Wednesday, December 28, 2005

Investment Banking Downturn in 2006?

The Financial Times, Lex, 28 December 2005

At the world's investment banks, 2005 will be celebrated as a vintage year. Merger and acquisitions volumes and equity markets have revived while the fixed income boom has continued beyond all expectations. Many markets experienced ideal trading conditions, with big, well-flagged movements - for example, in US interest rates.

In the traditionally slow third quarter, Goldman Sachs, Lehman Brothers, Merrill Lynch and UBS all announced their best ever revenues and profits - beating records set during the internet bubble. For the US houses, the bonanza continued in the fourth quarter with another set of excellent figures.

Globally, investment banking revenues will have risen 13 per cent to $205bn this year, estimates Morgan Stanley. While employees will be hoping for fat bonus cheques, shareholders have also done well. With the exception of Morgan Stanley, Citigroup and JP Morgan, the listed investment banks have handsomely outperformed the markets. Greenhill, the US boutique, saw its shares nearly double, while Lehman, Australia's Macquarie and Nomura of Japan are up by almost 50 per cent.

From such an elevated peak, the only way is down. The critical question for investors is how rapidly profits will descend in 2006. There are several factors arguing for a gentle decline. First, equity markets will start the new year at higher levels, boosting broking commissions and fund management fees. Second, the M&A cycle is only just past the trough. In Europe, 2005 was the first year in what tends to be a six or seven-year recovery in merger volumes; in the US, it was the second year. While M&A fees account for only about 7 per cent of industry revenues, takeovers feed through to other parts of the business since they require financing and hedging, boost stock trading volumes and create new private banking clients. This will give the banks a tailwind in 2006.

More fundamentally, investment banking is becoming a better, more stable business. Innovation, from equity derivatives - a speciality of two French retail banks, Société Générale and BNP Paribas - to leveraged finance and commodities is one explanation. UBS says half of its fixed-income trading revenues come from products invented in the last five years. This is a statistic of which a drug company would be proud. A broader customer base also helps. The rise of hedge funds has created a new class of clients, and the prime brokerage business that serves them now generates around $5bn in revenues and grew nearly 30 per cent in 2005.

Some investment banks, notably UBS, Credit Suisse and Merrill Lynch, also own large, generally undervalued wealth management operations that balance their business mix. These are not only growing rapidly, but are also highly cash generative and produce excellent returns since they require little capital. Yet brands and a global presence provide high barriers to entry. Finally, a case can be made that the banks have improved risk management since the last downturn. However, none of these positive developments will be able to offset a deterioration in the near-perfect trading conditions of the past year. This applies particularly to the fixed income business, which now accounts for half of industry revenues at more than $100bn a year. A flattening yield curve, declining volatility levels and narrowing credit spreads all suggest tougher times ahead. The first quarter, usually the strongest for trading income, will be a key test.

Meanwhile, the pure investment banks are experiencing greater competition from big commercial banks expanding their wholesale divisions, whether that is Barclays and Royal Bank of Scotland in Europe or Bank of America in the US. In Europe, this is leading to deteriorating loan spreads and looser lending standards. Spreads on syndicated loans for investment grade borrowers are at seven-year lows, according to CSFB. The average debt ratio for leveraged buyouts has risen to 5.5 times earnings before interest, tax, depreciation and amortisation, from 4.6 times in 2004.

Not only does this increase the risk of bad debts in a downturn, it also shows that investment banks are more often having to use their balance sheets to win or retain business. This rising capital intensity explains why this year's record profits have not gone hand-in-hand with record returns. Merrill's peak profits, for example, translated into only a 16 per cent return on equity for the first nine months of 2005. This has sparked a debate, primarily in the US, about what to do with the surplus capital the investment banks are generating. Given that all of them are currently producing returns well above their cost of capital, investors should be delighted that they are redeploying most of this into expanding their businesses. If market conditions turn down, however, managements that have until now jealously guarded their cash must be willing to start handing it back. An early sign that some companies are coming around to this point of view was the decision in September by Goldman Sachs to repurchase an additional $6bn or so of stock - the first buy-back intended to do more than merely offset the dilution of share option programmes.

The coming year, therefore, is likely to prove more difficult, with a decline in fixed income revenues - of, say, 15 per cent - outweighing further growth in equity trading and the primary businesses of merger advice and underwriting. Providing the downturn is fairly gentle, most banks should continue to be nicely profitable. A more challenging environment will, however, test not only their risk control but also their discipline on costs and management's willingness to put shareholders before employees. If they rise to the task, there will be something to cheer in 2006 as well.