History Lesson 1

1. History Lesson 1 Why History? Early days of capitalism afford uncluttered view of the financial process. Still live with the effects of the far past. (Repeal of Glass-Steagall in 1999). Industrial Revolution gave rise to new economies of scale and scope which meant that growing companies’ needs for capital outstripped a single family’s fortunes.

2. History Lesson 2 At the same time, with specialization of activities (and expertise), there were growing sources of capital. The problem was how to bring these two together.

3. History Lesson 3 In the US, in the late 19th century, demand for capital exceeded available savings. The US was a developing country, and acquired most of its development capital from Europe. Powerful financial intermediaries arose in this setting. Why?

4. History Lesson 4 The suppliers of capital wanted high return and low risk. However, there was virtually no credible information about the companies seeking capital. There was no SEC, no GAAP, and little macroeconomic / industry data. Suppliers of capital had to rely on the reputation of the intermediary - not the user of capital.

5. History Lesson 5 After establishing credibility, the intermediary is in position to dictate terms to the users of capital and the suppliers of capital. Additionally, powerful intermediaries, like the House of Morgan, were in a position to design the economic system.

6. History Lesson 6 The Death of the Banker focuses on the relative bargaining strengths of: the users of capital, intermediaries, and the suppliers of capital. Its theme is that the power of financial intermediaries has steadily declined since the early days.

7. History Lesson 7 An example of the bargaining strength of financial intermediaries is what Chernow call the “Gentleman Banker’s Code.’’ This refers to “unwritten rules that governed the relations between premier banks and borrowers . . . Companies agreed to comprehensive relations with their banker; if it was learned that they had even talked to competitors, they would be politely shown the door.

8. History Lesson 8 Remember, the borrowers needed the bank’s reputation. The lending of one’s reputation is known as bonding. From The House of Morgan, (p. 38): Under the Gentleman Banker’s Code, bankers held themselves to be responsible for bonds they sold and felt obligated to intervene when things went awry.

9. History Lesson 9 From DoB (p. 29): “Such bondage possessed signal advantages for companies in those days. A banker’s seal of approval ensured that firms would enjoy unimpeded access to capital at highly attractive rates. Nowadays we justly deplore the short-term orientation of many companies whereas Morgan and his partners represented ‘patient money’ and could afford to take the long view. Acting as bulwarks, they permitted young companies to ripen and develop without excessive shareholder interference.”

10. History Lesson 10 A relationship with Morgan was deeply involved. In the early days, it usually entailed at least 1 Morgan partner on the Board of the corporation. A 1991 study by Bradford De Long found that companies with a Morgan partner on the Board of Directors added 30% to their common stock’s market value.

11. History Lesson 11 In a 1995 paper in The Journal of Finance, Carlos Ramirez finds that companies with Morgan ties were less liquidity constrained than companies without bank ties. Liquidity constraints are measured by the correlation between a company’s capital investment and its cash flows from operations. The idea being that if you must rely on internal capital for investment, you are capital constrained.

12. History Lesson 12 From DoB, p. 33: “At bottom, the real power of old-line bankers lay in their monopoly over information, a commodity even rarer than capital in those days. Since companies didn’t issue annual reports, quarterly reports, or even press releases, Wall Street bankers profited from the gross imbalance between what they knew about these companies and what the poor benighted masses did.’’

13. History Lesson 13 The contrasts between the bargaining strengths of the three parties today relative to 1877 are stark. Today, large companies have better reputations and access to capital than the investment banks. Investors have found strength in numbers. Pension funds are exerting influence on management to improve stock performance.

14. History Lesson 14 Chernow argues that in the 1960’s the profitable activities of investment banks has shifted from relationships to transactions. Most of this class focuses on the problems associated with informational asymmetries in financial transactions.