Danger Ahead: Fixing Wall Street Hazardous to Earnings Growth

By Christine Harper and Yalman Onaran

April 28 (Bloomberg) — 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.


“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.”


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