Commentary: Back To Making Money The Hard Way

The casino days may be over for investment banks as interest rates head back up

Wall Street firms have worked hard over the last decade to convince investors that their earnings are not volatile. They have bought or built every conceivable sort of financial-services business to diversify their sources of revenue, ranging from selling stocks to writing aircraft leases. And when investors got the jitters earlier this year about the likely impact of rising interest rates on investment banks' earnings, they had a ready answer: When debt-based businesses slow down, others pick up the slack.

Unfortunately, that's not entirely what is happening as Federal Reserve rate hikes loom. Goldman Sachs (GS ), Morgan Stanley (MWD ), Lehman Brothers (LEH ), and Bear Stearns Cos. (BSC ) all announced second-quarter earnings that soared by double digits compared with the same quarter of 2003. Morgan Stanley's earnings even doubled. But compared with the first quarter of this year, the four firms' combined net earnings still slid by 5% on average and their revenues dipped an average 2%. That was worse than 2003, when their earnings rose 5% and revenues were 4% higher in the second quarter than the first.

After basking in a sweet spot for quite a while, the banks may be headed for a rough patch. Goldman Sachs, Lehman, and Bear Stearns racked up record earnings in the first quarter largely because their bond and mortgage businesses were booming at the same time that stock and merger businesses were showing new signs of life.

Now the firms face a tricky balancing act. As interest rates rise, their debt-based businesses will likely slow. Yet revenues from equities trading and investment banking could remain soft because of the traditional summer slowdown in stock market activity and dealmaking. "Our outlook for the business environment in the coming months remains optimistic," Goldman Sachs Chairman and CEO Henry M. Paulson Jr. said in a statement. "But we are mindful of the effect of continuing interest rate and geopolitical concerns on market sentiment."

Some strains are already evident. Until now, many investment banks have taken advantage of declining interest rates, trading bonds for money manager clients and for their own accounts. "Investment banks have been behaving like casinos and making large proprietary bets," says Wall Street veteran Michael D. Madden, a partner at private-equity firm Questor.

But the momentum is slowing. Goldman, Sachs & Co.'s fixed income trading revenues were up 15% year over year in the second quarter. But a year ago such revenues soared 44% compared with the same 2002 quarter. Research analyst James F. Mitchell at Buckingham Research Group expects the four investment banks' combined fixed income trading revenues to rise by 12% this year, after jumping 46% in 2003.

The firms insist they will not suffer from a downdraft as severe as past periods when rates have gone up. They argue that debt markets are now broader: Banks no longer deal only in simple loans and bonds, but now sell everything from collateralized loan obligations to interest rate derivatives. "There are so many different things that people do," Goldman Chief Financial Officer David A. Viniar said in a June 22 conference call. "What's most important is levels of activity."

All the same, the stock market has hoisted warning flags about investment bank stocks. Morgan Stanley has fallen from a 52-week high of nearly $62 per share in March to its current $52. Goldman has sunk to $92 from just over $109 in the same period.

The stocks could turn out to be cheap at today's prices if the investment banks' predicament improves in the fall. That's when stock trading and investment banking usually pick up again. Companies already are issuing more stock and announcing more mergers than last year. And many analysts raised their yearend estimates for investment banks' profits after the firms' second-quarter announcements.

Still, investors should probably brace themselves. They may be in for a bumpy ride as investment banks navigate through choppier markets.

By Emily Thornton

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