Why Painewebber Got Out Of The Kitchen

For PaineWebber Inc., the turning point came in late 1990. Despite some profitable years, management decided it was too much of a crapshoot to stay in the business of proprietary trading--using the firm's money to trade for its own account. In a total about-face, the sixth-largest brokerage firm shut down almost all of its proprietary-trading desks. "I just don't understand how you can run a company and have this type of volatility. I don't think the losses are controllable," says Lee Fensterstock, who became executive vice-president and director of capital markets at PaineWebber Group in January, 1991.

Instead, PaineWebber decided to focus on executing big trades for institutional customers, earning commission income as a broker, rather than from its own trading. Good move? It seems so.

After three years of barely breaking even, the firm's institutional sales and trading business in 1991 earned $88 million before tax, a handsome 39% of PaineWebber's total pretax income. In 1992, the comparable figure was $142 million, or 42% of the total--more than the 41% that its retail brokerage business brought in.

True, Salomon Inc. and Morgan Stanley & Co. have earned bushelfuls of money over the years from their proprietary trading. But for PaineWebber, "it was not in the long run a money maker," says Sanford C. Bernstein & Co. analyst Guy Moszkowski.

HEADACHES. Like most Wall Street firms in the 1980s, PaineWebber embraced all types of trading with its own money--and had some good years. In 1988, the risk-arbitrage group accounted for much of the firm's $42 million earnings. By 1989, the firm had about five trading desks, with more than $2 billion in proprietary trading positions. It did U.S. stock-index arbitrage--commonly called program trading--for customers. But it considered this proprietary trading, because PaineWebber itself took substantial market risk. It also had a 30-person index-arbitrage operation in London and Tokyo.

For all that trading, however, PaineWebber never mastered the complexities of the business. And proprietary trading created many problems. "You wind up competing against your customers. It creates a potential conflict between two halves of the firm," says Fensterstock. Then, there is the tension between the 1,500 institutional sales and trading employees and about 25 proprietary traders--who can drain everyone's bonus pool. "When they win, they win, and when they lose, they can't give the money back," says Fensterstock.

PaineWebber's earnings would have been even higher last year. While it almost completely eliminated its risk-arbitrage operations in late 1990, three traders were still active. In the fourth quarter of 1992, Paine Webber took an $11 million loss on a $16 million risk-arbitrage position. It then shut down its arbitrageurs completely.

The real test will be keeping earnings strong when the Street isn't riding high. If PaineWebber can do that, abandoning proprietary trading will be the best loss it ever took.

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