Trade in Groups

Warren Buffett famously described Wall Street as a “community in which quality control is not prized” and which “will sell investors anything they will buy.” For approximately three years between early 2004 and the middle of 2007, a demand for mortgage paper greased the loan underwriting process led to a huge decline in the requirements for getting a loan, and it became very profitable to originate, repackage, and resell pools of mortgage loans.

Like most shoddy business practices, the consequences eventually catch up to those responsible. And, as this neat graphic from a New York Times article shows, quantifying asset writedowns against profits from 2004 through the first half of 2007 implies that about half the profits from the six largest investment banks have been erased. This ranges from a high of 153% of profits at Merrill Lynch (MER) to “just” 12% at Goldman Sachs (GS). More data from Bloomberg gives a better perspective on the magnitude of the problem; worldwide, banks have taken credit losses totaling $400 billion and have been forced to raise $300 billion in new capital, much of it at terms less than advantageous to existing equity shareholders.

As these kind of financial results would suggest, financial institutions have been cutting employees on formerly profitable trading desks, and investment banking has seen cutbacks as well because of a slowing deal environment; without access to debt capital, it becomes almost impossible to execute the leveraged buyout deals that brought in such great I-Banking fee revenue from 2005 to mid-2007. According to the last Bureau of Labor and Statistics (BLS) report on non-farm payrolls, unemployment in the financial sector increased 27% year-over-year. Still, with unemployment in the financial sector low relative to other areas at 3.7% and banks almost assured of going through substantial deleveraging that will lead to lower profits for a multi-year period, either jobs will continue to be cut in the industry or compensation will have to be dramatically lowered.

Based on my conversations with people close to the capital markets, there is still a significant lack of liquidity that is hampering a recovery, and despite predictions about a return to normalcy in the second half of 2008, they are planning for several more quarters of reduced deal volume. Even on the other side when things return to a “new normalcy,” the existing business models of many of the larger financial institutions is going to have to pass a tough examination of how profitable they can be with reduced leverage available. The ability of banks to earn a higher spread on assets, and not leveraged equity, will be the new litmus test facing the industry, and will determine in large part how quickly rehiring and restoration of confidence in the capital markets occurs.