Shrunken Street
By Francesco Guerrera and Ben White
Published: May 19 2008 03:00 | Last updated: May 19 2008 03:00

Bill Winters' New York office is so large and sparse that he could easily take a small victory lap without bumping into any furniture. But on a recent visit, the co-head of JPMorgan Chase's investment banking division was not in a celebratory mood.

JPMorgan has weathered the financial turmoil better than most rivals and harnessed its relative health to buy Bear Stearns, a coveted rival, at a bargain basement price. But despite the headlines proclaiming Jamie Dimon, JPMorgan's boss, the new "King of Wall Street", Mr Winters - a seasoned banker with a keen memory of past crises - believes this is no time for coronations.

"It is the most important period in my 25 years in the industry," he says. "We have been in a 20-year bull market. Aside from the odd blip, we have not seen a fundamental market dislocation such as the current one in a very long time."

Mr Winters is not alone in sensing that the havoc wreaked by the credit crunch on the US financial services sector has left Wall Street at a historic juncture. As US banking leaders pick through balance sheets devastated by billions in mortgage-related losses and try to salvage their credibility with shareholders angered by the slump in share prices, they face decisions that could shape the industry for years to come.

"I don't regard this as a mere cyclical downturn," says a veteran US banking executive. "There is going to be a fundamental change in the structure of the industry. Periods like these give rise to once-in-a-lifetime opportunities."

The main unknown is what kind of financial industry will rise from the ashes of the current crisis. Will investment banks such as Goldman Sachs and Morgan Stanley lose their edge over broader-based institutions such as JPMorgan as investors and regulators curtail their ability to boost profits with risky trades and mountains of debt? Will weakened firms such as Lehman Brothers and Merrill Lynch fall prey to commercial banks such as Bank of America and Wells Fargo? Can Citigroup, a wounded giant in desperate need of a boost, overcome its managerial and operational shortcomings to fend off calls for a break-up?

The answers to those questions will depend on how the credit crunch plays out in the coming months. A recent spurt in the stock market and signs of defrosting in parts of the credit markets, such as leveraged loans, have sparked some optimism among Wall Street executives. Industry titans such as Mr Dimon, Morgan Stanley's John Mack and Goldman Sachs' Lloyd Blankfein have publicly ventured that we are closer to the end than the beginning of the crisis.

In private, however, few others believe Wall Street is out of the woods. Pessimists point to the fact that, even after some $300bn of losses and writedowns on derivatives and securitised products, many financial services groups have yet to wake up from their credit nightmare.

This month AIG, the world's largest insurer, plunged to its biggest quarterly loss since its listing in 1969 after suffering $15bn in fresh writedowns on credit derivatives. Even Warren Buffett's Berkshire Hathaway had to withstand a surprise $1.6bn loss on derivatives in the first quarter - a mishap that reinforced the billionaire investor's famous description of the asset class as "financial weapons of mass destruction".

A recent report by Moody's, the credit rating agency, predicted that Merrill Lynch - which has already suffered more than $30bn in writedowns and losses - faced a further $6bn loss on its mortgage-related securities, while BofA could take another $2bn writedown. Other analysts expect a similar fate to befall the rest of the banking sector for the next few quarters as commercial banks, investment banks and brokerage houses struggle to rid themselves of billions of dollars in toxic assets.

But the prospect of more capital market disruption is not the only fear haunting the inhabitants of Manhattan's wood-panelled corner offices. Wall Street is growing increasingly concerned at a new source of troubles for the financial sector: the over-exposed US consumer. After being rocked by derivatives and other exotic products, banks, particularly those with large retail business, have been hit by the double-whammy of a slump in consumer spending and a sharply slowing domestic economy.

"The crisis has so far been driven by capital markets but it is quickly spreading to the real economy," says an executive at a Wall Street firm. "There is a hell of a lot more bad news to come on that front."

Some of it is already beginning to seep out. With consumer confidence at a 28-year low and the number of unsold homes on the market at a 26-year-high, "maxed out" Americans are falling out of love with their credit cards.

Charge-off rates - credit-card balances that the banks have given up on recouping - have already overshot their long-term average. Yet they remain some 26 per cent below the peak reached in 2003, a full two years after the beginning of the last recession, in a clear sign that the worse may still be to come - especially if employment levels and economic growth continue to fall.

The rapidly deteriorating health of the US consumer has not been lost on the nation's biggest lenders. Over the past few months, banks such as Citi, JPMorgan, BofA and Wells Fargo have added billions of dollars to their reserves to build a sizeable cushion against future losses.

If the eye of the credit storm does move from the trading floor to Main Street, commercial banks and the consumer businesses of "universal banks" are likely to suffer most. "We have only seen the beginning of loan losses at commercial banks," says Mike Mayo, an analyst at Deutsche Bank.

But even if the likes of Citi and BofA appear more exposed to the next wave of problems, investment banks such as Goldman and Morgan Stanley can hardly rest easy. Aside from further writedowns, they face a structural shift in their business model that could limit their scope to increase profits at the heady rates of the past few years.

The convulsions in capital markets and Bear's implosion are almost certain to usher in new rules that will hit earnings growth at investment banks by curbing their ability to take debt on to their balance sheets. A regulatory overhaul expected over the next few years is likely to strip the Securities and Exchange Commission of its powers over investment banks and hand them to the Federal Reserve. In return for acting as a lender of last resort to brokers, the Fed is likely to curb debt-to-equity ratios, also called leverage.

This would bring them in line with the Fed-regulated commercial banks, whose leverage levels are much lower. That, in turn, would force investment banks to sell off positions, reduce their activity in areas such as prime brokerage - lending to hedge funds - and slash costs to safeguard profits. "We would have to shrink to grow," is how a worried executive at a Wall Street firm puts it.

The shifting regulatory landscape, coupled with the painful experience of the credit crunch, has highlighted the risk taken by investment banks that rely on flighty capital markets without the buffer of a deposit base.

Once criticised as "lazy" low-margin assets, consumer deposit accounts proved a boon to banks such as JPMorgan - and were sorely missed by casualties such as Bear. Some Wall Street executives believe that investment banks will look at building a retail deposit base, perhaps by buying into insurance or other steady annuity businesses - or be driven into the hands of a commercial banking partner.

The investment banks viewed as the most likely takeover candidates are Merrill Lynch and Lehman Brothers.

Ken Lewis, BofA chief executive, is now famous for saying late last year that he had endured "all the fun" he could handle in the investment banking business following big mortgage-related trading losses.

But he is thought to covet Merrill's blue-chip brokerage network and might be more comfortable buying an investment bank than building one himself. BofA has its own consumer loan loss problems and will be occupied for much of the rest of this year with the integration of Countrywide, the troubled mortgage lender it bought for $4bn. After that, a bid for Merrill would not be a huge surprise.

John Thain, Merrill Lynch's recently installed chief executive, has insisted that Merrill is not for sale. "But at the right price, of course it is," says a senior financial institutions banker.

Lehman's management is widely admired on Wall Street and was instrumental in helping the bank survive rumours about its liquidity position in the days after Bear's collapse. But despite aggressive diversification efforts in recent years, the bank is still viewed by many as too reliant on domestic fixed-income revenues and is seen as a likely takeover candidate for a big overseas bank such as HSBC.

Should this consolidation occur, just two pure investment banks would be left standing: Goldman Sachs and Morgan Stanley.

But even Morgan Stanley is occasionally mentioned as a possible takeover target for JPMorgan's Mr Dimon. Such a deal, reuniting the historic House of Morgan seven decades after its split, is a sentimental favourite, but it is not viewed as likely given the huge overlap in the two institutions' investment banking activities.

If Mr Dimon does not target another investment bank, however, he is certain to move in coming months to build JPMorgan's retail business in the US. He has made an approach to Washington Mutual, one of the largest US regional banks, but had his offer dismissed as too low. He could try again if WaMu runs into further troubles with its mortgage portfolio or turn his sights to other regional banks such as SunTrust in Atlanta or Pittsburgh-based PNC.

Once the current round of recapitalisations is complete and would-be buyers are convinced further large mortgage losses are unlikely, big banks in the Midwest such as Comerica, Fifth Third, National City and Key Corp are expected to sell to larger, more profitable rivals such as Wells Fargo.

The expected merry-go-round of consolidation is almost certain to shake up the balance of power on Wall Street: as stronger players such as JPMorgan expand, weaker competitors such as Citi retrench.

Vikram Pandit, the latter's chief executive, provided a graphic example of this trend this month when he announced an aggressive plan to shed some $500bn in non-core assets from the company's $2,000bn-plus balance sheet.

The move confirmed the view of many Citi-watchers that the bank's plight, which forced it to record two consecutive quarters of billion-dollars losses and take huge writedowns on mortgage bets, is so serious that its only hope of surviving constant calls for a break-up lies in a dramatic shrinkage of its business.

To many experts, this redrawing of lines is a natural by-product of a crisis as deep as the current one. John Ott, a partner at Bain, the management consultancy, believes that the tough times will motivate more groups to refocus on their core competencies and sell their also-ran businesses. "Regulators and shareholders will force banks to shed non-core businesses and go back to what they do best," he says.

If "back to the core" does indeed become an industry slogan, the next few years will be marked by a flurry of smaller deals - such as Citi's recent sales of its leasing unit and Diners credit card operations - rather than a swathe of mega acquisitions.

"Crises have traditionally forced structural changes in our industry," says a veteran Wall Street executive. "But my guess is that large mergers are going to be off for some time because management teams and boards are deeply sceptical of the current valuations. What we are going to look back on is a collection of sales of smaller businesses."

That, in turn, will challenge the strategic nous and tactical mettle of Wall Street's ruling elite - a particularly important test for chief executives such as Mr Pandit, Mr Thain and Mr Blankfein, who have never led a financial institution during such a turbulent period.

Wall Street's finest may still be treated as kings, but their focus for the next few years will be to ensure that their realms do not dwindle yet further.

 

Copyright The Financial Times Limited 2008