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Bond Woes Add To Banks' Problems


Bond traders have been the new rainmakers on Wall Street, thanks to low interest rates, few defaults, and a rise in the number of aggressive fixed-income hedge funds. In fact, bonds have been one of the only bright spots in banking. Commercial lending is so fiercely competitive that banks are forced to slash rates. The chase for customer deposits is cutthroat. And the weak stock market is taking a toll on everything from money management and retail brokerage to fee generators such as mergers-and-acquisition advice.

Now, even the fixed-income business is reeling. That's threatening earnings for the second quarter and beyond, after the banks' record profits in the first quarter. John E. McDonald of Banc of America Securities (BAC) cut his 2005 estimate for Citigroup (C) by 8 cents a share, to $4.07, citing tougher capital markets, higher credit-card losses as personal bankruptcies rise, and a more cautious outlook for its retail brokerage. Merrill Lynch & Co.'s (MER) Guy Moszkowski forecasts a 20% decline in trading across the board and shaved second-quarter earnings estimates for Goldman Sachs (GS) and Morgan Stanley (MWD), by 10% and 5%, respectively.

The bond woes began when Standard & Poor's (MHP) cut its credit ratings on General Motors (GM) and Ford Motor (F) to junk status on May 5. Those downgrades led to losses at hedge funds that had feasted on trading complex instruments called credit derivatives, whose value is based on the price of the underlying bond. The turmoil in the bond market hit three of the banks' profit engines: bond sales, in-house bond trading, and the so-called prime brokerage business, which caters to hedge funds. "These businesses were going gangbusters, the interest-rate cycle was going in the right direction, and hedge funds were booming," says Denis Bastin, director of Mercer Oliver Wyman's (MMC) corporate and institutional banking business. "Now everything is starting to sour at the same time."

Bond trading profits are tumbling fast. JPMorgan Chase & Co. (JPM) President James Dimon warned on May 31 that they could fall more than 60% in the second quarter. Citigroup (C) CEO Charles O. Prince had told analysts a few days earlier that the credit climate is as bad as it was in 2002, when the Enron and WorldCom bankruptcies spooked the market.

Will other businesses step up as bonds falter? Analyst David A. Hendler of New York research shop CreditSights doesn't think so. He figures that Lehman Brothers Inc. (LEH), for instance, needs a 78% jump in its equities and M&A business by yearend to offset the drop in fixed-income revenue. Merrill Lynch, which collected nearly $2 billion in such revenue in the first quarter, needs a 36% boost in other areas to make up for lost bond revenues, he says.

But banks' other business units will probably see lower, not higher, profits. The flatter yield curve -- which means long-term interest rates aren't that much higher than short-term rates -- is eating into income because banks make money on the difference between the two as they borrow short and lend long. If long-term rates don't rise above 4% soon, posits UBS (UBS) analyst Matthew O'Connor, banks could lose up to 5% of their earnings this year.

AGGRESSIVE LENDING

The recent hedge-fund rout makes matters worse, although by how much is anyone's guess. Some analysts worry that banks and hedge funds are too closely linked. Banks give hedge funds loans, buy and sell stocks and bonds for them, and sell them the insurance on those trades. Banks get the funds to invest in them, too. "Banks have been aggressively lending to hedge funds, and someday it will be a real problem for them," says Barry Colvin of Tremont Capital Management Corp., which runs a hedge fund of funds.

All this clouds the outlook for bank stocks. Typically they post more than 10% gains in the 12 months after the Fed stops raising rates, says Banc of America's McDonald. But that may not happen this time, he says, because bank stocks are trading at higher multiples -- 11.6 times next year's estimated earnings -- than they usually are at this point. Looks like neither bank stocks nor profits will get a lift until more of the mainstay businesses pick up.

By Mara Der Hovanesian in New York


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