SEPTEMBER 28, 2010.
What's the Matter With Wall Street?
There are too many traders, bankers and salesmen to support the new level of business. Thanks to Dodd-Frank, the shrinking of finance will continue.
By ANDY KESSLER
What's wrong with Wall Street? I don't mean the painfully slow and dreadful new Oliver Stone movie. I mean the real Wall Street. The stock market has been on a tear this month and is up a few percentage points for the year. But the stocks of most Wall Street firms are actually down close to 15% for the year.
It wasn't supposed to be this way. The Federal Reserve's near-zero interest rate policy makes it almost impossible for Wall Street not to make money by borrowing at next to nothing and buying anything, especially Treasury bonds. This gives banks easy profits and the wiggle room to write off the toxic mortgage assets that never got cleared out.
While most firms won't release earnings for another three or four weeks, Jefferies investment bank set off air raid sirens last week by announcing disappointing earnings, which CEO Richard Handler blamed on "painfully slow trading." And there's more trouble down the road.
One obvious problem is that the yield curve has flattened. While short-term rates are near zero, Ben Bernanke's Fed, via quantitative easing, has been working furiously to lower long-term mortgage rates. In January, Wall Street could borrow in the short-term market at 0.15% and buy 10-year bonds paying close to 4%. Today they can still borrow cheap at 0.14%—but 10-year bonds are only paying 2.6%. That's a huge difference in nine months, and profits suffer.
Meanwhile, trading in equities at NYSE Euronext is off 21% from a year ago. NASDAQ is seeing lower volumes from this spring as well.
In the first place, up-and-down markets sometimes induce investors to sit on their hands. Also, more of the total trading volume is being done by those mysterious high-frequency trading shops. Using fast connections, they probe the market with a flood of offers to buy and sell shares and pick off profits for themselves at the expense of Wall Street firms trying to do large trades for their customers.
The banking side of Wall Street is not making up the difference. There are deals to be done—HP and Dell's bidding war for 3Par was exciting—but a $1.6 billion deal is small potatoes. Microsoft is about to raise almost $5 billion by selling bonds but at an interest rate so low it's almost impossible for Wall Street to charge anything but negligible fees. Similarly, the initial public offering (IPO) market is not very busy: Periods of economic uncertainty are not the time to pay up for emerging companies.
There are a few big deals out there, including General Motors. But to run the GM IPO, Goldman Sachs, according to a story in Bloomberg last month, bid 0.75% for the fee it would share with all the other underwriters, instead of the typical 2%-3%. They didn't get a lead role, but the 0.75% fee stuck, practically pro bono.
The financial industry has certainly seen slow periods of stock and bond trading and sparse banking before, especially after the dot-com bust. But banks made up for it by inventing high-margin products like collateralized debt obligations. Many of those financial products are down if not out for quite some time. It's hard to imagine mortgage-backed derivatives will add much to Wall Street's bottom line for many years.
In my estimation, there are too many traders, bankers and salesmen to support the new level of business. Wall Street firms also have too much capital that they scramble to generate returns on. Both need to shrink over the next five years.
The government will be providing some assistance on both these fronts, though not of a helpful kind. The Dodd-Frank Wall Street Reform and Consumer Protection Act contains vague language to get rid of the highly profitable proprietary trading desks from Wall Street firms. No one really knows how regulators will enforce the so-called Volcker Rule, but many aren't waiting to find out.
J.P. Morgan is closing its 100-person prop trading desk and reassigning many traders to its asset management division. Last week, Credit Suisse lost a profitable commodity trading group to a hedge fund set up by Blackstone. Expect stories like that every week until prop trading is no more, but with nothing to make up for lost profits.
Perhaps Wall Street firms should go back to the classic service model of yesteryear—provide access to capital and smart advice to growing wealth-creating global corporations. It sounds quaint, I know, more "Mad Men" than Masters of the Universe. But it's going to happen.
And not because I say so but because Wall Street faces headwinds that will force its hand. We are at the bitter end of a 30-year interest rate cycle. Declining interest rates are the ideal environment for economic growth. In January 1981, short-term interest rates were 19.08%—now they are 0.14%. Thirty-year mortgages in October 1981 were 18.45%—now they are 4.28%. Over this period the stock market rose tenfold.
Wall Street made a fortune over these 30 years and grew from small partnerships into the giant behemoths of 2007. But the behemoths began to collapse under the challenge of generating the huge returns they promised shareholders.
At some point, the powers that be will figure out that rising interest rates will be the cure for what ails the U.S. economy by driving the dollar higher, commodities back toward their extraction values, and encouraging commitments of capital based on market mechanisms, not the wishes of the government and the Federal Reserve. That will not be good news for Wall Street, which doesn't do well in a rising interest-rate environment. See the 1970s. Time to hunker down and get back to basics.
Mr. Kessler, a former hedge fund manager, is the author most recently of "Grumby" (Vigilante, 2010).
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