Economic Crisis

You know things are bad when…

You know things are bad when even the big investment banks can’t make money. And that’s in markets that have been rigged for their benefit for many years. A raft of third quarter earnings announcements by big US investment banks shows that they are struggling. We continue to tip toe through “crash season”.

Goldman Sachs (NYSE:GS)…Morgan Stanley (NYSE:MS)…JP Morgan Chase (NYSE:JPM)…Bank of America (NYSE:BAC)…Citigroup (NYSE:C). It’s a roll call of the creme de la creme of the US investment banking industry. Their tentacles spread into every nook and cranny of global financial markets, feeling out the best profit opportunities on offer.

So you’d be forgiven for thinking that life would be pretty good for these leviathans of loot (or should that be looting?). But a raft of weak earnings figures shows the mammoth money movers continue to languish in the realms of low profitability.

In particular all the banks’ fixed income businesses have taken big hits, and are bringing in a lot less money than last year.

All of them have reported third quarter results in the past week or so. One thing has been clear right across the board – revenues have been weak. This is despite ongoing largesse from the world’s biggest central banks, those dispensers of welfare for the wealthy. In particular all the banks’ fixed income businesses have taken big hits, and are bringing in a lot less money than last year.

Like so many things in finance, “Fixed Income” is actually a misnomer. It refers to the fixed coupon interest payments on a standard government or corporate bond (a bond being nothing more than an easily tradeable loan).

In reality fixed income departments are a mish mash of many different businesses and “product factories”, as bankers like to call them. The difference being that real factories that make real things tend to be well run.

It’s always struck me as ironic that investment banks are stuffed full of very smart people that spend their days dole out expensive advice to investors, corporations and governments, and yet they are incredibly badly run. They’re the very definition of short term thinking and capital misallocation. You can be well paid if you work at at investment bank, but you are ill advised to invest in one.

So fixed income departments trade standard bonds, but also variable rate debts, complex derivatives like swaps and options (of many kinds), world currencies, commodities…the list goes on. They also do straight lending to big corporations.

Because fixed income departments are so wide ranging in their disparate activities they tend to be the largest part of investment banks, or the investment bank divisions of commercial banks.

(The other main areas are “Equities” – share trading and derivatives thereof – and “Investment Banking” or “Corporate Finance” – mergers and acquisitions, debt and equity capital raising).

Given their size, the fortunes of fixed income businesses will pretty much determine the profits of the investment bank as a whole. They also use up most of the investment banks’ capital, due to ever tighter regulations.

So if an investment bank can’t make money in fixed income then it will be sure to make a terrible return on its capital. A low share price is sure to follow.

Let’s see how they are doing relative to last year, going from least bad to worst. Bank of America and JP Morgan both saw fixed income revenues fall 11% year-on-year in the third quarter. Citigroup was down 16%. Goldman Sachs collapsed 33%. But Morgan Stanley takes the crown, down 41% over the same quarter in 2014.

Those are huge falls by any yardstick. Especially because these businesses have massive “operating leverage”. Costs are partially fixed, so when revenues rise or fall profits move up or down faster. In a typical investment bank in a normal year revenues could fall 20% and profits would be down 40%, or thereabouts, and vice versa.

When times are good, they are very, very good. But when they are bad they are horrid.

So investment banks have massive operating leverage. When times are good, they are very, very good. But when they are bad they are horrid.

All these banks are already struggling with extremely tight new capital regulations brought in since the global financial crisis. Put simply this means they can’t be as leveraged as before. That makes them less risky – and less likely to need a government bailout in future. But it also means that profitability is always going to be poor to modest, since revenues are lower but costs remain high.

For example, the return on equity at Goldman Sachs was about 7% in the third quarter, on an annualised basis. Return on equity is an essential measure of profitability in capital intensive businesses like banking. It’s the profit divided by the shareholders’ equity (also known as net assets or book value).

That’s a pretty pathetic return. I can remember the days when Goldmans was consistently making returns on equity of 30% or more. This is important.

Like any business, a bank’s profits can be used for two things. They can be invested into growing the business or they can be paid out to shareholders in the form of dividends or stock buybacks. So a low return on equity means either low future growth – and hence low capital gains – or low payouts to shareholders – a low income yield – or both.

All these banks have price-to-book ratios around or below 1, which is to say they are trading around or below liquidation value. Often that marks out an investment bargain.

But in the case of the investment banks that apparently low valuation is well deserved. They have structurally low profitability due to tight capital rules. What’s more, profits remain volatile due to uncertain revenues and high operating leverage.

Sometimes things are “cheap” for a reason. Investment bank shares fall squarely into that category.

The bigger point is this. Central banks still have interest rates pinned to the floor and are propping up asset markets. Some are still printing money in the form of quantitative easing. You know things are bad if the big investment banks are still struggling to make decent revenue in this environment. We could be on the cusp of something really bad happening.

Our recommendations to do nothing and play it safe are still in place. Patience remains our watchword.

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.