As we see earnings reports from investment banks begin to trickle in, it's interesting to look in and read the "tea leaves." Obviously, it's way too soon to actually determine what businesses will be good and look good going forward, but making some informed observations and expanding a table of numbers to some commentary is a valuable exercise.
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One note, Deutsche Bank, Credit Suisse, U.B.S., Barclays (essentially Lehman), and R.B.S. were not included in the table because their reporting requirements are different and for lack of time. That being said, each is a niche player in a subset of the categories here, versus the five firms listed--each is a major competitor now in every category (Banking, Trading, and Wealth Management/Asset Management). The one exception is Barclays, due to it's acquisition of Lehman's businesses.
One other detail to mention is that, where possible, I backed out marks from this past quarter due to a firm's own credit improving or deteriorating. Also, I tried to make common sense adjustments where things were unclear. For example, Morgan Stanley provides an ambiguous "other" category in it's trading businesses--these were largely negative and due to hedges, so I added these into fixed income trading. This is just one example.
First, we'll look at product lines. The subtotals are what's most important here, but I will look into each category on a firm by firm basis within a section. Okay, that was confusing, but you'll see what I mean.
Banking: I'll admit, that I have no idea, none whatsoever, how Citi posts a negative revenue number in the "Banking" category. Now, it's no secret that M&A volumes have declined by a significant amount (over 36%, according to the FT). Debt volumes tables are actually up by 23%, and equity volumes are down by 45%. Interestingly, the only firm that saw a significant decline in this segment was Goldman. If we're being honest, one probably can't read too much into this category. The dynamic of this market, given it's past reliance on firm's committing capital to a transaction through lending and "taking down" unsold securities, including the technically non-securitized leveraged loan market, is likely to show a significant change. Also, the marginal deal volume, driven by private equity and high yield companies will be the source of true growth going forward--until that returns, firms will be competing for slices of a small, or even shrinking, pie.
Trading: This segment is truly bifurcated. Anecdotal evidence tells us that certain fixed income products, such as interest rate products and credit, saw large revenue gains across the board. For fixed income specifically, this will be a bellwether quarter--this was the first entire quarter where the new landscape for sales and trading was present. Obviously, the absence of Lehman and Bear Stearns is a major part of that, but also the movement of traders and salespeople from one firm to another had largely played out before this quarter began.
There is, however, another underlying dynamic in the fixed income markets that will shake itself out in due time: the rise of the regional broker/dealer. These firms have been springing up like weeds. A lot of seasoned traders and salespeople have decided to "wait out" the storm at these sorts of firms--the compensation model is much more of an "eat what you kill" mentality. Typically, there is a 25-45% "commission" for trades. However, there is no ability of the firm to take risk, you must match a buyer and a seller and can never take delivery of securities. This means that trades are hard to get done, and traders can go days, if not weeks, without doing a single trade. However, if someone makes $1 million on a trade, they have just made their year. The rise of these firms, however, according to everyone (including their inhabitants) will be short lived--in a few years most of these firms will be much smaller, or gone. Likely, one or two larger regionals (as they are called) will survive and become the second- or third-tier trading firm of tomorrow.
Equity trading is an entirely different situation--here, the revenue at many firms is linked to their prime brokerage business (this is the part of the firm that serves as the back office for hedge funds) in addition to the traditional equities business. I would expect that equity revenues, on balance, are subject to decrease as volatility (the traders source of proprietary revenue) decreases and hedge funds disappear.
It should be noted that the ratio of fixed income revenue to equities revenue was very consistent and lumpy across firms--two firms were 2.5x, two firms were 3.7x, and one was 1.7x.
Private Wealth Management and Asset Management: This is an orphan category. First, most firms seem to report both businesses as one or another category, but don't break these out separately--this complicates our ability to truly reason intelligently about this business. However, we know one thing: fees are going down as assets go down. Almost every single firm showed a decrease in revenue in this segment. Bank of America is the lone firm to show an increase, but I would bet that's good evidence they are presenting historical numbers that do not include it's major acquisitions, like Merrill.
Further, the game of musical chairs for brokers/financial associates/private wealth managers/whatever else, is shifting the landscape of this business. The first quarter likely saw most of this market settle (with respect to margins and market share), but with the Smith Barney transaction announced early in the quarter, it's very likely that the dust hasn't yet settled.
Now that we've looked at business lines, the next step is to look at individual firms. From this past quarter, I think there's a lot of insight to be gained from how each business has managed performed.
JP Morgan Chase: This firm the market had the most confidence in, and for good reason. Their capital ratios are strong, they grew revenues across almost all business lines, and they are a large bank with a "fortress balance sheet" (their words). Much like Citi and Bank of America, the health of the firm is viewed through a larger lens than an investment bank.
A year ago, JPM looked very different. Their revenues now look more like their competitors, when broken down by category. JPM's revenue looks like Citi's and Bank of America's (although, BofA is more heavily skewed towards brokerage/private wealth/asset management, likely due to their U.S. Trust acquisition and Merrill's Thundering Herd). Honestly, their exposures and commentary seems to indicate that JPM's businesses will improve as the environment improves. As a firm, they seems to have done a good job of capitalizing on competitors' weakness and avoiding any large landmines--writedowns were small compared to their peers. Outside the scope of our discussion, but still worth noting, is that their mortgage portfolio's performance seems to have leveled off as well, further evidence of good risk management.
Citi: What can can I say that hasn't already been said? (See: Citi's Earnings: Even Cittier Than You Think.) Now, nothing in their revenues signals a problem. However, far-and-away the largest problem with understanding how Citi is going is the fact that they no longer have to mark-to-market over $60 billion in assets. Citi is also going through what I refer to as the "endangered ship" dynamic: as the ship is taking on water, if, to lighten the load and stay afloat, you need to throw the food overboard, you do it and figure out how to fix that problem later. In Citi's need to reduce expenses through headcount reductions, they have had to cut some of their most effective people (you don't save much money cutting the cheap, expendable people). Unfortunately, there also exists a large body of anecdotal evidence that all says the same thing, that the survivors at Citi aren't the most effective employees, but rather are the most politically savvy employees.
Going forward, there can easily be more writedowns in Citi's Alt-A and other "near prime" products. I'll admit that I don't know how one has to recognize or reserve against losses for securities and loans moved into "Held to Maturity" or "Held for Investment" accounts, but those products can face a large decline very quickly.
Now, from their revenues, it seems that Citi did as well as could be expected of any bank with their size and risk tolerance. However, with writedowns being hidden away and their profiting from their own credit declining, in addition to their weakening talent pool, it seems pretty clear that something needs to change or we'll, at the least, see them generate less revenue, or, at the worst, disappear. It's also not very transparent what the whole Citi Holdings situation means.
Bank of America: I'll be honest, one can't really divine anything from this quarter. It seems pretty clear form the 1,005% jump in revenue that no comparison is apples to apples. Likely this is because Merrill isn't reflected in their 1Q08 numbers. I suppose that's fine, but it makes them hard to gauge over time.
Merrill, also, has a few problems it needs to deal with. We know they have offloaded most of their C.D.O. exposure and seem to not have much more exposure to troublesome mortgage products. However, this doesn't even come close to jiving with their huge $15 billion loss in the fourth quarter. That loss indicates to me that their risk management and control procedures are completely failing. In fact, if Merrill made large bets in the fourth quarter on illiquid products, there is almost no way they can get out of those positions. Whereas in the fourth quarter one could purchased C.M.B.S. bonds, taken large positions in C.D.S. on sub-prime or other mortgage bonds, or done any number of other things, it's almost impossible to work out of those positions. This jives well with BofA's cautious but open stance to the P.P.I.P. Also, the losses in the fourth quarter jive well with press accounts that Thomas Montag sent out orders to up the risk being taken on the Merrill trading floor without giving much guidance. In short, it seems like there is a large risk of further losses--I'm nervous about Merrill's trading units until BofA can show they have them under control.
It's also important to note that Merill and BofA's trading operations haven't yet been integrated. I personally know very senior people on both sides of the acquisitions that are waiting to learn their fate. This complicates things much more as internal power struggles, politicking, and other wasteful behaviors or negative incentives are likely to restrain BofA's ability to compete in their trading businesses (and, probably, all their investment banking businesses).
Morgan Stanley: This quarter, ironically, Morgan Stanley is the anti-Citi. Their marks were fair (C.M.B.S. marks are conservative, for example), they specifically stated that the new F.A.S.B. move will not affect their method for marking positions, and they were hurt by their improvement in credit quality.
Another interesting point made by Morgan Stanley was that their trading revenues didn't go up as much as others because they don't take as much risk. One area that is quite worrisome is the equities revenue dropping off a cliff. If that revenue has merely remained flat, there would have been nearly no contraction in revenue year-over-year. To put the number in perspective, Morgan Stanley's equity trading revenue changed by more than the revenue of Goldman's entire firm. It does seem that prime brokerage has been hit hard and client activity has gone way down (according to their commentary). Against the backdrop of their competitors, though, this looks like a troublesome line item.
The other large change was in their private wealth business, but their earnings talk about a one-time gain in 1Q08 (I didn't bother backing this out of their 1Q08 numbers).
Goldman Sachs: Well, it's pretty clear what happened here. Goldman hit a home run in fixed income trading. This statement, though, is like observing someone died of a disease without knowing the details. This is not a one-off result on Goldman's part. As a matter of fact, this is their most consistent function--they quickly allocated capital where market opportunities existed. Goldman has something they call "the grid." Every week (maybe more often) they (senior people at Goldman) take stock of what they think opportunities are in the market. Senior traders go to Lloyd and David and Gary and tell them how their markets are trading and what they are seeing. Then, balance sheet is reallocated if there is a pressing need--up or down, business by business. This is why Goldman was easily able to monetize the opportunities in fixed income this quarter--roughly 2 months into their quarter (including December), they allocated a lot of balance sheet (think 9 digits) to opportunities in the rates markets. In essence, Goldman operated smoothly and transparently this quarter by doing so well.
Goldman, as readers of my blog already know, was lucky enough to constantly fail at pushing into risky mortgage products and C.D.O.'s. So it's unclear if they have anything significant in inventory that is likely to be written down. The largest visible risk to Goldman going forward is their status as a bank, which will require them to de-leverage significantly. This process will reduce their overall R.O.E. in the long-term. We'll see if their gains in market share and higher margins won't balance out the negative technical headwinds for the near future.
Alright, well, I bet you're as tired of reading this as I am of writing! Please feel free to drop me a line if you have any questions, disagree, or just want to chat. I'll try to monitor the comments and respond when necessary.
