Morgan and Goldman: It'll Get Harder


By Emily Thornton Interest rates giveth, and interest rates may taketh away. That truism has become the new source of anxiety on Wall Street. On June 22, Morgan Stanley (MWD) and Goldman Sachs (GS) both announced blockbuster quarterly earnings. But the messages from both firms' chiefs underscored that a tricky balancing act lies ahead.

In news releases, Goldman Sachs Chairman and CEO Henry M. Paulson Jr. and Morgan Stanley chief Philip J. Purcell emphasized the strength in the diversity of their business lines. And Paulson added that while Goldman is "optimistic" about the future, "we are mindful of the effect of continuing interest-rate and geopolitical concerns on market sentiment."

Should investors dump their brokerage stocks? Not so fast, argues Sanford Bernstein analyst Brad Hintz. Brokerage stocks are already down this year in anticipation of tough times. Morgan has fallen from a 52-week high of nearly $63 in February to around $51-and-change as of the afternoon session on June 22, while Goldman was selling at around $90, down from just over $109 in the same period.

CASINO-STYLE BETS. And in the fall, equity-trading and investment-banking volumes will likely pick up. Energy-trading revenues also will be robust as long as geopolitical events look uncertain. "We have all been told 'don't fight the tape' and 'don't argue with valuation,' but with the price-to-book valuations of these firms now in the lower third or fourth deciles of their historical trading range, it's difficult to avoid the conclusion that the market may be discounting an overly negative outlook," Hintz wrote in a report.

The reason for the negativity is that over the past year, almost ever major Wall Street firm has racked up record earnings by taking advantage of interest-rate slides while trading bonds for money managers and their own accounts. The second quarter was no exception: Goldman Sachs' quarterly earnings jumped 71% from a year ago, to $1.19 billion, as its value at risk -- the estimated one-day trading loss the firm could conceivably incur -- rose to $69 million, up from $59 million from the same quarter the previous year.

At Morgan Stanley, second-quarter earnings nearly doubled, to $1.2 billion, as its value at risk climbed to $72 million from $54 million for the same quarter a year ago. Bond trading also boosted earnings increases at Lehman Brothers (LEH) and Bear Stearns (BSC) reported similar gains just a week earlier. "Investment banks have been behaving like casinos and making large proprietary bets," says Wall Street veteran Michael Madden, a partner at private equity firm Questor.

BROADER BASES. Some analysts worry that over the summer, investment banks could be caught between a rock and hard place. Once interest rates start to rise, their bond businesses could slow. Meanwhile, retail-brokerage and equity-trading numbers could also remain soft due to a traditional summer slowdown. "We expect the fiscal third quarter of 2004 to be one of the more challenginguarters for the brokers," warns brokerage analyst Daniel Goldberg at Bear Stearns.

Investment banks make no secret of the fact that the days of easy money from issuing and trading bonds are probably over, though they don't expect the drop in revenues from rate rises to be as steep as in the past. The fixed-income markets "are secularly very different from the last time we had a rise in interest rates, and as a result, probably broader in their base," says Morgan Stanley Chief Administrative Officer Stephen Crawford. Echoed Goldman Chief Financial Officer David Viniar: "The businesses are so much more diverse now and there are so many different things that people do, that what is most important is levels of activity and people being willing to transact."

Still, investors should probably brace themselves for a potentially bumpy ride in this sector of the market for the rest of the year. Thornton is investment banking editor for BusinessWeek in New York


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