It's a risky and often scary business. Naturally, the big firms are loath to talk about their major snafus. But snafus there are. Like last January, when Goldman Sachs & Co. apparently lost between $75 million and $300 million trading Vivendi Universal stock for the company, says investment-banking boutique Fox-Pitt, Kelton Inc. Goldman won't comment. Neither will Lehman Brothers Inc. about a deal last year in which, according to market talk, it was left holding the bag on thousands of shares in Spanish bank Santander Central Hispano as the price cratered.
An occasional hit may come with the turf, but the banks are on the hook for big amounts every day. And they need to be more open about what they're doing. Using complex mathematical models that crunch data from past financial market meltdowns, Putnam Lovell NBF Securities Inc. figures that the seven major investment banks could be in the hole for $300 million on a day when everything goes wrong, a 23% jump from 2000. It estimates that Goldman's daily exposure has soared 65%, to $46 million. "You're seeing more risk-taking across the board because to make money you need to take more risk these days," says James F. Mitchell, a securities industry analyst at Putnam.
Investors and rating agencies are concerned about the increase in the banks' own capital that is tied up in trading, both for their clients and for their own portfolios. For example, the inventories of securities the big firms hold swelled 24% in two years, to $1 trillion at the end of last year. They're also trading much more with freewheeling hedge funds than with traditional customers such as staid insurers and mutual funds. And that has ratcheted up the risk even further. "You're dealing with a clientele that has more credit risk," says David A. Hendler, securities industry analyst at research firm CreditSights.
Given all the gyrations in revenues from trading, some firms' financial results are on a roller coaster. On Jan. 22, J.P. Morgan Chase & Co. is expected to announce it made about $1 billion from trading in the fourth quarter, up from $365 million in the third. By contrast, Goldman suffered a 40% drop in its fixed-income-trading revenues, after racking up a record $1.3 billion in the third quarter.
Firms are quick to argue that risk-taking is their business, and that they have more tools to manage it than ever. "We assume risk in very liquid markets in a way that generally limits our downside and has served our clients and shareholders well," says Goldman spokesman Bruce Corwin. Indeed, the firms may be coping with the risks better than before. "This time investment banks have not crashed and burned as they have in past recessions," says Thomas C. Goggins, manager of the John Hancock Financial Industries Funds.
Still, to calm investors' jitters, firms are starting to disclose more about their trading. In December, Goldman revealed in its quarterly report how much money it had at risk in trading. Morgan Stanley is breaking out trading revenues by category, though it still doesn't say how much money each product makes--or loses. "There's no doubt that investors are looking for more [information], and that's something we want to be a leader in," says Morgan Stanley Chief Financial Officer Stephen Crawford.
That's the right attitude, but they all have a long way to go. The big firms pushed to diversify away from trading in the '90s. Now they're back at it. But there's a difference. Once, most firms were private partnerships gambling with their partners' money. Now, they have shareholders. And that means the stakes are a lot higher. Thornton covers investment banking.