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Inside Wall Street Two Arrows

Investment Banking
by WealthEffect Staff

For brokerage firms, trading has increasingly become a means to an end, that end being investment banking transactions. Here, brokers advise companies on restructuring, public offerings, mergers and acquisitions.

The fees for these advisory and underwriting services can be enormous. This is particularly true of IPOs of stock, where investment banking fees on each share of stock sold can be ten times the commissions from the trading desk.

Wall Street, in recent decades, has also resuscitated a term from the glory days of turn-of-the-century American finance: merchant banking. At that time, bankers such as J. P. Morgan created huge industrial corporations to provide for and profit from this country's extraordinary growth in the early 1900s. These bankers were not only the principal lenders; they also became major shareholders.

The concept became less fashionable after the 1929-1932 bear market, when the equity values of highly leveraged companies were decimated. Obviously, leverage cuts both ways. In good times, once the interest on the debt is paid, all that is left goes to the shareholders; in bad times, if the debt isn't paid, there's usually nothing left for the stockholders, except lawsuits. Still, merchant banking has an impressive ring to it, with its British origins and its centuries-old tradition.

Another concept that involves greater risk is bridge financing. This is when the investment banking department of brokerage firms lend huge sums of their own capital to allow a client to proceed immediately with a takeover. In time, the broker sells bonds for the company and uses the proceeds to retire its loan.

This approach was forced on the industry in the 1980s by the Drexel Burnhm's overwhelming competitive advantage in the high-yield bond market. Since no firm could sell bonds more quickly than Drexel, the answer was for investment bankers to simply lend to the client directly — a bridge loan. The client acquirer gets its money immediately, and the investment banker gets its money back eventually (it is hoped) once new bonds are floated.


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