David H. Komansky, CEO of Merrill Lynch & Co., is a gregarious, even jolly man. Yet on Oct. 6, during the International Monetary Fund annual meeting in Washington, he was uncharacteristically grim. Referring to a sobering day of client meetings the day before, Komansky says, "the fear and depression are terrible."
Komansky is not just feeling his clients' pain. He is deciding how much to shrink head count and capital committed to various world markets, in anticipation of a continued slowdown in underwriting and trading. When Merrill announces its third-quarter earnings on Oct. 13, it is expected to announce that 3,000 employees out of 60,000 will be pounding the pavement. J.P. Morgan and Citicorp are also planning 5% staff cuts.
GRAPHIC PROOF. The global contagion has hit Wall Street with a vengeance, and nobody is safe. On Oct. 7, spooked by Federal Reserve Chairman Alan Greenspan's dour comments, the ten largest money-center and investment banks all hit new lows in the stock market, with Lehman Brothers Inc. down 72%, Merrill down 66%, and Chase Manhattan Corp. down 50% from their 1998 highs. Commercial and investment banking analysts are slashing their estimates, and rating agencies are awash in downgrades for financial firms. The $3.6 billion bailout of Long-Term Capital Management came too late to save the $700 million in losses at giant Swiss bank UBS and alarmed Congress about financial institutions' exposure to hedge funds.
Wall Street, along with the commercial banks, is also facing a new threat: world disillusionment with unfettered capitalism. Will governments allow global capital markets to continue to operate freely? At the IMF conference, World Bank officials, finance ministers, and even hedge-fund billionaire George Soros called for capital controls and stricter regulations and disclosure for banks, brokers, and hedge-funds worldwide. This is bad news for the U.S. financial industry. "We're at a turning point for global capitalism," says Robert D. Hormats, vice-chairman of Goldman Sachs International. "If you inhibit capital flows in a serious way, emerging-market growth prospects diminish. That's bad for everyone, including Wall Street."
For the once mighty masters of the universe, the new environment is depressingly down-to-earth: a significant slowdown in their major businesses, further losses, shrinking balance sheets, shriveled bonuses, layoffs, greater regulation, and consolidation. "It will be a period of lower earnings with probably some cutbacks of personnel and rationalization of business strategies," says Jerome P. Kenney, executive vice-president at Merrill. On Oct. 6, Merrill's brokerage analyst even recommended dumping certain brokerage stocks.
Commercial banks have been feeling pain for months, and there seems to be no letup. J.P. Morgan and Bankers Trust are the money center banks that are expected to fare the worst, says CIBC Oppenheimer analyst Steven Eisman. Not only do they have major investments in emerging markets, but they are dependent on proprietary trading for some 30% of their bottom line. "Today, those trades are producing losses," says Eisman. The consensus forecast for Bankers Trust is a $350 million third-quarter loss. Even though that's less than 3% of its $11 billion capital base, its stock hit 136 last spring, and is now around 49 3/16. "There's no place you can hide from the global crisis," says Nancy Bush, a bank analyst for Ryan Beck & Co. "In 1988, we understood that the problems in the banking sector were commercial real estate. But this--this is much less definable. We may enter a period where banks just decide to circle the wagons."
The current flight to quality is hurting weaker, less diversified players, as Bankers Trust's stock slump shows. "1998 is a tough year, and 1999 will potentially be tough," says Charles G. Ward III, managing director, Credit Suisse First Boston. "But the strong firms will be fine. The weaker firms will be pushed out." Historically, this means the foreign banks that piled in late, such as second-tier French and German banks.
RUMORS, RUMORS. Market confidence is the key, since financial firms are highly leveraged institutions that fund themselves by rolling over short-term commercial paper. Witness the recent travails of Lehman. The firm has been plagued by rumors, most of which appear to be false: that it sustained huge losses when a satellite it owned blew up; that it had $5 billion of LTCM related losses; that the Fed was pressuring BankAmerica Corp. to acquire Lehman. Says Richard A. Grasso, the chairman of the New York Stock Exchange: "They've gotten hit with lots of rumors and innuendo, none of which is true."
But in an extremely nervous market, the perception of a problem can be as damning as the real thing. Analysts are worried that Lehman is too dependent on bond trading and not diversified into more stable areas such as asset management.
The immediate issue for Lehman and others is, are investors still willing to own its debt? Already, Lehman is paying top dollar to raise money: Its one-year debt is selling at about 3.65 percentage points above the London Interbank Offered Rate, vs. 1% above LIBOR earlier this year. Lehman has equity capital of $5.3 billion that supports a $134 billion balance sheet, a typical degree of leverage. Its total long-term debt and equity is $34 billion. But it has $7.7 billion in commercial paper outstanding with an average maturity of more than 100 days that has to be constantly rolled over.
Lehman chief executive Richard S. Fuld says Lehman is in good shape to weather the storm. It's still selling its short-term paper, and it has almost doubled its long-term Capital in the past two years. "The marketplace is beginning to realize that all of these rumors are totally bogus. The firm is strong and stable, and the market is realizing that," says Fuld.
Even the strongest firms hunker down in times of high risk and volatility by reducing assets. That by definition reduces earnings and return on equity. The best brokerage firms have posted ROEs for the past four years of 25% to 30%. Now, they will be lucky to get ROEs of 15%. "Financial firms are shrinking their balance sheets," says Sanford C. Bernstein analyst Sallie L. Krawcheck. "If they don't have the big balance sheets, they can't earn the same returns."
U.S. financial institutions may also be headed into a more unforgiving regulatory environment. Arthur Levitt Jr., the Securities & Exchange Commission chairman, is under congressional pressure to beef up the SEC's scrutiny of securities firms. This could lead to ongoing examinations of the firms' books and records to gauge their exposure to hedge funds.
There are a few bright spots. Lower-priced companies mean potential bargains for leveraged buyout firms, which have about $100 billion ready to spend. Apply a modest amount of leverage, and that's $400 billion of spending power.LBO firms may even get financing in the middle of a credit crunch, thanks to a resurgence in mezzanine lending, which is privately placed subordinated debt that will finance LBOs, says CSFB's Ward.
But that is little consolation to owners of financial-services stocks. With all the recent wealth destruction, many bankers have been personally pounded. For example, as much as half of the 1997 bonuses of top Merrill Lynch bankers were paid in Merrill stock, which has cratered from 109 to 37 3/4. In a word: Ouch!