Financings and Trading
Security Underwriting
2. Trading
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Client related trading
Proprietary trading
L10: Financing and Trading of Investment Banking
Capital Markets Financing
 A capital markets financing is a long-term funding obtained through the
issuance of a security in a regulated market or through a private placement
 The security can be debt (bonds, debentures, or notes), equity (common stock)
or a hybrid (both debt-like and equity-like characteristics, such as preferred
shares or convertibles)
 A capital markets financing is underwritten by investment banks (the banks take
on risk when purchasing securities from an issuer and then reselling those
securities to investors) or distributed by banks as a private placement on an
agency or principal basis
 In the US, a securities offering must either be registered with the Securities and
Exchange Commission (SEC) through a registration statement ( a portion
of which is called a “prospectus”) or sold as a private placement pursuant to an
exemption from this registration requirement
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L10: Financing and Trading of Investment Banking
Underwriting and League Tables
 A group, or “syndicate” of investment banks underwrites a securities offering
 The issuer must decide which banks in the syndicate will act as the “lead
bookrunners” of the transaction
 These banks determine the marketing method and pricing for the transaction
and, therefore, receive the highest underwriting allocation and a
proportionately higher percentage of the gross spread
 The investment banking industry keeps track of underwriting participations by
all banks and this becomes a basis for comparing banks’ underwriting
capabilities
 This underwriting record is called a “league table”: every different type of
security (and geographic region) has its own league table
 See exhibit 3.2 (page 43)
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L10: Financing and Trading of Investment Banking
Financing Considerations
 Bankers focus on liquidity (cash balances, marketable securities,
and available lines of credit), cash flow multiples, debt/earnings
multiples, cost of capital and rating agency considerations before
recommending whether a client should raise financing and, if so,
whether it should be in the form of debt, equity or a hybrid
security like convertibles
 Bankers analyze liquidity as a percentage of market capitalization,
total debt, annual interest payment obligations and other balance
sheet and income statement metrics
 These metrics are then compared with results from other
companies in the same industry to determine whether the client
has relatively more or less liquidity than its competitors
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L10: Financing and Trading of Investment Banking
Equity Offerings
 When a company sells stock to the public for the first time in an
SEC-registered offering, this is an Initial Public Offering (IPO)
 Subsequent sales of stock to the public by the company are called
“follow-on” offerings
 Selling shareholders can sell shares using the company’s
registration statement, which is called a “selling shareholders” or
“secondary” offering, with proceeds received by the shareholder
and not the company
 The difference between the purchase and sale price of a securities
offering is called the “gross spread” and represents compensation
for the bank for undertaking a distribution effort and certain legal
risks
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L10: Financing and Trading of Investment Banking
Types of Equity Underwritings
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L10: Financing and Trading of Investment Banking
Benefits and Disadvantages of an IPO
 Benefits include: access to public market funding, enhanced
profile and marketing benefits, creation of an acquisition
currency and compensation vehicle and liquidity for
shareholders
 Disadvantages include: SEC reporting requirements, costs
associated with on-going reporting (including SarbanesOxley), disclosure of sensitive information and short term
focus by management to meet investor expectations in
quarterly reports
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L10: Financing and Trading of Investment Banking
IPO Pricing
 An investment bank determines the expected value of
the company based on comparisons with publicly traded
comparable companies or values derived through other
methods (including DCF analyses)
 This is an imperfect process that requires analysis of both
historical operating earnings and revenues and forecasts
of future earnings and revenues
 In order to encourage investor interest in an IPO
company that does not have a track record as a public
company, typically, bankers will set an IPO price at a
discount to the determined value
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L10: Financing and Trading of Investment Banking
Green Shoe Option (Overallotment Option)
 Allows an investment bank to sell short securities that are equal to 15% of the
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securities sold in a public offering
For example, bank sells 100 shares for a company @ $100/share = $10,000
Bank simultaneously sells short 15 company shares @ $100/share = $1,500
If company’s share price increases after the offering, the bank buys 15 shares
from the company @ $100/share and delivers these shares to the short buyers
The company therefore sells 115 shares and receives proceeds of $11,500
If company’s share price decreases after the offering, the bank buys 15 shares
from the market at, say, $99/share and delivers these share to the short buyers
These market purchases mitigate further downside price movement in the stock
If share price increases, the bank earns $11,500 x 2% gross spread = $230
If share price decreases, the bank earns $10,000 x 2% gross spread = $200 plus
trading profits of $100-$99 = $1 for each share sold short, so earnings of $215
L10: Financing and Trading of Investment Banking
SEC Registration Process
 When a company files a registration statement with the SEC, this starts a “quiet period”,
which ends when the SEC declares the registration “effective”, meaning that all required
information is provided (which could take several days to several months, depending on
the company)
 The securities are priced and sold immediately following effectiveness
 During the quiet period, the lead bank may conduct a roadshow for the company to
discuss the prospective offering with investors and an internal presentation to sales
professionals to get them ready to sell the offering
 The company and bank are only allowed to discuss information provided in the
prospectus with prospective investors in order to avoid the discussion being deemed an
“offer to sell” securities, which is a “gun jumping” violation
 For Well-Known Seasoned Issuers (WKIS filers), a registration statement may become
immediately effective and usable for offerings, without SEC review, allowing the issuer,
through the bank, to immediately make offers to sell after filing, which avoids the
potential gun jumping problem
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L10: Financing and Trading of Investment Banking
IPO Timetable
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L10: Financing and Trading of Investment Banking
Types of Bond Underwritings
Types of Bond Underwritings
Best Efforts
 Comprises a majority of transactions
 Issuer of bond bears price risk
 Least expensive
 Market deal
Bought Deal
 Investment bank buys the bond at a certain rate
 Generally seen in competitive markets
 Investment bank bears the price risk
Backstop Commitments
 Rate is “backstopped” or committed to, but
issuer will get the lower rate if it clears the
market
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 Investment bank commits to a worst case price
L10: Financing and Trading of Investment Banking
Investment Grade and Below Investment
Grade (High Yield or Junk) Bonds
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L10: Financing and Trading of Investment Banking
Bonds vs Loans
 A bond is debt in the form of a security, issued as a long-
term obligation of a borrower with a specific maturity
and coupon
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L10: Financing and Trading of Investment Banking
Client Related Trading
•
Traders basically buy and sell securities to make profits, but client-related traders also
have the additional objective of helping investing clients trade profitably
•
If a client can’t trade profitably with an investment bank, the client may eventually stop
trading with that bank
•
As a result, sometimes traders decide to accept lower trading margins (and occasional
losses) to accommodate client investment objectives and to facilitate greater trading
volume
 Traders divide their focus into two principal areas:
 supporting primary market transactions, which involves purchasing securities directly from a
corporate or government issuer, reselling those securities at a profit, and standing ready to
repurchase securities at any time
 participating in the secondary market by buying and selling previously issued securities at a
profit
 In order to provide this “market-making” service, a bank keeps an inventory of securities
and makes “bid” and “offer” prices on these securities based on their risk and liquidity
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L10: Financing and Trading of Investment Banking
Research
 To gain insights into the securities that they trade
 Trading-desk-based research that they initiate (proprietary data)
 Public available data
 Research can focus on specific securities, industries, and
financial products, or on general economy, political, or
regulatory topics
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L10: Financing and Trading of Investment
Banking
Sales
• Sales professionals cover individual and institutional investing
clients
• Their role is to bring to clients value-added investing or
hedging ideas, as well as pricing from traders
• Sales teams have the dual objective of helping both traders
and investing clients create profits, but sometimes it is
difficult to meet the objectives of both sides
• In addition to providing pricing information, sales
professionals provide investment ideas developed from
research and analysis
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L10: Financing and Trading of Investment Banking
Prime Brokerage
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•
The Prime Brokerage business is housed in the Trading Division and focuses principally on hedge
funds and other clients who borrow securities and cash to support their investment business
•
In addition to lending, other services provided to investing clients include trade clearing, custody
and settlement, real estate and computer assistance, performance measurement and performance
reporting
•
These products and services bring in fees that can be several billion dollars per year at some banks.
•
Hedge funds sometimes borrow securities to enable them to sell the securities short (selling a
borrowed security, with the obligation to return it after repurchasing it in the market in the future)
•
Depending on a hedge fund’s strategy, shorting is used to create downside security price protection
(a hedge) or to generate a potential gain based on speculation that a security’s price will drop
•
Hedge fund cash borrowings from investment banks (called “margin loans”) require the use of
securities as collateral
•
If the value of the collateral drops over time, banks will exercise margin calls to receive repayment
of a portion of the loan
L10: Financing and Trading of Investment Banking
Securities Lending
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•
Many large institutional investors own sizeable blocks of stock that they expect to hold
for an extended period of time
•
These investors are often willing to lend their shares to investment banks, who re-lend to
other parties for a fee (which is split between the lenders and the bank)
•
Lenders receive cash collateral when they lend shares, and the collateral is adjusted daily,
based on a mark-to-market value of the shares lent. Usually the required collateral is 2%
to 5% greater than the value of the shares
•
The lenders will pay interest on the cash collateral at a rate close to or considerably less
than the market rate, depending on demand and supply conditions for lending of
different stocks
•
The rate of interest paid by lenders to share borrowers is called “rebate”. It depends on
market demand of the security
L10: Financing and Trading of Investment Banking
Securities Lending -- Example
• If an investor lent 4,000 shares of IBM stock when the stock
traded at $100 (valued at $400,000), the borrower might be
required to post $416,000 in cash collateral with the stock
lender when the stock was borrowed
• If the loan was for one month, the market interest earned on
the $416,000 cash collateral at 4% p.a. would be $1,387
• Because IBM shares are fairly easy to borrow, the stock lender
might pay a rebate to the stock borrower at a rate of 3.5% p.a.,
or $1,213 (the lower the rebate, the higher the effective cost
for the borrower in creating a short position)
• The 50 basis point spread, or $174 difference between market
rate and the rebate rate paid to the stock borrower
• mostly kept by the stock lender,
• a portion to the investment bank that facilitated the transaction
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L10: Financing and Trading of Investment Banking
More on Securities Lending
• Shares are difficult to borrow when
• Demand exceeds supply
• Large portion of the stock is held by insiders who are restricted from lending
• Investors who might normally lend shares decide they want to sell the shares the next day
• Investors owning the shares are concerned about potential negative share price consequence if
there is excessive shorting in the stock
•
When shares are loaned, title to the shares is transferred to the party that the borrower
sells stock short to
• This means that the short buyer receives dividends if title is held on a “record date” and is able to
vote if a shareholder election is held
• In most cases, the stock loan agreement provides that whenever short buyers receive dividends,
the borrower (and short seller) must pay to the lender a cash amount that is equal to the
dividends received
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L10: Financing and Trading of Investment Banking
Still on Securities Lending
• Sometimes shares are sold short without taking steps to borrow
the shares, which is called “naked” shorting
• If this shorting activity is done to avoid settlement failure, this is
considered legal naked shorting
• For example, if an investor agrees to sell stock, but fails to deliver
shares to a buyer on the settlement date, the buyer may need to
sell stock short to avoid settlement failure (and associated costs
and penalties) if the buyer has already resold the stock that should
have been received in the original settlement
• There has been considerable regulatory analysis of legal naked
shorting and non-legal naked shorting (selling stock short without
taking steps to borrow it and without legitimate settlement
concerns)
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L10: Financing and Trading of Investment Banking
FICC Trading
• Interest rate products
– foreign exchange, government bond trading and interest rate
derivatives
• Credit products
– corporate bonds (investment grade, high yield and distressed debt
securities), mortgage-backed securities, asset-backed securities
(credit card receivables, automobile loans, computer leases, trade
receivables, equipment leases, etc.), structured credit and credit
derivatives
• Commodities
– Contracts on commodities are traded in the energy (electricity,
natural gas, and oil) and metals (precious metals and base metals)
sectors
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L10: Financing and Trading of Investment Banking
Structured Credit Products
• The Structured Credit business is primarily focused on collateralized debt
obligations (CDOs) that are linked to bonds (collateralized bond
obligations, or “CBO”) and loans (collateralized loan obligations, or “CLO”)
• A CDO is a debt security underwritten by an investment bank that is
backed by a pool of non-investment grade bonds or loans. Because the pool
includes a broadly diversified group of assets, credit rating agencies have
given an investment grade rating to certain tranches in many of these CDOs
• In a CDO, a special purpose trust is formed to purchase non-investment
grade bonds and then the trust issues three or more tranches of bonds (each
with a different credit rating) to investors who purchase these securities as a
means to receive slightly higher coupons than similarly rated straight bonds
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L10: Financing and Trading of Investment Banking
CDO
What is a CDO?
Basic Structure
• A CDO is comparable to a finance company
CDO Balance Sheet
Assets
Liabilities
– Borrows money (liabilities)
– Invests in collateral (assets)
Senior
– Has residual value (equity)
• The equity of a CDO represents an ownership
stake in an entity and is the first loss position
• The assets are typically managed by a seasoned
asset manager with a strong track record in the
respective CDO asset class
CDO Collateral Pool
Mezzanine
• Repayment of liabilities relies on the
performance of the underlying collateral pool
and asset manager
• Credit enhancement and tranching creates
different rating levels, allowing involvement by
a wide investor base
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L10: Financing and Trading of Investment Banking
Equity
CDO (cont.)
CDOs Offer a Spread Pick-Up to Similarly Rated Securities
AAA Spreads to Swaps/LIBOR (in basis points)
45
40
35
30
25
20
15
10
5
0
39
33
28
5
7-12 Yr
Structured Finance CDO
350
6-10 Yr
High Yield CLO
10 Yr CMBS1
10 Yr Industrial Bonds
BBB Spreads to Swaps/LIBOR (in basis points)
315
300
250
200
200
150
82
100
50
49
0
7-12 Yr
Structred Finance CDO
6-10 Yr
High Yield CLO
10 Yr CMBS1
Note 1: Commercial mortgage-backed securities.
Source: J.P. Morgan US Fixed Income Markets 2005 Outlook. Spreads data as of November 18, 2004.
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L10: Financing and Trading of Investment Banking
10 Yr Industrial Bonds
Credit Default Swaps
• A credit default swap (CDS) is a contract between two
counterparties whereby one party makes periodic payments in
return for receiving a payoff if an underlying security or loan
defaults
• For example, if an investor purchased $10 million of a five-year
$100 million bond issued by Company ABC and then decided to
protect their investment risk by entering into a CDS on a $10
million notional amount of the Company ABC bond, they might
pay 2% of $10 million annually for five years in exchange for the
right to deliver defaulted bonds in exchange for $10 million if
Company ABC defaults
• The party that receives an annual fee is a credit protection seller;
the fee payer is a credit protection buyer
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L10: Financing and Trading of Investment Banking
Credit Default Swaps (cont.)
• None of the cash flows from the CDS directly involves
Company ABC, but it is their bond that is the subject of the
CDS contract. A CDS is essentially an insurance policy to
hedge against default
• Because there is no requirement to own the actual underlying
security or loan when entering into this type of contract,
many CDS credit protection buyers engage in this transaction
purely for speculative purposes
• The CDS market came under regulatory scrutiny because of
its massive size, lack of regulation and potential to permit
insider-trading activity
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L10: Financing and Trading of Investment Banking
Credit Default Swaps (cont.)
• The cost of CDS sometimes increases considerably in the weeks prior to
the announcement of a corporate takeover by a private equity fund
• Upon completion of a leveraged buyout, the target company’s credit
rating generally deteriorates because the buyout is financed in large part
by leveraging the target’s balance sheet. Because this increases the
riskiness of the company’s outstanding bonds, the result is an increase in
CDS pricing relative to these bonds
• During 2007 and 2008, prior to announcement of a number of
acquisitions by private equity funds, CDS pricing for the target company
increased substantially, suggesting that CDS credit protection buyers
became aware of the acquisition before it was publicly announced
• Speculators evidently purchased CDS on private equity target companies
before the announcement and then sold CDS after the announcement,
creating a substantial profit
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L10: Financing and Trading of Investment Banking
Proprietary Trading
• Proprietary traders are non-client related traders who trade
solely for the benefit of their firm
• They have no responsibility to balance their profitability
interests with the interests of clients of the firm, and therefore
can be considered competitors to these clients
• At some investment banks, they are covered by sales
professionals within the same firm and are considered one of
the most important clients of the sales team
• At other firms, internal sales contacts are limited. Even when
proprietary traders are allowed to trade with their own firm,
they always trade with others as well, including competitor
firms, and will execute transactions with whichever firm best
enables them to achieve profits and mitigate risks
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L10: Financing and Trading of Investment Banking
Proprietary Trading (cont.)
• Proprietary traders take positions in interest rate and credit
products, mortgage-related securities and loan products, and
multiple kinds of asset-backed securities
• They also take positions in commodities and currencies, as
well as in the derivatives of all of these products
• In the equity world, they take positions in all forms of equity
and equity-related products, including derivatives
• Their positions can be long or short and, in many cases, are
leveraged by borrowing, using their positions as collateral
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L10: Financing and Trading of Investment Banking
Proprietary Trading (cont.)
• Proprietary traders do their own research and rely on the
research of others as well
• They build models that track credit markets, regulatory and
legal developments, accounting and tax developments,
market anomalies and economic events
• Their models attempt to predict mean reversion or a collapse
in historical relationships, among other phenomena
• Basically, the proprietary trading business is similar to the
business conducted by hedge funds
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L10: Financing and Trading of Investment Banking
Proprietary Trading (cont.)
• Proprietary trading desks at investment banks have become
significant competitors to hedge funds, who are the most
important clients of the bank’s client-related trading business
• This sometimes creates conflict and some hedge funds have, as a
result, limited their trading activity with those investment banks
that have the largest proprietary trading businesses
• Although Goldman Sachs does not break out revenue for clientrelated trading and proprietary trading, it is possible that
proprietary trading represented larger revenue and earnings than
were achieved during 2007 by Och-Ziff, the largest publicly
reporting hedge fund in the U.S. and one of the largest hedge
funds in the world
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L10: Financing and Trading of Investment Banking
Comparison of Goldman Sachs and
Och-Ziff
Goldman Sachs vs. Och-Ziff
($ in millions)
Net Revenues
Operating Expenses
Pre-Tax Earnings
2008
2007
2008
2007
2008
2007
Goldman Sachs
Trading & Principal
Investments Division
$9,063
$31,266
$11,808
$17,998
$(2,745)
$13,228
Och-Ziff Funds1
$587
$1,126
$271
$307
$316
$818
Note 1: Economic income figures are shown to present an apples-to-apples comparison of the two years. Och-Ziff significantly
reorganized its operations in 2007 such that GAAP financials would not be comparable from 2007 to 2008.
Source: Respective 2008 10-K filings