I've been a longtime reader and follower of Seeking Alpha articles and have found the materials absolutely enriching for an investor like myself. Most articles discuss valuation, multiples, projections, and industry comps when explaining their thesis on banks, however, not a lot of articles discuss more operational topics like the fundamental management of a business. This article is about the Financial Sector and will assist an investor in understanding how a bank generates revenue from their Securities and Prime Brokerage operations.
In the last 12 months, the Financial sector has roared back, returning 72% to investors of Direxion Daily Financial Bull 3X Shares (NYSEARCA:FAS) and 43% to investors of Bank of America (NYSE:BAC), beating the SPDR S&P 500 (NYSEARCA:SPY) by 60% and 13%, respectively (SPY returned 20.66% in the same period). Most investors seem very convinced that the Financial sector is a solid bet for 2014, and the strong views on Financials is synonymous on and off Wall Street based on the trading price appreciation of various banks, asset managers, and private equity/investment management firms. So if everything is roaring back, why are there still investors like myself still not sold on these explosive returns? In this article I will be addressing what Prime Brokerage Margin Agreements are and why they are curtailing revenue growth for banks and other sell-side institutions (the sell-side includes banks, research firms, and should be known as the party that offers products/services to the buy-side firms, which include hedge funds, investment managers, sovereign wealth funds, etc.). My article/study focuses on one specific revenue generating business on bank income statements: the Securities and Prime Brokerage revenue. To put this into perspective, I will be using Bank of America as an example to better understand the basis of my publication, however, I want to disclose that this is only an example and I have no tangible nor definite evidence of any outdated margin agreements at Bank of America.
Based on BAC's most recent filings, it is clear there is a decline in Securities revenue. However, before this is taken out of context, business expenses moved in proportion to this decline in Securities revenue, and for the record, the industry has gone through a variety of revenue constricting developments, including regulatory reform (Dodd Frank, Volcker Rule, etc…), lower trading volumes, fines off of fraudulent activities, and tighter profits in especially the securities sales & trading businesses in the last five years. So, how can a functioning operation like a bank with fundamentally reasonable business mandates experience sliding securities revenues simply based on regulation, economic activity slowdowns, and other catchy news headlines explaining the underperformance quarter on quarter? Well, I came across articles on Hedge Week and Risk Net (Hedge Week article here, Risk Net article here) that cover all the various aspects of a prime services or prime brokerage operation and it was obvious that the margin agreements could be outdated at almost all sell side investment banks to better explain the declines in Securities revenue during a time of increased prime brokerage client assets (increased hedge fund client assets, more on this later). Here is a Prime Brokerage Agreement from 1994 (form found here), by SIFMA, to better understand my basis. The basis for my article is to explain the underperformance of a couple of divisions within a bank to build a better understanding of what is slowing down banks operatively from a Securities revenue perspective. Two more sources that led to my conclusion that Margin Agreements are outdated is a Davis Polk & Wardwell publication covering Prime Brokerages and the Lehman Collapse (publication found here) and a Forbes article covering the basics of Prime Brokerage (article found here).
Before diving into the details, let's discuss why the bank's prime brokerage businesses are very important with something that is very topical: huge asset inflows into the Hedge Fund, or Alternatives, industry. Based on a recent article by Reuters (article found here), hedge fund assets are expected to reach a record $3 trillion by the end of 2014 as investors (family offices, ultra high net worth individuals, sovereign wealth funds, other types of high asset management clientele) plan to add fresh money into various hedge funds without the expectation of gigantic returns for 2014 since 2013 provided reasonable satisfaction (even though hedge funds underperformed the S&P 500 in the same period). The new view in the hedge fund industry is "lose less money in a down market, and it's okay to make less than the market in an up market." Based on the most recent Hedge Fund Review report (report found here) on global Hedge Fund Assets Under Management (AUM), the hedge fund industry grew 9.8% in 2013 by AUM across all hedge fund strategies. Basically, large amounts of cash inflows into the hedge fund industry are imminent and are expected to grow overtime, given the specialty of fund management tailored to institutional investors. This is an important data point because the majority of clients in a bank's prime brokerage business are hedge funds and alternative asset managers.
So, in theory, the prime brokerage and securities business should be in the upswing for investment banks like Bank of America , Citigroup (NYSE:C), Goldman Sachs (NYSE:GS) and JP Morgan (NYSE:JPM), however, that doesn't really seem to be the case based on the 2013 10K filings for the Securities industry from a revenues perspective. Now, it turns out, and this is not specific to any bank but a general theme across prime brokerage firms, that prime brokerage margin agreements that were signed with clients from the pre-2000 era remain the same and have not undergone the needed updates to reflect the current market environment or changes in bank balance sheet elasticity (which has tightened). Many readers might be confused by that, so here is another way of explaining it: when a client, say Hedge Fund X, signed on with a bank's prime brokerage business in say 1998, that client had some favorable margin terms on their agreement since prime services was a bit more inefficient and balance sheets were significantly more levered back in those days. Nowadays, getting away with the margin agreements signed by hedge funds and banks are significantly different and include sophisticated funding models to manage both the bank's risk against the client's market exposure and the rate at which clients can borrow funds for outstanding leveraged market positions (including both fixed income and equity securities). If this is still confusing, let's run through an example. Let's say Prime Brokerage XYZ (usually a sell-side bank) signed a margin agreement with Hedge Fund X in 1998, the Prime Broker probably gave the client a margin agreement that allowed the client to leverage over 6.0x, with cost effective borrowing rates at various borrowing levels when on margin, and freedom to trade with virtually anything that had an instrument ID or CUSIP (without consideration to instrument processing across different global exchanges; like OTC clearing in Europe vs. OTC clearing in the U.S.). The key detail that shocked me was that the prime brokerage margin agreement's borrowing levels when Hedge Fund X went on margin, and how much cheaper it was to do so, was significantly more favorable for a hedge fund than a new client signing on in 2013 (in brief, the hedge fund costs of doing business with a prime broker have increased due to the economic and business environment).
Now, this may seem a bit unusual to most readers and investors since many people are under the impression that margin accounts borrow at the market rate when they go on margin. The answer to that is Yes, there is a market rate at which margin accounts borrow funds from, however, those rates differ on the institutional level and are more favorable to prime broker clients that signed margin agreements back in the pre-2000 era. The next question most readers and investors might have is why don't they renegotiate the agreements? Well, each major prime brokerage firm has about 2,000 active global clients and those clients usually have a private equity arm, sub funds, different portfolio managers, and further levels of separate entities with their own margin agreements. It would take an army of lawyers and consultants to go through every single margin agreement that was signed years ago and to settle on more current and favorable margin agreements for the bank's prime brokerage business and hedge fund client (which would be consuming the more unfavorable end of the new margin agreement). Another reason why a prime brokerage business may not renew their margin agreements with institutional clients is because various prime brokerage firms can offer different products and services to clients at different rates, which may possibly drive clients to switch prime brokerage firms. With all the regulatory implications and economic conditions, a bulge bracket bank is in no position to hire an army of lawyers or personnel to increase the profitability or the revenues of one of their core businesses since the up-front expenses could be colossal for several years, and that is without the guarantee that clients will remain clients with the prime brokerage firm due to the new unfavorable terms. Let's not forget, the prime brokerage business is extremely competitive, consider yourself as an investor who is choosing between Fidelity and E-Trade as your personal brokerage provider.
Over the course of my research (Hedge Week, Hedge Fund Review, Forbes, Davis Polk & Wardwell articles and publications), there were notes that various bank prime brokerage businesses on-board clients differently, some with and some without favorable methods of margin agreement renewals, however, planning for a margin agreement renewal ten years in advance is very not Wall Street-like (or Corporate-like), and that is why this has become an issue during a time of tight balance sheets and very high securities regulation globally. The last thing banks really need are lost sales from margin agreements to erode their bottom lines more.
For an idea on the current situation, another Reuters article (article found here) covers the current ranks of the top prime brokers and some of the challenges they face with even their biggest clients. Here is an excerpt from the article touching on the point my article is trying to address: "While a share of business from the biggest traders, for instance Brevan Howard or Moore Capital, can deliver tens of millions of dollars in commissions [per year], brokers are finding some clients unprofitable and are sometimes demanding higher fees, a greater share of business or even telling them to look elsewhere." The article highlights Goldman Sachs , JP Morgan, Bank of America , Citigroup and other large investment banks in the United States with sizable market-shares of the industry.
To give prime brokerage margin agreements revenues more perspective, a bank like Bank of America could benefit between 15% and 20% more fees/commissions revenue for prime brokerage business with clients. BAC currently manages around $60 billion in prime brokerage assets and as hedge funds continue to realize high net investment inflows, prime brokerage businesses across the Street should experience a lift in business revenue. It would make sense for that growth in business to reflect favorable margin agreements for both the bank and their clients.
Finally, the issue of outdated margin agreements may not seem like a large issue now, when hedge funds manage about ~3% of the world's global investable assets, but what if assets continue to grow at current rates (roughly 10% per year based on Hedge Fund Review), offering investors stable returns and wealth preservation overtime? What if hedge funds end up managing 30% of the world's investable global assets? The bank prime brokers will be sitting on the short end of the deal all because of the complex management of prime brokerage margin agreements that stand outdated and favorable to hedge fund clients. For prime brokerage banks that were mentioned earlier, the revenues may slightly increase, but not at the levels they should be growing at.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.