High-Wire Act
Wall Street banks lost nearly half-a-trillion dollars in market cap last year. How do they get it back?
By Aleksandrs Rozens January 14, 2008
In 2007, the top Wall Street firms saw some $400 billion worth of market capitalization evaporate, largely the result of concerns related to credit market problems. Now, many of their most important and regular sources of income have been diminished dramatically, and this year the firms will be performing what amounts to Wall Street’s version of a high-wire act: trying to generate profits by making markets with far less capital.
The credit mess that mushroomed last summer is generally expected to linger into the first two quarters of 2008, and at the same time income from many business lines is expected to wither. For example, a bond industry trade group expects fixed-income issuance to drop by 15% this year, mostly because of the mortgage bond market problems, sapping an important well of capital for other advisory activities such as mergers and corporate lending.
Wall Street firms can also expect to see a drop in fees earned from mega-merger deals because the credit market flu has limited the size of M&A activity. Much of the 2008 merger business is expected to be relegated to middle-market companies — deals worth $500 million to $1 billion. At the same time, weakened equity markets could hurt the prospects of fees from IPOs. Factors such as the slope of the US yield curve will determine the level of activity in bonds and the US economy’s well-being may determine how many trading orders are made for company stocks.
As Charles Geisst, author of several books about the history of Wall Street and a business professor at Manhattan College, puts it, there is little cause for optimism on Wall Street in 2008. “It is going to be one of Wall Street’s worst years,” he says.
“Investors out there are saying these institutions look a lot riskier to me today than they looked a year ago,” says Sharon Haas, managing director at Fitch Ratings. “We have been down this road before in terms of what the downside of a credit cycle looks like.”
The challenges faced by firms such as Bear Stearns, Citigroup and Merrill Lynch are tied to issues that hobbled these banking giants in 2007 — many got involved with the underwriting of debt backed by risky mortgages and were stuck with massive inventories of securities that have lost their value because of downgrades, defaults and delinquencies. These firms reported massive losses related to holdings of subprime mortgage debt and CDOs that repackaged the riskiest slices of subprime bonds. Now, there is a realization on Wall Street that the losses will continue to sap company earnings while at the same time the firms have fewer sources of new business to make up for the losses. What’s more, it has become more costly to borrow money and this has forced some firms to turn to overseas investors or — as Merrill Lynch did with its mid-market lending business — sell off certain business lines.
“Losses were shrugged off because relative to earnings they were not huge,” says Chris Low, chief economist at FTN Financial. “But now the realization is that the earnings won’t be there for a while.”
As a December report by analysts at UBS points out, “no matter how you look at it, the earnings environment for the brokers is challenging given the mixed macro backdrop [slower GDP growth and declining CEO confidence], sharply slower structured credit revenues, less capacity to take risk, and less frenzied M&A environment.”
“They have lost credibility with investors. Reputations take years and years to build, minutes to destroy,” says Jeff Auxier, fund manager at Auxier Focus Fund which has $500 million worth of assets and includes Citigroup shares in its portfolio.
Losing the lifeblood of profits
Underwriting securities backed by home loans got its start in the 1980s, and by the 1990s the process of reselling consumer debt grew to include home equity loans and lines of credit, as well as credit card and auto loans. The process of parceling debt into securities broadened to include corporate loans and debt used to finance deals. Wall Street’s securitization and loan syndication was akin to a Detroit auto production line that enabled larger and larger mergers. Money from a wide range of sources flowed, enabling buyers to snare large businesses with aggressive, outsize bids.
A drop in home sales will dampen the underwriting of mortgage securities. That drop is expected to be more pronounced in the so-called non-agency market — bonds backed by loans that are not guaranteed by US housing agencies Freddie Mac and Fannie Mae. These non-agency loans can include jumbo mortgages and home loans to less credit-worthy consumers. Spread premiums for these riskier securities have widened dramatically, making it difficult to underwrite certain home loans.
The upwelling in mortgage debt markets is largely behind the Securities Industry and Financial Markets Association’s forecast of a 15% decline in fixed-income issuance in 2008 to $3.4 trillion. In addition to a drop in issuance of mortgage debt, SIFMA expects Wall Street to underwrite fewer corporate bonds and asset backed securities. Corporate debt issuance is expected to fall 14.8% to $965 billion, while asset-backed issuance will drop 36% to $325 billion. Mortgage-related issuance, meanwhile, is expected to plummet 13% to $1.7 trillion.
So, which firms will be impacted most by the expected decline in mortgage debt underwriting? According to Thomson Financial, the biggest underwriters of mortgage debt last year, globally, were Lehman Brothers, Morgan Stanley, Bear Stearns and Royal Bank of Scotland’s Greenwich Capital Markets.
The banks that relied on repackaging loans into CDOs and RMBS and have had an over-reliance on subprime will have the most challenging time with revenue replacement, says Meredith Whitney, analyst at CIBC World Markets. But the debt market’s ugly derailment also poses problems for the broader capital markets, which have come to rely on cheap credit.
“The debt market is the most critical factor of the capital markets. Everything relies on debt markets for growth,” says Whitney, noting that if the debt markets remain shuttered companies will have fewer ways of funding themselves and this will impede their growth. As a result, if the debt markets remain closed, “it is unlikely you will get a raging equity market,” she warns, adding that “the single biggest risk is that lending power gets further diminished.”
Meanwhile, an increasing number of economists have warned of an economic slowdown. A recession and the debt market problems eroding other business lines for Wall Street firms may mean that it could take years — by one analyst’s estimate until 2010 — for banks and brokerages to produce earnings that match 2006 and 2007 results.
“Where do they get the business? What business lines will be strong? None of them look that strong,” says Dick Bove, analyst at Punk Ziegel.
Triage on Wall Street
Last year, investment bankers assembled some of the largest mergers and acquisitions on record, but much of this activity was fueled by the low cost of credit. Now that banks have a tougher time parceling out this debt because of problems in the CDO and CLO markets, the pace of behemoth M&A deal activity has been slowed sharply. That means firms will focus more on the middle market company universe for advisory work.
Top players within the category of M&A deals worth $100 million or less include Houlihan Lokey, Sandler O’Neill and RBC Capital, according to Thomson. For deals running between $100 million and $500 million, advisory work was dominated by Goldman Sachs, Credit Suisse, UBS and Morgan Stanley. Advisory work for deals $500 million to a $1 billion was largely dominated by Goldman, Lehman, UBS and Merrill Lynch, as well as Citigroup last year.
While the dollar size of M&A deals may drop off in 2008, bankers may find themselves advising a greater number of smaller deals.
Fred Green, a partner at Weil Gotshal who co-heads its M&A practice, believes that private equity fund managers have plenty of money to put to work and they are willing to place it in smaller deals if larger deals can’t get financed. After all, he says, “sponsors have raised a huge amount of funds, the money has been committed, investors want it to be invested and fees are being paid to managers to put that money to work.”
The middle market is not an unusual place for many of these fund managers because while they juggled $40 billion deals in recent years, many of the seasoned veterans were nursed on smaller transactions. “Managers of the largest PE funds started in what we call today the mid-market. They know how to operate in that space,” says Green.
Green believes that buyers likely won’t chase up prices of companies in the near term because there simply are not enough willing lenders. A banker with a Wall Street firm who specializes in real-estate company buyouts told IDD last week that bankers, for now, are holding off from large transactions because Wall Street is not sure it could readily sell off debt to finance the deals through its loan syndicate desks.
“In the climate we are in right now, companies bought recently may be worth less today because others who you might resell to cannot come up with the same amount of acquisition debt, and that directly affects price, ” says Green.
Not only does that put a cap on the purchase prices, but it limits what PE fund managers can do if they want harvest — or sell — an investment in a business. “If they cannot sell it at a price they are satisfied with, maybe they’ll try to exit through an IPO,” says Green.
That move to take a company public may mean that an investment bank with private equity fund clients may not earn fees for advising a merger, but it could generate fees related to a public offering. Last year, leaders in the business of taking companies public included UBS, Credit Suisse, Morgan Stanley, JPMorgan and Goldman Sachs, according to Thomson.
The cost of money
In addition to a drop in income from various business lines, Wall Street faces another issue in 2008: a rapid rise in funding costs that has limited its ability to readily make markets. This, in turn, has prompted investors such as mutual funds to hold off from actively participating in debt markets, further diminishing liquidity that has been fragile since last fall.
Fitch’s Haas says that firms selling a hybrid corporate debt security known as an enhanced trust preferred recently paid an 8% coupon, up from 6% last spring. In an effort to keep their heads above water, some Wall Street firms may lower dividends or in worst cases temporarily forgo dividend payments. “Not only have institutions lost market capitalization,” they may not earn enough to cover a dividend, especially those that record a quarterly loss, says Haas.
Meanwhile, the market for insuring corporate debt against defaults — credit default swaps —offers an idea as to how much funding costs have risen for the Street.
For example, credit default swap spreads for five-year corporate debt issued by Bear Stearns last week were at 235 basis points, out from 21 basis points just a year ago. Lehman five-year credit default swaps are at 151 basis points, out from 21 basis points last January and Merrill Lynch five-year credit default swap spreads are at 158 basis points, compared with 16 basis points in January 2007. Citigroup has seen its five-year CDS spreads vault to 97 basis points from 8 basis points in January 2007, while Bank of America swap spreads are at 72 basis points, compared with 8 basis points in early 2007.
With a little help from our friends ... overseas
Some of the rise in borrowing costs, and the drop in investor appetite for big banks and brokerages, has led to a relatively new development: investment by non-US entities in big Wall Street players.
Geisst, author of “Wall Street: A History From Its Beginnings to the Fall of Enron,” has made a career out of tracking Wall Street, specifically watching for recurring patterns. One thing has become clear to him: some of the spoilers that hurt Wall Street in the early 1980s have returned. Back then, he recalls, Street firms were hobbled by the rising price of oil, inflation and a weak dollar. The only element missing from that ugly recipe today is inflation.
Geisst says Wall Street may be able to manage the latest downturn by turning to sovereign wealth funds. Overseas money has already been brought in to buttress firms such as Citigroup, Bear Stearns and Merrill Lynch. That added capital infusion may allow firms to weather the drain on their bottom line from the credit markets and actually return to making markets.
“You will see more of that. Sovereign wealth funds definitely played a greater role in their recap efforts,” says Haas. “This will continue as long as they have liquidity and money to invest.” Indeed, late last week it was reported that both Merrill and Citi are looking for even more capital from overseas.
There may be a limit, however, to overseas money if the efforts appear to be too dilutive or prompt shareholder protests. For example, in the case of Morgan Stanley, a December UBS report notes that the firm’s capital injection is dilutive, but “helps Morgan shore up capital ratios, please the regulators/rating agencies, absorb any future write-downs and maybe provide some dry powder to invest.”
Layoffs and morale
In addition to losing income from fees for underwriting debt, Wall Street can expect to incur expenses from layoffs that are sure to come with the slowdown in business. These layoffs could result in a drop in productivity, as morale could be hurt by the staff cuts and this, in turn, could erode a firm’s franchise value.
According to Whitney, the most recent cuts of magnitude on Wall Street were in 2002 and 2003, and these numbered in the tens of thousands. For example, Merrill reduced its staff from 72,000 in 2000 to 48,000 in 2003. Morgan Stanley’s employee count went from 63,000 in 2000 to 51,000 in 2003.
Some firms already appear to be trying to take steps to ensure employees do not defect to competitors. Consider the case of mid-market specialist Jefferies & Co. The New York firm saw its net income drop in the fourth quarter because of a falloff in investment banking activity and a rise in compensation costs. Whitney says that compensation likely was an effort by the firm to preserve morale of its employees.
Finally, Wall Street firms have a diminished appetite for risk, which will lessen fees earned from lending to hedge funds or limit proprietary trading activity.
Recession and business lines
Last week, Merrill Lynch said the US has entered a recession. Goldman economists warned that a recession is very likely in 2008 and with that prediction they warned that the US jobless rate could climb further. Typically, Wall Street would welcome the rate cuts that come with an economic slowdown, but this time around credit markets remain in a stubborn logjam so the fixed-income side of a business may not bring as much revenue.
That expected 2008 economic slump could also impact firms with corporate loans and debt, as this recession is expected to be one in which consumer spending will plummet. That means some businesses such as retailers will fall behind on payments or violate loan covenants. Expectations of trouble for US businesses has led observers to believe that at least one viable business line for Wall Street firms likely will be advisory work for corporate restructurings.
While the credit markets have locked up, firms likely will be able to generate some income from within the conventional mortgage market where securities are backed by home loans with a US housing agency guarantee. Demand for agency mortgages, though, will be determined by the slope of the US yield curve. Banks, some of the biggest buyers of agency mortgage debt, typically like to borrow in the short end of the curve and put that money into longer duration assets such as mortgage securities — a process known as the carry trade and one that requires a steep US yield curve. In the opening days of 2008 the high-yield market has seen a pickup in new issuance and analysts at Bank of America noted in a report that as much as $70 billion of new debt could be sold in January.
Then, there are commodities trades to process and these will likely be kept active by the high prices of oil, precious metals and various agricultural products. Also, firms such as Morgan Stanley, JPMorgan and Goldman may be able to weather problems by stepping up efforts in non-US markets where they have been leaders in bringing companies public and raising debt. As UBS analysts noted in a report about Goldman Sachs, firms with asset management business units that are expanding and can generate revenues from principal investments will have slightly more breathing room this year.
But, a drop in economic growth could also bring about a rout in commodities prices. Oil and precious metals as well as agriculture futures have seen their prices soar, attracting investors. But what happens if commodity prices begin a pronounced retreat because of a drop in raw materials that typical accompanies an economic slowdown?
“Where do you get business in a recession? You don’t do as many mergers, stocks will be weak, so less IPOs and follow-on equity offerings are done,” says Bove. “If you are in a recession, commodities go down. You have to find something that really will percolate.”
aleksandrs.rozens@sourcemedia.com
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