Notes on investment banking prepared by Jacob Westerberg on a lecture by profess

or Robert Shiller at Yale University

February 4, 2010 Investment Banking The term bank is misleading since this is of
ten used in everyday life as a synonym for a depository institution. A depositor
y institution is an institution that accepts deposits from individuals and compa
nies and later on the owner can take the money back at an interest. Meanwhile th
e institution makes loans, or invest the money at higher interest rates than the
y give out on the deposits and that is how they make a profit
(e.g. a savings- ,savings and loan- or commercial bank).
Historically and at
present however a majority of institutions do both. Investment banking means the
underwriting of securities. They arrange for the issuance by other institutions
of securities (i.e. if Ford Motor Company would want to issue
new shares or bonds they would go to an investment bank and the investment bank
would underwrite the issuance).
A pure investment bank is not a depository
institution, nor is it a broker/dealer because they are not trading in securitie
s although they would deal in securities as part of the underwriting process.
The Glass-Steagall Act of 1933 The stock market crashed in 1929 causing tremendo
us chaos in the financial markets. Carter Glass (D), a senator from Virginia, an
d Henry Steagall (D), a representative from Alabama, put together a bill that pa
ssed congress and was signed by President Roosevelt that was designed to control
speculation and basically stated that investment banking cannot be combined com
mercial banking or insurance. (e.g. J.P. Morgan & Co,
one of the biggest banks of the US, which was founded by James Pierpont Morgan w
as informed that it had to chose whether it wanted to be an investment bank or a
commercial

Notes on investment banking prepared by Jacob Westerberg on a lecture by profess

or Robert Shiller at Yale University
bank and J.P. Morgan & Co decided to be a commercial bank. Two individuals that
at this time worked with the investment banking department, Henry S. Morgan and
Harold Stanley, then decided to open up Morgan Stanley, a new investment bank. S
ince 1933 J.P. Morgan has gotten back into investment banking however and the co
mpanies are today competitors)
The problem was that in the US there was a division between investment banking a
nd commercial banking while in Europe there was not which resulted in a lot of c
omplaints from companies in the business saying that the laws of the US handicap
ped them against there foreign competitors. Finally part of the Glass-Steagall A
ct was repealed by the Gramm-Leach-Bliley Act of 1999 (GLBA) which led to a wave
of mergers between investment banks, commercial banks and insurance companies,
many occurring just before the bill but were given waivers (e.g. The commercial
bank Citicorp merged with the insurance company Travelers Group to form the cong
lomerate Citigroup).
Financial Crisis of 2007-2010 Many of the investment banks buckled during the fi
nancial crisis. The first to fail was The Bear-Stearns Companies, a global inves
tment bank, securities trading and brokerage firm until its collapse and fire sa
le to JPMorgan Chase in 2008 (for $10 a share, a price far below the 52-week hig
h of
$133.2. The Federal Reserve helped smooth the process by giving a $29bn line of
credit to JPMorgan in exchange for the promise that JPMorgan would buy Bear-Stea
rns. This controversial decision by the Fed was made to minimize the contaminati
ng effects of the Bear-Stearns crash. Ironically Bear-Stearns was one of few fir
ms that survived the 1929 Wall Street Crash without laying off a single employee
).
The crisis saw the lat of
the US investment banks which hadnt gone bankrupt or been acquired in a bankruptlike state convert to bank holding companies which are eligible for emergency gove
rnment assistance (the Troubled Asset Relief Program

Notes on investment banking prepared by Jacob Westerberg on a lecture by profess

or Robert Shiller at Yale University
(TARP) is a program of the United States Government designed to purchase assets
and equity from financial institutions to strengthen the financial sector).
The Underwriting Process
Investment Banks
Issuing Firm
One investment bank is chosen by the

rm.

Lead-underwriter
1
Syndicate of Underwriters
The lead-underwriter chooses a syndicate of underwriters. Group of intermediarie
s between issuer and investors.
Group of Sellers
Book-building
Paperwork
- SEC Registration Statements - Credit ratings - Legal approval - Printing Secur
ities SEC Approval
2
- Distribute the prospectus - Meet with potential buyers - Book promised sales Analyze feedback from brokers Final price is determined Tombstone is published
in newspapers
Single price is offered
3
Collect investors subscriptions: - Fully subscribe - Under-subscribe - Over-subs
cribe
The scheme above depicts the underwriting process in a somewhat simplified matte
r.
1. Search for an investment bank When a company is going to or is thinking about
issuing new securities investment banks pitch proposals to the issuing company
and

Notes on investment banking prepared by Jacob Westerberg on a lecture by profess

or Robert Shiller at Yale University
basically the investment bank with the highest bid wins (although its not
always that simple).
The reputation of an investment bank is very important,
it is important both in being selected as a lead-underwriter or counderwriter an
d in managing to sell the securities investors. When an investment bank pitch th
ere is an important choice to make, whether to offer a firm commitment (also bou
ght deal) or best effort. With a firm commitment (most common) the IB guaranteer
s the issuing corporation a fixed price for the securities and takes on the risk
of selling them to investors. In the case of best effort no price is guaranteed
but the investment bank simply promises to try to sell the securities, if the i
ssuing firm demands a minimum price which the investment bank cant get the deal f
alls through. After an investment bank has been hired by the company to be the l
ead-underwriter it in turn search for co-underwriters. The reasons most IPOs are
handled by more than one underwriter are two-fold. Primarily to decrease the ris
k for a single institution since underwriting is a risky process, and secondly b
ecause it expands the network of potential buyers since no single investment ban
k has all connections that are sometimes needed.
2a. Paperwork Market supervisory agencies such as the Securities and Exchange Co
mmission (SEC) in the US and the Financial Services Authority (FSA) in the UK pl
ay a crucial role in the issuance of securities since they have to approve it. R
egistration requires, among other things, a preliminary prospectus (also the red
herring, the document is often printed with red borders) which is supposed to giv
e away all available information about the

Notes on investment banking prepared by Jacob Westerberg on a lecture by profess

or Robert Shiller at Yale University
security. The period (up to three weeks) when the new security is waiting for ap
proval is called a cooling off period, during which time the underwriters are look
ing for potential buyers [building the book]. Once the security gets the approva
l it is said to be effective. 2b. Book-building During the cooling off period the
underwriters are allowed to circulate the preliminary prospectus and collect bi
ds on shares (bookbuilding), or rather promised sales to investors. The promises
are at this stage not binding but rarely do investors pull out last second sinc
e if they do they probably wont be offered to participate next time. At the end o
f the book-building a single issue price is decided on which is believed to be a
ppropriate, to determine the best issuing price is the essential quality of the
investment bank.
3. Subscription When the price is decided the issue is offered and the binding o
f investors starts. Both the investment bank and the issuer seek for the subscri
ption to be full and rather for it to be over-subscribed than under-subscribed s
ince this much like a concert where the tickets are out leaves the public thinki
ng that the company is hot (Morgan Stanleys
IPOs on Wall Street during 2009 were considered to be very successful, on average
the securities gained 18% in the month after the IPO).
Technically if an issue is
over-subscribed this means that the company could have raised more capital and v
ice versa if the issue is under-subscribed. If an underwriter consistently sligh
tly underprice securities so that the book gets over-subscribed future interest
in shares they issue will of course

Notes on investment banking prepared by Jacob Westerberg on a lecture by profess

or Robert Shiller at Yale University
increase since investors will earn a profit as soon as the securities hits the m
arket.