End of the Line for Brokers? by Jacqueline Doherty
Highlighted companies: Bear Stearns (NYSE:BSC), Goldman Sachs (NYSE:GS), Lehman Brothers (LEH), Morgan Stanley (NYSE:MS), Merrill Lynch (MER), Citigroup (NYSE:C), JPMorgan Chase (NYSE:JPM)
Summary: After a four-year run that has seen shares of some Wall Street brokerage stocks more than double in price, analysts have begun cutting-back on earnings estimates amid worries of increased risk and slowing growth. Brokerage firms take the bulk of their profits from the following business lines: 1) Prime-brokerage services, which provide cash-management services, lend on margin, clear trades, provide reporting services, and lend stock to cover short positions. 2) Fixed income services, which sell home-equity asset-based securities and mortgage-backed securities. 3) Private-equity investments - the firms raise funds and broker deals between private investors looking to increase ROI and non-publicly-traded companies. 4) Proprietary trading. In each of the categories, the article raises significant question-marks as to their ongoing profitability. 1) Prime-brokerage lines are suffering from increased competition to court high-volume hedge funds, leading to decreased profit margins. Newer players in this arena are lending money against securities under riskier terms, increasing risk-exposure across the board. 2) A housing-industry slowdown would reduce the production of new mortgages, leaving firms with bloated overheads. A 25% drop in mortgage applications suggests this scenario may be soon-in-coming. 3) The recent flood of money into private equity (see Unleashing Leverage in this week's Barron's) may signal the beginning-of-the-end for the private-equity party, as huge waves of capital push funds to invest in sub-par ventures. The decline of initial public offerings [IPO] in the U.S. by approximately 50% makes it more difficult for firms' private-equity shops to exit their initial investments via IPOs. 4) Although investment banks don't normally divulge proprietary trading gains, most firms acknowledge recent gains have been substantial. Extrapolating such strength into the future may be unrealistic.
Quick comment: Since gaining an astonishing 40% between March, 2005 and May, 2006, the Dow Jones US Investment Services Index ($DJUSSB) pulled-back heavily between May and June. Present market action suggests investors are unsure whether the investment services industry is in for trouble, as the article suggests, or whether the recent pullback is merely a stepping-stone on the way to even bigger gains. Probably the easiest way to play the Barron's article's bearish perspective is to short the streetTRACKS KBW Capital Markets ETF (NYSEARCA:KCE).
2-yr Chart of the Dow Jones Investment Services Index
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