Wall Street's money-making machine is broken, and efforts to repair it after the
biggest losses in history are likely to undermine profits for years to come.
Citigroup Inc., UBS AG and Merrill Lynch & Co. are among the banks and
securities firms that have posted $310 billion of writedowns and credit losses
from the collapse of
the subprime mortgage market. They've cut 48,000 jobs and ousted four chief
executive officers. The top five U.S. securities firms saw $110 billion of
market value evaporate in the past 12 months.
No one is sure the model works anymore. While Wall Street executives and
regulators study what went wrong, there is no consensus solution for restoring
confidence. Under review are some of the motors that powered record earnings
this decade --leverage, off-balance-sheet investments, the business of
repackaging assets into bonds through
securitization, and over-the-counter trading of credit derivatives.
Without them, it will be difficult to generate growth. ``Brokerages will have a
tough time for a
while,'' said Todd McCallister, a managing director at St. Petersburg,
Florida-based Eagle Asset Management Inc., which oversees $14 billion. ``The
main engine of its recent growth,
securitization, will be curtailed. Regulation will be cranked up. Everything is
stacked against them.''
Last month's collapse and emergency sale of Bear Stearns Cos., the fifth-largest
of the New York-based securities firms, demonstrated the perils of Wall Street
business practices
developed after the 1999 repeal of the Glass-Steagall Act. The change allowed
investment banks and depository institutions to compete with each other.
Glass-Steagall
``Investment banks leapt into commercial banking without the deposit base, while
commercial banks went into investment banking without knowing risk management,
and this
is where we end up,'' said Brad Hintz, a New York-based analyst at Sanford C.
Bernstein & Co., referring to the credit crisis.
Citigroup, the largest U.S. bank by assets, sought to compete with securities
firms like Goldman Sachs Group Inc. by taking bigger trading risks and hatching
off-balance sheet
financing vehicles for securitized assets. The plan backfired, and the New
York-based bank has been forced to book $40.9 billion of writedowns and credit
losses. Charles O. ``Chuck''
Prince resigned as Citigroup's chief executive officer in November.
UBS, Switzerland's largest bank, also tried to bolster profits by investing in
securitized assets and setting up a new hedge fund, Dillon Read Capital
Management, under
John Costas, the former investment bank chief. UBS has reported $38 billion
of writedowns since July, more than its securities unit generated in total
earnings since 1998. Peter Wuffli, the Company's former CEO, and Marcel Ospel,
the former chairman,
were forced to leave.
Short-Term Borrowing
Marcel Rohner, Wuffli's successor, said last week at the firm's annual
shareholder meeting that he will scale back the investment bank and ``no longer
aim to offer everything to
everyone.'' At Bear Stearns, a strategy of originating mortgages and other types
of loans failed in part because the company lacked a base of insured deposits
and relied instead on
short-term borrowing in the capital markets. When lenders lost confidence in
the firm's management, the cash disappeared.
The turning point came with the Federal Reserve's decision last month to
orchestrate the takeover of Bear Stearns and make loans available to investment
firms for the first
time since Glass-Steagall was enacted in 1933 to rein in speculation after the
1929 stock market crash. Now U.S. Treasury Secretary Henry Paulson has proposed
extending the Fed's oversight to include securities firms.
`Real Catalyst'
As regulators weigh new restrictions that may be years in the making, investor
pressure is forcing changes at companies including Morgan Stanley, Merrill
Lynch, Lehman
Brothers Holdings Inc., Citigroup and UBS. All are cutting leverage, or the
amount of assets they hold with borrowed money, by selling some stakes and
raising capital. And that means
eroding profitability.
``There's an overwhelming negative sentiment that still is out in the
marketplace,'' Erin Callan, chief financial officer of Lehman Brothers, said in
an April 11 interview. ``I don't see
a reason to be too optimistic about it changing, or what the real catalyst for
change would be over the next several months.''
As banks and brokers shore up their capital, their revenue prospects are bleak,
according to Kian Abouhossein, a JPMorgan Chase & Co. analyst in London who
covers European
investment banks such as Frankfurt-based Deutsche Bank AG, and Credit Suisse
Group and UBS in Zurich. He estimates that corporate and investment banking
revenue at the European firms will drop 28 percent in 2008 and a further 2
percent in 2009, dragged down by declines in fixed-income and equity trading.
Structured Credit
``The revenue environment for investment banks has deteriorated significantly,
in particular since the beginning of March,'' Abouhossein wrote in an April 22
note to investors. He
cut his 2009 estimates for investment banking pretax profits to "only slightly
above 2004 levels.''
Leading the decline will be a 70 percent drop in revenue this year from
structured credit, which includes bonds backed by mortgages as well as pools of
bonds or loans,
Abouhossein said.
By 2009, revenue from that business will be 81 percent below the peak in 2006,
he said.
Securitization, used by banks and brokerage firms to repackage loans into bonds
they could sell to investors, is slowing dramatically after losses on securities
linked to mortgages.
Sales of securities backed by home loans that don't have guarantees from
government-sponsored firms tumbled 92 percent in the first quarter from a year
earlier, according to
newsletter Inside MBS & ABS.
Trading Fees
Wall Street turned to securitization as revenue for more traditional businesses
dwindled. Fees for stock trading dropped by 70 percent since 1975, when
regulators abolished fixed
commissions. For investors, bond trading costs fell by more than 50 percent
after traders were required in 2002 to report sales to a centralized
computer-system, bringing
transparency to an opaque market.
Structured credit generated an average 16 percent of fixed-income revenue at
Deutsche Bank, Credit Suisse and UBS in 2006, estimates Abouhossein. It may have
accounted for
more than 30 percent of earnings at the U.S. securities firms, said Charles
Peabody, an analyst at Portales Partners LLC in New York who recommends selling
all the brokerage stocks.
``The creation of those products bleeds into a lot of different areas,'' Peabody
said. Slicing and dicing mortgages into securities was one of the ways
financial institutions increased their leverage ratios, according to Margaret
Cannella, New York-based
head of global credit research at JPMorgan.
Factor of Five
Instead of having to hold enough capital to guard against losses on the home
loans themselves, the firms opted to keep only the most-creditworthy portions of
the
securities they created --enabling them to hold more assets with less capital.
At the end of 2002, Citigroup held $1.1 trillion of assets, or 12.7 times its
$86.7 billion of equity. By the
end of last year, the bank held $2.2 trillion of assets, or 19.3 times its $114
billion of stockholders' equity, according to company reports.
When a security is downgraded from AAA, the highest rating, to BBB, the
ninth-highest, the amount of capital a bank is required to hold to protect
against losses rises by a factor of
five, Oppenheimer & Co. analyst Meredith Whitney explained in a March 27 report.
`Never Come Back'
``Most securitization, especially if it's leveraged, will never come back,''
JPMorgan's Cannella said. ``Securitization won't die out completely, but it will
be a much smaller
market.'' Wall Street firms have kept some of the securities they originated,
either on their balance sheets or in off-balance-sheet vehicles. Now the bill is
coming due at
banks from Tokyo to Toronto.
Canadian lenders have reported $6.5 billion of writedowns on their securities.
In February, Canadian Imperial Bank of Commerce posted the second-biggest
quarterly loss
in its 141-year history because of the charges.
Canadian Finance Minister Jim Flaherty agrees to some extent that securitization
has devolved into a self-dealing mechanism. ``There is an element of that,''
Flaherty
said in an interview last week. Off-balance-sheet vehicles, used by companies
to provide a
profit stream from assets they can't -- or don't want to -- own outright, also
have come under scrutiny by accounting authorities.
Citigroup in New York and London-based HSBC Holdings Plc are among the banks
that opted to provide credit lines to such structured investment vehicles when
assets held by the entities lost value and outside financing dried up.
Downgraded VIEs
Financial firms are allowed to keep so-called variable interest entities, or
VIEs, off their balance sheets as long as they're not the ones that stand to
gain or lose the most from
the entity's activities. When bonds held by VIEs are downgraded by ratings
firms, as
Standard & Poor's has done with $339 billion of collateralized debt obligations
since July, the assets often have to be brought onto the balance sheet and
charges on their
valuation taken against earnings.
Citigroup's ``maximum exposure to loss'' in unconsolidated VIEs was $152 billion
at the end of December, according to the bank's annual report. The entities
owned $356 billion of assets that included CDOs. Goldman Sachs and Morgan
Stanley, the two biggest U.S. securities firms, together faced a maximum loss of
$34 billion as of February, according to their filings.
Erosion of Trust
``Ultimately there is a responsibility for those who create these and put them
off balance sheet,'' said Robert Litterman, a former risk manager at Goldman
Sachs who now
serves as chairman of the fund-management unit's quantitative investment
strategies
group. ``Institutions will see that. If they're ultimately going to be
responsible, then what's the point of putting it off balance sheet?''
The collapse of Bear Stearns and the freeze in credit markets resulted from an
erosion of investor trust in the way Wall Street was funding itself, said Joseph
Mason, a finance
professor at Drexel University in Philadelphia.
``This is a run on bank liabilities, on the loans that were pushed off the
balance sheet,'' he said. ``The banks sacrificed liquidity for profit.'' Bear
Stearns's chairman ultimately paid a price for the failed strategy. James
``Jimmy'' Cayne, who stepped down as CEO in January after 15 years at the helm,
sold his company stock for $61 million last month, almost $1 billion less than
the stake was worth a year ago.
`Real Magnitude'
What distinguishes this credit crunch from others that preceded it is the
opacity and complexity of today's credit instruments, said Henry Kaufman, a
former economist at New York-based Salomon Brothers who has been following Wall
Street for five decades. The railroad crisis of the 1970s, the savings and loan
collapse in the 1980s and the Asian and
Russian debt defaults in the 1990s all involved excessive use of credit, lax
lending and heavy reliance on leverage, he said.
The use of off-balance-sheet financing in the current market makes it ``tougher
to assess the real magnitude of the losses,'' Kaufman said. Trading in credit
derivatives, one of the
fastest-growing businesses for Wall Street over the past 10 years, has also
come
under scrutiny amid concern that one participant's failure to honor a contract
could destabilize the entire industry. That danger, known as counterparty risk,
is driving
veterans of the derivatives market to call for more transparency and perhaps
the
creation of a central clearing agent or exchange.
Clearing House
``We must have transparent and accessible trade data,'' Paul Calello, CEO of
Credit Suisse's investment bank, told a gathering of the International Swaps &
Derivatives Association in Vienna earlier this month. ``If we need to create an
industry utility to do it, so be it.''
Gerald Corrigan, a former president of the New York Federal Reserve Bank who
now works for Goldman Sachs, is helping to lead a group of Wall Street
executives studying ways
to address the credit-default swaps quandary. A statement from the group on
April 14 said it will examine areas in which stronger infrastructure for
derivatives in general, and for credit
default swaps in particular, is ``badly needed.''
One proposal already put forward by a group of 17 banks, brokers and industry
groups is a central clearing house and counterparty for credit derivatives
trades, which could help
alleviate concerns about individual trading partners.
Blankfein to Fuld
Anything that limits trading in credit derivatives, even though it might make
the business safer, is likely to cut into profits, said David Hendler, an
analyst at CreditSights Inc. in
New York. ``It helps everybody to get counterparty risk better measured and
monitored and margined for, so it doesn't trigger systemic risk,'' Hendler said.
``The trade-off for a clearing
house is you have less customization of derivative solutions, so it could stifle
innovation and customization and flexibility in these contracts.''
With some of these profit sources subsiding, Wall Street executives say
privately that they're struggling to find new sources of growth to make up for
the business they've lost.
Wall Street CEOs Lloyd Blankfein at Goldman Sachs, John Mack at Morgan
Stanley, Richard Fuld at Lehman Brothers and Vikram Pandit at Citigroup all told
shareholders at annual meetings this month that the credit crisis is closer to
the end than the beginning. Still, none forecast an immediate earnings rebound.
`New Equilibrium'
``At the end of every quarter, Wall Street CEOs say that was the worst
quarter,'' said Michael Farr, president of Washington-based Farr, Miller &
Washington LLC,
which manages about $550 million. ``None of them has suggested a catalyst that
will grow their profit margins. Why would I buy financials believing in their
`we're at the end'
propaganda?''
The financial services sector, whose share of U.S. corporate profits almost
doubled to 38 percent last year from 21 percent in 1994, may take a long time to
recover, said Jeffrey Knight, deputy head of investments at Boston-based Putnam
Investments, which oversees about $190 billion of assets.
``The financial sector is shrinking to a new equilibrium,'' Knight said. ``It's
potentially decades before financial assets can garner so much of the nation's
economy.
Nothing in this article is, or should be construed as, investment advice.
Rohit
9868245473
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