Unstructured Finance

S&P calls baloney on Wall Street’s “cyclical” profit view

July 2, 2012

By Lauren Tara LaCapra

Ask a Wall Street CEO whether his bank will be able to make as much money as it used to make, once customers start trading and doing deals again. He will inevitably respond with some form of “Yes!”

Ask just about anyone else with a shred of common sense and the answer is more along the lines of “hahaha…you’re kidding, right?”

This conversation is known on Wall Street as the “Structural vs. Cyclical” debate. On the structural side, you’ve got those who are convinced that new regulations, higher capital requirements and clients’ mistrust of big, conflicted i-banks will keep  a lid on profits for firms like Goldman Sachs, JPMorgan and Morgan Stanley. On the cyclical side, you’ve got people like Goldman CEO Lloyd Blankfein and JPMorgan CEO Jamie Dimon, who keep insisting that everything will be just fine once various “headwinds” subside.

But the longer this so-called “cycle” of weak Wall Street profits trudges on, the broader the Structural Change Coalition gets.

On Monday, S&P came out with this blaring headline: “The Weakness In Capital Markets Revenues Is More Of A Structural Than Cyclical Phenomenon.”

The news was actually that S&P had become more optimistic in its outlook for 2012 capital markets revenue: analysts now forecast a decline of up to 10 percent instead of up to 20 percent. But because the structural vs. cyclical debate has been raging on for some time, S&P felt the need to come out with a point of view, S&P analyst Stuart Plesser said in an interview.

“We feel the returns of 2007 are not going to recur,” he said.

Indeed, while big i-banks have historically generated returns of 15 percent in OK times and above 20 percent in great times, last year they generated an average return on equity of 7 percent, Plesser said.

An even sharper contrast can be found at Goldman, which has a reputation for minting money in OK times and swimming in money in great times. In 2011, Goldman’s return on equity was  just a measly 3.7 percent, compared with 32.7 percent in 2007. (Ouch.)

S&P’s  analysts believe this kind of earnings drought is more structural than cyclical, and they are not the only ones on Wall Street to have come out with this apparently controversial conclusion.

JMP Securities analyst David Trone downgraded bulge-bracket banks in May, calling the group “un-investible,” partly because of the European debt crisis, but also because of bigger regulatory issues that will inhibit big banks’ profits for the foreseeable future. He went as far as to say that big investment banks would be better off under Glass-Steagall than the Volcker rule.

Meanwhile, Goldman CFO David Viniar argues that Volcker will actually make the bank more profitable. Morgan Stanley executives have drawn similar conclusions about derivatives trading, which nearly everyone expects to become drastically less lucrative once trades move to central clearing and exchanges.

It’s not surprising that Wall Street executives are trying to be optimistic about the future. After all, their bonuses depend on how much their companies can earn.

But Wall Street profits have been declining for the better part of three years and shares of big banks have been trading at discounts to book value, on and off, for even longer.

As anyone on Wall Street will tell you, cycles don’t last that long.

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