Wall Street, Circa 2010: Disaggregation and Specialization

The Wall Street of today is almost unrecognizable from that at which I worked for almost two decades. The rise of the trading culture, first brought into the mainstream by John Gutfreund and Salomon Brothers in the 1980s and which lasted for more than 20 years, is now a vestige of the past. Huge trading losses have been posted. Risk limits have been taken down. “Structured Product” is now a dirty word. Securitization? Don’t want to hear about it. Asset-backed what? Sell – sell now! What started as a way to manage risk and to parse it out to those best positioned to bear it – the mortgage-backed security – evolved into something that lost its raison d’etre. The course of increasing complexity and distance from its intended goal, risk management, was a key contributor to the financial crisis we are encountering today. Much has been written about the “why” of Wall Street’s demise, but I’d like to consider a slightly different question: What now? What does a functional Wall Street of tomorrow look like? What businesses does it choose to be in? Where and how can it bring value to clients, both issuers and investors, in ways that are logical, straightforward, transparent, and consistent with its objective to increase its own shareholder value?

Industry structure: Disaggregation and Specialization

What used to be the bulge bracket Wall Street firms and their international peers had become financial supermarkets. Securities trading and issuance. Corporate advisory services. Asset management. Retail brokerage. Even insurance. In essence, the Sandy Weill model of the one-stop financial enterprise. This model was doomed from the get-go and the financial crisis will only hasten its demise. The concept of internally diversifying cash flows by seeking to operate a pile of loosely-related businesses under one roof never made sense, theoretically or otherwise. And yesterday’s announcement that Citigroup is looking to unload Smith Barney only reinforces the point – although Morgan Stanley clearly has a different view of things.

Disaggregation of Securities Dealers and Equity Research

Securities Dealers, those that help companies issue capital and to make markets in those and other securities, will continue do this. One related businesses will be bundled with securities dealers: Investment Banking. Issuers need advice on how and when to issue, and may also want M&A advice: Investment Bankers will continue to provide this service. The difference between how it used to work and how it will work in the future is the disaggregation of Equity Research. The major securities houses will have global distribution platforms for connecting issuers and investors, and to provide markets on a worldwide basis. There will be relatively few of these players as the cost of maintaining a global distribution platform is huge and, in my opinion, a natural oligopoly. But research will be “open sourced,” as the charade sometimes called “Wall Street single-stock research” is finally exposed.

Having the securities underwriter issue a “puff piece” as part of the IPO selling process is a waste of time, money and is fraught with conflicts. The Global Settlement was just that – a settlement. It wasn’t a solution. There only reason for bulge bracket firms to pay for costly research operations is if they help Investment Banking land deals. Bulge bracket research budgets in the early 2000s were in the $500 million to $1 billion+ range. If one were to disaggregate commissions into payment for research and execution, it is safe to say that investors attributed little value to Wall Street research. So how did the gap get filled? Investment banking mandates, together with outsized commissions on “hot” IPO deals that precipitated the Global Settlement in the first place. Transparency will enter the research venue, where investors buy research from the best providers at a known cost. There is no reason why a securities dealer should have better research than anyone else, and given that this is not their area of specialization it isn’t clear that they should be in this business at all. Added complexity is almost always a bad thing, and securities dealers have enough to manage without operating a separate research arm.

Disaggregation of Securities Dealers and Commercial Banking

A solid idea in concept, but fraught with conflict and potential magnification of risks. Seems logical from the Wall Street perspective; let’s simply migrate up the right hand side of the balance sheet, providing everything from bank loans to term debt to mezzanine, convertibles to preferreds to common stock. The problem is, however, that bank debt and bridge loans were used as levers to secure other, higher margin pieces of business such as IPOs, M&A, junk bonds and derivatives. So what you’d get are a bunch of very smart, very aggressive, very crafty, super-money motivated product specialists pressuring the commercial bankers to make loans whether they liked them or not. “It’s for the good of the (firm) relationship” was the siren’s song. What they really meant to say was “It’s for the good of my P&L (and the basis for my year-end bonus)”. This is clearly not the best way to manage risk or allocate capital.

The risks borne by securities dealers – market risks – are fundamentally different than those absorbed by commercial bankers – credit risks. This is why large financial firms have two discrete risk hierarchies governing these distinct exposures. However, if one takes the evolution of the markets to the limit, then market risk and credit risk effectively intersect, e.g., a company’s debt is as liquid as its stock and every slice of the right hand side of the balance sheet is listed and tradable. In this case a company’s credit risk would be priced, in real time, by the market, and one could assess the appropriateness of the risk/reward trade-offs embedded in each security. Arbitrage would keep the relationships efficient. This is what capital arbitrage trading strategies seek to do today, but by using a mix of liquid (listed equities) and less liquid (credit derivatives, bonds and bank loans) assets. But the time when credit and market risks intersect is a ways off, and building integrated platforms predicated upon this condition that are laden with conflicts results in a flawed business model.

Disaggreation of Securities Dealers and Retail Brokerage

The bundling of retail brokerage and securities was a mistake of both scale and conflicts of interests: scale because the entities are simply too big and the cultures to different to manage, and there are few natural synergies between the two businesses; and conflicts because retail brokers are more heavily compensated to push proprietary in-house products than third-party products, resulting in advice to clients that is biased, at odds with the fiduciary responsibility brokers have to their clients. How can Morgan Stanely resolve this conflict? They can’t. A combined Smith Barney/Morgan Stanley retail brokerage operation will be a prime candidate for spin-off when the IPO market recovers. The integrated financial enterprise resulted in a broken system; the crisis will provide the impetus to fix it.

Disaggregation of Securities Dealers and Proprietary Trading

Wall Street firms generally have several pools of trading risk, some of which are customer-related and others which are purely proprietary. Being in the securities business means taking market risk. Firms will underwrite deals, buy positions from customers without having the other side of the trade, shape its book to best position it to make money from customer flow, etc. However, this is very different than taking non-customer driven, proprietary positions in the market. Given the need for separation between the customer-serving flow traders and the proprietary traders, it is not clear that securities deals need these proprietary trading operations at all. Since they can’t benefit from information about customer flow, there are no true synergies between this operation and the rest of the securities business. In good times these businesses can mint money and help bolster the bottom line. But in bad times these businesses are a distraction and can cause management to lose focus on what really matters – firm clients. Morgan Stanley’s decision to pare back its proprietary trading is no surprise; if the goal is to create a less volatile, more customer-focused, sustainable franchise, then it stands to reason that this is yet another business that need not be part of the legacy Wall Street mix.

Disaggregation of Securities Dealers and Illiquid Assets

OTC derivatives – CDS, swaps, etc. – were the engine of growth and profitability at many Wall Street firms. Part of the appeal was opaqueness, e.g., I can hide how much I’m making. Part of the appeal was capital efficiency. These businesses consumed tremendous resources to function effectively – credit, documentation, legal, operations, etc. However, this opaqueness has also contributed to its downfall, as the need to unwind and/or settle mind-bending numbers of transactions and the collateral impacts has highlighted a fundamental flaw in the OTC derivative market’s evolution. These weaknesses can be addressed by shifting a large number of these transactions to exchanges, substantially increasingly liquidity, transparency, simplicity and collateral management. The securities dealer of 2010 will have an active and profitable derivatives business; it will just look more like stock trading circa 1990 than what it has for the past 20 years. Will there be some “exotic,” hard-to-price risks that will reside on the Securities Dealers’ balance sheet? Certainly. But it will be a small number that is aggressively managed to ensure that it stays small and doesn’t get out of hand.

Conclusions

The Securities Dealer circa 2010 will be laser-focused on client business: raising capital, distributing risk, and trading within the scope of customer flows. This is the culture and this is what they do best. Equity research will become an industry unto itself, moving beyond the “independent research” moniker it wears today. In tomorrow’s world all research will be independent. Who wants biased research? The jig is up. Corporate lending will be done by commercial banks. Glass-Steagall separated Investment Banking and Commercial Banking for a reason. While I don’t think that these regulations are necessary, as an investor I’d prefer to put my money into a pure-play Securities Dealer and a pure play Commercial Bank than a combined entity any day. Better managed. Fewer conflicts. More profitable. Retail brokers will become independent enterprises, offering their clients an open-source platform of the best products and service available, without the incentive to push a single house’s product line. They will compete on client service, financial planning, portfolio design and after-fee performance. This would be an attractive business for investment, as it will possess stable cashflows and a strong brand free from conflicts. Proprietary trading will likely be done outside the province of the Securities Dealers, in a healthy hedge fund and institutional asset management framework (more on that in another post). And the illiquid asset business – OTC derivatives, etc. – will move towards exchanges, looking more and more like a stock trading business under the Securities Dealer’s umbrella.

2010 will be a better world on Wall Street. Greater focus. Fewer conflicts. More profitable. Less risky. It is now up to Mr. Market to make this happen.

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