mercredi 27 juin 2007

The worst is never certain

On Tuesday 26th June, the price of gold has plunged once again, to 642$/once, and the price of silver even more at 12,25$/ounce.
It could even make one doubt about the case for precious metals.
A few days before my favourite Gold Stock had plunged even more, threatening to break its oldest support levels.

But the weakness of Gold is paradoxically reassuring me on my investment in this gold stock. It means that there is nothing specifically wrong in this company. The context is just temporarily bad.

And I have no doubts that the price of gold is going to rebound because the US Dollar is getting weaker and weaker against more and more currencies, especially the Euro and the Pound Sterling.
The Swiss Dollar could follow and maybe even the Japanese Yen (from its current lowest level).

I think a perfect storm is building on the currencies front.
Ultimately, the weakness of the dollar is going to transform itself in a new rebound for Gold.

I think currencies are the precursor of gold moves, because they their transaction volumes are huge and undisputable.
Also the price of the crude could play a role in these new movements, and the medium term trend is up.

For all these reasons, I believe the recent weakness in Gold is probably a Bear Trap.

I wouldn't wait for the end of the summer to be positioned in precious metals.

If only because a geopolitical crisis could develop at any moment, and it could be the worst one in a very long time.

Of course the worst is never certain.
But we should prepare for the eventuality of something big, in matters of investment.

The worst is never certain

On Tuesday 26th June, the price of gold has plunged once again, to 642$/once, and the price of silver even more at 12,25$/ounce.
It could even make one doubt about the case for precious metals.
A few days before my favourite Gold Stock had plunged even more, threatening to break its oldest support levels.

But the weakness of Gold is paradoxically reassuring me on my investment in this gold stock. It means that there is nothing specifically wrong in this company. The context is just temporarily bad.

And I have no doubts that the price of gold is going to rebound because the US Dollar is getting weaker and weaker against more and more currencies, especially the Euro and the Pound Sterling.
The Swiss Dollar could follow and maybe even the Japanese Yen (from its current lowest level).

I think a perfect storm is building on the currencies front.
Ultimately, the weakness of the dollar is going to transform itself in a new rebound for Gold.

I think currencies are the precursor of gold moves, because they their transaction volumes are huge and undisputable.
Also the price of the crude could play a role in these new movements, and the medium term trend is up.

For all these reasons, I believe the recent weakness in Gold is probably a Bear Trap.

I wouldn't wait for the end of the summer to be positioned in precious metals.

If only because a geopolitical crisis could develop at any moment, and it could be the worst one in a very long time.

Of course the worst is never certain.
But we should prepare for the eventuality of something big, in matters of investment.

mardi 19 juin 2007

Retournement de tendance ?

C'est la première fois que le cours de l'once monte alors que les marchés action baissent.
Est-ce le début d'un renversement de tendance ?

dimanche 3 juin 2007

Heading for a fall, by fiat?

Today, I am publishing some articles from The Economist, because I noticed that they are temporarily free online and make a very interesting reading.

The first one below is an old Economics focus that seems to predict a rise of Gold (which is rare in the Economist newspaper). The others tend to exhibit the usual bias against Gold, and lastly I copied a whole special survey about Investment Banking that contains everything you need to know about modern exotic products such ad CDO, CDS, and more.

Of course they don't recognize the whole extent of the risks that exist in this system


Economics focus

Heading for a fall, by fiat?
Feb 26th 2004
From The Economist print edition

The trouble with paper money

IS THE problem with the dollar only that it is falling? It has certainly been doing that. This month, it fell to $1.29 against the euro. This is its lowest-ever rate against the euro, and represents a decline of 19% since the beginning of 2003. In trade-weighted terms, the dollar has fallen less over the same period (15%), but mainly because Asian central banks have been intervening heavily to stem their currencies' rise against it. Of late, it has been wobbling around unconvincingly: America needs a weaker dollar to correct its current-account deficit. But given the dollar's role as a currency of last resort, some wonder if its decline heralds not just an economic adjustment by the United States, but a crisis of sorts in the value of paper money itself.

Money in its present form is a relatively new invention. For most of human history money meant either gold or silver, either directly, or indirectly by means of the “gold standard” which meant, at least in theory, that all paper money was backed by gold. Enthusiasm for the gold standard evaporated in the 1930s, when it made dreadful conditions worse. But it was adopted in a watered-down version after the second world war, when only the dollar was backed by gold. This arrangement made some sense, since America held three-quarters of the world's gold stock. But it came to an end in 1971, when inflationary pressures in America caused the country's manufacturers to become uncompetitive and forced the country off the gold standard. Since then the world has relied on “fiat money”, so-called because it is created by government fiat and is backed only by the promises of central bankers to protect the value of their currencies. It is the value of those promises that some are now questioning.

Promises, promises
Certainly, those promises have only been worth much in recent years. In the early years of fiat money, inflation took off, especially in America, in part because of the two oil shocks of the 1970s. This debased the value of the dollar, and the price of gold climbed from $35 an ounce to $850.

It was only in 1979, in his famous “Saturday night special”, that Paul Volcker, then chairman of the Federal Reserve, raised interest rates sharply to clamp down on inflation. The gold price subsequently fell sharply and in its place came a bull market in government bonds that has, with a few sharp interruptions, continued to this day. Although central banks around the world still hold about 30,000 tonnes of gold in their reserves, many have been offloading their stocks over the years. They can earn only a nugatory rate of interest on these stocks (by lending them out) compared with what they can earn on government bonds. For most people, gold has been relegated to the status, in the words of Keynes, of a “barbrous relic”; its price has risen only feebly when investors have fretted about inflation.

Those who doubt the continued worth of paper money as a store of value point to two things. The first is that the price of gold has been rising even though official inflation is low. From $253 an ounce in the late 1990s, gold now fetches just over $400 an ounce, and it rose as high as $430 an ounce earlier this year. It is not just the price of gold that has been rising: so, too, have the prices of precious and base metals. There may, of course, be many other reasons for these rises. China's rapidly expanding economy is gobbling up metals and other commodities for its factories. Moreover, the rise in the price of commodities also reflects the weakness in the dollar: these rises look much less impressive when quoted in euros or yen. But the rise in the price of gold in particular has raised questions.

The biggest of these—and the second main reason for concern—is the amount of debt that rich-country governments have been running up. America's official budget deficit has surged in the three years since George Bush became president, to around $520 billion and climbing. But this is just the shortfall this year. The government's total future liabilities are much larger. In fact, according to a forthcoming book by Laurence Kotlikoff, an economist, the present value of the American government's future obligations, taking into account promised pensions and health-care benefits, is a staggering $45 trillion. European governments are only slightly better at managing their budgets—witness the breaching of the single currency's growth and stability pact. Japan's attempts to coax its economy back to life have left it with a gross national debt of some 160% of GDP, the highest of any big country. No country has tried harder to debase its currency.

In theory, such debts would not be tolerated for long by investors, since the easy way out for central banks is to “monetise” them with inflation. Bond prices would fall (and thus yields rise) as investors worried that they would be paid back in a debased currency. But capital markets currently seem oblivious to spiralling debts. At some 4%, yields on ten-year American Treasury bonds are close to their lowest in two generations, although this is partly explained by huge purchases by Asian central banks. Yields elsewhere are also very low, nowhere more so than in Japan, where ten-year government-bond yields are now 1.3%.

The problem may be that bond investors, far from being far-sighted, are in fact myopic, and are perhaps being fooled by the temporary disinflationary effects of excess capacity and debts built up over the bubble years in both Japan and America. Perhaps, too, investors have been lulled into a false sense of security by the performance of central banks in recent years, and the independence that has been granted to many of them by governments. But this very aura of inviolability may be storing up problems, since it means that governments can borrow still more at cheap rates. And if governments then find themselves crushed by debt, you can rest assured that this independence will be taken away. And then, once again, the paper in your pocket will only be as good as a politician's promise.

All that glisters


All that glisters
Nov 30th 2004

Is the rise in the price of gold merely the flipside of the dollar’s fall? Or does it point more broadly to a loss of faith in central bankers’ promises?

ALAS, the nearest that Buttonwood gets to visiting jewellery shops these days is a trip to Claire’s Accessories, a chain of fabulously tacky shops beloved of his daughters. To be fair, Claire’s (“Where getting ready is half the fun”) does not pretend to be anything other than cheap and cheerful. Nothing seems to cost more than £2.99. The jewellers in Bond Street, just round the corner from The Economist’s offices, are about as different from Claire’s Accessories as it is possible to get. The stuff in them costs rather more than £2.99. And their already steep prices have been going up because the prices of precious metals have been rising, gold’s not least. In the past week, gold has topped $450 an ounce, its highest level in 16 years—and up from a low of $253 in the late 1990s. What, if anything, does this tell us about investors’ faith in paper currencies.

The financial world, it sometimes seems, is broadly divided into those who believe in gold as the ultimate currency and those who don’t. In the latter camp are most economists, the most famous of whom, John Maynard Keynes, described gold as a “barbarous relic”. But even as late as the 1960s, Charles de Gaulle, then president of France, claimed that gold was the “unalterable fiduciary value par excellence”.

Gold or silver were money for most of human history, either directly or indirectly. Once paper currency was introduced, it was, in theory at least, backed by either of the two metals. Silver was gradually edged out as a monetary metal in the 19th century, from which time the “gold standard” reigned supreme. This arrangement, in its purest form, collapsed in the 1930s, but it continued in a bastardised form after the second world war, when America, which by then held three-quarters of the world’s gold reserves, again tied the dollar to gold, and the rest of the world’s currencies tied themselves to the dollar. In 1971, the dollar was forced off the gold standard because of mounting inflationary pressures. Since then the world has had so-called fiat currencies, which are backed by nothing more than the promises of central bankers and politicians that they will uphold the value of those currencies. Fans of gold—known as gold bugs—wonder whether those promises are worth the paper they aren’t written on.

They certainly weren’t in the early years. Inflation ate away at the value of anything with a fixed monetary value, and during the 1970s the price of gold rose from $35 to $850. But in 1979, Paul Volcker, then chairman of the Federal Reserve, stomped on inflation and the price of gold fell sharply. In its place came a bull market in the price of government bonds.

The dollar, it must be said, fared less well. It may have become the world’s reserve currency, even without the backing of gold, but it has been anything but a splendid investment, especially in recent years. While its internal value has not fallen as much as it once did, thanks to lower inflation, its external value—ie, in relation to other currencies—has been in remorseless decline, albeit punctuated by some longish rallies. In recent weeks, encouraged by malign neglect from American politicians and central bankers, the fall has shown signs of becoming a rout. As the dollar has fallen, so the dollar price of gold has risen.

It used to be that gold bugs touted the yellow metal’s credentials as a hedge against inflation. But the link was anyway pretty feeble, except for currencies with hyperinflation. And though consumer prices have risen a bit this year, it would be hard to make the case that inflation is about to roar anywhere in the developed world. Why, then, is gold prospering at a time when inflation is low? Perhaps it reflects nothing more than the fall in the dollar: gold transactions are denominated in dollars, and in euros the rise in the gold price has been anaemic.

However, there is no law that says a falling dollar must translate into a rising gold price. Apart from a rise in demand for jewellery, the rise in the price of gold may, at the margin, reflect demand for real, hard assets, as opposed to the paper sort. And the reasons are not hard to find, for across the developed world, debts have escalated alarmingly in recent years—and in America not least, hence the vast and growing current-account deficit. While central bankers are generally trusted not to “monetise” these debts by rolling the printing presses, history would suggest that this displays a touching naivety. As James Grant, publisher of an eponymous financial newsletter, and the most erudite of the gold bugs, says: “[Alan] Greenspan, the figurehead of the dollar, was trading at three times book in the late 1990s; I think he may return to book value.” Or lower.

Gold’s virtue, says Mr Grant, is that it is a monetary metal, because of its scarcity and, of course, its history. Actually, Buttonwood can’t help feeling, gold’s history counts against it. Of all the metals, the market for gold is probably the most rigged. It is because of history that central banks hold in their reserves almost a quarter of all the gold that has ever been mined. They would like to sell at least some of it, but the vast amount that they hold means doing so would drive the price down. In 1999, central banks therefore came to an agreement to restrict gold sales. The agreement—or cartel, if you will—was extended in September. But it would presumably be torn up if the gold price rose sharply: the Bank of France said this month that it wants to offload some 500 tonnes over the next five years.

And that would presumably limit gold’s upside. Perhaps a better argument can be made for other scarce metals: platinum, say, or silver. Silver, after all, not only spent centuries vying with gold as a form of money, but also has many industrial uses and is not held by central banks; annual demand is much higher than annual production. Along with many other metals, the price of silver fell sharply in April, but unlike gold it has not even regained the ground it lost. Also in its favour is that it is not exactly sold in industrial quantities at Claire’s Accessories.

The little yellow god

Dec 1st 2005
From The Economist print edition

Even at $500, it's still a barbarous relic

NOTHING swells the breast so much as the thought that you have been proved right at last. After riding high at the start of the 1980s, gold bugs had a miserable couple of decades. The price declined relentlessly, mocking their credo that the security of the financial system ultimately depends upon the yellow metal. Lately, though, the faithful have enjoyed their reward. In the past five years the price of gold has doubled. This week in Asian trading it briefly surpassed $500 a troy ounce—a level last breached in 1987. You can almost feel the bugs' excitement as the message sinks in: gold is back.

This being gold, the resurgence has brought forth all manner of alarming prophecies. The price is an omen of rampant inflation; bonds are doomed; the dollar is about to fall prey to the United States' reckless deficits; the euro will shortly be revealed as a worthless creation of bureaucrats.

The world is an unpredictable place. But, with the possible exception of a fall in the dollar, not much of the above catalogue of doom looks likely; and none of it has much to do with gold's good run. The dull truth is much less bullish for gold. Investors have put money into a wide range of metals, and precious metals' prices, including gold's, have risen with the base. Meanwhile, gold remains fundamentally unattractive. It yields nothing and central banks are sitting on vaultfuls of the stuff that they want eventually to sell. Gold bugs hope that $500 is the threshold at which mainstream investors will start once again to take an interest in the metal. Caveat emptor.

The fascination of gold lies in its being not only a commodity but also a store of value and means of exchange. The glamour and the mystique lie in the latter, monetary part. This is what draws gold bugs, but their story doesn't quite add up. The unbalanced world economy still faces risks. But the most recent rises in the gold price have come against a strong dollar, which is normally a sign of weaker gold and continues to confound warnings of a collapse in the greenback. Oil prices are plainly far higher than they were, but they have come off their peaks. Moreover, there have been few signs so far that oil prices are feeding through to a 1970s-style stagflation. Nothing in either bond or stockmarkets suggests that investors see much danger of such a thing happening.

Bear on bullion
Gold's renewed shine is best explained by thinking of the metal not as money but as a commodity dug out of the ground. In the past few years the price has climbed because mining companies stopped locking in prices by selling gold in advance—in effect, withdrawing a huge source of supply. Even then, gold has captured only 40% of the gains of other metals in The Economist's metals index, which has almost doubled since the start of 2003 thanks partly to fundamental demand from emerging markets and partly to investors in search of better returns than those from other assets. Gold would have done better had Chinese demand risen as fast as some expected; in fact, figures from GFMS, a consultancy, suggest it has been flat, even falling, over the past 20 years. Chinese investors now have other places to put their money.

Gold is still cheap compared with its peak of $850 in 1980. Today, adjusting for changes in American consumer prices, it is worth only a quarter as much. Gold bugs might see that as a chance to buy; others as a reminder of gold's enduring capacity to disappoint.

The New French Connection


The New French Connection

At long last the United States has a friend in the Élysée Palace. In his victory speech, newly elected French President Nicholas Sarkozy assured Americans that they could "count on France."

This is in sharp contrast to former President Jacques Chirac's repeated attempts to undermine U.S. policy. Indeed, during his election campaign -- and despite disapproval at home -- Mr. Sarkozy came to Washington and deplored the "arrogance" of the French veto threat that preceded the Iraq war. Next week President Bush will meet Mr. Sarkozy at the annual G-8 summit in Germany, the first face-to-face test of France's new attitude.

French Foreign Minister Bernard Kouchner is also a U.S.-friendly champion of human rights who, in the name of humanitarian intervention, had supported regime change in Iraq. Granted, Mr. Kouchner was not an advocate of America's military strategy in Iraq. But he did oppose a French veto at the U.N. Security Council and campaigned for active interference against the dictator. At the time this was a courageous act.

The most important difference between Messrs. Sarkozy and Chirac may be in their approach to the war on terrorism. Where Mr. Chirac luxuriated in ambiguity and fear of his own Muslim population, Mr. Sarkozy believes the fight against terrorism is a shared global responsibility that cannot be borne exclusively by America. France and her European neighbors must urgently address their own domestic problems of Muslim extremism, and not have their foreign policy held hostage to those internal pressures. How this translates into concrete measures beyond the sharing of intelligence is unclear at this early stage; but Mr. Sarkozy is less likely to allow his foreign-policy positions to be manipulated by France's Muslim community and perceived threats of terrorist retaliation.

He has advocated highly controversial measures to encourage integration, proposing public financing of mosques and the training of imams to reduce reliance on foreign funders such as Saudi Arabia. He has been a proponent of affirmative action for the Muslim minority and hopes that an invigorated French economy will provide more positive outlets for the discontented and disenfranchised. He has recommended increases in French and European defense spending.

Likewise Mr. Sarkozy is unlikely to revive the idea of Europe as anti-American counterweight, which was favored by Mr. Chirac and former German Chancellor Gerhard Schröder. He has warned both Iran and Syria that attempts to drive a wedge between Europe and the U.S. would be futile. Heated debates will ensue about specific actions towards these countries, but thus far Mr. Sarkozy has sided with the U.S. on the need to limit Iran's nuclear capabilities.

Mr. Sarkozy's good will affords the U.S. a unique opportunity to encourage a European coalition focused on the need to balance Russian, not American, actions in Europe. The EU-Russian summit held recently in Samara exposed profound tensions between Europe and Russia on issues such as the future of Kosovo, the deployment of antimissile systems in Poland and the Czech Republic, and energy security. With Mr. Kouchner on the scene, a focus on human rights and phased independence for Kosovo may shed a more critical spotlight on Vladimir Putin's imperious ways.

How hard will Mr. Kouchner be allowed to push? Recently he expressed support for a proposal made by presidential candidate Ségolène Royal to boycott the 2008 Beijing Olympics to protest Chinese support for the Sudanese government over Darfur. No doubt realpolitik and the broader context of French-Chinese relations will dampen such fervor. But generally the U.S. will have a more responsive partner in the EU and at the U.N. Security Council on such critical issues as Iran, North Korea, Darfur, Kosovo and human rights in general. On the African front Mr. Sarkozy is also aligned with U.S. interests, calling for reforms and policies based on results rather than on personal friendships with African leaders.

Can the Bush Administration nurture and build upon this good will? Mr. Sarkozy has challenged the U.S. to lead the struggle against global warming, saying "We're friends but we're different." And Mr. Sarkozy proved it by creating a super ministry of the environment and sustainable development. The G-8 summit unfolds while Mr. Sarkozy is fighting for a majority in the Assemblée Nationale. Accommodation from the U.S., however modest, would greatly enhance the relationship.

Mr. Sarkozy's arrival is an opportunity not to be squandered or trivialized. It could herald a major shift in U.S.-French relations and reinvigorate the broader trans-Atlantic alliance -- provided the U.S. has learned that it cannot win every argument and that respect goes a long way, especially for countries that have seen their power and prestige irretrievably decline This time, there will be no haughty and tricky Jacques Chirac to blame if the relationship fails.

Ms. Kravis is a senior fellow at the Hudson Institute.

Risk and reward

International banking

Risk and reward
May 17th 2007 From The Economist print edition

Worried about credit risk? You should fret more about pension funds than banks

REMEMBER the days when loans were discussed over lunch at the Rotary Club and sealed with a handshake? Pretty soon, the idea of a banker knowing the name of the person he is lending to—let alone inside details of his credit history—could be as quaint a feature of banking's past as bowler hats and Bonnie and Clyde.
Thanks to technological and financial wizardry, loans are now made with little contact between borrower and lender, and are shuffled around the financial system like so many cards at a poker table. Lately, the results of this “arm's length” banking model have looked reassuringly positive. As our survey in this issue describes, international investment banks such as Goldman Sachs and Deutsche Bank have become vast financial-liquidity factories, turning loans into tradable securities, selling them on and earning record profits as a reward. With banks' risk portfolios more diversified and less stodgy than before, banking crises are rare: the closure of a small bank near Pittsburgh in February was the first such institution in America to fold since June 2004.
Yet just because credit risk is more evenly spread does not necessarily mean the system as a whole is safe. Indeed, it may be prone to less frequent, but more violent, shocks, spreading from individual banks throughout the financial system. Thanks to the relentless dealmaking between financial institutions, if (or rather when) liquidity dries up, risks that the banks think they have outsourced to hedge funds, insurance companies and pension funds might cascade back onto their books.
Three forces have enabled the biggest banks to boost the volume and complexity of financial instruments, and the speed at which they are traded. Each has an element of recklessness. The first is the explosion of credit derivatives, which protect buyers from the risk of default. By selling these, banks have brokered insurance contracts to the new holders of risk that in good times produce steady streams of income, but could require huge payouts if markets ever seize up.
The second is the rating agencies, the new arbiters of credit risk. Banks were once the experts on whom they lent to, with inside knowledge on their borrowers. Now that they sell their exposures, they have blithely passed this responsibility on to outsiders, such as Moody's, Standard & Poor's and Fitch Ratings. The agencies have done fabulously well from the stream of new business, but they are further away from borrowers.
Third, the ability of banks to sell their loans may well have led to a lowering of lending standards. Why double-check somebody's books if you are selling on the risk in a matter of days (or even hours)? That became painfully evident this year after American finance companies lent to needy borrowers with poor credit records in the “subprime” mortgage market. Borrowing is also getting easier for private-equity firms, one of which this week threw yet more caution to the wind by proposing to buy Chrysler (see article). Banks have started lending to them with worryingly easy-going covenants, which give lenders scant power to intervene if a loan risks going bad.
Basel: more exciting than you thought
Privately, virtually every investment banker expresses nervousness about the hard-to-quantify “tail risks” in the new banking model. Some have built up plump liquidity cushions in case of disaster. But what about the regulators?
The main answer is the Basel 2 banking accord, due to be introduced next year. In terms of banking, it has plainly had a healthy effect: banks have strengthened their risk-management systems and spread their risks—so much so that many should be able to hold less capital against their loans. The danger, however, is that by focusing on the health of banks, the regulators have shunted problems into less supervised realms of the financial system, such as the pensions industry. If pension-fund trustees, with less experience than banks in judging credit risk, have allowed the wrong investments, the consequences would be grave indeed

The alchemists of finance

The alchemists of finance
May 17th 2007 From The Economist print edition
Maria Jeeves
Global investment banks are taking ever more risk, and are devising ever more sophisticated ways of spreading it, says Henry Tricks (interviewed here). Is that reassuring or worrying?
AT LEAST since 1823, when Byron's Don Juan described “Jew Rothschild, and his fellow Christian Baring” as the “true Lords of Europe”, investment bankers have inspired awe, envy and, rightly or wrongly, a measure of disdain. Exactly 100 years ago the undisputed patriarch of the modern industry, J. Pierpont Morgan, stemmed the Panic of 1907, a financial crisis caused by unregulated trusts (the hedge funds of their day). Acting, in effect, as lender of last resort from his Wall Street office, he was briefly feted before Americans realised the danger of having such power vested in one man. Cartoonists then mercilessly mocked him. After his death in 1913 the Federal Reserve was set up.
The investment-banking industry was further constrained during the Depression of the 1930s, when Wall Street firms such as that founded by Morgan were split into commercial banks and securities houses. The latter—today's investment banks—underwrite stocks and bonds and advise companies on mergers and acquisitions, rather than collect deposits and make loans. In the 1980s and 1990s they developed a reputation for gluttonous excess. But a lot has changed since then.
Intensely private partnerships have become publicly traded companies. Commercial banks such as Citigroup and JPMorgan Chase have muscled back into investment banking. And European warhorses such as Deutsche Bank, UBS and Credit Suisse have joined the race for global supremacy. The bets, and the profits, have got bigger, though investment banks are trying to keep quiet about that, for several reasons.
First, they are under more scrutiny. Wall Street firms had their wings clipped by Eliot Spitzer, New York's former attorney-general, for plugging worthless shares during the dotcom era. Being publicly traded companies has tamed some egos, too. Star traders do not enjoy the same headroom on salaries (albeit very large salaries) as they did when they were partners in the business. At UBS, a Swiss bank which in 2000 moved into the American equity markets by merging with PaineWebber, a brokerage, “fiefs” are explicitly banned. Richard Fuld, boss of Lehman Brothers, a fast-growing Wall Street firm, imposed a “one-firm culture” when it was spun off from American Express in 1994. Now, says Scott Freidheim, a top executive, Mr Fuld uses “culture” in speeches more often than any other word except “the”.
Meanwhile another group has overtaken the investment banks in the excess stakes: their money-spinning clients in the private-equity and hedge-fund industries. Already they throw the biggest parties, do the boldest deals and launch the most celebrated initial public offerings. The IPO of part of Blackstone, a private-equity group, might well raise more money than Goldman Sachs's did in 1999, when even the company's doormen and drivers became extremely rich.
Yet when investment bankers discuss the fabulous fortunes accruing to these firms' founders, they do so without envy. “Theirs is a truly pioneering role,” says Anshu Jain, head of global markets at Deutsche Bank, one of the world's top trading banks. “Pioneers in any industry get a disproportionate share of the spoils.”
Even if they are no longer the pioneers, the investment banks have played a crucial part in bringing about the extraordinary changes seen in the financial markets, starting in the 1980s and accelerating dramatically in the past five years. Technology and innovation have brought unprecedented breadth, depth and richness to financial instruments. According to McKinsey, a consultancy, the stock of shares and public and private debt securities held in America grew from 2.4 times GDP in 1995 to 3.3 times in 2004. In Europe the increase was even more dramatic, albeit from a lower base. These figures do not include derivatives, notional amounts of which traded privately, or “over-the-counter” securities, which had soared to $370 trillion by last June, from $258 trillion less than two years earlier, according to the Bank for International Settlements (BIS). Given such torrid growth, the markets are becoming increasingly vital to global financial stability.
There have been thrills and spills along the way. The stockmarket crash of 1987 and the seizing up of credit markets after Russia defaulted in 1998 both exposed huge flaws in the industry, forcing central banks to step in to prevent what they feared might be lasting damage to the real economy. Even so, regulators reckon that on balance the growth of markets has been a good thing, making the financial system safer than more traditional forms of bank lending. The trouble is that given the complexity of the new instruments and the range of clients and countries involved, they can never be absolutely sure that a monumental crisis is not brewing somewhere.
What worries both bankers and regulators is not so much the threat from hedge funds or private-equity groups but the implications for the financial system of a possible collapse of an investment bank (or large complex financial institution, as they clumsily call it). At a time when America's housing market has exposed the danger of overexcitement on Wall Street, it is worth exploring how these institutions are evolving, how they handle the risks attached to what they do, and how well those risks are spread around the financial system. That is what this survey sets out to do.
Risk-takers Anonymous
Investment banking is in a state of evolution rather than revolution. The essence of the business has always been taking calculated (and sometimes miscalculated) risks. But now traders place bets in more places, with more clients and using more complicated gambling devices than ever before.
Brokerage used to be described as a haulage business, lugging money, as a member of the Rothschild dynasty once put it, “from point A, where it is, to point B, where it is needed”. The idea of describing themselves as glorified delivery men may well still appeal to the cynics on the trading floor who work with shirtsleeves rolled up and hail each other loudly in Brooklyn or mock cockney accents. But any haulage firm would be flabbergasted by the trading profits and returns on equity seen in investment banking in recent years, especially among Wall Street's big “bulge-bracket” firms. Svilen Ivanov, head of capital markets at Boston Consulting Group, notes that earnings from capital-market-related activities at the top ten global investment banks have risen by almost two-thirds in two years, from $55 billion in 2004 to $90 billion last year. That sort of profit increase is comparable with Apple's rewards for inventing the iPod, he points out. Yet in investment banking there is nothing nearly so tangible to which to ascribe the gains.
Bankers themselves are fuzzy about explaining their trading profits, bandying about phrases such as “deploying our intellectual capital”. But it is clear that three powerful forces are at work, all of them overlapping and mutually reinforcing, and all fundamental to the gushing liquidity the world is currently enjoying.
The first is the alchemist's trick of turning debt (mostly leaden) into derivatives (mostly liquid); the second is the emergence of a new class of leveraged client (hedge funds and private equity); and the third is seeking out new capital markets, and clients, around the world. Moreover, in all these pursuits the firms are now using not just their clients' money but, to differing degrees, their own too.
Joseph Perella, an industry veteran who last year struck out independently with an advisory boutique, Perella Weinberg, observes that putting a firm's own capital into mergers, acquisitions and other transactions is one of the biggest changes in investment banking since the 1980s. “It's not just one firm sticking its neck out. It's across the board.”
But using the banks' own capital creates potential conflict. Not only do they risk putting their own interests before those of their clients; they are also increasingly exposing themselves to the dangers of an abrupt turn in the credit cycle. They are arranging ever bigger debt issues for private-equity firms and hedge funds and so are encouraging a borrowing binge that could breed financial instability. For the time being all this is hugely profitable. But it is also making the banks far too complacent for their own good.
The driving force behind all this has been an unusually benign economic climate. The global economy is at its least volatile since the 1960s, real interest rates are low and companies are generating huge profits. What some call “the great moderation” has been a boon to financial markets around the world, particularly those trading in the multifarious debt instruments concocted in the laboratories of Wall Street and the City of London. The opening up of Asian economies has brought down the price of traded goods, helping to fight inflation. Meanwhile, high savings rates in that part of the world, combined with ageing populations in the West, have helped to push up demand for long-term investment instruments such as bonds.
At the same time the search for yield, as investors seek to compensate for low returns in high-quality markets such as government bonds, has increased demand for instruments of greater complexity, such as credit-default swaps (CDSs), collateralised debt obligations (CDOs) and other derivatives. That has pushed down implied volatilities to multi-year lows, arguably making the assets appear more reassuring than they actually are.
Regulation has helped, too. Under the Basel 2 banking accord, whose trickier provisions are due to come into force in the European Union next January and in America starting a year later, capital will be allocated according to the riskiness of assets. That has encouraged banks to make more use of credit derivatives to diversify their credit portfolios, and to sell more assets into the capital markets to be repackaged into debt securities.
All of which means that investment banks have generated many of their trading profits from derivative trades—with each other, with their banking clients or with hedge funds which increasingly use the instruments as speculative tools. The demand for loans to repackage into securities, such as CDOs, has helped fuel the generous credit conditions that have underpinned private equity's leveraged buy-out (LBO) boom as well.
The wild east
To cap it all, over the past few years markets around the world have opened up in a way unmatched since before the first world war, and investment banks have seized the opportunity to expand internationally. Since the start of the 20th century, when America first emerged as an economic power, the world's financial-market activity had increasingly gravitated towards American share and bond markets. The introduction of the euro in 1999, and the rapid growth of economies in Europe and Asia, lured investment bankers in the other direction. The share of investment-banking fees earned from Europe was growing long before America's regulators woke up to the damage caused to American markets by aspects of the Sarbanes-Oxley act and other red tape. Last year, by some estimates, revenues from Europe and Asia overtook those from America for the first time (see chart 2).
In the meantime London has become an impressive rival to New York as a global financial centre. Michael Klein, the boss of corporate and investment banking at Citigroup, describes Britain's capital as New York, Chicago, Houston and Washington, DC, rolled into one, because it trades all the assets of the first three and is regulated on the spot as well. Instead of Greenwich, Connecticut, it has Mayfair for hedge funds. London, moreover, is a hub for Europe, and stronger economies on the continent mean growing markets for capital; typically, such markets increase at double the rate of GDP when economies expand.
London's position as a springboard for emerging markets vastly increases its allure. America and Europe between them may still account for almost four-fifths of all investment-banking revenues, but fees are growing fastest in the developing world. That reflects the might of companies such as Gazprom, Russia's energy behemoth, and the recently listed Industrial and Commercial Bank of China, which Mr Klein admits are both vying with Citigroup in size. He notes that 140 of Citigroup's top 1,000 clients are from emerging markets, whereas 15 years ago the number was only 40. Russia and China are among the world's biggest IPO markets. And many developing countries are seeking to strengthen their domestic capital markets, which means that the biggest global investment banks—such as Citi—hope eventually to deploy enormous resources there: trading desks of perhaps 1,000 people, not 25.
Given the markets' increasing complexity, how do investment banks manage the growing risks they face? There are lots of things they need to do, from finding enough brainboxes capable of handling the intricate assets being created to measuring the correlations between instruments that are supposed to spread risk but may do the opposite if liquidity dries up. It is mildly reassuring that hardly a week goes by without regulators in the world's main markets pressing the industry to improve its risk-management techniques—but rather worrying that the same regulators pay considerably less attention to where the risk may end up.
Maria Jeeves
Investment bankers themselves have a vested interest in not blowing up their firms. The biggest banks are thought to be investing hundreds of millions of dollars a year in technologies to measure risk and stress-test it. Comfortingly, regulators who scrutinise the banks' risk-weighted capital say it is stronger than ever. But capital is only one line of defence. The banks' ability to cope with liquidity crises and credit crunches is harder to gauge.
Financial markets send out mixed messages about the confidence of investors in the institutions themselves. The investment banks' share prices appear to reflect the belief that their equity will be safeguarded rather than that earnings will be stable. As David Viniar, chief financial officer of Goldman Sachs, puts it, the firm, whose risk appetite is second to none, has increased revenues in 18 out of the past 21 years, but quarterly income has been more volatile. “It's a growth business and it's not going to get more stable,” he says.
Taking risks and managing them is an investment bank's core business. Bankers believe risk-taking is how their industry supports entrepreneurs and hence economic growth. The trouble is that new risks are almost invariably explored before there is a good way to measure them.
Ultimately, business and credit cycles tend to reveal which risks are excessive—and whatever junior traders may think, the business cycle is far from dead. Richard Portes, professor of economics at the London Business School, recalls first debating its possible demise back in 1969. Since then he has discovered a comment by Leon Fraser, an American banker, speaking after the great crash of 1929, which convinced him that boom-bust cycles in finance will always be with us. Mr Fraser's immortal words were: “Better to have loaned and lost than never to have loaned at all.”

Les fleurs du mal

May 17th 2007
From The Economist print edition

Exotic instruments are not for everyone

WHEN investment banks talked about exotic assets in the 1990s, they generally meant tiger-cub or puma economies such as Vietnam or Peru. Today the frontiers of finance involve anything from weather to mortality risk, from emissions to catastrophe insurance.

Now that technology and financial engineering have made it possible to isolate and trade all manner of risks, the insurance industry is marching ever more eagerly into the capital markets. Last year AXA, a French insurer, issued so-called mortality catastrophe bonds to protect itself in the event of large death tolls caused by, say, avian flu or terrorism. The bonds were put together by Swiss Re, a reinsurer, which had hired Jacques Aigrain, a former JPMorgan Chase investment banker, as its chief executive. It expects the market for insurance-backed bonds to leap from $25 billion now to at least $150 billion by 2015.

The investment banks are not standing idly by. ABN Amro, a Dutch bank now in a takeover battle, late last year led a collateralised debt obligation packaging the natural catastrophe risks of Catlin, a Bermuda-based insurer. Deutsche Bank is experimenting with markets in “event-loss swaps”—natural-disaster versions of the debt market's credit-default swaps. The risks of less unexpected deaths are also being packaged and traded. According to Fitch, a ratings agency, bonds linked to life insurance and mortality rates and sold to hedge and pension funds reached $5.4 billion last year, from next to nothing a few years ago.

So far, so ghoulish. But the principle could be extended to all walks of life. Perhaps farmers will be able to buy weather products at their local bank as a hedge against a poor harvest. Or emissions trading, which investment bankers love to discuss to display their green credentials, might become a vibrant global market.

Not so fast, says Tim Roberts, head of McKinsey's financial-institutions practice in London. This being a risk-taking business, investment bankers are naturally testing the boundaries. But it takes two to make a market, and many more to create a mass market. Hedge funds have emerged to hold some of the more exotic risks, perhaps waiting for markets to develop. Insurance products, unlike mortgages, are not standardised, says Mr Roberts. Even the mortgage-backed securities market in Europe has developed in fits and starts and has yet to be fully integrated. It takes time for legal frameworks and market infrastructures to adapt. Catastrophe bonds which offer protection against severe environmental shocks have been under discussion for at least a decade, explains Mr Roberts, but have only recently started to take off: “There's collective agreement that the capital markets have been slow to deliver to the insurance industry.”

For those who see themselves as pioneers in these new markets, there is an unhappy precedent. Charles Sanford, who from 1987 to 1996 was chairman of Bankers Trust, an American bank, was a visionary when it came to risk. He developed the concept of “particle finance” in which every form of risk could be isolated and sold to the buyer with the biggest appetite for it. But during his tenure Bankers Trust was hit by huge lawsuits over sales of derivatives, which it was forced to settle with clients such as Procter & Gamble. It never quite recovered its standing before eventually falling into the arms of Deutsche Bank in 1999.

Black boxes

May 17th 2007
From The Economist print edition

Investment banks' inventions for transforming risk are ingenious, but hard to fathom

ADVANCES in technology and information have always been good for capital markets. Richard Sylla of New York University's Stern School of Business argues that financial globalisation started earlier than previously thought, around 1816. At that time packet sailing ships began to make regular scheduled crossings between New York and British ports, cutting the average time it took for mail—and information about securities prices—to cross the Atlantic. Later that century the telegraphic transatlantic cable, along with steam shipping, heralded the huge growth of global markets between 1870 and 1914.

The computer is the cable of our age, and it has turned investment banks into hothouses of financial innovation. The financial principles are not new: parallels have been drawn between the spectacular growth of credit derivatives in recent years and the introduction of wheat futures in America in the mid-19th century. But thanks to computing power the products have become infinitely more malleable. They are designed to appear complex and impenetrable. But they are not patented, and staff turnover across the investment-banking industry is estimated to be up to 20%, so ideas travel quickly. Margins fall, products go through the inevitable boom-and-bust cycle and the whole thing starts all over again.

The peephole into this mysterious world of debt is a single line in many investment banks' trading accounts known as FICC, for fixed income, currencies and commodities. For the five big Wall Street firms (Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns) taken together, these revenues have quadrupled since the start of this decade, according to Dominion Bond Rating Service, a rating agency (see chart 3). Back in 2000, when stockmarkets were booming, share-trading generated twice as much revenue as did fixed income. But it has been growing far more slowly, to only $27 billion last year, against $44 billion for fixed income.

From copper to catastrophe
FICC encompasses a broad swathe of assets, from American subprime mortgages to Japanese yen, copper futures to catastrophe insurance, General Motors bonds to Zambian debt. Some of the fastest growth has been in tried-and-tested asset-backed securities such as commercial and residential mortgages, which have soared since 2000 whereas straight company debt issuance has stagnated (see chart 4). But the most profitable area has been the growth of derivative and structured credit products, such as CDSs and CDOs.

These have enabled banks to separate credit risk from interest rates and trade that risk among those who want to hold it and those who don't. This process has freed credit risk from the underlying bonds, leading to an explosion of secondary-market activity. For the banks it has been a goldmine, but for outsiders it is devilishly hard to know how much risk the new instruments entail.

The cornerstone of the new market is the CDS, a form of insurance contract linked to underlying debt that protects the buyer in case of default. The market has almost doubled in size every year for the past five years, reaching $20 trillion in notional amounts outstanding last June, according to the Bank for International Settlements. That makes it far bigger than the underlying debt markets. Some 70% of these products are linked to an individual issuer and are not much more complex than selling a bond short. The fun starts with the other 30%. The mathematicians of Wall Street and London have found ways of bundling indexes of CDSs together and slicing them into tranches, based on riskiness and return. The most toxic tranche at the bottom exposes the holder to the first 3% of losses but also gives him a large portion of the returns. At the top, the risks and returns are much smaller—unless there is a systemic failure.

CDOs grew out of the market for asset-backed securities which took off in the 1970s and encompassed mortgages, credit-card receivables, car loans and even recording royalties. The structured CDO is a more complex variation, using lots more leverage and bundling bonds, loans and CDSs into securities that are sold in tranches. According to the Bond Market Association, an industry body, $489 billion-worth of CDOs were issued last year, twice the level in 2005. One-third were based on high-yield loans and are known as collateralised loan obligations (CLOs). The rest involved mortgage-backed securities, CDSs and even other CDOs (which become supertankers of leverage, known as CDO2 and CDO3).

Investment bankers are fascinated by the possibilities created by structured products, which they think offer almost limitless ways for their clients to manage risks. Some of the more ambitious are working on risk-transfer instruments that deal with weather, freight, emissions, mortality and longevity (see article). The most immediate opportunities, though, may be in asset classes—such as property derivatives—that have already proven successful in America but are still emerging in Europe and barely exist in developing countries.

Anshu Jain at Deutsche Bank says over half of the firm's trading profits last year came from this ill-defined area, which he loosely calls “intellectual capital”. About one-third of the business was done with hedge funds and the other two-thirds with financial institutions needing to match assets and liabilities, such as insurance companies. He believes that this aspect of trading may be less cyclical than other sources of revenue, such as proprietary positions.

Matt King, a credit strategist at Citigroup, says that demand for CDOs has lately been stimulated by the approaching implementation of the Basel 2 capital accord, which encourages banks to swap risky loans on their books for CDO tranches to avoid high capital charges. This has been helped by the increasing willingness of banks to sell loans into the capital markets in order to diversify their portfolios. Huw van Steenis of Morgan Stanley estimates that some 78% of senior secured loans in America have now been sold in this way, compared with 29% in 1995. In Europe 53% are now securitised, up from 12% in 1999, still leaving considerable room for expansion. Alessandro Profumo, boss of UniCredit, a booming bank that has stitched together an investment-banking franchise across Italy, Germany, Austria and central and eastern Europe, says it sells €40 billion-50 billion ($54 billion-68 billion) of loans a year and would eventually like to make it a lot more.

Maria JeevesSuch financial innovation not only spreads the risk for investment banks' clients. It may also make the banks themselves more diversified as they search for the holy grail of finance: unrelated portfolios that do not all melt down at the same time. There is little correlation between credit and government bonds, for example. When credit spreads widen, investors flock to “safe haven” products such as government bonds.

That is the theory, at least. But there are doubts, which may help explain the low multiples on investment banks' earnings. Guy Moszkowski, securities industry analyst at Merrill Lynch, describes the institutions as “black boxes”, revealing little about their overall exposures. A senior banker agrees. “There is a total lack of transparency. We make it impossible for our investors and analysts to understand what is going on.” He thinks that investors would be more impressed than scared if there were more disclosure, but accepts that it is difficult to reveal all unless competitors do the same.

Astronomical leverage
CDOs and CDSs generate other concerns too. One is the leverage embedded in them, which does not appear on banks' balance sheets. A senior European financial regulator draws particular attention to the way banks value deeply subordinated portions of CDOs. “They offer very attractive returns, but could fall off a cliff if something goes wrong,” he says. Lombard Street Research, a firm of economic analysts, calculates that such parts of a CDO might be geared up about nine times, and that the leverage will be many times greater still if a hedge fund has invested in them with borrowed money. The leverage becomes “astronomical”, the firm reckons, when the CDOs are based on other CDOs.

The second concern is the possible need to pay out on CDSs if a wave of defaults were to hit. The attraction for the CDS seller, as with any insurance contract, is receiving a steady stream of payments for a risk it hopes will not occur. If its calculations are wrong, the result can be devastating. The BIS says the best way to gauge the total volume of CDS exposures is by their gross market value, which was $294 billion last June. That is a small fraction of the $20 trillion in notional amounts outstanding, and the whole lot would never blow up at once. But there would still be tidy sums involved if the sellers—including investment banks—ever had to pay up.

Capital spenders

May 17th 2007
From The Economist print edition

Relentless competition is forcing financial firms to take more risks with their own capital

INVESTMENT bankers would hate to admit it, but traditionally they have borne some resemblance to estate agents, matching buyers and sellers of financial assets instead of houses and land and taking a fee on the transaction. Yet investment banks have recently changed out of all recognition. These days, if they were estate agents they would not only suggest a suitable property to buy and offer to handle the transaction but also propose a loan, come up with sophisticated products to offset the risk of rising rates, provide help with the down-payment, sell you funky insurance products and, if they decided the property was a bargain, even buy it from under your nose.

In short, investment banking has migrated from an agency model towards a principal one. The industry is not just offering its clients a growing array of products to buy and sell; it is making bigger bets with its own capital, too. According to Merrill Lynch, in 2005 one-third of the industry's revenues came from principal trading of debt and equity and only 15% from the commissions business, once the industry's bread and butter.

Maria JeevesThe main engine of transformation has been competition. Wall Street's sensitivity to charges that it operates as an underwriting oligopoly dates back at least to the Glass-Steagall act of 1933 when commercial banks were forced to sell or close their underwriting business, in effect reinforcing the franchises of “bulge-bracket” securities firms. But since the repeal of Glass-Steagall in 1999, commercial banks and investment banks have jumped onto each other's turf. JPMorgan, elbowed out of securities trading by Glass-Steagall (Morgan Stanley was carved out of the old House of Morgan to become the underwriting business), is now near the top of the global M&A league tables. Its market share has grown by about 50% since 2001, says Mr Moszkowski at Merrill Lynch.

European universal banks such as UBS, Credit Suisse and Deutsche Bank, constrained by the lack of opportunities in their overbanked home markets, have also muscled into the American big league. UBS was one of the top share underwriters in America last year. Barclays Capital too, the investment-banking arm of the British bank, has successfully targeted America, concentrating on fixed-income products and commodities.

At the same time private-equity firms and hedge funds have mercilessly fished in Wall Street's talent pool. Some, such as Citadel, a hedge fund, have ventured into market-making in securities, an old Wall Street role. Others have gone for niche markets. Star-studded boutiques such as Greenhill and Perella Weinberg compete with banks in M&A. In trading, margins on cash equities, which used to be Wall Street's signature business, have been hit by electronic platforms and by rules to increase price transparency, such as Regulation National Market System (known as Reg NMS) in America.

The result, according to industry leaders, is growing pressure to explore new sources of profit. “I don't know an industry that is more competitive,” says Lloyd Blankfein, boss of Goldman Sachs. “That is what is driving the innovation cycle.”

The colour of their money
As commercial banks with trillion-dollar balance sheets compete with them for deals, the big five Wall Street securities firms are finding themselves under growing pressure to provide clients with financing as well as advice. Advising on mergers and acquisitions is still the most profitable, and headline-grabbing, business on Wall Street (and Goldman remains top of the tree). Lending on deals offers lower margins if higher volumes. But, as Mr Blankfein puts it, “you have to offer advice and capital together.”

Citigroup, for example, claims to earn $5-8 from funding and other fees for every $1 it gets from advising clients on acquisitions. Thanks to debt underwriting, last year Citigroup and JPMorgan Chase bagged more investment-banking business than many of their Wall Street rivals. Those banks can rely on huge balance sheets, backed by cheap retail deposits, to make loans. The loans also give them recurring income to fall back on when market conditions worsen. Wall Street securities firms do not have access to such a stable supply of funding, so they have to raise capital in fickle markets instead.

Still, they have found inventive ways to take on commercial banks at their own game. Goldman, for example, secured a backstop facility of at least $1 billion from Sumitomo Mitsui when it bought a stake in the Japanese bank in 2003. Merrill Lynch, Goldman and other Wall Street firms have acquired banking charters in America to gather deposits.

Owners beware
Increasingly the firms are buying their own investment assets too. For years they have been using proprietary trading desks to take positions. Now they have ventured into private equity as well, putting a growing proportion of their capital into long-term, illiquid investments, such as property or companies. Merrill Lynch, for example, holds a stake in Bloomberg, an information provider. Goldman has stakes in power plants across America, golf courses in Japan and a $5 billion stake in the vast Industrial and Commercial Bank of China. Brad Hintz of Bernstein Research notes that the share of the industry's capital held in such illiquid investments is growing very fast. At Merrill Lynch and Goldman they accounted for about half of the firms' equity capital last year, up from just over a quarter in 2005. That could be alarming if markets dry up and asset values plummet.

According to Dominion Bond Rating Service, all five Wall Street firms, Goldman, Merrill, Morgan Stanley, Lehman Brothers and Bear Stearns, almost doubled their equity capital between 2001 and 2006. Their assets grew just a tad faster, suggesting that they are expanding their businesses on firm foundations. Regulators have also had a clearer view of their capital since 2004 when their holding companies became Consolidated Supervised Entities, globally supervised by the Securities and Exchange Commission and subject to Basel Committee capital guidelines. Some of the supervisors believe their capital cushions are more substantial than they used to be.

There is no reason for complacency, however, because markets can respond in unpredictable ways, and nobody knows how severe such “tail events” could be. According to Timothy Geithner, president of the Federal Reserve Bank of New York, which keeps a close eye on Wall Street's exposures, “risk management is better and capital cushions are stronger than they were, relative to risk. But the banks are not invulnerable. We'd like to make sure that they're sufficiently strong to withstand adversity in the tail. The shape of the tail is very uncertain.”

Shareholders are not entirely sanguine either. Investment banks are mostly measured on their price-to-book value. Unlike the assets of a bank or an industrial company, most of the securities on their balance sheet have a book value that can be calculated daily and can be easily liquidated. That puts a floor under their price. Currently the big Wall Street firms are trading at more than twice their book value, reflecting last year's average returns on equity of about 25%, which is higher than their cost of capital. Their long-run average is 16% (see chart 5). Goldman, with a staggering 33% return on equity last year, has the highest valuation. But with so much more capital now deployed, the banks have to work harder to improve returns.

There is growing uncertainty about future earnings, however, pushing price-earnings multiples close to historic lows. This is partly because investment banking is a cyclical business, which may be peaking. It is also because their earnings are, to put it mildly, opaque. As Mr Hintz (a former chief financial officer of Lehman and treasurer of Morgan Stanley) candidly admits: “We can't be totally confident how they make money trading or how sustainable trading is.”

Merchants of boom

May 17th 2007
From The Economist print edition

Advising on, financing and investing in buy-outs is a great business. But banks should not be too greedy

THE definition of merchant banking has changed many times over the centuries. Jews in medieval Italy, unrestrained by the Catholic ban on usury, advanced money at high interest rates to grain farmers to secure an option on their crops and then shipped the grain. One of the great investment banks of the 19th century, Barings, began life as a London outpost for the family's West Country wool business, operating as both merchant and banker. But it soon discovered that trading capital was a better way to get the attention of kings and emperors than shearing sheep.

Today Wall Street banks are once again investing large quantities of their own and their clients' capital in businesses, enjoying the same easy credit as their private-equity clients. They call it merchant banking, taking their cue from the grandfather of the industry, J. Pierpont Morgan, who created the world's first billion-dollar company in US Steel. Since the 1980s Wall Street has built up merchant banking in boom times, only to rue it bitterly afterwards. In the past three years acting as a principal has again become a big source of profit, and also of controversy, as banks try to negotiate the blurry line between advising clients, lending to them and pouring their own money into deals.

Advising companies in the S&P 500 and the FTSE 100 used to be the pinnacle of an investment banker's ambitions, and mergers and acquisitions among listed companies still account for 75-85% of global M&A volumes. But in the past three years private-equity firms have been lining the bankers' pockets. Freeman & Co, a New York consultancy, reckons that buy-out firms paid $12 billion to investment banks last year, more than three times as much as four years ago. The top private-equity fee-payer, Kohlberg Kravis Roberts (KKR), spent $783m. The top payer among the publicly listed companies, Xstrata, a global mining group, spent only $245m.

Nice little earner
A fringe benefit of advising on buy-outs is the invitation to invest in them. Here investment banks may use their own capital, as well as raising funds from outside investors in the hope of making money alongside their private-equity clients. Indeed the banks' own funds sometimes put those of their clients in the shade, though you rarely hear them trumpeting the fact. This year Goldman Sachs set itself the task of raising a mammoth $20 billion for its latest private-equity venture. It already has $145 billion of assets under management in its alternative investment funds, and $70 billion of committed equity capital in its merchant-banking arm.

Being one of the world's biggest private-equity funds, as well as one of the biggest advisers to them, could cause serious conflicts of interests. Goldman is likely to provide the third-biggest equity portion, behind TPG Capital and KKR, of the $45 billion bid for TXU, a Texas energy company. The TXU bid could become the biggest buy-out ever. At times it was hard to tell whether it was Goldman's deal or that of its clients.

Yet investment banks serve so many masters at the same time that sometimes they cannot avoid ruffling feathers. Goldman, along with other banks, has appointed senior people to prevent this happening or at least minimise the effects. “We can't avoid conflicts,” says the firm's Mr Viniar. “We have to manage them.”

In 2004 Credit Suisse (then called CSFB) and JPMorgan Chase went head-to-head with private-equity paymasters such as TPG, KKR and Blackstone and won a $1.6 billion battle for Warner Chilcott, a British pharmaceuticals company. It proved a pyrrhic victory because it upset some of the banks' biggest clients. Unusually, one of them, TPG, aired its grievances in public.

But the most gripping action in private equity is in financing. The main funding tool of the buy-out boom is what is known as leveraged lending: essentially, loans to borrowers with too much debt on their balance sheets to be judged as investment grade by rating agencies. In the heady days of the 1980s, leveraged buy-outs relied on junk bonds. But leveraged loans are now more popular than junk bonds, because they are quick to arrange and put a lender closer to the front of the repayment queue if the borrower runs into trouble.

According to Standard & Poor's LCD, a division of the rating agency, the first three months of 2007 were the busiest ever for the American leveraged-loan market. New loans totalled $183 billion, up 55% from the first quarter of 2006. The fastest growth came from private-equity groups, which raised $53 billion in three months, two-thirds more than a year earlier.

As in other parts of the debt markets, the liquidity has been fed by the large number of investors willing to buy tranches of collateralised debt obligations or, in the case of leveraged lending, collateralised loan obligations, a market which has rallied since 2002. Once bankers have underwritten the loans, they can sell them on to CLO funds rather than keeping them on their books, which may help to explain their willingness to take greater credit risks than before.

However, developments in the past year suggest that borrowers now call the shots and raise nagging concerns about underwriting standards. Buy-out firms have squeezed spreads on loans and bonds to levels that make bankers' eyes water. And despite the record investment pouring into private-equity funds, their principals have lately been passing round the hat among investment banks for “bridge equity” as well as bridge loans to do the largest deals.

For the first time, borrowers have also convinced banks to relax terms on covenants—the checks in place to make sure the issuer comes back to the table at the first sign of distress. Steve Miller, who tracks leveraged loans for S&P LCD, says that since the formation of the market in the 1980s, spreads and leverage have risen and fallen “like hemlines” and only covenants have remained constant.

But now, he says, new “covenant-lite” loans give borrowers rather greater latitude if their market sours. Such loans amounted to $48 billion in the first quarter, or one-third of the entire market, compared with just over 1% in 2005. He expects the covenant-lite market to slow, but still believes there has been a big relaxation of lending standards. As he puts it, this is “not your father's market, or your older sister's, for that matter”.

Regulators, too, have begun to express concern, seeing parallels, perhaps, with the over-optimism about the subprime mortgage market. “We are not entirely comfortable with the very high degrees of leverage in some company borrowing situations, such as private equity,” says Thomas Huertas of Britain's Financial Services Authority. “We take the old-fashioned view that the business cycle hasn't been repealed. When we see these types of deal structures it looks like the corporate equivalent of saying ‘house prices will always go up'.”

Bankers are not unaware of the risks they are running. As one senior financier in Europe confesses, “It's a bit like lending money to your children.” But the profits they can earn from the so-called triple play—advising on, financing and investing in buy-outs—make it hard to resist. Merrill Lynch, for example, reportedly earned $75m in fees for advising on the buy-out of HCA, an American hospital operator, helping to underwrite $22 billion in bank loans. It also took a $1.5 billion equity stake.

But the banks would be wise to look back on recent history. The exuberant junk-bond era of the 1980s, when high-yielding debt securities fuelled a wave of takeovers, ended with the bankruptcy in 1990 of Drexel Burnham Lambert, which had dominated the market. During the following decade, banks such as Chase Manhattan formed venture-capital arms to invest in technology start-ups. They lost heavily when the tech bubble burst.

Perceived conflicts of interest have led some investment banks to give private equity a wide berth. JPMorgan Chase, UBS, Deutsche Bank and Morgan Stanley have all retreated from merchant banking in the past half-decade, a move which some of their bankers now rue bitterly—but may eventually give thanks for.


May 17th 2007
From The Economist print edition

Hard-hit equity traders are fighting back

IT IS not just in the debt markets that risks are being divided into their component parts. The equities business, too, is splitting the financial atom. The profitability of share-trading by large investors, which used to be at the heart of brokerage, has fallen since the collapse of the dotcom boom. The old system, in which brokers provided money managers with research as well as orders, in exchange for plump commissions, has been overtaken by electronic transactions in which shares are processed cheaply in vast shoals. Since 2003 the 20-year decline in commissions at the largest firms has been accelerating (see chart 7). Firms have weathered the storm because of a pick-up in equity underwriting, which is highly profitable. But when the cycle turns, equities trading and research will need to change. Big wallets and sharp wits will be needed to survive.

The biggest clients, such as mutual funds, did themselves a lot of damage with their lemming-like behaviour during the internet bubble, and are exposed to competition on many fronts. Hedge funds are chipping away at their business, charging high fees in exchange for the promise (often unkept) of performance above stockmarket benchmarks. Cheaper index-linked products such as exchange-traded funds have also undercut the money-management business. Mutual funds, in turn, have taken their troubles out on brokers, squeezing trading costs even lower.

As commissions have fallen, hedge funds have helped ease the pain for the brokers. They turn over share portfolios so quickly that they partially make up in increased volume what dealers lose from lower fees on each trade. Hedge funds have also developed lucrative prime-broking relationships with a trio of investment banks that moved into the business early—Morgan Stanley, Goldman Sachs and Bear Stearns—borrowing money and shares from them and often paying a lot for advice. But the profitability of the prime-brokerage business has attracted many other investment banks: Lehman Brothers, Merrill Lynch and Deutsche Bank are all energetic late entrants. Mr Hintz of Bernstein Research reckons this may have brought down prime-brokerage returns for all.

The increasingly clear divide between active investments—those that attempt to beat the market—and passive investments, which attempt to track it, is also changing the business. For example, the mutual-fund industry is becoming split between dirt-cheap algorithmic index-tracking and higher-margin products that either include hedge funds or try to emulate them.

One of the fastest-growing segments is 130/30 funds, which borrow heavily from the long/short hedge-fund model. Merrill Lynch estimates that assets under management in such funds total about $50 billion. Besides making it possible to carry long-only positions (a bet that selected stocks will rise), they also allow 30% of long stocks to be leveraged and 30% to be sold short (or borrowed and sold on the assumption that the price will go down). This type of fund requires greater stock-picking skills from a manager than a plain variety and commands much higher fees. It is also subject to the law that not everyone can beat the market all the time.

Brokers go for broke
Brokers, for their part, are also putting more of their capital into supporting their own and their clients' equity punts, ie, acting as principals rather than agents. Equity derivatives are flourishing, which means brokers are increasingly making their own leveraged bets in order to write hedging contracts for clients. Rohit D'Souza, head of global equities at Merrill Lynch, describes this as “providing capital to support our clients' ideas”—much as his fixed-income counterpart would.

On top of this, proprietary risk-taking is increasing. According to Mr Hintz, Wall Street's equity-related value at risk (VAR), which estimates the amount it could lose in a short period if markets fell sharply, has soared from about $80m in 2002 to upwards of $140m last year. Somewhat reassuringly, profits appear to be rising faster than the VAR. Clients, however, worry that their ideas could at best be copied, at worst used against them, by the proprietary-trading desks. Some of this, such as “front-running” (a broker trading on its own account before executing orders submitted earlier by the customer), is illegal, but is thought to go on all the same.

Maria Jeeves
Their excesses during the dotcom boom are coming to haunt equity traders. America's Regulation National Market System and the European Union's Markets in Financial Instruments Directive (MiFID) will require brokers to pursue the best possible deals for clients rather than automatically funnel them through their own systems. This has already produced quite a flurry of rival electronic platforms offering low prices.

Analysis of companies, too, is under pressure. In America research was split off from investment banking in 2003, with painful effects. Mr Hintz reckons research budgets on Wall Street fell by a third between 2000 and 2005. In London regulators are forcing banks to disentangle the cost of research from the cost of trading, which leaves many wondering how analysts will pay for themselves.

Who needs research?
But there is a fighting spirit in the research departments, just as there is on the trading floors. Candace Browning, head of global research at Merrill Lynch, displayed it in March with a letter to clients complaining bitterly that research was being “Napsterised” (referring to Napster, the website that pioneered free music downloads). She condemned the “never-ending litany” of statements predicting the demise of research carried out by investment banks, and vowed to deny non-clients access to such research.

In fact, investment-banking research departments do have a future. Like trading desks, they have to become more bespoke, catering to hedge funds and others who want ideas that will generate fast profits. But they will live and die by their quality, not by the big names of their employers. If their independence is compromised, as it so often has been in the past, there are plenty of up-and-coming boutiques to steal their clients from them.

Here, there and everywhere

May 17th 2007
From The Economist print edition

Investment banks are scouring the globe for new business

MAKE the mistake of describing Goldman Sachs as “sort of a global bank” to Lloyd Blankfein, its boss, and you get a thundering response: “Sort of! What do you mean, sort of?”

Empire-building is as important to investment banks today as it was to their forebears more than a century ago, when Citibank had offices from Mexico City to Manila and Deutsche Bank financed railways from the Wild West to Baghdad. As in that earlier era, capital now moves effortlessly across time-zones, political systems and asset classes. Within the past decade Europe's single currency has taken root and China and India have grown flush with capital, as have oil exporters such as Russia and the Gulf states. Japan, too, has begun to emerge from a decade of stagnation. America, meanwhile, has wrapped up its own financial markets in red tape and may be losing its hegemony.

Huw van Steenis at Morgan Stanley in London estimates that securities markets outside America are expanding three times faster than those within, which they overtook in size in the first half of 2006. The pace of debt and share issuance in Europe since 2002 has easily outstripped that in America. Since 2005 volumes of mergers and acquisitions outside America have been larger than inside. And revenues of the biggest Wall Street banks' subsidiaries generated from trading in Europe have doubled since 2000 (see chart 8).

Yet there is room for further growth. McKinsey calculates that in 1995 the outstanding stock of debt and equity securities in the future euro-zone countries was 1.3 times the size of their collective GDP. By 2004 it had grown to 2.4 times. But it still fell short of America's, where the capital markets were more than triple the size of the economy. Investment banks' sales and trading revenues in Europe still represent only 50-60% of those in America.

Gregory Fleming, the ebullient head of markets and investment banking at Merrill Lynch in New York, predicts that in perhaps only seven years' time up to 75% of his firm's global markets and investment-banking revenues may come from outside America, compared with 50% now. “This is not because of a lack of growth in this country. It is more because of growth of economies around the world,” he says. “For the first time there is a broad-based global financial system.”

Next stop the N11
Having already occupied Europe, the top ten investment banks have set their sights on the rest of the world, too. Almost all of them are now increasingly involved in the so-called BRIC economies, Brazil, Russia, India and China. Next in line may be some of those Goldman has dubbed the N11 (for next 11); in alphabetical order, Bangladesh, Egypt, Indonesia, Iran, South Korea, Mexico, Nigeria, Pakistan, the Philippines, Turkey and Vietnam.

Banks have travelled these trade routes before in moments of global bullishness, probably once a decade, only to retreat hastily after some emerging-market crisis. But this time they believe it will be different. They are not just seeking to sell cheap emerging-markets assets to investors from the rich world. The developing world, with big, commodity-rich companies and surplus savings looking for safe returns, is itself shopping in the West for everything from Treasury bonds to wax museums and steel plants.

The abundance of petrodollars and hard-currency reserves is one reason why the world is awash with liquidity and long-term interest rates are low. But many emerging markets have lower domestic borrowing costs too, thanks to investment-grade debt ratings and nascent domestic capital markets. Mr Klein of Citigroup notes that it now costs the same to borrow overnight from a bank in China as from one in Germany. “The last remaining wall separating emerging markets from developed markets, the cost of capital, has been almost eliminated in the past four years,” he says.

As a result, large developing-country companies with global ambitions, such as China's CNOOC, Russia's Gazprom or India's Tata Steel, can get access to international finance as readily as their counterparts from the rich world. That means investment banks have to deploy more staff on the ground to find out what these firms are up to. “These are large, highly complex companies with increasingly complicated needs. To really understand a company like Gazprom requires more than just an occasional visit from head office,” explains Jonathan Chenevix-Trench, chairman of Morgan Stanley International.

Putting down roots
But what is the best way to tackle global expansion? Citigroup, for example, has offices in 106 countries and can afford to deploy lots of staff. For the first time this year it has put large emerging-market companies under the leadership of a single global corporate bank. It is also betting heavily on stronger domestic markets in countries such as Russia and China. Its philosophy, says Mr Klein, is “when you enter a country, you don't leave.”

The philosophy of pure investment banks, such as Morgan Stanley, is changing too. “Banks used to take a cyclical approach to emerging markets, investing when assets were cheap. When there was trouble, they would sell,” says Mr Chenevix-Trench. “Now it's not a matter of trading assets in these countries, it's a matter of building businesses.”

To underline these new priorities, the lifts in Morgan Stanley's headquarters in London's Canary Wharf display posters about the firm's growing involvement in the Middle East. The firm has moved 40 bankers to Dubai, and has recently signed a joint venture with the Capital Group in Saudi Arabia, where it acts mainly as an intermediary for the region's vast wealth. In Russia, where it has a bigger presence, dating back to before the dark days of 1998, it is targeting not just initial public offerings and acquisitions but also a growing domestic market. Last year securities trading in Russia rose by over 60%, it estimates.

Maria JeevesMorgan Stanley is also one of many banks excited by talk of a resource-rich “great crescent” stretching from Russia through Central Asia to North Africa. The optimists—of whom there are many in investment banking—believe this region could eventually provide the equivalent of another Germany to capital-markets revenues. McKinsey expects the share of petrodollar-related revenues in the industry to grow between 9% and 15% in a decade. The potential pitfalls, however, are huge, especially in Russia, where the rulebooks are new and untested and talent is so hard to come by that the best people shuttle between global and local banks.

Caution is indeed warranted. Credit Suisse lost $1.3 billion after Russia defaulted on its domestic debt in 1998, and Merrill Lynch sacked staff just after the default (only to re-hire them months later when the markets proved more resilient than it had expected). Earlier this year Merrill secured a broking licence in Moscow, but has moved cautiously.

Many investment banks expanding in emerging markets have trouble finding local people whom they can trust to maintain the firm's risk-management culture. This has become all the more important because investment banks are increasingly devolving risk-taking responsibility to regional hubs and even local offices. Risk management is following.

“As recently as five years ago, Merrill Lynch had a New York-centric operating model with a lot of global products managed from here,” says Mr Fleming. This is changing. Banks now tend to believe that the closer they are to their markets, the better they are able to assess the risks.

Lehman Brothers is also actively considering decentralisation, says Jeremy Isaacs, its chief executive in London. Until now the people running its main global divisions have been based in New York. But in early May the firm announced that the new head of its global fixed-income business would be working from London.

The region that probably has a greater variety of local peculiarities than anywhere else—and where investment-banking revenues have grown fastest recently—is Asia.

The art of courtship

May 17th 2007From The Economist print edition

In Asia, banks have to try harder

“IN THIS part of the world relationship is everything,” says a seasoned British banker in Hong Kong. UBS, a Swiss bank, has learned that lesson too. In 2002 it helped the Chinese government with a landmark initial public offering for Bank of China in Hong Kong. At about the same time it worked with China to design a quota system allowing foreign banks limited rights to trade Chinese shares (and won the first quota). And it employs Leon Brittan, the former European Union commissioner who negotiated China's entry into the World Trade Organisation, to take tea with the country's leaders in Beijing.
These attentions paid off earlier this year when UBS won permission to take control of its joint-venture partner, Beijing Securities. If everything goes as planned, that will make it the only foreign bank besides Goldman Sachs to manage underwriting in the local market. Morgan Stanley has a 34% stake in China International Capital Corp, which was the top share underwriter last year, but it is a passive one. Other banks keen to establish joint ventures in China's brokerage industry will have to wait, because China has stopped issuing new licences.
Goldman, too, has practised the art of courtship. Hank Paulson, now America's treasury secretary, is said to have visited China at least 70 times when he was the firm's chief executive. There is a lot at stake. A senior UBS manager acknowledges that his firm could be called upon to help bail out other brokers if something went wrong. But both UBS and Goldman are undoubtedly delighted to be firmly ensconced in China as their rivals watch in envy. For China is arguably the most important prize as investment banks scramble back into Asia, putting the mishaps of the late 1990s behind them.
According to Freeman & Co, investment banking fees from Asia grew at 18% a year between 2001 and 2006, faster than in Europe and three times as fast as in America. Growth was strongest in India, rising by 47% a year from a low base, but the fee pool in China and its region was almost the size of Japan's, which has a much larger domestic market (see chart 9). Most firms predict that double-digit revenue growth will continue across the region in the next few years.
A strategy for Asia is more complex to design than for Europe or America. The financial systems across the region are at vastly different stages of maturity and there is a bewildering array of regulations, legal systems and compliance requirements. In Hong Kong and Singapore, for example, investment banks trade everything from foreign-exchange futures to credit derivatives and structured products. South Korea has become one of the world's biggest markets for warrants in the few years since it started trading in equity derivatives. India has a vibrant local stockmarket and sophisticated retail investors, but currency and other controls make it a frustrating place for international brokers.
China, as ever, blows hot and cold. Curiously, at present more investment-banking revenues come from Taiwan than from the mainland, though China's are growing faster, says Lehman Brothers. The value of the Chinese stockmarket tops $1 trillion, but after a huge run-up at the start of this year the market fell when officials sought to calm down overexcited retail investors. The regulatory environment in Beijing is hard to gauge and enforcement of securities law is haphazard. Bankers say local brokers have often misused clients' funds.
Watch it grow
But there are plenty of reasons for risk-takers to salivate over the region. Australia provides the second-largest source of fees in the region after Japan, according to Lehman Brothers. It is also replete with private-equity money (much of it on the rebound after a rebuff from China). Hong Kong and Singapore compete to attract hedge funds. Some banks have made fortunes from pouring private-equity-style capital into the region. Goldman earned $5.2 billion from a small stake in the Industrial and Commercial Bank of China, which issued a record-breaking $22 billion-worth of new shares last year; Merrill Lynch and the Royal Bank of Scotland tripled their money from investing in Bank of China. Liquidity is abundant because the region saves so much. Yet no bank has established a fully integrated investment-banking model in Asia, which means all comers have a chance to make their mark.
Merrill Lynch believes India may be the land of greatest opportunity in the near term, judging China more of an IPO prospect (the bank was lead bookrunner for the ICBC flotation, which paid it handsomely). Last year it paid $500m to raise its stake in DSP, a leading Indian broker, to 90%. Goldman and Morgan Stanley have abandoned their Indian joint ventures because regulations have eased, believing they can do better on their own there. Citigroup and UBS, among others, have successfully entered alone. All want to book a bigger share of investment-banking revenues that have risen tenfold since 2002. The spoils have not been divided evenly, however: local brokers have dropped down the league tables. None of them advised on Tata Steel's takeover last year of Corus, an Anglo-Dutch steel company.
China is likely to keep a careful eye on the experience of India's domestic brokers. As the head of a top global investment bank in China puts it, the authorities are prepared to see a securities market that is less than fully Chinese, “just not a predominantly foreign one”. They want to retain control to stop markets becoming too volatile and threatening domestic stability. A compliant domestic brokerage base is easier to steer than the thundering herd from Wall Street and Europe.
Many instruments still cannot be traded in China. Currency controls impede all manner of things that could be useful to Chinese firms. Hedging is extremely difficult. For banks such as Morgan Stanley, which has acquired a local licence by buying a small bank, each new product it hopes to sell requires a separate stamp of approval, which can take months. And because local banks still account for almost all domestic lending, there is no securitisation of bank loans.
Yet even with such constraints, there are plenty of ways for banks to make money in China. IPOs are the biggest, and even if the giant listings of recent years are close to exhausted, there are still mid-market firms needing to raise capital. China's vast corporate underbelly contains lots of growing companies that are not yet ready for public markets but are prepared to offer bold investors long-term stakes through private placements. Such issues are handled quietly, but a banker says hedge funds in Hong Kong are mopping them up.
Some bankers believe that the keenest foreign firms may have got a little ahead of themselves. “It's like kids going to the sweet shop for the first time,” says a long-time Hong Kong banker. Others are playing a waiting game. JPMorgan Chase, for example, appears to believe that at a weaker point in the economic cycle it will find opportunities to make a decisive move into China. Not all are wholly sympathetic to Mr Paulson who, in response to mounting congressional pressure against China's trade surplus, is urging the country to free up the capital markets. Some, such as Robert Morrice, chief executive of Barclays Capital in Asia, note a lack of reciprocity in the West in granting access to emerging-market banks.
Clearly there will be setbacks in Asia. Last year Merrill led the underwriting of a bond issue for a government-owned Thai bank launched hours before the military coup. After a debate about whether to exercise the bond's force majeure clause, the issue was repriced and relaunched.
Getting the risk management right is one of the reasons why banks like UBS prefer to have full control of operations in the region. But Peter Wuffli, the bank's chief executive, argues that diversification matters most and can improve stability over time. When regulators express concern about the bank's growing exposure to far-flung places, he has the perfect riposte. What business has lost UBS the most money in recent history? Not emerging markets, he says, but lending on property in Switzerland in the late 1980s.