Earlier this month Marc Faber caught my attention for predicting that the stocks of brokers are set-up for a fall similar to the stocks of the home builders 12 months ago. An article in yesterday’s Barron’s discusses this idea in greater detail;
NOW MIGHT BE A GOOD TIME TO RING UP THAT BROKER who put you into Ford shares two years ago and let him know his best days are probably behind him.
Following a remarkable four-year run that’s more than doubled the value of some Wall Street brokerage stocks, analysts have begun to pare earnings numbers amid worries that slower economic growth and higher rates have substantially increased the risks for this high-flying cyclical group that includes Bear Stearns (ticker: BSC), Goldman Sachs (GS), Lehman Brothers (LEH), Morgan Stanley (MS), Merrill Lynch (MER) as well as global financial conglomerates like Citigroup (C) and JPMorgan Chase (JPM).
The brokers are victims of their own success. Results have been great in all of their most important business lines, including equities, mergers and acquisitions, asset management and private equity. The firms’ prime brokerage services, which mainly serve hedge funds, have thrived, and improved markets have spurred record proprietary trading gains. Even fixed-income profits in areas like mortgage securities have held up despite the Federal Reserve’s interest-rate hikes.
“There’s nothing that can get better. Every cylinder has been firing away,” contends Charles Peabody, an analyst at Portales Partners, a New York financial-services research boutique.
Peabody is among those who believe a more hostile environment won’t allow the brokers to jump from success to success much longer. The Fed’s tighter monetary policy has drained liquidity from U.S. markets and central banks around the world have started to follow the same path. As funding gets more expensive, investors’ appetite for risk will decline, making it tougher to underwrite profitable equity and debt offerings or to continue Wall Street’s incredible streak of trading gains.
No doubt rallying stock and bond markets would continue to bolster brokers’ shares, but the odds against that occurring seem to be growing. The bottom line, says Peabody, who rates the brokers a Sell: “I think you could have earnings drop 30% next year.” That presumably would take a commensurate chunk out of the stocks.
Brian Rauscher, director of portfolio strategy at Brown Brothers Harriman, also has a Sell recommendation on the group because he believes their relative-earnings-estimate revisions have peaked. In other words, the group’s earnings aren’t going up as quickly as they had in the past. And, before this cycle ends, Rauscher believes, earnings estimates will start to get cut.
A quick reversal of fortune is possible if private-equity gains slow or margins in the prime brokerage business get skinnier because of increasing competition. A housing-industry slowdown could dramatically reduce the production of new mortgages, leaving some firms with bloated overheads. And if the recent stock-market rally turns out to be a bear-market bounce, the summer doldrums that have depressed equity underwriting volumes could extend into the fall.
The dollar value of initial public offerings in the U.S. for this summer is down 49% this year and the number of IPOs is down by 52%. Similarly, the value of IPOs worldwide is off 9% and the number is down 25%, says Thomson Financial. The decline not only hits underwriting profits but also makes it more difficult for private-equity shops — including those within Wall Street firms — to exit their investments via IPOs.
The flood of money into private equity (see Eliminate the Middleman) may ultimately shrink returns in one of Wall Street’s most profitable areas. Private-equity investments have boasted returns of 20% or more for the past three years, so everyone and his uncle has raised a fund. Total fund-raising doubled from 2004 to 2005, when it exceeded $100 billion, reports Brad Hintz, an analyst at Sanford C. Bernstein. As venture capitalists of the late 1990s can attest, excellent returns attract huge waves of capital, which in turn can kill the returns for those who are late to the party.
Goldman Sachs has the largest private-equity division on Wall Street, having raised an $8.5 billion fund last year. The company reported $354 million of gains and overrides from corporate and real- estate-principal transactions in the second quarter alone. The problem with these returns, as well as those from proprietary trading, is that they’re usually nonrecurring. So a firm must run faster each quarter to top its previous returns.
Investment banks don’t typically divulge their proprietary trading gains or losses, though most acknowledge the profits have been substantial. The success has also persuaded the firms to take on more risk with their own capital. At Goldman the average daily value-at-risk, or VaR, was $112 million last quarter, almost twice the $60 million reported a year before. VaR estimates the potential loss in value of a firm’s trading positions on a bad day.
“Everyone is extrapolating the strength of proprietary desks into the future, and I think that’s a mistake,” says Doug Kass, head of hedge fund Seabreeze Partners.
Uncertainty is evident in the wide spread of analyst opinion about Goldman’s earnings per share next year: $14.48 to $21.05. It’s also why multiples in the sector, which range between nine and 11 times ‘07 estimates, might not be as low as they first appear. If, say, 30% of earnings disappear overnight, multiples jump pretty fast.
A Goldman spokesman counters that history is on the firm’s side. “Over the course of a business cycle, our geographic, business and product diversity can be expected to deliver earnings growth, as they have in 18 out of the past 21 years,” he says.
A housing slowdown may also hurt brokerages that have built up massive businesses around residential mortgages. Last year $460 billion of home-equity asset-backed securities were sold, up from $74 billion in 2000, and $991 billion of mortgage-backed securities were issued, up from $185 billion five years prior, according to Thomson Financial.
Lehman dominates this market. In 2003 it acquired Aurora Loan Services, a residential loan originator, and it has since made additional acquisitions. Now it can originate loans, service them, securitize and sell the bonds backed by the mortgages and then trade the securities.
In the first half of 2006 Lehman originated about $31 billion of residential mortgage loans. It also purchased loans in the open market and pooled them to securitize $67 billion of residential mortgages in the first six months of the year. But not everything is securitized every night. At the end of the second quarter, Lehman had $4.2 billion of loan inventory on its books.
The firm also held about $800 million of non-investment-grade interests in securitizations at the end of the quarter. Underwriters often retain the most junior, risky pieces of a securitization if investors won’t. The value of these volatile residual securities typically are hit first if more mortgage holders than expected default or prepay their mortgages. It’s unclear how much of Lehman’s inventory is hedged for interest-rate or credit risk, and the firm declined to comment. In any event, Lehman seems to have a vested interest in the continuation of the housing boom.
While Lehman and Bear Stearns have the most active mortgage operations, juicy profits have lured others into the game. Most recently Morgan Stanley purchased Saxon Capital, which originates and services subprime residential mortgages, for $706 million.
If the residential mortgage market declines — as the 25% year-over-year drop in mortgage applications suggests — brokers might soon find they have lots of folks looking for something to do. The firms hope their origination arms will gain market share to keep the flow of mortgage loans going. They’re also eyeing the reset of adjustable-rate mortgages in the next few years and the global expansion of the mortgage business as new sources of business.
The prime-brokerage business also runs the risk of disappointing investors. Morgan, Goldman and Bear Stearns control almost two-thirds of this business, estimates Hintz of Bernstein. The shops cater to hedge funds and lend out stock to cover short positions, provide cash-management services, lend on margin, clear trades and provide reporting and custody services.
Hedge-fund clients tend to execute about 20% of their trades on their prime broker’s equity desk. Hintz estimates the hyperactive funds now generate 30% to 35% of the U.S. securities industry’s equity commissions. Their high portfolio turnover and interest in exotic — read: higher-margin — securities makes them hugely attractive Wall Street clients.
Here, too, competition has arrived and profits will be tougher to come by. Merrill, Lehman, UBS and Deutsche Bank are among those who have jumped in. Hedge funds increasingly split their prime business among two or three players instead of staying with just one shop.
And the business may be getting riskier as new entrants offer easier borrowing terms, says Hintz. Firms are more inclined today to lend the same amount against a security or a portfolio for 30 or 60 days, whereas in the past the loan varied daily with changes in the security’s price. Such a change exposes the broker to more risk should the value of the security drop sharply. Newer entrants are also extending loans against entire portfolios instead of against specific securities.
“They’re becoming liquidity guarantors to the hedge funds,” says Hintz, who has Market Perform ratings on Goldman, Morgan, Bear and Lehman, and Outperform ratings on Merrill and JPMorgan Chase.
Morgan Stanley’s prime brokerage unit, says a spokesman, expects “demand for these types of services will increase, not decrease, as modern asset managers trade in an increasing number of different asset classes and markets.”
Hintz estimates that Morgan and Goldman’s prime-brokerage pretax net income will rise about 12% annually over the next few years, down from the 20% gains enjoyed in past years. Bear Stearns, which has the most exposure to domestic business, is the most vulnerable of the three and may find it can increase the group’s bottom line by only 3% in that time.
Growth like that might not satisfy investors who’ve come to expect much more from their brokers.
I plan on taking a short position on the brokers this week. My favorite short candidates are Lehman Brothers (NYSE:LEH) and Bear Stearns (NYSE:BSC).
