What qualifies as success on Wall Street?
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Usually, it’s mega-earnings and bumper bonuses. But in 2008, it was simple survival. Those firms that lived to fight another day should be thankful. But the next 12 months are hardly going to be a picnic.
For starters, investor, counterparty and client confidence in the financial sector as a whole won’t return just because the year has changed. Arguably only government intervention in the form of debt guarantees and preferred stock investments kept more firms from following the likes of Lehman Brothers Holdings Inc. and Washington Mutual Inc. into insolvency.
That intervention helped shore up stock prices: Goldman Sachs Group Inc. and Morgan Stanley ended the year 80% or more above their lows. But both still trade at a discount to book value, a sure sign that shareholders remain wary about their prospects. These and other banks will have to prove they have weaned themselves off government aid before true confidence is restored. And the real test of that won’t come until around mid-year when the Federal Deposit Insurance Corp.’s debt guarantee programme is scheduled to end.
Meanwhile, Wall Street faces the prospect of more regulation. Some of that is already in place for Goldman and Morgan now that they have become bank holding companies overseen by the Federal Reserve. But lawmakers are also on the prowl: In December Congressman Barney Frank, chairman of the House Financial Services Committee, revealed that he regarded 2009 as “the best year for public policy since the New Deal”.
It’s unclear what shape that will take, though leverage limits and even prohibition of certain types of products or investments have been mooted. That would crimp earnings that are already under pressure. Goldman Sachs and Morgan Stanley each had to rely on some tricks to post even a 5% return on equity in 2008 after posting fourth-quarter losses: Goldman paid just 1% in taxes while Morgan Stanley added $2.8 billion (Rs13,636 crore) in revenue from buying back its own low-priced debt.
Sure, writedowns on dodgy assets should decline next year. There might even be write-ups if markets improve much. But that will probably be offset by losses stemming from any increases in the price of their own debt.
Accounting issues aside, Wall Street’s core businesses are moribund. The boom in mergers and acquisitions and selling new stocks and bonds is over. And extreme volatility has made trading much more perilous: For some asset classes last quarter it was impossible just to hedge inventory needed to make markets for client trades.
Even in more stable markets it’ll be harder to turn a profit in trading: Leverage has been slashed: Morgan Stanley, for example, has cut gross leverage from around 33 times capital at the end of 2007 to 11.4 times. Hedge funds, which provided much of the juice for trading in recent years, are shrinking. And the crisis has added another layer to assessing risks: A bad trade doesn’t just mean a loss but could shatter whatever brittle confidence investors and counterparties may still have in a franchise.
Perhaps that’s why Morgan Stanley has all but given up on proprietary trading, for now at least. Executives are now turning the firm’s focus back to trading for clients, though that still carries risk, as the fourth quarter showed. Goldman’s bosses, meanwhile, are sticking to their risk-taking roots. That, they reckon, should earn shareholders a 20% return on equity over a business cycle. That’s five percentage points more than what their Morgan Stanley counterparts are expecting.
Hitting either target in 2009 is going to be tough, absent a sudden market boom somewhere. In fact, just about the only units likely to see much growth at either firm are their fledgling retail bank operations. That might give some comfort on funding costs for part of their balance sheets. But in an overbanked market that’s hardly a boon for shareholders.