Bear Stearns melted down in March and has disappeared inside JPMorgan Chase & Co, Merrill Lynch absorbed more than $40 billion in write-downs and rushed into the arms of Bank of America, and Lehman Brothers is being sold for scrap after it declared bankruptcy on Monday.
Now investors and analysts worry whether even the largest securities firms, Goldman Sachs Group Inc and Morgan Stanley, may be vulnerable as markets lose confidence in the financial foundations on which investment banks are built. “If you accept that the broker-dealer model is broken -- for now at least -- it does reasonably lead you to question whether Goldman Sachs and Morgan Stanley can survive. I think that’s an increasingly reasonable question to ask,” said Les Satlow, a fund manager at Cabot Money Management in Salem, Massachusetts, which manages about $500 million.
That uncertainty was reflected as shares of Goldman sank 12% and Morgan dropped 14% on Monday, the day Lehman filed for bankruptcy and a day after Merrill agreed to be acquired. For Goldman, which is expected on Tuesday to report its worst quarterly results since going public in 1999, it was the stock’s biggest one-day drop in eight years. Morgan Stanley, which has been shedding assets since an embarrassing Q4 loss last year, likewise will be under pressure to show its house is in order when it reports results on Thursday.
Bottom line: the formula that powered Wall Street profits for most of the past decade -- tapping capital markets for debt that can multiply trading and investment returns -- is now a liability. “The days of the gun slingers are gone,” said Greg Church, president of Church Capital Management in Philadelphia. “Going out to the market, borrowing money and leveraging up is over. Down the road, they’ll all be owned by banks.” Overnight, investors began to pay close attention to leverage, which helps measures how much debt firms use to increase their trading bets, the quality of assets on the balance sheet and the sources of funds used to keep the firms running.
Even after shedding big parts of its mortgage book during the second and third quarter, Lehman still held roughly $80 billion in hard-to-sell property assets that have been falling in value. Gross leverage remained lofty, with total assets that were 21.1 times the size of its stockholders’ equity. In this more hostile environment, where investors will punish companies seemingly flush with cash and capital, Goldman and Morgan Stanley may also feel pressure to merge with a big deposit-rich bank.
“These companies also probably thought, not too long ago, that a crisis of confidence couldn’t happen to them. Recent events demonstrate no rational presumptions can be made simply based on fundamentals,” Fox-Pitt, Kelton analyst David Trone said. “These two will look at potential commercial bank partners.”
Most analysts and investors stress they do not expect Goldman and Morgan to melt down. UBS analyst Glenn Schorr said Goldman and Morgan have less concentrated risk positions than Lehman or Merrill, relative to their equity; deeper pools of ready cash and more reliable sources of funding. Goldman and Morgan also have valuable asset management and private wealth advisory businesses.
Lehman for example held risky “problem” assets that were 4 times the size of its tangible equity, Schorr said. Morgan Stanley’s risk asset ratio was 1.7 times equity and Goldman’s ratio was closer to 1.4 times equity, by comparison. The Big Two also have done better jobs spreading bets across markets and countries. Lehman still derived the majority of its profit from mortgage securities, despite years of banking and equities expansion, while Merrill dove into mortgages and leveraged lending just as these markets peaked. “Goldman and Morgan Stanley are more diversified, much less leveraged and have negotiated these risk issues more soundly,” said Timothy Ghriskey, head of Solaris Asset Management.
The surviving firms are also likely to gain more business with the competition thinning. That said, even successful investment banks may take another look at joining forces with a commercial bank to gain access to deposits, a more reliable funding source in bad times.
Federal regulators, meanwhile, are expected to introduce more restrictive, bank-like regulation for investment banks. No less an authority than Ken Lewis, Bank of America’s CEO, forecast more consolidation among banks and brokers. “For seven years, I’ve said that the commercial banks would eventually own the investment banks because of funding issues. I still think that,” Lewis said on Monday on a conference call to discuss the Merrill acquisition. “The Golden era of investment banking is over.” (Reuters)