Tuesday, June 24, 2008

You Read It Hear First...... Reuniting Commercial & Investment Banks

Late in March, I wrote this post concerning the ultimate result of the Fed's decision to open the discount window to investment banks. In that post, I wrote,

"Looking beyond simply Bear Stearns, can anyone truly justify the existence of all four of Goldman Sachs, Merrill, Lehman and Morgan Stanley? Especially in the modern world of large private equity firms and hedge funds? The former provide additional underwriting, M&A advisory and asset management, while the latter focus on providing trading capacity and investment management.

Other than emotional reaction of former employees seeing their old firm's name vanish, what would be different if one or more of those names were bought by or merged with a commercial bank?

Contrary to Andy Kessler's view, in the Wall Street Journal this past January, about which I wrote here, it's unlikely now that an investment bank will do the buying. With their high leverage and dependence upon commercial banks for funding, I suspect the investment banks are the more vulnerable. Now having access to the Fed discount window, it's only a matter of time before the regulators get around to levying a new regulatory framework on the investment banks."

In today's Wall Street Journal, Dennis Berman writes, in an article entitled, "Maybe It's Time To Put the Banks And Wall Street Dealers Back Together,"

"Speculation has in recent weeks mounted that one of the Street's brokers may even buy a commercial bank. Whether true, the rumors speak to three deep changes under way.
First, looming Federal Reserve assistance and regulation could force brokers to keep reserve ratios similar to that of deposit-taking banks. Second, short-term bank funding now is regarded with suspicion. It is capable of being yanked at a moment's notice, sending a bank such as Bear Stearns to the brink of bankruptcy (it is now part of
J.P. Morgan Chase). Third, the securitization markets also have contracted, which is in turn forcing the investment banks to shrink their balance sheets.

In theory, these problems are all solved by putting a large, plodding typical bank -- with stable deposits and returns -- next to the more-speculative realms of investment banking and trading.
Citigroup, the prime "universal bank" sounded good in theory, too. It has performed miserably since its creation after Congress rolled back the Depression-era limits a decade ago. That misses the relative success of J.P. Morgan Chase and Bank of America, the country's two other big universals."

I'd disagree with Berman's evaluation of Chase's and BofA's 'relative success,' as I described the entire publicly-held financial sector's woeful performance in yesterday's post.

But Berman has finally arrived at the same conclusion I did last three months ago. He further observes,

"Three or four years out, the investment-banking model is coming to an end," says Brian J. Sterling, co-head of investment banking for boutique adviser Sandler O'Neill & Partners. "If it walks like a bank and quacks like a bank, it's going to have capital ratios like a bank." "

No argument from me. In fact, I concluded that March post with these thoughts,

"A natural consequence to this will probably be even more smart financial services people migrating back to the privately-financed arena. Just like consumer goods merchandising has the 'wheel of retailing,' whereby new entrants compete at the low-cost end of the market, as existing players migrate upwards in terms of quality, service, selection and price, so, too, it seems, will financial services now have its own version of this 'wheel.'

Only in financial services, the 'wheel' is between publicly- and privately-held concentrations of capital and risk management. Again, viewed from afar over decades, the story of commercial and investment banking for the past forty years has been a gradual selling of transactions, asset and risk management businesses at their 'tops,' as formerly-private banks of both stripes went public, followed by managerial ineptitude, decline in risk management, and excesses in pursuit of growth via more risk.

Now that the public is absorbing the brunt of the losses, via equity ownership of these firms, the logical next step is for the better executives to join the early-adopters in forming new, or joining existing private equity and hedge fund shops."

It seems nearly everybody missed the real event of late March. It wasn't helping Bear Stearns avoid the unraveling of its entire book of credit default positions. It was the opening of the Fed window to investment banks, and the inevitable changes in regulation and/or capitalization requirements that will follow.

Yes, you read it here first. Three months ago.

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