Professor Robert
Shiller: I wanted to talk today about investment banking,
which is a subject of some interest around here.
First, I thought I would–there’s been so much
news; I want to just briefly comment
about what’s going on in the world today with our financial
crisis. Notably, I think that this is
the–it could be the biggest financial crisis since The Great
Depression and as evidence of that,
we’re seeing a lot of talk about what changes should be
made. I think it reminds me of the
very basic fact that we live in a financial world that was
created in the wake of The Great Depression.
So many of our financial institutions were created in the
1930s because that was a time when everything was being shaken
up and it was a time when people were willing to consider
something really different. If you just look back where
various of our institutions–when they were
created–it’s most likely to be in the 1930s.
We are not yet at such a crossroads.
The financial situation is not as bad as it was in the 1930s,
but it’s getting bad and as a result we’re starting to see
proposals for big change. Notably, on Monday,
the Treasury Department, under Secretary Henry Paulson,
announced a proposal for fundamental change in our
financial markets. This proposal,
if implemented, might be the biggest change
since The Great Depression. However, the news is calling it
dead on arrival; it’s unlikely that the Paulson
proposal will be implemented partly because it’s being
proposed by a Republican administration–well,
not just Republican, just an administration that’s
coming to an end and we’re having an election.
This Paulson proposal probably has very little chance of being
implemented as is, but it’s put in to change the
discussion and it’s going to be talked about a lot and I suppose
it will influence what happens. The interesting thing is that
the next President of the United States will likely have a
mandate for big changes. Maybe it’s just as well that
Fabozzi, et al. are slow to do a second edition
of their book because if they got it out this year it would be
a bad year to get it out because everything is changing.
I studied the Paulson proposal carefully, since I’m writing a
New York Times column about it, which will appear Sunday.
Reading the various commentaries about the proposal,
I had the impression that not many of them are very–thinking
very deeply about it. They typically–they like to
talk about the politics of it and this thing,
that it’s dead on arrival or it’s–someone said it’s an
amateurish proposal. All the groups that stand to
win or lose from it are all figuring out what it does to
them and they’re taking the positions out of self-interest.
So, I wanted to write something that was more perspicacious,
if I could manage that. The interesting thing is,
actually everyone calls it the Paulson proposal,
but it was apparently mostly written by a young man who is in
his early thirties. You may not consider that
young, but I think that is young.
He could have taken this course from me ten
years–actually, he didn’t go to Yale.
I looked it up; he went to American University,
both undergraduate and–his name is David
Nason–undergraduate and then he got a law degree at American
University. Then he just went to work for
the government. As far as I know,
he doesn’t publish; he’s not in the newspapers,
but he’s gotten the ear of the Treasury Secretary.
They spent many weekends together figuring out what
should be done about the system and they wrote up a proposal.
I like many aspects of it; actually, it’s an interesting
proposal. It’s not so much what’s in the
proposal as it is that this is the time for reconsideration.
One interesting thing that they proposed is that we should have
what they call “objectives based regulation.” We have–this is David Nason
and Henry Paulson, although it’s not signed by
them, it’s signed by The Treasury.
So, The Treasury–it’s called a blueprint,
a blueprint for reform of our financial regulation. It’s built around what they
call “objectives based regulation.”
That means that the different regulators should each have
their own objective, so they have a three-part
proposal. The market stability regulator,
which would make sure that the markets don’t freeze up on
us–we don’t have a systemic crisis.
There would be a prudential financial regulator and then,
three, there would be a business conduct regulator,
so that’s the main part of the proposal.
What they’re doing is emphasizing the different
objectives of regulators. The market stability is going
to be the Fed, but it’s not just banking.
They want it to be–the Fed’s role would be broadened so that
it’s not just a banking regulator, it’s the whole
financial system. It’s supposed to be maintaining
the stability of the system. Then the prudential financial
regulator is supposed to regulate–it’s supposed to aim
at protecting the U.S. interest in various
institutions that are guaranteed by the government,
such as banks that are federally-insured or enterprises
that have government guarantees or apparent government
guarantees, like Fannie Mae and Freddie Mac.
Then the business conduct regulator is supposed to
regulate–what I saw is it would be aimed at–consumer
protection; that it would make sure that
businesses are protecting individuals.
I find this interesting because it calls to mind some of the
problems we had with the subprime crisis.
One very important problem was, in the U.S.
we have regulation divided up in crazy archaic ways.
Different agencies were formed at different times and they have
specific missions. For example,
we have the Office of the Comptroller of the Currency.
The OCC was founded in 1863 to supervise national banks but it
only supervises national banks. Well, why not state chartered
banks or why not credit unions or other things?
Well, it’s just an accident of history.
So, what these people are proposing is that we merge
various agencies so that–define new agencies of the government
that are separated by these different objectives;
so, an objective defines an agency–a regulatory agency. What they want to do is merge
the OCC and the OTS merger; that’s one of the proposals.
I wonder why they don’t carry it further, but that’s the thing
they emphasized. The OCC is Office of the
Comptroller of the Currency–regulates national
banks. The OTS is the Office of Thrift
Supervision; it regulates savings banks.
So, we put the two together–that sounds sensible,
I guess. Why are they separate?
Various other things that they talked about had that form.
They want to merge the Securities and Exchange
Commission and the Commodity Futures Trading Commission.
The Securities and Exchange Commission is the principal
government regulator for securities.
They make sure that everything is on the level and working
right. They help prevent fraud,
misrepresentation, manipulation of information in
stocks and bonds. The CFTC is the Commodity
Futures Trading Commission and it regulates our futures
markets. There has been,
over the years, a lot of turf battles between
the SEC and the CFTC because it’s sometimes unclear whether
something is a security or a futures.
For example, when they started trading stock
index futures, both these agencies thought it
was in their turf because it involved both stock indexes and
futures. Anyway, Paulson is proposing
merging these. That makes sense and it seems
like getting rid of some of this division of regulatory agencies
is very beneficial. The division is what hampered
regulators from dealing with the financial subprime crisis.
People knew that a lot of bad loans were being made or loans
were being made to people who shouldn’t be getting them.
Low-income people were being given adjustable rate mortgages
with very low starter rates, called “teaser rates,” that
would be raised in the future. They were given them with–in
such a way that after the rates were raised, they likely
couldn’t afford to pay the mortgage anymore or they’d be
under great stress in trying to do so.
So, a family that bought a house–a low-income family buys
a house they can barely afford it, then the rates go up on
them. The parents would have to take
out second jobs to try to–they’re just going to go
bankrupt when that happens. It was, in some cases,
unethical and it was plainly a problem and yet the regulatory
agencies in the U.S. weren’t stopping it.
Another reason why the regulatory agencies weren’t
stopping these problems was because they often saw their
mission in different terms. When I gave a talk at the OCC
in 2005, I was asking them about, why aren’t you policing
these mortgages? Their first answer was,
well you have to remember we were set up in Abe Lincoln’s day
to manage the national banks–that’s our mission.
I may be overstating their answer, but I got that flavor
from them. You want us to go out and
protect consumers, well of course that’s a nice
mission, but that’s not our mandate. I think that what Paulson and
Nason want to do is to create a separate business conduct agency
that is aimed at consumer protection.
So, it would be working parallel with these other
agencies to–but their job would be to represent the consumer and
that sounds like a good idea to me.
The thing I stressed in my column was the market stability
regulator, which is the Fed. What they want to do is expand
the actions of the Fed, so that they’re not–you can
describe the Federal Reserve or any central bank,
traditionally, as a banker’s bank.
Remember, I told you the story of how the first–the Bank of
England was the first central bank and it made banks keep
deposits at the Bank of England. In other words,
the banks were like customers of the Bank of England;
they had to keep deposits there and the Bank of England watched
them to make sure that they were behaving responsibly and had
authority over them because it had market power.
Well, the Fed is like that now, but what Paulson and Nason
wanted to do is make it more than a banker’s bank.
They want it to be a bank for the whole financial system.
That’s what’s already happening. In fact, it’s just happening
rapidly as we speak. I mean, in this last month,
things have changed. The Fed has never given loans
to anyone other then a depository institution that is a
bank until last month, except they did so in the
Depression. There was this long gap in the
1930s; the Fed was making loans to
private companies that were not banks and then they stopped
doing that, until last month. They created the–I mentioned
it last time, the Term Securities Lending
Facility and the Primary Dealers Credit Facility,
which are lending outside the banking system.
What Paulson wants to do is make that official that the Fed
is no longer just a central bank;
it’s a market stability regulator.
This is going to be very controversial,
but I think it’s a good thing to raise.
In my opinion, this is the trend anyway and I
think we’re going that way. The problem is that in a modern
financial economy, we have so much instability,
which is already built into the system, that we rely on
something like a central bank to do things that help stabilize
markets. I think that we’re probably
going that way anyway and I think that in the next
presidential administration we’ll see an expansion of the
role of the Fed. I wish the Fed had behaved
better in the recent crisis in the sense–they didn’t seem to
recognize the bubbles that we had in the stock market in the
’90s and the housing in the 2000s.
If they are our market stability regulator,
you’d hope that they could do a better job.
But, they’re what we have and I think that we should probably
give them the authority to do that job and I think that’s what
we need to do. I was generally positive about
their Treasury proposal. Another thing that they want to
do, which has been talked about for some time.
Yes? Student: [Inaudible]
Professor Robert Shiller: Yeah.
He asked, why do the news media think that the crisis is already
over? Secondly, why do they think we
can prevent–that’s paraphrasing.
I don’t know if the news media are concluding anything,
but you do see–we have seen—over recent years,
we’ve seen a lot of suggestions that the turning point is just
around the corner and the news media report that.
I think there’s a bias towards optimism among business
economists or among business people in general.
It’s not considered good form to say, I think we’re about to
have a crisis of confidence and the whole house of cards is
going to collapse. It’s also not–it’s generally
not in a business person’s interest to suggest that,
so we’re all instinctively trying to promote each other’s
confidence and that’s what business people do.
They carry it a little further than that.
I was asked to be on Kudlow and Cramer–Kudlow and Company
show–I guess it was two nights ago.
I turned them down, but they wanted to put me on
opposite the CEO of Coldwell Banker, who is claiming that the
crisis is just about to end. I did a little research,
thinking I still might go on the show.
I looked up CEO of Coldwell Banker, but I found that there
was another CEO–this is a real estate broker’s firm.
There was another CEO a year ago who was on TV–just exactly
a year ago–saying, I think this is the best time
ever–the best time in at least ten years to buy a house.
He said, the inventory is high; the market is bottoming out and
so on. He was spectacularly wrong,
but I notice he’s also no longer CEO;
so, these things happen. There is a general bias.
On the other hand, I have to respect these people
that usually financial crises end okay.
There are repeated scares and usually it’s all right.
We had a big scare in 1998; it started with the Asian
financial crisis and then it spread to Russia and there was
this terrible collapse in Russia in 1998,
when the government couldn’t pay its debts.
Then that spread to the U.S. and people were very fearful,
but the Fed, under Alan Greenspan,
was very quick to respond and the whole thing didn’t turn out
to be anything so bad. The Fed again did like what
it’s doing now; it rescued this company called
Long Term Capital Management. Your question about whether we
can prevent this kind of thing in the future is a deep question
and I think that the problem is that our financial markets are
inherently somewhat unstable. When we start thinking up
really important new ways of doing financial business they
start to grow and they get huge. They get bigger and bigger
before you know it and it’s just amazing how things can suddenly
grow and then nobody understands them;
so there’s a vulnerability. I was just–got the latest
number–do you know how much credit default swaps there are
outstanding? According to the Bank for
International Settlements, there are now fifty-two
trillion dollars worth of credit default swaps outstanding;
fifty-two trillion dollars with the GDP of the United States is
fourteen trillion. How can there be fifty-two
trillion dollars of–these things only came in in the last
ten years or so. I called an economist at the
BIS and said, can you please explain it to
me? Where is this fifty-two
trillion coming from? I got a note from him and I’m
still trying to figure it all out.
That’s what happens; the system performs very well
and then it becomes vulnerable. Nobody understands all of it,
so that’s the problem. The other side of it,
though, is there was a recent study that looked at financial
crises and compared countries that have had financial crises
with countries that haven’t. The conclusion was that
countries that have experienced financial crises are generally
more successful, on average, over the long haul,
than countries that haven’t. In that sense,
a financial crisis is a sign just that you’re moving with the
times and you’re making a lot of money.
Then things suddenly blow up on you, but you’ll recover and
you’ll figure something out and then you’ll move from there.
I don’t know that Paulson’s proposal–I kind of like them,
but I think that they’re not enough;
that’s why I’m writing a book about this.
I think there’s a lot more to be done.
Even if you did everything that I would do, we would still have
a vulnerability to financial crises.
Part of the reason why I’m endorsing this market stability
regulator is that I think that there’s no way that we can just
guarantee–there’s no way we can set up a system that is both
very effective in allocating resources and that is also very
stable. Just like when we went to the
moon–when we sent people up into space–one of those space
shuttles blew up. Well, that’s what happens,
but most of them made it all right.
So, that’s the way it is in finance as well.
Anyway, I’m here to talk today about investment banking,
which of course is relevant to–this is all part of this
general thing. Let me–I said earlier that
investment banking seems to be a great interest of students at
Yale; that’s because they get some
really great jobs there. It’s a–investment banking is a
very important economic institution and it’s
fundamental–what they do is fundamental to what happens in
our economy. So, as a result,
people who work for them have a chance for a great economic
success. I’m not saying you want a job
at an investment bank because it’s also demanding and
difficult. I’ve talked to some of our
students who have taken jobs at investment banks and sometimes I
think they’re probably too demanding.
As a young person, you should be enjoying your
youth and not getting dragged in to some huge investment bank.
There are some terrible stories–young people who
took–who left college five, ten years ago and they got a
job at Bear Stearns and Bear Stearns demand–I’m just making
this story up, but it must be something like
this for somebody–demanded eighty-hour, hundred-hour week
devotion to the job, but they kept paying in Bear
Stearns stock. The student was making millions
every year. Meanwhile, his youth was going
away and now this imaginary student is now thirty-three
years old, never had time to marry or start a normal life.
Then, the whole thing blows up and all the Bear Stearns stock
is worth just about nothing; so, that’s the kind of mistake
you don’t want to make. I find the industry very
interesting. You have to form some kind of
balance in your life and not let anyone demand a hundred hours a
week of your time. If they do, you should sell the
stock they give as soon as you can and diversify.
I also like investment banking because I created one.
We have–my colleagues and I founded an investment bank
called Macro Markets and I’m not actually running it,
I’m co-found–it’s named after a book I wrote called Marco
Markets. We’re not a very big,
important bank yet, but it makes me interested in
the whole field. We have only hired one Yale
student so far, we’re too tiny to–so we’re not
hiring, in case you wonder. It was a student in this class
that we hired, but again, that’s all history. Anyway, what is investment
banking, which is the subject of this?
Investment banking means the underwriting of securities. That is, arranging for the
issuance by corporations of stocks and bonds.
The term bank is misleading because we often use it.
A depository institution is an institution that accepts
deposits and makes loans or invests the money from the
deposits. Do you know what I mean by a
deposit? If you go to a savings bank,
or a savings and loan, or a commercial bank and you
say, I want to open up a checking account–that’s a
deposit; or, I want to open up a saving
account–that’s a deposit. The thing about a deposit is
you deposit your money as an individual and there are
millions of people that all deposit in a depository
institution. Then, later on,
whenever you want, you can take your money out.
Meanwhile, they invest the deposits some way or another at
a higher interest rate than they pay on the deposits and they
make the difference and that’s how they make a profit.
I often use the word bank to refer–and so does everyone–to
a depository institution. If you look at what the law
says, they tend to use the word depository institution.
An investment bank, if it’s doing a pure investment
banking business is not a depository institution.
If you go into an investment bank and say,
I want to open up a deposit, they’ll say,
you should go next door to the credit union or something–we
don’t do that. So, the word bank is somewhat
misleading. On the other hand,
historically, most institutions do both.
If you go around the world, most banks–most depository
institutions–are also involved in investment banking.
Let me just write over here–investment banking does
underwriting of securities. What does that mean?
That means they arrange for the issuance by other institutions
of securities. For example,
if Ford Motor Company wants to issue corporate bonds or they
want to issue new shares, they would go to an investment
bank and the investment bank would say, okay we can
underwrite for you, but we’ll do it for you.
A pure investment bank is not a depository institution and it’s
also–a pure investment bank is not a broker-dealer either.
They’re not trading in securities, although they would
deal in securities as a part of the underwriting process.
But, they’re not–you wouldn’t go to a pure investment bank
either and say, I want to buy a hundred shares
of Ford Motor Company, where is your stockbroker?
They wouldn’t be dealing with that.
They wouldn’t–they deal–their customers are companies and they
wouldn’t do that either. But in many cases firms do a
mixture of different activities, one of which is investment
banking. There’s a peculiar story that
refers particularly to America–the United States–and
that is the Glass-Steagall Act of 1933.
Again, you see, everything happened in the
’30s. The stock market crash in 1929
caused tremendous chaos in the financial markets.
Carter Glass was a Senator from Virginia and he and,
I think it’s Henry, Steagall put together a bill
which passed Congress and was signed by President Roosevelt
that said that we want to make a law saying that investment banks
cannot be combined with commercial banks or insurance.
Investment banking had to be a separate firm.
This is what they said in 1933. You could not be both a
depository institution and an investment bank.
So, they said, after this Act every bank has
to choose one or the other. Do you want to be an investment
bank or a commercial bank? For example,
then JP Morgan in the United States was founded by a man
named James Pierpont Morgan and it was one of the biggest banks
in the U.S. In 1933, it was told,
you got to make a choice; are you an investment bank or a
commercial bank? JP Morgan made a choice and
said, well we’ll go to be a commercial bank,
so they stopped their investment banking business in
1933. They’ve since gotten back into
it, but that’s–but for a long time they became a commercial
bank. What happened?
They had a lot of people at JP Morgan who were doing investment
banking and they were upset because JP Morgan was shutting
them down. There was a Mr.
Stanley–I forget his first name now–who was–I mention him
because he was a Yale graduate. He got the guys together from
JP Morgan who did investment banking and JP Morgan was dead
already, but his son,
the young Morgan, and he created Morgan Stanley.
I have the suspicion that Mr. Stanley put the son of JP
Morgan on just for the prestige of the name–it sounds a lot
better, Morgan Stanley. This became an investment bank
and now JP Morgan and Morgan Stanley, over seventy-five years
later, are competitors. That is the important history
of Glass-Steagall. The problem is that,
as the years went on, in the U.S.
we had a division between investment banking and
commercial banking, but in Europe and other places
in the world, banks were under no such
restriction. So, there was a lot of
complaints that our laws in the U.S.
were handicapping the U.S. banks.
Finally, Glass-Steagall was repealed and it didn’t happen
until 1999; so we have the
Gramm-Leach-Bliley Act of 1999, which repealed Glass-Steagall.
That led then to a whole wave of mergers of investment banks.
JP Morgan and Morgan Stanley could presumably have merged but
they didn’t; they’ve become too much of
competitors and they just developed their own–they just
internally adopted more broad definition of their business.
There are lots of mergers that we can talk about that came
either–sometimes they occurred just before 1999. For example,
Travelers–The new Gramm-Leach-Bliley Act also
allowed insurance companies to merge with commercial banks.
So, Traveler’s Insurance and Citigroup merged in 1998.
I know that’s before the bill, but that was as the bill was
just about to happen. Then JP Morgan and Chase merged
in 2000; and then UBS and Paine Webber
merged in 2000; and Credit Suisse,
a Swiss bank, and Donaldson,
Lufkin, & Jenrette–Donaldson was the
Dean of our business school here at SOM–that merger occurred in
2000. Those are some examples.
So, now we’re seeing a movement back toward–so that a bank has
an investment banking business within it, but it’s not just an
investment bank. It’s sometimes hard to define
what something is. There’s been a lot of news just
in the last year or even more recently, like yesterday or this
morning’s paper about investment banks because under the current
financial crisis they are buckling;
a lot of them are in trouble and that’s why it’s big news.
I’ll give you some examples. I mentioned Bear Stearns; Bear Stearns was founded in
1923 by Joseph Bear and Robert Stearns.
I tried to find something out about them and they don’t seem
to be very well-known. They’re not on the Web–there’s
no Bear Stearns–there’s no Joseph Bear admirer club on the
Web, but whatever they set up was really big for a while.
From 1923 to 2008, when it went bust–so it lasted
eighty-five years–so, it has investment banking
business, but it also has private equity
business and private banking. It started to get in trouble
during the current–in fact, it was maybe the first U.S.
investment bank to get in trouble in the current financial
crisis because it was in June 2007–they had some of their
funds collapse. They had funds that were
investing in subprime mortgages and this is a sign there’s
something wrong. The names of these funds were
the Bear Stearns High-Grade Structured Credit Fund.
Notice they say “high-grade.” You know what high-grade is
supposed to mean in finance? That it’s not going to fail on
you. They had another one called the
Bear Stearns High-Grade Structured Credit Enhanced
Leveraged Fund. Now, that sounds a little bit
like a contradiction. You should, as a consumer of
financial products, wonder when they put both
high-grade and leveraged in the same name.
High-grade is supposed to mean safe, but leveraged sounds like
the opposite, doesn’t it?
If you–leverage means that they borrowed a lot of money to
buy risky subprime securities. So, if they borrowed 80% of the
money, the securities only have to lose 20% of the value for you
to be wiped out; so that shouldn’t be high-grade
if it’s so leveraged. Anyway, these two funds were
wiped out and Bear Stearns had to give–deal out $3.2 billion
dollars; that was last summer,
but the news kept getting worse and worse.
Apparently, Bear had invested a lot in its securities that were
unstable and so it finally became where rumors started
developing that Bear was–it was really rumors that killed Bear.
The rumors started going that Bear is in trouble,
so you’re going to be–they’re going to be in bankrupt before
long. This is exactly the market
stability problem that Paulson is talking about.
Once the rumors get started, everybody is saying,
don’t do anything with Bear; don’t lend them any money;
just stay away from them. Even young people who are
getting jobs–and they were right to think this–don’t even
take a job with them because you’re going to be on the street
again shortly. It’s that kind of rumor that
killed Bear Stearns. They couldn’t pay their bills
and they were finding it difficult to sell their assets
to come up with money, so the Fed decided to bail them
out. This was a huge Fed bailout.
Well, they didn’t want–the Fed didn’t want to bail out the
stockholders; they didn’t want to just give
money to people who had invested because firms are supposed to be
allowed to fail. So, what the Fed did is it gave
a line of credit to JP Morgan–a non-recourse line of credit–to
buy Bear Stearns. What it amounted to was that
the Fed would take troubled securities that Bear Stearns
couldn’t sell. It would take that as
collateral for a twenty-nine billion dollar loan to JP Morgan
under the condition that JP Morgan would buy Bear Stearns.
It was supposed to be at two dollars a share,
so that left the total value of Bear Stearns at a little over
two hundred million, which is pretty tiny compared
to what they were worth, which was in the tens of
billions a short while ago. The Fed didn’t want a
disorderly collapse. So, it was a twenty-nine
billion dollar loan to JP Morgan;
this is highly controversial these days because the Fed isn’t
normally doing this sort of thing.
Why would it be lending money to JP Morgan to buy another
company? You say, how is that benefiting
the average person in this country?
It does benefit them because if they didn’t do this,
Bear Stearns would have dumped its assets on the market.
It would go down in flames; lots of its debts would
become–lots of people who had accounts with Bear Stearns would
find that their accounts were destroyed. Then what would it do?
It might lead to contagion to other financial institutions.
People would say, well it happened to Bear–who’s
next? There would be this huge
pulling back. So, the Fed decided to bail
them out and that’s what they did.
Now, it’s not clear that it’s over, if you read this morning’s
paper. Lehman Brothers is another
investment bank that is rumored to be in trouble,
so it’s got to do something about these rumors because it
can kill them–just the rumors. No one will want to do anything
with them; it was in this morning’s paper
or yesterday’s news that they have arranged to raise capital
on the markets. It was not entirely clear–that
means, they’re getting people who are willing to invest give
them money–invest in the company.
It’s a sign of confidence in Lehman Brothers that someone
would do that at this critical time.
Another story that came in yesterday–UBS,
I mentioned before, was a Swiss bank but it’s not
Swiss; it’s international now.
It started out as the Union Bank of Switzerland–that’s what
it stands for–Union Bank of Switzerland–which was the
result of a merger between two Swiss banks around 1900.
Then it, as I mentioned, merged with Paine Webber and
it’s become an international corporation;
so they just call themselves UBS.
In this morning’s newspaper, it said that UBS announced that
it has lost–what was it? Does someone remember what the
numbers were? Student:
[Inaudible] Professor Robert
Shiller: They’ve lost nineteen billion? That’s a huge loss–nineteen
billion dollars is a substantial part of their market cap,
but they are also announcing that they are arranging to raise
capital as well. The news that these firms,
which are rumored to be in trouble, are managing to raise
capital buoyed markets yesterday and we had a big upsurge in the
stock market. It was, well,
yesterday was the first day of the second quarter and the
newspapers were reporting that it was the biggest upsurge on
the market on the first day of a new quarter since 1938.
I looked at that with some curiosity because 1938 was not
such a great year after all, it was still in the Depression.
I think the market didn’t do great after that then,
so this doesn’t predict much one way or the other. Anyway, this is where we are
now, it’s an interesting situation.
If you are thinking of taking a job at one of these companies,
you might consider looking at their situation because some of
these companies could follow the way of Bear Stearns at this
point. We have the Fed aggressively
lending and trying to prevent another thing,
but you know the Fed is not in the business of making sure that
your career is a success. They’re in the business of
preventing a systemic failure; so, while the Fed arranged for
an orderly dissolution of Bear Stearns, it didn’t do a whole
lot of good to Bear employees who–we’ll see what happens to
all of them. I don’t know the whole story,
but it’s a tumultuous world out there;
it’s not like you live in an academic environment where Yale
University has been in business for over 300 years and it looks
so stable here. Well, this is a very stable
business; these other businesses are not
so stable. Anyway, I wanted to talk about
the underwriting process and what it’s done.
I think underwriting of securities is–it’s
analogous–the investment banking business is analogous to
the business done by ordinary commercial banks in the sense
that it deals with a moral hazard problem and an asymmetric
information problem. We were talking about what
banks do–commercial banks. Remember, I was telling the
story that the big problem with lending to companies is that
it’s hard to tell whether they are deserving of the loan or
not. So, a commercial banker is
someone who lives in a business community, and keeps abreast of
everything that’s going on, and plays golf with all the
local business people, and has a sense–hears the
gossip–has a sense of who’s responsible,
who will pay back a loan, who’s got a business that’s
really going, who’s got a business that’s
sick and on the way out; that’s what a bank does.
Everyone else who wants to invest doesn’t know this,
but they put their money in the bank and then that’s the idea.
The moral hazard is the moral hazard that the company,
which receives a loan from the bank, would take the money and
run. The asymmetric information
problem is that you, as an investor–if you were to
make loans directly to a company,
you would be suffering at a disadvantage because you know
less than other people. You don’t play golf with these
people and so you would end up taking on the worst loans–loans
that would fail. The same thing applies to
underwriting because–but they do it in a different way.
Instead of certifying–instead of creating deposits at a bank,
they underwrite securities and they are not taking the money;
they’re just an intermediary between you the public and the
issuer of the security, but it’s much the same thing.
It’s the reputation of the bank that makes it possible for firms
to issue securities. The underwriting process is
very important to understand because it’s a process that
allows issuers of securities to take advantage of the reputation
of the underwriters. The issuer of the security may
not be so well-known or not so well-understood,
so the–what happens is, the underwriter–what’s a good
analogy? I was going to say,
it’s like a dating service, but I guess dating services
don’t do this, right?
They don’t testify to the moral character;
they should. Do they do that?
Does anyone do that? They probably can’t, right?
That’s an even bigger moral hazard problem.
When you’re looking for a spouse, you have a huge moral
hazard problem and there’s nobody there to help you as far
as I know. At least in the business world
we have professionals; they’re matchmakers in a sense.
They’re trying to match up a company that’s issuing
securities to buyers of the securities and this is an
important reason for a difference between investment
banking and other aspects of finance.
Investment bankers, compared particularly to
traders, investment bankers like to cultivate an image of sober
responsibility and good citizenship because they thrive
on their reputation. So they–to be successful as an
investment banker, you have to be so impressive
and such high character that companies like Ford and GM will
come to you to represent them in the sale of their securities.
As a result, investment bankers tend to be
well dressed; they tend to be patrician in
their appearances and manner. In contrast,
traders tend to have vulgar accents;
they shout on the phone; they slam the phone down;
they roll up their sleeves; they dribble food on their
shirt. I may be putting them down too
much. I, personally,
think that we have a strength at Yale because of our patrician
image in providing people to work for this field.
Typically, investment bankers go to the symphony on Saturday
night. But beyond that,
if you open up the program at the symphony,
you’ll see their name under platinum sponsor on the program.
That’s the kind of people that go into investment banking and
they do it because they have to manage this underwriting process
well. What is the underwriting
process? Well, what happens is a company
that is thinking of issue–let’s say you’re any company,
a big company–it doesn’t matter.
People don’t trust big companies even if they’ve been
around a hundred years. So, if Ford Motor Company–it’s
been around since when? Something like around 1900.
But people sure don’t trust it anymore because it’s had a
history of trouble. It’s not a question just of
morality or anything; it’s a question of,
are you willing to buy their securities.
So, they would go to an investment banker and say,
we need money; we’d like to raise it by,
say, issuing shares in our company.
Then they would probably contact a number of investment
banks and try to make a deal. Now, there are two kinds of
deals; there’s a “bought deal” and a
“best efforts.” The difference is,
some investment bankers will tell the company,
we will–you want to issue these shares,
fine; sell them to us;
we’ll take it; we’ll give you a price.
Of course, the investment bank doesn’t want to hold these
shares, but the investment bank knows the public well enough to
know which shares it can sell. In a bought deal the investment
bank is taking the risk that they might not be able to sell
the shares at a decent price; they might lose on it.
Also, there’s a different kind of offering, which may be the
best you could get; it’s called a best efforts
offering. Here, the investment banker
will not buy the deal, but it will say that we will
use our best efforts to place this and if you have a minimum
price, we hope we can get above that;
otherwise, the deal will fall through.
The underwriting process is–takes the form of–it’s
actually very much regulated by the Securities and Exchange
Commission. So, the process is formalized.
In order to issue securities, you–we’re talking about public
securities here–you have to register them with the SEC.
So, the SEC then becomes a partner or an adversary in your
effort to issue these securities.
The SEC, the Securities and Exchange Commission–all this
might be changed next year, who knows, but this is the way
it is right now. The law says,
there’s a pre-filing period; you have to file with the SEC
to get your securities effective.
The idea–say Ford Motor Company wants to issue new
shares. They go to the investment bank,
then the investment bank negotiates with the firm–with
Ford–about what kind of securities it wants to issue and
what price is reasonable. During this period,
the SEC says there’s no talk to the public about the shares.
During this period, no talk publicly; the SEC wants to manage the
process so that everything is done appropriately.
At this point, during the pre-filing period,
the investment bank forms a syndicate of other underwriters
and they sign an agreement among underwriters.
Usually, one investment bank is not big enough to handle a big
issue and it wants to get help of other investment banks,
so they form a syndicate of underwriters during the
pre-filing period. There’s a lead underwriter,
which Ford Motor Company approached first,
and the lead underwriter promised to take on the issue,
but the lead underwriter doesn’t want to do it itself.
The reason it doesn’t want to do it just itself is that in
order to sell and issue to a broad public,
you have to make use of a broad network of contacts with the
public and no one investment bank has them all.
So, they form a syndicate–a group of investment banks that
are all participating in the issue of the security–and then
they file and then there’s what’s called a “cooling off
period,” when the security is in
registration. They file with the Securities
and Exchange Commission a prospectus for this–a
preliminary prospectus. This goes to the Securities and
Exchange Commission for approval;
it’s not really approval of the issue, but it’s registration of
the issue. The preliminary prospectus is
called the “red herring.” The “red herring”–it’s lost in
history why they call it that; there’s different theories
about it. A herring, of course,
is a type of fish and the best explanation that I can get for
this name for the preliminary prospectus is that it was
referring to an activity that hunters used to do with dogs.
I don’t know if I should tell you these stories,
but I like to know why they call it a red herring.
If you have hunting dogs, they’re supposed to track down
a fox by their sense of smell. So, one pace you can put your
dogs through is to try to confuse them.
They would take a red herring, which is a very smelly kind of
fish, and they would drag it around over the trail of the
fox; it’s very difficult for dogs to
still smell the fox over that smell.
The word red herring became known as a euphemism for
something trying to distract and confuse and so it was a joke.
I think it was a joke on Wall Street that the prospectus is
really just there to try to confuse you, so they called it
the red herring. The preliminary prospectus is
now often printed with red borders on it to indicate that
it’s the red herring and it’s only preliminary.
Finally, the Fed evaluates the prospectus and makes sure that
it accords with all regulations. It puts it up on its website at
the SEC while it’s in registration.
Again, during the “cooling off” period, firms are allowed to
circulate the preliminary prospectus.
Underwriters are allowed to circulate the preliminary
prospectus with potential buyers,
but they’re not supposed to say anything besides what’s in the
preliminary prospectus. What they’re concerned
about–the SEC is concerned about people overselling
securities and they might point out advantages of it and not the
disadvantages. The idea of a pro–what’s in a
prospectus? A prospectus is a document that
completely tells everything about a security.
The whole idea of the SEC is that we’re not letting anyone
pull the wool over your eyes; that’s why it really shouldn’t
be called a “red herring.” It’s not supposed to deceive
you; it’s supposed to pour out
everything about the security. One thing that’s in a
prospectus–a preliminary or final prospectus–is the company
thinks of everything bad that could ever happen.
If you read prospectuses, they’ll say awful things.
If you read them carefully, they’ll say this company could
lose everything–we could be sued;
we could be going to jail; we might have done all
sorts–maybe I’m exaggerating, but the lawyers put everything
imaginable that could go wrong with this investment in there.
They do it–of course, it’s in kind of fine print,
but it’s all in there so that it’s disclosed.
So later, if someone loses money in the investment and
wants to sue them, then they’ll say,
well look it’s in our prospectus.
The reason that the SEC doesn’t want them to talk about
securities at this point, except to give the prospectus,
is so that they can’t conceal and hide these things.
This is the SEC process; the process says that the
underwriters have to give out the prospectus and that’s all
they can do; they can’t have a separate
brochure. They can’t–your broker can’t
say, well we’re thinking of issuing a security;
we’ve got this prospectus, but I’m going to send you a
brochure instead–that’s easier. The SEC says,
no way, because that brochure will be a sales job and it won’t
have all of this in there. Anyway, then eventually the SEC
approves it and when it’s approved then it’s effective and
then the underwriters can start selling the security.
At that point, they actually say it’s a
best-efforts offering; then they go around and they
try to–they get buyers of the security lined up.
Now, you have to understand that there’s a problem issuing a
new security. Securities that are already out
there and trading–everybody knows about them.
There’s a market for them, but if you’re issuing a new
security, especially if it’s a company that is issuing shares
for the first time–an IPO is an initial public offering.
An IPO is the first time that a company issues shares,
so the company is not known to the public and it’s very hard to
get IPOs started because the company is just not known.
It’s very important that the underwriters are able to get
attention and get the market going for the IPO.
During the “cooling off” period, firms also are allowed
to place, according to the SEC, something called a tombstone;
that is an ad in the newspaper, which will announce the
security. It’s a very dignified ad
because it has to meet with the approval of the Securities and
Exchange Commission, but a tombstone will say,
Ford Motor Company–one million shares offered.
Then it will list all of the underwriting syndicate,
so it will be a list of all the investment banks that
participated in the issue. That’s the basic process that
underwriters go through to issue securities.
Now, part of the thing is–I just want to close
with–basically, I think that investment banks
are very similar to impresarios in what they do.
What I mean by an impresario is someone who manages a singer or
a musician in concerts, but it’s a little different.
An underwriter is managing the career of a security,
just like somebody else would be managing the career of a
singer; they’re very concerned about
their reputation and they’re very concerned about getting
sold out performances all the time.
Now, one thing about IPOs is that they are very hard–to get
a new security for a new company going–because nobody knows this
company. The price movements of an IPO
tend to be very volatile and it’s because of the difficulty
in getting IPOs going; underwriters have peculiar
practices in issuing them. It tends to go like this:
underwriters tend–and there’s been a lot of documentation of
this–to under price IPOs. That is, they sell them for
less then they could get and that means that IPOs tend to be
oversubscribed. This sounds strange–why would
it work this way? You can try this;
call your broker, if you have a broker–does
anyone here have a broker? Maybe somebody does.
Think about this anyway–you could call a broker and inquire
and say, hey I hear about IPOs; I’d like to get in on some.
What do you think the broker will say?
Well, the broker will say, okay let me see what I can do
for you. And he doesn’t call you back.
You wonder, well why does this person not want my business?
Well, the reason is that you haven’t been a good guy;
you haven’t been giving the broker other business.
And you hear stories about IPO’s that did spectacularly
well–it jumped 30% on the first day and you say,
hey I want that. But it becomes sort of a game
that they’re playing. It’s a little bit like trying
to get tickets to some rare concert.
I mean, people will sometimes–or there’s someone
coming to Toad’s whose–I don’t go there,
but if you know about someone who is very famous coming to
Toad’s and you have trouble getting tickets.
Is that right? Has anything like this happened
here? It happened somewhere anyway
and so you might end up standing in line for hours for the first
time when the ticket office opens.
Then it sets up rumors going that, wow, this is a difficult
concert to get into. People start trading the
tickets afterwards or someone’s out there asking more money than
it says on the ticket. Well, you have to understand
that that whole event was staged by an impresario.
So, there’s someone who’s responsible for the reputation
of this performer. This guy says there’s no way
that our performer is going to go in and perform to a half
empty house; we’ve got to pack them in;
we want people lining up on the streets because it gives a sense
of excitement that this person is a star.
You know this, right? These stars are managed and
they’re not just spectacularly good singers;
the impresario is critically important in maintaining the
career of a singer and the impresario is very concerned
about appearances. So, you don’t want to charge a
really high price to get into Toad’s because,
then it would only be wealthy people from the suburbs who
would be coming and it would destroy the whole atmosphere of
the place. So, you’ve got to charge
reasonably low-priced tickets and then a lot of people will
come flocking to you and then that would create the
excitement. The underwriters do the same
thing with IPOs, so they underprice them
typically and it creates this huge excitement about,
can I get in on this IPO? That excitement generates more
business and it also generates a reputation for the underwriter.
People see the tombstone and they know that this IPO did
extremely well; it jumped a high amount in the
first day and people think this underwriter is really something.
I want to get in on other offerings of that underwriter.
So, the reputation of the underwriter grows;
it’s really a reputation business and these people know
something about investor psychology and you might
consider it some kind of market manipulation.
It’s all perfectly legal because the SEC allows this kind
of thing but–anyway, coming back to–the problem
that we’re having now is that I’m emphasizing that investment
bankers need a reputation. Their whole business is a
reputation business. When something happens to Bear
Stearns, it’s critical for the whole industry.
Now, when it’s happening repeatedly to various other
banks, it becomes a critical turning point.
The stock market went up a lot yesterday because of the
encouraging news that some of these investment banks were able
to raise more capital and it’s an ongoing saga,
but it’s all a saga that’s played out in terms of
investment. So, I find it difficult to
predict what’s going to happen next.
It’s very hard to know. Right now–as of yesterday,
we had some encouraging news but this is something that we’ll
just have to keep watching. I think this will play out over
years. This thing is not going to be
over tomorrow, so we’ll have more interesting
things to talk about later this semester and there will be
things to watch–to follow up on over the years.
Okay, so we’re going to talk next period about investment
management.