Commentary: Now Brokerages Have to "Pay (More) to Play"

By Emily Thornton

It must have been a frustrating moment for Merrill Lynch Chairman and CEO David H. Komansky. On May 11, the captain of America's No. 1 retail brokerage acknowledged in a CNBC television interview that, in theory, combining Merrill's investment-banking muscle and HSBC's huge balance sheet could "make sense." His remarks sparked a flurry of speculation that London-based banking giant HSBC Holdings PLC (HBC ) planned to take over Merrill Lynch & Co. (MER )--even though Komansky repeatedly said no deal was in the works. "You don't merge with someone twice your size. You get acquired. We don't want to be acquired," he emphasized on May 14. HSBC denies a pending deal, and analysts don't expect one any time soon.

But the buzz highlights the latest woe on Wall Street. "The continued speculation underscores the need for scale and the growing importance of the balance sheet in the investment banking business," says Henry McVey, securities-industry analyst at Morgan Stanley. What McVey means is that in a world of decimated initial public offerings and mergers and acquisitions, investment banks are now being forced to offer all types of financing to clients, including credit lines, to land lush investment banking deals. These offers take the form of everything from bridge loans to low-margin commercial paper. "It is what is being called on the Street `pay to play,"' says Tanya Azarchs, managing director of financial-institution ratings at credit rating agency Standard & Poor's Corp. "If brokers want to play in the sweet spot of the market, they also have to pay."

It's a thorny issue that is not going away any time soon. Megabanks such as J.P. Morgan Chase Co. (JPM ) and Citigroup Inc. (C ) are on the warpath. They believe that by offering companies a one-stop financial shop where they can get everything from credit to merger advice, they can grab investment-banking business from rivals Goldman Sachs (GS ), Morgan Stanley (MWD ), Merrill Lynch, and Lehman Brothers (LEH ). "We love markets like this," says Donald McCree, co-head of the North American credit-markets business at J.P. Morgan Chase. "We view it as an opportunity to gain clients."

To some extent, they're right. On May 9, J.P. Morgan, a unit of J.P. Morgan Chase, earned $34.5 million for jointly issuing $11.8 billion in corporate bonds for a new client--long-distance phone service operator WorldCom Inc.--with Salomon Smith Barney, a unit of Citigroup. J.P. Morgan believes it landed what turned out to be the largest-ever bond deal for a U.S. issuer partly because it was also able to help the company out with a $4.5 billion loan. Salomon Smith Barney now ranks as the No. 2 issuer of both debt and equity worldwide, with a market share of 11.7% (chart). And it is quickly gaining share in equity underwriting, handling 9% of all equity issued worldwide so far this year, up from 7.6% in 2000, according to Thomson Financial Securities Data Corp.

PRESSURE COOKER. Brokerage executives acknowledge they may need to use more of their own capital to finesse deals. Gone are the days when a little good advice guaranteed a successful IPO. "We are under pressure to help clients finance deals. We will respond as always using our balance sheet with caution," Morgan Stanley Chairman and CEO Philip J. Purcell said at a Goldman Sachs financial-services conference on May 14.

The problem for investment banks is that it is more difficult for them to lend at razor-thin margins. Unlike banks, they do not have cheap deposits to draw from. Moreover, investment banks must value their loans each day at market prices, which forces them to acknowledge potential losses on their positions.

Does all of this mean that brokerages like Merrill will give up the fight--and their independence? "Companies with delicate cultures like Merrill are going to be very wary of changes," says Guy Moszkowski, securities-industry analyst at Salomon Smith Barney. But creating a balance sheet that would rival Citigroup's by teaming with HSBC sure would make Merrill's life easier.

Thornton covers investment banking in New York.

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