Investment Banking 2.0: Into the Future

Bear Stearns? Gone. Lehman Brothers? Gone. Merrill Lynch? Gone. What next? I had the pleasure of hearing Nouriel Roubini speak at a planning dinner for the 2009 Money:Tech Conference, and he had more than a few thoughts on the topic. I respect Nouriel and his analytical thinking a great deal, and he and I have had similar views of the inevitable credit-driven storm dating back quite some time. But on the issue of what will happen to the surviving investment banks, and what should happen, he and I have differing viewpoints.

According to Nouriel, the "Axe of the Apocalypse" as I like to call him, Morgan Stanley and Goldman Sachs are close behind Lehman and Merrill. His argument? Investment banks are largely financed with overnight funding, creating a massive asset/liability mismatch, and are heavily levered. In the wake of Lehman's collapse, a run on the investment banks will continue, pushing them into the arms of banking acquirers with large, stable deposit bases. This will create a universal bank that is better positioned to weather the market turmoil. While Nouriel has a valid argument, I believe his view is simply wrong, strategically, tactically and ethically.

The problem with the investment banks is that they've generally financed themselves for the good times, not the bad times. This means an excessive dependence on short-term funding and high leverage. This generated high ROEs in good times, supporting large payouts for employees and shareholders alike. But when times turned bad, compounded by poor risk management and mind-bogglingly stupid investment decision, such a capital structure has come back to haunt many a firm. Nouriel says solve the problem by joining investment banks and commercial banks, and using core deposits as a vehicle for extending the duration of the investment bank's liability structure. I say no. I say that Goldman Sachs and Morgan Stanley should materially alter their financing strategy, lengthening duration by issuing different tranches of preferred stock, subordinated debt and term debt, de-levering in order to weather the storm and accept lower ROEs in the process. This also means that these firms, their culture and their employees won't be destroyed, which is what invariably happens when investment banks do M&A deals. If my strategy is to operate my firm as an independent entity, and I tactically want to keep my key employees in their seats to ensure continuity and resources for when the market turns, I want to control my own destiny. This means securing some of that liquidity-driven option value, which can only be gotten by putting a more conservative, less leveraged, more flexible capital structure in place.

The ethics issue is an interesting one. Felix Salmon, who was sitting at my table at tonight's dinner, raised the issue of an FDIC subsidy in the event that investment banks were subsumed by commercial banks. This point was further amplified by a commenter on this blog, referring to my critical post earlier today concerning the BAC/MER deal:

Looking at this deal from a somewhat "old school" view, it is just toxic for BAC and the rest of the banking system. The theory is that MER gets access to a more stable funding source. Well, IF Merill did not have such unfathomable assets on the books with such monsterous leverage it would not ahve any trouble getting funding. Lenders have to make loans to make money. They cannot profit if there are writeoffs on cheap loans. MER would not have such a funding problem if they did not deserve it. And, IF MER was a qualified borrower, they would get the funding without much problem.

What is being carried out is a transfer of the potential MER losses to the FDIC. And that is exactly what Glass Steagell was put in place to prevent. BAC has a balance sheet with goodwill representing 50% of equity. Recall that when FNM was revealed to be using tax loss carryforwards as assets everyone finally wised up that those cannot be used to pay any bills. Which counter party to BAC will take goodwill as payment?

In almost every case, the normal banks which have gotten involved in the chase to replicate the IB transaction and deal environment have enjoyed tremendous losses as a result. Banking should still be required to be seperate from the IB business without the cross ownership. This merger is financial nonsense.

- Augustus

Augustus, I agree. The deal is a scam. A sham. And should be slammed. If these deals continue, and if Nouriel is right, what I see happening is a new wave of boutique investment banks opening for business - the next generation of Evercores, Gleachers, Beacon Groups and Greenhills. Top talent will not stay inside these monolithic mega-firms; if Citigroup is any example, these firms are not good places to work as integration disruption continues for many, many years. Value accretion? I'd say not. So once these boutiques are created what will happen? Some will merge to achieve the benefits of scale. And soon enough, we'll once again have multi-product, multi-geography investment banks as we've had for generations. The universal banking utopia was Sandy Weill's fantasy. In the real world such institutions don't function well. They are too large. Too diffuse. Lacking in a unified culture. Hard to risk manage. Bound for failure.

Investment Banking 2.0 will be the re-emergence of the boutique, the focused, nimble, high-touch firm that was the bedrock of capital formation in the early years of the stock market boom. Because these mega-firms being created at the urging of the Treasury are not sustainable. They'll live just long enough for investment banking losses to be absorbed by the commercial bank's larger capital base, after which the best talent will flee for greener pastures.

Comments

[Kenosha Kid]

What seems to be missing from all these predictions is an analysis of what investment banking clients actually want/need... Advisory services, the core offering of "boutique" firms, are valued less and less by corporations - which have developed more and more sophisticated internal capabilities. One of the reasons that the large institutional investment banking model has failed is that these firms have been forced to use their balance sheets to generate profits, and often even in order to generate advisory mandates. And the use of balance sheets is more of a commercial bank's talent than an investment bank's. In short, it is unclear that there is sufficient demand for advisory services to support an abundance of "boutiques" beyond Lazard, Greenhill, etc. And so the combination of investment and commercial banks may be inevitable. Indeed, it is a continuation of a trend that started ten years ago or more.

[fred wilson]

if you look at any industry, the companies where the owner is the CEO (Murdoch, Jobs, Steve Cohen) are the ones that outperform. rollups run by hired managers are to be avoided at all costs

[David Merkel]

And, I suspect, many/most of them will stay private partnerships, which will make them more risk averse. It will be "back to the future" and probably be a good thing for all involved.

[Agustin]

What about the integration of Merrill's broker culture to Bank of America's personal bankers (tellers with suits)? A failed marriage awaits.

Having worked at Merrill, I still say that Stan O'Neal ran Mother Merrill into the ground. He wanted Merrill to be like "Goldman."

[Danny]

I think you're right on the IBank structure, but I think Nouriel is right on what the current crisis is going to bring. The IBanks should be structured more along the lines of what you are saying, but it is simply too late in the game to do that. The repo market is collapsing, there is little to no access for these firms to access the capital markets at decent terms, and deleveraging is extremely difficult as it just exacerbates the downward spiral of asset prices.

[Aaron Cohen]

Roger:

I'm waking up to your blog and promoting your blog. Please increase your volume during these times. I really find you to be helpful right now.

I really think the repeal of Glass Steagall (and even the move from Private to Public) has been devastating for the investment banking industry, but aren't you surprised that GS has been able to maintain their culture and come through this crisis so well?

I think it's worth thinking about how Goldman was able to maintain their commitment to quality post-ipo in the formation of Investment Banking 2.0.