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Future of the Street
By MICHAEL SANTOLI
Wall Street is likely to reinvent itself in coming years -- and emerge stronger than before the current crisis hit.
RIVEN BY A CREDIT CALAMITY OF ITS OWN making, Wall Street is in self-preservation mode. Having seen Bear Stearns spiral into a forced liquidation, investment-banking executives are recognizing heavy losses, raising capital, forcibly shrinking balance sheets, trimming payrolls and otherwise trying to ensure that their firms survive the crisis.
In many respects, every crisis on the Street is unprecedented, and it's easy to argue that the current one is worse than most, given that -- by some estimates -- a full two years of brokerage-industry profits will have evaporated in write-downs and losses on mortgage bonds, buyout loans and the like before the reckoning is complete. Almost all of the industry's profit growth during the four years through 2006 came from a combination of an overheated "securitization" market and increased borrowing to amplify returns. Those profit levers are broken, leaving the business misshapen, with too much capital in the wrong places, too many people and too few obvious alternatives for returning to profit growth.
Tom Reis
A leaner and more globally oriented industry will come into view by 2010.
Yet, in one form or another, the industry will survive. And if historical form holds, Wall Street will reorient itself toward new businesses and fresh opportunities, even as the echoes of premature eulogies for the Street are still audible.
Although most eyes are fixed on the mayhem of the moment -- $140-a-barrel oil, a fresh Sell recommendation on Citigroup and a 2008 low for the market -- the time seems ripe to take the long view, gauging the ways in which Wall Street is likely to reinvent itself in the next couple of years.
Who will be the winners and the losers? How will jobs, and profit sources, change? Conversations with a score of industry analysts, consultants, professional investors and investment-banking executives have yielded some answers that might surprise you.
THE MOST LIKELY CHANGES will speak to the Street's policies regarding the use of capital; its regulatory burden; the way firms pay rainmakers; and the attraction of more stable lines of business, such as wealth management.
For a time, perhaps a couple of years, Wall Street is likely to be a less lucrative and less "fun" place to work. The recent rounds of layoffs, often targeting 5% of a company's staff, are just the start; some firms eventually will jettison 10% of their employees, including plenty of high-paid senior types.
Yet, the leading Street players should emerge from the crisis stronger. Investment banks will refocus on their core role as mediators of global capital flows among investors and issuers, with clear advantages accruing to those with the best-developed global franchises.
Perhaps you think the banks and brokers squandered too much of their clients' trust, and proved themselves so woefully inadequate as risk managers that even the giants won't revive.
Well, look back seven years to what the skeptics said about the industry's prospects after the tech bubble had burst. The Street had fattened for years at the trough of over-hyped initial stock offerings bolstered by tainted research. It had financed a technology-spending boom that finally crashed. No one could confidently predict from which direction the next gravy train might arrive.
Barron's Michael Santoli, but its next incarnation could be an even more profitable one. (June
Wall Street may be left a little smaller after the dust from the credit crisis settles, says Barron's Michael Santoli, but its next incarnation could be an even more profitable one. (June 27)
It was impossible to know at that time that a period of "free money," abetted by ultralow interest rates, would stoke a new bull market in debt and fuel a giant housing bubble. Wall Street firms once again got in too deep, repackaging mortgages -- with the help of pliant credit agencies and credulous investors -- into something they weren't (namely, safe and predictable slices of broader debt pools), and then parking large helpings of the newfangled securities on their own books.
Too often these instruments were highly customized to fit an investor's precise needs, or threaded through a loophole to win some minimal but necessary credit rating. Rather than act in its traditional role as the middleman between the issuer and investor, the Street increasingly created new life forms in its experimental petri dish.
To grab as large a piece of this deal flow as possible, firms ramped their use of borrowed money to pile more and more assets on their books. Brokerage firms are inherently leveraged, holding a large inventory of securities atop a sliver of equity capital. But gross leverage -- assets divided by equity -- surged from an average of 21 in 2003 among the largest brokers to 30 at year-end 2007, according to analyst Glenn Schorr at UBS. Net leverage, which excludes the generally stable "matched book" of short-term Treasury repurchase agreements, rose in the period to 17.2 from 14.
Indeed, both London-based analysts at Morgan Stanley and consultants at Oliver Wyman suggest that about half of investment banks' increased return on equity since 2003 came via higher leverage levels alone.
Aside from the availability of cheap debt, the willingness to take on more leverage was stoked by a mass case of "Goldman envy" among competitors of Goldman Sachs (ticker: GS). Witnessing Goldman's superior returns and greater reliance on proprietary trading, Merrill Lynch (MER), Morgan Stanley (MS), Citigroup (C) and Lehman Brothers (LEH) interpreted the firm's advantage as principally a matter of Goldman's greater appetite for risk, rather than (so far) its demonstrated ability to be one step ahead of the market and manage risk skillfully.
THE JOB OF REDUCING leverage -- through asset sales, hedges and portfolio mark- downs -- is underway, and likely to continue for some time. This should crimp overall lending and trading volumes for a while.
Eventually, securitization may lose its status as a core business, following the path of other once-central activities such as Nasdaq market-making. But securitization won't disappear entirely, and the Street will continue turning the attributes of all manner of assets into investable derivatives.
John Garvey, head of PriceWaterhouseCoopers' financial-services consulting practice, says, "How will firms lure investors back? Products will be more standard, less tailored, more transparent."
Part of the increased transparency is sure to be mandated under a new regulatory structure. A consensus is coalescing around the idea that the Fed might take a central role in overseeing financial firms in a system based on the markets in which the firms operate, rather than on now-archaic distinctions between banks and brokers.
That, in turn, could help pave the way for brokerages to buy depository institutions. If the brokers are going to be regulated by the Fed, why shouldn't they seek the seemingly more stable funding streams of banks?
Regulators will demand more objective and specific disclosures of firms' holdings and hedges, while perhaps using the large prime-brokerage operations that serve hedge funds to get a read on the aggregate positioning and risk-taking of large investors. And the authorities will want to monitor firms' liquidity levels and perhaps enforce stricter minimum-capital standards.
This could mute brokers' return on equity in the future, the measure that has most directly driven their stock valuations. There's a chance, however, that if investors gain confidence that investment banks are more stable and are warehousing less market exposure and "event" risk, the stocks could win slightly higher valuations.
After all, even when Goldman was booking a 40% ROE, its shares never traded much above 10 times earnings, implying that the market refused to credit the firm with an ability to repeat such bonanzas indefinitely.
IN WHAT COULD BE A MAJOR step toward greater transparency, some derivatives activities are apt to migrate from the opaque over-the-counter arena to public securities and futures exchanges.
Richard Repetto, analyst at Sandler O'Neill, is among those who believe the upended investment-bank business model is an opportunity for exchanges such as Chicago Mercantile Exchange (CME), which can boast clear real-time pricing and reliable trade-clearing mechanisms.
This doesn't mean a halt to the growth in OTC derivatives, which have been expanding by 30% annually since 2003. But it means that firms increasingly will look to exchange-traded prices, benchmarks and data products to price their holdings.
Wall Street firms have discussed forming a consortium to more publicly trade such instruments as credit-default swaps, which offer the chance to bet on or protect against changes in issuers' debt-repayment capacity. After launching such an effort, firms likely would nurture it with their trading flow and perhaps profit as it evolves into a stand-alone business.
The crumbling of the industry's greatest profit sources in the past year have helped remind executives of the broader challenges to their business, ones that have been present for years but were masked by the credit boom. Margins have been under assault in traditional client-trading businesses, hedge funds are constant poachers of talent, and buy-side firms are finding ways around the Street's intermediary role.
The balance of power is shifting toward the large hedge-fund and private-equity shops and away from the sell side. As hedge-fund boutiques grow into full-fledged institutions, they are sourcing more of their own deals, investing directly in issuers and internalizing trading and processing activities that they used to outsource to the Street.
It shouldn't come as a shock if a hedge-fund complex buys an investment bank. At the same time, Street firms will keep buying up and developing hedge funds of their own, if only to tap top talent and stay in the flow of the smart money.
All this will intensify the scrutiny that Wall Street executives apply to every aspect of their business. Technology will continue to displace people in low-value-added trade-execution areas as large firms try to automate the to-and-fro of stock and bond trading among clients.
Less-obvious weaknesses in management practices have also become more glaring, such as the inefficient way that traders and bankers are compensated. For instance, several industry pros remarked that firms typically "charged" their trading desks fairly uniform rates for the use of the firm's capital, without much regard to the liquidity or risk of each desk's trading book. This led to overpaying some heavy risk-takers in good times and to effectively subsidizing some desks with others.
More broadly, the Street will increasingly pay bonuses in ways that place an employee's financial interests in line with those of the company (and its shareholders), rather than the interests of narrow business units. Less cash, more restricted stock and longer-dated equity options are likely to become the norm.
Some types of traders and securities packagers will see their earnings power decline, the way eliminating investment-banking fees from research budgets has depressed analyst pay following the tech bust.
And might some firms finally recognize that Wall Street, for all its meritocratic conceits, routinely overpays for "average" performance? Why must the industry forever pay out at least half its revenues to employees, regardless of how good or bad a year was? Shareholders may agitate for more for themselves.
AS FOR NEW BUSINESS LINES that might help the Street regain its animal spirits, one intriguing bet is...simplicity. Brokerage firms have, in a sense, spent the last few years selling complexity to institutional investors-ever-more engineered and idiosyncratic debt and equity instruments.
One senior trading executive says he sees an opportunity for firms now to become part of the solution and use their advisory and capital-allocation capabilities to help clients unwind, modify or simplify their portfolios.
Infrastructure finance and the management of privatized infrastructure assets could also gain prominence, as this space becomes a distinct asset class and source of deals.
The other big story could be a reminder of proven truths, once forgotten. For instance, successful firms will better balance the riskier and the more stable business lines. Any honest reckoning of Merrill Lynch's capital-markets exposure leads to the conclusion that without its powerful retail brokerage, its one-half ownership of asset manager BlackRock (BLK) and its 20% stake in Bloomberg, Merrill would have been a candidate for the Bear Stearns treatment. "In financial services, the portfolio theory plays out," says Garvey of PriceWaterhouse Coopers.
Truly global firms will continue to widen their advantages, benefitting from surging capital flows worldwide. Rapid economic development and headlong wealth creation across the world invite the capital-intermediation skills that U.S. and European firms have honed over the years.
Goldman is an obvious and proven leader in this, but institutions such as Morgan Stanley, HSBC (HBC) and Citigroup have been hot on the trail.
Effective global strategies are essential in a world where India's Tata Motors (TTM) has nearly the same market value as General Motors (GM). What's bad for Detroit doesn't have to be bad for Wall Street. But the industry will have to fully own up to the errors of its past and then keep its eyes firmly on the road.
By MICHAEL SANTOLI
Wall Street is likely to reinvent itself in coming years -- and emerge stronger than before the current crisis hit.
RIVEN BY A CREDIT CALAMITY OF ITS OWN making, Wall Street is in self-preservation mode. Having seen Bear Stearns spiral into a forced liquidation, investment-banking executives are recognizing heavy losses, raising capital, forcibly shrinking balance sheets, trimming payrolls and otherwise trying to ensure that their firms survive the crisis.
In many respects, every crisis on the Street is unprecedented, and it's easy to argue that the current one is worse than most, given that -- by some estimates -- a full two years of brokerage-industry profits will have evaporated in write-downs and losses on mortgage bonds, buyout loans and the like before the reckoning is complete. Almost all of the industry's profit growth during the four years through 2006 came from a combination of an overheated "securitization" market and increased borrowing to amplify returns. Those profit levers are broken, leaving the business misshapen, with too much capital in the wrong places, too many people and too few obvious alternatives for returning to profit growth.
Tom Reis
A leaner and more globally oriented industry will come into view by 2010.
Yet, in one form or another, the industry will survive. And if historical form holds, Wall Street will reorient itself toward new businesses and fresh opportunities, even as the echoes of premature eulogies for the Street are still audible.
Although most eyes are fixed on the mayhem of the moment -- $140-a-barrel oil, a fresh Sell recommendation on Citigroup and a 2008 low for the market -- the time seems ripe to take the long view, gauging the ways in which Wall Street is likely to reinvent itself in the next couple of years.
Who will be the winners and the losers? How will jobs, and profit sources, change? Conversations with a score of industry analysts, consultants, professional investors and investment-banking executives have yielded some answers that might surprise you.
THE MOST LIKELY CHANGES will speak to the Street's policies regarding the use of capital; its regulatory burden; the way firms pay rainmakers; and the attraction of more stable lines of business, such as wealth management.
For a time, perhaps a couple of years, Wall Street is likely to be a less lucrative and less "fun" place to work. The recent rounds of layoffs, often targeting 5% of a company's staff, are just the start; some firms eventually will jettison 10% of their employees, including plenty of high-paid senior types.
Yet, the leading Street players should emerge from the crisis stronger. Investment banks will refocus on their core role as mediators of global capital flows among investors and issuers, with clear advantages accruing to those with the best-developed global franchises.
Perhaps you think the banks and brokers squandered too much of their clients' trust, and proved themselves so woefully inadequate as risk managers that even the giants won't revive.
Well, look back seven years to what the skeptics said about the industry's prospects after the tech bubble had burst. The Street had fattened for years at the trough of over-hyped initial stock offerings bolstered by tainted research. It had financed a technology-spending boom that finally crashed. No one could confidently predict from which direction the next gravy train might arrive.
Barron's Michael Santoli, but its next incarnation could be an even more profitable one. (June
Wall Street may be left a little smaller after the dust from the credit crisis settles, says Barron's Michael Santoli, but its next incarnation could be an even more profitable one. (June 27)
It was impossible to know at that time that a period of "free money," abetted by ultralow interest rates, would stoke a new bull market in debt and fuel a giant housing bubble. Wall Street firms once again got in too deep, repackaging mortgages -- with the help of pliant credit agencies and credulous investors -- into something they weren't (namely, safe and predictable slices of broader debt pools), and then parking large helpings of the newfangled securities on their own books.
Too often these instruments were highly customized to fit an investor's precise needs, or threaded through a loophole to win some minimal but necessary credit rating. Rather than act in its traditional role as the middleman between the issuer and investor, the Street increasingly created new life forms in its experimental petri dish.
To grab as large a piece of this deal flow as possible, firms ramped their use of borrowed money to pile more and more assets on their books. Brokerage firms are inherently leveraged, holding a large inventory of securities atop a sliver of equity capital. But gross leverage -- assets divided by equity -- surged from an average of 21 in 2003 among the largest brokers to 30 at year-end 2007, according to analyst Glenn Schorr at UBS. Net leverage, which excludes the generally stable "matched book" of short-term Treasury repurchase agreements, rose in the period to 17.2 from 14.
Indeed, both London-based analysts at Morgan Stanley and consultants at Oliver Wyman suggest that about half of investment banks' increased return on equity since 2003 came via higher leverage levels alone.
Aside from the availability of cheap debt, the willingness to take on more leverage was stoked by a mass case of "Goldman envy" among competitors of Goldman Sachs (ticker: GS). Witnessing Goldman's superior returns and greater reliance on proprietary trading, Merrill Lynch (MER), Morgan Stanley (MS), Citigroup (C) and Lehman Brothers (LEH) interpreted the firm's advantage as principally a matter of Goldman's greater appetite for risk, rather than (so far) its demonstrated ability to be one step ahead of the market and manage risk skillfully.
THE JOB OF REDUCING leverage -- through asset sales, hedges and portfolio mark- downs -- is underway, and likely to continue for some time. This should crimp overall lending and trading volumes for a while.
Eventually, securitization may lose its status as a core business, following the path of other once-central activities such as Nasdaq market-making. But securitization won't disappear entirely, and the Street will continue turning the attributes of all manner of assets into investable derivatives.
John Garvey, head of PriceWaterhouseCoopers' financial-services consulting practice, says, "How will firms lure investors back? Products will be more standard, less tailored, more transparent."
Part of the increased transparency is sure to be mandated under a new regulatory structure. A consensus is coalescing around the idea that the Fed might take a central role in overseeing financial firms in a system based on the markets in which the firms operate, rather than on now-archaic distinctions between banks and brokers.
That, in turn, could help pave the way for brokerages to buy depository institutions. If the brokers are going to be regulated by the Fed, why shouldn't they seek the seemingly more stable funding streams of banks?
Regulators will demand more objective and specific disclosures of firms' holdings and hedges, while perhaps using the large prime-brokerage operations that serve hedge funds to get a read on the aggregate positioning and risk-taking of large investors. And the authorities will want to monitor firms' liquidity levels and perhaps enforce stricter minimum-capital standards.
This could mute brokers' return on equity in the future, the measure that has most directly driven their stock valuations. There's a chance, however, that if investors gain confidence that investment banks are more stable and are warehousing less market exposure and "event" risk, the stocks could win slightly higher valuations.
After all, even when Goldman was booking a 40% ROE, its shares never traded much above 10 times earnings, implying that the market refused to credit the firm with an ability to repeat such bonanzas indefinitely.
IN WHAT COULD BE A MAJOR step toward greater transparency, some derivatives activities are apt to migrate from the opaque over-the-counter arena to public securities and futures exchanges.
Richard Repetto, analyst at Sandler O'Neill, is among those who believe the upended investment-bank business model is an opportunity for exchanges such as Chicago Mercantile Exchange (CME), which can boast clear real-time pricing and reliable trade-clearing mechanisms.
This doesn't mean a halt to the growth in OTC derivatives, which have been expanding by 30% annually since 2003. But it means that firms increasingly will look to exchange-traded prices, benchmarks and data products to price their holdings.
Wall Street firms have discussed forming a consortium to more publicly trade such instruments as credit-default swaps, which offer the chance to bet on or protect against changes in issuers' debt-repayment capacity. After launching such an effort, firms likely would nurture it with their trading flow and perhaps profit as it evolves into a stand-alone business.
The crumbling of the industry's greatest profit sources in the past year have helped remind executives of the broader challenges to their business, ones that have been present for years but were masked by the credit boom. Margins have been under assault in traditional client-trading businesses, hedge funds are constant poachers of talent, and buy-side firms are finding ways around the Street's intermediary role.
The balance of power is shifting toward the large hedge-fund and private-equity shops and away from the sell side. As hedge-fund boutiques grow into full-fledged institutions, they are sourcing more of their own deals, investing directly in issuers and internalizing trading and processing activities that they used to outsource to the Street.
It shouldn't come as a shock if a hedge-fund complex buys an investment bank. At the same time, Street firms will keep buying up and developing hedge funds of their own, if only to tap top talent and stay in the flow of the smart money.
All this will intensify the scrutiny that Wall Street executives apply to every aspect of their business. Technology will continue to displace people in low-value-added trade-execution areas as large firms try to automate the to-and-fro of stock and bond trading among clients.
Less-obvious weaknesses in management practices have also become more glaring, such as the inefficient way that traders and bankers are compensated. For instance, several industry pros remarked that firms typically "charged" their trading desks fairly uniform rates for the use of the firm's capital, without much regard to the liquidity or risk of each desk's trading book. This led to overpaying some heavy risk-takers in good times and to effectively subsidizing some desks with others.
More broadly, the Street will increasingly pay bonuses in ways that place an employee's financial interests in line with those of the company (and its shareholders), rather than the interests of narrow business units. Less cash, more restricted stock and longer-dated equity options are likely to become the norm.
Some types of traders and securities packagers will see their earnings power decline, the way eliminating investment-banking fees from research budgets has depressed analyst pay following the tech bust.
And might some firms finally recognize that Wall Street, for all its meritocratic conceits, routinely overpays for "average" performance? Why must the industry forever pay out at least half its revenues to employees, regardless of how good or bad a year was? Shareholders may agitate for more for themselves.
AS FOR NEW BUSINESS LINES that might help the Street regain its animal spirits, one intriguing bet is...simplicity. Brokerage firms have, in a sense, spent the last few years selling complexity to institutional investors-ever-more engineered and idiosyncratic debt and equity instruments.
One senior trading executive says he sees an opportunity for firms now to become part of the solution and use their advisory and capital-allocation capabilities to help clients unwind, modify or simplify their portfolios.
Infrastructure finance and the management of privatized infrastructure assets could also gain prominence, as this space becomes a distinct asset class and source of deals.
The other big story could be a reminder of proven truths, once forgotten. For instance, successful firms will better balance the riskier and the more stable business lines. Any honest reckoning of Merrill Lynch's capital-markets exposure leads to the conclusion that without its powerful retail brokerage, its one-half ownership of asset manager BlackRock (BLK) and its 20% stake in Bloomberg, Merrill would have been a candidate for the Bear Stearns treatment. "In financial services, the portfolio theory plays out," says Garvey of PriceWaterhouse Coopers.
Truly global firms will continue to widen their advantages, benefitting from surging capital flows worldwide. Rapid economic development and headlong wealth creation across the world invite the capital-intermediation skills that U.S. and European firms have honed over the years.
Goldman is an obvious and proven leader in this, but institutions such as Morgan Stanley, HSBC (HBC) and Citigroup have been hot on the trail.
Effective global strategies are essential in a world where India's Tata Motors (TTM) has nearly the same market value as General Motors (GM). What's bad for Detroit doesn't have to be bad for Wall Street. But the industry will have to fully own up to the errors of its past and then keep its eyes firmly on the road.
by 2010 , i see wall street just starting out on a bull run like no other , houseing will rebound,taxes cut, oil drops , the Dollor $ will rise , so buy on the dips for the next two years and make some profit within 4 years !!
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The way it looks today.
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