1:22
What is underwriting?
This is the business in which this bank helps
the issuer to publicly sell its securities,
both bonds and stocks.
Now here, it's important to say a few words about the normal development of any business.
what's a classic story?
You start somewhere in the garage,
and then later people start to write some software,
and then the company grows,
and then it becomes very well-known,
it reaches nice financial results,
and everyone knows that the owners of this company are really wealthy people.
But, it is not until the moment when you decide to go public,
namely to issue shares of stock,
and to sell it to the public,
offering them to become their partners in a certain way.
And at that time,
the price label is affixed.
So you can say that before the IPO of Microsoft,
everyone knew that Mr. Gates was a wealthy individual,
but it was not until this moment when the price tag was affixed.
Everyone knew that Facebook was a great company but it was not until
the IPO of Facebook that they realized how much Mr. Zuckerberg is "worth" let's say.
So this process really deals with a lot of private information.
Look, I am an issuer and they say,
"Buy my stock," and people say, "Why?
Why would we profit from that?
And if so, then how much money are we expected to make and so on and so forth?
So someone should help this process and that someone is an investment bank.
Not only that, you do not offer to sell
the stock to just people at large and sometimes not to all these small people.
You would like to go to some institutions,
the investors with a lot of money,
so that these people would buy big chunks of stock from you.
So you can see that in this process there are certain players,
namely the issuer, then the final investors,
then in between stands the investment bank,
and there's a certain process.
So in our terms,
the investment banks in this case play an important role as companies or institutions
that provide the alleviation of
the fundamental information asymmetry between the issuer and the buyer.
We will, in the next episode,
study that on the model of private information and underwriting.
But for now it's important to say this,
so all public securities,
namely stocks, bonds, they are placed by underwriters.
Moreover, in some cases,
the underwriter buys up the significant chunk of the issue,
and then later resells that to its clients,
or in some cases,
they may provide some additional pieces of stock.
If for example, if the stock you should goes nicely, then they can say,
"Well, why wouldn't we sell some more?"
So all that is studied in detail a little bit later.
Now supposedly, so we are talking,
wondering about the filling of this big pool.
Now there is a huge pool of stocks and bonds there.
But the next question is, who ensures liquidity?
And then, we enter into the second part that is called trading.
Well, you can say, "Wait a minute.
Trading is done by a lot of people,
these are brokers, dealers, individuals."
Now there are lots of people in the high frequency trading,
so not all of these companies and people are investment banks.
Well, indeed not all of them, but oftentimes,
the investment bank plays a crucial role in initial support of this trading,
and it provides support for a long time for some specific kinds of financial instruments.
So that is an important part,
and oftentimes there is a conflict of,
well, "conflict" who interest between underwriters and traders,
because people within in this mix say, "Well, we,
underwriters, we keep making solid money,
because we collect commission for all of these issues, and you guys,
you speculate and oftentimes,
you can easily blow a lot of this money in your poor transactions."
But, then comes the third important thing that is called in general, consulting.
6:13
When you do the issue of them, clearly,
you do road shows,
you do interact with your clients, but at the same time,
maybe the issuer comes and says, "Well,
I'd like to do an IPO," and this bank might say,
"You know what, now it's not the best time,
why wouldn't wait a little bit?"
Why is that so? Because the investment banks knows it's clientèle.
They feel the trends sort of roughly speaking.
Are these people willing to buy stocks right now?
Or, are they willing to rather buy bonds right now?
Or maybe they prefer to stay in cash for a while?
And all that might be an important piece of advice to the issuer,
if they let's say, postpone the issue,
because if they did so, they would collect much less money than,
otherwise, would have expected.
Not only that, consulting is very specific in
transactions like M&A, mergers and acquisitions.
We will not talk about that in this course because in this specialization,
we have the four course that deals specifically with
mergers and acquisitions in much greater detail,
and we'll discuss that part of the business there.
But for now, if let's say two companies merge, then clearly,
the terms of this merger how you pay,
because you're talking about huge purchases in one company,
may be bought for dozens or hundreds of billions of dollars.
And so, the important thing is to do proper evaluation,
the import thing to feel whether the market is
prepared to engage in transactions of that kind, because otherwise,
you won't be able to raise this amount of money in any way,
neither in the way of fixed income investments,
nor in the way of equity investment.
So, there's a lot of job here too,
and this is sort of a stable flow of business because you have to be,
not only an experienced specialist,
but also to really feel the market sentiment,
because that is why issuers and the participants of M&A transactions,
they come to an investment bank and say, "Well,
would you help us to really implement this transaction?"
And the final but not the least important,
they would say sometimes the most important part of
the business of the investment bank is,
I'll put it research and innovation,
it deserves telling a few words.
Now, the investment bank always monitors,
not only its potential issuers,
but really surveys the market.
Like, what the trends are?
What these people are likely to do?
What these people are unlikely to do?
What they would like to do? And so on and so forth.
Here, the story is very important because to some extent,
we can see that there seems to be a potential for the investment bank.
In some cases, to come closer to the issuer,
because these are two big companies,
for example, then to this public.
However, the important message here is that, the people with money,
these blue bags, whether they are large or small,
they are the clients of an investment bank too.
Because without this money,
and this bank would not be able to do proper underwriting,
without this demand, they are no longer interested in trading,
and clearly these, again,
when they engage in them and the transactions,
these people who provide financing,
they are the final investors in this story.
So here, we can see that feeling the flavor of that,
feeling the needs of this money base is fundamentally important.
And on top of that,
some of these clients both the issuers and sometimes the investors,
they may have an idea about,
why wouldn't we think about offering another financial instrument?
Now, let's say I'm an issuer,
and I would like to do some creative financing.
I would like to do that for me.
But, if I am an investment bank,
I have all these other clients with money so maybe I haven't invented that.
But, I have a huge incentive to develop that and to market to some of my other clients.
That's the key driver of innovation.
Not only do I do research in the investment bank,
but sometimes I feel some ideas of my clients,
both issuers and investors.
And it must be said that it is the investment banks,
who actually offered all new financial instruments in this world.
So they invented and marketed collateralized debt obligations.
They were active in selling derivatives on stocks,
bonds, commodities, and all other things.
These people, they offer these things and they support the market,
and then they do evaluation,
and they do a lot of that.
Well unfortunately, when you offer innovative products,
then there is the issue of risk here once again, because oftentimes,
you may have a proprietary model of evaluating risk here,
and not oftentimes, all the people are in the position to understand this.
And therefore, the new products when they are aggressively marketed,
they sometimes increase the overall risk temperature of the market if you will,
and as a result, that may be the starting point for some of the market bubbles,
and then later crises.
Unfortunately, well, it's not necessarily unfortunately,
but for the public at large,
it's unfortunately when you see these crisis,
because a lot of people lose a lot of money.
But, the innovative activity of investment banks cannot be,
not only stop, but even slow down,
because these people are on the front edge of innovation,
and they will always think about
something else because that provides competitive advantage.
So we will study some of
these important contributors to bubbles and crashes in this course too,
and we will see how that contributes to this turbulence and growing risk.
So that was the major overview of that.
And now, we are in the position to
analyze how exactly do investment banks deal with private information,
that is clearly core here?
Because you have issuers, you have people,
and there is a lot of a gap between them that should be filled.
So starting from the next episode,
we will discuss how that is mitigated by the investment bank,
and how it can be analyzed,
and how we can understand what's going on.
Konstantin KontorDirector and Professor of Finance and Strategy
