Chapter 5

If becoming a public corporation increases the risk in investment banking, how do publicly traded investment banks succeed in selling stock to investors?

Although investment banks may take on more risk than commercial banks or most other financial firms, they also may deliver higher returns. Investors who find this trade-off between risk and return to be attractive will buy the investment banks' stock.

Underwriting

An activity in which an investment bank guarantees to the issuing corporation the price of the new security and then resells the security for a profit

Is an investment bank that buys securities with its own capital acting as a financial intermediary?

An investment bank that buys securities with its own capital is not acting as a financial intermediary. It is buying securities with the expectation of profit from the yield or from changes in the prices of the securities. Investing in this way does not involve acting as an intermediary by funneling funds from savers to borrowers.

why did investment banks become more reliant on repo financing and more highly leveraged during the 2000's?

Because by the 1900's most o these banks had converted from partnerships to publicly traded companies. As trading became a more important source of profits, investment banks, increasingly borrowed to finance investments in securities and direct loans to firms.

What does 'breaking the buck' mean?

Breaking the buck' means that the net asset value of the money market fund had fallen below $1 to $0.97. As a result, investors in the mutual fund would take a capital loss of 3% when they redeemed their shares.

Why was it significant to the financial system?

Breaking the buck' was significant because it was highly unusual for a money market mutual fund to allow the price of its shares to drop below $1. Investors in money market mutual funds were willing to accept the relatively low interest rates these funds offered relative to some other investments only if they were sure that they would not suffer a capital loss from a decline in the value of the shares. 'Breaking the buck' badly hurt investor faith in money markets and reminded them that their higher return had come at the acceptance of higher risk.

How are banks able to attract small savers if small savers can usually receive a higher interest rate from money market mutual funds than from bank savings accounts?

Deposits in bank savings accounts are covered by federal deposit insurance whereas money market mutual fund shares are not. Also, money market mutual funds restrict savers to writing checks only above a specified amount, such as $500 (Money market savings aren't as liquid as bank deposits.)

hedge

reduce risk

Federal Deposit Insurance Corporation

reduces the risk to depositors.

Secondary Offering

represents security sales by a firm that has sold securities previously.

Repos

short term loans with the securities serving as collateral.

A run on a financial firm

the attempt by investors to get their money out before the firm fails.

Due diligence process

the bank researches the firms value once it chooses the investment bank that will underwrite its securities.

Spread

the difference between the price guaranteed to the issuing firm and the issue sold in financial markets kept

Leverages

the financing of investments by borrowing rather than using capital

Repurchase agreement

the selling of securities under the condition that sellers are to buy back the securities at a slightley higher price within a short time. (the next day or within a few days)

finding leverage ratio

value of assets divided by the value of equity

What are the disadvantages to an employee working in a firm with an "up or out" policy?

A disadvantage is that risk averse people may not apply for jobs at investment banks or other firms using the up or out policy do to fear of being fired after just a few years. Some people who don't apply may actually be more productive than some people who end up being promoted at these firms.

Syndicate

A group of investment banks that jointly underwrite a security issue.

What is a 'run' and what is 'contagion'? Why would one money market mutual fund having broken the buck cause a run on other money market mutual funds?

A run is a rush to withdraw money before everyone else does. One money market mutual fund breaking the buck signaled that other money market mutual funds might also do so. Investors became worried about the value of the assets in their money market mutual funds and whether they would be able to redeem their shares at the usual value of $1 per share. Given the low interest rates paid on money market mutual fund shares, investors were not willing to risk capital losses on their investments. The fear generated by the 'breaking of the buck' by one money market mutual fund spread to the whole industry. This is 'contagion'.

Why have runs on commercil banks become rare while multiple shadow banking firms experienced runs during the financial crisis?

Commercial banks do not typically have bank runs because their deposits are insured by the Federal Deposit Insurance Corporation (FDIC) which reduces the risk to depositors. The shadow banking industry, however, is not covered by the FDIC because their short-term borrowing is not in the form of deposits.

in what ways are contractual savings different than commercial banks?

Contractual savings institutions do not raise funds through deposits but rather, receive payments from individuals as a result of contract. They also have access to a wide range of assets than commercial banks.

." Why might competitive pressure lead a hedge fund manager to take on more leverage? Would the same reasoning apply to managers of an investment bank?

If a hedge fund manager sees that other hedge funds are earning higher rates of return because of the leverage they employ, the manager may feel the need to increase the leverage at his or her fund to compete. The same reasoning applies to investment banks and their proprietary trading.

What incentives would the partners in an investment bank have to turn it into a public corporation?

If an investment bank went public, it would have more access to capital because it could sell stock to the public and not have to rely entirely on the funds contributed by the firm's partners. Going public also reduces the risk involved to the top executives, as it is not solely their money that is being invested.

financial engineering

designing new securities. involves developing new financial securities or investment strategies using sophisticated mathematical models developed by people with advanced degrees in economics, finance and mathematics,

investment banking

financial activities that involve underwriting new security issues and providing advice on mergers and acquisition.

In what ways are insurance companies financial intermediaries?

Insurance companies re financial intermediaries in that they obtain funds by charging premiums to policyholders and then use these funds to make investments.

In what ways are investment institutions different than commercial banks?

Invest institutions do not raise funds through deposit and they have access to a wider variety of investment assets than commercial banks.

"By unlocking the capital markets and helping firms to manage risks, investment banks are important conduits of credit." How do investment banks 'unlock capital markets'?

Investment banks 'unlock capital markets' by knowing the ins and outs of financial markets and knowing the current willingness of investors to buy different types of securities as well as the price investors are likely to require.

What are the differences between investment banks and commercial banks?

Investment banks involve underwriting new security issues and providing advice on mergers and acquisitions, whereas commercial banks primarily involve taking deposits and making loans

How do investment banks help firms to manage risk?

Investment banks use the knowledge (knowing the current willingness of investors to buy differet types of securities as well the price investors are likely to require) to help firms raise funds through stock and bond issues

How do these activities make investment conduits of credit?

Investment banks use this knowledge to help firms raise funds through stock and bond issues. Investment banks help firms use derivative contracts and design new securities to help corporations manage risk. Investment banks are conduits of credit for all of the above mentioned reasons. In this role, they help match savers and borrowers and decrease the risk of borrowing and lending.

What is 'Lehman paper'? Why was the Lehman paper in the fund's portfolio worthless?

Lehman paper' is commercial paper that Lehman Brothers had issued to raise funds. The Lehman paper was worthless because Lehman Brothers had gone bankrupt.

What risks did Long-Term Capital Management's high leverage pose to the firm?

Leverage increases gains but can also magnify the losses. These losses were so massive that they created systemic risk to the rest of the system. If Long-Term Capital Management had defaulted on its loans, many other financial firms would have taken large losses as well.

What is leverage?

Leverage involves using borrowed funds to invest rather than using capital or equity to invest.

Return of investment

increases in the price of object divided by the amount invested

If there are no advantages to employees, how are investment banks able to find people willing to work for them with an " up or out" policy?

People are willing to work for these firms if they believe that they can quickly demonstrate their high productivity, earn a promotion, and have a secure job. To attract new hires, many 'up and out' firms offer an above-average starting salary.

book value

Value of the firms assets minus the value of the firms liabilities

In what ways does shadow banking differ from the commercial banking system?

Shadow banking systems are less regulated than commercial banks and so can invest in more risky assets and become more highly leveraged than commercial banks. Unlike commercial banks there is no federal deposit insurance for the investors who provide funds to the shadow banking system.

What are the advantages to an employee working in a firm with an "up or out" policy?

The advantage of the 'up or out' policy to investment banks and other firms is that workers have an incentive to work very hard during their first years with the firm to demonstrate that they are worthy of being promoted.

Shadow banking system

non bank financial firms or is a collection of nonbank financial institutions that channel money from savers to borrowers

What information from this excerpt indicates that Long-Term Capital Management was highly leveraged?

The excerpt indicates that the Long-Term Capital Management hedge fund used $5 billion in capital to get an additional $125 billion in funds. The $125 billion in funds were then used to control $1.25 trillion in securities. So, Long-Term Capital Management was highly leveraged because it used relatively little capital and a great amount of borrowing to control investments that were many times larger.

Initial Public offering

The first time a firm sells stock to the public

What became of the large standalone investment banks during the financial crisis of 2007-2009?

The large stand alone investment banks either went bankrupt, were taking over, or converted to bank holding companies to obtain access to Federal Reserve lending to survive the financial meltdown.

In what sense is an investment bank that engages in underwriting acting as a financial intermediary?

Underwriting is financial intermediation because the bank brings together savers and the firms who issue new securities.

What is underwriting?

Underwriting is where investment banks guarantee (typically) a price to the issuing firm for new stocks or bonds and then sell the new issue at a higher price in financial markets or directly to investors (private placement.)

Repo Financing

a way of borrowing funds through use of repurchase agreements.

In what ways are investment institutions similar to commercial banks ?

because they are financial intermediaries that raise funds and invest them in loans and securities

Hedge funds compete for investor funding

by offering higher rates of return than alternative investments.

Prosepectus

contains all the information about the firm that a potential investor would find relevant to making a decision to buy the firms stocks or bonds , including the firms profitability and net worth, as well as risks faced by the firm

in what ways are contractual savings similar to commercial banks?

contractual savings institutions are similar to commercial banks because like all financial intermediaries, they raise funds and invest them in loans and securities.