Chapter 1.

Key Elements of Investment Banking [00:00:00]

Professor Robert Shiller: All right. Now, are we in order? OK. All right.
Today, we want to talk about investment banking, which is different from commercial
banking. And today we have a guest, Jon Fougner, who took this course almost 10 years
ago and has been working in investment banking since. I’ll introduce him in a few
minutes, but I wanted to start with just the elements of investment banking, and then I
wanted to talk about changes in it that came about after the financial crisis of 2007
through 2009. OK.
The topic is investment banking. And that is a term, a 20th-century term, that first
became big and important, I’d say, in the 1930s, but preceded that by some years. And it
refers to a business of helping other businesses create securities. If someone wants to
issue stock, they go to an investment banker to help them. Or if you want issue bonds,
you go to an investment banker. It can be a corporation that goes to the–for-profit, it can
be a non-profit corporation, it can be a government. I suppose even an individual, who is
incorporated, can go to an investment bank. That’s the investment banking business.
Now it differs–it shares something with the consulting business, because investment
bankers serve often as consultants. A company will come to an investment banker with a
problem, and they want to raise money by issuing new shares, for example, to solve that
problem. But if it’s a good investment bank, they will do more than just issue shares for
them. They’ll talk about their whole corporate strategy. So, in that sense, an investment
bank looks like a consulting firm, but they don’t do pure consulting. That makes the
distinction.
Maybe, they’re in many ways a favored consultant, because they bring money, all right?
You can talk to a consultant, who will bring you no money, and another consultant, who
has his hands on money somewhere. And that helps a lot. The advice and the money
together help a lot.
So, investment bankers are different from traders, because usually they deal with creating
something–about making a corporation or a government–making it work, enabling them
to do something that they want to do. And then, being realistic about it, and coming up
with the money to do it. And so, that’s how investment banking differs from consulting
[correction: trading].
And it differs from commercial banking in that a pure investment bank does not accept
deposits. You can’t go to your investment bank and say, I’d like to open a savings
account. They don’t do it, OK? I’m talking about a pure investment bank.
But let me just give you something about this business. I’m going to come in a moment to
point out that most investment banking businesses are not pure investment banks. But
let’s talk about what a pure investment bank does.
It does underwriting of securities. That means–suppose you’re a company and you want
to issue shares. You need someone to go to bat for you, someone who knows the kind of
people who might buy your shares, and can vouch for you. So in some sense, it’s a
reputation thing. The investment bank has contacts among people who make big
investments, and they manage the issuance of your new shares, and that’s called an
underwriting.
If it’s the first time you’ve issued shares, it’s called an IPO, or initial public offering. So,
you’re a private company, it’s just you and a few friends own the company, but now you
want to go public, you would generally go to an investment bank, and talk to them about
how to do it. And the investment bank would solve that problem for you by doing an
underwriting.
So, traditionally there’s two kinds of underwriting. Also, there’s also something called a
seasoned offering, and that means, for a company that has already gone public, and it
already has shares traded, so that the shares are seasoned, but you want to issue more
shares. So, you can go to an investment bank to do that, as well. OK.
There’s two kinds of deals. There’s a bought deal, and then there’s a best efforts. With a
bought deal, the investment bank buys your shares. They go in and say, you know, we
know that we can get market for your shares. We will buy them ourselves and resell them
on the market. A best efforts offering is one where the investment bank doesn’t buy it and
doesn’t promise anything. They say, we’ll make our best efforts to place this offering,
OK? So, those are the basic things that they do.
The methods that they use are regulated by the Securities and Exchange Commission in
order to make–the SEC in the United States, and regulated similarly in other countries.
So, that’s the basic investment banking business.
So, if you’re thinking of where to place yourself, I think investment banking suits very
well people who are–it’s not good for autistic people. If you’re autistic, be a trader, OK?
Then, you just get on the phone, and you buy and sell all day, and you can be rude, and
you can have coffee stains on your shirt, and you don’t have to know anything about
classical music. OK? But investment bankers are a different–I see Jon is laughing. Tell
me, what you know about classical music. I assume that was a part of your training at
Goldman. He says no.
It’s a whole different industry. So, if you go to the symphony and look around, you’ll see
lots of investment bankers there. But you won’t see any traders. You nod on that
[POINTING AT JON FOUGNER], maybe.
We talked about moral hazard. I think that an important part of what investment banks do
is, solve a moral hazard problem. And that problem is, that companies, who issue shares,
don’t have a reputation. And so, what do I care, I’ll issue shares, right before we’re going
to go bankrupt, OK? We know inside that we’re going to go bankrupt, so hey, let’s just
see, if we can milk this company, before the public knows it, and issue shares. That’s a
moral hazard. And the investment bank is in business to prevent that moral hazard. They
do the due diligence, they check you out, and then after that, people are more trusting of
you. So, I think investment banking is built around trust, it’s establishing trust.
So, that’s how it differs from a lot of–that’s why it’s important that these people be
cultivated and impressive. They tend to be well-spoken. I can ask Jon, whether he agrees
on all this, but it’s my impression, you can tell when the investment bankers walk in the
room. They dress differently, they look differently. I don’t know what it is. It’s something
about reputation, it’s what it’s built around.
Chapter 2. Principles and Culture of Investment Banking [00:09:50]
The investment banking industry–let me just–since I’m talking about the nature of
investment banking and since we have a Goldman Sachs representative here. I put on
your reading list a book as an optional reading by Charles Ellis called The Partnership,
and it’s a history of Goldman Sachs. Goldman Sachs was an investment bank until just
very recently, and we’ll talk about that. They’re still in the investment banking business,
but now they’re officially a commercial bank.
It’s an old, venerable firm, and Goldman Sachs emerged in the early 21st century as, I
think, the most highly respected and esteemed investment bank in the world. Amazingly
successful, and amazingly well-respected.
Ellis wrote a book just a few years–Ellis is on the Yale Corporation. He’s a distinguished
businessmen and author himself, and he wrote a book about Goldman Sachs, which is
largely admiring. Like, how did this happen? How did this phenomenon of Goldman
Sachs come about? And I suggested–I didn’t assign–I suggested, you read one chapter,
was called Principles. And it says something about Goldman Sachs, and it refers to, in
that chapter, the chairman of Goldman Sachs, John Whitehead, in the 1970s wrote down
a list of principles that guide Goldman Sachs. And Ellis seems admiring of these
principles. Not everyone would agree. It’s a matter of taste, I guess, if anything.
Whitehead is now–I just looked it up–he’s 88 years old, and is retired from Goldman,
must have retired some years ago. What kind of an organization? Ellis says, that the thing
that struck him about the organization is loyalty. But that’s not alone, that people feel a
strong loyalty toward their company. That’s not on Whitehead’s list.
So, Whitehead’s list. What is his first principle of Goldman Sachs? “Our client’s interests
always come first.” These sound a little bit like bromides. I’m sorry, but I read them
thinking, it is the most successful investment bank in the world, so maybe there’s
something beyond–I think, there is something beyond platitudes here. Second, “our assets
are people, capital, and reputation.” That’s a coincident with what I said.
“Uncompromising determination to achieve excellence.” Well, everybody says that, so
maybe discount that. “We stress creativity and imagination.” Well, those are sort of
bromides, maybe. Then, Whitehead issued some guidelines–this is also in that chapter
later–for Goldman Sachs employees, and these seem to be a little bit more candid. ”The
boss usually decides, not the assistant treasurer. Do you know the boss?” That’s sort of
something I’ve learned from my own interaction with people–the boss really does decide,
and Goldman Sachs goes for the top. And maybe this is obnoxious, I don’t know–they
don’t want to talk with underlings.”You never learn anything when you’re talking.” That
means, be a good listener. ”The respect of one person is worth more than the
acquaintance with 100.” ”There’s nothing worse than an unhappy client.” The one thing
that–I don’t if it’s on Whitehead’s list–but I think it really says something about
investment banking, and that Ellis says, is that they shun publicity. They don’t want to be
in the newspaper, they want to be known by the president. They want to be known by a
few prominent people. They’re kind of social climbers, in a way. But it’s all built around
some basic principles of service, and they want to be talking to the top guy, and they
don’t want to be in the newspaper.
I’m going to quote Ellis on this. Now I’m quoting Charlie Ellis. I call him Charlie. I
know him. He’s a friend of mine. “Making money, always and no exceptions, was a
principle of Goldman Sachs. Nothing was ever done for prestige. In fact, the most
prestigious clients were often charged the most. Absolute loyalty to the firm and to the
partnership was expected. Personal anonymity was almost a core value. The real culture
of Goldman Sachs was a unique blend of drive for making money and the characteristics
of family, in ways that the Chinese, Arabs, and old Europeans would well understand.”
So, I’m giving you a flavor of what an investment bank is. You might be repelled by it.
You know, is making money so important? And if you are repelled by it, you probably
don’t want to work for Goldman Sachs. On the other hand, they’re kind of respecting
some economic principles, right? Working for a firm like this, you can make huge
amounts of money, and then at the end, you can give it all away to charity. And that’s the
new capitalism, right? So, what’s wrong with that? What are you going to do with all
this? If you make $100 million, what are you going to do with it? You’re going to give it
away, right?
I mentioned at the beginning, I mentioned Andrew Carnegie’s book, The Gospel of
Wealth. Maybe that’s what this is all about. On the other hand, some of them don’t give it
away, and some of them live lavishly. Different people have different impressions of this
business. But I want to make sure I have time for our guest and I’m sort of running out of
time.
Chapter 3. Regulation of Investment Banking [00:16:54]
I wanted to talk about what has happened in the crisis. There’s so much to say about this
topic. Maybe, I should talk first about the first crisis. In 1933, the U.S. Congress passed
the Glass-Stegall Act, which forced investment banks–it prevented investment banks
from doing commercial banking, or commercial banks from doing investment banking. It
split them in two, and it said you have to decide, are you a commercial back, or are you
an investment bank? The Glass-Steagall Act was the act that created the FDIC, the
Federal Deposit Insurance Corporation, the first successful national deposit insurance act
in the world. And part of it–it makes sense–if you’re going to insure the commercial
banks, you better watch what they’re doing and prevent them from doing dangerous
business. So, the dangerous business was investment banking, and they forced companies
to decide.
So, J.P. Morgan, which was doing both investment banking and commercial banking in
1933 had to decide. What is it? Investment banking or commercial banking? So, they
picked commercial banking, and that means they fired all their investment bankers. So,
these guys regrouped and they formed an investment bank, called Morgan Stanley.
[Harold] Stanley was a Yale graduate and [Henry S.] Morgan was, I think–not J.P.
Morgan, it was his grandson. Morgan died around 1911 [Correction: 1913]. And so, those
were two separate one. J.P. Morgan, commercial bank. Morgan Stanley, investment bank.
But since then, we’ve repealed the Glass-Steagall Act, and that occurred with the
Gramm-Leach Act [correction: Gramm-Leach-Bliley Act] of–what was that–1999. Well,
Gramm-Leach[-Bliley] repealed Glass-Steagall, and now these businesses, they generally
do the same business, both commercial and–yes, Gramm-Leach[-Bliley] was 1999. OK.
Since then, as you recall, we’ve had a financial crisis. And in that financial crisis, Glass-
Steagall got brought up again, because it seemed that the crisis was related to a number of
shenanigans that firms were undertaking. And the government had to bail out commercial
banks. We talked about this, and it’s very controversial. So, the question is, did these
banks get in trouble because we repealed Glass-Steagall? A lot of people came on saying
that. These banks were doing all kinds of screwy things that were dangerous, and we’re
insuring them, so it can’t be. So, a lot of people said, we have to go back. There was
some inherent wisdom in Glass-Steagall that we’ve lost. And this was debated.
Now incidentally–I didn’t mention this–Glass-Steagall was somehow confined to the
United States. Outside of the United States, I don’t know if there was any country, but as
far as I know, U.S. was the only one that did it. So, outside of the United States they had
what was called universal banking. And these banks outside of the U.S. were doing both
investment banking and commercial banking. They sailed right through the whole
century without being divided up. So, the reason why we got Gramm-Leach[-Bliley] was,
that people started to say, you know, we’re at a competitive disadvantage. We Americans
are at a competitive disadvantage to Europe, because we can’t do both, and they have
more freedom than we. And so eventually, in 1999, we said, they could do both, so that
U.S. also became a universal banking country.
But then problems arose. And the problems were–Paul Volcker, who was chairman of the
Federal Reserve Board in the late ’70s, early ’80s, proposed something called the Volcker
Rule. And the Volcker Rule was not a full return to Glass-Steagall, but–and this is now in
the Dodd-Frank Act. It’s Section 619. It doesn’t say Volcker Rule there, but that’s what it
is, and it prohibits proprietary trading at commercial banks. And it also says, that
commercial banks can’t own hedge funds or private equity [addition: private equity
funds]. So, that was the Volcker Rule that was put in.
There was also another rule added, which is analogous to the Dodd-Frank Act
[correction: analogous to the Volcker Rule], also. And this is in the Dodd-Frank Act of
2010. There was a senator. Her name was Blanche Lincoln, a Democrat from Arkansas,
who proposed the Lincoln Rule. Unrelated to Abraham Lincoln, as far as I know. And the
Lincoln Rule was–Lincoln Amendment, and that is Section 716 of Dodd-Frank. It says
that–doesn’t prohibit banks dealing in swaps, but it said swap dealers barred access to
Fed window, discount window. And so effectively, it prevents banks from dealing in
swaps anymore.
As a result of this, Goldman Sachs has got to shut down–or it appears that–the Volcker
Rule says banks have until October 2011 to comply. So, it means that Goldman Sachs has
to shut down–Goldman Sachs had to become a commercial bank, too, so it’s no longer–
it’s an official commercial bank now. And because of the Volcker Rule, it appears that it
has to shut down its proprietary trading, which was a huge part of its profits. And
Goldman Sachs will never be the same again, apparently. But it’s not clear what will
happen. It depends all on how Dodd-Frank is enforced.
I think that the people that are in the banking industry are going to try to claim, that some
of the activity that was done by their proprietary traders–that is, people who were trading
the market on–true investment banking shouldn’t involve the investment banker buying
and selling securities trying to make a profit. That’s not underwriting of securities, that’s
proprietary trading. Volcker Rule says that you pretty much can’t do it anymore, unless
you’re a pure investment bank, but if you’re a commercial bank, you can’t do it anymore,
and they’re kind of forced to become a commercial bank. But they’re going to try to steer
around these rules, and I think that maybe they can. They’ll re-define something that
looks something like proprietary trading, and then continue to do what they’re doing.
We’ll have to see. These things are long and arduous.
You know, one thing that strikes me about finance is, that it’s so rules-based. There are
so many laws, there are so many lawyers, that nobody can grasp the magnitude of the
regulations that these people live under. And you see these landmark bills, but none of us
understands them, because the real content of them is involved in hundreds of pages of
legal documents, that never cease to amaze me with their complexity.