investment Banking, parte 1

Investment banking

Vincenzo Capizzi1. Borrowers firms are usually. Function of the financial system is:

• Settlement of transactions;
• Give money in order to the (regolamento);
• Allow the flow of funds/capitals from lenders/savers (risparmiatori) to borrowers;
• To balance differences in risk/return profiles.

Its aim is in corporate subjects or individuals.

Indirect finance banks: deposits based on checking account and (conto corrente) who raise money from savers and create loans to the borrowers/corporates.

The overlapping between direct finance and financial institutions means the complex interactions between banks and capital markets.

Assignment 0

2. Real answer. First reason the overlapping area between capital markets and banks is because there are some financial intermediaries acting as delegated investors, that is, they invest on behalf (per conto) of other investors, for instance small retail investors.

Example of that: asset managers, investment banks, mutual funds.

Benefits they give:

• Diversification opportunities;
• Skills and know-how of the manager (for instance, of the mutual funds);
• Access to capital markets (Ex: because if I have maybe 6 thousand of €, I can buy a share of a mutual fund, giving me the possibility to take a risky position in dozens and dozens of stocks invested by the mutual funds).

2. Second kind of overlapping area: there are some another financial institutions operating in the capital markets (so, in the direct finance chain) that is as enhancer, they improve the efficiency and the function of the capital markets, providing liquidity or information for instance (very important for the investors).

Example of these institutions: financial advisors, research department of banks, rating agencies (Moody’s, S&P).

They give a grade which immediately allows us to understand the quality, the default risk underlying the stocks.

3. Third: there are called instrumental financial intermediaries, in order to facilitate the closing of a given deal/trade of securities.

So, in the primary markets, we find sellers and underwriters of securities; in the secondary market, we meet brokers, dealers, market makers and specialists.

Difference between sellers and underwriters

Difference between sellers and underwriters.

IPO or Bond issue: We consider a company desire to raise money by issuing and selling bonds in the capital markets.

So, it needs money because it has to make a huge investment and one financing strategy in order to raise money is issuing bonds in the capital markets and then, with the outcomes coming from the sale of the bonds in the capital markets, the company will raise the money for the investment.

Imagine I am the investment bank acting as bond seller: I take the mandate to support another person, Aldo, in the primary capital market selling his bonds.

And imagine that another person or all the other people are investors: the market.

I, the investment bank, have to sell the bond issued by Aldo to the market (the other people) and if I’m able to sell the entire amount of the available bonds, Aldo will be able to raise all the expected money and I will get a selling fee, that is a percentage of the overall securities sold.

So, in this case, I am acting as seller of securities.

Aldo, if I’m investing as seller, raises an amount of money depending on the number of securities/of bonds that I’m able to sell to the market: it depends on their interest/on the market appetite/on the market interest.

But what if Aldo raises an amount of money equivalent to just the 60% out the overall issue?

It means that the market participants aren’t interested in such an issue because they are asking just less Bonds.

But the investment bank might offer a sort of guarantee against market risk to Aldo, because I can choose to act as underwriter.

This is different to a seller, because the last one is only selling securities, but he’s not taking on his own the market risk: so, if the market demand for these securities, he will sell; but if the market don’t demand or don’t demand the entire portion of the overall Bonds, it will be okay anyway.

But, in the case the investment bank offers the guarantee, the investment bank can underwrite the 100% of the bond issue: in this case, it will assure that Aldo will be able to raise all the expected money, selling the 100% of the bonds.

If, after the outcome of the primary market, it comes out that the market bought just the 60% of the available securities, the investment bank will buy the remaining 40% as underwriter: that means that Aldo has sold all the 100% of securities: this is the so called fully underwritten close.

Against the partial underwritten close.

Ex: the investment bank decides to underwrite just the 50%, because not the 100% anymore, but maybe it notices the market or the 50% of the bond issue will be asked surely by the market and so the investment bank guarantees the full sale of the securities just with the 50% of the underwritten close.

If I am an investment bank acting just as seller, we say that the kind of services offered by the investment bank is a service based on a best effort basis: I will try to do as much as possible to sell securities without taking on my own any kind of market risk.

Best effort means no guarantees.

Guarantees are taken during a partial or full underwritten close.

Difference between brokers and dealers

Difference between brokers and dealers: brokers just allow the meeting between demand and supply and the search of the right counterpart; dealers, in the case of the transaction with the client, close the transaction with the dealer, so they offer.

That means that the dealer has a non-security portfolio: he quotes a big price and a less price and can benefit from capital gains or capital losses.

Market makers are a kind of dealer.

So, there are some segments of the capital markets where it’s compulsory (obbligatorio) to close a deal with a market maker: so, if I want to buy or sell securities, the only official counterpart in such segments of capital markets is represented by market makers.

And, for this reason, the price in which are sold or bought stocks is the market price.

Specialists

Specialists.

We find these in segments of the capital markets where small caps are traded (società a piccola capitalizzazione): so, company with small capitalization, not that liquid, not that famous.

A specialist is a kind of market maker acting only a single stock of a given small cap.

Es: we found specialists on the NASDAQ or on the Nuovo Mercato alla Borsa Italiana.

Advantage for specialists: last year Aldo invested buying stocks of a small cap company: this small cap is a company not that famous or known.

Maybe Aldo’s expectation was to wait some years and, after some years, when the company would have higher volume of sales, cash flows, turnover (fatturato), then at that time Aldo would sell the stock realizing a huge capital gain.

But imagine that now Aldo has an unexpected liquidity need and decides to sell the stocks: so the problem is that maybe Aldo is not sure that he would be successful selling these stocks, because there maybe couldn’t be the demand for these stocks.

Maybe there isn’t the price at the end of the day for those stocks, because the price is the result of the meeting between demand and supply, between sell orders and buy orders.

But, if there are specialists, Aldo, as singular retail investor, is sure that his investment is liquid, because at least will be able to sell immediately his stock to the specialist, which is a sort of dedicated market maker, whereas the standard market makers are obliged to sell any kind of securities sold in that segment of the capital markets where there are market makers.

Source of financial innovation

Last topic: source of financial innovation (fonte di innovazione finanziaria).

It means that the financial innovation takes place in the financial system, within banks, financial institutions, research and development department of financial institutions and happens that the new products becoming mature and well known can be put in the capital markets and therefore they can be traded on the daily base on the capital market.

If we think at the major financial innovations taking place in the last decades (derivatives, securitization, highly debt obligations), we are talking about products currently traded in the capital markets, but the origination/the source of innovation comes from financial institutions (!).

So, financial institutions are source of financial innovation, instrumental to a better and more efficient function of the capital markets, they are enhancing the quality of trade and negotiation taking place in the capital markets.

These are all activities carried on by investment banks in the direct finance channel.

That’s the reason why there is overlapping between direct and indirect finance: for one hand, these are competitive allocative channels; but, on the other hand, we couldn’t have efficient capital markets without the presence of financial institutions acting in this way.

Securitization process

Securitization process.

It is important because allows bank to put in market the loan: so, it allows to transform loans in securities and sell in the market securities having as an underlying asset a given original bank loan.

Therefore, thanks to the securitization process, if I transport and sell in the market the loans, I also sell in the market the credit risk represented by the borrower that has with me its obligations as written in the below contract.

Many and many banks in these years are packaging and selling in the market “bad loans”.

Synonymous of “bad loans”: NPL, Non-Performing Loans: are loans given by banks to borrowers with high default risk, so it’s high the risk that the borrower wouldn’t be able to meet its contractual obligations signed with the bank and therefore to repay back interest or the principal of the loan according to the amortization schedule.

Quota capitale di un mutuo: principal; quota interessi: debt service; mutuo: mortgage loans; rata: instalment.

How does the securitization process take place?

The originator is the bank having inside a loan portfolio.

The bank sells a portfolio of loans to a newly created company, called SPV, Special Purpose Vehicle: it’s an empty box (!): newly created just in order to buy these bad loans from the bank.

And, if the bank sells this portfolio of bad loans, first of all, it gets money, and second, it’s able to get money before the natural maturities of the loans (indeed, maybe, the maturity of the loans is 5 or 10 years!) and, in this way, it is able to anticipate the payback of its loans and transfer credit risk to the investors, even though the bank itself created those loans.

Where does the money come from in order to buy these loans: so, how does the SPV find this transaction?

It sells securities to the investors: these securities are called Asset Back Securities, AB-Securities.

So, the SPV sells securities to investors and, with the proceedings coming from the selling, is able to buy the bad loans from the banks.

The investment bank here is acting just as seller of securities (to the investors).

Then, there is a rating agency that assigns a grade to these securities.

And how the SPV would be able on a periodic basis to pay the coupons (cedole) and in the end of the life to pay back the nominal amount of the bond?

Thanks to the money paid by debtors.

There is a servicer collecting money from the debtors, giving the money to the SPV and the SPV has the possibility to pay coupons to investors.

If the debtors aren’t able to pay their obligations of the loans, the investors won’t receive their coupons.

So, for this reason, these are high risky securities, because the embedded risk (incorporato) is the credit risk (!) coming from the original debtor.

The SPV beyond (oltre) the money raised by selling ABS securities may raise money through equity or senior or junior tranche (senior it means a guaranteed tranche with some collaterals; junior with no collateral).

Assignment 1

3. Assignment 1: should it be forbidden to place on the market “bad loans” as securities?

Answer (prof): The reasons why it isn’t forbidden securitization of NPL:

• Financial innovation argument: so, the heart of financial innovation is to produce and to put new products in the market, which means new risk-return opportunities for investors and then it’s up to the investor to decide whether to take the opportunity to invest or not invest and what percentage of his wealth to put according to a diversification perspective.

But remember that a wider set of investment opportunities increases markets’ completeness, that is the capability of the market with the contracts that can be offered to investors to intercept all their possible risk-return profiles.

Ex: if we have in the market only 2 products, like stocks and Bonds, we can raise the interest of people desiring to sustain the underlying risk of stock or the underlying risk of bond; but if we put in the market convertible bonds or ABS, we are increasing the probability to keep high the interest of investors not satisfied by the previously existing securities in the market: then, now, more investors can get access to the market because they can find the securities which are coherent with their risk-return profile;

• It might widen (allargare) the benefits of portfolio diversification;
• Credit Enhancement mechanisms: even though we are talking about risky securities, in the securitization process, we might improve the quality of the securities (for instance, adding guarantees or collaterals, or adding assets to buy or adding cash flows to the ones the securities offer): this is called the Credit Enhancement mechanisms, that is a mechanism aimed at increasing/upgrading the quality of the securities, through guarantees, collaterals, ecc…

In the securitization process (slide 21), the Credit Enhancer can’t be put during the investment bank-investors relations, but might be a third part giving a guarantee to the SPV or an alternative source of cash flows: for instance, we put a plant (impianto) in the SPV, we rent this plant and we get an alternative source of cash flows that can integrate the cash flows coming from the underlying borrower, which we already know are bad quality’s.

In this case, we are creating a security whose default risk is different and lower than the default risk of the original borrower (!).

We are adding collaterals or other assets, which we can sell in case of trouble (!), achieving cash flows with which I can pay coupons to bond holders;

• The issue of disclosing the right information about the ABS’ quality (and the right price): in the last years, in the market, the true issue about securitization wasn’t the risk of these securities, but the wrong information given to the investors (!).

Many investment banks, placing securities in the markets, were not giving the right information dealing with the riskiness (rischiosità) of these securities.

So, the problem is not putting in the market risky securities, but is that, when putting them, we have to ensure fully disclosure dealing with the implied (implicito) underlying risk, revealing the true information.

And so, for instance, regulation may oblige SPV to fully disclose also the identity of the borrowers we are talking about.

It's a matter of regulation: so, there could be some protective measures set by the authorities, like minimum ticket size or monitoring mechanism (in order to control how take place the periodic payment of the underlying borrowers).

Minimum ticket size means that the regulator might say that those risky securities might be bought either by professional investors or by individual savers having a minimum amount of available wealth of 10 million dollars, for instance, because the idea is to protect the small retail investors and if someone, before investing, has maybe 10 million dollars, we presume that the investors take an advisor and, in any case, we presume that, even though they buy a small amount of risky securities that are not that aware about the risk, we are talking anyway about what are called HNW individuals, High Net Worth individuals (individui ad alti patrimoni) that is (individuals with net worth higher than 1 million dollars) or UHNW: Ultra High Net Worth individuals (individuals with net worth higher than 10 million dollars).

If individuals have net worth higher around 500.000-600.000 dollars, they are considered an affluent individual: one individual that are assisted with particular care because maybe tomorrow may enter in the family of HNW individuals), professional investor (that means that the regulator might say that only big professional investors are allowed to buy those risky securities).

• The negative consequences of prohibitionist rules and laws: that means that if we prohibit that kind of securities, the day after each research department of a bank, is able to invent a new security with a different name but same risk-return profile (indeed, the financial contract is the risk-return combination); second point, it develops the black market and this black market may be more dangerous than the official market, because isn’t regulated and there aren’t protective measures for investors.

Organizational structure of a large bank

Where does the investment banks fit inside the overall organizational structure of a large bank?

This is the standard organizational structure of a bank identifying all the major Strategic Business Units, SBUs.

They are also called (ASA, Area Strategica d’Affari).

They are: … slide.

In each SBU reference single target client: the distribution process and