The Financial Times has an interesting, counterintuitive take on the fallout from the subprime mess as various investment banks have made significant writedowns of their fixed income assets. Indeed, the recent performance of these banks' stocks seems to reflect this take. Instead of punishing the stocks of these banks further, the markets are actually responding positively to them. [UPDATE: Merrill Lynch today announced $5.5B in writedowns from CDOs and subprime. Its stock is up as I write.] First, there's a sense of "I hope they've learned their lesson--for know." Second there's relief that things haven't gotten even worse. As bad as things may appear, these investment banks haven't exactly gone to the poorhouse just yet.Nevertheless, these banks are not quite in the clear. A large fall in consumer spending prompted by the subprime mess may still inflict copious damage on other parts of the banks' activities which have proven relatively resilient to the housing carnage. As they say, stay tuned.
Bankers are counting the cost of the crisis. After almost two months spent weathering the storm in the global debt markets, the world’s leading investment banks are adding up the damage to their balance sheets from the sudden jump in the cost of risky credit and the liquidity drought that has left them holding billions of dollars in unwanted assets.The numbers are large: this week alone, Citigroup, Deutsche Bank and UBS have announced asset writedowns of almost $13bn (£6.4bn, €9.2bn) between them for the third quarter of the year. This comes on top of losses already disclosed by Goldman Sachs, Morgan Stanley, Lehman Brothers and Bear Stearns. Merrill Lynch and JPMorgan Chase have yet to outline their own exposures but are also expected to have suffered setbacks.
Yet this splurge of red ink has been surprisingly well received. Shares in UBS have risen nearly 9 per cent since the Swiss bank on Monday announced a $3.7bn writedown and its first quarterly loss since the collapse of Long-Term Capital Management, the hedge fund, in 1998. Other investment banking shares have also rallied in a sign that, after weeks marked by rumour and uncertainty, investors were happy to have the bad news out in the open.
Analysts at Morgan Stanley describe the blood-letting as “cathartic”. Indeed, it even produced some apparently perverse results. “It seems the more money you lose, the more your shares go up,” one investment banking chief observes.
The news on Wednesday that Merrill Lynch had sacked its head of fixed-income trading and its head of structured credit products might have been expected to unnerve investors ahead of its earnings statement due in two weeks. But the market was already expecting Merrill to reveal billions of dollars of writedowns and the shares barely flinched.
The Morgan Stanley analysts estimate that Citigroup, Bear Stearns, Deutsche Bank and UBS all generated a return on equity of less than 10 per cent in the third quarter. This compares with an average for the sector of 18 per cent over the past decade and a low of around 11 per cent during the downturn in 2001-02. Not all banks are being hit equally. Lehman and Morgan Stanley, which both reported for the three months to the end of August, earned a return of 17 per cent, while Goldman Sachs outperformed with a return on equity of 32 per cent.
Even for the worst affected banks, however, the writedowns so far are not life-threatening. Investment banks’ balance sheets and capital reserves remain healthy. Despite writing off almost $6bn, Citigroup will still make money in the third quarter. UBS, which slipped into the red, will report profits of about SFr10bn ($8.5bn, £4.2bn, €6.0bn) for the first nine months of 2007. “Essentially we lost a quarter,” Marcel Rohner, the Swiss bank’s chief executive, said this week.
There is also increasing optimism that many of the badly affected businesses will recover sharply in the fourth quarter. Citigroup said this week that its fixed-income business had already returned to a more normal level in September. Indeed, some divisions have even benefited from the turmoil. Market volatility has boosted trading volumes in interest rate swaps as well as in the foreign exchange markets.
Yet despite investors’ relief, the investment banking business is still facing substantial questions about its prospects. The credit squeeze has prompted many bankers and analysts to ponder the business model that helped produce such fabulous profits over the past three and a half years...
Faced with higher interest rates and tougher terms, private equity groups are likely to scale back their borrowing. This will hurt the large and lucrative leveraged finance departments that most investment banks had built. “With the cost of capital back to that of three to four years ago, as are activity levels, leverage loan revenues and deal activity are likely to turn back the clock several years,” Morgan Stanley’s analysts said this week.
The collapse in the US subprime mortgage market has also put an end to the business of originating risky home loans and repackaging them for sale to investors seeking highly-rated securities that offer an extra yield. Most executives acknowledge that it is likely to be years before investors are again likely to buy securities backed by subprime mortgages.
The structured finance departments, which specialise in creating complex investment products based on a wide range of underlying securities and derivatives, have also found that demand for their skills has waned. They are now more likely to be employed in unravelling the structures that they created.
Richard Bove, financial institutions analyst at Punk Ziegel, says investment banks could cut more than 10 per cent of their workforce to reflect reductions in fixed-income revenues. So far, most of the cuts have come from mortgage origination units spread across the US. But some have come from the ranks of highly-paid New York traders and bankers...
Brad Hintz, analyst at Sanford Bernstein, says the 2007 credit crisis is playing out much like previous repricing cycles, which he says have lasted an average of 4.8 months. Previous credit squeezes have generally reduced fixed-income revenues by 21 per cent and had an impact on two quarters’ results, according to Mr Hintz. “Currently, the 2007 decline looks somewhat deeper than the average of the last five cycles, but the bond market appears to be adjusting a little faster to a new credit environment than it did in previous periods,” he says.
There are other encouraging signs. Though nobody expects a return to the easy-money days, the market for leveraged loans is improving as rapidly as the optimists hoped. Banks were forced to sell loans funding the $26bn buy-out of First Data, the payments processor, at a loss. But underwriters reported strong demand, suggesting confidence is returning.
Analysts argue that investment banks are quick to cut costs and move resources around. The groups have already started to shrink their mortgage and private equity advisory businesses to match revenue reductions, bringing mortgage-related redundancies at Bear Stearns, Lehman Brothers, Credit Suisse and Morgan Stanley. The optimists point to the ability of the industry to find new ways of making money as market conditions change.
“What people forget about this industry is that it is very mobile with capital and, to the extent that there aren’t opportunities in certain credit markets, capital will be reallocated to other areas,” says William Tanona, analyst at Goldman Sachs.
But the events of recent months may also have implications for the entire structure of the business. Many bankers predict that there will be a shift back to the old banking model where lenders that arrange credit for customers hold it on their balance sheets rather than selling it on to other investors.
This could apply not just to the US mortgage market – where action by regulators looks set to restrict the scope for future excesses – but also to corporate lending, in particular leveraged loans. “The same problems that have arisen from the separation of the arranger of the debt from the holder of the debt in residential mortgages have also been seen in other debt markets and there is likely to be reaction against that,” says one senior Wall Street executive. Some of the techniques that have allowed investment banks to make money out of off-balance sheet vehicles of various sorts may also come under scrutiny.
That view may prove to be wishful thinking by bankers longing for a return to a less competitive world. But investment banks that are backed by large balance sheets – such as Citigroup, JPMorgan Chase and Deutsche Bank – clearly believe the competitive advantage could shift their way. “We are looking forward to a world when you can charge for credit again,” says a senior executive at a big universal bank. Brady Dougan, chief executive of Credit Suisse, this week told investors he thought his bank would take market share away from its competitors...
If the US economy slows significantly, the investment banks will see a sharp decline in high-margin businesses such as merger advice and underwriting equity issues, according to Sanford Bernstein’s Mr Hintz, a former chief financial officer of Lehman Brothers. “As unemployment rises, retail brokerage activity will slow and new investment flows into asset management businesses and retail brokerage accounts typically shrink.” Sharp economic declines tend to enhance the performance of fixed-income businesses but these generate lower returns for the banks, he adds...
It could also hurt those banks that have used their balance sheets to make large proprietary bets, particularly through private equity deals. “During a short, sharp, correction it’s the underwriting positions that get hit hardest,” says one investment banking chief. “In a longer downturn the principal businesses suffer more.”
