Investment Banking Earnings Highlight Wall Street's New Vulnerabilities

The collapse of The Bear Stearns Cos. and Lehman Brothers Holdings Inc. (OTC: LEHMQ), the forced takeover of Merrill Lynch and the decisions by Goldman Sachs Group Inc. (NYSE: GS) and Morgan Stanley (NYSE: MS) to get commercial-banking licenses seemed to signal that the investment-banking business model was dead.

Since then, however, Goldman Sachs, in particular, has posted an astonishing run of profitability, earning gigantic sums even while the rest of the U.S. economy languished.

But now it may be time for those Wall Street heavyweights to pay the piper: Heavyweights Goldman Sachs and Morgan Stanley are posting their third-quarter results this week. U.S. investment banks are looking at their worst quarter since just after the Lehman collapse. And analysts are slashing revenue forecasts just as the top players in this closely watched and often-vilified sector are getting ready to announce bonuses.

A Look Behind the "Velvet Rope"

For Wall Street investment banks, it's been quite a ride – one that's quite literally lasted for decades, in fact.

The question, now, is whether or not that ride is over.

To answer that question, we need to understand some investment-banking basics.

With a firm such as Goldman or Morgan Stanley, there are essentially three types of businesses: advisory, trading and principal investment.

In the advisory business, investment banks advise corporate clients about mergers, proposed stock-and-bond issuances, and capital restructurings. A more recent development has the investment banks managing money for institutional and individual investors.

In the trading business, investment banks trade bonds, stocks, currencies and derivatives. The banks act as principals on trades, but do not intend to hold onto the items traded.

In the principal investment business, the investment bank invests in stocks, bonds derivatives, real estate, hedge funds, private equity or anything else it chooses as principal.

There have always been elements of the trading and principal businesses in investment banking. It's part-and-parcel of both businesses.

For instance, if you're an investment bank, you can't act as underwriter for new stock-and-bond issues without being able to find buyers for the securities, or without being able to trade them in the secondary market.

Then there's the principal-investment business. Let's face it, the temptation for any investment banker worth his salt who spots a good deal is to invest in it, or to get his partners together to invest in it.

Finding such nuggets of gold was what brought the original Wall Street partnerships together.

Of course, principal investment did not always work. As John Kenneth Galbraith, author of the best-selling stock-market crash postmortem, "The Great Crash: 1929," said about Goldman Sachs' investment trust promotions in the months leading up to that historic stock-market debacle: "The autumn of 1929 was, perhaps, the first occasion in which men succeeded on a large scale in swindling themselves."

Nevertheless, Wall Street's business changed after about 1980. The major investment "houses" got a lot bigger in terms of both assets and employees. They also changed in structure from private partnerships owned by their top management to public companies owned primarily by outside shareholders. With the larger size, the advisory business became less important, so traders, who now made most of the money, not only got top billing – they took over top management.

The downside of this approach was seen in the years leading up to "The New Great Crash: 2007," and was perhaps best exemplified by the now-infamous Goldman Sachs Abacus transaction.

In that deal, a Goldman employee (later dubbed as the "Fabulous Fab" by the media) constructed an artificial collateralized debt structure that was deliberately designed to fail, and did do in cahoots with a major hedge fund manager.

In the Wall Street of 1980, such a transaction would have been unthinkable – legal or not.

When the top investment bank partners were corporate financiers, selling deals that were designed to fail would have involved far too great a reputation risk to be tolerated. As Galbraith said, the 1929 investment trust promotions, that earlier era's equivalent of Abacus, were notable because of the losses borne by Goldman Sachs and its partners. The deals may have been thoroughly unsound, but in the fevered atmosphere of the time they were designed to succeed, not fail.

Back to the Present

The flood of cheap money unleashed on the capital markets by U.S. Federal Reserve Chairman Ben S. Bernanke in late 2008 achieved their desired objective: They revived the financial markets, which enjoyed a huge boom. Consequently, Goldman Sachs – fully oriented toward trading and principal investment – made out like a bandit.

On the other hand, Morgan Stanley, which had remained oriented more toward its traditional advisory business, did much less well.

In 2009, Goldman Sachs recorded an astounding $13.39 billion in net income. Morgan Stanley earned only $1.15 billion. In the first quarter of 2010 – the final quarter of the Bernanke-sparked recovery – the trend was similar, albeit less pronounced: Goldman earned $3.5 billion to Morgan Stanley's $1.8 billion.

Fast forward to this year's second quarter, when stock markets declined, although U.S. debt markets were strong, the trend reversed: Goldman Sachs' net income fell 83% to $613 million (actually about $2.1 billion before special charges), while Morgan Stanley's net income held up at $1.96 billion.

Why is that worthy of note? For the first time in several years, the advisory business proved to be more profitable than the trading and principal-investment businesses.

In fact, aggregated analyst forecasts from Credit Suisse Group AG (NYSE ADR: CS), Morgan Stanley and JP Morgan Cazenove (NYSE: JPM) on the nine banks they collectively cover suggest that revenue from fixed-income, currency and commodities will be down by an average of 33% from the same quarter in 2009, states a report from Financial News.

Going forward, there are a number of factors that will make investment banking less profitable. The factors worth considering include:

• The fact that new financial-services legislation sharply restricts leverage, and limits the amount of principal trading that houses with banking licenses can undertake.
• Bernanke's cash injections to the market have mostly been absorbed and the bond bull market cannot have much further to run; hence profits from simple "gapping" (borrowing short-term and lending long) will disappear.
• If stock and bond markets are subdued (as I expect) trading volumes will decline, while "flash crash" episodes in which the market drops 10% without any apparent reason will bring restrictions on the highly profitable "fast trading" (also referred to as "high-frequency trading").
• On the advisory side, clients are much more aware than they were of the conflicts of interest involved in the investment banking behemoths' advisory activities. Hence advisory work will continue its recent drift towards smaller "boutiques."
• European and Asian banks' partial disappearance from the U.S. market after their subprime-mortgage losses has finally been reversed, and the survivors are competing actively again.
• Finally, the revved-up profitability enjoyed by Goldman Sachs and Morgan Stanley because of the disappearance of three of their five major competitors (albeit two of the three, Bear Stearns and Merrill Lynch, simply absorbed by larger houses) has ended.

[Editor's Note: If you have any doubts at all about Martin Hutchinson's market calls, take a moment to consider this story.

Three years ago – late October 2007, to be exact – Hutchinson told Money Morning readers to buy gold. At the time, it was trading at less than $770 an ounce. Gold zoomed up to $1,000 an ounce – creating a nice little profit for readers who heeded the columnist's advice.

But Hutchinson wasn't done.

Just a few months later – it's now April 2008 – with gold having dropped back to the $900 level, he reiterated his call. Those who already owned gold should hold on, or buy more, he said. And those who failed to listen to him the first time around should take this opportunity to remedy their oversight, he urged.

Well, we all know where gold is trading at today – in the neighborhood of $1,370 an ounce.

For investors who heeded Hutchinson's advice, that's a pretty nice neighborhood.

Investors who bought in after his first market call are sitting on a profit of as much as 78%. Even those who waited, and bought in at the $900 level, have a gain of as much as 52%.

And let's face it, with the U.S. Federal Reserve getting ready to launch "QE2" (and, by that, we're not referring to a luxury ocean liner – but rather a new round of "quantitative easing" that many of us fear will be highly inflationary), gold and other precious metals are likely headed much higher.

But perhaps you don't want just "one" recommendation. Indeed, smart investors will want an ongoing access to Hutchinson's expertise. If that's the case, then The Merchant Banker Alert, Hutchinson's private advisory service, is worth your consideration.

For more information on The Merchant Banker Alert, please click here.]

News and Related Story Links:

• eFinancial News.com:
  Analysts forecast slump in third-quarter revenue.
• JP Morgan Cazenove:
  Official Website.
• Wikipedia:
  John Kenneth Galbraith.
• Wikipedia:
  The Great Crash: 1929.
• Observer.com:
  Goldman's Fabulous Fab May Escape SEC Lawsuit.
• Money Morning Special Report:
  What Really Caused the Stock Market 'Flash Crash.'
• Money Morning News Analysis:
  Thursday's Wild Stock Market Ride Spotlights 'High-Frequency Trading' as the Latest Worry For Investors.
• Money Morning Market Commentary:
  High Frequency Trading: Wall Street's New Rent-Seeking Trick.