Next year will be little better than this one for investment bankers. Their long-term future is none too bright either

Investment banking
Wall Street's annus horribilis

IT IS scant consolation to the thousands who have lost their jobs in finance, but the next generation wants to be better prepared. Some 200,000 students have signed up to play “Wall Street Survivor”, an online stockmarket-simulation game.

Investment bankers are also focused on survival, but in the real world. Of Wall Street’s five big securities firms, only Goldman Sachs and Morgan Stanley remain. After an infusion of government capital they have become banks and are now trying to work out how—even whether—they will make money again.

Since Lehman Brothers went bust three months ago, almost every asset class has been hammered. Even Goldman, once considered invincible, is likely to report a heavy fourth-quarter loss on December 16th. Underlining the depth of the malaise, Lehman is hawking its French investment-banking unit for a princely €1 ($1.30).

Many of those left on Wall Street are underemployed. In the worst global economic slowdown for a generation, capital-market activity has contracted sharply (see chart). The volume of initial public offerings has fallen by more than half since last year. Debt markets would be moribund, were it not for government-guaranteed issuance. The net revenues of the 12 firms in the Boston Consulting Group’s investment-banking index tumbled to $6.2 billion in the third quarter, from $27.1 billion a year earlier. There is still money to be made trading currencies, interest-rate products, equity derivatives (popular when markets are volatile) and corporate restructuring. But this is relatively thin gruel compared with the recent past.

No wonder market greybeards, including Alan “Ace” Greenberg, a former boss of Bear Stearns, have been queuing up to pronounce the old Wall Street dead. But what will take its place? Morgan and Goldman appear to disagree about the answer.

Convinced that the era of big, highly geared bets is over, Morgan has shrunk its balance-sheet from $1.3 trillion to a shade over $750 billion. It expects to earn a return on equity of three to five percentage points less as a result of lower leverage. Retail banking, once mocked as deathly dull at the white-shoe firm, will become its “fourth leg”. Having come so close to failing, Morgan is going all out to win back clients who fled. It says most have returned.

This marks a stunning about-turn for John Mack, Morgan’s chief executive, who must feel a bit like the Grand Old Duke of York. On returning to run the firm in 2005, after the ejection of the risk-averse Philip Purcell, he declared that it was under-leveraged and needed to push into mortgages, proprietary trading and private equity. These businesses are now being dramatically “reshaped”, ie, shrunk.

Goldman, in contrast, seems determined to hold on to its risk-taking culture. Lloyd Blankfein, its chief executive, insisted recently that this year’s trauma need not alter Goldman’s “core”, a key part of which is trading with its own capital. Unlike Morgan, Goldman is not rushing into high-street banking, though it plans to set up an internet bank to help gather deposits. Goldman believes it can continue to punt its own money as long as its risk management remains strong.

Mr Blankfein rejects the idea that lower leverage will reduce profits, arguing that other factors, such as market share, are more important. Goldman has not changed its goal of a 20% return on equity over the cycle. But Brad Hintz, of Alliance Bernstein, thinks the bank may have to make do with eight to nine percentage points less as bets with borrowed money become less acceptable. “Gravity affects everyone, even Goldman,” he says.

Goldman could make up for some of this lost revenue in less capital-intensive businesses, such as asset management. There are fresh opportunities, too, such as distressed debt—a field in which Goldman excelled after the last bust. But it is more crowded this time.

Moreover, regulators and politicians are likely to impose restrictions. The investment banks’ new overseer, the Federal Reserve, has so far imposed few extra shackles. Barack Obama’s economic team understands the dangers of over-regulation. But members such as Paul Volcker, a former Fed chairman, want to see a balance struck between financial innovation and economic stability.

Congressional views are less nuanced. This week Morgan and Merrill Lynch, sensing the political winds, said their senior executives would forgo bonuses for 2008; John Thain, Merrill’s boss, had asked for up to $10m after steering the bank to safety in a merger with Bank of America (BofA). Banks are also tightening “clawback” provisions, which require those whose trades cause subsequent losses to pay back all or part of their bonuses. This robs Wall Street of one of its biggest attractions. Traders may head for less well-known boutiques in order to avoid scrutiny.
Another turn-off is the legal trouble that the big firms will face next year. The wave of litigation over dodgy debt instruments is still swelling. In collateralised-debt obligations alone, Merrill and BofA face estimated settlement costs of up to $5 billion. Dealing with such cases can prove a huge distraction, as Citigroup discovered after the dotcom collapse.

There are a few grounds for optimism. The loss of Lehman and Bear, and the retrenchment of wannabes such as UBS, has cut out a lot of competition (though new rivals are emerging, such as Barclays Capital). And since they mark all their assets to market, Morgan and Goldman may have felt the worst of their pain. For commercial banks, by contrast, the deepening recession will bring more credit losses. Meanwhile, those that have bought investment banks are not all finding it easy to meld the cultures. “Let’s wait until 2010 before declaring the universal-bank model victorious,” says a Wall Street executive.

It is, indeed, hard to look ahead anywhere with much optimism. When business does come back it will be only at the level of five years ago, believes another senior investment banker. Revenue from credit derivatives will fall as they gravitate towards exchanges, eroding spreads for dealers. Large parts of structured finance are dead. America’s government is working hard to revive markets for securitised debt, aware that banks lack the balance-sheet capacity to absorb all of those credit-card receivables and auto loans. But a return to past glories looks far-fetched.

The biggest fear on Wall Street is that finance, which accounted for a staggering 40% of corporate profits at the height of the credit bubble, faces decades of relative decline. The survivors will get the spoils, but the booty looks unappealing. It could be a long time before online-game developers start work on “Wall Street Thriver”.

Dec 11th 2008 NEW YORK From The Economist print edition

Illustration by; S. Kambayashi.