Where have all the major investment banks gone?

At the start of 2008 there were five major investment banks: Bear Stearns, Goldman Sachs Group, Lehman Brothers, Merrill Lynch, and Morgan Stanley. But by the end of the year, like the victims in an Agatha Christie murder mystery, then there were none: Bear Stearns was acquired by JPMorgan Chase, Lehman Brothers went bankrupt, Merrill Lynch was bought by Bank of America, and Goldman Sachs and Morgan Stanley became, voila, regulated bank holding companies.

Even so, the survivors -- especially Goldman Sachs, JPMorgan Chase, and Morgan Stanley -- still retain sizable, healthy investment-banking businesses, in our estimation. And two other smaller firms, Greenhill and Lazard, are still nearly pure investment banks with above-average profit margins. As we see it, all five firms have an opportunity to capitalize on the recent shrinkage of investment-banking capacity and win greater market shares over the next three years.

Traditionally investment banking has been one of the most lucrative financial-services businesses, and we think it should remain so, although somewhat less lucrative on balance than it was in the modern Gilded Age -- the storied last 25 years when investment banks lived fast and prospered. During those heady times, when balance-sheet leverage was easy to come by, investment banks like Goldman Sachs generated returns on equity of more than 30%. We think their returns on equity could remain relatively high going forward but lower than in the past due to more conservative risk-management practices; we think returns on equity could possibly average about 15% in the long run and 6-8% in 2009.

When the economy improves, we think there still should be ample investment-banking business to go around -- bread-and-butter services such as advising on mergers and acquisitions, trading securities, sponsoring initial public offerings of stock, and helping corporations restructure. Indeed, we think it’s likely that investment banks will rebound before the commercial banks do, mainly because of money-making opportunities this year to trade securities and help companies in beleaguered industries such as banking, health care, media, automotive, and retailing that need, like Humpty Dumpty, to put themselves back together again.

In trading, bid-ask spreads are now abnormally wide to compensate the investment banks for assuming the heightened risks that are a byproduct of the financial crisis. Although trading volume is down, the larger trading spreads make the profit per trade higher than usual for the investment banks. For example, in mid-March, the spreads on investment-grade bonds were as much as 73% higher than they were last fall.

In short, the financial crisis has swelled risk premiums both domestically and worldwide, to the benefit of the investment banks. In the United Kingdom, for instance, investment banks are charging the highest fees in at least 30 years to guarantee that all shares in companies’ rights offerings are sold. (In a rights offering, an investment bank offers common stock to a company’s existing shareholders at a discount and purchases any shares not bought.) According to data provider Dealogic, fees on rights offerings of more than $1 billion have risen to 2.5-3.5% since last September, compared with 1.5-2.5% before then.

The abrupt consolidation that’s occurred in investment banking has also contributed in no small part to the larger bid-ask spreads and fees. "Clearly there is a pricing advantage to those who are still in the game," observed Colm Kelleher, Morgan Stanley’s chief financial officer, at an industry conference in January. "You are seeing a systemic or thematic increase in margins."

Those fatter margins are confounding some financial pundits who anticipated a much leaner future for investment banking. The conventional wisdom was that the profits of many investment banks would shrivel as a result of a reduced use of leverage. In the Gilded Age, the investment banks pumped up profits by injecting billowing quantities of leverage into their investments and loans. That practice had to be tempered once some of them became bank holding companies and once they began to strengthen their balance sheets as protection from the financial crisis. For instance, Goldman Sachs’ leverage ratio of assets to equity (the amount of borrowed money applied to the amount of equity) fell from 26.2 in November 2007 to 13.7 a year later, according to Bloomberg News.

Also, worries were rife that investment banks would be hurt by the sharp downturn in their merger-and-acquisition business, which has been the source of big fees. To be sure, such fees have been relatively scarce lately. Year-to-date through mid-March, announced mergers and acquisitions were down 28% from the already low levels of the same period in 2008, Bernstein Research calculates.

Although merger-and-acquisition activity is certainly far from robust, we think it’s likely to pick up as the economy recovers. M&A activity historically has moved in lockstep with an expanding gross domestic product. In the interim, we expect at least some mergers and acquisitions to be consummated. As long as there are chief executives with animal spirits, there will be acquisitions for investment banks to shepherd.

Citigroup, for instance, has found that to be true recently. It has generated the most revenue of any banking firm from advising on global mergers and acquisitions this year, according to Thomson Reuters; the firm has taken part in 37 deals valued at $138.3 billion. Recently The Wall Street Journal joked that Pfizer’s $68-billion acquisition of pharmaceutical competitor Wyeth was "a gift from heaven for Wall Street banks" because it produced fees for Citi and six other firms. In essence, what Citi’s recent flurry of investment-banking business tells us is the M&A market may be down, but it’s not completely out. We also think another key business that’s now down, equity underwriting, should rebound in concert with the economy.

We think what all the pessimism about investment banking’s future fails to take into account is this: the firms have a diverse mix of businesses with different demand cycles, which helps smooth their revenue streams. For instance, although the mergers-and-acquisition business tends to correlate positively with economic growth, the restructuring business tends to be counter-cyclical, i.e., it surges in bad economic times, when corporate bankruptcies and debt defaults are on the rise. So any weakness in the M&A business has the potential to be partly offset by strength in the restructuring business, which is how diversification in financial services is supposed to work (and how we think it’s likely to work for at least some of the investment banks in the near term).

If the pricing of corporate bonds currently is any criterion, debt defaults may be exceptionally high going forward -- a potential bonanza for investment banks’ restructuring business. According to Deutsche Bank, the prices of investment-grade corporate bonds are reflecting a potential five-year default rate of 40%. A default rate that high may be unduly apocalyptic, but as The Wall Street Journal noted, "Even if one makes the unlikely assumption that bondholders recover nothing after default, prices suggest a 25% default rate over  five years.”  The worst five-year investment-grade default rate since 1970 is a mere 2.4%.

In all, the investment banks that we think have the most auspicious business prospects -- Goldman Sachs (market capitalization: about $58 billion), Greenhill (about $2.1 billion), JPMorgan Chase (about $106 billion), Lazard (about $3.6 billion), and Morgan Stanley (about $25 billion) -- appear likely to remain soundly profitable in 2009 and beyond.

Boutiques well positioned

We think Greenhill and Lazard, the two “boutique” investment banks, have perhaps the greatest growth prospects in both the short and long runs.  They are focused on providing investment-banking advice, particularly on mergers and acquisitions and restructurings; up to now, they have avoided branching out into services like financing, trading, research, or lending that the bigger investment banks provide.  In the marketplace, that singular focus was once viewed as a competitive disadvantage for Greenhill and Lazard.  But not now.  Today Greenhill and Lazard are perceived as being blissfully free of conflicts of interest; they are esteemed in the marketplace as highly objective purveyors of advice, since they don’t peddle additional services to clients.

What’s more, we think the boutique firms should be appealing employers to the rainmakers who bring in business to the major investment banks.  The more jobs and bonuses are slashed by the big investment banks in response to soft business conditions and the federal government’s dictates, the more enticing the boutique firms evidently appear to rainmakers with wandering eyes.  Over the past year, for instance, Greenhill has expanded its cadre of managing directors by 40%, according to Keefe, Bruyette & Woods, a financial-services firm.  Most of the new hires came from the big firms.

So, even though the major investment banks have disappeared, investment banking hasn’t.  Indeed, we think investment banking is still alive and well, even in what figures to be the post-Gilded Age.

The views expressed represent the opinions of Turner Investment Partners as of the date indicated and may change. They are not intended as a forecast, a guarantee of future results, investment recommendations, or an offer to buy or sell any securities. Opinions about individual securities mentioned may change, and there can be no guarantee that Turner will select and hold any particular security

for its client portfolios. Earnings growth may not result in an increase in share price. Past performance is no guarantee of future results.

Turner Investment Partners, founded in 1990 and based in Berwyn, Pennsylvania, is an investment firm that manages more than $15 billion in stocks in separately managed accounts and mutual funds for institutions and individuals, as of December 31, 2008.

As of March 31, 2009, Turner held in client accounts 1.0 million shares of Goldman Sachs Group, 1,290 shares of Bank of America, 71,160 shares of JPMorgan Chase, 150 shares of Morgan Stanley, 351,236 shares of Greenhill, and 269,580 shares of Lazard.