The Future of Investment Banks…
Posted on: July 20, 2008 - Email Article - Printable Version
As the biggest fixed income credit crisis unfolds, one issue remains wary: Will there be a pure-play investment bank in the end? No, most likely there won’t be… As the financial sector recovers some of its losses this past week, there are still major regulatory and sector changes that will have a major effect on the industry. The financial sector, which is down more than 28% this year, is in a transformational change which will have ever-lasting effects on the broader economy. With the exception of Goldman Sachs Inc. [GS: 173.51, 0.00 (0.00%)], all investment banks have struggled over the past year to minimize losses while at the same time calm the market’s fears on them. In the next 18-24 months, expect regulatory changes to affect all investment banks from Goldman to Lehman Brothers [LEH: 0.00, N/A (N/A)].
One thing is for sure, as these investment banks and commercial/investment banks have tried to minimize their losses they have also de-levered their balance sheets to ensure investors that they are well capitalized. One of the most noticeable is Citigroup Inc. [C: 4.18, 0.00 (0.00%)], as they have announced they will be selling off over $500 billion in “legacy assets” to free up their balance sheet. Many banks have also done the same, although not in scale, to free up some of their balance sheets and improve their tier 1 ratios. Pure play investment banks have been forced to reduce their leverage from the 32-40x range to below 25x as investors feel they may no longer have the adequate capital in these tough environments. With this de-leveraging comes lower return on equity (ROE) ratios, which are regarded as the key metric used in the valuation of financial services companies.
Be sure to expect more regulation in the near term as The Fed was forced into negotiations with JP Morgan Chase & Co. [JPM: 43.18, 0.00 (0.00%)] to acquire the then 5th largest investment bank in the U.S., Bear Stearns. With the Fed now taking the risk of Bear Stearn’s $28+ billion in assets, expect to see regulation changes from congress on how these investment banks operate and manage risk. The Fed is now faced with a “moral hazard” issue by bailing out an investment bank. If Lehman were to fall, would they be bailed out as well? Changes will most likely regulate how much these investment banks can lever themselves, which will limit their robust profits which they saw in 2006 and the first half of 2007. Changes will also come with The Fed’s discount window lending policy, as it will most likely be left open to financial sector companies, especially investment banks, but with tremendous regulations stipulations. Having this borrowing facility will also provide these companies with stronger credit ratings and will be accepted better by the markets.
So why won’t there be a pure play investment bank at the end of this crisis? All investment banks, including Morgan Stanley [MS: 30.02, 0.00 (0.00%)] and Lehman Brothers [LEH: 0.00, N/A (N/A)] will, will be changed in some way. These investment banks will have to merge with a commercial bank or start up their own retail banking operations. The latter of those two will be too difficult and will require tremendous capital expenditures to start. Investment banks will seek to merge or purchase retail banking operations to have more assets to borrow against to expand their profitability right now. Physical assets and deposits are the cheapest ways of funding expansion. For this reason, expect to see a major merger or purchase in this industry. The only exception may be Goldman. Goldman is now placed in a unique position to jump ahead of the pack with the recent announcement of Wachovia Corp.’s [WB: 0.00, 0.00 (0.00%)] new CEO Robert Steel, who just happens to be a former executive of Goldman.
-Steve Murray
The mutual fund that the author of this article manages holds a long position in Goldman Sachs (GS).
The Following Stocks Were Mentioned In This Article: C, GS, JPM, LEH, MS, WB
Comments
I’m a friend of Charles and Mark from high school. Love this site so far. What do you think about a long position right now on Lehman if I’m planning to hold for 3-5 years? Are they in any sort of danger of going under? You mention mergers in here, if they were to merge, how do you think that affects the stock price? Realistically, what do you think the timetable is for seeing any sort of return from Lehman or any other bulge bracket bank?
As much as Lehman prides itself as an independent investment bank, I believe that they will not exist as a publicly traded independent investment bank. I mentioned publicly traded, because I think that the most logical option that Lehman has is to be taken private by a p/e or another type of fund. This is because over 30% of Lehman’s shares are owned by its employees. After Bear Stearn’s employees got screwed from the $10 per share buyout, I don’t think you will see the same thing happen with Lehman. I would stay away from Lehman as an investment, as you will kill yourself in this volatile market. Don’t try to catch a falling knife either if they go down, it will only hurt you in the long-run. If you are interested in picking away at some investment banks, look at the best of breeds. They will be the ones who take off during a turn-around.
Steve Murrays last blog post..Why Visa Will Thrive