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It's The Thick Of Hurricane Season For Banks

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By ROY C. SMITH and INGO WALTER

Bloomberg News

Published: September 19, 2008

This is the peak of the hurricane season in the financial markets.

Just as Hurricane Katrina devastated New Orleans a few years ago and Hurricane Ike recently swept over the Texas coast, Hurricane Mortgage-Debt has done a job on Wall Street. The collapse of Lehman Brothers Holdings Inc. and the sale of Merrill Lynch & Co. has caused more damage and dislocation than anything experienced in 75 years.

The damage has principally affected the world's market for wholesale finance, which last year accounted for $25 trillion of transactions originated by the leading commercial and investment banks.

Ten firms accounted for about 65 percent of these transactions. They are the clear market leaders, most of them with balance sheets in excess of $1 trillion and each with ambitions to use leverage, risk-taking skills and global client contacts to earn returns with growth rates of 15 percent to 20 percent annually. (The 10 firms include Merrill Lynch and Lehman, but not Bear Stearns Cos., which was on the verge of collapse when taken over by JPMorgan Chase & Co. in March.)

As in all bubbles, people were asked to believe that 15 percent to 20 percent returns could be sustained in an economy growing at only a third of that pace, before inflation.

So these same 10 firms have had to absorb almost $200 billion in write-offs on illiquid securities. These losses have gone right to capital, which has to be replaced.

Consequently, share prices have been decimated, and the firms have been forced to raise new equity capital in difficult markets to survive the financial storm of the century.

2 Giants Left

Five of the 10 major wholesale firms made dramatic leadership changes at the top. Only two of the so-called independent investment banks remain standing, Goldman Sachs Group Inc. and Morgan Stanley. These are both sizable firms with total combined assets that exceeded $2 trillion as of May.

Despite the government's hands-off position on Lehman Brothers, the surviving wholesale players are surely considered by their regulators to be "too big to fail" and therefore eligible to be taken over or otherwise bailed out by regulators to rescue their creditors, if not their shareholders.

Wall Street is known as a blustery place, with dangerous coastlines where many ships have foundered in storms through the years (including 12 major U.S. and European firms since 1990). But the robust and resilient characters inhabiting this world are accustomed to picking themselves up and getting back into things. Sooner or later, the winds blow out and the industry deals with the damage.

This time, though, there are likely to be at least two major changes that affect the way Wall Street puts itself back together and alter how they do business in the years to come.

The first is the response of the regulators to the present crises: Backed by public outrage at the need for taxpayer funds to bail out bondholders and creditors of these private businesses (including Fannie Mae and Freddie Mac), they must now think that enough is enough.

Failure to rescue Lehman seems to draw a line under financial bailouts. In the future, government regulators are going to have to get this industry under control. The tendency of big investment banks to create havoc in the markets, through their ability to turbocharge the use of leverage and financial innovation to create or magnify speculative bubbles, somehow needs to be constrained.

The fact that the largest banks are covered by the too-big-to-fail safety net means that the government is going to have to attach some strings to the guaranty - bigger and stronger strings, now that everyone knows how much trouble can result from not applying them.

Setting Terms

Politically, it can't be otherwise. The government now gets to set the terms of new constraints on the major financial firms in order to protect the public from the banks. The specifics won't be known until the next U.S. administration takes up the matter and international consensus has been sought.

It is likely that much tougher constraints will be imposed on minimum capital adequacy, the use of leverage and off-balance sheet activities. These constraints may take their toll on market efficiency, creativity and profitability, but they will keep the industry on an even keel in the future. The constraints will be resisted and unpopular, but they will be worth it, and the banks will adjust.

Another change is going to be in the attitude of the banks' own investors: Stockholders of the big global wholesale banks have been horrified by what has happened to their investments. Most bank shareholders are large "sophisticated" institutional investors such as pension funds, mutual funds, hedge funds and sovereign wealth funds, which manage client assets and have a powerful fiduciary responsibility.

These institutional investors are surely going to rethink the wisdom of investing in corporate structures that turned out to be not only risky but, in retrospect, hard to manage and control.

The big-balance-sheet business model hasn't worked to provide the sort of shareholder returns that were promised after the Travelers-Citicorp combination in 1998. Either the strategy can't work - no real synergies exist to justify a merger of dissimilar retail and wholesale businesses - or the strategy is simply too difficult for management to implement on the massive scale at which these enterprises operate.

Shareholders have a right to expect management to come up with strategies that balance risks and rewards. In the future, the market isn't going to pay much for banks that can't offer such a balanced approach, and may very well pay a premium for those that do.

Avoiding Risks

Perhaps the rest of the stand-alone firms will be forced to merge with goliaths, but the goliaths will recognize that they can perform better without the riskiest parts of investment banking on their books, and spin them off - as American Express Co. and Sears Roebuck did with their investment banks, Lehman and Dean Witter, respectively.

Maybe if Citigroup Inc. spun off what's left of Salomon Brothers, UBS AG shed PaineWebber, and JPMorgan Chase & Co. got rid of JPMorgan, the industry might stabilize under new regulatory constraints with more stand-alones to meet investors' objectives.

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