Banking & Securities: Back to Main Street

-- With the merger and IPO markets likely to remain sluggish, Wall Street layoffs will continue

-- A lack of demand for financial services could trigger a new round of consolidation

During the 1990s, top-tier commercial banks such as FleetBoston Financial Corp. (FBF ) and Bank of America Corp. (BAC ) spent billions to expand into the realm of investment banking. Back then, it seemed a sure pathway to lucrative dot-com IPOs, consulting fees, and growth potential for years to come. But investment banking has fallen from grace. As the financial-services sector adjusts to life beyond the boom, tried-and-true commercial banking has proved that it can adapt more quickly. And once again in 2003, the commercial players will outperform the investment bankers.

Thanks to relentless cost-cutting, the major securities firms have stanched the bleeding. After a 27% drop in earnings in 2002--which leaves Wall Street profits at roughly a third of their 2000 peak--profits are expected to begin creeping up again in the coming year. Frank A. Fernandez, chief economist of the Securities Industry Assn., expects profits for the 270 member firms of the New York Stock Exchange to rise 5% to 6% in 2003, to around $23 billion.

Even that's no given, however. The industry is struggling with an uncertain stock market and the one-two punch of accounting scandals and high corporate debt burdens, which have left the all-important merger and underwriting markets paralyzed. Plus, as part of Wall Street's $1-billion settlement over charges of misleading research, the 10 largest Wall Street firms must shell out $450 million to establish a new independent research consortium--an enormous new overhead. "I think what everybody in the industry is confronting right now is a hangover from the bubble that we all enjoyed in the late 1990s and 2000s," says Samuel Molinaro, chief financial officer for Bear Stearns Companies.

As for dealmaking, gridlock may be giving way. The volume of mergers and acquisitions has climbed recently, in part because of leveraged buyout activity, and underwriting registrations are up 20% from a year earlier. But even if dealmaking stays strong, it won't soon return to boom levels. So some firms have responded by looking for profits elsewhere. Some analysts believe Goldman Sachs Group Inc. (GS ) generates as much as 20% of its pretax income from proprietary trading.

At the same time, Wall Street continues to shed workers. Some 75,000 have been cut since the industry hit its peak in 2000. In the process, banks are going back to the drawing board and overhauling underperforming businesses. "Investment banks are figuring out what business will look like in five years," explains Barbara A. Yastine, CFO of Credit Suisse First Boston.

By contrast, the commercial banks enter 2003 in much better shape. While some big players such as Citigroup (C ) and J.P. Morgan Chase & Co. (JPM ) took their share of hits from soured loans, their robust consumer business made up some of the difference. In all, banks have generated billions in new fee income, thanks to a continued boom in mortgage refinancing plus a related surge in home equity lending. Even so, some analysts are starting to question how much longer the refi boom can persist.

The universal banks also benefited from the stock market turmoil. During the 1990s, banks had to turn to costly brokered deposits for funding as loan demand grew faster than deposits on hand. But with investors now bailing out of stocks and pouring money into safer bank accounts, bank funding costs have dropped from 4.59% in late 2000 to an average of 2%. That wider spread helped fuel a 27% bump-up in bank profits in 2002, to $42.6 billion, according to U.S. Bancorp Piper Jaffray analyst Andrew B. Collins. For 2003, he anticipates a further 16% gain.

There's no guarantee that the banks' good luck will last. The biggest question is whether consumers can continue to juggle their already heavy debt loads, particularly if unemployment keeps rising. Some banks are already reining in their lending practices: After suffering $232 million in losses from home-equity loans, Chicago-based Bank One Corp. (ONE ) tightened its home-equity loan standards, deciding to cease buying home equity loans from other lenders.

Banks are taking on more risk by holding onto more of the mortgage and auto loans they originate, rather than selling them off to Wall Street investors. That should boost profits, but it also subjects the banks to greater losses if these borrowers default. "It's a significant change in their business model," Collins notes.

Loan pricing is expected to get tighter too, which will pinch banks' margins. Some bankers also fear that as they scramble to compete for the few companies that do want to borrow, a new round of credit problems will ensue. "There'll be a tendency to be aggressive with lending standards, and bad loans will be made," warns David A. Daberko, CEO of Cleveland-based National City Corp.

Still, after years of envying investment banks, many lenders have decided the traditional banking biz ain't so bad after all. After writing off much of the $1.2 billion purchase price of Montgomery Securities, BofA's new CEO, Kenneth D. Lewis, has sworn off any more big Wall Street deals. "There's too much of a culture clash," he says. Instead, he plans to spend $1.4 billion to open 550 new branches over the next three years. Banks have concluded that businesses with no deposits may also have no returns.

By Dean Foust in Atlanta, with Heather Timmons and Emily Thornton in New York

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