The magazine notes that the share prices of the big investment houses have
not kept pace with their spectacular profits, which are expected to remain
high, and links the reluctance to invest in the leading banks to their
increasingly risky proprietary trading in complex derivatives and other
opaque instruments: "Variables such as value at risk (a measure of how much
banks stand to lose if markets turn against them) and the ratio of risky
assets to equity have been rising, suggesting that investment banks' returns
have been souped up by trading with borrowed money...Analysts are troubled
by the possibility that they do not understand the trading operations of
banks." According to one, "there may be enormous risks" associated with Wall
Street's turn to the multi-trillion, highly-leveraged, and largely untested
derivatives markets; "we just don't know". Wall Street famously climbs a
wall of worry, but this one seems to loom ever larger.
==============================
Wall Street v Wall Street
Jun 29th 2006 | NEW YORK
>From The Economist print edition
America's investment banks are enjoying excellent results. The stockmarket, however, is unimpressed
IF EVER an industry had reason to complain about the whims of the stockmarket, it would be investment banking. The share prices of Wall Street firms have looked a little pale for a while, compared with their beefy earnings; and in the past couple of weeks one after another has reported excellent results only to see its shares trashed. Go back to June 12th, when Lehman Brothers, which has had a splendid few years, announced that its second-quarter earnings were up yet again, by half. Applause? Lehman's share price fell on the day of the report and fell again the next day. It was accompanied on its descent by that of Goldman Sachs, which on June 13th imparted the grave news that its earnings had more than doubled.
These two are not alone. Since late April, the share price of Bear Stearns, for example, has slipped too, although the firm has reported excellent results. As if to convince the industry that the world really has turned upside-down, the market has been kindest (or least unkind) to the investment bank that did least well: the price of shares in Morgan Stanley, where earnings, disclosed on June 21st, rose by a still healthy 25%, dropped by a bit less than 10%. Lehman's price has fallen almost three times as far.
Stifle, if you can, any joy at Wall Street's turning on itself, and ask why this might be. The market is not being as beastly to other financial firms. Although investment banks can take some solace from seeing asset managers suffer some of the same treatment-their earnings are up, their share prices down-commercial banks have largely been spared. A possible explanation lies in fund managers' and banks' assets: fund-management companies make fees from holding equities, which are down a bit, whereas commercial banks make money from extending credit, the quality of which has so far shown little sign of deterioration.
As good as it gets? Drawing a similar inference about investment banks is not as easy. A falling share price suggests that the market thinks it increasingly likely that profits have peaked, but analysts forecast that they will keep rising. At worst, they say that increases in profits will not be quite so huge-which still sounds quite attractive. Clearly, the investment banks' expenses are rising. Witness the telling signs of opulence that appear in New York every time the banks are hot: nicer parties, smarter attire, exorbitant rents for summer houses in the Hamptons. Layoffs have ceased for the time being and firms are competing for bankers. Even so, investment banks are less carefree with their money than they were. Bankers' pay is tightly tied to revenue, so that it rises during good times, but less quickly than earnings, and falls when business slows.
Investment banks' biggest worry is the steady increase in interest rates. This has a direct impact, by increasing the financing costs of their trading operations and lowering the value of the bonds they hold. Less directly, it may lead to less underwriting and fewer buy-outs, as well as a slowing of economic growth. These concerns have been sharpened by the early dislike that the financial markets have taken to Ben Bernanke, who became head of the Federal Reserve at the start of February.
But none of this ought to be terrifying. Markets like to test new central-bank governors until they establish their credentials. Higher interest rates should hurt deals, but big mergers are being announced every week. Debt underwriting may have peaked, but it is still strong: all the investment banks are doing well in Europe, where companies are at last borrowing from capital markets, rather than sticking with commercial banks. And equity underwriting, which is more lucrative, could have a long way to run. Outside America, the market for initial public offerings has come alive. There are plenty of reasons why lights burn in Manhattan skyscrapers into the small hours.
The lack of harmony between growing earnings and declining share prices is most evident in the low valuations of leading firms-notably, the two stars of the moment. Lehman's shares trade at less than ten times expected earnings and Goldman Sachs's at nine times. Compare these with newspaper companies, under siege for their dim prospects, whose shares fetch 18 times earnings and soft-drink companies, at 20. Among the numerous sectors of the market, only residential-property companies have lower valuations, reflecting the steep climb in mortgage rates in recent months and clear signs that housing sales have cooled. Clearly, the market believes that investment banks' successful run cannot be sustained. Why?
Perhaps the best answer has less to do with obvious problems (of which there are few) and more with growing suspicions. Variables such as value at risk (a measure of how much banks stand to lose if markets turn against them) and the ratio of risky assets to equity (see chart) have been rising, suggesting that investment banks' returns have been souped up by trading with borrowed money. This is true not only of firms known to be big traders but also of those, notably Morgan Stanley, that had until recently been more reluctant.
Analysts are troubled by the possibility that they do not understand the trading operations of banks. Although traditional advisory and underwriting services have recently improved, trading has been the fount of profitability. The big investment banks contend that they know what they are doing: after all, they have long been in the business of managing and reducing risks for their clients. Investors worry, apparently, that their money might turn out to be the Wall Street wizards' insurance should this theory be wrong.
A rumour swept the markets in mid-June that Goldman Sachs had lost plenty in a derivative contract tied to market volatility. Although Goldman loses and (more likely) makes money all the time, people were rattled. "There may be enormous risks; we just don't know," says David Hendler, of CreditSights, a research firm. And if you don't know, steer clear.