Prop till you drop?

Their stock prices have risen, their bonds have tightened, and now they’ve recorded a couple of good sets of quarterly earnings. One or two even managed record or near-record earnings for the second quarter. So far it has been a good year for US investment and universal banks. Are they finally putting three years of pain behind them?

Bank executives won’t commit themselves. They’ve been caught out in the past predicting upturns and corporate restructuring, or bragging about deal pipelines based more on wishful thinking and wistful conversations than hard, fee-paying mandates.

It’s been left to the Securities Industry Association to beat the drums of optimism. Frank Fernandez, the SIA’s chief economist and director of research, issued a report at the end of July entitled “Turning the corner”, in which he said that “the three-year decline in the securities industry appears to have come to an end as top-line revenue growth resumed, and the sources of this revenue growth broadened beyond just the fixed-income side of operations”. Profits are rising and should remain strong in the near term, he continued, and “compensation is rising and employment gains are expected for the industry as a whole by year end”.

There’s certainly anecdotal evidence for that. Banc of America Securities, for example, has been reorganizing its equities trading operations since hiring new heads for the business last year, and is still looking to fill a few gaps. That has become harder since equity markets started to improve around the start of the March attack on Iraq. “It sounds perverse, but we could have done with the bear market continuing for another six weeks or so,” says Peter Forlenza, the firm’s head of cash equities. “We have a couple of positions to fill, but are finding it harder to hire at the rates we were able to just three months ago.”

Overall improvement The overall environment has certainly improved as well. The US economy might still be churning out schizophrenic data, but few are seriously expecting too many more credit problems. In fact Dina Dublon, JPMorgan’s chief financial officer, at the bank’s earnings conference call last month, declared “the death of the current credit cycle”. As one of the banks that suffered most from over-extending credit to what turned out to be risky companies and sectors, JPMorgan ought to know.

The problem is, it’s getting much harder to tell how the banks are making money. Sell-side analysts certainly aren’t able to. For the second quarter in succession many of the consensus earnings per share estimates have been widely off the reported figures. Of the three major universal banks (Bank of America, Citigroup and JPMorgan) and the five major US brokers (Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley), consensus estimates were close for just Citi and Morgan Stanley. In both cases the banks beat consensus by three cents a share. The rest were way off the mark – Lehman beat its consensus estimate of $1.17 for EPS by 50 cents.

It could be that investor relations departments are not doing as good a job as before, or that analysts are not as good at digging information out of them. Or it may be that the way banks make money has changed so much in recent years that it is more difficult for the company to offer decent guidance.

For example, most investment banks now routinely mention on their earnings calls that the equity pipeline data is almost irrelevant as so many secondary deals are done more like debt deals, bought in full and priced and, with luck, placed, overnight. That also increases the risk to the bank in the deal, and fees are also generally much lower.

A London-based senior executive at an investment bank gives another example: one of his bankers was called in to offer extra advice to a company involved in a protracted merger. The advice was that there wasn’t much else to add to what the company’s other advisers had already done. So he received a cheque for around $300,000 for his services. But, says the executive, “while he was there he noticed a hedging mismatch in their treasury department. He told the derivatives experts, who found it was even more severe than at first thought.” They fixed the problem, and earned more than $20 million.

Taboo status But a lot of the more obvious blame lies with banks’ increased propensity for proprietary trading, as Euromoney pointed out in last August’s cover story and in several other articles since. Back then, though, it was virtually taboo to talk about prop risk; banks and brokers spent much of the 1990s doling out the corporate spin that fee income was good and prop trading bad. The lack of fee income soon put paid to that.

Now, though, it seems that prop trading is fine. Most are still reluctant to say how much prop trading they do, leaving investors in the dark. JPMorgan is one of the few banks that gives an estimate. David Coulter, CEO of the investment bank, told investors prop trading accounted for roughly 40% of the bank’s second-quarter trading revenues of just over $2 billion. That’s a fair whack, but at least the bank is telling everyone.

But prop-trading revenues are hardly sustainable, and certainly are not predictable. Morgan Stanley’s fixed-income trading revenue in the first quarter, for example, which includes commodities, shot up 497% from the previous quarter. Much of that probably came from prop-heavy energy trading, according to CreditSights banks analyst David Hendler. What’s more, there seems to be a general feeling that prop trading is fine as long as banks hit their earnings estimates and publish their value-at-risk figures. VaR can be useful, but it’s a poor indication of whether a bank has made or lost money prop trading. Last year, for example, JPMorgan recorded losses across all its trading books in the third quarter, yet its VaR stayed within generally accepted bounds. Goldman Sachs, on the other hand, did the opposite and made a bundle.

But will there be enough opportunities for the rest of the year? Bond spreads have tightened significantly, the euro-dollar trade is not as volatile as it used to be, and the Vix equity volatility index is resting comfortably in the low 20s. Yet for all the bullishness of the SIA, few are expecting the second half of the year to bring much in the way of fee income. Summer is usually slow, or nursing a crisis, and only September and October tend to be busy months. We might have reached the end of the worst of it, but there’s no rosy future out there just yet.

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