[Related to the Making the Connection ?] Until the early? 1980s, all the large i
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[Related to the Making the Connection?]
Until the early? 1980s, all the large investment banks were partnerships. The funds the banks used to finance their operations came primarily from the? partners' own equity in the firm. If a bank made? profits, the partners shared? them, and if the bank suffered? losses, those were shared as well. The financial writer Roger Lowenstein has described the situation at the Salomon Brothers investment bank in the late? 1970s, as the partners worried about an investment that had not been going? well: "The?firm's capital account used to be scribbled in a little? book, left outside the office of a partner named Allan? Fine, and each afternoon the partners would nervously tiptoe over to? Fine's to see how much they had? lost." In? 1981, Salomon Brothers was the first of the large investment banks to? "go public" by converting from a partnership to a corporation. By the time of the financial? crisis, all the large investment banks had become publicly traded corporations. As we noted in Chapter? 9, with?corporations, there is a separation of ownership from control because although the shareholders own the? firm, the top management actually controls it. The moral hazard involved can result in a principaldash–agent ?problem, as the top managers may take actions that are not in the best interest of the shareholders.
One way to reduce moral hazard is for shareholders to monitor the behavior of top managers. But as investment banks in the early 2000s moved away from traditional activities such as underwriting and giving advice on mergers and acquisitions and toward trading in complex financial? securities, such as CDOs and CDS? contracts, shareholders and boards of directors did not understand these activities or their risks and therefore could not effectively monitor the? firms' managers. Some commentators and policymakers have argued that as a? result, investment banks took on more risk during the housing boom by increasing their leverage and buying what turned out to be risky? mortgage-backed securities. They did so because top managers would not bear the consequences of heavy losses to the extent they would have had the firms remained partnerships. Michael? Lewis, who worked for several years as a bond salesman at Salomon Brothers and later became a financial? author, has? argued:
No investment bank owned by its employees would have leveraged itself 35 to 1 or bought and held? $50 billion in mezzanine CDOs. I doubt any partnership would have sought to game the rating agencies . . . or even allow mezzanine CDOs to be sold to its customers. The hope for? short-term gain would not have justified the? long-term hit.
Other commentators are skeptical of this argument. Many top managers of investment banks suffered significant losses during the financial? crisis, which suggests that the moral hazard problem may not have been severe. At both Bear Stearns and Lehman? Brothers, two of the most highly leveraged investment? banks, both of which still held billions of dollars worth of CDOs as their value began to? fall, a strong tradition resulted in most managers owning significant amounts of company stock. As the stock in these companies lost most of its value during the financial? crisis, the personal fortunes of many of the? firms' managers dwindled. Richard? Fuld, the chairman and CEO of Lehman Brothers at the time of its? bankruptcy, suffered losses of about? $930 million from the decline in the value of his Lehman Brothers stock.
The debate over why investment banks became more highly leveraged and took on more risk in the years before the financial crisis is likely to continue.
?Sources: Michael? Lewis, "The? End," Portfolio?, December? 2008; Roger? Lowenstein, When Genius? Failed: The Rise and Fall of? Long-Term Capital Management?,
New? York: Random? House, 2000, p.? 4; and Aaron? Lucchetti, "Lehman, Bear Executives Cashed Out? Big," Wall StreetJournal?, November? 22, 2009.
What incentives would the partners in an investment bank have to turn it into a public? corporation?
A.
Going public eliminates the risk involved to the top? executives, as it is not solely their money that is being risked.??
B.
Going public provides more access to capital and leverage.
C.
A and B are correct.
D.
Neither? A, nor B is correct.
If becoming a public corporation increases the risk in investment? banking, how do publicly traded investment banks succeed in selling stock to? investors?
A.
Publicly traded investment banks have difficulty selling their stocks to investors.
B.
Investors love to take high? risks, hence they are willing to take the high risk of investing in? highly-leveraged investment banks.
C.
Investors desire investment? banks' stocks because of the potentially high profits of these banks due to their access to high leverage.
D.
Publicly traded investment banks succeed in selling stock to investors regardless to the high risk because of backing by the Federal Reserve.
Explanation / Answer
Question (1). What incentives would the partners in an investment bank have in turning it into a public corporation?
Answer:- (C)- Both A and B are correct
Question (2).
If becoming a public corporation increases the risk in investment banking, how do publicly traded investment banks succeed in selling stock to investors?
Answer:- Publicly traded investment banks succeed in selling stock to investors regardless to the high risk because of backing by the Federal Reserve.
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