Wall Street’s Elite “Analysts” Programs

By Roy C. Smith and Charles J. Murphy

Andrew Sorkin’s June 2, 2015 article about the death of Sarvshreshth Gupta, a 22 year-old first-year analyst at Goldman Sachs has created a lot of buzz at NYU Stern where many undergraduates have long sought similar jobs as Wall Street analysts.

These jobs are very highly valued for the training, prestige and future opportunities they provide. They are widely sought by the best and the brightest and most competitive undergraduates from all over the world. They also pay very well (for 22 year-olds).

But, they do come with an expectation of 80-100 hour workweeks, and a total immersion in the firm that allows very little time for developing a “real life.” It has been this way since anyone can remember.

Part of the reason for this is the unpredictability of activity in capital markets, which includes prospecting for and executing new issues of securities, IPOs and mergers and acquisitions. This year’s activity level, for example, is considerably higher than last year’s; when activity levels surge it is “all hands on deck.” The work has to get done, something everyone knows and pitches in to help achieve as a team effort.  

Periodically there are quiet periods, which don’t get discussed much, though these too can be consumed by greater marketing efforts.

But another part of the reason for the high workload for young “analysts” (those with Bachelor degrees) and “associates” (MBA’s) is cultural. The firms believe that having a relatively small staff of high-grade junior employees to handle the business provides a more intense form of training that produces a cadre of highly professional mid level employees with long-term career potential.

Analyst positions originally were awarded with a two-tear contract, after which the individuals were expected to go back to school for a MBA. In recent years, the two-year contract has been replaced with an open-ended job offer with the understanding that some, but not all, of the analysts will be upgraded to associates.

The first two years at the elite firms is focused and intense to a degree that most twenty-somethings have never experienced. It is a tough, sink-or-swim process that separates out those that have the aptitude, personality and preference for this type of work that requires balancing the needs of several different deal-teams against moveable deadlines. It can be nerve-wracking and physically demanding; in some ways it is similar to the elite military training for Seals or Special Forces units.

It is tough, especially for foreign-born individuals to whom the high-pressure American work environment is completely alien, but that doesn’t mean people are expected to work themselves to death.

Of course the firms have a responsibility to provide some sort of watch over their young analysts to be sure they are not loaded down with more than they can be expected to deliver. Some sort of mentoring has to be part of the package with intervention from time to time to shift the work around to spread out when deliverables are due so they are not all due at once, a common nightmare.

Most of the firms recognize this and indeed have attempted to ease the pressure by hiring larger analyst classes, reducing weekend work and by offering counseling and other support services. Nevertheless much of the pressure on the analysts is self-induced and too often individuals struggling with their jobs are unwilling to seek help for fear of appearing weak or falling behind.

But the analysts themselves need to understand a few basics too.

First is the simple fact that the training is all about establishing a reputation for being professionally reliable, which means getting the work done accurately and on time, without pestering others with a lot of questions about how it is to be done. Reliable analysts get promoted, those that aren’t don’t.

Second, its about handling chaos and disorder.  Most analysts work on several deal-teams at once, the requirements for deadlines, meetings, etc. change from week to week, sometimes creating convergence or overloads on the system. It can certainly seem chaotic, but successful analysts learn to look ahead a week or two, prioritize and anticipate what has to be done, and plan accordingly. If conflicts emerge (you can’t be in two places at once), let your boss know well ahead of time, maybe suggesting an alternative way out. This also means that there are times when the analyst has to say he or she is too busy to take on a new assignment.

Third, a tough training environment is going to have to be endured before you can really judge whether or not the work (and the career) is what you want. The analyst programs are supposed to test endurance, but you probably won't really know whether this type of work is for you or not until you have completed the intended two-year training cycle. You can always decide to do something else later, but, for most people, the best advice is to stick it out.

There are many benefits to completing a two-year hitch as an analyst. Some then decide to seek MBAs or other graduate degrees with the expectation that their analyst experience will help them gain a coveted position as an associate in a top financial firm. Others may stay on, being promoted to associate without going back for an MBA. And many decide to go on to hedge funds, private equity firms or other non-financial destinations where they can establish the kind of work-life balance they want.

Mr. Gupta may have committed suicide, for reasons that may have been job related but could have involved other factors as well. He apparently did not adjust well to the job he had, and tragically, neither he, his family, nor his superiors at Goldman Sachs were able to recognize his distress and help him deal with it. It was a horrible misfortune that should result in closer attention to struggling analysts in the future.

But the overall success of the analyst programs at Goldman Sachs and other top firms in not in dispute. They produce very well trained and competent finance professionals that can go on to very rewarding work at their original firms or elsewhere.

Messrs Murphy and Smith are former investment bankers who are Professors of Finance at NYU Stern School of Business.

Fear of the Workers Could Cripple People’s Paradise

by Roy C. Smith

from eFinancial News, May 25, 2105

 

Many China observers have pointed out that rapid growth without basic reforms brings the risk of a major financial crisis. China said it would undertake the reforms, but last week, fearful of strikes and other protests amidst declining growth, it abandoned them. Fasten your seat belts.

After the financial crisis of 2008, China did what other countries did – it provided fiscal and monetary stimulus to restore growth, at the cost of significant increases in debt and the risk of nonrepayment. Unimpeded by a democratic political process, China’s fiscal and monetary stimulus efforts were the largest ever undertaken by any country.

It worked,but only for a while. China’s GDP growth rate, which had been 13% in 2007 but more than halved to  6% in 2009, rebounded to 12% in 2010, but its total debt increased by $21 trillion, from 158% of GDP in 2007 to 282% in mid 2014, according to a McKinsey study. Loans issued by financial institutions and non-financial corporations grew from 96% of GDP to 190%. Nearly half of this debt was related to real estate, but much of the rest is in stimulus projects undertaken by various provincial, city and other local governments.

During this time, the central bank was seeking to reform the financial system, by clarifying the limits of deposit insurance, adopting market rate lending and deposit taking practices and by reining in lending for real estate and stock purchases, and for speculative projects by local governments.

To get around these rules, the loans were made instead to off-balance sheet subsidiaries of local authorities known as “local government financing vehicles”.  By the end of 2014, $560 billion of such debt was outstanding.

But China’s growth rate has declined sharply since 2010, putting serious pressure on the ability of local governments to repay debt amounting in total to about $3.5 trillion. Debts to money-losing state owned enterprises (SOEs) and other corporations (about $6 trillion altogether) are also a problem.

China has been awash in money for the past few years in an effort to reverse the declining growth conditions. Instead, the excess liquidity has pushed up real estate prices in major cities by 50% since 2008 and the Shanghai Stock Index by 120% since November.

Even so, large parts of China are still suffering from deteriorating economic conditions.

In April, Premier Li Keqiang visited three “rustbelt” provinces in the northeast where he observed much weaker growth than expected and disgruntled workers. Strikes and other worker protests have been running about three times the rate of recent years.

Few existential threats to the ruling Communist Party are greater than massive worker protests.

So the Party did the most pragmatic thing it could to safeguard its interests – it abandoned reform to renew monetary stimulus.

In April, the Politburo announced a programme of “prudent monetary policy” to offset the effects of the cyclical downturn into which the economy has settled. This was followed by a joint directive issued by the finance ministry, the banking regulator and the central bank, explicitly banning financial institutions from delaying funding to any local government project started before the end of 2014, and requiring that any projects unable to pay existing loans should have their debts renegotiated and extended.

SOEs in similar difficulties would no doubt receive the same benefit, though such too-big-to-fail treatment presumably could be managed quietly.

Accordingly local government and SOE debt will increase further, as will the portion of it that is distressed, hoping to push the problems far out into the future.

Thus, China seems to be sliding into an inevitable financial crisis similar to those experienced by Japan in the early 1990s and by Thailand, South Korea and Indonesia in the late 1990s.

These earlier Asian crises were similar in nature – they all contained stimulus efforts to encourage growth, asset bubbles, massive lending to SOEs or large, distressed industrial groups, and market crashes once the difficulties became publicly known.  The crashes brought tough economic times, changes in government and long periods of growth rates well below pre-crisis levels.

In 1978, Deng Xiaoping announced a fundamental change in government policy to achieve economic growth by allowing a private sector to develop. At the time, the average Chinese had realised very little, if any, economic improvement since Mao’s Revolution in 1949, the Great Leap Forward of 1958-61 and the 1966-76 Cultural Revolution.

Deng’s policy has been a great success, but having now abandoned Communism, the people may wonder why they need a Communist Party running everything. The president, Xi Jinping, is well aware of the dichotomy, and is hoping to trade more prosperity, less corruption and an enhanced, more powerful national image for continued Party control.

But there is another side to the bargain. The opening of the economy to market forces that is part of Deng’s legacy had to be accompanied by reforms and disciplines necessary to make a market economy function effectively. Otherwise the massive Chinese economy, spurred on by recurring stimulus, misallocation of resources, corruption and devolution of decision making authority away from Beijing, could tear itself apart.

The government has apparently understood the need for such reforms, and recognised that the growth rate is likely to settle at  around 7%. But implementing reforms in a decelerating economy has proved more difficult than Xi and his colleagues expected.

Recent indicators suggest that China’s growth rate in 2015 may fall below 7%, which could result in a nasty backlash from the 280 million indigenous migrant workers likely to be the first to face layoffs. Hence, all hands to the pumps to check any further decline in growth.

However, having suspended reforms to sustain growth puts China in danger of greatly expanding its already large supply of non-performing loans, and one day having to face the consequences of owning up to them.

All this suggests a financial reckoning to come, one that could be very rough.

Unlocking Cuban Economic Renewal with Foreign Investment

By Roy C. Smith and Ingo Walter

The joint announcement by Presidents Barack Obama and Rául Castro last December about normalization of relations was an electric moment in both the US and Cuba. Since then, the buzz of excitement about what might happen next has been in full force - with many Cuban small businesses launched and a parade of important visitors from the US and other countries hoping to get in on the action as new investment and trade deals are negotiated.

Some people argue that a Congress unwilling or incapable of revoking the thicket of US trade and investment embargo legislation will allow others to leapfrog American companies in the most attractive sectors as the Cuban train picks up speed. This may be so, at least for a while. Florida’s Senator Marco Rubio, a Cuban-American contender for the Republican presidential nomination, has said “there is no way this Congress is going to lift the embargo”

But maybe the danger of losing out to the Europeans and Chinese is not so serious as the train, so far is only moving ahead in fits and starts, leaving plenty of chances to hop on later. But whether companies will want to will depend mainly on the seriousness and persistence of both countries’ reform efforts. So far, there’s not been much applause from the bleachers.

Formation of small businesses, and the purchase and sale of certain private property, had been authorized in Cuba well before the joint announcement last December. Since then, some government salaries for Cuban doctors and other professionals were raised, and Cuba has recruited a small bank in Florida to act for it in US dollar transactions.

Meantime, negotiations have begun on re-establishing embassies, but these are heavily politicized and slow going. The US has released some Cuban spies, and has dropped Cuba from a list of countries supporting terrorism. Mr. Obama has also announced some minor rules changes affecting American tourist visits - and allowing them to return with a few Cuban cigars. Mr. Castro attended the “Summit of the Americas” meeting in April, where he met with the President for the first time in 50 years. Mr. Castro has since met with the Pope, the President of France and other dignitaries, but without generating any important economic news.

A Cuban official recently spoke of a 4% target growth rate of the Cuban economy for 2015, up from 1.4% last year, in anticipation of more (as yet unannounced) market reforms and surge of tourists. However, the shaky Venezuelan economy, on which Cuba has long been dependent for handouts, is expected to contract by 6% this year, approaching “basket case” territory from which its ability to continue assistance to Cuba is doubtful.

There seems to be a consensus among informed Cubans that the motivation for economic reforms and reconciliation with the US comes from fears that the future of Cuban “Socialismo” is dim without Castro brothers to hold things together. Better to have limited reforms they can control than to have a fall into the jungle of market capitalism after they are gone.

So what should those limited reforms be?

Cuba’s economy remains backward and uncompetitive by almost any standard – most dramatically in agriculture, finance and the ability to attract foreign direct investment.

With large amounts of uncultivated land, Cuba still imports more than two-thirds of its food. Much of what is cultivated locally is still done “by hand” -  i.e., with oxen as the pre-1992 Russian tractors wore out and could not be replaced.  The limited foreign exchange earnings Cuba generates are mostly used for food imports.

Cuban banking, built on the old Soviet model, is especially backward. Most Cubans don’t have checking accounts, not to mention credit cards or access to loans. People queue weekly to withdraw small amounts of cash, and queue again to pay bills. No wonder Visa, MasterCard and foreign banks are so anxious to set up shop and secure first-mover benefits, transforming one of the last remaining virgin markets for financial services. But, so far, credit card usage is to be confined to foreigners.

Despite signals that it would like more foreign direct investment (FDI), Cuba has received remarkably little so far, largely because of difficulties on the Cuban side.  The Embargo prevents US FDI, but not direct investment from Europe, Asia or Latin America. There are questions about how profitable a market of 11.4 million poor people could be for goods or services produced in Cuba under local conditions in a joint venture with a Cuba state-owned partner.

All sizeable Cuban businesses continue to be owned by the state, so there will have to be privatization on the scale of East Germany in the 1990s, mostly in the form of sales to foreign investors since there is no Cuban capital market. For their part, investors appreciate a decent business infrastructure, property rights and a reliable legal system. None of these exist as yet in Cuba that are up to international standards even for emerging markets.

Reforming the FDI rules is the necessary first step. Without the capital and knowhow foreigners can bring, Cuba’s economic revival will be limited to the small-business sector, but that won’t be enough to pull the economy out of the deep ditch that 50 years of Socialismo has created.

Letting foreign agribusinesses into Cuba through direct investment is low-hanging fruit and an important opportunity. Not only should Cuba be able to feed itself, it ought to be able to produce ample surpluses for export to plug the drain on reserves.

Another good place to start is the Mariel Deepwater Port Project, a joint endeavor begun in 2009 with the Brazilian government, which contributed $800 million in financing. The project is still under construction. Cuba has awarded the contract for operating the port to a Singaporean company. There are scores of proposed foreign projects waiting approval. In the long run, a lifting of the US Embargo and the completion of the expansion of the Panama Canal will buoy the Mariel project. But it will still have to be competitive for transshipments with other Caribbean ports. For that to happen, Cuba needs to get much more aggressive in approving FDI proposals for Mariel that make economic sense. Perhaps this is starting. One of the world’s largest shipping companies, CMA-CGM of France, just signed a deal to establish a large logistics hub at Mariel.

The tourism sector offers yet another FDI opportunity. The Cuban buzz has already attracted many more tourists than before, but they are having trouble finding places to stay in. Most of the hotels are government run and dilapidated without much room or appeal. It would be both smart and easy to sell (or lease) the old hotels to European or Latin hotel companies to redo and then run. Some of this has already happened, although the latest trophy property is Havana is being developed by the Cuban Army. Meantime, Airbnb is hoping to sign up the adventurous and budget-conscious for vacations in Cuban family apartments.

Finally, beginning a long overdue effort to modernize the Cuban banking and financial sector has to be a high priority. Such an effort takes a long time, and will need much in the way of imported knowhow. Advice on modern central banking and prudential regulation is available from the World Bank and the IMF, even though Cuba is not a member of either one, or from the US Federal Reserve or the European Central Bank. All of these agencies should be willing to help, if asked, on the assumption that Cuba will join the IMF sometime in the future.

In the meantime, teaming up, for example, with an important Mexican bank to create a payments and clearing system for retail checking accounts, and developing a structure for credit facilities would be very useful. Even better, run a competition to charter 3 or 4 foreign banks and let them complete for the Cuban market – no need to reinvent the wheel – though the Castros may object to letting foreign banks gain a large share of the Cuban market.

 For years Cuba has blamed it’s lack of economic progress on the US embargo, but there is no embargo on FDI and trade with the rest of the world. The more Cuba moves to encourage diverse foreign investment from the rest of world, the more US companies will pressure Congress to lift the embargo.

It is asking a lot of Rául Castro to have a clear vision of the economic and financial system he wants to bequeath to the next generation of Cubans. Such things are hard to envision, even by experienced economists. But there has to be a starting point, as all the former socialist transition economies came to appreciate.

            Getting FDI right in the beginning will make more difference to economic rejuvenation than anything else Mr. Castro might do.

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.