If You're Not Scared of Big Banks, You're Not Looking Hard Enough

The collection of big U.S. banks had to be feeling pretty good about themselves. JPMorgan Chase (NYSE: JPM  ) and Bank of America (NYSE: BAC  ) both beat analyst estimates and, heck, even Citigroup (NYSE: C  ) managed to post a $4.4 billion profit.

That's right, I said "Citigroup" and "profit."

But of course, it was destined to be shattered thanks to the SEC and its fraud suit against Goldman Sachs (NYSE: GS  ) . Now everybody is looking at the big players in the industry all cockeyed again and poor Vikram Pandit is probably wondering what awful things he did in a past life to deserve his current fate.

Goldman suit or not, though, Wall Street is still far from healed. More credit losses could still be on the way and the whole industry is badly in need of reform. And in the midst of all of this, there's something particularly worrisome about the banks' first-quarter earnings reports that overeager investors may have missed.

But first, some background
Goldman Sachs is a perfect example of the evolution of the investment banking industry. Back in 1998, the company generated 40% of its revenue from investment banking advisory services and another 33% from asset management. That made the firm pretty safe and secure, but not too terribly exciting.

Through acquisitions and a general realignment of the company's focus, by 2000 the firm had boosted its equity trading from less than 10% of the business to more than 20%. Stymied by the bursting of the Internet bubble and falling commissions in equity trading, Goldman shifted its focus to fixed income, where it could feast on huge commissions and black box trades by working in areas like asset-backed securities where there were no exchanges and most products were anything but standard.

By 2006, Goldman's fixed income, currency, and commodity (FICC) division was close to 40% of the company's revenue. Investment banking and asset management had been relegated to support roles, now generating just 15% and 17%, respectively, of the company's revenue.

And though I'm focusing on Goldman here, the trend was very similar for other major Wall Street firms. In 2006, trading and principal investments in FICC generated around half of the revenue at Lehman Brothers and Bear Stearns.

The rise and fall of FICC
But how exactly was fixed-income trading able to become such a massive part of Wall Street's revenue? The housing bubble, silly!

Easy credit and the housing mania allowed traders to make big bets on a sure thing (after all, housing prices never go down, right?) and gave pension funds and overseas investors a huge appetite for exotic paper like MBSes, ABSes, and CDOs.

Though it was all very irrational, it made perfect sense that Wall Street was making big money off of it. That is, until it didn't.

As we all know, the turnaround hit like a category five hurricane and the Streetwide feasting on the housing bubble led to a reckoning that cascaded through Wall Street and overseas to companies like UBS (NYSE: UBS  ) and ING Group (NYSE: ING  ) , leaving a trail of massive losses behind it.

Ready for the scary part?
We're now supposedly on the other side of all of that. Most of the bailouts have been paid back, Citigroup is profitable again, and Ken Lewis has finally been booted from Bank of America.

Yet I wouldn't touch the big banks with Angelo Mozilo's money. Why? Take a good look at the first-quarter reports coming out of Wall Street. FICC trading and investing is absolutely booming. Morgan Stanley (NYSE: MS  ) , Goldman, JPMorgan, Citigroup, and Bank of America reported a combined total of around $26 billion in FICC trading revenue in the first quarter. The $7.4 billion that Goldman notched is more than half of what it registered for the entire year in 2006 and represented 60% of the company's total first-quarter revenue.

All of these businesses are black boxes so we have no idea what's actually generating all of that revenue. Is it real? Is it in any way sustainable? Is it leaving these companies exposed to more losses? Is it just one big replay of the tragic story we just lived through?

It'd be silly to expect to get real answers to any of these questions. And as long as that's the case, if you're an investor eyeing any of these companies, you need to either get comfortable with making speculative bets, or start looking elsewhere for investment opportunities.

Now that you've heard my piece, why not weigh in with your thoughts? Scroll down to the comments section and let me know whether you think I've given banks a bad rap.

Ready for a nonbanking investment idea? Fool Jordan DiPietro thinks he's found a quality stock that's trading for dirt cheap.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy assures you no Wookiees were harmed in the making of this article.


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  • Report this Comment On April 22, 2010, at 5:02 PM, danp18 wrote:

    I agree with your comments. Banks are still very weak,as all the bad asset has been taken off the books. Also in North East Housing market has not been corrected as it should be. Change of 2-7 % in housing from the peak is surly not a correction. When and if interest rates started to go up, housing value will come down and at that time, banks may loose more on their bad assets.

  • Report this Comment On April 23, 2010, at 12:45 PM, revjr11 wrote:

    I'm inclined to agree with you on this, but whats your take on Fairholme creating a notable position in Citi and claiming that "its balance sheet is better than ever"? His rationale is that after being under Government scrutiny for so long, this is a clear value play. He's used similar rationale in becoming the largest shareholder of AIG after only the Govt. What's your take on this? Is Fairholme falling into the same trap as everyone did before? He avoided financials like the plague until now. What's changed his mind that hasn't changed yours?

  • Report this Comment On April 23, 2010, at 1:02 PM, revjr11 wrote:

    I'm inclined to agree with you on this, but whats your take on Fairholme creating a notable position in Citi and claiming that "its balance sheet is better than ever"? His rationale is that after being under Government scrutiny for so long, this is a clear value play. He's used similar rationale in becoming the largest shareholder of AIG after only the Govt. What's your take on this? Is Fairholme falling into the same trap as everyone did before? He avoided financials like the plague until now. What's changed his mind that hasn't changed yours?

  • Report this Comment On April 23, 2010, at 7:26 PM, TMFKopp wrote:

    @revjr11

    Wow, what can I say. I have a tremendous amount of respect for Bruce Berkowitz, but I'm not quite sure how he's making that call. When it comes to the balance sheet in particular, there's just so little good data from the big banks and that makes it really hard for investors to really judge what kind of exposure is there.

    Perhaps Berkowitz has seen something I haven't, perhaps he's gotten his hands on information not widely available, or maybe he's speculating that the balance sheet risk has gone away. He's a great investor and I wouldn't be surprised if he turned out to be right and made good money on that bet.

    The bottom line is that we don't know exactly what Berkowitz's analysis is, and it's rarely (never?) a good idea to invest in something just because a savvier investor has done it. If your personal analysis leads you to believe the risks are passed for Citi, go for it. But if you just like the fact that Berkowitz has gone after it then go for FAIRX instead.

    As for me, I'm no Berkowitz. I'm an individual investor writing for other individual investors and to me the opacity and complexity alone make the big banks really difficult bets for individual investors.

    And let's be clear here too, even if Citi doubles or triples from where it is today, it still won't be one of the decade's best performers. There are smaller stocks out there that are too small for big institutions to bother with, that have businesses that are much easier to evaluate, and have the potential for much greater returns.

    Matt

  • Report this Comment On April 24, 2010, at 6:31 PM, jsv614 wrote:

    It makes sense that the govt. has made sure Citi's balance sheet dsnt have any timebombs waiting to explode. It also seems as if Pandit is serious about returning to "traditional" banking. Does anyone know whether he truly supports financial reform (with more than lip service)?

  • Report this Comment On April 27, 2010, at 1:25 AM, vikas4 wrote:

    Essentially are these investment banks, oh, sorry, trading houses, not feasting on the SMEs or the real value additive concerns ?

    or on the mania created in front in front of the retail investors?

    seems a clear connection where the short term wealth is getting transferred (in bank books) and the long term in ....some offshore accounts

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