Banking: It'll Take More Than Free Toasters

>>With the mortgage boom over, bank profits could be less than half of last year's
>>If M&A activity doesn't pick up, Wall Street may be in for a tough slog

In the 1990s, the financial-services sector was like a Wall Street version of Fantasy Island, with commercial and investment bankers alike stumbling upon riches everywhere they looked. The surging stock market and booming economy helped generate record profits across the sector. But going into 2004, the more apt analogy may be America's Most Wanted, as the financial industry enters the New Year stalked by ambitious regulators and litigious customers. The scandals involve everything from analyst conflicts to the willingness of some mutual funds to grant customers -- and employees -- unfair trading privileges.

Given the legal and regulatory clouds hanging over the financial-services industry, 2004 could wind up a shadow of 2003 in terms of how banks, brokers, and asset managers performed. For banks, last year's record profits -- up 27%, to $54.9 billion -- flowed largely from factors that are now a thing of the past. In 2003, for example, the strengthening economy let banks recognize as profits funds they were reserving to cover problem loans -- a one-time boost that has largely played out. Consumer credit and mortgage lending also hit record levels that can't be replicated. Still, U.S. Bancorp Piper Jaffray (USB ) analyst Andrew B. Collins predicts that profits will rise to $60.5 billion -- a respectable 10% uptick over 2003's performance.

Profit growth will slow this year partly because mortgage activity, already off sharply in recent months, is expected to plunge. The Mortgage Bankers Assn. expects home lending to drop by 53%, to $1.59 trillion. Banks that profited most from the housing boom are stumbling. Washington Mutual Inc. (WM ), for instance, recently slashed earnings forecasts for 2003 and 2004 and said it would eliminate 2,900 jobs on top of the 4,500 positions it axed last fall.

Diving into Funds

The challenge facing the banks is whether the industry can offset the mortgage slowdown with a pickup in commercial lending. Through mid December, loans to businesses had declined (year-over-year) for 116 weeks running -- the longest slump since 1994. Collins expects a 3% to 4% rise in commercial lending. That's in line with the expectations of David A. Daberko, chief executive of Cleveland-based National City Corp. (NCC ), who recently told analysts that business borrowing will rebound more slowly than in past recoveries. Companies are managing their cash flow more tightly, he noted, raising productivity and holding down borrowing. "I think it will be a tougher business than in the past cycle," Daberko said.

Remarkably, the ever-widening mutual-fund scandals don't appear to have deterred small investors from diving back into funds. With the stock market on the rise, roughly $64 billion flowed into stock funds between early September and late November -- the highest three-month inflow since 2000 -- leading analysts to predict a 12% rise in profits for the asset-management firms in 2004. Those gains won't be shared evenly, though: Disgruntled customers have cashed out of funds accused of wrongdoing, such as Strong Financial Corp. and Putnam Investments (PEYAX ). Meanwhile, a staggering 55% of the inflows since September have gone to three big fund groups that haven't been tarred by the scandals -- Fidelity Investments, Vanguard Group, and American Funds (AMUSX ).

But given the regulatory zeal of New York State Attorney General Eliot Spitzer, it's hard to say that any fund will emerge from the current scandals unscathed. Both Spitzer and the Securities & Exchange Commission are digging into subpoenaed files and are likely to launch new cases. "There's more to come by way of managers trading in their own funds," predicts Jules B. Kroll, founder of Kroll Inc., a New York-based corporate-security firm that has conducted internal investigations for some asset-management firms. "We'll be dealing with new revelations and cries for regulatory reform well into next year."

Similarly, Wall Street is facing slower growth after a stellar 2003. Like their banking brethren, Wall Street firms rode last year's rate drop for all it was worth. Thanks to an 18% surge in corporate debt underwriting, to $2.73 trillion, profits for the securities industry were on pace to rise 117% over 2002's depressed levels, to $15 billion, on a 4.2% rise in revenues, to $104.5 billion. Now that corporate refinancings and mortgages are slowing, Wall Street isn't likely to repeat 2003's strong performance. "If the industry can just match their 2003 revenues, that will be a phenomenal year," says Leslie Bright, securities industry analyst for Fitch Ratings.

While the Dow Jones industrial average's climb back above 10,000 has once again lured small investors, the retail-equities houses are not poised to rake in the rewards. John H. Schaefer, president and chief operating officer of Morgan Stanley (MWD )'s Individual Investor Group, noted at a recent industry conference that the recovery in the retail business requires "two to three times the time it takes the market to get back to the top," suggesting that it could be several years before retail brokers are flush with profits.

The Dow's rebound is already building a renewed appetite among investors for initial public offerings. While at first blush, 2003 looked like a down year for IPOs -- only 84 companies came to market, vs. an average of 600 per year in the late 1990s -- that belies the momentum that was building at year's end. Underwriters closed 24 deals in December alone -- including the $3 billion IPO by China Life Insurance Co. -- although a number of those issuers had to drop their offering price to seal the deal. But with tech hotshots like and set to go public in early 2004, Wall Street underwriters are hoping those deals will serve as a springboard for as many as 200 other IPOs in the coming year.

For Wall Street firms, the key may well be whether there's a revival in mergers & acquisitions. Fresh activity would not only boost M&A advisory fees but also increase income from underwriting and proprietary trading. Richard J. Peterson, chief market strategist for Thomson Financial (TOC ), believes that with much of Corporate America still struggling to raise prices and having already cut costs to the bone, more companies will resort to mergers as a quick way to buy growth. "There's a lot of pent-up demand," says Peterson. Indeed, after a 13% rise in M&A activity during 2003, to just under $500 billion, Peterson expects the total to rise another 20% in 2004. Still, in a sign of the times, some of the most important deals that the financial industry will make in the coming year won't be with clients but with Eliot Spitzer and other regulators.

By Dean Foust in Atlanta, with Mara Der Hovanesian in New York and bureau reports

— With assistance by Mara Der Hovanesian

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