Wall Street: The Big Chill

A shakeout and hard times loom as one golden market after another dries up and old reliables falter

Richard S. Fuld Jr. is not sure how long the recession will last. But the chairman and chief executive of Lehman Brothers Inc. (LEH ) does know that he will have to move most of the staff who used to work at the firm's former headquarters next to Ground Zero into a new 32-story skyscraper in midtown Manhattan he will buy from rival Morgan Stanley Dean Witter & Co. (MWD ) for about $700 million. And he's certain how much worse business on Wall Street has gotten since September 11. "We were already headed into a recession," Fuld says. "Now mergers are way down, initial public offerings are way down, and financing markets are down."

Wall Street will never be the same. In time, the devastation in New York's financial district will be repaired. But by then, many firms will likely have dispersed--uptown, out of Manhattan to other boroughs, or to neighboring states. What's more, the way Wall Street works will change. Gone will be the gilded age of excess fired by a global infatuation with the stock market. A humbled financial-services industry will have to scrape by on a sparser diet of lower-margin business and far fewer deals. At the same time, it must strive to rebuild its credibility, shattered by overinflated deals, rosy-spectacled stock recommendations, and charges of conflicts of interest.

A dramatic shakeout is at hand in the $600 billion financial-services industry. Investment and commercial banks, brokers, money managers, and mutual-fund companies will all have to slash costs to survive the drop in business. That means deep staff cuts. Investment banks will be particularly hard hit: They are still staffed for boom times, with payrolls accounting for about half of their outlays. Credit Suisse First Boston (CSR ) plans to prune $1 billion of operating expenses next year, 70% of it by cutting 7% of its 27,500 employees. "We face a far more severe economic environment than anyone imagined prior to the tragedy," Chief Executive John J. Mack told employees. Even so, CSFB's head count will be one third higher than when it bought Donaldson, Lufkin & Jenrette last year. Goldman Sachs Group Inc. (GS ) may cut 400 people in October: It now has 23,000 employees, vs. 14,000 in 1999. And Morgan Stanley could lay off 10% of its 2,000 investment bankers.

As the pain spreads, the pressure to build new financial behemoths on the lines of Citigroup (C ) will grow. More than ever, commercial banks--including foreign ones--are trying to make inroads into high-margin investment-banking businesses such as advising on mergers, arranging IPOs, and asset management. Weaker firms are being pushed to the wayside as the number of deals dwindles and clients flock to the players with the deepest pockets. "You'll know the big game is on when we see transcontinental, trans-industry mergers, and they will be in the $100 billion range. That is going to be the endgame. And we're about there," says Philip J. Purcell, chairman and CEO of Morgan Stanley.

With more firms fighting over fewer opportunities, power is shifting to clients. Companies such as Ford Motor Co. (F ) are playing investment banks off against commercial banks by offering commercial lenders a crack at lucrative investment-banking deals and asking investment banks for credit lines to keep that business. In the process, they're undermining Wall Street's cozy cartel, which exacts fees as high as 8% for IPOs and 3% for mergers, according to Thomson Financial Corp. "I'm ready," says Beth Acton, vice-president and treasurer at Ford. "Many corporations have been looking at their overall investment-banking and commercial-banking relationships recently."

FALLEN STARS. Whatever happened to the Masters of the Universe? They rode the equity culture for all it was worth. But they were thrown when the high-tech bubble burst. And now they're floored by the rush of investors and companies to safe havens such as bonds. Even before the attacks, the financial system was under duress. Banks were wobbling under a pile of bad loans that had doubled in a year, to $192 billion. Hedge-fund stars such as George Soros and Julian H. Robertson Jr. had self-destructed. Mutual-fund investors had lost their appetite for equities. And online brokers were limping from the dramatic fall in trading, while traditional brokers were struggling to make profits from the dirt-cheap commissions they had to offer to compete.

Angry investors and corporate clients turned on Wall Street with a vengeance--slapping investment banks with lawsuits that could cost up to $5 billion to settle. The Securities & Exchange Commission and the U.S. Attorney's Office launched a major investigation into possible irregularities by banks and brokers during the great IPO boom. Ben Coes, chairman of Cambridge (Mass.) software startup Beachfire Inc., is bitter that investment bankers took his fledgling company public last year even as the Nasdaq market went into steep decline. "Bankers and venture capitalists were doing something that ultimately was not good for the economy," he says. "Was their advice good? No."

Today, the downdraft is even worse. September 11 accelerated the economic slowdown and left Wall Street panting through a business drought that some executives fear might last up to three years. Right now, investment banks are hanging on by issuing bonds, which have lower margins, or trading. But even that revenue could sputter out should the markets be numbed by terrorism. If that happens "it will get ugly," warns Henry McVey, securities industry analyst at Morgan Stanley.

Commercial banks, their earnings sagging from write-offs on loans and venture-capital losses, are racing to contain billions of dollars of exposure to airlines, insurers, and hotel chains. And hedge funds, which usually shine in crises, lost money in September, even if they beat the Standard & Poor's 500-stock index. "If there is a long recession that lasts for a year, you'll see [the financial-services] business really change," says CSFB's Mack.

BULKING UP. Propelling the industry down this path is a group of hard-charging bosses with an insatiable appetite for deals. According to Wall Street's conventional wisdom, commercial banks that have already morphed into giants could try to finish off traditional brokerages and investment banks. HSBC Holdings (HBC ) CEO John Bond has snapped up two American companies, Republic Bank of New York and Safra Holdings. And he won't rule out a future bid for No. 1 brokerage Merrill Lynch & Co. (MER ) Deutsche Bank (DB ), which made a run at J.P. Morgan last year before it fell into the arms of Chase Manhattan, can pay for deals in shares after listing on the New York Stock Exchange on Oct. 3.

Investment banks--especially the larger ones--also want to bulk up. Morgan Stanley's Purcell is mulling a string of deals to strengthen the firm's ability to raise capital and advise big clients such as pension funds from Tokyo to Frankfurt. In the U.S., he's eyeing money managers and retail brokers. Goldman Sachs Chairman and CEO Henry M. "Hank" Paulson wouldn't mind picking up a money manager, either. "We're always looking for something that adds value," Paulson says.

The fault lines between the strong and the weak are widening as companies and big investors such as mutual funds and insurers become choosier about whom to rely on for advice. "If you don't see one of the top few investment banks on a deal, you have questions right off the bat," says Joseph W. Skornicka, co-manager of Invesco Financial Services Fund. So investment banks are shaking up management teams and axing nonessential investments. Within three weeks of the attack, Merrill Lynch's new president, E. Stanley O'Neal, appointed new heads to run the firm's four core businesses.

Keeping employees motivated will be tough. Compensation consultant Johnson Associates figures investment bankers' pay will be at least halved this year. Senior bankers' compensation will probably tumble 80%. "Someone getting $3 million will get $1 million," says Alan Johnson, head of the firm. Bankers who survive the cuts may never again get the multiyear guaranteed payouts they earned during the good old days. For one thing, business on which they earn bonuses may not recover much. "Mergers and acquisitions and equity issuances could stay at this level or be 20% higher," says Michael Carpenter, head of Citigroup's Salomon Smith Barney corporate- and investment-banking unit. Besides, juggernauts will increasingly use teams to serve clients, leaving no room for overpaid lone rangers. "It's over," says Mack. "There will be no more multiyear contracts at CSFB."

The biggest threat still comes from the integrated megabanks. Citigroup's market capitalization at $215 billion is four times bigger than that of the largest investment bank, Morgan Stanley. Besides, Citi and J.P. Morgan Chase (JPM )--another behemoth built around a core commercial bank--already account for over one in three of the world's mergers. And they think it will be even easier to grab market share from investment banks during tough times. Along with other hybrid banks such as UBS Warburg and Banc of America Securities, they're determined to carve out a larger chunk of the $16 billion in fees Wall Street could earn this year by raising capital for companies, down from $26 billion in 2000. "We believe it's a huge opportunity," says John Costas, president and chief operating officer of UBS Warburg. For example, Salomon Smith Barney and others scored big points with Nashville's Gaylord Entertainment Co. (GET ) on Oct. 5 by lending up to $210 million on terms agreed on before September 11. "That means a lot to me," says Gaylord's CEO, Colin V. Reed. "And it will mean a lot when the times get good again."

Investment bankers say they've beaten back raids on their business before. But the commercial bankers are clearly making them nervous: Investment bankers have started to fight back by extending credit to VIP clients themselves. "We've taken that competitive weapon away," says Morgan Stanley's Purcell.

Commercial banks are eager to muscle investment banks because they face a raft of problems themselves. Many of the biggest banks are still working through high-price investment-banking acquisitions and trying to reduce expenses. J.P. Morgan Chase has cut 8,000 jobs this year, 20% more than expected when it merged last September. "Mergers are about a certain redundancy," says CEO William Harrison. "Anytime you have an economic downturn, you have overcapacity."

Earnings growth at big banks is set to tumble sharply. Analysts predict their profits will rise only 4% to 8% next year, sharply down from 1999's double-digit returns. Many banks are saddled with more bad loans than they had in the 1990-91 recession, when some went to the wall. Today, analysts say, nearly 8% of $1.56 trillion in outstanding credit-card debt, much of it backed by banks, could go bad in the next 12 months. As a result, banks are having to increase loan loss reserves. For example, U.S. Bancorp alone took a $693 million charge on Oct. 5.

Still, the giant banks insist they're sitting in the driver's seat because they have more capital now. "Like anyone with a commercial-loan portfolio, we're expecting more losses," says Harrison. "But that's why you have capital. Our model has a huge advantage."

The same can't be said by online brokers. Large players, such as Charles Schwab & Co. (SCH ) and E*Trade Group Inc. (ET ), also had ambitions to become one-stop shops for financial services. But those plans are being stymied by a drop in online trading. Consider Gordon L. MacPherson, president of a digital-video firm in Rockland, Mass., and an E*Trade customer since August, 1998. He used to make as many as 30 to 40 trades a day. Now, he makes at most one or two trades a month. "It doesn't make sense anymore," he says.

Now it looks more likely that many of the online crowd will be folded into the megabanks. Even Schwab has been forced to lay off 6,000 of its 26,000 staff, as its earning are expected to fall by a third to about $465 million this year. Some analysts still believe the likes of American Express (AXP ), J.P. Morgan Chase, or Wells Fargo (WFC ) could still buy E*Trade. Those that aren't acquired by larger players may have to merge with equally weak rivals.

FEE FALL. Money managers, too, look more vulnerable. Their fees have fallen along with the stock market and the value of the assets they manage. Savers are yanking money out of equity mutual funds--almost $40 billion in September alone--and scurrying into bond and money-market funds, which earn lower fees. Big mutual-fund families such as Oppenheimer Funds, Janus, Fidelity Investments, T. Rowe Price, and Putnam are laying off employees, and some are nixing underperforming funds. But analysts don't think they're being aggressive enough. "Managers are not going to be able to cut deep or quick enough to offset the revenue fall-off," says Glenn Schorr, senior analyst at Deutsche Banc Alex. Brown.

Some hope to find salvation on the acquisition trail. Eaton Vance bought Fox Asset Management and Atlanta Capital Management in October for more than $107 million, while Legg Mason (LM ) bought Royce & Associates for $115 million and could pay an additional $100 million based on performance. These deals may herald a wave of acquisitions of midsize firms that could engulf the likes of Bessemer Venture Partners and Neuberger Berman. But the shakeup "won't be limited to small fund complexes," says consultant Steven E. Bueller, national director of Asset Management Services at Ernst & Young.

But bulking up alone is no panacea. Wall Street's latest Holy Grail of creating conglomerates to provide all financial services to all people, along the lines of Continental Europe's universal banks, has lost some of its luster. "The challenge isn't why aren't we bigger, it's how with 20,000 people do we stay as special as we were with 5,000," says Goldman's Paulson.

Financial juggernauts that raced to be able to sell everything from equity to loans and insurance to credit cards are not home free yet. "Their greater diversification should have brought them greater stability," says Tanya Azarchs, financial-services analyst at Standard and Poor's. If it doesn't, "we could lower our ratings." Even mighty Citigroup, which has become so big that it considers itself in a league all its own, announced that it will have to take a $700 million charge in the third quarter because of insurance and bank branch losses related to September 11.

Further signs of strain may appear if large numbers of companies start to default on loans. "The conglomeration has increased the amount of risk in the entire system," says economist Henry Kaufman of Henry Kaufman & Co. "It is difficult to understand the magnitude." Relationships forged between corporate clients and hybrid banks may chill. While corporate clients were willing to let lenders provide strategic advice during the boom, they may not feel as comfortable if they have trouble paying back their loans. Swissair Chairman Mario A. Corti is already accusing his bankers of a "conspiracy" that forced it to file for protection from creditors on Oct. 2. UBS and Credit Suisse deny it. "The whole episode is very sad," says a Credit Suisse spokesman. "But there was no conspiracy to hurt Swissair."

RIGHT STUFF. There's a chance that tough times will pressure Wall Street's firms to take big risks in hopes of boosting results. And if a global recession drags on, there is a danger that protectionism will rise, slowing the move toward market-driven economies, open trade, and pension reform on which the new behemoths depend for their global expansion--and for their future megadeals.

Instead of betting the bank, financial-services firms could do themselves a favor by taking a critical look at their business lines before cutting too deep or becoming compulsive shoppers. "Tough times are times when you have to show what you're made of and perform," says Paulson. Only the firms with credibility and the right stuff will pull through--and they'll be getting by on a lot less.

Corrections and Clarifications Beachfire Inc., a collaborative negotiation software company, is still privately owned and based in Boston "Wall Street: The big chill," (Special Report, Oct. 22). Chairman Ben Coes is not ``bitter'' about advice from investment bankers to take Beachfire public last year: He considered it premature.

By Emily Thornton

With Heather Timmons and Mara Der Hovanesian in New York and bureau reports

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