GE Leads the Way Out of the Dark

By Roy C. Smith

from Financial News, May 4, 2014

GE is right to sell GE Capital – strategies change over time -- but it got credit from the market for making the change only when it said it would dump the whole thing, not just a few pieces. There is a lesson in this for the big banks.

In the 1960s and 1970s the most exciting companies in the US and the UK were multi-business “conglomerates”. These were publicly traded predecessors of today’s private equity funds. They were typically run by an aggressive, charismatic guy who promised to grow returns on investment (and stock prices) and based his conglomerate’s investment appeal on three attractions: making lots of acquisitions, ramping up leverage, and minimizing taxes.

These companies outperformed markets for years until they collapsed under the burden of managing the hundreds of dissimilar companies they had bought. In the 1980s most of them were broken up.

But one new chief executive in the early 1980s saw something valuable in the example of the conglomerates.  When 46-year-old Jack Welch took the helm at GE in 1981, his burning ambition was to turn the tired, legacy-driven electrical engineering firm into a powerful, change-driven growth engine. Welch’s contribution to the industrial conglomerate he inherited was to get out of weak businesses, acquire high-growth businesses, and do it all with leverage.

GE’s sleepy “captive finance company”, GE Capital, would have to help.

Under Welch, GE Capital grew to become a formidable financial conglomerate in its own right, operating in nine business areas with little or no connection to GE.

Because it was consolidated into GE’s business, GE Capital’s debt was rated AAA, which gave it the lowest cost of capital of any financial firm. Through its various tax shelters, GE Capital enabled GE to reduce its tax rate to levels well below 20%.

By the end of the 1990s GE was in 21 businesses. Its stock was trading at nearly 60 times earnings and valued at $500 billion, more than any other company in the world, with a return on equity of 25%. 

(Welch was aided by the world’s greatest bull market. From its low in the summer of 1982 until the close of 1999, the Dow Jones index rose fourteen-fold - a compounded growth rate of 16% for 17 years).

Welch retired as a business superhero in 2001, just in time to miss the bursting of the dotcom bubble that year, the 9-11 attacks that September and the financial crisis of 2008, stressful years for GE Capital as for all financial institutions. 

But even Jack could not have prevented the leverage working the opposite direction. By 2009, after struggling through two recessions, a major liquidity crisis, credit and trading losses, volatility spikes and market changes, GE Capital had become much more of a liability than an asset. GE’s exposure to GE Capital has dragged down its operating metrics and its stock price. Today GE’s market capitalisation is $286 billion, down 43% from 2000 high, and its ROE is half what it was then. 

Since the financial crisis, GE has lost its AAA rating and the US Financial Stability Oversight Council has designated its financial unit as a “systemically important financial instruction”, causing it to be as strictly regulated as a bank by the Federal Reserve.

Worse, from its investors’ point of view, is GE’s stock performance, which over the last 10 years has lagged well behind its peers and the market.  In that time Honeywell’s stock increased 180% and the S&P index 90%, while GE’s stock dropped 10%.

The strategic factors that caused Welch to load assets into GE Capital have now completely changed. The only question is why it took so long for GE to see the light.

Efforts at a gradual adjustment of the size and influence of GEC on GE by spinning off Synchrony, its consumer financing business (which it did last year), and selling a substantial portion of its real estate holdings (which it did last month), made little difference to GE’s stock price. 

 

The message did not get through to investors until the announcement by chief executive Jeff Immelt on April 10 that GE would get rid of all but a few necessary customer-financing parts of GE Capital. The GE Capital share price gained 10%, which it has held on to since. Clearly the market likes the idea of getting out of the dangerous finance businesses that for most of the last 15 years have contributed more problems than value. 

This continues to be true at several large global banks with large problem-causing investment banking and other units that they have nonetheless been reluctant to part with. Their reluctance comes from a fear of losing prestige, of facing the humiliation of shrinking and because shedding these units in current markets is difficult to do (but doable).

So far, the banks have done things piecemeal instead, cutting back here and there, instead of separating the business into independent companies – changes the market has not credited with being “strategic” enough to boost prices.

We are told that several banks are taking a fresh look at separating out their investment banking units, but don’t hold your breath.  Deutsche Bank just announced it would stay the course rather than combine, then shed, its retailing businesses, a strategic change favoured by many observers. Barclays has promised a report this spring, but so far has stuck to trimming rather than cutting. UBS is under pressure from an activist investor to get rid of the investment bank, but hasn’t responded. Credit Suisse has recruited a new chief executive, Tidjane Thiam, to apply an independent view to its business model, but we will have to wait to see.

The GE news should be instructive to these banks. Of the four banks mentioned, and the two US laggards (Citigroup and Bank of America) there ought to be one or two to test the water. 

It may be the only thing left they can do to improve their miserable market valuations.

Deutsche Bank's Wrong Call

By Brad Hintz and Roy C. Smith

(from Financial News, April 29, 2015)

 

On Monday’s investor call, Deutsche Bank’s Co-CEO Anshu Jain explained that “Strategy 2015+,” the most recent remake of the firm, had not met all of its targets, but it did meet some. It achieved its >10% Basel III core tier 1 ratio, and profitability, excluding litigation, was improved by the downsizing of the capital market business.  And its plan to spin off Postbank made sense because the ever-changing EU regulatory environment, which has constrained the ability of Deutsche to use retail deposits for institutional funding, doomed the economics of the earlier €6 billion acquisition.

But the bank has fallen very far short of its 12% return on equity target. And management has acknowledged that maintaining “optionality in our business model” (i.e., the capability to deliver a broad range of capital markets and banking products across all major markets) has proved to be a costly mistake for the bank.

Unlike Strategy 2015+, which focused on optimizing the risk adjusted balance sheet and achieving Basel capital targets, the new plan calls for a “profound deleveraging …of the CB&S balance sheet.”  Low return, low risk assets (such as matched book repo, the prime brokerage balance sheet, credit trading and bilateral derivatives) will all shrink. The institutional client base will be triaged to constrain the asset demand of low return clients, while continuing to support the bank’s high ROE client relationships.

Management is also attempting to boost margins and returns. Legacy retail branches will be closed, certain institutional product lines will be de-emphasized, back office activities streamlined and the international footprint reduced. Savings of €3.5 billion are targeted that should deliver a cost income ratio of 65% and a better, but still insufficient return on tangible assets of 10%.

Overall the bank aims to maintain a leading position in fixed income and commercial banking and to fortify relationships with corporations, and to capture more of the high margin equities and mergers business from legacy client relationships.

Mathematically, Deutsche Bank’s plan is sound – cut low return activities and grow high return units.

Unfortunately, all capital markets products and services are linked together. Institutional clients continue to demand full-service offerings. Issuers demand money market placement as well as low-margin DCM as quid pro quo for high-margin engagements. These inter-business connections make downsizing key units challenging for any bank – there is no bright line down the center of a fixed income floor that says ‘cut here’.

Deutsche Bank’s strategy of limiting low return balance sheet positions is neither radical nor new. UBS and Morgan Stanley announced long ago their intentions to reduce reliance on capital markets businesses but retain their investment banking franchises. Barclays is constraining its fixed income unit. Credit Suisse has been pruning around the edges of trading businesses, and under new management this summer may cut further. Goldman and JP Morgan Chase have already cut back sufficiently to deliver returns near their cost capital.

However, so far none of the legacy capital market banks has been willing to throw in the towel and so the war of attrition between them is likely to continue and a quick rebound in capital markets ROEs for any of them is unlikely.
But, not all of these firms have the managerial capability to be able to compete effectively in this race. So far, Deutsche Bank has proven to be a laggard. Publishing a wish list is not the same as convincing the market that the bank is capable of turning its latest strategy (which really is the same strategy as everyone else) into a winner.

The unspoken alternative to this latest of Deutsche Bank’s strategic announcements, is to have spun off the investment bank altogether into a separate company.   Given the difficulties it must face to make a full recovery and the continuing skepticism regarding capital markets, that would have been a better move.

The Bi-Polar World of Capital Market Banks.

By Brad Hintz and Roy C. Smith

(An edited version appeared in eFinancial News on March 23, 2015) 

Seven years after the crisis, global capital market banks have largely achieved compliance with tough new capital standards. However, the economic damage to their businesses in doing so has divided the industry into survivors, those institutions committed to strategies which are likely to succeed in a permanently changed world, and laggards, those firms that have lost their way, captive to an uncertain environment and unable to embrace the surgery needed to improve performance.

The banks have been forced to double the amount of capital held in reserves, cut leverage by half and adapt to a regime of stress tests, living wills, “systemic risk profiles,” new “capital cushions” and liquidity reserves. All of these measures have pleased the banks’ bondholders, who are happy to see Jamie Dimon’s “fortress balance sheet” become an industry standard. 

However, the cost of this achievement has been a form of death by a thousand cuts for equity holders and a division of the industry into survivors and those banks whose strategies are floundering . The survivors will eventually be able to use their market share, changing business mix and pricing power to deliver satisfactory returns, but the laggards, with ROEs well below their capital costs since the crisis, need to soon rethink their futures.

Struggling Against the Tide

In 2014, continuing a pattern of the past six years, only two of the top originators of capital market transactions earned more than their cost of equity capital. The average return on equity was an alarming 570 basis points below their cost of equity. Seven of the largest banks had stock prices trading below book value.

Exhibit 1 – Financial Performance of the Largest Capital Markets Banks

These results have occurred despite efforts by the pre-crisis leaders to cut costs and re-engineer operations. As a group, the banks have cut back average compensation, delayed promotion cycles, and reduced the percentage of highly paid managing directors on their trading floors. The composition of balance sheets has changed; matched repo books have declined, and credit inventories have fallen, while government security holdings have increased. New technology has been rolled out to provide traders with new risk management and trade pricing tools. Support functions have been outsourced and businesses automated. Teams of consultants have been employed to optimize inventories and control capital.

Even so, as the banks have attempted to improve, the rules guiding their businesses have continued to change. The US Volcker Rule has reduced earnings from market making. The OTC derivatives businesses have begun shifting to central clearing platforms, generating lower operating margins. The banks’ once-profitable commodities businesses are being discontinued due to regulatory guidance, and de-globalization has placed pressure on overseas operations.

Essentially, the banks have faced ever-moving regulatory goal posts on both sides of the Atlantic. Capital targets have been set, additional capital cushions added and then added to again. Tight leverage limits have been imposed. In December, the US Federal Reserve proposed new rules that would require the largest US banks to add a further capital cushion of 1.0% to 4.5% of risk-weighted assets beginning in 2016. The Basel Committee has proposed limiting “internal risk transfers” and Swiss authorities will further increase banks’ capital reserves to boost their “resilience.”

Regulators appear to be attempting to move the largest banks into a narrowly defined, safe harbor of common strategies with similar asset mixes and risk management techniques in order to restructure the industry as public utilities.  Janet Yellen recently noted that capital charges are leading the largest banks to consider spinning off some operations. She added, “…that’s exactly what we want to see happen.”

It is not surprising that increasingly skeptical investors are at last questioning the universal bank model.

Stale Strategic Responses

In light the above pressures, the capital market banks have outlined their strategic visions in an attempt to regain investor confidence. With few exceptions, the banks have not announced radical revamps. Rather, their plans have been (a) simple rebalancing of their business units to limit the performance drag of capital intensive trading or commercial lending businesses while (b) expanding the contribution of business segments viewed favorably by regulators (traditional retail banking, asset management and wealth management). But these plans have disappointed investors. Indeed, to investors much of the industry seems trapped in an autopilot mode, rolling out stale plans that represent only a pruning around the edges of a legacy business model and unwilling to abandon their hard won global footprints and capital markets franchises.

The Survivors

For the two capital markets leaders, Goldman Sachs and JP Morgan Chase, having cut expenses and improved capital allocations, a simple steady course strategy may work well enough. Their commanding positions in high margin business lines such as ECM and M&A and their global positioning and distribution strength should allow them to increase targeted markets during this time of industry transition. Essentially, these two firms are pursuing a “last man standing” strategy, positioning themselves to win a battle of attrition with weaker competitors. Given an average ROE performance of 10.6%, very near their cost of equity, these firms have the capacity and the time to pursue this strategy. 

UBS and Morgan Stanley are two potential survivors that have refused to remain captive to the current environment; they have announced intentions to reduce their reliance on the troubled trading businesses and materially shift their business mix. At UBS, this shift will happen by minimizing capital markets activities and emphasizing high net worth clients. At Morgan Stanley, the acquisition of Smith Barney from Citigroup caused its wealth management business to become half of total revenues. In 2014, these two generated an average ROE above 6% (still 500 basis points below their cost of equity), but the market has rewarded their strategy shifts by valuing them above book value.

Exhibit 2 - 2014 Market Share – Leading Capital Markets Banks by Transaction Originations 

The Laggards

The laggards, Deutsche Bank, Bank of America, Citigroup, and Barclays, state that they remain committed to traditional bank strategies of cross-selling underwriting and advisory, cash management, processing and lending services. At the same time, they are attempting to limit the capital intensity of underperforming trading units and promising to grow other lower risk or higher return businesses.

All of these banks have designated substantial “noncore” businesses they hope to shed, but, despite their disappointing return numbers, they have clung to capital markets businesses, dominated by fixed income franchises, whose capital intensity limits performance.

Deutsche continues to emphasize the power of an its underwriting and trading business which clearly is in the crosshairs of regulators. Barclays’ management has revised strategy several times as UK regulatory winds have changed, but remains tied to an overly large capital markets balance sheet while promising improving returns from credit cards and its international franchise.  Bank of America and Citigroup appear to be frozen in a state of strategic inertia, reacting to new regulation while hoping for the long-delayed cyclical recovery of their core businesses will eventually boost returns.

All of these firms remain powerful fixed income houses despite the economic pressure to resize this business.  Bank of America’s capital markets market share rose to 2nd place in 2014 (Merrill Lynch was 8th in 2007), Citigroup’s is now 3rd (it was 1st in 2007), Barclays’ is 4th (Lehman was 9th in 2007), and Deutsche Bank, 6th place (the same as 2007). However, in 2014, these banks booked an average ROE of less than 2% or nine hundred basis points below their cost of equity and trade at an average price book of less than .70.

Credit Suisse is in the most difficult strategic position of the lagging banks.  The new Swiss capital rules have negatively impacted the trading ROE of Credit Suisse, but it is difficult for this bank to radically shrink its capital markets businesses due to its business mix. Under Brady Duggan, management has pursued only modest restructuring. This activity has not persuaded investors, as the bank’s stock has lagged. Perhaps the incoming CEO, Tidjane Thiam, a former management consultant with a neutral view of the firm’s strategy, will be more inclined to consider other possibilities.

New Disciplined Competition

Two new banks, Wells Fargo and HSBC, have entered the list of the top originators for the first time. Neither bank has been previously associated with high performance investment banking or trading, historically preferring to stick to a retail banking dominant strategy. However, these two banks have opportunistically expanded into targeted and profitable areas of the capital markets. These firms appear to be pursuing a “market share at a reasonable ROE” strategy in capital markets. Wells Fargo, the world’s largest bank by market capitalization (yet with $1 trillion fewer assets than JP Morgan), generated a positive spread over the cost of capital of 570 basis points and price-to-book of 1.70 in 2014. Wells Fargo ranked 23rd in terms of market share in 2007, now (after its acquisition of Wachovia Bank) it is 10th. HSBC went from 16th to 9th. 

Why Such Inertia Among the Universal Banks?

If rule changes are making it harder to generate returns above the cost of capital, and if new regulatory initiatives are likely to continue to depress financial performance in the future, why are the industry laggards still clinging to the universal banking model?

There are three primary reasons:

First, despite all the challenges, the outlook for the industry is favorable. Global financial assets tend to be the driver of a large portion of bank revenues. Using the IMF forecast of global GDP as a driver, a growth rate for capital markets revenue of 4% to 6% can be expected over the next five years.  In banking, this is a very attractive growth rate.

Second, there is a strong belief among bank managements that the industry is in a period of transition that cannot continue indefinitely. Ever higher capital charges and operating limitations are being successfully met by resizing businesses and retaining capital.  The end result of these efforts is a constraint on credit capacity and inventory levels at the largest banks.  With dominant market shares and few new entrants in the market, the financial performance of the largest banks should therefore rebound as their cost of capital declines to reflect their stronger financial positions and as pricing adjusts to reflect the cost of new regulations.

Third, bank managements assume that it is the continuing uncertainty of regulatory rule changes, which are constraining banks’ business operations, not the nominal capital level itself. As the capital rules become certain, annual stress tests become more predictable and the rules-making process ends, the largest banks should be able to roll conform to regulatory provisions but deliver adequate returns. Regulatory stability will allow the leading banks to use their global customer relationships and their technology to fine tune business models and deliver improving returns.

The Market is No Longer Patiently Waiting

For leaders Goldman Sachs and JP Morgan Chase and for Morgan Stanley and UBS, banks that have made the necessary changes to shift their business mix toward less volatile businesses, the above  reasoning is realistic. They will be survivors as markets adjust and reprice.

The bottom half of the return rankings, however, include five large universal banks that have large investment banking operations that are depressing their returns on equity. These banks have unsustainable returns of 8.0% or less than their cost of equity, and trade at price-to-book ratios ranging from 0.54 to 0.81. These banks cannot afford to retain capital market franchises that are destroying shareholder value. They no longer have the option of waiting.

Where Are the Activists?

We have expected the laggards to eventually recognize reality and initiate major strategic changes. However, despite increasing evidence that they cannot return to what was normal in 2007 from where they are now, no strategic shifts have occurred to date.

Further, it is surprising that activist shareholders have not jumped in. Activist shareholders successfully directed underperforming Chase Manhattan Bank (1995) and Union Bank of Switzerland (1998) into mergers with smaller, better-managed Institutions.

But systemically important banks cannot easily be acquired. There are two options available: a spin off or a sharp resizing (or liquidation) of the underperforming businesses. We believe that these banks should investigate both of these options and pursue the one that promises to return the most to their shareholders.

We recently proposed the spin-off option for Deutsche Bank. This option would require incorporating its investment bank into a separate corporation in London or New York, providing it with sufficient financial support to be able to obtain Baa credit ratings, and distributing the stock to the banks’ shareholders.  Such an endeavor might include third party investments to shore up the capital position and provide credit lines. Such an endeavor might include third party investments to shore up the capital position and provide credit lines.

A spin-off would allow the new entity to become (at least initially) a non-systemic nonbank, which would give it more operational freedom. Also, it would re-establish a partnership culture that has successfully attracted talent and capital to firms in the past, and a spin-off would avoid the operating limitations and bureaucracy associated with being part of a large universal bank.

Alternatively, these banks could simply liquidate their trading inventories over time (at book value) and return capital to the parent company (trading at well less than book value) for distribution to shareholders. By reducing the size of trading activities, the returns on the remaining business should rise.

We believe that dramatic actions of this kind could benefit shareholders, and force the banks to be more retail- centric, better managed, surprise-free and regulatory- friendly enterprises that could aspire to approach the returns and price-to-book ratio of a Wells Fargo. 

Robust capital markets are essential to economic growth and recovery. We need to have all of the top players operating on all cylinders to make the most of the capital markets we have. But for this to happen, it is time for the weakest banks to resize and adjust to the changed economics of the business. 

Unfair and Unnecessary Legal Settlements are Hurting the Banks

By Roy C. Smith

Morgan Stanley recently agreed to pay $2.6 billion, about 42% of its 2014 earnings, to settle federal claims that it had deceived investors by misrepresenting the quality of the home loans that were packaged into mortgage-backed securities in the years preceding the 2008 financial crisis.

All of the major US capital market banks have been involved in similar settlements, which are paid by shareholders, not by individual wrongdoers.  

There is no precedent for all of the principle competitors in an industry being the subject of such lawsuits. Altogether the banks have paid more than $130 billion to settle charges of misconduct in a variety of areas before, during and after the financial crisis.  Several additional investigations that could lead to further settlements are ongoing.

The settlements certainly leave the impression that the banks must have done a lot of terrible things to have to pay out so much money.  Apparently the Federal Reserve thinks so: Janet Yellen, Chairman of the Federal Reserve, and William Dudley, President of the NY Federal Reserve Bank, have recently referred to the settlements as evidence of unacceptable “cultural” deficiencies that could affect the banks’ “safety and soundness,” and impose “systemic risk” that could threaten the financial system. If not addressed, they say, these cultural problems could require regulators to curtail some of the banks’ activities, or break them up.

In the long history of bank regulation prior to the financial crisis of 2008, cultural deficiencies have never been mentioned as a reason for regulatory intervention, nor have banks as corporate persons been sued for the misconduct of employees. 

So, this time is different. But what, exactly, did the banks do to justify such penalties?

Actually, there is no way to know.

There have been no trials requiring the presentation of evidence and a verdict by a jury. With few exceptions, the settlements have not included admissions of guilt, and all the case files have been sealed.

Though Morgan Stanley was the latest to do so, most of the major capital market banks have settled charges related to mortgage-backed securities before 2008.  Morgan Stanley bought subprime mortgages from New Century Financial Corporation, the country’s second largest subprime mortgage lender and a NYSE listed company that filed for bankruptcy in 2007.  Like the other banks, Morgan Stanley securitized the subprime mortgages it bought into mortgage-backed securities, obtained bond ratings from Moody’s and Standard & Poor’s, and then underwrote and sold them under rules for public offerings enforced by the Securities and Exchange Commission to knowledgeable institutional investors.

A different lawsuit filed in 2012 provided emails suggesting that Morgan Stanley employees were aware of the low quality of the mortgages they were buying from New Century.  Most of the other cases have reportedly had similar email evidence.

However, purchasing low quality subprime bonds was not illegal. Indeed, they are the rough equivalent of “junk” bonds (rated below “investment grade”) that have been widely distributed in securities markets since the 1970s. Their lower credit quality, reflecting a higher expected default rate, requires a higher interest rate than is offered for higher-grade securities.  Having a difference enables investors to choose the risk/reward package they want. Almost all investors in mortgage-backed securities are experienced professional investors aware of the risk contained in subprime mortgages.

The new issue process is extensively regulated and involves several layers of due diligence performed by independent parties. It is, as it is supposed to be, difficult, for any single party in the process to misrepresent the quality of the securities being offered.

Misrepresenting the quality of the bonds (or the mortgages or collateral to which they were tied) in the offering prospectus or disclosure memo would have been a violation of federal securities laws. Those injured by violation of the securities laws are entitled to bring civil suits against banks causing the injury.  However, the Morgan Stanley case (like most of the others) was brought by the Justice Department, not by a plaintiff experiencing a loss, or by the SEC.  Only the Justice Department can bring criminal cases involving federal securities laws, so the presumption is that if the settlement was with the DOJ, then the case that it might have brought would have been criminal.

Charging a bank with a criminal offense changes everything.  Banks have to hold licenses, which may be withdrawn if the banks’ owners (holding companies) become convicted felons. Losing a criminal case, even if a bank’s defense is solid, would be disastrous for a major banking or financial services company. Arthur Anderson, a major accounting firm lost its licenses after being convicted of destroying evidence in a criminal case related to Enron in 2002, and was forced into bankruptcy.  The Supreme Court subsequently overturned the conviction, but by then it was too late to save Arthur Anderson.

No board of directors of a major bank has been willing to face a trial in a criminal case, and according have invariably instructed their managers to settle such cases instead.  So threatening a criminal suit assures that there will be a settlement, the only question being for how much.  The DOJ seems to base settlement amounts on how much a bank can afford to pay, rather than on any assessment of damages done.

The Justice Department has preferred to sue banks rather than pursue individual officers or directors suspected of wrongdoing.  Substantial investigations have occurred but no person in an executive position of responsibility has been charged with any offense, because, as some prosecutors have said, they did not uncover sufficient evidence to secure a conviction.

If there is not enough evidence to convict an executive in authority, what evidence is there likely to be to convict the bank as a corporate person?

Logically, you might think none. But prosecuting corporations is a different matter. What prosecutors have to establish, according to DOJ guidelines, is that the corporation did not do enough to prevent fraud or other misconduct from occurring, or to detect and halt it when it did, or to cooperate with the government in bringing charges against responsible individuals.  These are different things to establish in court, but the DOJ has not had to do so because the cases were settled, not tried.

The process of threatening banks with criminal charges when no responsible officer or director can be found is a form of bullying that turns them into low hanging piñatas. The suits are not necessary to improve bank safety and soundness, and actually work against those objectives by diminishing the banks’ capital. They only serve as punitive measures to a population (shareholders) that has already paid in decimated stock prices, low returns on equity and a slow recovery to the way things were.

Of course, prosecuting unpopular banks has also had political benefits for the Obama Administration and for a number of state attorneys general.

Regulators like the Federal Reserve know more than most about bank activity and behavior, and accordingly want to force banks to improve their management and control functions. Since 2008, all the major banks have been attempting to do this, but they and their cultures have also been required by Dodd Frank and other new regulations to double capital requirements, halve leverage, maintain twice as much in liquid assets, drop out of certain businesses, and pay the $130 billion in settlements.

As a result the return on shareholder equity for all but one of the largest originators of capital market activity in 2014 (and for several prior years) was no better than, or in ten cases among the top twelve global capital market banks, much less than their cost of equity capital.  The Economic Value Added of the capital markets industry is currently less than zero, suggesting that the whole industry may no longer be economically viable.

The Federal Reserve needs to worry less about the culture and more about the future viability of its large capital market banks.

Building Character on Wall Street

Dec. 1, 2014

By Roy C. Smith

Michael Lewis, in a recent Bloomberg piece, noted that the world’s best and brightest young people have been filing unthinkingly into the Wall Street gladiatorial arena for at least three decades, where they face great pressures that demean their characters and ethical compasses, just to make the money. 

At the elite schools a great many students still want to work in “Wall Street” (i.e., in the global capital markets business) despite Mr. Lewis, the reputational damage the industry has sustained and the many uncertainties about the its future. As soon as the school year began again, students started maneuvering to secure jobs, either full-time or as summer interns. It's a stressful process in which the applicants well outnumber the vacancies.

A number of today’s prospective Wall Street recruits are my students. They know of the difficulties the industry has had to face since 2008, the new regulations, the litigation, the pressures on profits, and the layoffs, pay cuts, long hours and the slowdown in opportunities for promotion, but they still come.

Yes, they are young and relatively inexperienced, but they are not naïve or uninformed about the conditions in the business. Most can make about the same amount of money in other jobs, and are sensible enough to know that one should not take a job one is not enthusiastic about just for the money.

The real, underreported reasons they continue to come are three:

First, the work is dynamic, challenging and exciting.  Modern finance now touches just about everything that happens in the world. It is truly global in scope, very fast paced, and innovative. New recruits work in highly professional specialized areas, often simultaneously on several different teams that focus on a variety of different problems and opportunities for which good solutions are much valued. To get all the inputs they need, teamwork and collegiality is key, and teammates become close friends.

Second, the organizations they join are largely non-hierarchical, where people are accountable for what they do and given all the responsibility they are thought to be able to handle. To be put in charge of preparing and delivering a pitch to a new client can be very challenging for a youngster with only a year or two experience. Getting it right invites further opportunities. Few other professions provide such a steep curve of potential upward mobility, or a better way to test oneself against peers. 

Third, the training in financial market operations is exceptional and wide-ranging. After only a few years, employees at firms with a robust “deal flow” learn a great deal, become certifiably professional and begin to attract offers from other firms. While they are doing all this they also have the opportunity to see what they think of the way the industry works, the toll it takes on personal lives and the degree to which handling conflicts of interest or other ethical issues may be troublesome.

They also have the chance to see how management of the firms in the industry strives to pull together performance, compliance and accountability to shareholders. The managerial role in these firms is increasingly complex, demanding and important, and creates a different, broader set of career opportunities.

Many new recruits today know very well that the power and profits of the industry are shifting from “systemically important” firms to much smaller ones -- boutiques or specialized hedge or private equity firms.  For many years, the number of billionaires (to use one popular metric) in these smaller entities has vastly exceeded those from larger firms.

But what they also know is that the training they get at Goldman Sachs or Morgan Stanley or any of the other top firms is the ticket to new opportunities -- from within their own firms or from competitors or others.

What Michael Lewis misses is that the high-performance Wall Street culture, as controversial as it may be, is essentially one of providing for long-term success in a very competitive, risky and ever-changing marketplace.  This is not easy to do. Misjudgments and abuses occur, but these rarely, if ever, benefit firms as recent legal settlements demonstrate. A well-managed firm competing in capital makers must meet many increasingly transparent standards of professional, regulatory and reputational conduct in order to succeed over the long term. For this the firms seek talented, capable young employees with good character that they hope to fortify and improve on the job.

A couple of generations ago, most young men coming of age were required to spend a few years in the military. For most, then and now, this experience in small unit leadership, handling responsibility and accountability, and in just having to show up on time and get the job done no matter what, was invaluable. Few young people have that experience today.

The real world training the capital markets industry offers is a good substitute for the military. The training it offers in achieving performance objectives, in the context of a myriad of tough behavioral standards, is as good as it gets. A few years work in the industry can help to prepare young people for successful careers anywhere - in industry, entrepreneurship, government, or elsewhere.

Now is the Time for Deutsche Bank to Consider a Split

By

Roy C Smith and Brad Hintz

16 February 2015,  eFinancial News: Issue 936

 

It’s long well past time for Deutsche Bank’s long-suffering shareholders to challenge the holy writ of universal banking. The bank’s strategic challenges were made clear in late January when its fourth-quarter results showed return on equity of 2.6%, about 20% of its cost of equity capital. Management said the performance was “encouraging” – but the equity market continues to value the bank’s shares at only half book value.

Jürgen Fitschen and Anshu Jain, Deutsche’s co-chief executives, say they are committed to preserving the bank’s traditional “universal banking” strategy and determined to remain among the top five investment banks. But their “Strategy 2015+,” announced soon after they took over in 2012, now looks hopeless. Goals of a cost/income ratio of 65% and an after-tax return on equity of 15% by 2015 seem truly out of reach.

Yet, Deutsche Bank has been a relative winner, as other banks such as UBS, Morgan Stanley and Barclays have cut back their investment banking or trading activities. In 2014, Deutsche’s investment banking unit ranked third in both global debt underwriting and loan syndication revenue, according to Dealogic. Fitschen said: “We see good opportunities to win market share… when some of our competitors are pulling back from investment banking.”

Disappointing returns

But after four years of disappointing performance, it is time to recognize that shareholders have not profited from the bank’s gains in market share, nor are its unrealized expense aspirations the same as bottom-line performance. The massive regulatory changes since the 2008 crisis have severely affected the universal banking business model, bringing its viability into question. Constraints on the capital markets businesses continue to tighten as regulators pursue a goal of transforming the largest global banks into low-growth, but bulletproof, public utilities. There are now capital surcharges for systemically important financial institutions: “special” national capital buffers, leverage limits, liquidity standards, operating prohibitions against excessive risk-taking as well as proposals for new financial transactions taxes. All of these changes add costs and lower the return on equity of capital markets activities. Among the large banks, only Goldman Sachs has been able to generate returns near its cost of capital and that is because of a sharp reduction in compensation and continued liquidation of a legacy merchant banking portfolio.

And, there has been a tsunami of politically popular, punitive litigation that has stripped all of the universals of precious capital just as they need to increase it.

Deutsche Bank’s strategy of profiting from a war of attrition in investment banking cannot succeed. The firm still faces cost and margin issues, poor trading returns, continued demand for additional capital as well as cultural challenges in its London-based banking unit. Fitschen and Jain have promised a strategy update sometime in the second quarter. Rumors suggest this may involve the sale of recently acquired Deutsche Postbank. But, it is not Postbank that is hurting the bank, it’s the investment bank.

There is one successful example of a spin-off. After more than a decade building itself into a broad-based financial services company, American Express in 1994 reversed course. New CEO Harvey Golub decided to shed the Shearson Lehman investment banking and brokerage units, whose performance had seriously undermined the parent’s stock price. The brokerage business was sold to Smith Barney, and the investment bank, Lehman Brothers, was spun off to shareholders.

While these were controversial moves when announced, it is now clear that American Express shareholders benefited from the restructuring and that operating performance improved significantly, not only at Amex but also the companies it jettisoned.

Since then, however, the capital markets business has become more complex, and separating out trading and market-making from a modern universal bank would have major repercussions. Certain capital advantages related to portfolio risk analysis and netting of positions would be lost. The cost of funding for an independent trading entity would rise as the funding base shifted towards more long-term debt and institutional deposits. The marketing synergies between commercial lending and investment banking would be severed, which would be likely to erode market share. The shared technology and staff support costs of the universal banking structure would end.

Further, the newly independent investment bank would need to maintain sufficient capital and liquidity to meet regulatory requirements and to qualify for Baa/BBB credit ratings. For this to be achieved, the parent would probably have to take back some preferred stock or contingent convertible loans, as American Express did when Lehman was spun off, or third-party investors would have to be brought in.

Change is good

It would not be easy, but it could be done.

And it might create entirely new value. Determined managers of a newly independent investment bank would be forced to rethink their business model and accelerate the glacial rate of change in capital markets dominated for years by the universal banks. On the cost side, compensation ratios would fall, organizational structures would flatten, headcount would be reduced, back offices automated and support staff outsourced.

On the revenue side, an independent firm with limited financial resources would be forced to pursue the highest margin banking businesses and reduce commoditized products, while improving balance sheet turnover and returns on trading assets – all good for investors. After spinning off its investment banking activities, a smaller and de-risked Deutsche Bank, retaining some wholesale lending business, would still be a world-class commercial lender, a leader in serving mid-size industrial companies in Europe, a large and growing wealth manager and a powerful transaction services provider.

Its strong positions in the admittedly over-banked German and Italian retail markets still generate low-cost retail deposits that enable a profitable lending and investment portfolio. And without the siren song of investment banking and its maddening, constant fire-fighting demands on management, Deutsche Bank could focus on improving the banking and distribution businesses it knows best.

Most important, however, is the almost certain increase in shareholder value than would result from a break-up. The combination of the various individual business units might be valued on a stand-alone basis at as much as €55 billion. With today’s market value of €37 billion, reflecting investors’ grim view of the bank’s future, there is a lot of room for creating value through a restructuring. Spinning off the investment bank might be the best way to capture that value.

Roy C Smith is a finance professor at NYU Stern School of Business and former partner at Goldman Sachs. Brad Hintz is an adjunct finance professor at NYU Stern and former CFO at Lehman Brothers and top-ranked banks analyst with Sanford Bernstein

John C. Whitehead – Then and Now

By Roy C. Smith

John Whitehead died last week at 92. He had many accomplishments, the most important of which to me were his 37 years at Goldman Sachs, more than 18 of which as a member of firm’s important Management Committee. For the last 8 years he was co-Chairman of the firm along with John L. Weinberg, who was Chairman until 1990 and died in 2006 after 40 years with the firm. Whitehead is the last of the “old Wall Street” leaders to go.

John joined the firm in 1947. He became the principal assistant to Sidney Weinberg, a legendary figure who headed the firm for 38 years. John became a partner in 1956 after assisting Mr. Weinberg in one of his signature achievements, advising the Ford family on the initial public offering of the Ford Motor Company.

John headed the Investment Bank Division for many years, and authored Goldman Sachs’ “Our Business Principles,” the first effort by any firm in Wall Street to publish the ethical standards it followed and to which the firm still adheres.  

He was also the driving force behind moving a reluctant Goldman Sachs into becoming “a truly international firm.” He recruited me from the domestic corporate finance department to join this effort at its beginning in 1968 and for 20 years he was my ultimate boss (I had other bosses too).

His constant peroration to me, and others struggling to create an international business from next to nothing, was “just because these companies never hear of you, or Goldman Sachs, or investment banking, doesn’t mean you can't get them to do business with us.”

John retired in 1984, 30 years ago (and 15 before the firm went public), after feeling that investment banking was steadily drifting away from the world of small, intimate firms with which he identified. Even after leaving, John was one of the most visible individuals identified with the industry, of which he was often quite critical.  

Today, Goldman Sachs has about 100 times more revenue and 35 times more people than it did when John retired. Its market capitalization is $83 billion, as compared to about $300 million of total partners capital in 1984. But the firm is not just bigger; it is in a much more global, complex and dangerous business than he had ever imagined it could be. Even so, there are several investment banks that are twice as large as Goldman.

What used to be “global” meant having offices in London, Zurich, Tokyo and Hong Kong. Today’s Goldman Sachs has 39 international offices (23 in emerging market countries) vs. 16 in the US; roughly half the firm’s business-flow originates outside the US.

The business too is certainly more complex. The Glass-Steagall Act was repealed in 1999 and competition for investment banking transactions increased geometrically, putting great pressures on margins and profits. Trading became the dominant investment banking revenue source, thus requiring new management skills in funding and leverage, hedging and controlling risk exposure, handling conflicts of interest, and the sometimes difficult task “of separating “clients” (to whom loyalties were owed) from “counterparties” (to whom they were not).

And certainly the seismic changes since 2008 in the regulatory and litigation environment of the capital markets businesses has introduced compliance burdens and hazards that have not yet reached their outer limits.

Because of these changes, few of today’s leading investment banking firms earn their cost of capital, and the shares of several trade below book value.

Goldman Sachs has survived the crisis and its aftermath better than most. This is partly because the firm’s DNA still carries some of the essential elements from the Whitehead and Weinberg days.  Most important of these may be the goal of professional “exceptionalism” that has, since the beginning, eschewed large mergers, cultural dilution and loss of hands on control, and insisted on the preservation of a “partnership” senior manager compensation system, that is still unique in the industry.

Goldman Sachs has had several leaders since Sidney Weinberg died in 1968; John Whitehead, though a man of many other interests and activities in the last 30 years of his long, rich life, has been one of the most admired and lastingly influential.