Commentaries

Bond market not convinced by M&A boom

Investment bankers shouldn’t pin their hopes on a surge in mergers and acquisitions activity. That’s the message from the bond market in a recent survey by Bank of America Merrill Lynch.

Acquisitions can hurt bondholders because companies often take on debt when buying rivals, lowering their credit quality.

However, a recent survey by credit analysts at BofA shows bondholders aren’t too fussed. When asked how they were positioning their portfolios to deal with upcoming M&A, nearly 70 percent of respondents said they were doing nothing, and that M&A concerns were overdone for now.

Cazenove’s yield may muddy JP Morgan deal

As your friendly neighbourhood investment bank rarely tells you, something like 80 percent of deals don’t pay off. So why do one if you don’t have to?

That is the question facing the mighty City of London firm of Cazenove. Five years after Caz poured its investment banking business into a joint venture with the U.S. bank, JP Morgan <JPM.N>, it has to decide whether to go the whole hog and sell the remainder — or to hang on.

Technically the shares are the subject of a put and call arrangement — JP Morgan can force Caz’s investors to sell and vice versa. But it is hard to imagine the Americans obliging the shareholders to sell if they clearly don’t want to.

Which raises the question: why would they want to?

A deal has certain attractions for JP Morgan. The bank’s UK business would be simpler if it owned 100 percent of its UK investment banking operations. The current set-up is quite advantageous for Caz. Not least it gives it access to JP Morgan’s deep pockets and client list.

But these are also good reasons for Caz shareholders to hang on. Most commentators have focused on the cultural reasons for leaving the joint venture intact and these are indeed potent. But there are also good financial reasons to leave things where they are. Take the fact that the joint venture perches on JP Morgan’s mega balance sheet. This gives it the best of both worlds. It can use the U.S. bank’s financial heft to haul in equity capital markets business but it doesn’t carry the risk. Any duff underwritings land on JP Morgan’s plate.

This means the JV hardly needs any capital. Caz itself is a shell these days — its only asset is its near 50 percent stake in the joint venture. That in turn means almost all its profits are flushed through as dividends. Caz’s share of the joint venture’s after-tax profit last year was 46 million pounds, all of which was paid to its own shareholders (plus a further 3 million generated by Caz itself).

Squeeze is on for investment banks

Investment banks are facing a big squeeze. For an industry that was generating record revenues just months after the collapse of Lehman Brothers, this may seem unlikely. But the revival looks set to be short-lived. Increased regulation and greater competition means the super-charged returns the industry generated for most of the past decade are likely to prove elusive.

Analysts at JPMorgan believe 2009 will prove to be the high point in the investment banks’ relentless upward march. They expect revenues in 2011 to be no higher than in 2006. More significantly, the industry’s return on equity will fall to 10.8 percent, far lower than what they have got used to.

What explains this reversal? Regulation plays a big part. Contrary to the received wisdom that investment bankers are being allowed to carry on much as before the crisis, regulators have whacked up capital requirements for complex, illiquid products. These were the source of much of investment banks’ profit during the boom, and most of the trouble since. Higher capital charges will make a lot of what banks’ structured credit desks used to do unviable, and reduce the profitability of what remains. Caps on leverage will also make it harder for banks to juice returns.

Similarly, the drive to ensure more derivatives are traded on an exchange or, at the very least, cleared through a central counterparty will have a big impact. Blowing away the fog that surrounds derivatives will make it harder for banks to hide their true cost from clients and clear the way for new players to enter the market.

Indeed, competition is on the rise across the board. Investment banks enjoyed near-perfect conditions in the first half of the year, as volatile markets boosted trading activity while those that had survived the crunch were able to demand wider spreads. But many of the banks that got into trouble are now rushing back into the market, helped by cheap state-subsidised funding.

Of course, banks will not sit still. Anyone who witnessed the wholesale shift from equities into fixed income following the stock market crash of 2001-2002 will recognise that the industry has an extraordinary knack for rapid self-reinvention. Most houses are already cleaning up with fat fees as companies issue equity to pay off some of the debt they took on during the credit boom. Banks also have a long track record of circumventing new regulation.

Nevertheless, it’s hard to see any new business permanently filling the hole left by the structured credit collapse. Regulators will also be much more vigilant with banks seeking to pile risky assets — of any description — onto their balance sheets. This means the majority of future business is going to have to come from more old-fashioned activities such as underwriting, advising and trading — all of which are less profitable.

Investment banker admits: we overcharge

On the FT’s letters page, Robert Pickering tackles the familiar theme of bank profits and bonuses. The reason banks pay their employees so much, he argues, is because they make large profits. But why are their profits so large? 

The real marvel is that customers, both corporate and institutional, continue to be willing to pay so much for essentially commoditised services in a ferociously competitive marketplace served by multiple providers, thus generating these outsized profits.

What the FT fails to mention is that, until a year and a half ago, Pickering was chief executive of JPMorgan Cazenove, the London arm of the great House of Morgan. In other words, someone with intimate knowledge of the City of London’s inner workings is saying: we charge too much.

Pickering’s next job will presumably be in a different industry. I wonder what his successor has to say on the matter?

For Sale: Investment Bank, one troubled owner

So Deutsche Bank has written a large cheque to bail out Sal. Oppenheim — allowing the German private bank’s investors to subscribe to a 300 million euro share issue  which raises its equity capital to around 2.1 billion euros.

This is just part of the story though. The next step is apparently for Deutsche to take a stake in the 220-year-old private bank and for Sal. Oppenheim to sell off its investment banking business.

Sal. Oppenheim and Deutsche are giving little away — although the private bank says on its website that shareholders made the injection, which was financed by Deutsche and is the first step in a process of establishing a “strategic partnership” with the German lender.

A source tells Reuters that “interested parties” are already knocking on the door to buy Sal. Oppenheim’s investment banking business, which made a loss in 2008 — largely because of share trading losses.

The investment bank had been Sal. Oppenheim’s main money machine in recent years but in 2008 dragged its parent nearly 120 million euros into the red — its first annual loss since the Second World War.

Sal. Oppenheim’s 450-strong investment banking team not only sells M&A advice but also trades.

The challenge now is for the investment banking wing — led by partner Dieter Pfundt — to regain its magic touch and secure a decent price for its own business.

Bob Diamond in the red

Just how profitable is Barclays Capital?

At first glance, the answer would be: very.  According to Barclays’ results, Bob Diamond’s investment banking empire made a £1bn profit in the first six months of the year, double last year’s figure. That’s despite continuing hefty write-downs on toxic assets.

Indeed, as other parts of Barclays succumb to the economic downturn, Barcap, buoyed by last autumn’s acquisition of the North American operations of Lehman Brothers, more or less appears to be keeping the bank afloat.

So it was with some surprise that, ploughing through Barclays’ 124-page announcement, I came across the following on page 75:

Barclays Capital economic profit increased 11% (£12m) to a loss of £94m (2008: loss of £106m), due to a 100% increase in profit before tax driven by a very strong performance in the underlying business offset by a 104% increase in the economic capital charge reflecting an increase in economic capital allocation due to market volatility, an increase in the economic allocation for monoline exposures and further downgrades across credit markets, securitisations and loan exposures.

A little background: economic profit is an internal measure used by Barclays’ top brass to calculate the profitability of its divisions while taking into account the capital they consume. It is used when considering future investments and -crucially – when calculating bonuses.

What has happened is that Barclays has doubled its internal capital allocation for Barcap. As a result, the investment bank did not earn its cost of capital in the first six months of the year.

Deutsche Bank walks bad loan tightrope

    Deutsche Bank’s Josef Ackermann has bet that income from investment banking will more than cover bad debts buried in his balance sheet.     Ackermann is as usual putting a brave face on things, but looking at the hefty charges Deutsche is taking to provision against credit losses, it’s going to be a close call.     At the height of the financial crisis, Deutsche shifted assets from its trading to its banking book, thus avoiding mark-to-market write-downs and the need to raise more capital.     But dodgy loans catch up with you even if you hold to maturity — the losses just take longer to work their way through the pipe as loans become impaired.     Like Barclays in the UK, Deutsche’s sleight of hand may have helped it wriggle out of needing government help. But the Q2 charges have understandably rattled investors, with its shares down some 9 percent on Tuesday.     The big fear is that these charges are only the beginning and there are other skeletons in Deutsche’s cupboard.     But even if there is more bad news to come — and Ackermann is not overly optimistic in his outlook — the question is whether Deutsche can earn its way out. At first glance, it has successfully done this in the second quarter, beating estimates with a net profit of 1.1 billion euros ($1.57 billion) — helped by a lower tax bill — despite charges of 1.4 billion euros.     There are a few serious caveats other than the rise in bad debt provisions. Deutsche’s profit before tax was actually lower than some estimates, as were the revenue figures for some businesses including investment banking. Costs rose 9 percent.     Given that conditions for sales and trading and other investment banking activities could not get much better than they were in Q2, Deutsche is going to be closely watched.     Deutsche can’t do much more about its previous lending decisions. By focusing on avoiding past mistakes and growing its profits it might still squeeze through with no need to raise new capital, a move Ackermann has staked his reputation on doing without.     Deutsche has done well to bolster its capital ratios and cut risk weighted assets. But on the basis of these results, it’s going to be tight.

Credit Suisse pulls ahead of UBS

UBS has always looked down its nose at its cross-town rival, but Credit Suisse under Brady Dougan has turned the tables on the blue-bloods. As UBS remains mired in a potentially catastrophic legal tussle with America’s tax collectors, CS is winning market share across the board.

With its second quarter results, Dougan has shown that the storming first quarter was no flash-in-the pan. Stripping out various one-offs (including a counter-intuitive 1.1 billion Swiss franc loss thanks to an improvement in the value of its own debt), Credit Suisse’s net income increased 62 percent on the first quarter, to 2.5 billion Swiss francs. That is equivalent to a boom-like 27 percent-plus return on equity.

Dougan can point to some long-term strengths underpinning this result. The bank has increased its tier 1 capital ratio to a market-leading15.5 percent. And it has managed to attract funds to the private bank, despite the collateral damage inflicted on all Swiss banks by UBS.

As Dougan puts it euphemistically, “We have continued to prepare our Wealth Management business for the new environment by expanding our international footprint and building an efficient, global platform that complies with applicable laws and regulations.” In other words, CS is not going to repeat UBS’s mistakes, and is going to diversify away from an America whose sympathy for Swiss bank secrecy is disappearing fast.

However, despite Dougan’s talk of an integrated bank, CS’s results are dominated by the investment bank.  Asset management has only just turned a profit. Clients are continuing to withdraw their money, and at a faster rate than in the first quarter. Moreover, respectable results from private banking were helped by investment banking revenue booked from clients of the private bank. While this arguably shows the success of the “integrated bank” strategy, it masked a fall in recurring margins over the quarter.

So, investment banking dominates CS’s results even more than ever,  accounting for some 70 percent of net revenues, compared to less than 60 percent in 2005 . The bank has grabbed  share in equities, fixed income and some areas of investment banking. Dougan seems to think that CS is well-positioned whatever happens. If markets remain buoyant, CS will continue to grow share; if things turn down, there will be a flight to its well-capitalised quality.

However, the crisis is still fresh in the memory. Much of today’s investment banking profits across the industry result from a huge implicit subsidy via low central bank rates. Dougan will have to continue to engage in “close dialog with regulators around the world” if he wants to protect the bank from a taxpayer backlash.

Bankruptcy-related M&A at 5-year high – more to come?

This week’s Thomson Reuters Investment Banking Scorecard shows bankruptcy-related M&A at a five year high.

There were five bankruptcy-related M&A deals announced during the week, including the acquisition of venture-backed public company Nanogen by French investment holding company Financiere Elitech for $25.7 million. 

So far this year there have been 173 bankruptcy-related deals, the highest level since the same period of 2004 when there were 202.