Surprise! Wall Street Firms More Prudent as Partnerships

Some have taken notice that investment banks are much more cavalier with other people’s money that they are with their own dough. We’ve gone further in earlier posts, saying that investment banks shouldn’t be public companies (scroll towards the end).

A Bloomberg article points out the obvious: the Street has sustained losses unimaginable in the days of private partnerships. Even from a remove, some of their practices, such as large-scale LBO bridge financing and retaining unsold portions of underwritings, were unheard of in earlier cycles (in the 1980s, only a few firms relented and provided bridge loans and quickly got their heads handed to them. First Boston was bailed out and eventually absorbed by Credit Suisse as a result of a loan gone bad).

The story quotes some well known names from Wall Street’s past who decry the current state of affairs: former Salomon Brothers chief John Gutfreund; Peter Solomon, former head of investment bankings at Lehman Brothers; Goldman partner Roy Smith. Smith isn’t the first member of the Goldman old guard to attack current practices. Last year, former Goldman co-chairman John Whitehead criticized the outside pay packages.

From Bloomberg:

Less than a decade after Wall Street’s last major partnership went public, stockholders are paying the price for bankrolling the industry’s expanding risk appetite.

Four of the five biggest U.S. securities firms lost about $83 billion of market value last year, almost 90 percent of their net income since 1999, data compiled by Bloomberg show. That cut the annual average return for Morgan Stanley, Merrill Lynch & Co., Lehman Brothers Holdings Inc. and Bear Stearns Cos. during those nine years to 9.7 percent from 16.8 percent.

The private partnerships that once dominated Wall Street guarded their capital, used less leverage and limited their risk to trading blocks of stock for clients and shares of companies in mergers, said Roy Smith, a finance professor at New York University’s Stern School of Business and a former partner at Goldman Sachs Group Inc. Since raising money from the public, many of the biggest firms have abandoned that caution.

“If you’re betting with other peoples’ money, you’re more willing to take risk than if it’s your own,” said Anson Beard, 71, who retired from Morgan Stanley in 1994 after 17 years at the New York-based company, where he ran the equities division and helped with the initial public offering in 1986. “You think differently if you’re paid in cash and not in ownership. It’s heads you win, tails you don’t lose.”

Shareholders, stung by the securities industry’s losses last year on subprime mortgage-backed bonds and leveraged loans, may be in for more pain.

Shrinking Fees

Morgan Stanley, Merrill, Lehman and Bear Stearns have lost between 3 percent and 19 percent of their value this year in New York Stock Exchange trading on concern that they may be forced to take more writedowns if bond insurers like MBIA Inc. and Ambac Financial Group Inc. are stripped of their top credit ratings. Revenue from structured credit and leveraged finance has dropped and demand for takeover advice and underwriting may dwindle as the U.S. economy slows, analysts say.

Even Goldman has faltered. New York-based Goldman, which went public in May 1999, evaded last year’s market losses and reaped record earnings. This year, the biggest and most profitable securities firm has lost 13 percent in NYSE trading, while analysts predict earnings will drop as equity stakes in companies such as Beijing-based Industrial & Commercial Bank of China Ltd. lose value and investment-banking fees decline.

Merrill, which went public in 1971, outperformed the Standard & Poor’s 500 Index in just five of the past 10 years. The largest U.S. brokerage paid more to employees last year than it collected in revenue. Morgan Stanley, public since 1986, beat the index in four of the past 10 years. Both New York-based companies diluted investors’ stock last year when they sold stakes to foreign governments to shore up capital.

“Shareholders share in the downside and not necessarily in the upside, that’s the whole story,” said John Gutfreund, 78, who ran Salomon Brothers in the 1980s when it was renowned for the size of its trading bets. “It’s OPM: Other People’s Money.”…

“We’re essentially running all these investment banks and even the large universal banks on the same basis as if they were hedge funds,” said Smith, the NYU finance professor. Executives “make big gains on any gains in the firm’s income, whereas they’re not exposed, they don’t have to pay it back in the loss.”….

“The firms had to go public because to do these businesses you need so much balance sheet,” Beard said. “When the firms were private partnerships, you had to worry about how you were going to replace the capital” when a partner retired. “After we went public, we upped the cash compensation dramatically.”

The businesses exploded in size. Goldman had 50 partners in 1973, 75 partners in 1983 and 150 a decade later, according to Lisa Endlich’s 1999 book “Goldman Sachs: The Culture of Success.” As of Dec. 17, partners and managing directors numbered more than 1,700, according to the bank’s Web site.

The companies also borrowed more. Goldman’s leverage ratio, which measures assets relative to equity, was 26.2 times at the end of November, up from 17.1 times in November 2001, regulatory reports show. At Morgan Stanley, the ratio jumped to 32.6 from 23.6 in 2001….

“These firms are vastly bigger than they were, they’re not privately owned partnerships any more that are filled with people worried about getting their own money back,” said Smith, the former Goldman partner. “They’re in everything, everywhere in very large quantities.”

Last year demonstrated the pitfalls. The business of packaging home loans into securities soured when declining U.S. house prices triggered mortgage defaults and foreclosures rose to the highest level in 28 years, according to data compiled by the Mortgage Bankers Association in Washington.

Morgan Stanley, Merrill, Lehman and Bear Stearns wrote down a combined $38 billion of bad debt in 2007 — more than the four firms’ $30 billion of revenue from fixed-income trading in 2006. The writedowns ranged from $24.5 billion at Merrill to $1.5 billion at Lehman. Only Goldman profited by positioning itself to make money on the decline in subprime mortgages.

Merrill’s then-CEO, Stan O’Neal, was forced out in October after the company reported a third-quarter loss that was six times what it had forecast less than two months earlier. Rather than fire him, the board allowed him to retire so he could keep $161.5 million in restricted stock and options he’d been awarded during his tenure. In the prior two years, he’d also received $32.6 million in cash bonuses.

“There are no partners of Merrill Lynch, there are employees,” said Peter Solomon, a former Lehman executive who’s now chairman of New York-based investment bank Peter J. Solomon Co. “So they don’t share in the losses and gains the way they should, they are able to shed those on to shareholders.”…

“The partners at Lehman Brothers and the partners at Goldman Sachs and the partners at Morgan Stanley didn’t take risk that was disproportionate to their resources, and when they did, they paid the consequences so they tried not to,” Solomon said. These days, “shareholders and the customers are the people who are financing these guys. They’re financing casino operators.”

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One comment

  1. a

    The analysis is incomplete as long as hedge funds are left out of the picture. Unless something is done about the attractiveness of prime brokerage (IBs lending money to hedge funds), IBs won’t be able to rein in salaries, because hedge funds will be able to hire away their few talented traders for a lot more money. It all goes back to raising regulatory capital requirements, so that prime brokerage costs more, so that hedge funds pay more the funds they use to roll the dice, so that they have a harder time making money.

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