Financial Markets (2008)

ECON 252 (2008) - Lecture 17 - Investment Banking and Secondary Markets

Chapter 1. The Paulson Proposal: Opportunities for Stabilization and Surveillance [00:00:00]

Professor Robert Shiller: I wanted to talk today about investment banking, which is a subject of some interest around here. First, I thought I would — there’s been so much news; I want to just briefly comment about what’s going on in the world today with our financial crisis. Notably, I think that this is the — it could be the biggest financial crisis since The Great Depression and as evidence of that, we’re seeing a lot of talk about what changes should be made. I think it reminds me of the very basic fact that we live in a financial world that was created in the wake of The Great Depression.

So many of our financial institutions were created in the 1930s because that was a time when everything was being shaken up and it was a time when people were willing to consider something really different. If you just look back where various of our institutions — when they were created — it’s most likely to be in the 1930s. We are not yet at such a crossroads. The financial situation is not as bad as it was in the 1930s, but it’s getting bad and as a result we’re starting to see proposals for big change. Notably, on Monday, the Treasury Department, under Secretary Henry Paulson, announced a proposal for fundamental change in our financial markets. This proposal, if implemented, might be the biggest change since The Great Depression. However, the news is calling it dead on arrival; it’s unlikely that the Paulson proposal will be implemented partly because it’s being proposed by a Republican administration — well, not just Republican, just an administration that’s coming to an end and we’re having an election.

This Paulson proposal probably has very little chance of being implemented as is, but it’s put in to change the discussion and it’s going to be talked about a lot and I suppose it will influence what happens. The interesting thing is that the next President of the United States will likely have a mandate for big changes. Maybe it’s just as well that Fabozzi, et al. are slow to do a second edition of their book because if they got it out this year it would be a bad year to get it out because everything is changing. I studied the Paulson proposal carefully, since I’m writing a New York Times column about it, which will appear Sunday. Reading the various commentaries about the proposal, I had the impression that not many of them are very — thinking very deeply about it. They typically — they like to talk about the politics of it and this thing, that it’s dead on arrival or it’s — someone said it’s an amateurish proposal.

All the groups that stand to win or lose from it are all figuring out what it does to them and they’re taking the positions out of self-interest. So, I wanted to write something that was more perspicacious, if I could manage that. The interesting thing is, actually everyone calls it the Paulson proposal, but it was apparently mostly written by a young man who is in his early thirties. You may not consider that young, but I think that is young. He could have taken this course from me ten years–actually, he didn’t go to Yale. I looked it up; he went to American University, both undergraduate and — his name is David Nason — undergraduate and then he got a law degree at American University. Then he just went to work for the government. As far as I know, he doesn’t publish; he’s not in the newspapers, but he’s gotten the ear of the Treasury Secretary. They spent many weekends together figuring out what should be done about the system and they wrote up a proposal.

I like many aspects of it; actually, it’s an interesting proposal. It’s not so much what’s in the proposal as it is that this is the time for reconsideration. One interesting thing that they proposed is that we should have what they call “objectives based regulation.” We have — this is David Nason and Henry Paulson, although it’s not signed by them, it’s signed by The Treasury. So, The Treasury–it’s called a blueprint, a blueprint for reform of our financial regulation. It’s built around what they call “objectives based regulation.” That means that the different regulators should each have their own objective, so they have a three-part proposal. The market stability regulator, which would make sure that the markets don’t freeze up on us — we don’t have a systemic crisis. There would be a prudential financial regulator and then, three, there would be a business conduct regulator, so that’s the main part of the proposal. What they’re doing is emphasizing the different objectives of regulators.

The market stability is going to be the Fed, but it’s not just banking. They want it to be — the Fed’s role would be broadened so that it’s not just a banking regulator, it’s the whole financial system. It’s supposed to be maintaining the stability of the system. Then the prudential financial regulator is supposed to regulate — it’s supposed to aim at protecting the U.S. interest in various institutions that are guaranteed by the government, such as banks that are federally-insured or enterprises that have government guarantees or apparent government guarantees, like Fannie Mae and Freddie Mac. Then the business conduct regulator is supposed to regulate — what I saw is it would be aimed at — consumer protection; that it would make sure that businesses are protecting individuals.

I find this interesting because it calls to mind some of the problems we had with the subprime crisis. One very important problem was, in the U.S. we have regulation divided up in crazy archaic ways. Different agencies were formed at different times and they have specific missions. For example, we have the Office of the Comptroller of the Currency. The OCC was founded in 1863 to supervise national banks but it only supervises national banks. Well, why not state chartered banks or why not credit unions or other things? Well, it’s just an accident of history. So, what these people are proposing is that we merge various agencies so that — define new agencies of the government that are separated by these different objectives; so, an objective defines an agency — a regulatory agency. What they want to do is merge the OCC and the OTS merger; that’s one of the proposals. I wonder why they don’t carry it further, but that’s the thing they emphasized.

The OCC is Office of the Comptroller of the Currency — regulates national banks. The OTS is the Office of Thrift Supervision; it regulates savings banks. So, we put the two together — that sounds sensible, I guess. Why are they separate? Various other things that they talked about had that form. They want to merge the Securities and Exchange Commission and the Commodity Futures Trading Commission. The Securities and Exchange Commission is the principal government regulator for securities. They make sure that everything is on the level and working right. They help prevent fraud, misrepresentation, manipulation of information in stocks and bonds.

The CFTC is the Commodity Futures Trading Commission and it regulates our futures markets. There has been, over the years, a lot of turf battles between the SEC and the CFTC because it’s sometimes unclear whether something is a security or a futures. For example, when they started trading stock index futures, both these agencies thought it was in their turf because it involved both stock indexes and futures. Anyway, Paulson is proposing merging these. That makes sense and it seems like getting rid of some of this division of regulatory agencies is very beneficial. The division is what hampered regulators from dealing with the financial subprime crisis.

People knew that a lot of bad loans were being made or loans were being made to people who shouldn’t be getting them. Low-income people were being given adjustable rate mortgages with very low starter rates, called “teaser rates,” that would be raised in the future. They were given them with — in such a way that after the rates were raised, they likely couldn’t afford to pay the mortgage anymore or they’d be under great stress in trying to do so. So, a family that bought a house — a low-income family buys a house they can barely afford it, then the rates go up on them. The parents would have to take out second jobs to try to — they’re just going to go bankrupt when that happens. It was, in some cases, unethical and it was plainly a problem and yet the regulatory agencies in the U.S. weren’t stopping it.

Another reason why the regulatory agencies weren’t stopping these problems was because they often saw their mission in different terms. When I gave a talk at the OCC in 2005, I was asking them about, why aren’t you policing these mortgages? Their first answer was, well you have to remember we were set up in Abe Lincoln’s day to manage the national banks — that’s our mission. I may be overstating their answer, but I got that flavor from them. You want us to go out and protect consumers, well of course that’s a nice mission, but that’s not our mandate. I think that what Paulson and Nason want to do is to create a separate business conduct agency that is aimed at consumer protection. So, it would be working parallel with these other agencies to — but their job would be to represent the consumer and that sounds like a good idea to me.

Chapter 2. The Fed as a Market Stability Regulator and News Media Bias [00:13:45]

The thing I stressed in my column was the market stability regulator, which is the Fed. What they want to do is expand the actions of the Fed, so that they’re not — you can describe the Federal Reserve or any central bank, traditionally, as a banker’s bank. Remember, I told you the story of how the first — the Bank of England was the first central bank and it made banks keep deposits at the Bank of England. In other words, the banks were like customers of the Bank of England; they had to keep deposits there and the Bank of England watched them to make sure that they were behaving responsibly and had authority over them because it had market power. Well, the Fed is like that now, but what Paulson and Nason wanted to do is make it more than a banker’s bank. They want it to be a bank for the whole financial system. That’s what’s already happening. In fact, it’s just happening rapidly as we speak. I mean, in this last month, things have changed.

The Fed has never given loans to anyone other then a depository institution that is a bank until last month, except they did so in the Depression. There was this long gap in the 1930s; the Fed was making loans to private companies that were not banks and then they stopped doing that, until last month. They created the — I mentioned it last time, the Term Securities Lending Facility and the Primary Dealers Credit Facility, which are lending outside the banking system. What Paulson wants to do is make that official that the Fed is no longer just a central bank; it’s a market stability regulator. This is going to be very controversial, but I think it’s a good thing to raise. In my opinion, this is the trend anyway and I think we’re going that way.

The problem is that in a modern financial economy, we have so much instability, which is already built into the system, that we rely on something like a central bank to do things that help stabilize markets. I think that we’re probably going that way anyway and I think that in the next presidential administration we’ll see an expansion of the role of the Fed. I wish the Fed had behaved better in the recent crisis in the sense — they didn’t seem to recognize the bubbles that we had in the stock market in the ’90s and the housing in the 2000s. If they are our market stability regulator, you’d hope that they could do a better job. But, they’re what we have and I think that we should probably give them the authority to do that job and I think that’s what we need to do. I was generally positive about their Treasury proposal. Another thing that they want to do, which has been talked about for some time. Yes?

Student: [Inaudible]

Professor Robert Shiller: Yeah. He asked, why do the news media think that the crisis is already over? Secondly, why do they think we can prevent — that’s paraphrasing. I don’t know if the news media are concluding anything, but you do see — we have seen — -over recent years, we’ve seen a lot of suggestions that the turning point is just around the corner and the news media report that. I think there’s a bias towards optimism among business economists or among business people in general. It’s not considered good form to say, I think we’re about to have a crisis of confidence and the whole house of cards is going to collapse. It’s also not — it’s generally not in a business person’s interest to suggest that, so we’re all instinctively trying to promote each other’s confidence and that’s what business people do. They carry it a little further than that.

I was asked to be on Kudlow and Cramer — Kudlow and Company show — I guess it was two nights ago. I turned them down, but they wanted to put me on opposite the CEO of Coldwell Banker, who is claiming that the crisis is just about to end. I did a little research, thinking I still might go on the show. I looked up CEO of Coldwell Banker, but I found that there was another CEO — this is a real estate broker’s firm. There was another CEO a year ago who was on TV — just exactly a year ago — saying, I think this is the best time ever — the best time in at least ten years to buy a house. He said, the inventory is high; the market is bottoming out and so on. He was spectacularly wrong, but I notice he’s also no longer CEO; so, these things happen.

There is a general bias. On the other hand, I have to respect these people that usually financial crises end okay. There are repeated scares and usually it’s all right. We had a big scare in 1998; it started with the Asian financial crisis and then it spread to Russia and there was this terrible collapse in Russia in 1998, when the government couldn’t pay its debts. Then that spread to the U.S. and people were very fearful, but the Fed, under Alan Greenspan, was very quick to respond and the whole thing didn’t turn out to be anything so bad. The Fed again did like what it’s doing now; it rescued this company called Long Term Capital Management.

Your question about whether we can prevent this kind of thing in the future is a deep question and I think that the problem is that our financial markets are inherently somewhat unstable. When we start thinking up really important new ways of doing financial business they start to grow and they get huge. They get bigger and bigger before you know it and it’s just amazing how things can suddenly grow and then nobody understands them; so there’s a vulnerability.

I was just — got the latest number — do you know how much credit default swaps there are outstanding? According to the Bank for International Settlements, there are now fifty-two trillion dollars worth of credit default swaps outstanding; fifty-two trillion dollars with the GDP of the United States is fourteen trillion. How can there be fifty-two trillion dollars of — these things only came in in the last ten years or so. I called an economist at the BIS and said, can you please explain it to me? Where is this fifty-two trillion coming from? I got a note from him and I’m still trying to figure it all out. That’s what happens; the system performs very well and then it becomes vulnerable. Nobody understands all of it, so that’s the problem.

The other side of it, though, is there was a recent study that looked at financial crises and compared countries that have had financial crises with countries that haven’t. The conclusion was that countries that have experienced financial crises are generally more successful, on average, over the long haul, than countries that haven’t. In that sense, a financial crisis is a sign just that you’re moving with the times and you’re making a lot of money. Then things suddenly blow up on you, but you’ll recover and you’ll figure something out and then you’ll move from there. I don’t know that Paulson’s proposal — I kind of like them, but I think that they’re not enough; that’s why I’m writing a book about this. I think there’s a lot more to be done. Even if you did everything that I would do, we would still have a vulnerability to financial crises.

Part of the reason why I’m endorsing this market stability regulator is that I think that there’s no way that we can just guarantee — there’s no way we can set up a system that is both very effective in allocating resources and that is also very stable. Just like when we went to the moon — when we sent people up into space — one of those space shuttles blew up. Well, that’s what happens, but most of them made it all right. So, that’s the way it is in finance as well.

Chapter 3. What Is Investment Banking? A Historical Glimpse [00:23:31]

Anyway, I’m here to talk today about investment banking, which of course is relevant to — this is all part of this general thing. Let me — I said earlier that investment banking seems to be a great interest of students at Yale; that’s because they get some really great jobs there. It’s a — investment banking is a very important economic institution and it’s fundamental — what they do is fundamental to what happens in our economy. So, as a result, people who work for them have a chance for a great economic success. I’m not saying you want a job at an investment bank because it’s also demanding and difficult. I’ve talked to some of our students who have taken jobs at investment banks and sometimes I think they’re probably too demanding. As a young person, you should be enjoying your youth and not getting dragged in to some huge investment bank.

There are some terrible stories — young people who took — who left college five, ten years ago and they got a job at Bear Stearns and Bear Stearns demand — I’m just making this story up, but it must be something like this for somebody — demanded eighty-hour, hundred-hour week devotion to the job, but they kept paying in Bear Stearns stock. The student was making millions every year. Meanwhile, his youth was going away and now this imaginary student is now thirty-three years old, never had time to marry or start a normal life. Then, the whole thing blows up and all the Bear Stearns stock is worth just about nothing; so, that’s the kind of mistake you don’t want to make.

I find the industry very interesting. You have to form some kind of balance in your life and not let anyone demand a hundred hours a week of your time. If they do, you should sell the stock they give as soon as you can and diversify. I also like investment banking because I created one. We have — my colleagues and I founded an investment bank called Macro Markets and I’m not actually running it, I’m co-found — it’s named after a book I wrote called Marco Markets. We’re not a very big, important bank yet, but it makes me interested in the whole field. We have only hired one Yale student so far, we’re too tiny to — so we’re not hiring, in case you wonder. It was a student in this class that we hired, but again, that’s all history.

Anyway, what is investment banking, which is the subject of this? Investment banking means the underwriting of securities. That is, arranging for the issuance by corporations of stocks and bonds. The term bank is misleading because we often use it. A depository institution is an institution that accepts deposits and makes loans or invests the money from the deposits. Do you know what I mean by a deposit? If you go to a savings bank, or a savings and loan, or a commercial bank and you say, I want to open up a checking account — that’s a deposit; or, I want to open up a saving account — that’s a deposit. The thing about a deposit is you deposit your money as an individual and there are millions of people that all deposit in a depository institution. Then, later on, whenever you want, you can take your money out. Meanwhile, they invest the deposits some way or another at a higher interest rate than they pay on the deposits and they make the difference and that’s how they make a profit.

I often use the word bank to refer — and so does everyone — to a depository institution. If you look at what the law says, they tend to use the word depository institution. An investment bank, if it’s doing a pure investment banking business is not a depository institution. If you go into an investment bank and say, I want to open up a deposit, they’ll say, you should go next door to the credit union or something — we don’t do that. So, the word bank is somewhat misleading. On the other hand, historically, most institutions do both. If you go around the world, most banks — most depository institutions — are also involved in investment banking.

Let me just write over here — investment banking does underwriting of securities. What does that mean? That means they arrange for the issuance by other institutions of securities. For example, if Ford Motor Company wants to issue corporate bonds or they want to issue new shares, they would go to an investment bank and the investment bank would say, okay we can underwrite for you, but we’ll do it for you. A pure investment bank is not a depository institution and it’s also — a pure investment bank is not a broker-dealer either. They’re not trading in securities, although they would deal in securities as a part of the underwriting process. But, they’re not — you wouldn’t go to a pure investment bank either and say, I want to buy a hundred shares of Ford Motor Company, where is your stockbroker? They wouldn’t be dealing with that. They wouldn’t — they deal — their customers are companies and they wouldn’t do that either. But in many cases firms do a mixture of different activities, one of which is investment banking.

There’s a peculiar story that refers particularly to America — the United States — and that is the Glass-Steagall Act of 1933. Again, you see, everything happened in the ’30s. The stock market crash in 1929 caused tremendous chaos in the financial markets. Carter Glass was a Senator from Virginia and he and, I think it’s Henry, Steagall put together a bill which passed Congress and was signed by President Roosevelt that said that we want to make a law saying that investment banks cannot be combined with commercial banks or insurance. Investment banking had to be a separate firm. This is what they said in 1933. You could not be both a depository institution and an investment bank. So, they said, after this Act every bank has to choose one or the other. Do you want to be an investment bank or a commercial bank?

For example, then JP Morgan in the United States was founded by a man named James Pierpont Morgan and it was one of the biggest banks in the U.S. In 1933, it was told, you got to make a choice; are you an investment bank or a commercial bank? JP Morgan made a choice and said, well we’ll go to be a commercial bank, so they stopped their investment banking business in 1933. They’ve since gotten back into it, but that’s — but for a long time they became a commercial bank. What happened? They had a lot of people at JP Morgan who were doing investment banking and they were upset because JP Morgan was shutting them down. There was a Mr. Stanley — I forget his first name now — who was — I mention him because he was a Yale graduate. He got the guys together from JP Morgan who did investment banking and JP Morgan was dead already, but his son, the young Morgan, and he created Morgan Stanley. I have the suspicion that Mr. Stanley put the son of JP Morgan on just for the prestige of the name — it sounds a lot better, Morgan Stanley. This became an investment bank and now JP Morgan and Morgan Stanley, over seventy-five years later, are competitors.

That is the important history of Glass-Steagall. The problem is that, as the years went on, in the U.S. we had a division between investment banking and commercial banking, but in Europe and other places in the world, banks were under no such restriction. So, there was a lot of complaints that our laws in the U.S. were handicapping the U.S. banks. Finally, Glass-Steagall was repealed and it didn’t happen until 1999; so we have the Gramm-Leach-Bliley Act of 1999, which repealed Glass-Steagall. That led then to a whole wave of mergers of investment banks. JP Morgan and Morgan Stanley could presumably have merged but they didn’t; they’ve become too much of competitors and they just developed their own — they just internally adopted more broad definition of their business. There are lots of mergers that we can talk about that came either — sometimes they occurred just before 1999.

For example, Travelers — The new Gramm-Leach-Bliley Act also allowed insurance companies to merge with commercial banks. So, Traveler’s Insurance and Citigroup merged in 1998. I know that’s before the bill, but that was as the bill was just about to happen. Then JP Morgan and Chase merged in 2000; and then UBS and Paine Webber merged in 2000; and Credit Suisse, a Swiss bank, and Donaldson, Lufkin, & Jenrette — Donaldson was the Dean of our business school here at SOM — that merger occurred in 2000. Those are some examples. So, now we’re seeing a movement back toward — so that a bank has an investment banking business within it, but it’s not just an investment bank. It’s sometimes hard to define what something is.

There’s been a lot of news just in the last year or even more recently, like yesterday or this morning’s paper about investment banks because under the current financial crisis they are buckling; a lot of them are in trouble and that’s why it’s big news. I’ll give you some examples. I mentioned Bear Stearns; Bear Stearns was founded in 1923 by Joseph Bear and Robert Stearns. I tried to find something out about them and they don’t seem to be very well-known. They’re not on the Web — there’s no Bear Stearns — there’s no Joseph Bear admirer club on the Web, but whatever they set up was really big for a while. From 1923 to 2008, when it went bust — so it lasted eighty-five years — so, it has investment banking business, but it also has private equity business and private banking. It started to get in trouble during the current — in fact, it was maybe the first U.S. investment bank to get in trouble in the current financial crisis because it was in June 2007 — they had some of their funds collapse. They had funds that were investing in subprime mortgages and this is a sign there’s something wrong. The names of these funds were the Bear Stearns High-Grade Structured Credit Fund. Notice they say “high-grade.” You know what high-grade is supposed to mean in finance? That it’s not going to fail on you.

They had another one called the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund. Now, that sounds a little bit like a contradiction. You should, as a consumer of financial products, wonder when they put both high-grade and leveraged in the same name. High-grade is supposed to mean safe, but leveraged sounds like the opposite, doesn’t it? If you — leverage means that they borrowed a lot of money to buy risky subprime securities. So, if they borrowed 80% of the money, the securities only have to lose 20% of the value for you to be wiped out; so that shouldn’t be high-grade if it’s so leveraged. Anyway, these two funds were wiped out and Bear Stearns had to give — deal out $3.2 billion dollars; that was last summer, but the news kept getting worse and worse.

Apparently, Bear had invested a lot in its securities that were unstable and so it finally became where rumors started developing that Bear was — it was really rumors that killed Bear. The rumors started going that Bear is in trouble, so you’re going to be — they’re going to be in bankrupt before long. This is exactly the market stability problem that Paulson is talking about. Once the rumors get started, everybody is saying, don’t do anything with Bear; don’t lend them any money; just stay away from them. Even young people who are getting jobs — and they were right to think this — don’t even take a job with them because you’re going to be on the street again shortly. It’s that kind of rumor that killed Bear Stearns.

They couldn’t pay their bills and they were finding it difficult to sell their assets to come up with money, so the Fed decided to bail them out. This was a huge Fed bailout. Well, they didn’t want — the Fed didn’t want to bail out the stockholders; they didn’t want to just give money to people who had invested because firms are supposed to be allowed to fail. So, what the Fed did is it gave a line of credit to JP Morgan — a non-recourse line of credit — to buy Bear Stearns. What it amounted to was that the Fed would take troubled securities that Bear Stearns couldn’t sell. It would take that as collateral for a twenty-nine billion dollar loan to JP Morgan under the condition that JP Morgan would buy Bear Stearns. It was supposed to be at two dollars a share, so that left the total value of Bear Stearns at a little over two hundred million, which is pretty tiny compared to what they were worth, which was in the tens of billions a short while ago.

The Fed didn’t want a disorderly collapse. So, it was a twenty-nine billion dollar loan to JP Morgan; this is highly controversial these days because the Fed isn’t normally doing this sort of thing. Why would it be lending money to JP Morgan to buy another company? You say, how is that benefiting the average person in this country? It does benefit them because if they didn’t do this, Bear Stearns would have dumped its assets on the market. It would go down in flames; lots of its debts would become — lots of people who had accounts with Bear Stearns would find that their accounts were destroyed. Then what would it do? It might lead to contagion to other financial institutions. People would say, well it happened to Bear — who’s next? There would be this huge pulling back. So, the Fed decided to bail them out and that’s what they did.

Now, it’s not clear that it’s over, if you read this morning’s paper. Lehman Brothers is another investment bank that is rumored to be in trouble, so it’s got to do something about these rumors because it can kill them — just the rumors. No one will want to do anything with them; it was in this morning’s paper or yesterday’s news that they have arranged to raise capital on the markets. It was not entirely clear — that means, they’re getting people who are willing to invest give them money — invest in the company. It’s a sign of confidence in Lehman Brothers that someone would do that at this critical time.

Another story that came in yesterday — UBS, I mentioned before, was a Swiss bank but it’s not Swiss; it’s international now. It started out as the Union Bank of Switzerland — that’s what it stands for — Union Bank of Switzerland — which was the result of a merger between two Swiss banks around 1900. Then it, as I mentioned, merged with Paine Webber and it’s become an international corporation; so they just call themselves UBS. In this morning’s newspaper, it said that UBS announced that it has lost — what was it? Does someone remember what the numbers were?

Student: [Inaudible]

Professor Robert Shiller: They’ve lost nineteen billion? That’s a huge loss — nineteen billion dollars is a substantial part of their market cap, but they are also announcing that they are arranging to raise capital as well.

The news that these firms, which are rumored to be in trouble, are managing to raise capital buoyed markets yesterday and we had a big upsurge in the stock market. It was, well, yesterday was the first day of the second quarter and the newspapers were reporting that it was the biggest upsurge on the market on the first day of a new quarter since 1938. I looked at that with some curiosity because 1938 was not such a great year after all, it was still in the Depression. I think the market didn’t do great after that then, so this doesn’t predict much one way or the other.

Anyway, this is where we are now, it’s an interesting situation. If you are thinking of taking a job at one of these companies, you might consider looking at their situation because some of these companies could follow the way of Bear Stearns at this point. We have the Fed aggressively lending and trying to prevent another thing, but you know the Fed is not in the business of making sure that your career is a success. They’re in the business of preventing a systemic failure; so, while the Fed arranged for an orderly dissolution of Bear Stearns, it didn’t do a whole lot of good to Bear employees who — we’ll see what happens to all of them. I don’t know the whole story, but it’s a tumultuous world out there; it’s not like you live in an academic environment where Yale University has been in business for over 300 years and it looks so stable here. Well, this is a very stable business; these other businesses are not so stable.

Chapter 4. Investment Banks’ Underwriting Process and the Importance of Reputation [00:47:47]

Anyway, I wanted to talk about the underwriting process and what it’s done. I think underwriting of securities is — it’s analogous — the investment banking business is analogous to the business done by ordinary commercial banks in the sense that it deals with a moral hazard problem and an asymmetric information problem. We were talking about what banks do — commercial banks. Remember, I was telling the story that the big problem with lending to companies is that it’s hard to tell whether they are deserving of the loan or not. So, a commercial banker is someone who lives in a business community, and keeps abreast of everything that’s going on, and plays golf with all the local business people, and has a sense — hears the gossip — has a sense of who’s responsible, who will pay back a loan, who’s got a business that’s really going, who’s got a business that’s sick and on the way out; that’s what a bank does. Everyone else who wants to invest doesn’t know this, but they put their money in the bank and then that’s the idea.

The moral hazard is the moral hazard that the company, which receives a loan from the bank, would take the money and run. The asymmetric information problem is that you, as an investor — if you were to make loans directly to a company, you would be suffering at a disadvantage because you know less than other people. You don’t play golf with these people and so you would end up taking on the worst loans — loans that would fail. The same thing applies to underwriting because — but they do it in a different way. Instead of certifying — instead of creating deposits at a bank, they underwrite securities and they are not taking the money; they’re just an intermediary between you the public and the issuer of the security, but it’s much the same thing. It’s the reputation of the bank that makes it possible for firms to issue securities.

The underwriting process is very important to understand because it’s a process that allows issuers of securities to take advantage of the reputation of the underwriters. The issuer of the security may not be so well-known or not so well-understood, so the — what happens is, the underwriter — what’s a good analogy? I was going to say, it’s like a dating service, but I guess dating services don’t do this, right? They don’t testify to the moral character; they should. Do they do that? Does anyone do that? They probably can’t, right? That’s an even bigger moral hazard problem. When you’re looking for a spouse, you have a huge moral hazard problem and there’s nobody there to help you as far as I know. At least in the business world we have professionals; they’re matchmakers in a sense. They’re trying to match up a company that’s issuing securities to buyers of the securities and this is an important reason for a difference between investment banking and other aspects of finance.

Investment bankers, compared particularly to traders, investment bankers like to cultivate an image of sober responsibility and good citizenship because they thrive on their reputation. So they — to be successful as an investment banker, you have to be so impressive and such high character that companies like Ford and GM will come to you to represent them in the sale of their securities. As a result, investment bankers tend to be well dressed; they tend to be patrician in their appearances and manner. In contrast, traders tend to have vulgar accents; they shout on the phone; they slam the phone down; they roll up their sleeves; they dribble food on their shirt. I may be putting them down too much.

I, personally, think that we have a strength at Yale because of our patrician image in providing people to work for this field. Typically, investment bankers go to the symphony on Saturday night. But beyond that, if you open up the program at the symphony, you’ll see their name under platinum sponsor on the program. That’s the kind of people that go into investment banking and they do it because they have to manage this underwriting process well. What is the underwriting process? Well, what happens is a company that is thinking of issue — let’s say you’re any company, a big company — it doesn’t matter. People don’t trust big companies even if they’ve been around a hundred years. So, if Ford Motor Company — it’s been around since when? Something like around 1900. But people sure don’t trust it anymore because it’s had a history of trouble. It’s not a question just of morality or anything; it’s a question of, are you willing to buy their securities.

So, they would go to an investment banker and say, we need money; we’d like to raise it by, say, issuing shares in our company. Then they would probably contact a number of investment banks and try to make a deal. Now, there are two kinds of deals; there’s a “bought deal” and a “best efforts.” The difference is, some investment bankers will tell the company, we will — you want to issue these shares, fine; sell them to us; we’ll take it; we’ll give you a price. Of course, the investment bank doesn’t want to hold these shares, but the investment bank knows the public well enough to know which shares it can sell. In a bought deal the investment bank is taking the risk that they might not be able to sell the shares at a decent price; they might lose on it.

Also, there’s a different kind of offering, which may be the best you could get; it’s called a best efforts offering. Here, the investment banker will not buy the deal, but it will say that we will use our best efforts to place this and if you have a minimum price, we hope we can get above that; otherwise, the deal will fall through. The underwriting process is — takes the form of — it’s actually very much regulated by the Securities and Exchange Commission. So, the process is formalized. In order to issue securities, you — we’re talking about public securities here — you have to register them with the SEC. So, the SEC then becomes a partner or an adversary in your effort to issue these securities.

The SEC, the Securities and Exchange Commission — all this might be changed next year, who knows, but this is the way it is right now. The law says, there’s a pre-filing period; you have to file with the SEC to get your securities effective. The idea — say Ford Motor Company wants to issue new shares. They go to the investment bank, then the investment bank negotiates with the firm — with Ford — about what kind of securities it wants to issue and what price is reasonable. During this period, the SEC says there’s no talk to the public about the shares. During this period, no talk publicly; the SEC wants to manage the process so that everything is done appropriately.

At this point, during the pre-filing period, the investment bank forms a syndicate of other underwriters and they sign an agreement among underwriters. Usually, one investment bank is not big enough to handle a big issue and it wants to get help of other investment banks, so they form a syndicate of underwriters during the pre-filing period. There’s a lead underwriter, which Ford Motor Company approached first, and the lead underwriter promised to take on the issue, but the lead underwriter doesn’t want to do it itself. The reason it doesn’t want to do it just itself is that in order to sell and issue to a broad public, you have to make use of a broad network of contacts with the public and no one investment bank has them all. So, they form a syndicate — a group of investment banks that are all participating in the issue of the security — and then they file and then there’s what’s called a “cooling off period,” when the security is in registration.

They file with the Securities and Exchange Commission a prospectus for this — a preliminary prospectus. This goes to the Securities and Exchange Commission for approval; it’s not really approval of the issue, but it’s registration of the issue. The preliminary prospectus is called the “red herring.” The “red herring” — it’s lost in history why they call it that; there’s different theories about it. A herring, of course, is a type of fish and the best explanation that I can get for this name for the preliminary prospectus is that it was referring to an activity that hunters used to do with dogs. I don’t know if I should tell you these stories, but I like to know why they call it a red herring. If you have hunting dogs, they’re supposed to track down a fox by their sense of smell. So, one pace you can put your dogs through is to try to confuse them. They would take a red herring, which is a very smelly kind of fish, and they would drag it around over the trail of the fox; it’s very difficult for dogs to still smell the fox over that smell. The word red herring became known as a euphemism for something trying to distract and confuse and so it was a joke. I think it was a joke on Wall Street that the prospectus is really just there to try to confuse you, so they called it the red herring. The preliminary prospectus is now often printed with red borders on it to indicate that it’s the red herring and it’s only preliminary.

Finally, the Fed evaluates the prospectus and makes sure that it accords with all regulations. It puts it up on its website at the SEC while it’s in registration. Again, during the “cooling off” period, firms are allowed to circulate the preliminary prospectus. Underwriters are allowed to circulate the preliminary prospectus with potential buyers, but they’re not supposed to say anything besides what’s in the preliminary prospectus. What they’re concerned about — the SEC is concerned about people overselling securities and they might point out advantages of it and not the disadvantages. The idea of a pro — what’s in a prospectus? A prospectus is a document that completely tells everything about a security. The whole idea of the SEC is that we’re not letting anyone pull the wool over your eyes; that’s why it really shouldn’t be called a “red herring.” It’s not supposed to deceive you; it’s supposed to pour out everything about the security.

One thing that’s in a prospectus — a preliminary or final prospectus — is the company thinks of everything bad that could ever happen. If you read prospectuses, they’ll say awful things. If you read them carefully, they’ll say this company could lose everything — we could be sued; we could be going to jail; we might have done all sorts — maybe I’m exaggerating, but the lawyers put everything imaginable that could go wrong with this investment in there. They do it — of course, it’s in kind of fine print, but it’s all in there so that it’s disclosed. So later, if someone loses money in the investment and wants to sue them, then they’ll say, well look it’s in our prospectus.

The reason that the SEC doesn’t want them to talk about securities at this point, except to give the prospectus, is so that they can’t conceal and hide these things. This is the SEC process; the process says that the underwriters have to give out the prospectus and that’s all they can do; they can’t have a separate brochure. They can’t — your broker can’t say, well we’re thinking of issuing a security; we’ve got this prospectus, but I’m going to send you a brochure instead — that’s easier. The SEC says, no way, because that brochure will be a sales job and it won’t have all of this in there.

Anyway, then eventually the SEC approves it and when it’s approved then it’s effective and then the underwriters can start selling the security. At that point, they actually say it’s a best-efforts offering; then they go around and they try to — they get buyers of the security lined up. Now, you have to understand that there’s a problem issuing a new security. Securities that are already out there and trading — everybody knows about them. There’s a market for them, but if you’re issuing a new security, especially if it’s a company that is issuing shares for the first time — an IPO is an initial public offering. An IPO is the first time that a company issues shares, so the company is not known to the public and it’s very hard to get IPOs started because the company is just not known. It’s very important that the underwriters are able to get attention and get the market going for the IPO. During the “cooling off” period, firms also are allowed to place, according to the SEC, something called a tombstone; that is an ad in the newspaper, which will announce the security. It’s a very dignified ad because it has to meet with the approval of the Securities and Exchange Commission, but a tombstone will say, Ford Motor Company — one million shares offered. Then it will list all of the underwriting syndicate, so it will be a list of all the investment banks that participated in the issue.

Chapter 5. The Investment Banker as the Manager of a Security [01:05:40]

That’s the basic process that underwriters go through to issue securities. Now, part of the thing is — I just want to close with — basically, I think that investment banks are very similar to impresarios in what they do. What I mean by an impresario is someone who manages a singer or a musician in concerts, but it’s a little different. An underwriter is managing the career of a security, just like somebody else would be managing the career of a singer; they’re very concerned about their reputation and they’re very concerned about getting sold out performances all the time. Now, one thing about IPOs is that they are very hard — to get a new security for a new company going — because nobody knows this company. The price movements of an IPO tend to be very volatile and it’s because of the difficulty in getting IPOs going; underwriters have peculiar practices in issuing them.

It tends to go like this: underwriters tend — and there’s been a lot of documentation of this — to under price IPOs. That is, they sell them for less then they could get and that means that IPOs tend to be oversubscribed. This sounds strange — why would it work this way? You can try this; call your broker, if you have a broker — does anyone here have a broker? Maybe somebody does. Think about this anyway — you could call a broker and inquire and say, hey I hear about IPOs; I’d like to get in on some. What do you think the broker will say? Well, the broker will say, okay let me see what I can do for you. And he doesn’t call you back. You wonder, well why does this person not want my business? Well, the reason is that you haven’t been a good guy; you haven’t been giving the broker other business. And you hear stories about IPO’s that did spectacularly well — it jumped 30% on the first day and you say, hey I want that. But it becomes sort of a game that they’re playing.

It’s a little bit like trying to get tickets to some rare concert. I mean, people will sometimes — or there’s someone coming to Toad’s whose — I don’t go there, but if you know about someone who is very famous coming to Toad’s and you have trouble getting tickets. Is that right? Has anything like this happened here? It happened somewhere anyway and so you might end up standing in line for hours for the first time when the ticket office opens. Then it sets up rumors going that, wow, this is a difficult concert to get into. People start trading the tickets afterwards or someone’s out there asking more money than it says on the ticket.

Well, you have to understand that that whole event was staged by an impresario. So, there’s someone who’s responsible for the reputation of this performer. This guy says there’s no way that our performer is going to go in and perform to a half empty house; we’ve got to pack them in; we want people lining up on the streets because it gives a sense of excitement that this person is a star. You know this, right? These stars are managed and they’re not just spectacularly good singers; the impresario is critically important in maintaining the career of a singer and the impresario is very concerned about appearances. So, you don’t want to charge a really high price to get into Toad’s because, then it would only be wealthy people from the suburbs who would be coming and it would destroy the whole atmosphere of the place. So, you’ve got to charge reasonably low-priced tickets and then a lot of people will come flocking to you and then that would create the excitement.

The underwriters do the same thing with IPOs, so they underprice them typically and it creates this huge excitement about, can I get in on this IPO? That excitement generates more business and it also generates a reputation for the underwriter. People see the tombstone and they know that this IPO did extremely well; it jumped a high amount in the first day and people think this underwriter is really something. I want to get in on other offerings of that underwriter. So, the reputation of the underwriter grows; it’s really a reputation business and these people know something about investor psychology and you might consider it some kind of market manipulation. It’s all perfectly legal because the SEC allows this kind of thing but — anyway, coming back to — the problem that we’re having now is that I’m emphasizing that investment bankers need a reputation. Their whole business is a reputation business. When something happens to Bear Stearns, it’s critical for the whole industry. Now, when it’s happening repeatedly to various other banks, it becomes a critical turning point.

The stock market went up a lot yesterday because of the encouraging news that some of these investment banks were able to raise more capital and it’s an ongoing saga, but it’s all a saga that’s played out in terms of investment. So, I find it difficult to predict what’s going to happen next. It’s very hard to know. Right now — as of yesterday, we had some encouraging news but this is something that we’ll just have to keep watching. I think this will play out over years. This thing is not going to be over tomorrow, so we’ll have more interesting things to talk about later this semester and there will be things to watch — to follow up on over the years. Okay, so we’re going to talk next period about investment management.

[end of transcript]

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