naked capitalism

Today’s New York Times provides an interesting bit of context for investment banks woes: losses from July 2007 to present roughly equal the profits earned from the beginning of 2004 through that date.

The story merely alludes to the question of whether the rich bonuses of the boom years were warranted, but broaches another topic that the former Masters of the Universe may not want to consider: the industry is going to experience secular as well as cyclical changes. Drastic falls in employment are normal in the securities industry (peak to trough declines are typically 20%) and bonuses fall even more dramatically (producers who one earned in the $1 to $3 million range in the dotcom era had to make do with a mere $300,000 to $400,000 in the last downturn).

But at a minimum, investment banks are just about certain to be required to keep higher equity levels, and that alone will reduce profits. If credit default swaps do indeed move to exchanges, that eliminates another lucrative revenue source. Additional reforms are may well reduce the attractiveness of other activities.

From the New York Times:

The numbers are staggering. Between early 2004 and mid-2007, a period of unprecedented wealth on Wall Street, seven of the nation’s largest financial companies earned a combined $254 billion in profits.

But since last July, those same banks — Bank of America, Citigroup, JPMorgan Chase, Lehman Brothers, Merrill Lynch, Goldman Sachs and Morgan Stanley — have written down the value of the assets they hold by $107.2 billion, gutting their earnings and share prices. Worldwide, the reckoning totals $380 billion, much of which reflects a plunge in the value of tricky mortgage investments…..

But the finish line just seems to keep moving further away. Even when the losses end, bank executives are looking toward a new era of lower returns, thinner profits and fewer jobs….

“They are going to have to build a new business model,” Richard X. Bove, a financial services analyst at Punk Ziegel, said of investment banks. “I do not believe those businesses have the ability to generate the kind of profit they did in recent years without all the leverage.”…

The latest round of results is likely to draw special scrutiny because Wall Street firms are disclosing capital levels under new international banking standards known as Basel II. And Merrill Lynch, Citigroup and UBS are also expected to suffer from the ratings downgrades recently issued for MBIA and Ambac, two bond reinsurers….

“It’s a fairly unique situation, that you would give so much back,” said Alec Young, global equity strategist for Standard & Poor’s Equity Research. “The industry did enjoy real salad days over that period, but now the write-downs and losses have been so huge. It’s a significant percentage of the money generated.”

Even the winners in this cycle — JPMorgan Chase and Goldman Sachs — have had to pull out giant erasers to work through their loan books. JPMorgan, which had the financial heft to buy Bear Stearns, wiped out 15 percent of recent profits by lowering the values of its loan and mortgage assets. At Goldman, the cost of such write-downs is so far 12 percent of recent profits.

The banks are supposed to be especially good at valuing all the lumps of loans and assets they own. That is why many a Wall Street bonus is based on estimates of hard-to-value dealings in arcane assets. The very mortgage bonds that are now being written down, in fact, led to hefty bonuses for bank employees before the good times ended.

Some analysts predict that independent brokerage houses will merge with commercial banks, if the government begins regulating them. That uncertainty leaves executives at these companies unsure of how to plan for the future, said David Trone, an analyst at Fox-Pitt Kelton Cochran Caronia Waller, who is predicting bank consolidation.

“We’re in a weird limbo now,” Mr. Trone said.