Banks Didn't Deserve this Beating

Investment-bank stocks took a hit on the widening troubles in subprime lending, but S&P's Matthew Albrecht sees strength for the future

The escalating crisis in the subprime mortgage lending industry has put a crimp in financial stocks, including big investment banks and brokers that have some exposure to this once soaring business. However Matthew Albrecht, Standard & Poor's investment banking equity analyst, believes that while banks and brokers may suffer some short-term pain, they will flourish over the longer term as overall fundamentals remain strong.

For the week ended Mar. 2 (which includes last Tuesday's huge global sell-off), the S&P financials index dropped 4.9%, while its investment-banking and brokerage subindustry swooned 8.6%, the most of any financial subsector. Year-to-date, the investment-banking and brokerage subindustry is down 7.3%, about twice the drop of the whole financials sector.

Subprime lenders—which essentially handed out home loans to people with poor credit—have been shaken by rising default rates and declining housing prices, after enjoying spectacular profits earlier in the decade. Some of the latest shocks to beset the subprime industry include the disclosure by New Century Financial (NEW) of a federal criminal probe into its activities (see, 3/5/07, "Another Stumble for Subprime Lenders"), and the decision by Fremont General (FMT) to exit the business.

Nervous Investors

A number of large brokerage firms, Albrecht notes, have some exposure to subprime lenders. Bear Stearns (BSC; ranked 3 STARS, hold), Lehman Brothers (LEH; ranked 4 STARS, buy), Merrill Lynch (MER; ranked 3 STARS, hold), and Morgan Stanley (MS; ranked 3 STARS, hold) maintain some exposure to originations and securitizations, and they all hold some small portfolio of mortgages on their books. And while Goldman Sachs (GS; ranked 5 STARS, strong buy) doesn't originate mortgages, it does securitize them and holds a small portfolio of them on its books.

Albrecht, who notes that the big brokers acquired subprime originators to complete the vertical integration of their securitization businesses, is concerned that in the near term these moves will leave them "open to defaults by borrowers who originated loans recently." Albrecht indicated that while the subprime mortgage business doesn't typically represent a large portion of these banks' and brokerages' operations, they still have exposure to the independent originators in the form of lending commitments. "Many of them also originate mortgages themselves, and securitize their own mortgages in addition to ones that they buy," he adds.

Another headwind for the brokerage companies is the possibility that investors are becoming more risk-averse. "If that's the case, we may see reduced amount of leverage by investors," Albrecht says. "If investors become more risk averse, they may shy away from margin debt, and that would reduce some of the net interest income these brokers realize."

Fed Predictions

However, over the long term, Albrecht views brokerage companies' entry into subprime mortgages as a positive move, "considering they will be able to monitor the underwriting standards going forward." Albrecht also maintains a positive outlook for investment banks and brokerages as a whole, citing some positive catalysts in the market. "Investors are still flush with cash," he says. "Those that may have become more risk-averse and are no longer willing to look overseas for investments may be looking to purchase U.S.-based assets."

Plus, interest rates remain favorable, he says, and debt markets remain highly liquid, resulting in a solid M&A environment. "Additionally, the recent market pullback may have brought potential targets down to more attractive prices following a period of high multiples and rampant speculation," he says. Albrecht also notes S&P believes the recent pullback suggests that there's a higher chance the Federal Reserve may reduce its target rate at some point later in the year, "and that this has typically been a catalyst for these stocks." S&P Economics is calling for one rate cut later this year, followed by two more early in 2008.

Large investment banks and brokers now have a broader global reach than ever before, Albrecht says, another reason for his long-term bullish case. "We believe investment banks and brokers will benefit from continued GDP [gross domestic product] growth in the BRIC [Brazil, Russia, India, and China] countries and other developing regions, even in the event of a more widespread slowdown in the U.S. economy," he says.

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