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  • 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 yearsactually,

  • 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 Treasuryit'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.

Professor Robert Shiller: I wanted to talk

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17. 投資銀行とセカンダリーマーケット (17. Investment Banking and Secondary Markets)

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    陳韋達 に公開 2021 年 01 月 14 日
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