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Saturday, April 25, 2009

It’s Time to Restructure the Investment Banks

By Martin Hutchinson


It’s time to restructure the wheeler-dealers of Wall Street – the U.S. investment banks.

Just over a year ago, there were five major investment banks. Now there are only two – or none, depending on how you define the term.

While the investment banks have disappeared, most of the business they were doing is still around, and some of it is actually essential to the functioning of the U.S. and global economies. The crucial question to answer, then, is this: In five years’ time – when the present unpleasantness has sorted itself out – what form will the purveyors of those services take?

To answer that, some history is necessary.
A Look to the Past

Prior to March 2008 the five investment banks were Goldman Sachs Group Inc. (GS), Morgan Stanley (MS), Merrill Lynch (SQD), Lehman Brothers Holdings Inc. (LEHMQ), and The Bear Stearns Cos. Inc. – roughly in that order of size, prestige and market share.

Then Bear Stearns was rescued by JPMorgan Chase & Co. (JPM), Lehman went bust, Merrill Lynch was taken over in a very expensive deal by Bank of America Corp. (BAC), and Morgan Stanley and Goldman Sachs acquired banking licenses.

Since the Glass-Steagall Act – which maintained a separation between commercial banks and their investment-banking counterparts – was abolished in 1999, two of the previous commercial banks, Citigroup Inc. (C) and JPMorgan, have been able to get into the investment banking business in a pretty big way. And going forward, BofA will now be able to do so through Merrill Lynch.

The upshot: There are now five serious investment banking operations, all with commercial banking licenses – each of which is rated as “too big to fail.”

Goldman Sachs’ first quarter earnings, released Tuesday, provide us with a picture of how successful investment banks will make money: Goldman made $1.66 billion in the first quarter, after payment of preferred stock dividends. By far the largest revenue producer was its fixed-income, currency and commodities division, which at $6.56 billion accounted for 70% of $9.43 billion in total revenue.

Equities trading and commissions accounted for another $2 billion, or 21% of the total. Asset management and securities services accounted for $1.45 billion, 15% of the total.

True investment banking – advisory and underwriting work – accounted for $823 million in revenue, a paltry 9% of the total. That makes 115%; the other 15% represented losses on principal investments that had gone wrong.

Morgan Stanley’s quarterly report, released Wednesday, showed a first quarter loss of $578 million – after payment of preferred stock dividends. Here’s how Morgan’s business breaks down:

* Trading and commissions (debt and equity): 62% of total revenue.
* Wealth management and administration fees: 32%.
* True investment banking activities: 28% ($884 million, or just a tad more than Goldman).
* Other revenue: 14%.
* And principal transactions (including interest received and paid): A loss of 36% of total revenue.

Thus, Morgan and Goldman had pretty much the same business mix.

Goldman Sachs and Morgan Stanley have now acquired banking licenses, but they resemble no other commercial banks. They have no retail-deposit base, no branches, and very little mortgage lending or small-business lending. What’s more, since they have no obvious comparative advantage in those activities, it seems highly unlikely that they can develop these areas of business without a massive destruction of shareholder value.
Can Looks Be Deceiving?

Given these current competitive positions, these two institutions clearly face uncertain – and possibly even unstable – futures. And it’s the shareholders and U.S. taxpayers that ultimately seem to bear the brunt of the business risks Goldman and Morgan are certain to face.

Thus, the question we need to answer is this: What will these two institutions look like a decade from now?

There seems no good reason why many of the operations undertaken by Goldman and Morgan should be housed in institutions deemed “too big to fail,” since that makes them eligible for taxpayer-finance bailouts.

Principal transactions – in normal years, a contributor to profits – are basically the provenance of a hedge fund. If we don’t want to bail out hedge funds, as we did Long-Term Capital Management, we must impose limits on the size hedge funds can achieve: After all, it’s pretty clear that gambling casinos that are large enough to bring down the entire financial system should not be permitted.

If Goldman and Morgan are deemed “too big to fail,” their scope for hedge-fund-type activity must be sharply limited, perhaps to a mere 50% of capital. This would also have the huge benefit of reducing conflicts of interest between the major investment banks and their clients. Currently, the conflicts between their direct investment activities and both their advisory work and their wealth-management activities are much too severe to be eliminated by mere “Chinese walls” that are supposed to keep proprietary information from flowing from the advisory to the investment departments.

Trading and commissions, the major revenue-producers at both Goldman and Morgan, are perfectly acceptable investment banking activities. But there is no reason why brokers and traders should benefit from state bailouts, however necessary we may feel it to protect clients who have accounts with those brokers. Arguments that traders’ derivative books cause a “nexus” with other market participants – requiring traders to be bailed out by the public – can be eliminated by mandating central clearing for derivatives contacts, and imposing harsh capital requirements on contracts, such as credit default swaps, which seem to be especially dangerous to the financial system.

Wealth-management and investment-banking advice are the core activities of an investment bank, and Goldman Sachs and Morgan Stanley are the leaders in those fields. However, gigantic capital bases are not necessary to practice them. The only true investment-banking function that requires large amounts of capital is new issue underwriting (such as initial public offerings, or IPOs), but even that can be carried out with a capital base much smaller than Goldman and Morgan currently employ. After all, isn’t that precisely what syndication is for?

If the principal investment business is removed because of its dangers and conflicts, and the trading businesses are scaled back to a more manageable size, Goldman and Morgan would come to resemble much more closely their 1980s ancestors, and would ideally revert to being privately owned by their partners. Nothing significant would be lost to the U.S. economy by such a change, and a great deal would be gained by the removal of the taxpayer risks and conflicts of interest that we’ve outlined here.

In such an environment, we might expect that the three universal banks – JPMorgan Chase, Bank of America and Citigroup – would have an advantage because of their greater size.

However, Citi has made it abundantly clear with its repeated failures over the past 30 years that there is no significant advantage to be gained in combining the very high-skill activities of asset management and traditional investment banking with the low-paid, low-skill activities of retail banking, most corporate banking and most standardized trading. Thus, given good corporate governance (i.e. shareholders who demand value and rein in management self-aggrandizement), the investment banking and asset-management businesses would in the long term migrate from huge universal bank behemoths to moderately capitalized specialists, if such existed.

Leaving Goldman and Morgan as they are is bad for their shareholders, bad for taxpayers and bad for the U.S. financial system. They must be restructured.

Friday, April 10, 2009

Why Wall Street is Missing the U.S. Housing Recovery

By William Patalon III


Wall Street created the U.S. housing bubble and now it’s missing the real estate rebound.

And Andrew Waite understands why.

Waite is the publisher of the Personal Real Estate Investor, a glossy magazine that focuses on investors who buy houses or condos to manage for income or to fix up and sell for a profit. But he’s not some industry cheerleader whose statements are nothing but spin.

He’s a true expert on the U.S. housing sector who goes out of his way to "educate" journalists about the true state of the American housing market, and who criticizes most of the "indicators" in use as useless and irrelevant. Plus, as a onetime Wall Street venture-capitalist who subsequently joined Silicon Valley’s Sand Hill Road private equity crowd, Waite really understands how the Wall Street investment game is played - and, in the case of the U.S. housing market, the missteps Wall Street made and why.

"Wall Street analysts and economists do not understand the housing industry," Waite told Money Morning in a recent interview. "While stocks and bonds are relatively simple to analyze, housing is anything but. Unlike stocks, housing is a non-tradable asset."

But through the creation of mortgage-backed securities, Wall Street tried to transform housing into a tradable asset. That lack of understanding set the stage for the housing bubble. And it’s the same miscalculation that is keeping the big-money crowd from understanding that the housing market may have already bottomed - and may well be on its way back up.

Let’s look at both miscues.

Building a Bubble

Stocks and bonds are "tradable assets." They trade on central exchanges - in a very efficient manner - and play well into the kind of mathematical averaging that paves the way for all sorts of indices (the Standard & Poor’s 500 Index), and sub-indices (the Dow Jones Transportation Index).

That’s not the case with housing, which is very granular in nature - meaning how housing does in one neighborhood differs greatly from how it does in another. Housing is a "non-traded" asset because it is hard to trade - and when it does trade does so in a highly inefficient market.

As Waite says, housing is referred to as "real" property for a reason: Unlike stocks or bonds, which are paper representations of the underlying asset, housing is the asset itself. People live in houses, and most don’t buy them as investments - they buy them to live in. The typical house is owned for five to seven years, and only about 5% of the U.S. housing stock turns over in a single year. In a "normal" period - by that, I mean a stretch that’s not artificially souped up by the unrealistically loose credit that led up to the subprime-mortgage debacle - prices escalate perhaps 3% to 4% annually. And there aren’t the whipsaw pricing patterns that we see with stocks.

Even so, as part of its mission to transform housing into a tradable asset, Wall Street designed a reporting system that, true to form, was badly flawed, Waite says. The measures applied to the market - sample size, methodology, and statistical presentation - work well for assets that are dynamically traded, as stocks are. But they don’t work for housing:

* Stocks are analyzed by looking at the underlying company’s fundamentals, meaning the conclusions reached are very much tied to the specific earnings power of that firm.
* Housing, by comparison, is analyzed make "illogical" generalizations about the market that fail to reflect reality.
* Stocks are analyzed in a forward-looking fashion, being all about earnings projections and expectations.
* Housing analysis ends up being backward looking (45 days to 180 days), meaning the conclusions that are reached are likely outdated by the time we see them.
* Housing ends up being treated like a commodity, with "five-star" neighborhoods (where sales are brisk and the asking price is now being exceeded as prospective purchasers bid the values up in hopes of landing the house) being "averaged in" with "disastrous" one-star neighborhoods.

Says Waite: "Housing indexes and statistics emanating from Wall Street take a cynical view of housing … and they misrepresent the actual value of housing by ignoring the critically obvious point - most housing purchases are ‘buy, occupy and hold’," and aren’t a speculative play aimed at short-term profits.

By misfiring so badly, Wall Street established an environment in which housing prices were expected to escalate at better-than-their-historical norms, fanning the speculative flames. The easy credit made available by the mortgage-backed debt market only made matters worse. Banks made loans, and Wall Street bundled those loans into an asset-backed security - giving the banks back the cash that they could then use to make their next round of loans. Because the loans were "averaged" out, the resultant securities were given the highest credit ratings by the ratings agencies - which was more than the securities deserved.

It was a recipe for disaster - or, at least, for a bubble.

Wall Street never saw it coming.
Anatomy of a Rebound

Wall Street has also failed to understand the dynamics of a housing market recovery - which is already in the works, Waite says.

And he should know. The portion of the real estate market that Waite’s magazine caters to - the real estate investor - is significant. In fact, a groundbreaking study commissioned by the magazine, and conducted by real-estate researcher REALTrends Inc., in concert with Harris Interactive, found that real estate investors account for 22% to 28% of all home sales (existing and new) each year - a total of 1.5 million to 1.64 million houses each year. That’s a big piece of a $300 billion industry, so it provides a very solid sample.

According to Waite, the housing market bottomed last year. But that bottoming takes place in stages. Housing values continue to decline. But values can’t bottom, solidify, and then head north until sales volumes increase, Waite says.

"First you get volume, and then you get valuations," Waite says.

And it doesn’t get better across the board all at once: Sales will improve in a "predictable sequence" that start with the very best neighborhoods, work their way down to the really good neighborhoods, and finally reach the plain old good developments.

As noted, Waite says the very best neighborhoods are already seeing strongly improved sales, with actual bidding battles taking place as prospective buyers willingly pay more than the asking price in order to land the choicest properties.

As those markets sell out, and the credit spigots open, demand will move from the very best neighborhoods down to the "pretty good" residential properties, Waite says.

Three reports released over the course of three straight days the last week of March seem to support Waite’s view.

Sales of new homes rose 4.7% in February - the first increase in seven months, the U.S. Commerce Department reported March 26. The day before that report came out a government gauge of home prices posted its first gain in almost a year. And the third of that "hat trick" of upbeat reports issued that same week said that sales of previously owned homes - the biggest share of the market - also increased in February.

The plunge in housing prices is also starting to have an effect. In a second report issued March 26, the California Association of Realtors said that existing-home sales in the state were up 83% in February from the previous year. The reason: The median home price was down roughly 40%, which is helping shrink inventories to about a six months’ supply from 15 months in 2008.

If Waite’s theory is correct, as sales of new and existing homes pick up on a month-to-month basis, prices will follow.

But true to form, Wall Street is demanding proof.

The data "have allayed some fears that the housing market would continue to freefall," Omair Sharif, an economist with RBS Greenwich Capital, told The Wall Street Journal. "But it’s way too early to say if we’ve hit bottom."

But Waite fervently believes that bottom has already been hit and that it’s all uphill - over the long haul - from here.

"Wall Street would have you believe that putting money into a house is as sophisticated as putting money in a mattress," he said. "But as it continues to prove, nothing could be further from the truth."