Wall Street Eclipsing Regional Banks Seen in Trading RiseMichael J. Moore
Wall Street investment banks, loathed by investors in 2011 and hobbled by weak trading last year, are poised for a return to the spotlight.
JPMorgan Chase & Co., Goldman Sachs Group Inc. and Morgan Stanley are among U.S. banks reporting fourth-quarter results this week amid a rise in fixed-income and equity trading and the most mergers and acquisitions since 2008. Investment-banking and trading revenue probably jumped 44 percent in the period from a year earlier, according to estimates by Betsy Graseck, a Morgan Stanley analyst in New York.
The turnaround has led analysts such as KBW Inc.’s David Konrad and investors including Michael Holland, chairman of Holland & Co., to see more value in large banks with capital-markets operations than in regional ones focused on lending. The shift reflects optimism about trading and mergers and concern that low interest rates will squeeze loan margins.
“I would rather have exposure to banks that have capital-markets units than a pure-play bank,” said Keith Davis, an analyst at Farr, Miller & Washington LLC, which manages about $830 million. “If we get some clarity eventually on the budget and fiscal-cliff issues, risk will come back into the market and help trading volumes. And we’ve been primed for a long time for a spike in the M&A cycle.”
A pickup in trading and investment-banking revenue from the levels of the past two years could buoy an industry besieged by higher capital requirements, declining profitability and thousands of job cuts. It also may provide ammunition to supporters of the universal banking model. Investors and analysts including CLSA Ltd.’s Mike Mayo have called for breaking up the biggest banks because they have produced low returns on capital and trade below book value.
Goldman Sachs, which reports fourth-quarter results tomorrow, may earn $3.66 a share, about double the amount from a year earlier, according to the average estimate of 26 analysts surveyed by Bloomberg. Seventeen of them have increased their forecasts in the past four weeks. Morgan Stanley may earn 40 cents a share, the most in more than a year, according to estimates from Oppenheimer & Co.’s Chris Kotowski, who excludes charges related to changes in the value of the firm’s own debt.
Trading revenue probably will jump more than 10 percent in 2013, while advisory revenue may increase by 25 percent, said David Trone, an analyst at JMP Securities LLC in New York, who upgraded the largest Wall Street banks this month after rating them underperform the previous seven months. Daniel Loeb’s hedge fund Third Point LLC wrote in a letter to investors last week that it took a stake in Morgan Stanley in part because it expects corporate business to increase.
Companies announced $730.3 billion of global mergers and acquisitions in the last three months of the year, the most since the third quarter of 2008, according to data compiled by Bloomberg. Average daily trading of high-yield bonds jumped 45 percent from a year earlier, according to Trace, the price-reporting system of the Financial Industry Regulatory Authority. Global equity trading increased 6 percent from the third quarter, according to Bloomberg Industries.
The 80-company Standard & Poor’s 500 Financial Index rose 26 percent last year, its largest annual increase since 2003, led by a 109 percent gain in Bank of America Corp. The index beat the broader S&P 500 Index for the first time since 2006 as shareholders rewarded firms for cutting costs to improve returns and the European Central Bank helped head off a debt crisis.
Still, Wall Street banks trade at lower multiples of their liquidation values than regional lenders, leading some analysts to predict more potential gain if earnings or confidence improves. None of the five biggest firms -- JPMorgan, Bank of America, Citigroup Inc., Goldman Sachs and Morgan Stanley -- trade above 1.25 times tangible book. Wells Fargo & Co., U.S. Bancorp and Capital One Financial Corp. all trade at more than 1.5 times.
Share prices of the Wall Street banks have lagged behind those of regional lenders over the three years ended Dec. 31. The S&P 500 Diversified Financials Index, about 60 percent weighted to the top five investment banks, is almost unchanged over that period. The 50-company KBW Regional Banking Index climbed 21 percent in that span.
The increase was driven largely by a decline in overdue loans and write-offs, Kotowski said. Now banks’ trading desks may provide a similar bounce off the bottom.
“Previously, my view was that the commercial bank stocks were the more low-hanging fruit,” the New York-based analyst said. “That was basically right, but now it looks like you might have another quarter of stable trading revenues, and that’s a very encouraging sign for the investment banks.”
Investors should buy universal banks such as New York-based JPMorgan instead of regional lenders because they have lower price-to-earnings and price-to-book ratios and the Federal Reserve’s bond purchases will encourage trading while hurting lending spreads, KBW’s Konrad said in his 2013 outlook.
Holland, who oversees more than $4 billion in assets including bank stocks, agreed.
“The values around the world right now are in the large megalopolis kind of banks,” he said in a Jan. 11 Bloomberg Radio interview. “The banks once again at some point will move to an ascendancy we couldn’t possibly think about today in terms of where they’re trading relative to book value.”
Sunny investment-banking outlooks at the start of each of the past three years have been dashed by the lingering European debt crisis and sluggish economic growth. The 10 largest investment banks produced $91 billion of trading, advisory and underwriting revenue in the first half of 2011. They generated little more than half that amount in the next six months.
In 2011, Goldman Sachs and Morgan Stanley fell 46 percent and 44 percent, respectively, outpacing the 25 percent decline in the KBW Bank Index, while banks with capital-markets units such as Bank of America and Citigroup also were among the worst-performing financial stocks. In the first nine months of last year, those four firms produced single-digit returns on equity, as they grappled with a 40 percent decline in trading of U.S. equities from the same period in 2010 and a 5 percent drop in high-yield corporate bonds.
This year, cost-cutting and improved capital ratios at Wall Street firms have led some analysts to recommend their stocks whether or not business rebounds. Kian Abouhossein, a London-based analyst at JPMorgan, wrote in a note to clients this month that large investment banks will outperform the broader market even though he expects revenue from investment banking and trading to be unchanged this year.
Morgan Stanley, led by Chief Executive Officer James Gorman, 54, is cutting 1,600 jobs from its investment bank and support staff. Citigroup CEO Michael Corbat, 52, said his New York-based bank is eliminating 11,000 positions, while Charlotte, North Carolina-based Bank of America is in the midst of trimming $8 billion in annual expenses, including $3 billion from investment-banking, trading and wealth-management units.
The ECB’s bond-purchase program and the Fed’s efforts to bolster the U.S. economy have increased optimism about capital-markets business and boosted confidence in investment banks. At the beginning of 2012, the average of Goldman Sachs and Morgan Stanley’s credit-default swaps was 2.46 percentage points higher than the average of U.S. Bancorp and Wells Fargo’s, Bloomberg data show. On Jan. 11, that gap had narrowed to 0.85 percentage points, reflecting a smaller difference in investors’ expectations that the two groups will repay their debt.
That volatility could return quickly. Investment banks also face pressure from new regulations. Many market participants aren’t prepared for the move of interest-rate and credit-default swaps to central clearinghouses, which may hurt banks’ derivatives trading, Brennan Hawken, a UBS AG analyst in New York, said in a note this month. The move to central clearing will affect trades in the over-the-counter derivatives market, which had a notional value of $639 trillion as of June, according to the Bank for International Settlements.
Retail banks are squeezed by low interest rates, as they already have cut rates on deposits and other liabilities and now have to replace higher-yielding assets. They also face slowing fees if mortgage refinancings drop off. Fourth-quarter net interest margins, the difference between what banks pay to borrow funds and what they get from lending, probably will fall 5 basis points, or 0.05 percentage points, Morgan Stanley’s Graseck estimates.
JPMorgan said last month that compressing spreads on deposits may reduce net income by about $400 million in 2013 and runoff in its real-estate portfolio will cut interest income by about $600 million.
Concerns about retail banking helped push Wells Fargo’s stock down as much as 2.5 percent on Jan. 11, even as the San Francisco-based lender reported record fourth-quarter earnings. Wells Fargo said its net interest margin fell 10 basis points, and mortgage applications dropped 19 percent in the period. Interest income accounted for 48 percent of revenue.
Mortgage originations may fall to $1.4 trillion in 2013 from $1.75 trillion in 2012 as refinancings drop by a third, the Mortgage Bankers Association said in a report last month. Margins on selling those mortgages in the secondary market may decrease to 2.4 percent this year from 2.9 percent in 2012, Goldman Sachs said in a Jan. 3 note.
Commercial lenders may be able to mitigate a decline in mortgage production with an increase in corporate lending. Wells Fargo reported that commercial and industrial loans as of Dec. 31 increased 12 percent to $187.8 billion from a year earlier.
“What you saw in loan and deposit growth was better than expected,” said Marty Mosby, a Memphis, Tennessee-based analyst with Guggenheim Securities LLC who recommends buying Wells Fargo shares. “Wells was talking about this as being an inflection point this quarter as they saw demand for loans pick up.”
That possibility leads Farr Miller’s Davis to prefer investing in banks such as Citigroup or JPMorgan that have both capital markets and lending businesses.
“I would probably opt for a bank that is a hybrid,” Davis said. “I don’t think you have to necessarily go all in by buying a Goldman Sachs or Morgan Stanley. You can buy JPMorgan at almost as attractive a valuation and get both sides.”