Wednesday, April 9, 2008

The Investment Banks's Business Model is Broken

As the housing crisis deepens and it seems like the news can't get any worse, the contrarian side of me started to think about the next cycle and I asked myself one question. Has the bad news been priced into the financials?

The talking heads on CNBC shout on a daily basis that the financials and the market has hit a bottom and we need to get into equities. I came to a different conclusion after looking at history. From an equities standpoint, we are now down only 12% or so from the market highs last summer on the DOW. The average drop during a recession is 28%. This is going to be an above average recession so I can't even think we are close to a bottom until I see us down at least 28% on the DOW.

I then looked at the investment banks and started to analyze where they made their money during the past bull market cycle. What I found was a large percentage of their profits was securatizing AAA mortgage debt and selling it off to people all over the world. Well this game is completely over. Some firms have layed off everyone involved in this.

Another big profit maker for the investment banks was consulting on private equity buyouts. Well now that there are no credit markets, there is no money to finance these deals so this money maker has also come to a complete hault. Private equity is bailing out of these deals like Clear Channel as fast as they can because borrowing money got too expensive because the banks have no desire to lend after absorbing staggering losses in housing. The bank are currently focused on simply trying to survive and stay solvent.

Because of these troubles, the consulting fees on buyouts for the investment banks are now greatly diminished. The third area of big profit for the IB's is mergers and acquisitions. The M&A game has slowed down to a snails pace as the economy slows and businesses aren't nearly as profitable thus less desirable. As explained above, you also have the issue of expensive borrowing costs. There will still be action here but it will be greatly diminished.

So bottom line is the IB's have lost three of their most lucrative businesses. The way I see it these firms need to now reinvent themselves and restructure. They face a long period of massive drops in profits as they continue to take writedowns and have no new revenue streams to make up for these losses. They can't trade themselves into profits every quarter like Goldman did when they shorted subprime. This was a one time event. We are in a flat to down market so the trading the firms money will not be as lucrative. The brokerage area should still be strong IF people still want to trade in the market.

Looking at the low trading volumes the past few days the brokerage profits look to be average going forward. This is why they go on CNBC and pump stocks! Bear markets tend to have low volumes because there simply isn't a big appetite to buy equities. People tend to sit on the sidelines and wait for the shoes to drop.

So in conclusion, I see a long protracted period where the investment banks struggle and I don't think their stock prices have reflected this. Meredith Whitney who is a rising star based on her negative calls in financials explains it best as to why the financials will continue to struggle:

"Whitney pointed out that Wall Street firms were now brutally exposed to the whims of the ratings companies: Every time Moody's Investors Service and Standard & Poor's downgrade subprime mortgages, the Wall Street banks that own them are required to reserve more capital against the securities -- which both raises their cost of capital and dilutes the value of their existing shares.

" another is her argument that Wall Street firms will drift to their tangible book value -- or what you'd get for them if you sold them off, position by position. Several (Citigroup is still the prime example) still have huge amounts of goodwill built into their share price. Goodwill, Whitney argues, will vanish."

Goodwill based on past performance is not a fundamental reason to buy a stock. Enron performed well for a while too.

Overall, exposure to downgrades combined with already bloated prices due to goodwill does not bode well for these companies going forward. Until housing stabilizes, and Wall St. can find its next game, expect these stocks to struggle.

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