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Dour Mkts, Weak Economy Weigh On Outlook For US Brokerages

Jun 27, 2008 Market Outlook

By Jed Horowitz
Of DOW JONES NEWSWIRES

NEW YORK (Dow Jones)–Enough already with the cliches about the perfect storm.
For the big investment banks, it’s almost a cataclysm.

Let’s start with the basics. When the broad equity market suffers, brokerage
stocks inevitably do worse. (When it rains on the market, in that storm analogy,
it pours on the market’s conduits.) That’s because Wall Street depends on rising
stocks to stimulate capital-raising and deal-making activities by corporate
clients, as well stock buying by retail and institutional customers.

The market, of course, is wobbly. Primed by the seemingly endless climb in the
price of oil and other commodities, pessimistic earnings outlooks in both the
technology and rust-belt sectors and a dire economic outlook that has hog-tied
the Federal Reserve, the Dow Jones Industrial Average plummeted 358 points on
Thursday. It is now just 122 points shy of the quasi-official start of a bear
market, generally defined as a 20% drop from an index’s high.

The 30-stock Dow index is down about 14% year to date, about half the 28% drop in
the American Stock Exchange Broker-Dealer Index of 12 investment bank and
discount broker stocks. Lehman Brothers Holdings Inc. (LEH) and Merrill Lynch &
Co. (MER), components of the broker-dealer index, were off 65% and 38%,
respectively, before Friday’s opening.

Also pushing down equities: Monday marks the end of the second quarter,
encouraging big investment funds to winnow losing positions so they can
window-dress their quarterly holdings reports to investors.

But equities are only the start of the problem for investment banks. In recent
years, fixed-income sales and trading have been even more vital to investment
banks than equities and investment banking, generating as much as twice the
revenue between 2001 and last year’s third quarter.

Fixed-income markets are where most of the derivatives and other highly
structured products keyed off mortgages reside. Banks borrowed heavily to gear up
their origination, sales and trading of fixed-income products in the boom years
of 2005, 2006 and half of 2007 and had record results to prove it. But last
summer, the subprime-induced credit crisis surfaced, and the billions of dollars
of wounded assets that have haunted investment banks through write-downs and
losses for three consecutive quarters still hover.

That’s because investors who buy everything from short-term commercial paper and
other money-market instruments that finance investment banks’ daily operations,
to the corporate loans and mortgages that have weighed down their balance sheets,
remain reluctant to buy.

Until earlier this year, executives at the likes of the now-defunct Bear Stearns
Cos., Goldman Sachs Group Inc. (GS), Merrill, Morgan Stanley (MS) and Lehman were
cheerily saying they were taking the hits in preparation for an economic rebound
in the second half of the year. “Dialogues” with cash-rich corporate clients,
they repeatedly said, were intense and pipelines of future assignments were
growing.

Sure, they were raising billions of dollars of new equity from investment funds
of oil-rich nations and the occasional private-equity company to repair their
balance sheets and satisfy new risk-based capital standards. Yes, they have been
selling off home mortgages, commercial mortgages and corporate loans at big
discounts. And, for a while at least, it might be fair to expect returns on
equity of 20% and better to fall to the mid-teens, percentage-wise.

But give them time, they said. The second half of the year, or at least early
2009, looked promising. And don’t forget, they added, some 50% of revenue at
these companies is now coming from outside the U.S. Give them time.

Time, though, has become a rare commodity. The Federal Reserve Board has ended
its long run of interest-rate cuts - which helps banks that borrow on a
short-term basis - and is now focusing on fighting inflation, which points to
rate increases in the future.

Bankruptcy and unemployment rates remain low because banks are reluctant to push
scores of troubled industrial and consumer companies into defaults that will only
add to the banks’ stockpiles of troubled assets. But with gasoline, food and
other prices skyrocketing, a rapid rise in defaults in coming months is
inevitable, according to workout lawyers, bankers and distressed investors.

With the revenue outlook deteriorating, debt levels and distressed assets still
high, and the prospect of additional recapitalizations looming at ever-more
punitive levels, the forecast for investment banks remains doleful.

Merrill Lynch may be the first of the remaining big banks to feel the latest
impact, since it reports its second-quarter results in about two weeks. Lehman
analysts on Friday suggested Merrill will report a loss of $5.4 billion as its
large overhang of collateralized debt obligations sinks in value along with the
credit ratings of insurance companies like Ambac Financial Group Inc. (ABK) that
insured swaps hedging the CDO positions.

Lehman, Morgan Stanley and Goldman Sachs have already reported results for their
fiscal second quarters that ended last month. The scorecard: A $2.8 billion loss
at Lehman, a 61% profit decline to $1 billion at Morgan Stanley (helped by $1.5
billion of pretax profit on sales of two businesses) and an 11% profit decline at
Goldman to $2.1 billion.

In recent trading, Goldman shares were off 0.01%, Lehman was down 0.9%, Merrill
was down 0.09%, and Morgan Stanley was up 1.3%.

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