Investment Banks Enabled You To Bitch About Them On Social Media
I have made it clear that I am liberal, progressive, capitalist and proud of it. On the left, there seems to be a huge misunderstanding concerning “Wall Street”. I am not defending that entity or their actions concerning the crash of 2008, but aim to briefly explain, with the help of Balaji Viswanathan, what it is they do so fellow liberals and progressives have a greater understanding of corporate finance.
Mergers and Acquisition
When a big company buys another, they take the advice of an investment bank. They help value companies and identify the strength of each division or product. This data helps in negotiating the right price as deals can exceed going over $100 billion. In return for the advice, the bank gets 0.5%-1% of the deal as a fee.
IPOs and Bond Offerings
When companies go into the stock market for the first time (called an Initial Public Offering), investment banks help put the offering together. They help set the price and market it actively to their wealthy clients. This nets them a commission on the money the company raises from sales of shares of company stock to buyers in the market. The commission can be as high as 7% of the total money raised.
Investment banks do a lot of trading on their own though not so much after 2008. They might trade oil, bonds, stocks, buildings or gold taking confidence in its research that reaches very deep. These banks hire almost exclusively from the ivy leagues so the connections of their employees go very wide in industries and companies they are trading.
When large institutions and hedge funds trade in the market, they go through a prime brokerage. A regular online broker used to trade stocks would not be able to support a $100 million hedge fund trading in oil. This is where prime brokers come in.
Private Wealth Management
Many wealthy people don’t manage their own money. They use private wealth management to help them buy, for example, a mine in South America or a skyscraper in the middle east for 1-1.5% of the portfolio as their annual fees.
Distressed Debt and Private Equity
Institutions with loans that cannot get repaid due to debtors in default use investment banks like Goldman Sachs. The institution might sell the portfolio for less than half of its “book value” (what it’s worth if every debtor was paying on time). Investment banks then use their political and commercial connections to collect on the loans. They may also acquire whole businesses that are on the verge of bankruptcy and then turn them around.
Markets are often very choppy and volatile. A few extra sales or a few extra share purchases can change the stock price a lot. In those instances, a market maker uses their inventory of stocks in that company to provide a smoother movement. Each major stock has its designated market maker, and Goldman is a designated market maker for many stocks and makes money in the trades.
Investment banks analyze companies, bonds, currencies, commodities and even real estate to help its clients identify the best investment opportunities. Research on that level is often detailed and very complicated.
The Harvard Business Review (HBR) explains how banks are not only useful for innovation and wealth generation; they also make excellent scapegoats when things go wrong. Come famine, social unrest or economic downturn, bankers are at the top of the list of villains.
The vast majority of banks are honest. Many have done well, making rich some who worked in them. People don’t like when other people earn more than they do. When they earn 40 times as much as we do, it’s especially infuriating.
I have seen that with many of my fellow liberals and progressives and it’s a mistake in my opinion. HBR explains:
Banks — including investment banks — are not an accident. They have developed over thousands of years to meet commercial needs and will have to go on developing to survive. They lend money on the basis of risk, which means some of it will be lost. And they are not homogenous. Some are truly excellent. Some are truly rubbish. Most are in between and operate on a modest scale, a world away from complex financial instruments. Banking is not all Goldman Sachs.
We need banks or institutions that do what banks do. Furthermore, the past is not the future. Banks in many countries are already required to hold more capital and new regulation, new laws and new taxes post financial crash will mean that banks will become more constrained than they were before.
Still, bankers will be paid handsomely. Not because of market failure, but because the market is working. While governments can make sure that the market keeps working and then levy appropriate taxes to take their share, the earning ability of some individuals is huge. Even a miniscule percentage of an extravagant sum for the bank can mean an exorbitant amount in an individual banker’s pocket.
Reaction to banks are often visceral even when they are understandable. As in every previous financial crisis, the lessons need to be learned on the basis of dispassionate analysis, not gut reaction.
Afterall, much of this reaction is being channeled on social media. Guess what? Without investment banks, no Facebook nor Twitter for that matter.