HARDER TO FIND THAT FIXED - INCOME FIX / THE WALL STREET JOURNAL

HEARD ON THE STREET

OCTOBER 8, 2009, 12:55 P.M. ET.

Harder to Find That Fixed-Income Fix

By PETER EAVIS

When will Wall Street's biggest gravy train slow?

Ultraloose monetary policy and a rebound in bond investor confidence has helped firms like Goldman Sachs and J.P. Morgan Chase post blow-out fixed-income trading revenue so far this year. But as markets have stabilized, the easy trades have evaporated, and market-making margins are narrowing.

While third-quarter fixed-income trading revenue should remain strong, investors need to watch for signs that banks are overreaching. As fixed-income markets get frothier, the harder it becomes for banks to make bumper trading profits without taking on too much risk. Don't forget, bond desks produced huge losses in the recent past.

The numbers are staggering. In the first half, Goldman's $13.4 billion in fixed-income, currencies and commodities revenue accounted for 75% of overall revenue. The bank is expected to report as much as $24 billion in fixed-income and related revenue this year -- 50% above 2007's record. J.P. Morgan's $9.82 billion of first-half, fixed-income revenue exceeded the combined sum for the prior two years.

It appears investors are beginning to price in this trading success. Goldman trades at twice tangible book value, a sizable premium to 1.5 times at Morgan Stanley, whose bond trading has recently been anemic. On expected earnings, Morgan Stanley's multiple is only slightly below Goldman's.

One reason to be cautious about paying too much for trading revenues is that outsiders never really know how the money is made and to what degree strategies are sustainable. For instance, revenue can benefit from marking up distressed assets that could fall in later quarters. It is also tough to divine how much risk is actually being taken to make money.

One profitable bond trade earlier this year was extremely fleeting. Certain banks bought large amounts of mortgage-backed securities issued by Fannie Mae or Freddie Mac and agreed to sell them a few weeks later at a slightly higher price. Typically, it's almost impossible to make money on this trade, but low funding costs and market dislocation in the first quarter made it temporarily attractive. Bond traders say Goldman, among others, did this trade in size. Goldman says any such trade wasn't a material contributor to earnings.

In coming quarters, one exercise will be to compare bond-trading revenue with a measure of risk taking called value at risk. Although VaR is flawed, it can raise a red flag if it's increasing as revenue flattens or falls. In the second quarter, both Goldman and J.P. Morgan posted fixed-income-related revenue that was marginally up on the first quarter. Goldman's VaR fell, while J.P. Morgan's rose.

Given that it missed out on the first-half trading-revenue fest, Morgan Stanley's third quarter will arguably be the one to watch. If its VaR ramps up, but revenue disappoints, questions about Morgan's strategy will intensify.

Easy money doesn't stay easy forever.

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