can be solved by borrowing instead of issuing to the public. Then when you're borrowing from a local branch of a big bank, the people at the branch really know business in your community, and they're not going to be fooled as easily.
But it's also with It's also the same with investment banks. Studies have shown that investment banks that misprice issues suffer a market share loss afterwards. People, if they price them too low, in other words, the company says, I want to issue new shares, and the investment bank says, I think we should issue them at such a price, and it's too low, then the company is not happy.
They didn't get enough for their shares. If it's too high, then the investors are not happy. So they have to be happy. to find the right price. And that's how they're... There's two basic kinds of offerings that investment banks do. A bought deal is a... So imagine you're issuing shares of a company. You are a company, and you don't know what to do. You go to an investment bank.
The investment bank says, we'll buy those shares from you. But we're only a short-term investor. We'll flip them almost immediately. But we just want you to know that we can get this price for you. And then the investment. bank hopes to make a profit on reselling the shares. Another kind of deal is called best efforts, and that's a case where the underwriter said, I'll try to sell your shares at such a price, and if it's not sold, then we'll just try again.
It's over. We try, we couldn't sell them at that price. So it starts out. The process is defined by law and tradition. There's a pre-filing period when the... Imagine that you are a company needing to raise money. You first approach an investment bank, and then there's a call pre-filing period when you get advice from the investment bank about choices. Suppose you decide to go ahead, the underwriter forms a syndicate.
It's an agreement among underwriters. Typically, if it's a big offering, it's more than one underwriter. can handle. So they go to their competitors, well, there are other companies that also do underwriting, and they form a syndicate to issue your shares. And they designate a manager of the offering. The reason they do that is that it's all about trust and connections.
The reason you don't just issue your own shares is because nobody trusts you and nobody knows you, and you could be anybody. to be anybody. So you need contacts. So the investment bankers are among the most decorous of people, impressive of people. If you want a job as an investment banker, it helps if you are impressive and ethically, if you have a look about you, that looks ethical and sincere.
So investment bankers like to go to the symphony to be seen as among the upper crust people, because that's a look. It's their business. They have to sell these things, so they have to look right. And they have to have their connections that they maintain. So one underwriter can't handle a big issue. They've got to farm it out to all the salespeople. You can call them salespeople.
Then they file a registration statement with the securities and exchange period commission. And then there's a so-called cooling-off period before the issue in which they distribute what's called a preliminary prospectus, which describes offering. On the Wall Street, it's called nicknamed the Red Herring, meaning, well, I don't know why it got that meaning, but it's just a document that tells about all the risks that an investor will take by buying the security.
And that document is regulated by the SEC, so it has to be forthcoming about risks. Now, most people never read the prospectus who buy into the issue. I did a survey once about that and found that indeed they don't. That's because they trust that their broker read the prospectus and they trust their broker. Everything is built on trust. Not many people read these things.
Maybe it would be a good idea to read it sometime. You can have that experience someday. So then the underwriting process takes the members of the syndicate call their connections among investors and ask them what do you think you do, with this interest you, we think it's, they'll say that we think it's a solid investment at some price, but we're trying to find what the price is.
And then at that point, they do due diligence, there's a due diligence meeting between underwriter and the issuing corporation. They decide on an offering price. They write an underwriting agreement. They'll say how the underwriting is split up among members of the syndicate. In underwriting is a band of investment banks and broker dealers who come together to sell new offerings of equity or debt securities of a firm to investors when the issue is too large for a single firm to handle.
The syndicate takes on inventory risk by committing to purchase the full issue up front and selling it afterwards to investors in the market. It is compensated by the underwriting spread, which is the difference between the price paid to the issuer and the price received from investors. They have a dealer agreement. Dealers purchase from underwriters at a discount.
There's an effective date when it goes on the market. And then after the whole thing is done, when they've sold the issue, let's say it's new shares, the underwriter typically supports the price in the so-called aftermarket. The issuing market is the price initially. Everyone gets the same price in the initial offering. After that, then it's open to the market.
supply and demand, but then they typically support the price. That means suppose the price starts dropping days after the issue. The underwriter thinks that's a reputation concern, because if people bought into it and they lose 20% of their money in three days, they get annoyed and they start thinking badly of the underwriter. So the underwriter will typically go in and buy to support the price of the underwriter.
of the underwriting. That's called stabilization. Now some people thought it was unethical for an underwriter to do that because the stabilization seems like a market manipulation. They're not doing it because they want to buy it. They're doing it to prevent a panic or anger. But the SEC has decided that this stabilization is a good thing. And so they're legally allowed to conspire to fix prices.
fixed prices in market, at least until the entire issue was sold out. I think maybe it is a good thing. You want stable markets, and if the underwriter is willing to buy it, they're taking a risk. But anyway, we need somehow to supply capital to business. And the fundamental problem is that nobody in the real world, most people don't know the business. They don't...
They can't... figure out whether they're being tricked or not. So this kind of fixing looks okay to the SEC, and so it's done widely. I found a 1929 textbook on investment banking, and it says, the seller desires to have conditions so shape that the price of the issue will remain stable, or even better, it will rise slightly. That would be good news. So, in fact, there's some tendency to underpriced the new issue.
so that its price rises in the immediate aftermarket. If you just bought 10,000 shares of some company, it might even be a new company, you watch the news every day for a few days afterwards. You're really attentive for a while. So there's a tendency for underwriters to underpriced them a little bit in the market to establish a favorable psychological attitude of investors.
The term manipulated market is not ultimately. is not altogether a misnomer.
Initial Public Offerings: Why Prices Often Rise on the First Day¶
An initial public offering is an offering of shares in a company for the first time publicly. They could have privately placed shares, a small company. Like I had a company, K. Shiller-Weiss incorporated, formed with my student here at Yale, Alan Weiss. And we were private. We didn't issue shares very often. And we were not listed. You won't find anything about us.
on stock exchanges. Then we sold the whole company. That was in 2002. So there were never any shares, public shares. are shares that are regulated for the general public. It's very clear, the SEC does not judge the investment potential of companies. They don't get into deciding, is Facebook going to succeed or not. That's not their business. They only are deciding that it's not manipulative and distortion.
distortion-driven. So an IPO is an initial public offering. It's been documented that the price in the aftermarket tends to be higher than the offering price in an IPO. This is a well-known fact. It jumps immediately. And again, the issuer then might complain to the underwriter. The issuer then says, hey, you priced our issue at $25 a share. And the next day, it was third.
The next day, it was $30 a share. So why didn't you ask $30 a share? We would have gotten $5 more. And I can tell you what the underwriter will say. we do this all the time. He might not be so blunt about it. It's a trick. It gets people positive about our company. If you don't like this, go to some other underwriter. But I'll tell you the other underwriter won't be as successful.
He'll only get $20 a share for you because he doesn't have the goodwill of the public. So it's a sort of manipulation, deliberate. They underpriced the offering from what they know they could get. That way it sells out quickly, it looks great. In fact, it's also a problem with IPOs, is that you can't get into them as a purchaser. You try, you call up as a Yale undergraduate, a broker, and say, I have a little money, a few thousand dollars.
My parents gave me. I'd like to invest in an IPO. and your broker will say, come back in 10 years and we'll talk later. It won't do it. Why won't they? Well, because they underpriced them and they want to give that to their favorite customers. So this all sounds like a manipulation. Well, it is sort of, you know, in my book with Akronoff, Fishing for Fools, we describe the real world as filled with manipulation.
Everyone's trying to trick you. But we don't make it that evil. usually okay. And what IPO underwriters are doing is sort of okay. So you as an issuer of new shares are consoled by the fact that even though you didn't get that extra $5 for your shares, you got $25, which is pretty good. And that's just the way the world works. So they leave the money on... Now the other thing is this manipulation is in some sense too successful. Because in the long run, IPO prices tend to fall.
Jay Ritter, who is a professor at University of Florida, wrote a famous article in 1991, said that at least as of 1991, the average IPO jumped 16% on the first day in the aftermarket. So they're really underpricing. But then if you wait a while, wait a couple of years and it's gone. So they tend to fall. This is a secret that the IPO person broker won't tell you about.
That's why. you can't get into an IPO. So you are a hot-shot young student and you call a broker and say, I'd like in on this IPO. The broker is thinking, you know, this guy's just going to flip it. I don't want customers like this. You know you'll make 16% on the first day. But I'm not going to sell to you. I'm going to sell to you. I'm going to sell to some elderly couple who are not paying attention. They won't sell the next day. I know who I'm selling to. I don't want them to sell the next day because I might have to support it in the aftermarket.
So you say, no to you, hot-shot young guy, we're going to sell it to stable and it's all kind of manipulated like that. And then, you know, they'll notice that it went up the first day and they'll call me and say, it's looking good, isn't it? Then they'll just completely forget about it. And then they'll lose the money eventually. But you know, it's not all that bad. We put them into a decent investment, and eventually it'll go up.
But maybe not for three years, but hey, I know my clients. You have to hope these people have some ethics, and I think they do have some ethics. It's just the real world, right? There's a lot of tricks played. So I called this in some paper about the impresario hypothesis. I make it, what underwriters do is analogous what concert impresarios do. So suppose you are managing a artist, a singer, or an orchestra.
What do you do? Have you ever thought about how you would do this? Well, what you want to do is create talk about your client, right? You want sold-out conferences, and you want newspaper stories saying, people were standing in line all night to get into this such-and-such concert. And then that impresses the public. And then you fill up concert halls because the news spreads, and people think this is hot.
Well, but immediately you might ask, well, why don't you just raise the price on the concert? And then you make more money. But you see, that would be short-sighted. An impresario knows better. Keep the price low. And you want these hungry-looking young people coming to the concert and standing in line. You want that. And the only way you get that is if you underpriced it.
Because they can't afford. If you charge the maximum you could charge for the, you wouldn't fill up the auditorium, profit maximizing in the short run. You wouldn't fill up the auditorium and you'd get all these old people or comfortable-looking wealthy businessmen they would just destroy the whole atmosphere of the concert. So you've got to keep those young people, the excited people in. It's a it's a empressarios are known for this, right? They do stunts, they do publicity stunts and they also don't charge the highest price. That's why we have the price pop in IPOs at the beginning Thank you.
Goldman Sachs and John Whitehead: How Culture Supports Reputation¶
Now, Charles Ellis is a, well, he was a member of the Yale Corporation on the board of directors and connected to this university, but never a professor here. He wrote a book called The Partnership just before the financial crisis about Goldman Sachs. was maybe the most esteemed investment bank in the United States at that time. Very successful. And so what was the, so he wrote a book which was admiring of Goldman Sachs, though at times maybe it sounded a little critical.
So what was behind Goldman Sachs? Number one, making money, always and no exceptions. There's a different culture at Goldman Sachs than there is at the university. And if you ever go there, you'll see it rather starkly. Nothing was ever done for prestige. Although indirectly, of course, they want prestige, because that helps their business, but it's always money, money first.
The most prestigious clients were often charged the most. And then there is a sense of loyalty, absolute loyalty to the firm and to the partnership, and personal anonymity. You don't go around flaunting your name. You flaunt Goldman Sachs. All right. This is the, you don't go around. Goldman Sachs culture. It worked. This kind of thing works. So a unique blend of a drive for making money and the characteristics of a family in ways that the Chinese, Arabs, and old Europeans would well understand. John Whitehead then became, long ago, became chairman of Goldman Sachs, and he issued in the 1970s principles that sounded a little bit more idealistic.
I think companies have to assert principles, and leaders of companies have to do that. John Whitehead's principles, I think were contrary a little bit to what I just said, the old Goldman Sach. Whitehead wanted them to be a moral company. But again, they're still interested in making money. So he said, actually, the first objective is not money for Goldman Sach.
It's money for our client. We're all about money, but it's about money for the clients first. Second, our assets. are people, capital, and reputation. I'm doing typos here, sorry, that's reputation. That's, I was saying that the whole business of investment banking is about people. It's about trust, about building reputation. That's the asset. Uncompromising determination to achieve excellence.
Now this may sound a little bit like manipulation in itself, but I think it's serious. We stress great. creativity and imagination. He lived, what is that, 93 years? He was chairman of Goldman for 38 years. More of his guidelines. Talk to the boss. You're now a young person at Goldman Sachs. It's your first job, all right? You call up some big company. Who do you talk to?
You demand to talk to, not the assistant treasurer, but the CEO. or someone very high up. How did you get the nerve to ask to do that? Well, Whitehead wants it to be very clear. You are at Goldman Sachs. You talk to the CEO. There's something about ego that is profitable in business, and he wants gold. You have to live up to that. You don't talk to the assistant treasurer.
You never learn anything when you're talking. He wants you to be a good listener. And then you have to respect individuals. worth and there's nothing more worse than an unhappy client. I think there is some substance to these, but to these points that Whitehead is made. The new Goldman Sachs was drifting away from these, some of these, notably putting the client first.
And, you know, there was just a settlement in the news the other day about Goldman had to pay $5 billion for dishonest marketing. of mortgage securities. So, you know, they've slipped a little bit. Well, Whitehead died. You know, I think that leadership involves personal force. And Whitehead eventually, he lived a long time, but he eventually died. Also, they lost their partnership structure, which gave it less of a sense of family, and they lost some of their principles.
But not altogether, I think. There's still a lot. of good people at Goldman Sachs.
Rating Agencies: Public Information and the Issuer-Pays Conflict¶
Now I want to talk about rating agencies. As an alternative to trusting an investment banker, you can trust a rating agency. So what is a rating agency? It's an agency that publishes its information instead of keeping it secret for their favored clients. So the first beginnings of a rating agency were by a book written by Henry Varnham Poor, published in 1860, called History of Railways and canals in the United States.
But it was more than a history. It wasn't a history book for history buffs. It was focused on companies and what their situation was. So it was the beginning. He later, that later led to Standard and Poor's Corporation. Well, Pours in 1960 merged with standard statistics to form standard and poor, long after Henry Varnham Poor. But John L. Moody, founded the first true rating agency called Moody's Investor Services in 1909.
And he decided to give letter grades like in college. Now, already colleges were doing this grading system, A, B, C, D, grading system. So he thought people would understand that. He's going to grade companies for their integrity and ability to come through for you. And the best rating he gave was not A plus, it was A AAA, AAA, and then there was B's, C's, D's, and bad ratings as well.
In his 1933 book, The Long Road Home, Moody, I think maybe I said something about this, described his moral mission. He did, he said, I always, like any other young person, wanted to become a millionaire someday, but he said, you know, I always, like any other young person, wanted to become a millionaire someday. But he said, you know, I had other impulses as well, and one of my impulses was to tell the truth and tell everybody.
I don't feel like someone who should keep secrets. I wanted to publish it and get it out there, and those bastards who are playing tricks, they'll be exposed everywhere. So he sold books, Moody's investor manuals, describing every major company and what he thought of them. He loved to do it because he likes to criticize, I guess, or likes to, do that thing.
And it was a huge success, and it remains so today. Originally, they would not accept money from the people they rated. That broke down, Moody's said that as a principal, you read it. Well, it's just like, could I as a professor accept cash from you, would hand me money, and then that might be a bribe to raise your grade? Of course, that's obviously unethical.
But rating is a good. It should be the same for rating agencies, right? But that broke down in the 1970s when rating agencies found it difficult to keep up with all of the complicated securities that were being issued. And they started charging for companies. It got really crazy with the mortgage securities that took so many different forms and they're so complicated.
So rating agencies said they had to charge for it. And then it turned out to be a great business. Rating agencies, which were never big profit. centers started getting involved in all the complicated new derivatives finance. And we're making a lot of money. So it was hard to... So those of you who came with me to see the big short, will remember the scene when Steve Carroll, the actor goes into a rating agency and talks to a woman and then asks her, who's a manager of a department, there and asked her, what do you know about the underlying mortgages behind the security?
And she admits nothing. And then he said, well, why do you give it a rating? And then she said, well, if we don't, our competitors will. So that was an outrageous thing to say. You saw it in the movie. Whether it actually happened, I don't know. I wasn't there at that meeting. But I heard things like that in the early 2000s that the rating agencies were getting casual.
So the rating agencies have improved their act substantially because of new regulations and their loss of reputation. So there's now more care in, they still accept money, because their business kind of, they still accept money for ratings because their business kind of requires that now.
Glass–Steagall: Should Banking Businesses Be Separated?¶
The Glass-Steagall Act was one of the most famous acts of Congress in 1933. It did a number of things, notably it created the Federal Deposit Insurance Corporation, which was the first insurance of commercial bank deposits in the United States. So the idea of an investment bank was really created, of a separate investment bank was created by Glass-Steagall.
So the problem was that people thought that the crash of 1929, had something to do with banks and investment banking and commercial banking being in one operation and rip-off. There were rip-offs. So if a bank was both an investment bank and also a commercial bank, then the investment bank could use the knowledge from the commercial bank to do insider trading of securities, which somehow was connected back then to the 1929.
stock market crash. So the really important thing that's most remembered about the Glass-Steagall Act is it said that you can't be both an investment bank and a commercial bank. So that's why we have Morgan Stanley. Now, it's changed since then, but why Morgan Stanley separated from J.P. Morgan. Also, why first Boston Corporation separated from the Boston National Bank, I think it was called.
in 1934. It was because of the Glass-Steagall Act. But that was repealed. Oh, by the way, other countries didn't do this. So United States had a complete separation of commercial banking and investment banking, but other countries allowed what we call universal banking throughout this whole period. Over the years, these investment banks and commercial banks complained that they couldn't compete with European, or they're having trouble competing because they couldn't offer all the services that were seamlessly offered by European banks.
And so because of lobbying by banks, regulators nibbled away at Glass-Steagall and were beginning to allow commercial banks to get involved in certain investment banking operations. And then the Graham Leach Act of 1999, which signed by President Clinton, finally ended Glass-Steagall. So they can now do both. You can be both a commercial bank and an investment bank.
And that led to a wave of mergers of commercial banks and investment banks and insurance companies, which had also been kept separate. So there's some Merg, Travelers Group and Citicorp merged. Chase Manhattan Bank acquired J.P. Morgan, so it's now called J.P. Morgan Chase. And UBS, Switzerland bought Payne-Webber, Weber, Credit Swiss bought Donaldson, Lufkin, and Gen Rep.
That's all after. But now there are still people who want Glass–Steagall back. One of them is Paul Volcker, former Fed chairman, who is actually one of the most famous Fed chairman of all because he really whipped inflation. There was out-of-control inflation. And when he became Fed chairman in 1979, he created a recession, actually a worldwide recession. And he lobbied, among other central bankers.
We can't just keep feeding inflation, and it's going to have some cost. So it costs the so-called Great Recession, among the recessions so-called, well, there were two of them, in 1980 and 19801-82, which was a severe recession. But he seemed to break rising inflation. So he would have to break rising inflation. He wanted to put Glass-Steagel back with the Dodd-Frank Act, and he instead managed only to put in something called the Volker Rule.
is that commercial banks cannot invest, cannot do proprietary trading. They can do investment banking, but they cannot directly own hedge funds or other risky investments. So commercial banks are allowed to underwrite securities and do the normal activities associated with underwriting of securities, but they can't be just buying for their own account risky assets.