When the world of finance was rocked by billion-dollar write-downs, mass layoffs, declarations of bankruptcy, rumors of nationalisation of the world’s biggest banks and grim-faced government officials unveiling plans to bail out financial institutions, experts from London to Tokyo to New York turned to each another and asked, “What just happened?”
We’ll be parsing the events of 2007, 2008 and 2009 for decades to come; the scope of the crisis fallout—and blame—is still being assessed. For now, we know that the I-banking landscape has been permanently changed. In a nutshell, here’s what happened.
The U.S. housing market, which had risen steadily through 1990s, finally began to slow down. At the same time, mortgage lenders were making increasingly risky loans—approving mortgages for “subprime” customers who were at high risk of defaulting. (Later, the world heard horror stories about unemployed people being approved for expensive home loans, despite having no real proof of income.) Meanwhile, I-banks had figured out ways to securitise home loans and the risks involved with them, packaging and slicing these new securities into arcane derivatives. These derivatives wound their way through the world’s financial system, piling up in banks’ balance sheets. This created a ticking time bomb: as people began defaulting on their mortgage payments, these assets’ values evaporated, leading to massive write-downs and losses.
In the fall of 2008, the world’s investment banks were in a state of panic, fearing for their own—and others’—safety. Things that looked like assets on paper proved worthless. Because of the way credit risk was spread through the system, banks began freezing lines of credit to other banks and consumers: no one knew for sure who was liquid and who was on the verge of collapse. The credit crunch slammed the brakes on an already-slowing economy, and banks, mortgage lenders, insurers and public companies scrambled to avoid bankruptcy. Some were successful; some were not.
It’s unsurprising, then, that investment banking revenue has been less than stellar lately. Investment banks’ earnings had soared through 2005, 2006 and the first half of 2007. Then came the downswing. According to Dealogic, in the first quarter of 2009, global I-bank revenue was $9.2 billion, down from $15.4 billion in the first quarter of 2008, and far from the peak of $26 billion in the second quarter of 2007.
Because the United States and Europe were hardest-hit by the global recession, Asia and, to an extent, the Middle East and Africa, have risen in relative importance and fee income. Some banks have begun shifting resources and attention to Asia, where private equity and a reasonably-stable financial system have kept deals flowing.
Perhaps the most lasting legacy of the financial crisis will be its impact on Wall Street’s biggest players. Bear Stearns was the first to collapse, and the U.S. government helped engineer a sale of Bear to JPMorgan Chase in March 2008. Lehman Brothers toppled into bankruptcy and was sold in pieces to Nomura Securities, which now owns its European and Asia-Pacific businesses, and to Barclays, which owns its North American operations. (The U.S. government’s refusal to step in for Lehman, as it had for Bear, remains a source of anger and bewilderment for its former employees.) And after 94 years in business as an independent I-bank, Merrill Lynch (part of the so-called bulge bracket) admitted defeat and sold itself to Bank of America.
That left Goldman Sachs and Morgan Stanley as the last independent bulge bracket banks on Wall Street. But even they succumbed. In late 2008, both banks received permission from U.S. regulators to convert themselves into bank holding companies, a restructuring move that allowed them to receive government assistance—but also left them bound by strict regulations and rules regarding leverage and risk-taking.
This raises an important point: in the U.K. and in the U.S., banks that have taken government assistance (“bailout funds”) face the imposition of new operating requirements. In other words, governments have poured billions into their banks—and now they want a say in how they’re run, especially in light of the fact that many blame loosely-regulated derivatives trading for fuelling the crisis.
Will I-banks—or the banks that acquired the I-banks—ever go back to their unfettered ways? Maybe. In some cases, banks will be able to win back some freedom if they can repay their bailout allotments. But the bottom line is the days of high-flying, overleveraged risk-taking are over, at least in the near term. International and local regulators, politicians and taxpayers are watching banks like hawks, keeping an eye on everything from executive compensation to the state of the balance sheet.
Big banks, small banks
For the first quarter of 2009, J.P. Morgan—newly fattened by the addition of Bear Stearns’ business—topped the Dealogic revenue rankings, earning $828 million and holding an 8.2 percent market share. Bank of America Merrill Lynch was No. 2, with revenue of $695 million and a 6.9 percent market share. Citi was right behind, with revenue of $679 million and a market share of 6.8 percent.
As in the old days of the bulge brackets, big institutions continue to dominate the market. The top 10 major firms—five American, five European—account for over half of the industry’s revenue. Representing Europe in the top 10 are UBS, Deutsche Bank, Barclays Capital, Credit Suisse and BNP Paribas. Rounding out the top 15 are the I-banking divisions of smaller European and Japanese banks, including RBS, HSBC, Nomura, Lazard and Calyon.
In recent years a class of “boutique” I-banks—small, independent firms—has been on the rise, in some cases challenging their larger competitors for deals. Among the world’s preeminent boutiques are Evercore Partners, Allen & Co., Moelis & Company and Perella Weinberg. (Except for Allen & Co., which has just one office in New York, all of these firms have locations in London, New York and a handful of other key financial centres.)
For most boutiques, the selling point is simple: world-class service (their founders and top executives are often refugees from bigger banks) with a personal touch. Clients who worry about getting lost in the shuffle at, say, J.P. Morgan may turn to a boutique for personalised advisory and a guarantee of independence—boutiques that focus solely on advisory services are less likely to run into conflicts of interest with research and sales departments. Since they lack the trading floors and vast securities portfolios of their mega-rivals, boutiques have been largely untouched in the financial crisis. If anything, they’ve been able to pick up business, presenting themselves as a safer alternative to banks that are being kept alive by taxpayer funds.
M&A boom and bust
Mergers and acquisitions advisory was, for most of the late 1990s and early 2000s, a leading source of revenue for the global investment banking industry. In 2000 the world’s volume of M&A activity totaled almost $3.5 trillion; business dipped in 2001, and in 2002 deal volume was down to $1.2 trillion worldwide.
Things picked up in 2004 as a strong global economy, low interest rates and thriving stock prices raised confidence and spurred dealmaking. Global M&A activity was up to $2.7 trillion by 2005, and both Europe and the U.S. saw 30 to 40 percent increases in volume. Deals kept going through 2006, peaking in mid-2007. (Incidentally, European M&A once accounted for just 10 percent of the world’s dealmaking; now, it’s closer to 40 percent.)
A notable feature of the mid-2000s M&A boom was the major part played by financial purchasers, including some multi-billion dollar deals. Private equity groups, which were raising ever-larger funds, were buyers on an unprecedented scale. Some of the major investment banks played a significant role in this development. Management buyouts were also a thriving contributor.
The global recession that nearly destroyed banks in 2008 took a big toll on mergers and acquisitions. Without access to cheap, plentiful credit, potential buyers were less likely to buy. Embattled companies made less-attractive targets. And in a climate of no confidence, few CEOs wanted to take on any unnecessary risk. As a result, banks’ M&A revenues dwindled. The world’s I-bankers did just $2.6 billion of M&A business in the first three months of 2009, way off the peak of $8 billion in the fourth quarter of 2007.
Bankers vs. traders
Investment banks have long contained two cultures—traders and corporate finance advisers. It was the latter who traditionally became firms’ chief executives and chairmen. The lines have blurred, however, as former traders have risen in prominence at their respective firms. (Some corporate financiers have responded by heading out on their own to start boutique advisory firms.) Among the traders who worked their way to the top: Goldman Sachs CEO Lloyd Blankfein, a former commodities trader; Huw Jenkins, who led UBS until stepping down in 2007 after massive losses at the investment bank; and Oswald Grubel, a former floor trader who served as CEO of Credit Suisse until taking over for Jenkins at UBS.
Speaking of losses, traditional trading at I-banks consisted of dealing in equities, bonds and basic financial derivatives for currency and interest rate products. That changed when banks began inventing new kinds of derivatives, an effort to wring more return from, well, just about anything. New types of derivatives allow banks to trade contracts based on future energy prices, complicated bundles of currency prices, even the odds of another company defaulting on its debt.
What’s more, investment banks and brokerage firms used to act only as agents: they bought and sold securities on behalf of their clients. Now they’re just as likely to be principals in trades, using firm assets to make their own bets. When they get it right, traders have reaped big rewards for their employers. When they get it wrong, as the world discovered in 2007 and 2008, the losses can be devastating.
Compounding these issues is the fact that trading activity has increased as a proportion of I-banking revenue, and brokerage services have expanded at many banks. The growth of hedge funds drove banks to build prime brokerage units, which offer dedicated financing, securities lending, clearing, custody and advisory services to major investors and hedge funds.
Mergers and acquisitions groups weren’t the only ones to feel the pinch of the recession in early 2009. I-banks made revenue of just $1.8 billion in the equity capital markets in the first quarter, down from a high of $6.9 billion in the last quarter of 2007. Global debt capital markets revenue fared better, climbing from $2.1 billion in the last quarter of 2008 to $4.2 billion in the first quarter of 2009. Still, that’s far from the peak of $7 billion in the second quarter of 2007.
The European scene
Europe’s major commercial banks have traditionally provided investment banking services for corporate clients, and as economic divisions among European nations have relaxed, opportunities for cross-border bank mergers have expanded. Despite differences in legal, tax, accounting and regulatory systems, a number of banks have sought targets beyond their home borders.
Spain’s Banco Santander kicked off the cross-country mega-merger trend with its $17 billion acquisition of the U.K.’s Abbey National in 2004. This was followed a year later by Italian bank UniCredit’s $22 billion purchase of Germany’s HBV and Dutch giant ABN AMRO’s $7 billion acquisition of Banca Antonveneta of Italy. Not to be outdone, in 2006 France’s BNP Paribas spent $11 billion to buy Italy’s Banco del Lavoro.
But the biggest acquisition of all came in 2007 when a consortium led by the Royal Bank of Scotland beat out Barclays to buy ABN AMRO in a €70 billion deal—the biggest bank takeover in history. Joining RBS in the winning consortium were Spain’s Banco Santander and Belgium’s Fortis. Game, set, match? Not quite.
Both RBS and Fortis were slammed with losses in 2008, partially the result of bad investments linked to subprime assets, partially the result of the expensive acquisition. (Some observers wondered why, exactly, the RBS-led consortium decided that the onset of a global recession was a good time to forge ahead with such an outsized deal.) In late 2008, RBS joined HBOS and Lloyds TSB in accepting bailout funds from the U.K. Treasury; as a result, the British government ended up with a 58 percent stake in the bank. Disgraced CEO Sir Fred Goodwin resigned over the matter. It gets worse: in January 2009, RBS reported a £28 billion loss, the largest in U.K. banking history. Of this, about £20 billion was attributable to the ABN AMRO purchase. The U.K. government raised its stake in RBS by converting preferred shares to ordinary shares, and today RBS has, for all intents and purposes, been nationalised—the government holds a 70 percent stake.
Fortis also took a hit after the headline-worthy ABN AMRO deal, which drained the Belgian bank of capital. CEO Jean Votron stepped down, and in September 2008, Fortis announced that it would divest most of the ABN AMRO pieces it had acquired, mostly operations in Belgium and the Netherlands. Shortly thereafter, the Benelux governments had to step in, and in the end, the remains of Fortis were sold to its former consortium partner BNP Paribas.
Although they were not involved with the disastrous ABN AMRO transaction, U.K. banks Lloyds TSB and HBOS floundered in the global crisis. After accepting bailout funds from the government, the two banks were forced into a merger, forming a new entity called Lloyds Banking Group. It, too, is poised for greater government involvement.
Jobs and bonuses
Losses and write-offs led, necessarily, to layoffs, bonus cuts and pay freezes at many top banks in 2008 and 2009. For the full year 2008, the financial services sector cut over 225,000 jobs worldwide. London’s Centre for Economics and Business Research (CEBR) predicts that City jobs will total 296,000 by the end of 2009, down from a 2007 peak of 353,000. Economic turmoil has meant a mixed bag for prospective I-bank employees: some banks have limited new hires, while others are taking advantage of a flooded candidate pool to scoop up displaced talent at lower-than-usual pay scales.
Despite the grim numbers, the first half of 2009 brought tentative signs of a turnaround in London, where thousands of finance workers received pink slips in late 2007 and 2008. In May alone, 500 new jobs were created, driven by Barclays Capital’s announcement that it would hire 300 new equities bankers by the end of 2009. (Why? As BarCap reshuffled people to accommodate its purchase of Lehman in North America, positions opened up.) Other European and Asian firms, including Japan’s Mizuho Securities, UniCredit and Standard Chartered, began modest U.K. hiring efforts in the spring of 2009.
Jobs will likely recover before salaries do, and it may be some time before City bankers can count on receiving the colossal paycheques and bonuses to which they were accustomed. Most bankers in the City and on Wall Street finished 2008 with a wary “wait and see” approach about their compensation. Uncertainty about base salary raises and bonus payouts made it difficult for many people to predict what they’d be making in a year, let alone in a few years (unlike the old days, when promotions and raises were fairly locked-in). And at the uppermost levels of the boardroom, CEOs have come under increased pressure from lawmakers to cut compensation for the highest-paid executives, and to bring bonuses in line with profits.
According to the CEBR, total bonus payouts in the City peaked in 2006, when banks paid out an incredible £8.8 billion. For 2008, the CEBR estimated bonuses fell more than 60 percent, to £3.6 billion, and predicted that 2009 bonuses in the City would total approximately £2.8 billion—a 70 percent decline from 2006. Banks are also making modifications to bonus schemes, like shifting from cash awards to stock awards, and spreading payments across several years.
Banks that received bailout money from their respective governments (including Citi, J.P. Morgan Chase, Morgan Stanley and Goldman Sachs in the U.S., and Fortis, Lloyds and HBOS in Europe) will be further constrained in their ability to pay top execs top dollar (or top pound), unless they can repay the funds. Goldman and J.P. Morgan said in May 2009 that they were hoping to make repayments by the end of the year, in part because they want to be free of government oversight when it comes to compensation. And by June 2009, their hope turned into reality, as they, along with eight other firms, were given approval by the U.S. government to repay their bailout funds.
Still, look for bank pay scrutiny to continue on both sides of the Atlantic. Failure to repay bailout money could have serious consequences for American banks such as Citi and Bank of America (which were not part of the 10 approved to repay funds): U.S. President Barack Obama has called for a $500,000 cap on salaries and bonuses for bailed-out banks’ executives, and suggested that firm “excesses” (like private jets and corporate sponsorships) should be posted online for taxpayers to see. Gordon Brown took a similar stand, requesting a £25,000 cap on cash bonuses for bankers at RBS.