How Investment Banks Make Their Money
There were a lot of people who requested for this answer from a few e-mails I have been receiving, so I figured I will conduct an article which explains it. Investment banks have numerous methods in which they receive revenue. Just to inform you, the major investment banks are JP Morgan, Goldman Sachs, Meryll Lynch and Morgan Stanley. These investment banks have proven to be government backed, due to the size of the company’s operations and the how their overall performance impact our economy. An Investment Bank is exactly how it sounds. They handle other corporations, hedge funds, governments and individual investor’s funds, and also give them investment advice. Primarily, they have a number of top shareholders that invest huge sums of capital to the investment bank with expectations of the company’s stock to rise in the future, which will yield the investor a profit. These banks have traders and investments managers within its firm for various other methods of other financial gain.
The investment banks mentioned above all issue IOUs, which are loans. However, these IOUs cannot be compared to the US Treasury Bond as the T Bond has a history of no defaults, which reassures global investors and most crucially makes this particular investment known as a ‘safe haven’ investment in times of economic uncertainty or crisis, but for how long? Whenever they issue one of these IOU’s, they simply borrow from whoever purchases the IOU. The phrase simply means ‘I Owe You’ whatever the investors principal is, including the interest that is agreed. Their interest rates are usually higher than the US government treasuries as their investors would demand a higher rate on their investment considering they are not government and a collapse in the economy can affect their investment. The reason why the government treasuries are considered as a safe haven is simply because they own the printing presses, meaning they can print dollars to give you in any worse scenario, that’s if you are willing to accept it. The investment banks can’t simply do this, giving the government power. Every major investment bank operate in IOU issuing, from 1 month – 30-year maturity durations.
Reflecting back to the major investment banks being backed by the government, let’s take into consideration the 2008 financial crisis. Most of you may know of the $700 billion bailout money that all these investment banks received to make up for their risky Mortgage Backed Securities and other complex securities purchases. Each of these firms had huge amounts of investments in these securities, with leverage ratio’s as high as 16:1. When the value of these securities was revised by the Standard and Poor rating agencies, this devalued those assets, which ultimately led to a devaluation in global house prices. Let’s focus on Lehman Brothers. This is an investment bank that were heavily involved in the purchases of these risky securities. Unfortunately for Lehman, they did not receive any funding from the government. Barclays said they were willing to help out, if only the US Treasury could provide a back-stop. Evidently the US Treasury was not interested in providing a back-stop due to the risks, which led to Lehman Brothers filing for chapter 11 bankruptcy. Reflecting back to the IOU’s that each of these investment banks issue out, there are short-term to long-term IOUs. They could not make good on their T-notes, which were the IOU’s that had a relatively closer date to maturity – which will ultimately lead to a default on their loans. (Bear in mind that this was in the billions range if you calculate it collectively). Filing for bankruptcy for investment banks is clearly stating to the courts that they cannot make good on their IOU’s and they will need to disperse their assets in an orderly fashion in order for the payments to be returned to their investors and shareholders or its equivalent.
You may be wondering why the US Government will bailout all these firms and would not lift a finger if a company such as ‘EE’ or ‘John Lewis’ ever found themselves in any financial issues. It’s clearly because of the size of these major firms, most people consider them ‘Too Big to Fail’. An average large investment bank has a minimum of 15,000 employees worldwide, billions in assets under management and most crucially the savings of the elderly and the even the middle aged. It is safe to say these institutions are no corner store. The collapse of a company who is this large in terms of its operations and business will cause catastrophic impacts on any economy. 15,000 employees’ out of work will cause an outrageous decline in the US Job numbers, which ultimately decreases consumer spending and most crucially US government tax earnings. Thousands of savers losing their principle will create ‘hoarders’, meaning less people will be spending on consumer goods and services, which ultimately leads to a slow economy. It is pretty much similar to a domino effect, which the government was clearly adamant on avoiding, hence the bailout. With this all being said, to end the major financial crash that occurred in 2008 JP Morgan received $12 billion in bailout funds, Goldman Sachs received $2.9 billion, Bank of America purchased Meryll Lynch for $50 billion, Morgan Stanley received $9 billion, Bear Stearns was purchased by JP Morgan, and Lehman Brothers received nothing which definitely did contribute towards further catastrophic events in the global economy. The US government also bailed out AIG which is an insurance firm. They are not an investment bank, however they insured the defaults on all of the MBS assets that each investment bank owned, which was worth hundreds of billions. They received $150 billion of bailout money, which was the most for obvious reasons.
Investment banks have numerous of other methods of which it receives revenue. One of those methods are providing financing for clients with an interest. They also charge for the investment advice they give to their clients also.
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