Boom Times for the Powerhouse Banks

While investment banks' cork-popping gains may flatten in the coming months, the industry is confident the party's not over yet

The stock market is seesawing, housing is looking winded, and interest rates are climbing. So how can Wall Street's biggest investment banks—Morgan Stanley (MS), Lehman Brothers (LEH), Goldman Sachs (GS), and Bear Stearns (BSC)—be posting their biggest gains in recent memory? More important, how long can the good times roll for them?

The answer, analysts say, is that these powerhouse banks don't owe their latest stellar results solely to savvy investment strategies in the angst-ridden equities markets. Instead, they are reaping huge gains on deal-making among companies, advisory services, debt trading, and the hugely expanding markets for derivatives that big investors are using to protect themselves against risks in those volatile equities markets.

OFF-THE-CHARTS NUMBERS.

  And, to the bankers' credit, those businesses look like they'll be lively for a good while yet—even if the second half of the year doesn't shape up to be quite as bright as the first. Still, on a year-over-year basis, odds are that the firms will keep the steamroller going. "I don't see signs of a top here," says Jeffery Harte, a brokerage analyst with Sandler, O'Neill & Partners.

Morgan Stanley is the latest member of the club to post blowout results. On June 21, the firm reported fiscal second-quarter net income of $1.96 billion, up 111% from a year ago and up 25% from the first quarter of this year. It logged that stunning rise even though net revenues rose just 48% from the same period last year, to $8.9 billion. No wonder Chief Executive Officer John J. Mack said, "I could not be more pleased." (See BusinessWeek.com, 6/22/06, "Morgan Stanley's Mack Attack".)

The biggest engine for Morgan Stanley was its institutional securities unit. Fixed-income sales and trading—mostly driven by credit products and commodities trading—leapt 95%, to $2.4 billion. Underwriting helped mightily, up 77% to $670 million. By contrast, equity sales and trading, while no slouch in the skittish markets, was up a comparatively modest 54%, to $1.7 billion, and much of that gain hailed from Europe and Asia.

"HUGE M&A DEALS."

  While Morgan Stanley was happy to pocket such big gains in equity trading, it clearly didn't depend solely on them. Mergers and acquisitions and other business segments filled out the bottom line nicely. "Huge M&A deals are moving the needle," says analyst Meredith Whitney of CIBC World Markets.

Indeed, Whitney argues that a rich backlog of deals in the pipeline should keep the banks plenty healthy. Acquisitions and divestitures, equity underwritings, and bond deals are driving some eye-popping gains, like the 167% jump in second-quarter net income, to $2.3 billion, reported on June 13 by Goldman Sachs. Likewise, they helped fuel the 81% rise, to $539 million, that Bear Stearns reported on June 15 and the 47% increase, to $1 billion, clocked on June 12 by Lehman Brothers.

Brisk gains could easily continue, so long as the world economy continues to chug along, the analysts say. Even such threats as higher interest rates shouldn't derail the outlook, unless the Fed and other central banks hike them too high and choke off growth—a prospect generally dismissed by analysts.

NEGATIVE ASPECTS.

  Of course, the picture isn't wholly rosy. Even David H. Sidwell, chief financial officer at Morgan Stanley, warned in a conference call about the June 21 results that the firm's second half historically tends to be weaker than the first. Even investment bankers like to hit the beaches over the summertime and business in the closing quarter often winds up pushed into the first quarter of the next year.

The results, moreover, haven't been even among the firms. While Morgan Stanley's second quarter net income was up 25% from its opening quarter gain, the other outfits showed a slowing trend. Goldman, for instance, reported a 7% decline from its first-quarter net income, while Lehman Brothers logged an 8% sequential quarterly decline. For its part, Bear Stearns reported a modest 4.9% rise from its opening quarter.

Will the banks stun investors with more gains in the next quarter? Compared with last year, they likely will, but they'll be hard-pressed to equal the glowing growth of the past three months—especially if market skittishness continues.

SOLID FUNDAMENTALS.

  Why are market players so jittery? Analyst Whitney blames it on "de-levering" by big investors, especially hedge funds that borrowed heavily to finance earlier stock purchases. "Everyone had to sell assets," she says. "They were saying, 'oh my gosh, I've got to sell my winners to cover my losers.'"

But the fundamentals that drive markets are sound, Whitney insists. She looks at such factors as consumer spending, CEO attitudes, and the backlog of deals to keep powering the gains.

That's probably why investors are reacting enthusiastically to the latest earnings reports. After Morgan Stanley announced its results, investors hiked its stock 4.3%, to $59.48 a share, on June 21. They also gave the others a ride, boosting Goldman Sachs 3.2%, to $149.83, Bear Stearns 2.5%, to $135.45, and Lehman Brothers 1.9%, to $63.58. Even with the recent hiccup in the equity market—and continued worries over the economy, interest rates, and inflation—investors appear to be giving these big Wall Street firms the benefit of the doubt.