snider & howard - money makers; inside the new world of finance and business (2010)

In this book, the authors take an in-depth look at six of the fieldsdriving the economy, many of which were key actors in this recentdrama: investment banking, venture capital, private e

David Snider and Dr Chris Howard

ADDITIONAL PRAISE FOR MONEY MAKERS:

“David Snider and Chris Howard write with insiders’ knowledge and outsiders’perspective Through an impressive array of interviews and secondary re-search, they provide a remarkably coherent explanation of the industries driv-ing the modern economy—what they are, how they have evolved and beenaffected by the recent recession, and why they matter I would recommend thisbook both to my students and my friends who are curious about these fields.”

—Joel Fleishman, professor of Law and Public Policy at Duke University, member of the Board of Directors

of the Polo Ralph Lauren Corporation

“I was blown away at how insightful Money Makers is A fresh look at the DNA

of private equity, venture capital, hedge funds, and more I wish somethinglike this existed when I started my career in finance.”

—Jeff Bloomberg, Principal at Gordon Brothers, former Senior Managing Director for Retail and Consumer Products at Bear Stearns

“A revealing look at the mosaic of the financial community and its all-stars Ifyou want a road-map for understanding key finance and business fields this is the book for you!”

—Dr Dana Ardi, Managing Director and Founder of Corporate Anthropology Advisors,

former private equity executive

“Whether you are an aspiring financier, management consultant,

entrepre-neur, or simply want to learn what people in these professions do, Money Makers will be a critical companion in your journey Through their thorough

analysis and insightful interviews, Howard and Snider provide a valuable view of our financial industries and what makes them tick.”

re-—Christopher Gergen, Director of Duke University’s Entrepreneurial Leadership Initiative and coauthor of

Life Entrepreneurs: Ordinary People Creating Extraordinary Lives

“Howard and Snider provide a concise and dynamic view of the venture tal business Anyone who wants to understand the mechanics of this industrywill learn from and enjoy the book, particularly those who aspire to be ven-ture capitalists.”

capi-—Nicholas Beim, General Partner at Matrix Partners

MONEY MAKERS

Copyright © David Snider and Chris Howard, 2010.

All rights reserved.

The views expressed in this text are those of the authors and the interviewees cited and do not necessarily reflect the views of the organizations for which they currently work or have previously been employed.

First published in 2010 by PALGRAVE MACMILLAN® in the U.S.—a division

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Where this book is distributed in the UK, Europe and the rest of the world, this

is by Palgrave Macmillan, a division of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS.

Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world.

Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries.

1 Investments 2 Venture capital 3 Hedge funds 4 Banks and banking I Howard, Christopher, 1970– II Title.

HG4521.S71134 2010

A catalogue record of the book is available from the British Library.

Design by Letra Libre, Inc.

First edition: February 2010

10 9 8 7 6 5 4 3 2 1 Printed in the United States of America.

Conclusion 203

F O R E W O R D

This book is being published at an extraordinary time The fi-nancial markets and the economy in the United States have

been through a remarkably destabilizing period Today weare evaluating the damage, seeking to understand the root causes, andthinking about how public policy should be adjusted for the future

In this book, the authors take an in-depth look at six of the fieldsdriving the economy, many of which were key actors in this recentdrama: investment banking, venture capital, private equity, hedge funds,management consulting, and the management of important U.S corpo-rations The perspectives and conclusions offered are the result of scores

of interviews with the most important and knowledgeable people ineach of these areas This unusual access, combined with the authors’clear analysis, provides an excellent narrative for all types of readers

My own professional history has touched many of the areas thisbook considers I began my career in asset management then enjoyedalmost three decades in investment banking before having the privilege

to serve as under secretary of the U.S Treasury and then, for a brief riod of time, manage a major commercial bank During this period,the position of alternative investing (including venture capital, privateequity, and hedge funds) grew tremendously, increased trade, createdglobal markets and technology, and became an offensive tool as well as

pe-a key ppe-art of business strpe-ategy Money Mpe-akers provides importpe-ant

background and perspective on these shifts and how our current nancial landscape evolved as it did—both to enable so much prosper-ity and to put it all at risk

fi-I have always believed that well-functioning capital markets are acritical factor in successful economies When providers and suppliers ofcapital meet and make informed decisions, in their own self interest,both the economy and the citizenry win Capital is allocated in a supe-rior way and results in increased growth for the economy There must beclear rules and regulations that make this supplier-provider engagementfair, predictable, and confidence-building But professional participantsare also a key ingredient for this process to produce the best result.Indeed, several of these activities—venture capital, private equity,and hedge funds in particular—are very young industries, really onlyabout a generation old Surely given their recent rapid growth and vis-ibility, the future of these industries will be characterized by greatertransparency, more oversight and, in general, greater scrutiny Whilethe other activities considered here, such as investment banking, man-agement consulting, and the leadership of Fortune 500 companies, aremore established, they, too, have transformed substantially in the lastfew decades and experienced significant disruption in the wake of re-

cent events Money Makers provides a timely explanation of these

com-ponents of the economic landscape

There is no question that recent events have shaken everyone’sconfidence in many parts of our system It is very fair to ask hard ques-tions about what went wrong, what went right, and how we should ad-just public policy goals and the attendant regulation But to arrive atthe right answers we need to understand who these industry playersare, the rules they have been playing under, and how their own prac-

tices and cultures have been rapidly changing Money Makers will be an

important source of perspectives in that effort

Robert K Steel is the former president and CEO of Wachovia tion He joined the board of directors of Wells Fargo & Co upon the firm’s merger with Wachovia He previously served as under secretary of the Treasury for domestic finance In this role, he worked as the principal ad- visor to the secretary on matters of domestic finance and led the depart- ment’s activities with respect to the domestic financial system, fiscal policy and operations, and governmental assets and liabilities Prior to becom- ing under secretary, he was vice chairman of Goldman Sachs & Company

Corpora-I N T R O D U C T Corpora-I O N

Billionaires Julian Robertson and Henry Kravis did not in-herit large sums of money They have never invented a new

product or built companies that serve millions of tomers Yet by pioneering new ways to successfully invest, they havetaken investors’ money, produced large returns, and, in the process,made themselves extremely wealthy But how did they do it and whatare these industries that they have helped to create?

cus-Although the elite fields of business and finance play large and namic roles in the global economy, how they work remains a mystery

dy-to most outsiders Just over a decade ago, “hedge funds,” “private uity,” and “venture capital” were finance terms rarely discussed in themainstream media Today, they receive full-scale coverage A recent

eq-“Time 100: People Who Shape our World” included a publicity-shy

hedge-fund trader, a New York leveraged-buyout veteran, and a WestCoast venture-capital financier, along with assorted entrepreneurs andFortune 500 CEOs

This book describes the inner workings of the highly selective andoften secretive industries of the private sector: investment banking,venture capital, private equity, hedge funds, management consulting,and the management of Fortune 500 companies It reveals them fromthe perspectives of leaders in each field, who share insights, anecdotes,and recommendations that can be valuable to anyone with an interest

in finance and business

These six industries alone do not represent the entire business verse Real estate developers, accountants, commercial bankers, mutual-fund and institutional money managers, as well as governmentregulators (among others) play important roles in the economy How-ever, the descriptions of the businesses described here provide a broadunderstanding of the key players in the financial industry and many ofthe routes to power and monetary success.

uni-T H E P E R I O D O F F I N A N C I A L R E C K O N I N G

September 2008 through the first half of 2009 was one of the worst riods for business and finance in history Trillions of dollars in themarket value of U.S businesses disappeared, and with it went a com-mensurate amount of average Americans’ and professional investors’money Although investment bankers, hedge-fund managers, andCEOs of struggling businesses all received a huge amount of scrutinyfor creating an economic mess, only a fraction of the people in thesefields took actions that directly contributed to the recession

pe-The downturn was as brutal as it was unexpected Through thefirst half of 2008, many major sectors of the economy were growing.Nevertheless, a rapid succession of financial events wrought destruc-tion across the economy that autumn Some of the largest and most-respected firms on Wall Street disappeared in a matter of months BearStearns, Lehman Brothers, and Merrill Lynch—all investment banksoperating multiple lines of business—were forced to sell themselves or

go into bankruptcy Their fall was based, in part, on housing-related nancial products The ambiguity concerning the value of these finan-cial instruments (such as collateralized mortgage debt and creditdefault swaps) created so much uncertainty about the banks’ capacities

fi-to absorb investment losses and honor their financial commitmentsthat they were not able to continue operating as independent financialinstitutions

Fortune 500 companies went bankrupt, as did businesses owned

by private equity firms The hedge-fund industry, which had recordedyear after year of impressive results, saw its returns decline by 18 per-cent in 2008 On top of that, the market was confronted with outright

fraud Hedge-fund operator Bernie Madoff acknowledged that the

$50-billion hedge fund he ran was a Ponzi scheme Billionaire financierAllen Sanford, who promised investors safe, reliable returns, allegedlypoured his clients’ money into risky enterprises and his own lavishlifestyle Although these criminal activities hurt investors, this illegalbehavior was not the core reason for the recession

At the center of the economic debacle was the bursting of a based bubble It was inflated not only by the recent prevalence of greedand bad decision making, but also by years of too much borrowingand too little capital throughout the United States This permeated thefinancial system, in which investment firms used large amounts ofleverage It was exacerbated by the U.S government’s huge budgetdeficits and by the millions of consumers who spent in excess of theirsavings As President Barack Obama remarked in June 2009, “A culture

debt-of irresponsibility took root from Wall Street to Washington to MainStreet.”1

M O V I N G F O R WA R D

The face of business and finance has been changed irrefutably, but thekey industries and the functions they serve will persist Fortune 500companies remain the driving forces for jobs, products, and servicesthroughout the world Investment banks and management-consultingfirms continue to advise large corporations and private equity firms ontheir operations and financial transactions Private equity, venture cap-ital, and hedge-fund firms all still manage huge investment vehiclesand seek to allocate capital to dynamic businesses and financial assets.Although their worlds have been shaken, these industries are againmoney makers Investment banks as well as management consultantsare developing strategies to generate wealth and growth for theirclients Venture capital, private equity, and hedge funds are seeking tomake money for their investors, and Fortune 500 companies are work-ing to produce profits for their shareholders

The most successful of these institutions emphasize ethics and derstand the implications of their actions The absence of those con-siderations has historically led to economic misfortune, for both the

un-principal actors and the larger community Many private equity firmsthat added no value to portfolio companies and over-leveraged themwent out of business in the late 1980s Venture-capital firms that in-vested in unsound companies in order to take them public during the1990s technology boom have disappeared Investment bankers andhedge-fund operators who recently took too much risk or who brokethe law are out of work or in jail Business schools have been reminded

of the importance of emphasizing principles beyond the profit motive,and thousands of students have taken a professional oath that empha-sizes responsible value creation

Investment firms are often criticized for the massive salaries andbonuses that their leaders receive The huge amount of money thatthese executives make is a function of their capacity to raise capitalfrom investors and to rapidly and consistently increase that money In-vestors are never forced to place their money with a particular man-ager; they choose to pay high investment fees because they believe thatthose fees are justified by the acumen of the investment professional.Finance is Darwinian; those who do not produce generally do not sur-vive Those who create profits reap large benefits

All six of the industries described in this book, when they conductthemselves well, produce wealth and success that reach far beyondthose directly involved They make our economy operate more effi-ciently, produce returns for investors of all kinds (including pension-fund participants and nonprofits), allocate capital to generateeconomic growth, and create life-changing product innovations

T H E A U T H O R S

The contrasting experiences of this book’s two authors gives their laborative work a unique perspective on the world of business Chrisgrew up in Plano, Texas; David in the suburbs of Boston Chris was aBowl-winning college running back at the Air Force Academy David’sathletic career peaked in middle school Chris’s first job was in the mil-itary; David’s was on Capitol Hill They each explored a number of dif-ferent opportunities in the nonprofit sector, yet both ended uppursuing a career in business David took a position in management

col-consulting at Bain & Company before heading to the private equityfirm Bain Capital After graduate school and time in the military, Chrisattended Harvard Business School He chose to work at Fortune 500companies, taking a job in an international project management group

at Bristol-Myers Squibb and later in the Corporate Initiatives Group atGeneral Electric

They met when Chris was at GE and David was a student in highschool Their relationship evolved from one of mentor-mentee to alongstanding personal and professional friendship As Chris transi-tioned from business to academia, David entered the private sector.Throughout that time they maintained a discussion on the evolvingfinancial world David’s search to understand finance (in order to get

a job within it) was, in part, the genesis for this book Chris wanted

to work on this project to provide a text for students and young fessionals curious about these fields as well as the people, who, likehim, developed an interest in business later in life They both be-lieved that, given the hugely important position that these select in-dustries occupy, there ought to be a book that explored them fromthe inside out

pro-T H E C O N pro-T E N pro-T S O F pro-T H I S B O O K

Chapter 1 examines the investment-banking industry, which playedthe most public role in the recent economic crisis The industry con-tinues to serve critical financial functions that enable capital marketsand the broader economy Chapters 2, 3, and 4 describe the major fi-nancial industries beyond Wall Street: venture capital, private equity,and hedge funds Each industry controls billions of dollars on behalf ofinvestors and has a huge influence on the development of new compa-nies, the operations of business, and the movements of public financialmarkets Chapter 2, on venture capital, also discusses the experiencesand challenges of entrepreneurship, because that is so intricately linked

to the venture business Chapter 5 explores management consultingand bridges the divide between the “financial” economy and the “real”economy Although under the radar, consultants play an importantrole in advising key corporate and financial decision makers on most

mergers, acquisitions, and new, strategic business initiatives Chapter 6discusses the management of Fortune 500 companies These largeinstitutions employ millions, produce thousands of products andservices on which we depend, and play important roles in the fiveother fields.

I N S I D E R I N S I G H T S :

I N T E RV I E W S C O N D U C T E D F O R T H I S B O O K

The contents of this book come from research, the authors’ ences, and the insights of industry insiders Associates at top firms aswell as industry leaders were interviewed for every chapter to provide arobust perspective on the field Their insights are interwoven into thechapters, and there are some short profiles and interviews to providecontext for people’s personal experiences The education and profes-sional backgrounds of those highlighted are included in appendix B.The careers of a few of those interviewed have been controversial, butthis is not a book about leadership practices; it is about understandinghow these industries work and how fortunes and reputations can riseand fall within them Everyone interviewed has reached the pinnacle ofone or more areas of business

experi-Some interviewees preferred that their insights stay anonymous;however, the list below provides a sense of the range and depth of ex-pertise that contributed to the text:

• Alan Schwartz, executive chairman of Guggenheim Partners,former CEO of Bear Stearns

• Ben Casnocha, entrepreneur (founder of Comcate), recognized

as one of Business Week’s top entrepreneurs under twenty-five

• Bill Meehan, former managing director of McKinsey & pany and founder of the firm’s private equity and venture capitalpractice

Com-• Bill Shutzer, senior managing director of Evercore Partners, mer managing director of Lehman Brothers

for-• Bruce Evans, managing director of Summit Partners

• Chuck Farkas, senior director of Bain & Company

• Chuck McMullan, executive director at UBS Investment Bank

• Chris Galvin, former CEO of Motorola, chairman of HarrisonStreet Capital

• Craig Foley, founder of Chancellor Capital Management, firstinstitutional investor in Starbucks

• David Rubenstein, cofounder of The Carlyle Group

• JB Cherry, managing director of One Equity Partners

• Jamie Dimon, CEO of JPMorgan Chase & Co

• Jamie Irick, general manager at General Electric

• Jeff Hurst, cofounder and managing partner of CommonwealthCapital Ventures

• Joe Fuller, cofounder and CEO of Monitor Group

• Joyce Johnson-Miller, cofounder of The Relativity Fund, formermanaging director of Cerberus Capital

• Julian Robertson, founder of Tiger Management, hedge fund oneer

pi-• Ken Weg, former vice chairman of Bristol-Myers Squibb

• Kip Frey, partner at Intersouth Partners

• Megan Clark, former vice president of technology at BHP ton, former director of N M Rothschild & Sons

Billi-• Noah Glass, entrepreneur (CEO of GoMobo), recognized as one

of Business Week’s top entrepreneurs under twenty-five

• Peter Nicholas, chairman and cofounder of Boston Scientific

• Richard Bressler, managing director and head of the StrategicResource Group at THL Partners, former CFO of Viacom

• Rick Wagoner, former CEO of General Motors

• Ron Daniel, former worldwide managing director of McKinsey

• Steve Pagliuca, managing director of Bain Capital

• Suzanne Nora Johnson, former vice chairman of Goldman Sachs

• Tim Jenkins, cofounder of Marble Arch Investments, former sociate at Tiger Management and Madison Dearborn Partners

As with many such deals, there were other potential buyers ing the same documents in order to determine whether they would makebids and, if so, for what amounts In this case, the other serious potentialbuyers were two private equity firms: Kohlberg, Kravis, Roberts & Co.and J C Flowers There was a great deal of bustle in the executive suite

examin-at the target company’s offices examin-at 383 Madison Avenue The J.P gan bankers were trying to determine the true value of the target com-pany’s $400 billion in assets and operating businesses as well as therisks posed by the financial products held on its balance sheet.3Therewas palpable anxiety among both analysts and senior bankers as theytried to understand the business and its current financial state The an-alysts were creating Excel models to value elements of the businessbased on current market prices and to evaluate what would happen ifthe market eroded further Senior bankers were using their knowledge

Mor-to inform the assumptions underlying the financial models

Like most deals on which the bankers worked, absolute tiality was required, as leaked news of a deal could move stock markets

confiden-or pose issues of insider trading (a type of securities fraud that occurswhen someone buys or sells a stock with company information notavailable to the public) However, this deal was, in many ways, unlikeanything the bankers had ever seen and required extreme secrecy Thepotential acquisition target was one of J.P Morgan’s competitors, BearStearns The imminent timing was not a result of the normal pressures

of a competitive process but of a fear that, without a buyer, BearStearns might be forced into bankruptcy, which could incite a global fi-nancial panic It was not only the CEOs of Bear Stearns and J.P Mor-gan, Alan Schwartz and Jamie Dimon, who were closely following thedeal, but also U.S Treasury Secretary Hank Paulson, Federal ReserveChairman Ben Bernanke, and the president of the New York FederalReserve Bank, Tim Geithner

On March 16, J.P Morgan rejected the potential acquisition, seeing

it as too risky because of the potential losses from some of BearStearns’s investments—notably its mortgage-related holdings Yetstrong encouragement from the Treasury Secretary and the Federal Re-serve’s guarantee to finance and assume roughly $30 billion of BearStearns’s mortgage assets led to the unprecedented acquisition Many

in the industry believed that the deal represented the avoidance of amajor financial crisis In fact, it was just the beginning of one

I N 2 0 0 8 , the investment-banking industry lost hundreds of billions

of dollars, saw many of its institutions disappear, laid off thousands ofemployees, and—in its own demise—precipitated a global recession.How could one industry nearly cause a worldwide depression? Whydid the U.S government believe that stabilizing U.S banks merited al-locating $700 billion to the industry? The answers to these questionsare found in this chapter

T H E H I S T O RY O F I N V E S T M E N T B A N K I N G

The U.S investment-banking industry dates from before the CivilWar, when Jay Cooke sold shares of government bonds to individualinvestors through a network of salesmen.4In the late 1800s, J.P Mor-gan and other investment houses played a large role in the industrial

mergers and restructurings of the railroad and steel industries The perity of the 1920s led to a massive expansion of investing and financialservices, and average Americans began to invest (or speculate) in thestock market Although the period culminated with a run on the banks,

pros-a stock-mpros-arket crpros-ash, pros-and the Grepros-at Depression, in the following decpros-adesthe investment banks that survived expanded along with American busi-ness As companies grew larger, so did their initial public offerings(IPOs), debt issuances, and other financial needs With those increasedcapital demands came greater profits for the investment banks

Banking firms continually sought to take advantage of new kets and changes in regulations, such as a 1981 law that, for the firsttime, permitted savings and loan (S&L) banks to sell the loans theyissued to other financial institutions This legislation laid thegroundwork for much of the housing mess that boiled over twenty-six years later Prior to 1981, S&L banks carefully evaluated potentialborrowers, knowing that they were on the hook if those borrowersdefaulted on their loans The change in the law allowed the banks tosell the loans (and the interest those loans generated) Although not

mar-an intention of the regulatory chmar-ange, S&L bmar-anks suddenly had lessincentive to conduct thorough diligence on loan applicants, becausethey did not carry all the risks if the borrowers defaulted Investmentbanks could now convert the loans they purchased into mortgage-backed securities and sell them to other investors

Another financial innovation in the 1980s was the high-yieldbond High-yield bonds were an important development because theyallowed companies that were perceived by investors as being somewhatfinancially risky to have access to debt capital from public markets Thepioneer of the debt instrument was Michael Milken, who built thebusiness for the investment bank Drexel Burnham Lambert Prior toMilken, Drexel Burnham was a mid-size bank By “creating,” develop-ing, and virtually monopolizing the high-yield debt market, Milken el-evated Drexel Burnham to a central role in finance and disrupted theinformal rules and hierarchy that had characterized the investment-banking industry for decades He and the firm left a lasting legacy onWall Street: pioneering new financial products is critical to rising tothe top of investment banking

In 1990, however, Drexel Burnham was forced into bankruptcy cause of losses and criminal charges related to its high-yield practice.Milken pled guilty to securities violations stemming from charges ofinsider trading and stock price manipulation, and served time in jail.Though particularly high profile, the incident was certainly not theonly scandal in the investment banking industry during the last coupledecades.

be-In 1991, Salomon Brothers was tarnished by charges that the head

of the government bond-trading department made illegal bids for U.S.Treasury securities, an incident that led to the ouster of the firm’s CEOand other members of the senior management.5Warren Buffett, whowas one of Salomon Brother’s largest shareholders at the time, stepped

in and ran the company for a few months to ensure that the firm vived the market’s brief loss of trust In 1994, Joseph Jett of KidderPeabody allegedly manufactured over $300 million in fictitious profits

sur-to hide actual investment losses and garner huge bonuses for himself.6

Nevertheless, in spite of such bumps along the way, the banking industry grew in size and profitability throughout the twenti-eth century

investment-In 2001, however, banks began to face a number of difficulties.Most noticeably, the United States was entering a recession on theheels of the tech bubble Not only was the economy headed down-ward, but the large pool of IPOs that banks had facilitated for newtechnology companies dried up Additionally, Internet technologiesmade it easier and less expensive to trade securities, which put down-ward pressure on the transaction fees that banks received from bro-kering such trades One of the few bright spots was the low cost ofborrowing money The U.S Federal Funds rate, which largely deter-mines the cost of borrowing for banks, was set at historically low lev-els Banks seized the opportunity and began to borrow more heavilyfrom other banks in order to increase their leverages and, in turn,their profitability By expanding the amount of money they couldtrade and lend, banks could boost their profits, as long as the addi-tional uses of money yielded higher returns than the costs of theloans Many also increased their lending to private equity firms,commercial real estate developers, and hedge funds—all leveraged

* Subprime mortgages are mortgages issued to less credit-worthy people Often these viduals have histories of failure to pay back debt or have declared bankruptcy An ad- justable-rate mortgage (ARM) is a home loan for which the interest rate can vary over the course of the loan, often starting at a low rate and increasing over time.

indi-investors Furthermore, new banking regulations, under the tional Basel II agreement, allowed banks to use more leverage thanthey previously could The Basel II rules were reliant on credit rat-ings, which proved inaccurate mechanisms for valuing the risks ofmany assets

interna-Although stocks and bonds decreased in value during the 2001 cession, home prices continued their long upward trajectory Invest-ment banks saw the U.S housing market as an area with significantprofit potential, given that increasing home values led to a very low de-fault rate on mortgages The banks increased the amount of resourcesthat were focused on residential real estate, buying up mortgages andexpanding the use of financial instruments, such as mortgage-backedsecurities, which could be bought and sold easily Aggressive lending,home building, and speculative-investor home buying drove up realestate prices and created millions of new mortgages for banks to pur-chase and securitize Banks valued these assets and the risks they posedwith complex models based on historical fluctuations in home pricesand mortgage default rates They began to believe—and to act—as ifhome prices could only go up

re-However, in 2006, the U.S housing market began to experienceturbulence Lenders who issued mortgages to highly risky borrowers(those with bad credit histories) experienced defaults They began tocut back on risky lending and to increase mortgage rates for existingborrowers Higher rates meant more defaults, and tighter lending poli-cies decreased demand for new homes Housing prices started to de-cline at rapid rates, and property owners who had adjustable-ratemortgages they couldn’t afford (often subprime borrowers), as well asreal estate speculators, started to default on loans.*

The declines in home prices and the increasing default rates werefar greater than the financial models had indicated was possible, and

the banks found themselves holding trillions of dollars in securities lated to the housing market, with prices dropping Soon after, banksbegan seeing the values of their investments in commercial real estatedecline as well.

re-Banks’ advisory business divisions, which facilitate corporatemergers and acquisitions (companies buying other companies) as well

as other capital market transactions (for example, IPOs and debt suances) also experienced declines Furthermore, the banks’ exposure

is-to private equity transactions created additional pressure on the ity of some institutions Between 2004 and 2007, private equity firmsconstituted a large and increasing share of financial deals Because ofthe amount of debt that had to be raised for the financing of thesetransactions, private equity deals were generally more profitable thancorporate mergers However, as a result of the debt used by private eq-uity firms to purchase companies, banks were often left with billions inloans (if the banks did not sell all the debt associated with the deals)

stabil-As the economy soured in late 2007, the market’s expectation of thelikelihood of a default on that debt increased, and the market price ofthe loans fell to only a fraction of their initial value The banks had towrite down the value of the loans, which decreased the strength oftheir balance sheets

In autumn 2007, due to housing market financial products and otherdebt related holdings, investment banks began to take multi billion-dollar write-offs, acknowledging that the assets they held had de-clined in value Unfortunately, the write-offs did not solve the banks’problems Many had used borrowed money to purchase investments;the amount of borrowing (as much as thirty dollars for every onedollar of equity) used to boost gains, ended up magnifying losses.Declines in asset values of only 4 percent wiped out many banks’ eq-uity in some investments, exposing them to large potential losses.With little demand for the banks’ debt investments, the values of theassets continued to decline, creating further strain on the banks’ fi-nancial stability With no buyers, banks could not get liquidity (cash)from their investments That downward spiral led to concerns thatperhaps banks did not have adequate capital to maintain operations

In March 2008, a rumor began to circulate on Wall Street that BearStearns, the smallest of the major investment banks, might be in anunstable position because of its large exposure to the mortgage mar-ket The previous summer, two of its internal hedge funds had beendevastated by losses stemming from mortgage-related investments.The hedge funds had purchased mortgage-backed securities and ap-plied huge amounts of leverage; when the investments went down, thefunds were nearly wiped out In March the firm still had $18 billion incash, an adequate amount to function (although less than one- twentieth of the total amount of the bank’s assets).7 However, WallStreet banks depend on more than cash to function; they rely on theconfidence of other Wall Street firms and their customers SuddenlyBear Stearns lost the confidence of both groups Investors began towithdraw funds, thereby depleting Bear Stearns’s cash supply WallStreet firms—which Bear Stearns needed to borrow money from andclear trades with—pulled back in order to limit their exposure In anattempt to stabilize the worsening situation the Federal Reserve andJ.P Morgan provided Bear Stearns with secured lending, but singling itout for assistance unintentionally further eroded confidence in the in-stitution The firm was left with few options, and the federal govern-ment eventually had to step in and broker a merger with J.P Morgan.The government determined that, given all the interrelated deals andlending between Bear Stearns and other investment banks, Bear’s col-lapse into bankruptcy could pose a systemic risk to the entire U.S.banking system.

Nevertheless, in September 2008, when Lehman Brothers facedsimilar liquidity issues and a loss of investor confidence, the federalgovernment declined to provide financial backing for a merger deal.Barclays, the British investment bank, was prepared to buy Lehman for

$5 billion plus the assumption of $75 billion of debt, but it needed proval from its shareholders before completing the transaction TheU.S government refused to support Lehman Brothers financially forthe three months required for Barclays to close on the transaction,fearing that things would get worse and that, consequently, Barclayswould walk away from the deal.8Faced with no access to capital and no

ap-banks willing to purchase it without guarantees from the U.S ment, Lehman filed for bankruptcy.

govern-Lehman Brothers, the counterparty on thousands of transactionswith other banks, was larger and more interconnected than BearStearns Key financial players felt that, if an institution that big couldfail, others could too Investment banks stopped lending, and even thelargest and most stable companies could not get short-term loans.Adding to the sense of market chaos was the potential failure of AIG—then the world’s largest insurance company—and a forced governmenttakeover of the mortgage-lending institutions Fannie Mae and FreddieMac To avoid a full-scale financial meltdown, the secretary of theTreasury and the chairman of the Federal Reserve asked the U.S Con-gress for $700 billion to buy the troubled assets that were weighingdown the investment banks and inhibiting the ability of the creditmarkets to function In the end, the Treasury Department decided touse the money allocated by Congress for the Troubled Asset Relief Pro-gram (TARP), in order to make capital injections into the banks Somebanks did not require capital injections to stay solvent However, Treas-ury Secretary Paulson felt that it was important for all nine of the majorbanks to accept the funds to avoid those who voluntarily took govern-ment money from being stigmatized “We did not need the TARPmoney,” notes J.P Morgan CEO Jamie Dimon The government “askedthe nine banks to take it Some of those firms may have needed it tosurvive Some probably needed it for comfort We were in neither ofthose camps, but I think there was a coherent argument that these ninebanks take it, in order to help stabilize the system and help those otherbanks to take it We didn’t think that J.P Morgan should be partisan orparochial and stand in the way of doing something that was good forthe country and, in fact, for the financial system of the world.”

To be proactive and avoid further issues, Merrill Lynch sold itself

to Bank of America On September 22, 2008, seven days after Lehmandeclared bankruptcy, Goldman Sachs and Morgan Stanley becamebank holding companies This change allowed them to raise money bycollecting deposits in the same way as traditional banks and to accessfunding from the U.S government Although some institutions were

forced to liquidate or sell, a catastrophic collapse of the banking ness and the world economy was avoided.

busi-T W O busi-T R E N D S busi-T H Abusi-T S P U R R E D busi-T H E D O W N busi-T U R N

Two trends in banking over the last decade helped to exacerbate therecent downturn The first is the globalization of banking The involve-ment of European banks in the U.S market has increased, as has therole of U.S financial products in emerging markets, such as Russia,India, and China Historically, financial disruption in the U.S was rela-tively contained to its banks and investors However, in this instance,rather than only U.S banks holding toxic debt from homeowners orhighly leveraged commercial real estate loans, investors around theworld took massive losses Developing economies that had seen mas-sive inflows of private capital, facilitated by new investment products,experienced sharp declines in their stock markets Negative and inter-connected currents fed on themselves Investors simultaneously expe-rienced massive losses in their U.S and international stock portfolios,which motivated them to pull back on new investments U.S corpora-tions experienced fewer sales from domestic and international mar-kets, which forced them to lay off people and shutter some overseasoperations Job losses, investment declines, and decreasing housingprices led consumers to spend less Their decreased consumption im-pacted countries that were dependent on exporting goods to the U.S.The virtuous cycle of increasing wealth driving increasing consump-tion and growth was thrown into reverse, and much of the economicvalue creation of the previous decade was undone

The second trend is the increasing use of quantitative models tomake trades and measure risk As computing power became greaterand greater, the number of investment decisions that were made algo-rithmically kept growing “In our business, there are no patents tospeak of, so everything is about staying in front of the curve and cre-ativity We keep creating new areas of high-profit margin When theyget created, they become commoditized, and then you have to find thenext area of opportunity,” explains Alan Schwartz, executive chairman

of Guggenheim Partners and former CEO of Bear Stearns The

prob-* The Glass-Steagall Act of 1933 was a bill regulating the banking industry In 1999, a key provision that prohibited banks whose primary focus was an investment business from re- ceiving deposits, was repealed.

lem was that banks’ risk management did not always evolve as quickly

as the products that traders were creating and banks were selling Inmany cases, the banks’ policy makers did not have a deep understand-ing of the risk the banks were exposed to and, as a result, they wereblindsided in late 2007 and in 2008, when things started to fall apart

“By 1999 when Glass-Steagall*was repealed, banks were free to sume innovative, derivative products,” wrote Amar Bhidé, a professor

con-at Columbia Business School “CEOs appeared to turn a blind eye toreckless bets—not a bad policy, since they were richly rewarded forshort-term profits.”9Yet that behavior led some banks to a state wherethey became unable to sustain themselves as independent companies

Recently, critics of the industry have argued that investment banks’penchant for risk-taking in the last decade was a function of theirbeing public companies rather than private partnerships They arguethat these firms took on undue risk, knowing that, if things went badly,

it would be the shareholders (not managers) who would be most fected However, the employees of many firms, especially those that nolonger exist independently, owned a large portion of their companies’stock Bear Stearns’s employees held roughly a third of the company’sstock and lost over $5 billion when the business was sold to J.P Mor-gan Similarly, Lehman Brothers’ employees owned about 30 percent ofthe firm’s stock, which became worthless.10

af-I N V E S T M E N T B A N K af-I N G T O D AY

The consolidation in the banking industry that ensued in 2008 allowedsurviving firms to strengthen weaker areas of their businesses throughacquisitions J.P Morgan gained highly regarded prime brokerage, aswell as commodities, equity, and fixed-income trading businesses fromits purchase of Bear Stearns Barclays Bank, which had a relativelysmall investment-banking advisory division in the United States, pur-chased a large portion of Lehman Brothers’ business Bank of America,

which had a somewhat unsuccessful investment-banking division,picked up Merrill Lynch’s investment-banking advisory practice as well

as its extensive network of investment brokers

Although the number and the legal structures of the large ment banks have changed, the functions that these institutions serveremain the same As J.P Morgan CEO Jamie Dimon wrote in hisMarch 2009, letter to shareholders, “The investment banking business,

invest-in many ways, will never be the same Leverage will be lower and tain financial products will likely cease to exist But the fundamentalbusiness will remain the same.” Investment banks still advise compa-nies on financial transactions, manage investments for clients, researchand trade financial products, and invest their own capital Althoughthe opening quotation for this chapter may seem anachronistic, it isstill true Investment banks continue to play a key role in the U.S econ-omy, as they have for over a century, and financially reward those whosucceed in the industry

cer-M O V I N G F O R WA R D

For a period of time, there will be fewer jobs in investment bankingand lower compensation, at least in certain areas Nevertheless, the in-dustry will persist Globally, banking jobs will increase, although less

so in New York “Partially that’s because we are going to drive nesses to other parts of the world and partially it’s because banking is

busi-a much more mbusi-ature business in the U.S thbusi-an it is in the emergingmarkets,” explains Jamie Dimon The biggest change will be in theleverage that firms use in their own investing In 2007, investmentbanks were leveraged 30 to 1, meaning that they were putting to useroughly thirty dollars of debt for every one dollar they had in equity.They did this to increase their returns and profitability That will nolonger be the case, and banks will likely have to comply with a stricterregulatory regime In particular, the conversion of Goldman Sachsand Morgan Stanley into bank holding companies subjects them tomore rigorous restrictions

Banks will place a higher emphasis on risk management, nating some potential profit opportunities Additionally, banks that

elimi-took significant capital injections from the federal government, ticularly Citigroup and Bank of America, may have to bear the brunt ofhigher government scrutiny and regulations Although some of theinvestment strategies and products that were used to produce signifi-cant profits in the past will cease to exist, the disappearance of largecompetitors may afford the industry’s survivors more opportunitiesfor success in the future After a series of losses, many investmentbanks returned to profitability more quickly than expected The issuefacing the banks today is whether they can return to the levels ofmoney making that existed before the recession, without excessiveleverage or posing risks to themselves and the broader financial sys-tem Dimon believes it is possible “If the whole industry has to useless leverage, then the products will simply get re-priced to bring theinstitutions back to a fair return That’s economic theory Whetherthe returns in 2007 [at the peak] were real or not is a different ques-tion At some other firms in the industry, a lot of the ‘profits’ in the

par-2007 timeframe were clearly not real.”

H O W I N V E S T M E N T B A N K I N G W O R K S

F O U R T Y P E S O F B A N K S

Investment banks are a subset of the banking industry and have a cial legal structure to execute their roles in the capital markets Thereare four main types of banks: retail banks, commercial banks, invest-ment banks, and universal banks Retail banks are focused primarily

spe-on collecting deposits from individuals and organizatispe-ons and makingloans Commercial banks are focused on serving the banking needs ofcorporations For example, a commercial bank may offer a working-capital loan to fund the operation of a business After World War II, 60percent of lending in the United States was done by retail and com-mercial banks By 2008, that was down to 20 percent In large part, thisshift was a result of the growth of money-market funds, bond funds,and securitization—all financial vehicles related to the investment-banking industry.11Universal banks engage in retail, commercial, andinvestment-banking practices

T H E R O L E S O F I N V E S T M E N T B A N K S

Investment banks play critical roles in nearly every aspect of theeconomy They are both the brokers and bankrollers of the businessworld and, recently, of the finances of everyday Americans Theyare hired by companies and investors to buy and sell businesses,assets, stocks, and debts, as well as to simultaneously arrange thefinancing of these transactions Imagine trying to sell a house with

no real estate broker to advise you on price or attract buyers, and

no financial institution to provide a potential buyer with a mortgage.Investment banks act as brokers for corporations: they help them tosell corporate divisions, to buy other companies, and to raisemoney by issuing equity (stock) or debt (bonds) They help localgovernments and nonprofits, such as universities and hospitals,borrow money for new infrastructure projects These organizationsgenerally use investment banks to raise money by issuing bonds,which the organizations pay back over time with revenues fromprofits or fundraising

In the past few decades, investment banks have also played largerroles in the finances of millions of U.S citizens Student loans, homemortgages, and car loans, although issued by an array of financial in-stitutions, were packaged by investment banks and sold off in pieces toinvestors This process is known as securitization and occurs when anasset or group of assets is made into a security that can be traded onthe market For example, in the case of home loans, this involves pack-aging multiple mortgages together and then selling securities com-prised of these loans to investors The investors take the risk that thedebtors will make their loan payments; in return, the investors receivethe interest on those loans

Investment banks also serve key functions for hedge funds Thisrole is referred to as prime brokerage The banks are involved witheverything from raising investor capital to clearing trades and findingsources of debt for those that use leverage Many hedge funds depend

on loans to leverage their investments and achieve large, above-marketreturns, and investment banks are often their conduits for these loans

I N V E S T M E N T B A N K I N G S E RV I C E S

Investment banks are comprised of several businesses related tothe capital markets Although the organizations are referred to as

“investment banks,” the investment-banking division is only one part

of the firms’ overall operations This division serves corporations,governments, and private equity firms in major financial transac-tions: buying or selling companies, going public, and offering debt

on the public market The investment-banking division is a relativelystable operation, in that it is not financially leveraged or exposed topotential losses in the way that trading divisions are It is a servicebusiness and, as long as deals are done, the bank is paid Of course,when the economy goes into a recession, deal flow (the quantity offinancial transactions being completed) drops, as does the number ofpotential clients

Investment Banking Groups

The investment-banking division is segmented both by industry andproduct Bankers at all levels are assigned to specific groups, to fosterthe development of expertise in that area Industry groups includetechnology, media and telecom; defense and aerospace; healthcare;consumer products and retail; financial institutions; financial sponsors(private equity firms and other investors); and government Productgroups are based on the types of financial transactions that a bankwould be hired to conduct: mergers and acquisitions, equity-capitalmarkets (transactions related to stock), debt-capital markets, lever-aged finance, credit risk management, and others For any particulardeal, people from the relevant industry and product groups areteamed up At a bank, the culture within different groups varies, based

on the people who are running things and the types of clients beingserved

Attracting Clients

Investment banks attract clients by means of personal networks andeffective presentations That means “being in the flow of relevant

information and being positioned to capitalize on and enhance existingindividual relationships,” says Chuck McMullan, an executive director

at UBS Investment Bank He explains, “Rarely does a banker identify aunique opportunity from afar, schedule a meeting with a new client,and generate a deal; although it can happen, you can’t build a careerthat way.”

In many instances, a company interested in investment-bankingadvisory services will host a “bake-off,” at which it will invite a fewbanks to give presentations on why they are best suited for the pur-pose As Chuck McMullan implies, being invited requires “being inthe know” about possible deals, maintaining personal relationships inthe industry, and having a strong reputation Often, multiple firmswill present to the potential client on the same day The banks will as-semble pitch books for these meetings, highlighting their previous ex-periences and detailing why they are well equipped to advise on aspecific transaction This competitive process can be pretty intense Alot of detective work goes into these bake-offs, with bankers trying tofigure out who their competitors are and using that knowledge to po-sition themselves

Banks are, to some extent, at the mercy of their clients’ whims;

on rare occasions that can mean an unusual selection process “Wewere trying to get in as the sell-side banker for a large video-gamecompany, going up against a couple of heavy weights with lots of ex-perience in the sector,” said an analyst at a boutique investment bank(the industry term for small investment banks focused on particularindustries or regions of the country) “On one of the calls prior to thebake-off, the company’s CEO told my firm’s managing director thatthe company once made a decision on an advisor by letting twobanks play the video game to win the business He hinted that itmight just come down to that again Later that afternoon, we wentout and bought an Xbox for the firm, and, for the next week, I spent

an hour each day teaching the managing director how to play thegame In the end, we got to work on the deal without it going to that,but, still, it just goes to show that, what the client wants, the clientusually gets.”

The Buy Side and the Sell Side

Bankers can be hired by a client on the “buy side” or “sell side” of atransaction A sell-side banker represents a company or private equityfirm that is selling a business, and a buy-side banker works with a partythat is making an acquisition The need to be responsive to the client isthe same in both roles, but the process is different in each On the sellside, the focus is on valuing the company, positioning it for a salethrough marketing materials and corporate memoranda (the formaldocuments sent to potential buyers), and then conducting the negoti-ated sale process The sell-side bankers, in conjunction with the seller,put together documents that potential buyers will want to view in con-ducting their own due-diligence processes The corporate memorandacontain information about the company’s market and products, cus-tomer lists, competitors, contracts, growth prospects, and financialstatements and projections They are often lengthy (fifty to one hun-dred pages) and can be quite time consuming to assemble These doc-uments are placed in a digital data room, to which access is given topotential buyers During the sales process, potential buyers often re-quest information not contained in the data room, and it is the invest-ment bank’s responsibility to prepare such materials For instance, abuyer interested in synergies with its own selling efforts might ask forhistorical sales by product or customer, and the bankers would have towork with the seller to compile that information

On the buy side, the bank’s role involves generating a list of tial acquisitions or analyzing a specific target business and determiningthe ideal financial structure for the purchase (for example, whether thebuyer should pay in cash or use some debt) The bank also does ananalysis of the value of the target business to help its client make an ap-propriate offer The value of an offer price, as well as its timing and po-sitioning, are critically important to the success of a deal If a buyerbids too high, it can look foolish for overpaying; if it bids too low, itmay lose the deal In leveraged-finance deals, which generally involve aprivate equity firm, the buy-side investment bank may play a role inproviding temporary capital commitments (such as acquisition facili-ties and bridge loans) for the debt portion of the acquisition These

poten-* When a business decides to purchase a number of companies and combine them into one entity, it is called a “roll up.”

commitments are later syndicated (sold off to others) in the loan or high-yield capital markets

leveraged-Analysis and Models

Investment banking analysts and associates build the financial modelsthat, among other things, may be designed to determine the proceedsfrom a sale, predict future operations, value companies, and assesstransaction scenarios Depending on the output required, such modelscan be incredibly complex “When I was an analyst, we had a clientwho was interested in rolling up* assisted living/nursing homes,” saidArash Farin about his time as an analyst at Goldman Sachs “The clienthad an ambitious plan and needed hundreds of millions of dollars tomake all these acquisitions The client was putting up the equity, andour firm was potentially going to offer the debt The model was de-signed to project future cash flows of the entire portfolio, based on asmany details about each facility as possible, and there were dozens ofproperties we had to analyze Putting the numbers together involved

65 MB of data—five spreadsheets linked together The deal team cluded a managing director, a vice-president, an associate, and myself.”Arash Farin had inherited an early version of the nursing homemodel from someone who had been involved with the deal previously.When he could not make sense of how it was constructed, he had to

in-“reverse engineer” the entire financial model to ensure that there were

no errors, a process that consumed an entire weekend

is representing a seller, there is generally a sliding scale for the fees

For example, if a bank is trying to sell a company for $100 million, itmight receive 2 percent of the sale price for the first $75 million and

4 percent of every dollar paid above that level On larger deals, thepercentage would likely be lower Some firms have minimum fees,and some firms are on retainer, meaning that they are continuallypaid to look at potential transactions for a corporation or private eq-uity firm Even in a retainer situation, the bank has an incentive tocomplete a deal because it receives a “success fee” when it works on adeal that actually closes Large transactions can be tremendously lu-crative for the bank For instance, one $20 billion deal can bring inmore than $200 million in fees

S A L E S A N D T R A D I N G S E RV I C E S

Like the investment-banking division, the sales and trading (S&T)division makes money when transactions occur Yet rather than mak-ing tens of millions of dollars in fees from a single deal, the sales andtrading division generates money from commission fees charged forthe execution of transactions for clients (as well as from proprietarytrading profits) Sales and trading clients are generally entities thatpurchase large amounts of public securities; they may be mutualfunds, hedge funds, insurance companies, or corporations The divi-sion engages in primary transactions (for example, new security is-suances, such as IPOs or bond sales) and secondary transactions(trading securities on the public market) A primary or secondarytrade is either proprietary (when the bank buys a security itself) or aflow trade (when the bank orchestrates a trade between two outsideparties)

Primary transactions (debt and equity issuances) are relativelycomplex processes that involve multiple divisions within a firm Forexample, if a university decides to issue bonds (debt) to build a newbuilding, it will retain the services of an investment bank, which willput together a preliminary statement about the issuance The bank willassemble a working group, with bond experts from the sales and trad-ing side of the firm and the university’s financial advisor The groupwill create a sales-point memo and provide highlights of it to the sales

and syndicate desk, which is responsible for issuing the securities tothe market The memo will include such information as what is secur-ing the bond (whether there is a revenue source that will be used to payback the debt), what is pledged as collateral (such as other securities orreal estate), what the purpose of the debt is, and the credit rating of theuniversity The underwriting desk will enter information about the is-suance into a trading system, to be able to disseminate informationand take orders electronically The sales department is then responsiblefor selling the debt to the market.

On debt and equity issuances, the bank will buy the security at aslightly lower price than it believes it can sell it for This “spread” pro-vides the bank with a profit cushion in case it is not able to sell all thesecurity on the market Secondary transactions involve trading securi-ties on the market Trades for clients, called market making, includebuying a stock for a pension fund and orchestrating the sale of debt by

a mutual fund to a hedge fund

The sales and trading division is divided by investment areas: fixedincome, currency, commodities (together referred to as FICC), equi-ties, and derivatives Within each of those areas are more specializedgroups, such as municipal government debt (municipal bonds arecalled “munis”) and European equities

Investment banks use their access to inexpensive capital (borrowedmoney with low interest rates) and large balance sheets to engage inbillions of dollars of transactions Their ability to access capital at lowrates is, in part, a function of the significant trading and lending thatoccurs between the firms This allows trading to be incredibly prof-itable, but it also makes the banks heavily dependent on one another’sability to meet their obligations This became apparent when the col-lapse of Lehman Brothers nearly pulled down the investment-bankingsystem

Profit and Loss in Sales and Trading

The proprietary trading groups can be important profit centers forbanks The strategies they utilize differ and are highly confidential, butthe objective is to use money borrowed cheaply by the firm and maketrades that garner returns higher than the cost of the borrowed money

* As long as the pricing of a debt instrument remains stable, if the interest the debt produces exceeds the cost of borrowing for the investor, a positive “carry” is generated.

In many ways, these groups operate like hedge funds and employ many

of the strategies to be discussed in Chapter 4 For example, a proprietarytrading group might engage in a multi-layered “carry trade,” in which

it shorts yen and lends money in dollars Since the interest rate thebank pays on the borrowed yen is much lower than interest rates it col-lects on the loan in the United States, the trader is able to profit fromthe difference (assuming the currency exchange rate does not movesignificantly).* These groups also employ algorithmic programs tocapture small profit opportunities that arise as a result of pricing dis-crepancies across global markets

Sales and trading divisions utilize a great deal of advanced puter technology to execute many of their trading functions Unlikeinvestment-banking divisions, which rely largely on Excel and Power-Point programs that have been around for decades, S&T divisions in-vest millions of dollars in sophisticated computer and electronictrading systems These tools are used to effectively route trades orders(to buy and sell at optimal prices), identify and capitalize on inefficien-cies in the market, and avoid disclosure of large buy or sell orders Se-crecy in large trades is important to prevent people from profitingthrough pre-buying or selling just before a large order For instance, ifFidelity wants to buy a million shares of stock in a company, it doesnot want prior knowledge of its large order to increase the stock price

com-as it is making the purchcom-ase

Sales people and traders not only sell and trade traditional assets,they also create securities called structured financial products Clients’financial needs often cannot be met by traditional securities, so theyturn to investment banks to help them structure new instruments Forexample, airlines’ operating expenses are highly influenced by the cost

of oil, which fuels airplanes In order to mitigate massive fluctuations

in operating budgets, the airlines work with investment banks to tradeoil derivatives A derivative is a financial contract based on the value ofsomething else, such as oil The oil derivatives that airlines buy

through banks permit the airlines to buy oil at prearranged prices.Owning a derivative can cost an airline money if oil prices drop, but italso protects it from being in a dire position if oil prices skyrocket.Similarly, companies that generate significant portions of their revenueabroad can hedge their exposure to fluctuations in foreign currencywith derivatives, in order to create more operational stability.

Within sales and trading there are two types of transactions: cashand synthetic Cash transactions involve a security available on thepublic market, in which one party pays another for that asset Syn-thetic transactions involve customized financial products and con-tracts, like the derivatives discussed above The cash trading business ismostly commoditized across the banks—meaning that there is very lit-tle difference in the service or product offered—so the bigger profitopportunities exist in synthetic trading

It was, in part, because of synthetic transactions that the sales andtrading divisions across Wall Street were making so much money in theearly 2000s However, in doing so they were taking huge risks In addi-tion to creating structured products, such as oil derivatives for the air-lines, the banks were also packaging various forms of debt—consumermortgages and car loans, commercial real estate loans as well as high-yield leveraged buyout loans—and selling them to investors Segments

of the consumer loan universe, namely mortgage-backed securities(MBSs), received high ratings from the credit agencies and, conse-quently, could be sold off to an array of investors who were looking forfinancial products with little perceived risk and solid returns In order tocreate these packaged securities, the banks had to purchase the underly-ing debt, so at all times they owned billions of dollars of these loans.The investment banks recognized that these products entailed riskand wanted to have a hedge on their exposure To protect themselves,some banks sought insurance to protect against losses from defaults onthe loans That insurance was called “credit default swaps,” and one ofthe largest providers was AIG The banks purchased these instruments,which paid out only if there was a default on the debt being insured AIGpresumably assumed that, although some loans might go into default,there was no reason that a huge portion of loans would simultaneously

do so Yet, in 2008, the massive deterioration in real estate–related

securi-ties and the market dislocation caused by Lehman’s bankruptcy left AIGowing tens of billions of dollars to credit-default-swap customers,namely large investment banks AIG had insufficient cash to pay theseclaims and, without massive bailouts from the U.S government, the firmwould have been forced into bankruptcy Had that happened, the invest-ment banks that held credit default swaps would have experienced blows

to their solvency The bailout of AIG was, in part, a stability measure forthe investment banking business, which had hedged its exposure againstthe potentially risky loans it made Despite the credit default swaps, thedeterioration in debt-related financial products still dramatically im-paired the stability of the banks Citigroup and Merrill Lynch, two bankswith particularly large portfolios of collateralized debt obligations, expe-rienced some of the most severe losses

Among the ensuing wreckage on Wall Street was the elimination ofthousands of sales and trading jobs In some cases, banks disbandedentire trading groups (such as mortgage-backed securities) fromwhich the banks no longer believed they could profit However, salesand trading, on the whole, remains a key aspect of the investment-banking business

A S S E T- M A N A G E M E N T S E RV I C E S

The responsibilities of the asset-management division usually includeoperating some alternative asset groups (internal private equity andhedge funds), managing investments for others, and offering services forinvestment firms, such as hedge funds Some banks also own parts ofmutual fund companies and have ownership stakes in other investment-related businesses

The primary function of the asset-management (or management) division is advising individuals and institutionalclients on how to invest their money Some firms have retail-typeinvestment-management services, such as Wells Fargo Advisors andBank of America Investment Services, which do not require largeaccount minimums Other asset-management groups focus on indi-viduals with high net worths These firms tend to provide their clientswith more services and a larger array of investment opportunities