Securities Firm Operations: Investment Banking, Brokerage, and Trading

Book: Financial Markets and Institutions, 11th Edition Author: Jeff Madura Publisher: Cengage Learning, 2015 ISBN: 978-1-133-94788-2

Chapter 24 is about securities firms, and it covers a lot of ground. These are the companies that sit at the center of capital markets, helping governments and corporations raise money, facilitating trades between investors, and sometimes trading for their own profit. Some are independent. Many are part of larger financial conglomerates. After the credit crisis, some became part of bank holding companies. But their securities operations remain distinct from traditional banking.

Investment Banking Functions

When people say “investment banking,” they mean several different activities. Securities firms help companies issue stocks and bonds through a multi-step process.

Origination is where it starts. A corporation decides to issue stock. The securities firm advises on how much stock the market can absorb without tanking the price. For an IPO, where there is no existing market price, the firm compares the corporation’s financials to similar public companies to determine pricing. The company registers with the SEC, files a prospectus, and the securities firm organizes a road show to pitch the offering to institutional investors.

Underwriting involves forming a syndicate. The original securities firm recruits other firms to share the risk and fees. Big names include Bank of America’s Merrill Lynch division, Goldman Sachs, and Morgan Stanley. Despite the name “underwrite,” most stock offerings are done on a best-efforts basis. The securities firm does not guarantee a price. The issuing corporation bears the risk.

IPO pricing is a balancing act. Price too high and the shares will not sell. Price too low and the issuing company leaves money on the table. Research shows that securities firms tend to underprice IPOs. Investors who get in at the offer price earn high short-term returns, often within the first few days. Those who buy shortly after the IPO generally do poorly.

Distribution happens after SEC approval. The prospectus goes out, and the sales force starts selling. Some issues sell within hours. If demand is weak, the syndicate has to cut the price.

Private placements skip the public offering entirely. The entire stock issue goes to a small set of institutional investors. Under SEC Rule 144A, firms can do this without the extensive registration required for public offerings. Lower costs, but less liquidity for the investors.

Bond offerings follow a similar process. The securities firm advises on the amount, coupon rate, maturity, and other terms. Bond placements tend to be easier than stock because bonds can be sold in large blocks to institutional investors. The flotation costs for bonds typically range from 0.5 to 3 percent, which can be significantly lower than for stock.

Securitizing Mortgages

Securities firms played a central role in the mortgage-backed securities market. They would obtain mortgages from originators, bundle them into packages (tranches) by risk level, hire a credit rating agency to rate them, and sell the packages to institutional investors.

This process was supposed to benefit everyone. Mortgage originators could focus on lending and servicing. Institutional investors could access mortgage investments with assigned risk ratings. Securities firms earned fees as intermediaries.

During the credit crisis, it all fell apart. Many loans defaulted. The credit ratings were too generous. Securities firms that invested in their own packages suffered large losses. They were criticized for not understanding the risk of what they were selling. Their defense was that they relied on credit rating agencies. Neither party covered itself in glory.

Advisory and Financing Services

Securities firms advise corporations on restructuring. They might recommend a carve-out (selling a unit through an IPO), a spin-off (distributing shares of a unit to existing shareholders), or a divestiture (selling off a division).

Merger advisory is a major revenue source. Securities firms assess potential synergies, determine whether the premium paid for a target is justified, and sometimes recommend which divisions to sell after an acquisition (asset stripping).

They also help finance acquisitions. For leveraged buyouts, they can help issuers sell stocks or bonds, and they may provide bridge loans as temporary financing until permanent funding is arranged. Some even take equity stakes in acquired firms.

Brokerage Services

The brokerage side of the business is more straightforward. Securities firms execute buy and sell orders for customers.

Full-service brokerages provide research, advice, and trade execution. Discount brokerages just execute orders. Online trading has pushed costs way down. The fee for trading 100 shares is typically $20 or less.

Some firms also manage customer portfolios, making buy and sell decisions on behalf of clients. They charge an annual percentage of assets under management, typically around 1 percent, plus transaction fees.

Proprietary Trading

This is where securities firms use their own money to trade. Equity desks, fixed-income desks, derivatives desks. When it works, proprietary trading supplements income from other operations. When it does not work, the results can be catastrophic.

Barings Bank collapsed in 1995 after a single trader, Nick Leeson, circumvented restrictions and racked up $600 million in currency trading losses in Singapore.

Societe Generale lost $7.2 billion in 2008 when trader Jerome Kerviel bypassed computerized controls to take massive positions in European stock indexes.

Bear Stearns suffered enormous losses from investing in mortgage-backed securities with heavy leverage. When creditors cut off credit, the liquidity crisis forced a government-assisted rescue.

Lehman Brothers had the same problem but did not get rescued. It filed for bankruptcy in September 2008.

The underlying cause in every case is the same. The incentive structure rewards risk-taking with enormous bonuses. Employees who generate high returns earn millions. The downside risk falls on the firm and its shareholders. This asymmetry virtually guarantees that some traders will take excessive risk.

Conflicts of Interest

Madura does not hold back on this topic. Securities firms face structural conflicts of interest.

In brokerage, their fees depend on trading volume. They benefit more from recommending frequent trading than from recommending a buy-and-hold strategy.

In merger advisory, they earn fees when deals close. So they have an incentive to push mergers even when doing nothing would be better for the client.

Some firms promoted specific securities to clients while simultaneously dumping their own holdings of those same securities. Employees referred to stocks they were recommending to clients as “junk” in internal communications.

These problems are driven by compensation structures. If bonuses are tied to transaction volume or revenue, employees will maximize transactions regardless of client benefit.

Regulation

The SEC enforces disclosure laws and has enacted several important rules:

Regulation FD (Fair Disclosure) from 2000 requires companies to disclose significant information to all market participants simultaneously. No more leaking earnings data to favored analysts first.

Analyst rating rules from 2002 prohibit analysts from promoting a stock for 40 days after their firm underwrites its IPO. Analyst compensation cannot be tied to the business they bring in. Ratings must disclose any recent investment banking work the firm did for the rated company.

The Financial Services Modernization Act of 1999 allowed banking, securities, and insurance to consolidate under one holding company. This created financial conglomerates that could cross-sell services. It also intensified competition because banks could now offer securities services.

The Securities Investor Protection Corporation (SIPC) insures cash and securities deposited at brokerage firms up to $500,000, including $100,000 for cash claims.

Valuation and Risk

Securities firm valuation depends heavily on economic conditions. Strong economies bring more IPOs, more mergers, more trading volume, and better returns on proprietary positions. Weak economies reduce demand across all services, and the correlation is high. Diversifying services does not help much when everything drops together.

Market risk is the big one. Rising stock markets boost trading volume and investment returns. Falling markets reduce both. Interest rate risk affects bond holdings and the volume of new bond offerings. Credit risk shows up in bridge loans and debt securities held on the books.

My Take

Securities firms are the most conflicted institutions in the financial system. They advise companies while trading for their own account. They recommend stocks to clients while potentially taking the opposite position. They design financial products (like mortgage-backed securities), rate them, sell them, and sometimes invest in them.

The credit crisis exposed all of these tensions. Bear Stearns and Lehman Brothers were brought down not by bad luck but by deliberate risk-taking amplified by leverage. The bonus structure incentivized exactly the behavior that destroyed both firms.

The regulatory response has been real but incremental. Regulation FD leveled the information playing field for small investors. Analyst rating rules reduced some of the most blatant conflicts. But the fundamental incentive problem remains. As long as the upside for risk-taking is unlimited bonuses and the downside is someone else’s problem, the same patterns will repeat.

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