For much of the last decade, Wall Street investment banks have posted tremendous returns. Bear Stearns, in fact, even outperformed the fabled Warren Buffett when measured by total returns on Bear versus Berkshire Hathaway shares in the five years ending June 2007 (just before the sub-prime debacle unfolded). However, to generate these gaudy gains, risk appetites grew insatiably large. Indeed, Bear's results were fueled by leverage; Buffett's were not. From 2002 to 2006, the five big firms prospered: Goldman, Merrill, Morgan, Lehman Brothers and Bear Stearns tripled earnings over the period, and in 2006, combined earnings for the group reached more than $30 billion; return on equity (ROE) was north of 20 percent — unusual for financial services. But the seeds of the sector's demise had been sown: The sub-prime bubble unwound, bankrupted Bear Stearns and knocked the rest of the group's shares into the gutter.
Yes, there has been plenty of carnage on Wall Street in the last year. In fact, nowhere has the red ink been deeper, the layoff notices more prevalent and the stock declines more precipitous than in the financial services sector. Almost every index that tracks the zone is down by nearly half from levels seen just one year ago, right before the sub-prime sector imploded. (Incidentally, the first signs of distress began to appear at Bear Stearns last July with the collapse of the mortgage securities hedge fund it managed.)
Is it time to buy? Remembering the famous Wall Street dictum, “Buy when there is blood in the (Wall) Street,” it may seem easy to answer affirmatively. However, a careful inquiry yields a different conclusion: Although the biggest pain for the financial services sector may be behind us, most of its profit centers of the last five years have disappeared, with no easy replacements to be found.
Indeed, the very nature of the business at the large brokerage firms has changed dramatically in the last 10 years — and not for the better. After the collapse of the Internet bubble, and the rich underwriting fees that went with it, the banking business model has also evolved — with less than stellar results.
The changes remind this buyside analyst of an anecdote he heard from a real estate consultant in the Phoenix area. The real estate pro observed that, at the tail end of the housing bubble in 2005 and 2006, local real estate brokers made up one of the largest pools of speculative investors. After all, the brokers had seen their clients get rich buying houses and wanted a piece of the “easy money.” Of course, these brokers took the plunge at the exact wrong moment, and got caught holding the bag in a disaster they helped create.
So too did the investment banks fall victim to their own snow job, as they made easy money after the Internet bubble burst by trading mortgage securities for their own accounts — the CLOs and CDOs — and all the rest of the witches' brew of bad paper they produced. This business is now gone, and will not be returning. The only thing that made it possible was the complicity of the rating agencies in certifying so much dirty meat as fit for consumption, and those chastened agents will not be doing that again soon.
Whereas in the Internet bubble the banks made their profits from underwriting fees — which involved little risk to the firm's capital — their profits in the housing bubble era became increasingly reliant on principal transactions revenues — where the firm's capital is put at risk. Competition, commoditization and disintermediation have meanwhile reduced their ability to generate profits from agency transactions, ones in which they do not risk capital and act largely as middlemen.
Put another way, the banks have gone from being securities industry bookies to bettors. No longer can they rely on “the vig,” the thin margin won by buying stock at $40.00 and selling it nanoseconds later for $40.25. With decimalization, the spread of electronic trading networks and the continued decline in brokerage commissions for both retail and institutional clients, most large I-banks now view trading as a loss center or, at best, a break-even proposition. They stay in the business only because they have to keep investment banking clients happy, and to provide information flow to their principal traders (i.e. the young Turks wagering the brokers' own capital on bets similar to ones made by clients).
More Pain Ahead
From 1996 to 2006 (prior to the mortgage/credit market debacle of 2007), the investment banks posted average annual revenue growth of 13 percent. Principal transactions grew 17 percent per annum, while agency transactions grew only 10 percent. In 2006, principal transactions accounted for 57 percent of industry revenues, up from 44 percent in 1996. These revenues dropped by 4 percent last year, and even a 23 percent gain in agency revenue could not stop the bleeding. Incredibly, it has only gotten worse this year: In the first quarter, principal revenue plummeted by a shocking 61 percent as trading in exotic securities ground to a virtual halt. Principal trading revenues still accounted for 40 percent of total revenues, suggesting that further downside in revenues is possible this year. Unsurprisingly, the firm most dependent on principal trading was Bear Stearns, followed by Lehman Brothers (whose stock was getting battered last month due to a $2.8 billion loss, a credit rating downgrade and “counterparty concerns”).
What raised risk levels at these firms? Principal transactions were the main cause, of course, but the real killer was the need for capital that trading created. Leverage at the banks reached unsustainable levels: At Bear each dollar of shareholder's equity was levered 32 times when the firm collapsed. At that towering height, a mere 3 percent decline in asset values would cause insolvency. Moreover, this leverage was funded not just through long-term debt that the banks could pay back at their convenience, but in the overnight repo market — which could withdraw liquidity with merely a day's notice. Borrowing short and lending long was the true downfall of Bear, and the Achilles' heel of the I-bank business model in the principal transaction era.
This weakness left them dependent on the kindness of strangers, and when this kindness vanished earlier this year, the I-banks were forced, hat in hand, to line up at the windows of the Fed, begging for money. The Fed has granted their wish, but is sure to extract further concessions. Now that banks can borrow from the Fed, how can they refuse regulation from the same source? The chief goal of this regulation will be to reduce risk levels and total indebtedness.
The banks will likely be left without the line of business that generated the largest growth in profits over the last five years, and be subject to an increasingly hostile regulatory landscape. The firms' margins on trading will drop, their returns on capital will be reduced and their ability to lever themselves into ever greater profitability will be gone. Buffett looks like a better bet now, proving once again that the best businesses are those that return cash to shareholders in both good times and bad.
*Nate Wendler is the nom de plume of an analyst at a hedge fund managing approximately $1 billion.