APPENDIX I The Business of an Investment Bank Most investment banks have similar functions, though they differ in their exposures to different lines of business. This appendix describes the investment banking business by exploring Lehman Brothers as a specific example. Lehman Brothers was involved in several lines of business, as shown in Figure I.1. Investment Banking Investment banking included acquisitions and strategic advisory services. In this division, Lehman Brothers advised companies that were considering strategic purchases of other companies or business interests. The mergers and acquisitions strategic advisory group was another division within investment banking. This division also offered advice and handled financing for firms that were purchasing other firms in deals that included mergers and acquisitions, restructurings and spin-offs, targeted stock transactions, share-repurchase strategies, government privatization programs, takeover defenses, and other strategic advice. Lehman was involved in underwriting, helping private companies become public companies by selling their shares to the public. Underwriting also involves helping companies borrow by selling debt to the general public. Lehman helped public companies raise capital and was involved in the housing market, underwriting agency securities (i.e., Fannie and Freddie bonds) and mortgage-backed securities. The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal, First Edition. Ludwig B. Chincarini. 2012 Ludwig B. Chincarini. Published 2018 by John Wiley & Sons, Inc. 381
382 Appendices FIGURE I.1 The Business of Investment Banking and Its Connection to Main Street Capital Markets Lehman s second line of business was in the capital markets.thisisavastarea for the typical investment bank; it involves selling, trading, and researching investment products. Equities Equity Cash The equities group and its subdivision equity cash products acted as a marketmaker for clients to trade equity securities all around the world. A marketmaker is willing to buy or sell any security an investor would like to buy or sell.
The Business of an Investment Bank 383 Because a market-maker is a known liquidity source, investors don t need to search for someone who wants to buy what they re selling or sell what they re buying. Lehman s market-making area served a variety of investors, including institutions and individuals. Equity Derivatives Some people consider equity derivatives the evil area of Wall Street. Warren Buffett labeled these financial weapons of mass destruction. 1 As a group, equity derivatives are virtually anything that trade based on underlying equity value. Investors trade every imaginable derivative, including derivatives based on equity, bonds, real estate, foreign exchange, commodities, and even the weather. That s right: Investors can trade a contract that depends on future weather conditions. 2 Forward contracts and options contracts are the most common derivatives. A futures contract works like this. Suppose a coffee company must deliver coffee beans to its wholesale buyer in three months, when the crop will be ready. The company s profits are very sensitive to actual coffee prices at harvest time. Company management may not want to deal with the uncertainty of coffee prices, especially when a sudden decrease in demand or increase in supply could cause a sudden drop in price. The business would like to remove the risk associated with movement in coffee prices. This is where derivatives come in. The coffee company might reduce its risk by selling a futures contract on coffee due three months from now. To do this, the coffee company agrees to sell the equivalent of its entire crop at a given price. An investor on the other side of the futures contract agrees to buy the coffee at that price. If coffee prices drop, the coffee company wins on the futures contract, but loses when selling the actual beans to the wholesaler, and is unaffected overall. If coffee prices rise, on the other hand, the coffee producer loses on the futures contract, but wins when selling the actual beans to the wholesaler, and is still unaffected overall. The futures contract lets the coffee producer lock in profits now regardless of future movements in the price of coffee. Options are slightly more complicated. They give the holder the right, but not the obligation, to buy or sell an underlying equity security. Suppose an investor has $100,000 invested in the stock market, saving the money for a down payment on a house. The investor worries that the stock market might decline in the next year or two. The investor could buy a put option on the equity investment for one year, two years, or longer. The put option gives the investor the right to sell the entire U.S. stock market
384 Appendices at a given price, an option that becomes more valuable as the equity market declines. In fact, if the investor bought the right amount of put options, the nest egg would lose nothing, even if the equity market declined by 100%. The only cost would be the option s purchase price. The market is full of various forwards, futures, and option contracts. Lehman Brothers helped investors buy both listedand over-the-counter (OTC) futures and options. Listed derivatives are traded on exchanges, are standardized, and have greater risk controls. Investment banks typically customize OTC derivatives to investors specific preferences. For example, Coca-Cola might purchase a rainbow option, which pays the company its top competitors performance. That hedges some of Coca-Cola s business risk. However, OTC options are less transparent than listed options. Lehman Brothers further divided its equity derivatives area into two businesses, one handling standardized volatility-related options and the other dealing with structured products. The structured product area created a lot of very customized, complicated derivatives. Equity Finance Equity finance works to find financing for investors and firms, making it possible for clients to purchase equities and other securities on margin or short-sell securities. 3 This group included the prime brokerage unit. Prime brokerage has grown in many investment banks over the past 20 years to support the trading activities of money management firms, especially hedge funds. Prime brokerage operations handle clearing and trade settlement, as well as other back-office operations, for hedge funds and other money managers. Arbitrage (Proprietary Trading) An arbitrage group, sometimes called the proprietary trading group, is the part of any investment bank that most closely resembles a hedge fund. Investors in this very diverse area look for equity market imbalances and trade accordingly, using internal money to make proprietary profits. For example, an arbitrage group might find two companies that should trade at the same value, but don t. (Remember the example of LTCM s trades around Royal Dutch and Shell? 4 They re not the only ones who look for such opportunities.) Lehman Brothers believed that its presence in the global capital markets; its access to advanced information technology, in-depth market research,
The Business of an Investment Bank 385 proprietary risk management, and its general assessment experience under rapidly changing market conditions gave it a comparative advantage in finding profitable trading opportunities. Fixed Income Fixed income is another large part of the capital markets division. Fixed income was particularly important at Lehman Brothers, which was known as one of the leading fixed-income specialists in investment banking. Fixed-income instruments pay a fixed, known stream of future income hence the term fixed income. Bonds are the most common example. Buy a stock, and you have no idea what the future returns will be. The stock could go up or down by any amount, making the income from it variable, not fixed. Bonds and other fixed-income instruments, by contrast, commit to paying a known payment on specified future dates. 5 As a broker, Lehman helped investors trade fixed-income instruments, 24 hours a day and around the world. The fixed-income area had several subdivisions. One of these was the fixed-income research department, which was one of the top such departments anywhere. It created bond indices that investors used to gauge bond segment performance. 6 Government and Agency Obligations The government and agency obligations group at Lehman Brothers worked with multiple government bonds, as well as bonds issued by Freddie Mac and Fannie Mae. Lehman Brothers was a primary dealer, with the privilege of being the first to purchase U.S. government bonds for its own account and for clients. 7 Lehman was also a market-maker in U.S. government bond securities and all major government bond securities. It stood ready to buy or sell when portfolio managers, hedge funds, or investors needed to buy or sell government bonds. Through this group, Lehman was also an underwriter and market-maker for bonds issued by Freddie and Fannie. As an underwriter, Lehman helped Freddie and Fannie publicly issue their debt. Corporate Debt Securities and Loans The corporate debt securities and loans group served a function similar to that of the government and agency group, but for corporations rather than for
386 Appendices governments. Lehman helped companies issue and sell fixed- and floatingrate debt, as well as preferred equity. Suppose General Motors, or another large company, needs to raise cash to run or expand its business. It can borrow the money by selling bonds. Fixedrate bonds pay investors a fixed interest rate at specified intervals. Floating-rate bonds pay a variable interest over the bond s life, based on some determined mechanism. Companies in need of funds turned to Lehman Brothers and other investment banks to help them design, issue, and sell both types of debt. This is one of the primary links between Wall Street and Main Street. High-Yield Securities and Leveraged Bank Loans Lehman s high-yield securities and leveraged bank loans group dealt with company debt that s less than investment grade. Investment banks help companies with credit ratings below BBB issue debt. Lehman Brothers also offered such firms loans for purchasing or acquiring other companies, and was a marketmaker in high-yield securities. Money Market Products At Lehman, the money market products group dealt with short-term fixed income. Money market securities typically have less than one-year maturities. Lehman was a leader in originating and distributing medium-term notes and commercial paper. Companies use commercial paper to borrow money for less than 270 days. Both banks and large corporations often use it to meet short-term obligations, such as payroll or inventory. It is not backed by collateral, so it s usually issued by large, stable businesses that are very likely to pay back the loan. Many businesses in the world rely on shortterm commercial paper to fund their operations, and rely on Wall Street to facilitate borrowing. This is another important link between Main Street and Wall Street. Mortgage- and Asset-Backed Securities The mortgage- and asset-backed securities group generated lots of profits for Lehman Brothers throughout the decade, but would also be the reason for Lehman s demise. In 2006, Lehman Brothers was the world s number-one underwriter of subprime mortgages. Freddie and Fannie bought mortgage portfolios, securitized them, and sold them to investors. Investment banks, including Lehman, did the same
The Business of an Investment Bank 387 thing. They packaged these mortgage pools especially subprime mortgage pools and sold them to investors. They also traded mortgage-backed securities on behalf of clients and for their proprietary trading groups. At Lehman, this group was also heavily involved in securitizing and trading asset-backed securities (ABS). An asset-backed security, not surprisingly, is any security backed by an asset. A mortgage-backed security (MBS) is a kind of ABS. Other ABS include securities backed by auto loans, student loans, or credit card loans. An investment bank might purchase a group of these loans perhaps 100,000 auto loans of similar credit quality then package them into a security and sell that security to an investor. The investor then receives the payment stream from that group of auto loans. Creative finance can make the basic security more complicated. For example, an investment bank might split the auto-loan portfolio into a CDO of various tranches with different characteristics designed to appeal to various investors. 8 Lehman Brothers participated in both the commercial and residential mortgage market. It also originated mortgage loans directly through its subsidiary savings bank, Lehman Brothers Bank. Lehman purchased mortgage lenders, including BNC in Irvine, California, and Aurora Loan Services in Littleton, Colorado, which helped them originate and securitize mortgages. All the investment banks were involved in the mortgage market, but Lehman was more involved than any of the others in creating, trading, and investing in residential and commercial mortgages and real estate. Municipal and Tax-Exempt Securities Lehman s municipal and tax-exempt securities group participated in all aspects of the municipal bond business, from origination to trading. States, cities, and local governments issue municipal bonds to finance their activities, from improving the roads or schools to building a new football stadium. It s another important link between Main Street and Wall Street. Financing The financing department was involved in facilitating financing for Lehman Brothers and its customers. It managed the company s matched-book activities, supplied customers with secured financing, and funded the company s activities. Matched-book funding involves borrowing and lending cash on a shortterm basis to institutional customers. Marketable securities or government
388 Appendices or government-agency securities in reverse repos typically collateralized these loans. Lehman made these agreements in various currencies and sought to generate profits from the difference between interest earned and interest paid. The financing unit worked with Lehman s institutional sales force to identify customers with cash to invest and/or securities to pledge to meet the firm s (and its customers ) financing and investment objectives. Financing also coordinated with the company s Treasury area to provide collateralized financing for a large portion of the company s securities and other financial instruments. Lehman was a major participant in the European and Asian repurchase agreement markets, which provided secured financing for the firm s customers in those regions. The firm s short-term financing provided an important link between Lehman and other investment and commercial banks. The financial system is fundamentally linked through this web of connections. Fixed-Income Derivatives The fixed-income derivatives group created, traded, made markets, and invested in the derivatives that are based on the underlying value of fixed-income products, including swaps, options, and futures. This area also included highly levered CDO and CDS fixed-income derivatives, which were based on underlying mortgages. Lehman lost a lot of money on these derivatives. Lehman Brothers Bank Lehman owned an actual bank, Lehman Brothers Bank. Like most other banks, it issued mortgages for commercial and residential real estate. Lehman believed that owning a bank let it move more easily into the mortgage securitization business, but the bank was also outside Lehman s core expertise. Foreign Exchange Lehman operated in global equity and fixed-income markets, so its clients needed foreign currency transactions. The foreign exchange division let clients trade foreign currency in both spot and derivative markets around the world. Lehman Brothers also provided crucial advisory services regarding foreign exchange to central banks and other clients. A corporate client might have business offices in Germany, but headquarters in the United States. Company profits depend on how well products
The Business of an Investment Bank 389 sell in both countries. Profits made in Germany also depend on currency movements between the Euro and the U.S. dollar. Profits are reported in U.S. dollars and many shareholders are U.S. investors, so the firm may want to stabilize exchange-rate fluctuations. Lehman Brothers could help the company buy or sell futures or options on the Euro versus the U.S. dollar, hedging future foreign-division profits. Global Distribution (Global Sales) The global distribution unit, or global sales, worked to sell and promote fixedincome and equity products to clients all over the world. Salespeople used Lehman s well-known research reports to help them. Research Lehman s research business was among the most elite, especially in fixed income, which distributed its reports all over the world. The group did quantitative, qualitative, economic, strategic, and traderelated research in equity and fixed income. A typical economic research piece might have discussed the economies of one or more countries, offering forecasts about inflation, GDP growth, and other important economic fundamentals. A typical trade research piece might have offered ideas on how to profit from a market anomaly, such as situations in which two companies are mispriced but should converge to the same value, or discussed how to use a foreign-exchange option to hedge foreign-currency risk. These reports were supposed to help clients, but far too often investment banks use their research as a way to push products. For example, a piece that J.P. Morgan published in the late 1990s showed that clients who traded more frequently made higher profits. The argument helped Morgan generate more trades and increase trading-division profits. The idea was enticing, but only valid if every trade was a good trade and it s hard to make only good trades. Client Services Private Client Services (Private Wealth Management) Private client services is an area within many investment banks, including Lehman. Some banks call it private wealth management. This group focused on the investment needs of very wealthy individuals and small to mid-sized
390 Appendices institutions worldwide. Private client service groups perform all kinds of functions, designing special investment vehicles for high-net-worth investors and managing clients money to achieve their goals. As an example, suppose a small company s CEO had a concentrated stock position in that company an undiversified and risky investment. Lehman (and other investment banks) worked to diversify the CEO s portfolio, trading company returns for returns on a more diversified index. Lehman could offset this risk through other customers with different goals, or use the portfolio as a natural hedge against the bank s broad holdings and obligations. Private Equity The private equity group worked with investments related to private companies on behalf of clients, the firm, and company employees. Private companies don t trade publicly in the stock market, so their needs are different than those of publicly traded firms. This group included several areas of specialization: merchant banking, venture capital, real estate, fixed income,andthird-party funds. The main areas were the venture capital unit, which invested in start-up companies, and the real estate area, which made commercial and residential real estate investments. This area s real estate investments later caused Lehman Brothers lots of problems. The venture capital unit helped provide financing for many new and innovative firms. Technology Through its LehmanLive platform, this unit distributed information and facilitated execution over the Internet. It also had strategic investments in various institutional trading networks throughout the world, including TradeWeb, Arca, and others. Corporate and Risk Management Corporate business handled the details of running Lehman Brothers; risk management was in charge of monitoring and managing Lehman s principal risks, including market, credit, liquidity, legal, and operational exposure. 9 This unit missed the massive risks in Lehman s real estate positions.
The Business of an Investment Bank 391 Summary Lehman Brothers and other investment banks are linked to Main Street by performing intermediary and financing functions for businesses. For example, Lehman s capital markets division bought Fannie and Freddie debt, which in turn facilitated Fannie and Freddie s growth, which made mortgages possible for millions of Americans. Lehman also originated and securitized mortgages through its fixed-income division and through Lehman Bank. Lehman provided short-term and long-term financing for U.S. corporations through its fixed-income unit. Through its client services area, Lehman provided venture capital funds for start-ups and other companies. Investment banks, including Lehman, can also became heavily involved in proprietary positions, including real estate. It s not clear whether this makes other businesses within Lehman more liquid and better functioning or if it improved financial system operations. It did, however, financially ruin Lehman Brothers.