The great Wall St earthquake

The disappearance of two more giant investment banks will transform an industry whose business model has been broken on the wheel of the credit crunch. By Nick Clark
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The Independent Online

And then there were two. As the investment banking industry goes through a period of unprecedented change, what seemed unthinkable a year ago has become a grim reality: Goldman Sachs and Morgan Stanley remain the only independents on Wall Street.

Yesterday marked the extraordinary collapse of Lehman. One of the most prestigious banking firms in the US has plunged from $80 a share a year ago to nothing. Its fate was sealed following intense negotiations over the weekend that culminated in its prospective bidders, Bank of America and Barclays, walking away and the refusal of the Federal Reserve to provide support.

Those carrying out boxes of their belongings in London and New York looked shell-shocked. The administrator, PricewaterhouseCoopers, also admitted its huge surprise that this could happen to such an institution.

James Eden, an analyst from BNP Paribas, said: "The failure of Lehman with no bail-out because of the bank's status is a unique event ... This will spark a massive confidence issue and exacerbate the risk re-pricing we are seeing in the credit market. Theoretically, the entire sector should go down and valuation multiples adjust durably downwards."

While devastating for the markets, Lehman's quick demise was not as much a surprise as the deal that did emerge late on Sunday night. After Bank of America had dropped its pursuit of Lehman it switched almost instantaneously to Merrill Lynch, another of the grand old names of Wall Street.

John Thain, the head of Merrill and a former Goldman Sachs banker, was commended yesterday on a move that stopped his bank from suffering a similar collapse before trading began and potentially starting a domino affect amongst its peers. Bank of America (BoA) announced the $50bn (£28bn) deal to buy Merrill Lynch yesterday, creating "the leading financial institution in the world with the combination of these two firms", according to Mr Thain. The deal is expected to close early next year.

Ken Lewis, the buyer's chief executive, said the the all-share deal, valuing Merrill at $29 a share, was "a great opportunity for our shareholders". He added that the merger "creates the company that instantly would have taken decades to build". Merrill Lynch brings a strong investment bank to complement BoA's huge retail business, boosting their asset management operations and creating a brokerage with more than 20,000 advisers and $1.5 trillion in client assets.

So following the day of upheavals, which Mr Eden called "Banking's bloody Sunday", only Goldman and Morgan Stanley, of the five great US investment banks remained independent (Bear Stearns collapsed in March and was taken over by JP Morgan).

Moreover, Goldman's stock plunged 11.77 per cent on opening, while Morgan Stanley was down 11.9 per cent. There is no indication that their status could change in the short term. But six months ago there was no indication that Lehman Brothers would vanish one weekend in September. There was also some talk, albeit quite flippant, over the summer that Goldman could even do the unthinkable and buy a retail bank.

The independent investment banking model may be in terminal decline. All over the world banking operations are being scaled back.

Analysts at Cazenove agreed. "Events over the last year have vindicated the strength of the universal banking model," they said yesterday.

In Europe, UBS is retrenching, slashing jobs, from the investment banking division. This was followed earlier this month by Commerzbank buying rival Dresdner Bank from the giant insurer Allianz, before saying it was to axe half the investment bankers.

In the latest bull market, banks had put their faith in borrowing cheap debt to fund trading. Their proprietary trading desks looked to ever-more complex derivatives to boost returns, which were backed by thinner assets – Lehman itself had positions open worth 30 times the value of their underlying assets at its peak. This came to a shuddering halt when the underlying asset, in this case mortgages, came under stress and the debt market hit a wall. Confidence evaporated and, with banks' over-reliance on the wholesale markets and with bank refusing to lend to each other, their access to capital has dried up.

The whole business model is flawed, according to Nouriel Roubini, an economics professor at New York University and former adviser to the US Treasury. He said that when short-term funding dries up the independent groups are left "structurally unstable". The ones that work "are part of a bigger conglomerate where there's a commercial bank like JP Morgan and Citigroup and so on". Market experts believe a radical shake-up could involve tying up with commercial or retail banks or scaling back to focus on advisory work. Investment banks will sell and advise rather than acting as principles and trading off their own books.

In August, Gerald Corrigan, a former president of the Fed and Goldman's managing director, said the banks would have to "accept changes to market practices that in the past have generated sizeable revenues but at the cost of weakening the underlying foundation of the markets". Mr Corrigan headed a panel that came up with 60 recommendations to help investment banks clean up their acts. These included stronger powers for risk managers to oversee the trading desks and an overhaul of executive pay, so bankers are rewarded over an entire cycle rather than their incentives linked to making quick returns.

Bank of America lifer looks for 'a thing of beauty'

It was quite a U-turn from Ken Lewis, the chief executive of Bank of America. Almost a year ago, speaking on a conference call in the wake of a dismal performance of his own company's franchise, he was asked if he would consider a takeover. "I never say never, but I've had all the fun I can stand in investment banking at the moment," he said.

Yesterday, Mr Lewis, now being tipped as one of the few winners on Wall Street, was telling the world of his joy at securing a deal to take over Merrill Lynch. "This company is going to be a thing of beauty when we get to the other side," he said.

BoA's investment banking business has never made a splash on the world stage. But rather than continue to build slowly, Mr Lewis leapt at the chance to take advantage of the troubles at one of the top broker-dealer brands in the world.

One analyst asked why the bank hadn't waited for Merrill's price to fall as it surely would in the wake of Lehman Brother's bankruptcy. Mr Lewis said he wasn't prepared to gamble. "We thought the long-term benefits were so overwhelming and such a strategic opportunity that we elected not to roll the dice," he said.

Mr Lewis is a Bank of America lifer, joining NCNB, a predecessor to the group, in 1969 as a credit analyst. He took over as chief executive in 2001 and under his tenure annual profits have grown from $7.5bn to $15bn, according to statistics from the bank. Last year, he was voted as one of the top 100 most influential people in the world by Time magazine.

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