Why we once needed investment bankers and don’t need them today. 

Once upon a time, investment bankers were useful.

Back before there were investment bankers, anyone who needed money for developing a business would go directly to family and friends.  Larger projects could mean taking a proposal to the local wealthy family.  Perhaps an acquaintance would arrange a referral or introduction, but the presentation and negotiations were directly between the person who had the money to invest and the one seeking to be the steward of that money.  

Direct investing was too limited before electronic communication

As projects grew larger throughout Europe, businesses raised money through direct relationships with “wealthy private individuals and influential politicians.”    [Samuel L. Hayes, III, A. Michael Spence, David Van Praag Marks, Competition in the Investment Banking Industry, Harvard University Press, 1983, page 6.]  As the amounts needed increased, the job of raising money took precious time away from developing the business, and often the money wasn’t raised in time to do any good.  The means of communication were limited to writings delivered on foot or horseback and to personal meetings.  Gathering information about prospective investors meant innumerable approaches to someone who might know someone.  As a result, a market grew for the services of an intermediary to find prospective investors and arrange the terms. 

Financial intermediaries exist to match the needs of people who want income from their money with the needs of those who want to use that money.  Some financial intermediaries, like banks, gather money from depositors and furnish money to individuals and businesses.  As the money flows into and out of these institutions, it is transformed in amount, in the interest paid and in the risk of loss.  Those of us who deposit our money in a bank have no control over where it goes, no knowledge of how it is used.

These depository institutions work well, but only within a narrow range of risk and reward.  Depositors are mostly interested in safety and convenience.  We’re willing to settle for low interest rates on savings and perhaps no interest on our checking account. Borrowers understand that banks want their money back, usually within a year or so, and  they want ways they can recover their money if the borrower doesn’t pay on time. 

Just having bank deposits and bank loans is not enough.  Many of us are willing to take more risk than a bank deposit, in the hopes of getting a higher return.  On the other side, there are businesses with a need for capital that can be used for longer times, and at a higher risk of loss, than banks would tolerate.  That’s where securities come into play.  These securities are agreements between the providers of money and the stewards who will be using that money.  Until recently, when options, futures and other “derivative securities” became popular, securities meant either part ownership in a business (“shares” or “stocks”) or a promise to repay the money with interest (“bonds”).    

The Role of Investment Bankers—in their Beginning Years

Investment bankers are financial intermediaries who arrange for securities to be issued  and purchased.  In idealistic theory, their “job is to serve the users and suppliers of capital by providing the facilities through which savings are channeled into long-term investment.” [Investment Banking in America: A History by Vincent P. Carosso, Harvard University Press, 1970 and 1979, page ix of the 1970 edition]  They’re also hired by companies who are trying to buy or sell businesses, in mergers or acquisitions.  Most investment banks also include groups of brokers, buying and selling securities as agents.  They usually have departments acting as dealers, trading in securities for the banks’ own speculation.  For all three of these functions, the banks gather information that is intended to give them a competitive advantage. Nobel Prize economist Paul Krugman described modern investment banks as “repositories of specialized information that could help direct funds to their most profitable uses.”

Our interest here is in the role of investment bankers in the movement of money between the people who have it to invest and the businesses and governments who want to use the money.  This chapter is a brief description of the need that brought about investment banking in America and how investment bankers have kept hold of their role until now, as they have developed into departments of securities broker-dealer firms or the very large commercial bank holding companies.  [This chapter is drawn from many sources, principally from three:  Wall Street: A History, by Charles R. Geisst, Oxford University Press, 1997,  Investment Banking in America: A History by Vincent P. Carosso, Harvard University Press, 1970 and 1979 (references are to the 1970 edition) and Competition in the Investment Banking Industry, Samuel L. Hayes, III, A. Michael Spence and David Van Praag Marks, Harvard University Press, 1983.  Charles Geisst is the author of several books about Wall Street, including 100 Years of Wall Street, McGraw Hill, 2000,  Monopolies in America, Oxford University Press, 2000, The Last Partnerships: Inside the Great Wall Street Money Dynasties, McGraw Hill, 2001 and Wheels of Fortune: the History of Speculation from Scandal to Respectability, John Wiley & Sons, Inc., 2002.  Professor Carosso’s book resulted from an offer to Harvard from Kidder, Peabody & Co. to pay for a scholarly history of that major investment banker.  Professor Carosso expanded it to include American investment banking generally.  Kidder, Peabody was started in 1865.  After it was acquired by General Electric in 1986, the firm was embroiled in insider trading scandals, depicted in James B. Stewart’s book, Den of Thieves, and the movie, Wall Street.  After a trading fraud was uncovered in 1994, GE sold Kidder Peabody’s assets and the firm ceased to exist.  Professor Carosso died in 1993.]  Competition in the Investment Banking Industry grew out of a study requested by the Antitrust Division of the Justice Department, when it was considering the competitive implications of a proposed merger of securities firms.  One of the three authors, Samuel L. Hayes, III, is professor of investment banking at Harvard Business School and the most-quoted authority on U.S. investment banking.]

Our structure for investment banking was drawn from what had been going on in England and Northern Europe.  In the 1700s, most investments were sold directly by the issuer to wealthy individuals.  That meant that managers of the enterprise had to develop the relationships with investors and negotiate the terms with each one.  They carried the risk that circumstances would change part way through the marketing effort, leaving them with less capital than they needed to raise.  The first intermediaries were called loan arrangers, and they would find both sides of a transaction and shepherd it through.  That certainly speeded up the process and saved time for the entrepreneur, but it still left the uncertainty of how much money would be gathered and when it would be available for use. 

Late in the 18th century, partnerships began using their pooled capital to buy an entire issue and then resell it to wealthy individuals.  This was attractive to the issuer because it had to deal with only one buyer in one transaction, before getting on with using the money for the business.  To purchase larger issues, these partnerships “often cooperated in putting together secret lists or embryonic syndicates for sharing the risks . . ..”  [Competition in the Investment Banking Industry, Samuel L. Hayes, III, A. Michael Spence and David Van Praag Marks, Harvard University Press, 1983, page 7]   

Even with these early intermediaries, the people who were waiting to use the money still had the risk that it might not get completed, or that it could be delayed.  The need remained for someone to take over the risk that the funding might not happen, or might come too late.  Borrowing a term from the insurance industry, there was an opportunity to “underwrite” this risk.  As competition heated up among financial intermediaries, some of them began agreeing to deliver the money, less their commission, at a specific date.  Now called “underwriters,” they took over the risk that something might go wrong before the investors had all paid for the securities they ordered. 

Before a securities issue (called “flotation” in Europe) came to market, underwriters gathered lists of other intermediaries and investors who expressed interest, negotiated the terms with the issuer and committed to pay at closing.  That basic structure is what investment bankers still do today.  However, we’ll see how the risk of a failed financing has been shifted almost entirely back onto the issuers, so the term “underwriter” is a today just a vestige of the original insurance concept. 

Of course, underwriting a risk provides comfort only to the extent that the underwriter has the resources to make good on the risk.  To achieve this credibility, the underwriting firms became groups of owners and lenders, so that they had access to substantial cash or liquid assets.  Some of them were private banks, which took in deposits from the very wealthy.  Others were merchant banks, offshoots of trading businesses.  They gradually came to be known as investment bankers.  For most offerings, several investment banks joined together to underwrite the securities.

At first, these new investment bankers “purchased newly issued securities as a group at a fixed price, then sold them individually at times, places and prices of their choosing.”  [Paul G. Mahoney, The Political Economy of the Securities Act of 1933, University of Virginia School of Law, Law & Economics Working Paper No. 00-11, May 2000, page 5, hhtp://papers.ssrn.com/paper.taf?abstract_id=224729.] This cooperative structure took away competition among them in negotiating with the business or government that was raising capital.  But they still competed in dealing with prospective investors.  Their next step was to eliminate that competition through the “syndicate system,” where the syndicate members agreed they would all sell at the same price and time.  It was up to the syndicate manager to complete negotiations and keep everyone else in line.  The reason for using this oligopolistic hierarchy:  “The profits to be made from such flotations were so immense and the mutual benefit of maintaining discipline among syndicate participants in the flow of capital was so clear that the competitive pyramid was an indisputable fact by the 1820s.  The early division of firms between the apex and the body of the pyramid was thus a natural outgrowth of competitive dynamics as they then existed.”  [Competition in the Investment Banking Industry, Samuel L. Hayes, III, A. Michael Spence and David Van Praag Marks, Harvard University Press, 1983, pages 8-9]

After the American Revolution, the new United States of America relied on the European investment bankers to finance its acquisitions and wars.  To pay France for the Louisiana Purchase in 1803, the United States hired Baring Bros., the dominant merchant bank in England.  The fact that the money raised would help Napoleon pay for France’s war against the English did not interfere with the underwriting.  As one member of the Baring family and bank put it, “Every regulation is a restriction, and as such contrary to that freedom which I have held to be the first principle of the well-being of commerce.”  [Stephen Fay, The Collapse of Barings, W.W. Norton, 1996, www.times.com/books/first/f/fay-collapse.html] 

Growth spurts for investment banking in the United States have come from financing wars.  Before the War of 1812, long-term financing in America was a sideline of merchants, to facilitate their main business, along with a few loan contractors.  Alex. Brown & Sons, which started as a linen merchant, is claimed to have conducted the first initial public offering in the United States, of Baltimore Water Company in 1808.  [https://www.alexbrown.db.com/Connect/publicSite/au_overview.jsp.  Alex. Brown is now part of Deutsche Bank.]   

The American Revolutionary War had been paid for largely by printing money.  That was financing of last resort and led to hyperinflation [“Inflation and the American Revolution” by H.A. Scott Trask, Ludwig von Mises Institute, http://mises.org/story/1273.]   Currency printed by the Continental Congress was worth one-thousandth of its face amount by war’s end, leading to the phrase, “not worth a Continental.”  The Continental Army also used “impression,” the confiscation of supplies rather than paying for them.  Bitter resentment lingered long after the war.

To pay for the War of 1812, the U.S. Treasury tried to get the public to buy $16 million in bonds.  The federal government had trouble finding buyers and nearly $10 million ended up being sold to what would later be called an “underwriting syndicate,” made up of the very wealthy John Jacob Astor and Stephen Girard and the former head of a British mercantile banker.  The government got only 40% of the bonds’ face amount, an immense discount.  This discount between the purchase price from the issuer and sales price to the investor is called the “underwriting spread.”  The syndicate financed the transaction with short-term borrowings and resold the bonds to their wealthy business acquaintances, at more than twice what they had paid.  [Wall Street: A History, by Charles R. Geisst, Oxford University Press, 1997, pages 18-19]. 

By the 1830s, private banks were formed in the United States to help finance roads, canals and then railways.  Merchants diversified into buying and reselling these new issues of securities.  [Wall Street: A History, by Charles R. Geisst, Oxford University Press, 1997, pages 37-39.]  The market also attracted European investment bankers who set up American firms.  [Wall Street: A History, by Charles R. Geisst, Oxford University Press, 1997, page 38-42]  Banks which took deposits from the public also got into the business of buying securities from issuers and reselling them.  That brought one of the problems that would later cause the legal separation of commercial and investment banking—banks making short-term loans to businesses in order to get the commissions on buying and reselling their long-term securities.  Investment banking as a stand-alone business in America may have begun with Nathaniel Prime, who left stock brokerage in 1826 to form Prime, Ward & King.  He “would approach a firm and offer to take an entire new issue of stock or bonds, and then distribute it to clients, many of whom were overseas.”  [Robert Sobel, Inside Wall Street, W.W. Norton, 1977, page 197]  

Financing the Mexican War (1846-48) helped bring in British private banks, which set up American affiliates.  They accepted deposits only from very wealthy British and Europeans, using the funds to buy new bond issues for resale.  The timing of their fundraising from the rich coincided with a flight of capital from Europe.  The concept of property was being challenged by European intellectuals, creating the first “red scare” of communism.  Marx and Engels had published The Communist Manifesto in 1848.  According to its opening words:  “A spectre is haunting Europe — the spectre of communism.”  [Karl Marx and Frederick Engels, Manifesto of the Communist Party, 1848, www.anu.edu.au/polsci/marx/classics/manifesto.html]  That spectre helped make wealthy Europeans ready to invest in the United States.  [Wall Street: A History, by Charles R. Geisst, Oxford University Press, 1997, 45]

The new business of investment banking got its big push from the Civil War.  Lincoln’s treasury secretary, Salmon P. Chase, failed at selling bonds to the commercial banks and failed again trying to sell bonds to wealthy individuals and businesses.  He brought in Jay Cooke, who had a new private banking house with experience organizing syndicates that included banks and brokers.  Cooke had learned about the securities business when he was a young reporter for the New York Herald.  His Wall Street-hating editor had him exposing securities manipulations. 

Cooke chose to sell the government’s war bonds to the general public, making sales in amounts as small as $50.  The bonds paid good interest and could be purchased by people of modest means.  Cooke had a sales force of 2,500, in every Union state and territory, and used newspaper advertising, posters and handbills.  There were night sales offices, called “Working Men’s Savings Banks.”  In one year, 1864, they sold $360 million in bonds.  [Robert Sobel, Inside Wall Street, W.W. Norton, 1977, page 199]

In marketing the war bonds, Cooke introduced what we today call “dual motive” marketing of securities.  In addition to safety, return and convenience, he also appealed to the patriotism of those who wanted to win the war and preserve the Union.  One of his newspaper ads read:  “But independent of any motives of patriotism, there are considerations of self-interest which may be considered in reference to this Loan.  It is a six per cent loan free from any taxation.”  [Quoted in Wall Street: A History, page 52, from Henrietta M. Larson, Jay Cooke: Private Banker, Harvard University Press, 1936, page 69.]  For a brief period, a century and a half ago, there was a model for the middle class to invest in securities. 

Cooke also adopted the European practice of repurchasing bonds in the aftermarket, to maintain the price level while new bonds were still being sold, a practice later to be called “stabilization” and protected by the Securities Act of 1933.

Cooke introduced a form of “underwriting commitment” between his underwriting syndicate and the issuer.  Unlike today, the syndicate did not commit to purchase and resell the entire offering.  Rather, the issuer had a period of direct marketing and the syndicate agreed to buy what was left.  The syndicate was underwriting the risk that the direct marketing effort would fail to sell the entire offering.  If that happened, then the members of the syndicate would purchase the unsold portion and try to resell it.  Today, this would be called a “standby commitment.” It is now used only in so-called “rights offerings,” where existing shareowners have the right to purchase a new issue of shares, usually at a discount to the market price.  Underwriters agree to buy any shares not taken by the shareowners.  The Cooke program, of a direct marketing by the issuer, with a standby commitment, hasn’t been in serious use since 1900.  All underwritten offerings must now be sold exclusively through the underwriters, and their full commission paid.  (My first client in an underwritten initial public offering had commitments from its officers, directors and their families to buy a substantial portion of the offering.  I tried to negotiate an exclusion of these shares from the underwriting and was told that it was never, never done.  The client was asked to turn over the names to the managing underwriter, so they could get credit for commissions on those sales.)

While the words “underwriting” and “underwriters” are still being used, they no longer have the original meaning of underwriting a risk, like insurance companies do.  Today, the underwriting agreement is only signed when all of the shares have been spoken for by investors and all regulatory steps have been cleared.  There is a period of just a few hours during which the underwriting syndicate owns the securities, before payment is received from investors, the underwriting commission collected and the balance turned over to the issuing business.  Even for those few hours, there is a “market out” provision in the underwriting agreement for a list of calamities that could occur and allow the underwriters to call off the closing.

In addition to Cooke’s sales to the United States middle class, the Civil War caused German immigrant merchants to start businesses to gather money from Europe’s wealthy families looking for safe havens from communism.  Some of these became major investment banking firms, such as Goldman Sachs and the late Lehman Brothers.  The War also caused New Englanders to start “Yankee houses,” such as J. Pierpont Morgan & Co., which has today become both J. P. Morgan Chase and Morgan Stanley.

After the Civil War, Jay Cooke tried to apply his war bond marketing system to bond issues for the Northern Pacific Railroad.  It didn’t work.  Cooke made at least three mistakes that are now classic “don’ts” of corporate finance.  One was that he advanced short-term funds to the railroad, which insisted on building rails faster than the bonds could be sold.  This put Cooke into a different relationship with the client, one of creditor rather than a service provider.  That affects judgment, like lawyers representing themselves.    Another error was to count on participation by other bankers (in his case the Rothschilds) without receiving a clear commitment.  (A client of mine once assured a prospective investor that a bank had made “a moral commitment” for a substantial loan.  The investor responded that “a bank is incapable of making a moral commitment.”  He went on to explain that my client may have had a moral commitment from a bank officer, but the officer may be transferred or easily overridden by a senior officer or committee.)

Cooke’s third mistake was to misjudge his market, the small investors.  Railroad bonds did not appeal to patriotism.  Instead of a “dual motive,” the investor was left with a straightforward financial risk/reward analysis.  That is a daunting challenge for a part-time investor.  With War Bonds, the only real risks were that the war would be lost, or that it would generate hyperinflation and make the money worth less when it was repaid.  There was no real comparison to be made between U.S. government bonds and a similar investment opportunity.  By contrast, railroad bonds mean assessing the feasibility of the new routes to be built, the competition, management.  (We advised on a direct public offering for a railroad, but used a dual motive marketing.  Rather than bonds, it offered shareownership to residents of its service area, to its riders, railroad buffs and other communities that wanted to support the railroad as well as try for a gain on the value of their shares.)

The advances Cooke had made to the railroad caused depositors in his private bank to withdraw funds.  Cooke went out of business in 1873, setting off a major panic on Wall Street. That “brought a speedy end to the first great effort of investment bankers to develop a large, permanent class of small investors,” while ones that survived sold “new issues abroad and to a select American clientele of large, individual and institutional buyers.”  [Competition in the Investment Banking Industry, Samuel L. Hayes, III, A. Michael Spence and David Van Praag Marks, Harvard University Press, 1983, page 26]

Before the 1890s, most businesses were still conducted as family partnerships.  So long as the entrepreneur/founder remained in charge, expansion capital came from retained earnings and bank borrowings.  When the business ownership passed on to the second and third generation family members, they were the ones who turned to investment bankers to raise capital and convert some of their holdings to cash. 

Railroads, their lawyers and lobbyists developed the law of corporations to become the favored form for larger businesses.  With incorporation, outside investment, beyond family and friends, became popular.  With the new corporate form, investment banking had gone from government securities through railroads to businesses in all industries.  By 1910, there were underwriting syndicates of more than a hundred banking and brokerage firms. Steady relationships were developed between investment banks and the regular issuers of securities, as well as with the money managers at commercial banks and insurance companies. 

Ever larger transactions were to come, from combining several competing businesses and selling securities in the consolidated business.  In 1901, J.P. Morgan put together the United States Steel Corporation, America’s first billion dollar business.  After the new business issued securities to the owners of the companies it acquired, Morgan managed an underwriting syndicate of about 300 firms as members.    

Along with the increased volume of securities offerings, “fewer and fewer corporations chose to sell their own securities, as had been common a generation earlier, when an issuer’s reputation often was greater than that of the banking house.”  [Competition in the Investment Banking Industry, Samuel L. Hayes, III, A. Michael Spence and David Van Praag Marks, Harvard University Press, 1983, pages 53-54]  Prestige became the principal competitive tool among investment bankers.  Their status was reflected in the newspaper advertisements for completed offerings, the so-called “tombstone announcements” with their pyramid listings from the managing underwriter at the top through several status tiers to the large base at the bottom.

Even with all this vast expansion to serve the demand for capital, the supply side for investment was still limited to institutions and wealthy individuals.  “Before World War I, only the very wealthy invested in securities.  Most of them lived in other countries.  Investment banks had the relationships with those investors.  They were the gatekeepers to raising capital within a few months.”  [Raghuram G. Rajan & Luigi Zingales, Saving Capitalism from the Capitalists, Unleashing the Power of Financial Markets to Creat Wealth and Spread Opportunity, Crown Business, 2003, page 220.]

We have a picture of investment banking in 1913, from Harper’s Weekly articles written by Louis Brandeis, a successful corporate lawyer who also took on many public causes before his 1916 appointment to the U.S. Supreme Court.  “The original function of the investment banker was that of a dealer in bonds, stocks and notes; buying mainly at wholesale from corporations, municipalities, states and governments which need money, and selling to those seeking investments.  The banker performs, in this respect, the function of a merchant; and the function is a very useful one.”  [Louis D. Brandeis, Other People’s Money: And How the Bankers Use It, National Home Library Foundation, 1933, page 5]  That original function was about to become subordinate to other, more profitable activities, as another war was to change Wall Street.

The Middle Class Enters the Investment Market

To pay for World War I, the U.S. Treasury issued the Liberty Bonds of 1917-18 and the Victory Bonds of 1919.  A total of $21.5 billion in bond sales were made in just over two years.  All of the bond issues sold out. According to Annual Reports of the Treasury Secretary, the first Liberty Bond issue was purchased by four million individuals and the second by nine million.  By the fourth issue, there were over 21 million individuals who purchased.  By comparison, the Treasury Reports estimated that about 350,000 individuals purchased bonds in the years before the war began.  [Paul G. Mahoney, The Political Economy of the Securities Act of 1933, University of Virginia School of Law, Law & Economics Working Paper No. 00-11, May 2000, hhtp://papers.ssrn.com/paper.taf?abstract_id=224729.], page 8, citing the Annual Report of the Secretary of the Treasury for 1917, H.R. Doc. No. 613, 65th Cong., 2d Sess., at 6 (1918) and the Annual Report of the Secretary of the Treasury for 1918, H.R. Doc. No. 1451, 65th Cong., 3d Sess., at 18 (1919).]

The Treasury Department made some direct sales, using marketing methods that Jay Cooke had developed for the Civil War.  There were small denomination saving stamps and bonds purchased on the installment plan.  However, the great majority of the bonds were sold through commercial banks, investment bankers and securities brokers, all working without commission.  There was a longer-term element of self interest. As Investment Bankers Association president Warren S. Hayden said, about expanding the market for securities, “the government will have done in a year or two what our private enterprise as it was before the war could not have done in decades.” [quoted in Investment Banking in America: A History by Vincent P. Carosso, Harvard University Press, 1970 and 1979 (references are to the 1970 edition), page 228.]  To sell the war bonds, the financial intermediaries had to market to the middle class, people who had never invested in securities.  They needed to be taught to trust parting with their money for nothing more than a piece of paper. 

The commercial banks were particularly imaginative and aggressive in selling Liberty Bonds and Victory Bonds.  They opened branches convenient to working people, kept evening hours and advertised.  The then largest American bank, the National City Bank of New York (now called Citibank), even had “a network of salesmen who went door-to-door.”  [Raghuram G. Rajan & Luigi Zingales, Saving Capitalism from the Capitalists, Unleashing the Power of Financial Markets to Creat Wealth and Spread Opportunity, Crown Business, 2003, page 220-21]  “Bonds were sold on the installment plan with interest charges offset by interest on the bonds, creating a virtually cost-free way for small investors to buy.”  [Lawrence E. Mitchell, The Speculation Economy, Berrett-Koehler Publishers, Inc., 2007, page 253]  Employers were encouraged to buy bonds and resell them to their employees, deducting installments from their paychecks.

“These developments changed the distribution process for new issues. Bankers perceived

that more money could be obtained from the millions of middle class wage earners than from a few wealthy families. Moreover, the Liberty Loan drives produced a generation of salesmen who were experienced at contacting hundreds or thousands of retail customers rapidly.  After the war, these salesmen created a nation-wide network of securities dealers who specialized in selling securities to individual investors.   These dealers employed 6,000 stock and bond salesmen in 1910, increasing to 11,000 in 1920 and 22,000 by 1930.” [Paul G. Mahoney, The Political Economy of the Securities Act of 1933, University of Virginia School of Law, Law & Economics Working Paper No. 00-11, May 2000, hhtp://papers.ssrn.com/paper.taf?abstract_id=224729.], page 12, citing the U.S. Dept. of Commerce, Bureau of the Census, Historical Statistics of the United States, Colonial Times to 1970, Part 2, p. 1104 (Washington, DC, US Government Printing Office, 1975).]

The new retail dealers formed the bottom rung of the distribution ladder. They purchased new issues for resale and held inventories of securities traded in the secondary markets to meet the growing demand of middle class households for investments.  The retail dealers were the base of the securities distribution pyramid, with the managing underwriter at the peak.  They were not included in the underwriting syndicates.  That membership was only for traditional investment bankers.  After selecting members of the underwriting syndicate, the managing underwriter would pick firms to become part of a “selling group.”  These dealers would be allotted a portion of the syndicate’s commitment, at a markup from what the syndicate paid the issuer but still at a discount from the price charged to the investor.  They had to sell at the same price and time set by the syndicate manager, or “bookrunner.” 

The managing underwriter’s power to include brokerage firms in the selling group continues to be a powerful tool for enforcing anticompetitive practices.  For instance, syndicate managers would keep out brokers which had participated in a “best efforts underwriting.”  That is where a broker agrees with the issuer to use its best efforts to sell the securities and to get paid only for what it sells.  Investment bankers will only do “all or nothing,” “firm commitment” underwritings and they discourage anyone breaking ranks with any other arrangement.

As attention turned to “the masses” for distributing securities, new securities brokers were formed and became members of selling groups.  J.P. Morgan & Co. and other established investment banking firms continued as wholesalers only, creating syndicates and selling groups of up to 1,200 firms.

The war bond success with smaller investors was the carrot for investment bankers to expand their buy side market.  The stick was the new federal income tax.  Investment banker Paul Warburg was quoted in The Magazine of Wall Street that taxes had “decreased the importance of the one-time class of professional capitalists as the exclusive field to cultivate for the purpose of placing investment securities.  The savings of the masses will become an element of growing importance in the regard, if private enterprise is to successfully finance the future of our country.”  [“Paul M. Warburg Says:  ‘Immigrants Are Potential Capitalists’,” June 26, 1920, page 226, quoted in Investment Banking in America: A History by Vincent P. Carosso, Harvard University Press, 1970 and 1979 (references are to the 1970 edition), page 251.]

As the War Bonds matured, Wall Street sold corporate bonds to the new investor class. By the 1920s, more businesses had begun using shares and bonds to raise capital, and more individuals were becoming investors.  Commercial banks, the institutions that took in deposits from the public and made loans to individuals and businesses, had been a big part of the War Bond campaigns.  After the war, they used the teams they had built to sell corporate bonds and then ownership shares to individuals.  Commercial banks had branch offices and consumer credit relationships, so they could serve the bank’s business loan customers who needed to sell securities for long-term growth capital.  The bank’s deposit customers became their market for bonds and stocks.

Commercial banks began acting like investment bankers, forming affiliates to underwrite securities issues.  Their market share got larger each year until, just before the Great Depression, commercial banks and their securities affiliates were the underwriters for nearly 37% of new issues.  By 1930, they were the selling firms for over 60 percent of the underwritten stocks and bonds.  “Their role in distribution made commercial banks by far the most important element in the investment banking business.  They relied heavily on salesmen and advertising, and the affiliates appealed directly to the parent’s deposit customers, with whose accounts and habits they were familiar.”  [Investment Banking in America: A History by Vincent P. Carosso, Harvard University Press, 1970 and 1979 (references are to the 1970 edition), page 279.]

Cutting Out Commercial Bank Competition—and the Middle Class

Investment bankers maintained their position as intermediary for raising money from wealthy individuals, institutional money managers and securities brokers.  Commercial banks were becoming the channel for money from the middle class.  We’ll never know what would have happened if the commercial banks had been able to continue their competition with investment bankers for supplying capital to businesses and government.  Instead, two related intervening events put investment bankers back into their monopoly control over the issuance and sale of new securities.

One event was the steep decline of the financial markets as we went into the Great Depression.  Long-term capital, for which bonds and shares are issued, is the fuel for growth.  There just wasn’t much growth during the 1930s and very little demand for the services of securities underwriters.  On the supply side, those who could have afforded to invest were not encouraged to do so in the Depression environment. 

The opening for investment bankers to get rid of their competition came with the public anger over money it lost on stocks and bonds purchased in the Roaring 20s.  Commercial banks had been full participants in the speculation and manipulation that was exposed after the 1929 stock market crash.  Stories of their bad practices were used to enact the Banking Act of 1933, prohibiting commercial banks from being investment bankers or selling securities.  More about investment bankers carried off this maneuver is in the chapter “The Traffic Cop on Wall Street.”

This law, known as Glass-Steagall after its authors, protected the investment bankers’ monopoly for another half century.  It also created the Federal Deposit Insurance Corporation, to guarantee bank depositors that they could get their money back if the bank failed.  It put ceilings on the interest rates banks could pay depositors, protecting them from price competition.  Banks with securities marketing affiliates had a choice:  Give up the securities business or operate without government-insured deposits.

After their success in lobbying Congress to get commercial banks off their turf, investment bankers could keep the capital channels restricted to their “preferred lists” of institutional money managers, securities brokers and wealthy customers.  There were good reasons for the less wealthy to avoid investing in the 1930s, but one of them was that no one was trying to sell them securities.  Investment bankers returned to what they had been doing before World War I opened up the middle class market—moving money from the wealthy to big business.

Our Government Bypasses Wall Street to Pay for World War II

In World War II, the U.S. government spent over $300 billion, more than it had spent in all of its pre-war existence.  The federal budget went from $9 billion in 1939 to $98 billion in 1945.  Some of the cost was met by increased taxes, but most of it was financed by selling bonds.  A total of $185.7 billion in bonds were sold to more than 85 million Americans, about half the total population.  Most of the bonds paid interest at less than the going rate for government and corporate bonds.  Marketing vehicles included the Payroll Savings Plan, where employers deducted bond purchase amounts from every paycheck, and savings stamps, at ten cents each, sold for children to buy and paste in booklets to be turned in for bonds.  Selling bonds to people at all income levels also soaked up money that might otherwise have been spent on the limited consumer goods that were available during the war, which could have caused inflation. 

World War II bonds were a great and successful direct public offering.  Unlike all of our other wars since the American Revolution, investment bankers were not chosen to underwrite the bonds.  The U.S. Treasury set up a War Finance Division which used all available media to bring Americans into regular bond purchases.   Advertising space and time were donated by newspapers, magazines and radio stations.  Movie stars and other public figures appeared at bond rallies and held radio telethons. Irving Berlin wrote the theme song, “Any Bonds Today,” performed by the Andrews Sisters.  Auctions for bond purchase pledges were held for items like Betty Grable’s stockings and  Man-o-War’s horseshoes.  Some businesses created and placed their own ads to promote bond purchases.

The actual selling to individuals was done by volunteers.  They were trained to go door-to-door and staff kiosks.  Without receiving any commissions or other pay, the volunteers  made telephone calls to arrange times to meet at a home, place of business or sales kiosk.  Communities were given quotas and put in contests for selling the most bonds.  One can only imagine what could have been done with the tools of the Internet.

Even with this immense and successful marketing, banks and other institutions and businesses bought three times the dollar amount of war bonds that were sold to individuals.  These sales were for the firms’ own investment and not for resale.  Investment bankers and other financial intermediaries were not a significant factor in financing World War II.  The biggest financial transaction in history had bypassed investment bankers.  Perhaps the relationship between Wall Street and the Roosevelt administration had something to do with it.  Maybe it was simply the realization that direct marketing from the government to the public would be better and cheaper.

When the last War Bond had been sold, there was no recorded sign of financial intermediaries using the direct offering program to market other securities.  New securities issues were still dominated by the same investment bankers and they stayed with their underwriting syndicates, selling to other broker/dealers, institutional money managers and wealthy individuals.  The process was very much like the post-World War I of the 1920s.  The big difference was that investment bankers and securities broker-dealers had the market all to themselves.  Commercial banks had been frozen out by Glass-Steagall, the Banking Act of 1933.  The New Deal securities laws entrenched registered securities broker-dealers as the monopoly for selling securities.  It had become unlawful to even attempt to act as a financial intermediary for securities, without first being registered with the SEC as a broker-dealer.  [Securities Exchange Act of 1934, Section 15]

Wall Street—But Not Investment Bankers--Court the Middle Class

After the war, many retail brokerage firms did seriously try selling to the middle class.  They focused on trading previously owned securities on the exchanges and in the over-the-counter markets.  They also sold from their allotments of securities in underwritten public offerings.  “Having a stockbroker became as necessary as having a minister or a psychiatrist in the new American middle-class society . . ..”  [Wall Street: A History, by Charles R. Geisst, Oxford University Press, 1997, 274] The bull market that developed after President Eisenhower’s 1952 election continued for more than fifteen years.  Thousands of retail brokers were hired.  Commission rates on trades were fixed by the New York Stock Exchange, so there was no price competition among brokers in the trading of existing securities. 

Even with this growth in the Wall Street sell side, “investment banking in the 1960’s was as highly concentrated as it had been sixty years earlier.  In some respects it was even more so.  No matter how measured—firm size, capital employed, underwritings, syndicate managements—a relatively few large houses, mostly located in New York City, conducted most of the nation’s new issues business.”  [Investment Banking in America: A History by Vincent P. Carosso, Harvard University Press, 1970 and 1979 (references are to the 1970 edition), page 505.] Sales of new issues of securities have continued to be sold to the same people and in the same way.  Institutional money managers are invited by the managing underwriter to “road show” presentations and private meetings.  Brokers working for firms in the underwriting syndicate or selling group telephone their customer list and may cold call some prospects. 

While investment bankers continue to deal only with institutional money managers and wealthy individuals, others on Wall Street are marketing to the middle class--mostly selling mutual fund shares to investors and running a casino for traders in derivatives, commodities, currencies and other zero game gambling.  Managing underwriters will bring retail brokerage firms into their underwriting syndicates and selling groups, but there is no real marketing effort to retail customers.  None of the lessons from selling war bonds was introduced into the underwriting pattern.  In fact, the federal securities laws were presented as an absolute barrier to the advertising and soliciting that would reach those who are not finance professionals.  This isn’t true but it provides a quick and easy answer to why there is no effort to reach a mass market.

The real reason that investment bankers don’t sell shares directly to the middle class is because they don’t have to.  They can make their full commission without spending the extra time and money to reach the mass market.  Underwritten offerings are the last holdout of the fixed commission, and the commission is technically paid by the issuer, not the investor.  That means that the underwriter gets the same amount per share, whether the sale is for 100 shares or 10,000 shares.  Obviously, the underwriter is going to focus on the prospects who can buy 10,000.  These prospects are their counterparts on Wall Street’s buy side.  With a few “road show” breakfasts, luncheons and dinners, along with some telephone calls, an entire issue can be placed. 

The commission of nearly all Initial Public Offerings of stock has been maintained at seven percent, among all the Wall Street investment bankers.  Competition among the investment bankers is all about who knows whom, which image and promises are the most persuasive and other nonprice subjective issues.  There just is no price competition.   (I once described this phenomenon to a friend who had a perfect score on the Law School Aptitude Examination, graduated from Harvard Law School and had then chosen to surf and play his guitar.  When I told him that I didn’t believe that investment bankers even spoke out loud about how they stifled competition, he responded, “They don’t need to.  It’s in their mother’s milk.”)

Mutual Funds Come Between Investment Bankers and the Middle Class

Another layer of financial intermediary was introduced into the process, the mutual fund manager.  Investment bankers get their full commission from the issuer, mutual fund managers get their fee based on the size of their fund and brokers are paid for selling mutual fund shares.  The sell side was vastly expanded by the success of mutual funds.  They have become the mechanism for gathering money from the middle class.  Wall Street money managers are the marketing arm for Wall Street to attract funds from the retail market.  These mutual fund managers then become the buy side for the new securities issues underwritten by investment bankers, another financial intermediary earning commissions on the public’s money.

Mutual funds are a creature of the Investment Company Act of 1940, which was one of the last New Deal laws to tackle Wall Street abuses, the investment trusts that had sold to the unsophisticated small investors in the 1920s.  These trusts had often been riddled with conflicts of interest and many were near total losses after the Crash of 1929.  The Investment Company Act placed serious reporting and regulatory requirements on funds that sold shares to the public and invested in securities.  The new investment pools created to comply with the new law were marketed as “mutual funds.”  Today, there are over 10,000 mutual funds, more than the number of companies with shares traded on U.S. stock exchanges and active over-the-counter markets.

By the early 1960s, over half of all new shares sold to the public were those issued by mutual funds.  This is likely why the SEC stopped included mutual fund shares in its reports of new security offerings.  [Investment Banking in America: A History by Vincent P. Carosso, Harvard University Press, 1970 and 1979 (references are to the 1970 edition), page 498].  A whole new layer of intermediary was placed between those investing smaller amounts and the businesses with public shareownership.  The arguments for inserting another intermediary taking another percentage of the investors’ money are usually “professional management” and “portfolio diversity.”  While analyzing the value of mutual funds as the way for individuals to invest is outside the subject of this book, the recorded averages are unfavorable.  [Statistics summarized by Motley Fool show, “The average actively managed stock mutual fund returns approximately 2% less per year to its shareholders than the stock market returns in general.”  www.fool.com/School/MutualFunds/Performance/Record.htm.  On diversification, the conclusion from analysts is that it can be achieved within a modest personal portfolio.  www.fairfieldnationalbank.com/investments/WealthManagement/GrowingYourWealth/ReducingRisk.asp.]   But it is clear that there is every incentive to sell only to those who buy in very large amounts, so long as Wall Street insists on using the expensive, inefficient marketing methods developed a century ago. 

In all of the process of marketing new securities, mutual funds are about the only place where the mass marketing War Bond lessons are used today.  The mutual fund industry has lobbied a series of minor modifications to the SEC rules about advertising.  They have become omnipresent in magazines and newspapers, on television and radio and now on the Internet.  They have adopted all of the tools of direct marketing.  Now, many of them  are “no load” funds, selling their shares directly through advertising, without paying a broker or using a sales representative.

The result is that the flow of capital from nonwealthy individuals to businesses passes through at least two sets of intermediaries, each taking a percentage fee.  The underwriting investment banker sells its clients’ shares to the mutual fund manager, who either sells its mutual fund shares directly to the individual or pays a commissioned broker.  Why couldn’t the issuer bypass all two or three of these intermediaries and market directly to the individual?  Part Two of this book shows how this is beginning to happen and what can be done to move it along.

An argument can be made if favor of keeping the in investment banking business separate from selling securities to retail customers.  There could be some value in having a group of specialists who served only the businesses and governments issuing securities.  Kind of like the English system of barristers and solicitors, the investment banker would serve the interests of the client and the capital markets, without being influenced by the business of dealing with investors.  Retail brokers and buy side money managers would take care of the demand side, while investment bankers focused on supply side needs and concerns.

Financial Derivatives Become the Investment Banker’s Stock in Trade

Whatever validity that argument might have had, it went away with the changes on Wall Street after the bull market of 1953 to the late 1960s.  Stocks and bonds began to have competition from other financial instruments.  Out of the commodity futures markets came securities used to hedge stock and bond investments.  This was the beginning of the market for “financial derivatives,” so called because they were derived from the risk and price movement in other securities.  On the buy side of Wall Street, derivatives became accepted and popular because the purchaser could get the effects of price changes by using only a fraction of the money it would have taken to buy the underlying stock or bond.  On the sell side, these new derivative securities were relatively free of competitive pressure on commissions and fees.

Bigger changes came with the end of monopoly pricing on stock trading commissions. Monopoly pricing of commissions had been set by the New York Stock Exchange since it began in 1792, resulting in huge profits during the bull market of the 1950s and 1960s.  Fixed commissions meant that every brokerage customer paid the same fee schedule to buy or sell stocks or bonds.  There was no price competition and no break for large orders over small ones.  Customers retained their brokers based on personal relationships, reputation for good results or other nonprice factors.  Increasingly during these years, brokerage customers included money managers for pension funds, mutual funds and other institutions.

As mutual funds came into increasing popularity in the 1960s, their professional money managers joined with managers of pension funds and others to pressure for discounts on their huge transactions.  They had much more market power than individual investors and some brokers began finding ways to circumvent the Stock Exchange rates.  In 1971, the NASDAQ Trading Market began to compete with the Stock Exchange.  Recognizing the inevitable crumbling of fixed rates, the SEC required a phasing in of negotiated commissions.

When fixed commissions went away, brokerage firms began finding other ways to make profits.  They looked to transactions that weren’t easy to compare, that could not be shopped around for the lowest price.  This led to bonds issued by foreign companies (the Eurobond market) and by American companies that didn’t carry investment grade ratings (the junk bond, or high-yield market).  It also led to the creation and selling of new securities that were simply markers for the movement in stocks, bonds and other financial measures (the derivatives market). 

As former retail securities brokers began to diversify into creating transactions and securities, they were moving in on the underwriting business.  Unlike commercial banks, they had no legal impediments to becoming investment bankers.  That’s because they were registered as securities brokers and dealers.  They could buy and sell securities for their own account, as well as for customers’ accounts.

A major goal of Roosevelt’s New Deal had been to separate the functions of broker and dealer.  The securities laws define a “broker” as someone “in the business of effecting transactions in securities for the account of others,” while a “dealer” is “in the business of buying and selling securities for his own account.”  [Securities Exchange Act of 1934, sections 3(4) and 3(5)]  The drafters of that New Deal legislation wanted to force Wall Street firms to choose whether they would be a broker or a dealer.  A lobbying blitz by the Investment Bankers Association kept that restriction out.  This dealer status allows investment bankers to keep the firm commitment underwriting structure, where they technically purchase and resell a new issue of securities.  They receive money from the investors and transfer it to the issuing business, less their “underwriting discount.”

The lobbying victory against separating brokers and dealers not only allowed brokers to add underwriting and trading for themselves.  It also allowed investment bankers to diversify into being a broker, an agent for the resales of securities.  By the 1970s, most investment bankers had acquired or developed brokerage businesses, to participate in the trading of securities, including the new derivatives.  At the same time, most Wall Street retail brokers had pirated employees from investment banks and gone into competition for underwritings.

Investment Bankers Become Traders for Their Own Accounts

The other business investment bankers built was trading in securities with their own money, being a securities dealer, for the firm’s own profit.  However, being a dealer requires lots of capital.  To have that capital, the Wall Street partnerships began incorporating and having public offerings of their own stock.  [For an illustration of the argument that incorporation was a major contributor to Wall Street’s crash, read “The End,” by Michael Lewis, in a brief sequel to his book Liar’s Poker, in Portfolio.com, November 11, 2008, www.portfolio.com/news-markets/national-news/portfolio/2008/11/11/The-End-of-Wall-Streets-Boom/index.html]  Those that had been primarily investment bankers, distributing new issues of stocks and bonds, became major traders in securities for their own account with their new public capital.  Partners gave up ownership of the profits, but more than replaced it by bonuses taken from the new proprietary trading gains.

Buying and selling with their own money became the dominant business for the most profitable investment banks, like Goldman Sachs:  “Before the financial crisis, everyone on Wall Street used to joke that Goldman wasn't so much an investment firm as a giant, risk-laden hedge fund. It seems that old label still applies.”  [Matthew Goldstein, “Goldman: The Same as it Ever Was,” Business Week, April 21, 2009, www.businessweek.com/bwdaily/dnflash/content/apr2009/db20090421_616379.htm?link_position=link18]  "By 2007, some of these banks were essentially public hedge funds, taking massive, highly levered bets on the housing market."  [Robert J. Rhee, Associate Professor of Law, George Washington University, "The Decline of Investment Banking: Preliminary Thoughts on the Evolution of the Industry 1996-2008," Journal of Business and Technology Law, Volume 5, number 1, page 97, University of Maryland School of Law, http://www.law.umaryland.edu/academics/journals/jbtl/issues/5_1/5_1_075_Rhee.pdf]

As investment bankers began to have public shareowners, they became subject to the need for steadily increasing earnings.  Underwriting new securities issues is a boom and bust business.  But the business cycle for mergers and acquisitions is generally the mirror of the public offering cycle.  When new stock offerings slack off, it is usually because market valuations, such as price/earnings ratios, are at the low end of their trading range.  By contrast, companies with depressed stock prices are hunted by acquirers.  Investment bankers often call on senior executives of companies, with ideas for what businesses they might acquire or how they might defend themselves against a hostile takeover.

A major diversification for investment bankers was to expand their advisory fee business for mergers and acquisitions.  Like public offerings, M&A advisory agreements usually called for fees to be paid at closing, based upon a percentage of the transaction size.  If the client was a target company, the fee might be for successfully fighting off an acquisition, or for getting a better price than the original offer.  M&A work was an ideal

complement to public offerings.  The same types of personalities and skill sets are involved.  The decision makers at the prospective clients are the same people. 

Investment bankers diversified their businesses even further away from underwriting new issues of securities, beyond brokerage, proprietary trading and M&A advisory work.  Some started or bought real estate investment operations.  Others acquired money management firms, placing the firm on both the sell side and the buy side of capital transactions.  They went after the international markets, usually starting with opening offices in London.  Investment banks even poached on the business of the big commercial banks, in the syndication of large loans to business and government.  Loans that are too large for one bank to make are divided up among many lenders, with a fee going to the bank that put the syndicate together.  Not only did investment bankers begin competing in this role, but they included pension funds and other large pools of managed money as syndicate members.  Whatever creativity there may have been in the investment banks, it went into alternative profit sources, rather that improving the flow of capital from individuals to businesses.  The underwriting business was left to remain largely the same as it has been for the last century.

With all this new business and diversification, Wall Street firms became victims of the very monster they had created.  The shift from long-term investing to frequent trading had made for much more frequent buying and selling, which earned more brokerage commissions and more opportunities for profitable trades for their own account.  However, the securities intermediaries were now public companies themselves.  They had to respond to the same pressure for quarter-to-quarter profit increases.  For example, Merrill Lynch, which had grown huge from being the broker for the middle class, was reported in 2001 to have changed its strategy “to focus the firm’s brokerage business on attracting wealth investors with at least $1 million in assets.  The move away from small investors is part of a broader plan to boost profits at the big securities firm.”  Its president, Stanley O’Neal, plans “to expand in areas where the firm can achieve high profit margins, such as equity derivatives.”  [The Wall Street Journal, November 2, 2001, page A1]  Running a casino for high rollers was to be more profitable than moving capital from individuals to businesses.  Merrill Lynch went on to gigantic losses in 2008, firing Mr. O’Neal and being acquired by Bank of America.

As investment bankers diversified, others were on the move as well.  This expansion of roles became a two-way street.  Large corporations began bringing some of the capital-raising functions in house.  The SEC adopted its Rule 415, which allowed businesses to register a proposed offering and then wait until the market was at its most favorable to actually sell the offering.  This took away the dependence upon one investment banker and allowed the company to shop around for someone to bring them the best terms.  Traditional relationships were weakened.

Wall Street Commercial Banks Become Investment Bankers Again

Commercial banks didn’t just stand by and watch investment banks encroach on their turf.  While the Banking Act of 1933 (Glass-Steagall) still kept them from direct competition, a big opportunity was handed to them as the investment bankers developed the new derivatives market.  Many of these derivatives, like interest rate swaps, were not “securities” and commercial banks could muscle into the market.  “Swap trading began a revolution that would pave the way for commercial banks’ intrusion back into investment banking after decades of separation.”  [Wall Street: A History, by Charles R. Geisst, Oxford University Press, 1997, 347]

That revolution won a big battle when the Federal Reserve Bank effectively overruled Congress in 1990 by giving first JP Morgan and then other money center banks limited permission to underwrite securities.  The Fed first interpreted the Banking Act of 1933 as allowing no more than ten percent of a bank’s revenue to come from the securities business.  As the Federal Reserve permitted more encroachments, increasing the ten percent limit on investment banking revenue to 25 percent, a full-scale, and successful lobbying effort was launched for repeal of the wall between commercial banking and investment banks.  JP Morgan prepared a study called “Glass-Steagall: Overdue for Repeal,” which argued against the investment bank oligarchy, pointing out that well over 90 percent of U.S. debt and equity underwritings were managed by 15 investment bankers.

The distinction between investment bankers and commercial banks went away almost completely in response to the credit crisis in late 2008.  Independent investment banks were acquired by commercial banks, were liquidated or were allowed to become parts of bank holding companies.  How will that change the underwriting process?

Investment Bankers No Longer “Underwrite” Securities Offerings

In the Funk & Wagnalls 1911 Dictionary, “underwrite” is defined, in finance, as “to engage to buy all the stock in (a new enterprise or company) which is not subscribed for by the public.”  That fits with the insurance concept of “underwrite.”  It represents a transfer of risk from the business raising capital to the financial intermediary.  The investment bankers were the experts in the market for securities, so they could best judge the risk and adapt to it.  They also had the opportunity to diversify their risks, among several companies and over different market timing.

“For a fee or premium, the underwriter agreed to take up whatever portion of the issue was not purchased by the public within a specified time. And just as insurance companies frequently reinsure large underwritings with other companies in order to distribute the risk, so the initial underwriter often protected himself by agreements with sub-underwriters, to which the issuer was not a party. The typical underwriting syndicate was not limited to investment bankers or so-called issuing houses. It included or even consisted entirely of insurance companies or investment trusts or other institutions, or even large individual investors who thus obtained large blocks of securities at less than the issue price.  . . This method of distribution is called in the United States ‘strict’ or ‘old fashioned’ or ‘standby’ underwriting. It is seldom, if ever, used here except in connection with offerings to existing stockholders by means of warrants or rights”  [Louis Loss, Joel Seligman, Troy Paredes, Securities Regulation, Aspen Publishers, 2009, Chapter 2.A.1]

 A “firm commitment underwriting” is what investment bankers call their practice for the last 80 years or so.  It is neither an underwriting nor a firm commitment.  The risk of an offering selling remains with the company seeking money.  Until all of the steps have been completed and all of the shares have been spoken for, the company has only a “letter of intent” to rely upon.  It specifically is not a commitment to complete an offering.

Why We Still Have Investment Bankers Today

We no longer need investment bankers to raise capital for business.  Their market first existed because of the painfully slow communications media that existed until the electronic age.  They gathered information about prospective investors and handled the steps in a marketing process: letting prospects know the securities are going to become available, gathering indications of interest, negotiating a price and closing the transaction.   Today all of this can be done by a few people at a computer terminal.

Of course, this possibility has been true for over a decade.  Michael Lewis described it in a 1999 article:  “There are some obvious barriers to the Internet taking over the market for initial public offerings: SEC regulations, investor habit, the desire of some corporate CEO's to have someone around to blame when things go wrong. But it is a short and logical step from selling stocks over the Internet to raising money for a private company over the Internet, and then to raising ALL money over the Internet.  Which is to say that it's only a matter of time before computers -- instead of Wall Street bankers -- stand between borrowers and lenders.”  [“How Capitalism Will Eat the Capitalists,” Bloomberg News, April 22, 1999]

Its been over ten years since that observation by Michael Lewis and we still have the same process for new issues as it was a century ago.  What has happened to maintain the underwriting system?  One explanation is that an artificial need for the system has been created as the real need faded away.  Investment bankers have kept up the myth that they are the only ones who can sell securities offerings.  They’ve had a lot of help from the government in perpetuating that myth.  The legal obstacles are so intimidating that it is easy to believe that only the professionals can surmount them.  SEC rules and practices are extremely restrictive for any written communication (including electronic).  But for oral communications it has been anything goes, except being caught in outright fraud.  Of course, underwritten securities are sold by oral communications, either by telephone or in meetings.  The only written material is the prospectus, which is delivered after the purchase order has been taken.

Meanwhile, the regulatory hurdles for direct securities offerings remain in place or become higher.  When the investment bankers lobbied Congress to exempt their underwritings from state securities laws, they limited it to securities approved for listing on the major stock exchanges, including Nasdaq.  Those listings are available only to proposed firm commitment underwritings.  Since no one can do firm commitment underwritings except SEC-registered broker-dealers with sufficient capital, businesses still believe they need investment bankers to raise capital from the public.

The barriers to raising capital without Wall Street can easily come down.  Our communications technology and direct marketing ability can replace the monopolistic maze maintained by Wall Street.  Is there any real need at all for investment bankers?  (Once I was talking with a partner in one of the oldest Wall Street investment banking firms.  We were discussing changes in the way money could be moved and whether there was still any real need for investment bankers.   He said that there would always be investment bankers, because CEOs needed someone they could talk to about matters that they couldn’t discuss with anyone else, especially their board of directors, subjects like “this business has about peaked and is headed for a big decline; how do I take care of myself.”)

Who is going to tell entrepreneurs that they don’t need investment bankers?  Surely not the securities lawyers, who depend heavily for clients upon referrals from investment bankers.  Not the accountants, who hope to be recommended as auditors by a prospective client’s investment bankers.  And not the management of companies who have recently completed underwritten offerings.  They will have been indoctrinated with the lore of investment bankers as the only path to riches.  Even Nobel laureate Paul Krugman described investment banks in his 2009 book as “repositories of specialized information that could help direct funds to their most profitable uses.”  [Paul Krugman, The Return of Depression Economics and the Crisis of 2008, W.W. Norton & Company, 2009, page 83]  The phrase sounds like an academicians version of Gordon Gekko’s line about insider tips, from the movie Wall Street:  “If you’re not inside, you’re outside.” 

What about the investor side of raising capital?  Don’t we need Wall Street investment bankers to gather information and make judgments for us?  Well, first there is the conflict of interest.  If a public offering doesn’t get sold, the investment banker doesn’t get paid.  Beyond that, we are no longer in the days before the Internet and all the raw data and advice at our fingertips.  As the legendary investment professional Peter Lynch said over 20 years ago, “I can’t imagine anything that’s useful to know that the amateur investor can’t find out.  All the pertinent facts are just waiting to be picked up.  It didn’t use to be that way, but it is now.”  [Peter Lynch, with John Rothchild, One Up on Wall Street, Penguin Books, 1989, page 182]

Couldn’t Wall Street be reformed to serve the interests of capital formation for America’s businesses, governments and individual investors?  Roger Martin, Dean of the Rotman School of Management at the University of Toronto, wrote:  “In response to the question: What does Wall Street have to change to produce better leaders, a different culture and a more long-term focus? Forget about it. Don't even waste time thinking about it. The purpose of Wall Street firms is to trade value for their own benefit not to build value for the economy either short-term or long-term. While at one point in its history, a non-trivial part of Wall Street's activity involved financing the growth of American companies, that is now a minor piece of its business. Wall Street is primarily engaged in encouraging individuals and companies to trade value between one another and tolling the parties for the service, and trading against the outside economy for its own account. . . Wall Street has only one prerogative and that is to maintain the illusion that it adds value so that it can charge spectacular sums for its services. . .  And increasingly, Wall Street has recognized that the above businesses earn chump-change in comparison to the consistently super-normal returns of their best business of all: proprietary trading, in which Wall Street makes supernormal returns trading for its own account. Given that Wall Street can't demonstrate that it provides valuable trading insight for outside clients, it begs the question: how can it earn super-normal returns trading on its own account? The answer is not a very reassuring one: proprietary trading based on proprietary information. And the very best proprietary information is information that comes closest to being illegal. This is not a zero-sum game. Wall Street wins and everybody else loses. . . So I think it is foolish to think about Wall Street producing leaders that help build the economy. That isn't in the DNA. Wall Street exists, first and foremost, to benefit Wall Street and that isn't going to change anytime soon.”   [The Washington Post, September 16, 2009, http://views.washingtonpost.com/leadership/panelists/2009/09/a-las-vegas-illusion.html?hpid=smartliving]

As another writer described it, “In a soundbite, the U.S. financial system performs dismally at its advertised task, that of efficiently directing society’s savings towards their optimal investment pursuits.  The system is stupefyingly expensive, gives terrible signals for the allocation of capital, and has surprisingly little to do with real investment.”  [Doug Henwood, Wall Street:  How it Works and for Whom, Verso, 1997, page 5.]

Even if we could do without Wall Street, why not just leave it alone?  The reason we need to bypass Wall Street is that it is causing great harm to our country.  It is even more true today than when Franklin Delano Roosevelt said, “Practices of the unscrupulous moneychangers stand indicted in the court of public opinion, rejected by the hearts and minds of men.”  [Franklin D. Roosevelt, Public Papers and Addresses, vol. 2, New York: Russel & Russel, 1933, page 12]