For Investment Banks, Mergers Are Looking Attractive Again
Aug 19, 2008 Mergers and Acquisitions, U.S Hot Stocks
By Matthias Rieker
Of DOW JONES NEWSWIRES
NEW YORK (Dow Jones)–In banking circles, convergence talk is back.
Mergers between investment banks and commercial banks had become rare until
JPMorgan Chase & Co. (JPM) bought Bear Stearns, but falling profits and tougher
funding have hurt Lehman Brothers Holdings Inc. (LEH), Morgan Stanley (MS),
Merrill Lynch & Co. Inc. (MER), and Goldman Sachs Group Inc. (GS). The result is
some experts think this profit pain is permanent, and commercial bankers are
starting to suspect that a broad capital markets business can diversify earnings,
help growth and provide more services for commercial customers.
So with such low valuations for banks and securities firms right now, it might be
time to talk: “Those are not going to be high-premium deals,” one investment
banker said. Low prices will assure the deals will more quickly benefit earnings.
Diversification once topped the agenda at financial services companies -
particularly after the 1999 revision of the Glass-Steagall Act allowed banks,
securities firms, and insurance companies to operate under one roof. But then
they started selling businesses that distracted from core lending and deposit
operations, like securities businesses.
Now the focus is on raising and preserving capital, so buying an investment bank
might seem counter-intuitive, but valuations are so low they might be too
tempting for executives to resist: “Those are attractive businesses,” the
investment banker said.
Some observers think Lehman, Merrill Lynch, and Morgan Stanley might believe they
are better off merging soon. Goldman Sachs, the strongest of the four, is likely
to stand alone for now but might eventually consider a bank partner.
“Given what Lehman is going through, I can’t imagine they are not talking” about
a deal, another investment banker with a big Wall Street firm said - though talks
are a long way from negotiating a sale. Lehman is also reportedly looking to shed
all or parts of its asset management business.
Spokespeople for Lehman and the other securities firms declined to discuss the
matter.
The credit crisis has crushed lucrative businesses like the securitization of
subprime loans and exotic mortgages. “Certain businesses may never come back,”
said Peter Nerby, an analyst with Moody’s Investors Service. Profits will suffer,
something investors will have to get used to.
Investment banks also tied capital to long-term assets that historically were
held on the balance sheets of commercial banks, like leveraged loan and revolving
credit. Those activities may be hard to fund, particularly if, as planed, the
Federal Reserve Board closes the discount window in January.
The Fed has traditionally been the funding source of last resort for banks, but
after the collapse of Bear Stearns brokers were given access. In the week ending
March 20, the first discount borrowings were available, brokers took out $28.8
billion - $16.8 billion more than commercial banks that week. But a week later,
discount borrowings peaked at $37 billion. Since late May, the balance at the end
of the week remained zero, according to Fed data.
“The discount window is more political” than a real necessity for the survival of
the investment banks, one M&A lawyer said. And the capital raises in recent
months have shown that brokers can get the funding they needed.
But Moody’s Nerby said that brokers could see their debt ratings cut when the
discount window closes. It’s unclear how much the Fed’s open tap helps to calm
brokers’ counterparties even if the firms don’t actually borrow.
Regulation may be another problem: “I think they should be regulated like banks,”
one investment banker said. That would likely curb investment banks’ risk
appetite, and add costs.
Still, not all investment banks are equal. In 2006, about half of Lehman’s
revenue came from the fixed income market, compared to about a third at Merrill
Lynch, Moody’s Nerby said. “Each of these businesses have different prospects,”
he said about the four.
Overall, brokers have diversified investment banking, cash equity, and asset
management and all four major investment banks have strong liquidity. He said
Goldman Sachs’s competitive position has never been stronger and is probably
taking market share from Citigroup Inc. (C) and UBS AG (UBS).
Citi and UBS are examples of universal banks that have run into the same problems
as the brokers, and are plagued by bigger writedowns of the value of assets tied
to the secondary consumer loan market.
“You can’t tell me that the universal banking model generally works better,”
Nerby said. Other observers agreed. Particularly if investment banks return to
their historic businesses, shed operations that require long term funding, and
generally contain risk as smaller, nimbler organizations, they can survive
independently. “Keep the assets liquid,” Nerby advised.
But if brokers aspire to compete with banks in lending and other businesses, they
need to get deposits to add stable funding - and deposit require retail banking
branches, investment bankers said.
The problem is that buyers are few and far between. Bank of America (BAC),
Wachovia Corp. (WB), HSBC Holdings Plc (HBC), and Barclays Plc (BCS) are most
commonly mentioned. Observers disagree whether Deutsche Bank AG (DB), a large
commercial lender, could decide to beef up its U.S. operations.
HSBC’s Chief Executive Michael Geoghegan, asked specifically whether he is
interested in buying Lehman, answered with a simple “No.”
Wells Fargo & Co. (WFC) and U.S. Bancorp (USB) have the potential of merging with
a broker-dealer, but are unlikely to have any appetite to get into the capital
markets business. And BNP Paribas (BNPQY 13110.FR) has shunned big deals. None of
the spokespersons for those banks were willing to say whether their companies
would be interested in buying an investment bank.
Merrill Lynch could be an ideal target for Bank of America. The Charlotte banking
giant would get an attractive brokerage network and an extremely valuable stock
of high-net worth customers, a fit for its U.S. Trust unit. Bank of America would
certainly like the deposits Merrill Lynch has been gathering since it started to
offer banking some years ago.
Of course, BofA’s CEO Kenneth Lewis said only in October, “I’ve had all of the
fun I can stand in investment banking at the moment. So to get bigger in it is
not something I really want to do.”
Though he has softened that frustration since, BofA might not need a broker’s
global infrastructure for its commercial banking operations. In June, Bank of
America sold its prime brokerage business to BNP Paribas.
Merrill Lynch Chief Executive John Thain said during a conference call sponsored
by Deutsche Bank analyst Michael L. Mayo: “We don’t have any pressure or desire
to either consolidate or be consolidated.”
Wachovia is unlikely to do any deal right now, since its new CEO Robert Steel is
working out a plan to heal the bank from the hits it is taking in the consumer
lending business after the adjustable-rate mortgage book it got with the
acquisition of Golden West Financial has caused so much pain.
But Steel might not have abandoned Wachovia’s ambition to join the exclusive
group of universal banks in the U.S. Morgan Stanley and Merrill Lynch might be
difficult to integrate, because Wachovia would have to merge their retail
brokerage businesses with its own Wachovia Securities LLC, but Lehman has no
retail brokerage business. (In fact, last year Merrill Lynch’s then-CEO E.
Stanley O’Neal contacted his Wachovia Corp. counterpart, G. Kennedy Thompson, to
explore a possible deal, but nothing came of it, and both men eventually lost
their jobs.)
For bankers, the integration risk of buying an investment bank remains high - a
point James Dimon, JPMorgan Chase & Co.’s chairman and CEO, has often said and
why he made sure the price for Bear Stearns was low enough for the bank to
mitigate that risk.
For Bank of America and Wachovia, a no-premium deal might be the way to get
there.
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