Happy days

FINANCE & ECONOMICS
Investment banking

Dec 29th 2004 NEW YORK

From The Economist print edition

Once again, it is wonderful to be a Wall Street banker

INVESTORS contemplating modest returns on shares and bonds in 2004 could be excused for assuming that Wall Street had a similarly modest year. Indeed, in the past month there have been plenty of apparent distress signals: Credit Suisse First Boston (CSFB) announced a restructuring that involved lots of layoffs and may lead to further departures. J.P. Morgan Chase quietly sacked people in New York and London. Deutsche Bank did likewise in Germany and is expected to make cuts elsewhere. Firms continue to pay fines for transgressions during the last bull market.

Save your tears. A strong fourth quarter (ending on November 30th) meant record earnings for almost all America's top investment banks. Since 2002, the share prices of Lehman Brothers, Merrill Lynch and J.P. Morgan Chase have doubled; that of Friedman Billings Ramsey, a boutique based in Washington, DC, specialising in real-estate investment trusts and initial public offerings, has quadrupled. Greenhill, a merger-advisory firm that went public in May, has seen its share price shoot up by 40%. Such amenable conditions no doubt helped soothe the internal strife blocking the initial public offering of Lazard, which was filed on December 17th.

Even more impressive than the level of Wall Street profits is the source. In 2003 gains came mainly from trading bonds. In 2004, they came from everywhere, including areas hit by the three-year slump, such as equity underwriting, equity trading and asset management, and businesses that had looked doomed, including trading in commodities and foreign exchange.

Some financial firms made huge one-off gains from private-equity investments. Revenues from mergers and acquisitions were up by 50% or more, and may have further to run. December was a great month not only because many deals were consummated but also, say bankers, because more began to look likely. Chief executives have regained their self-confidence: companies are flush with cash, and are less worried that an acquisition will unearth a scandal.

Banks are gearing up accordingly. Two years ago, Merrill Lynch cut its workforce and costs by one-third, so that it thrived even in difficult conditions. It is hiring again. Lehman Brothers, Goldman Sachs and Bank of America are reportedly scouting for additional New York office space. Pay is rising too. After a three-year gap, financial firms are once again throwing parties at exorbitantly expensive restaurants.

Although the good times are back, something did change during the slump. The big firms remained profitable, as they failed to do in the downturns of the 1970s and early 1990s. Some did much better than others. J.P. Morgan Chase has been transformed from an also-ran in mergers and acquisitions into either the second or the third in the league (behind Goldman Sachs, the perennial leader), depending on whether its own acquisition of Bank One is counted, according to Thomson Financial, a data-analysis firm. Its rival for the number-two slot is Citigroup, another climber. Citigroup is also likely to finish the year as the most active underwriter of high-yield debt, displacing CSFB, and secondary offerings of equity, pushing out Goldman Sachs. J.P. Morgan Chase's standing has also risen in these categories.

The rise of these two huge universal banks might suggest that they point the way to the future of Wall Street. However, a close look indicates that management matters more than structure. Lehman Brothers, one of the purest investment banks, has become more formidable in almost every market it contests. Since the late 1990s, it has nearly doubled in size, yet its costs remain relatively low and its management has been stable. Over the past five years, its balance sheet has improved and it has avoided common mistakes, such as bad acquisitions or mistimed expansions. While other firms have gone public or expanded access to outside capital, the proportion of Lehman's equity owned by employees has increased.

Lehman's ascent has not gone unnoticed: CSFB's restructuring has many elements in common with Lehman's approach, including the emphasis on costs and inside ownership and a focus on a fairly narrow band of core clients. Every firm has become obsessed with efficiency. Not long ago, more than 60% of CSFB's revenues went towards compensation. Lazard, in its share prospectus, pledges to keep compensation below 57% of revenue. The top firms are aiming for below 50%. One theory among bankers is that the recent spate of layoffs may be a ploy to hold down demands for bonuses.

Not every part of Wall Street is thriving. After all the legal settlements, businesses with the most obvious conflicts of interest are in trouble. Experienced equity analysts, who can no longer be paid explicitly out of investment-banking revenues because this compromises the independence of their judgments, are moving jobs or firms. Merrill Lynch's individual-client business, which always sold products from outside sources, is doing well. Morgan Stanley's, which is accused by the Massachusetts state attorney-general of using undisclosed compensation to push its high-cost in-house mutual funds, is not.

However, old legal problems may be less of a threat to future profitability than areas where all seems dandy. Increased competition in traditional operations has driven banks into riskier activities: they have made a lot of money, for instance, in proprietary trading. Their values at risk (a measure of exposure to trading losses) have mostly risen relative to trading revenues (see chart). Profits here can be volatile. Morgan Stanley and J.P. Morgan Chase were both hurt in the third quarter by poor results from their fixed-income desks.

And a by-product of increased scrutiny from prosecutors and regulators has been a shift of capital to the corners of the financial markets where fees are highest and transparency lowest. Thus a second area to watch is profit derived from hedge funds and private-equity groups. No line item on investment banks' accounts delineates the importance of these groups. But there is no doubt that they matter.

Cost-conscious mutual funds grumble about paying a nickel a share for trades; hedge funds may happily pay four times as much for a profitable idea. They also pay banks for margin loans and clearing, and the private-client side of investment banks for bringing in customers. Private-equity firms may pay for this too, as well as fees for arranging the sale and purchase of companies. They will resist quibbling over a bill if they can get the first look at a deal.

Where this will lead is hard for an outsider to know. These customers may prove to be Wall Street's most valuable for years to come. Yet they may be, like technology companies in the 1990s, the beneficiaries of an investment fad which inflates investment banks' profits in the short term, only to cause vast harm later on. The next bust, after all, will have to start somewhere.

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