U.S. Investment Banking Sector’s Rough Weekend Provides Investors With a Roadmap for Future Profit Plays

By Martin Hutchinson
Contributing Editor

It was a rough weekend for the U.S. financial system. Investment banker Lehman Brothers Holdings Inc. (LEH) collapsed and, as I predicted last week, the problems were not confined to Lehman.

As Money Morning detailed yesterday, Merrill Lynch & Co. Inc. (MER) has been taken over in a rescue by Bank of America Corp. (BAC), while the mortgage bank Washington Mutual Inc. (WM) and the derivatives-happy insurance company American International Group Inc. (AIG) remain in deep trouble. But what does it mean for the rest of us, as investors in particular?

Looking, first, at the investment banks themselves, the main problem as I discussed last week was that the so-called “Big Five” investment banks (soon to be the “Big Two”) were thoroughly over-levered – with total assets-to-capital ratios of 30:1 or more – compared with the traditional brokerage house ratio of less than 20:1.

Investment banking is an intrinsically cyclical business, but Wall Street’s greedy-and-aggressive top management forgot about that as they chased profits and bonuses during a stretch in which money was always easy to obtain. The commercial banks – even giant Citigroup Inc. (C) – were fortunately much less levered. For once, we must all bless government regulations, which are much stricter for deposit-taking institutions – meaning the government rules have so far prevented big commercial banks from following the investment banks into collapse.

AIG shouldn’t have had problems, at all; it’s primarily an insurance company, and those firms typically operate with very little leverage. However, when you look at AIG’s balance sheet, it has leverage of about 15:1 – similar to the big commercial banks – and it has also made a specialty of speculative trading in derivatives. That was an attractive business for many years but like other such businesses has recently run into trouble. AIG is currently seeking a federal bailout; it is fairly unlikely to get it – although an AIG bankruptcy would certainly cause turmoil in the various derivative markets.

On the commercial banking side, things aren’t very rosy either, despite the fact that big commercial banks are less levered. Citigroup has had huge subprime problems, but is so large and internationally diversified that, in the long run, it may be able to ride out the storm. JPMorgan Chase & Co. (JPM) appears solid, and its top executives must, right about now, be congratulating themselves for having received a $30 billion subsidy from the Fed to take over Bear Stearns – before the government turned ornery and parsimonious.

Wachovia Corp. (WB) had historically been one of the strongest banks in the U.S. market, but due to its spectacularly ill-timed $20 billion purchase of a California home mortgage company in 2006, it now has serious asset quality problems.

Bank of America is an interesting case. It has a retail banking franchise similar to that of Wachovia that had been active in home mortgages and had the usual problems. It also made a big home-mortgage-market push with its purchase of Countrywide Financial Corp., but that purchase was undertaken back in January, when prices were far below those of 2006, so Bank of America probably got a bargain. On the other hand, Countrywide had been the largest and most aggressive of the home-mortgage lenders, so there is a very decent chance that its portfolio is substantially worse than others, possibly giving Bank of America an agonizingly difficult decision of whether to continue supporting it if new problems continue to appear.

As for BofA’s proposed buyout of Merrill Lynch, one must admire the cool and savvy of Bank of America Chairman Kenneth D. Lewis in rejecting the more-obvious possibility of bailing out Lehman – in favor of the much-more-attractive opportunity presented by Merrill Lynch.

Merrill Lynch has the largest retail brokerage operation in the United States – providing it with a huge branch network; it thus provides superb synergy with the primarily retail-oriented nationwide branch network of Bank of America. The only caveat is that with $1 trillion in assets Merrill is a big bite to swallow. And with the Merrill buyout following Countrywide, as it does, there’s always the chance for some post-deal indigestion.

Going forward, I’m happy to say, it’s not all gloom and doom, meaning we must be approaching the end of what we’re calling the “fail-and-bail” cycle.

Both Goldman Sachs Group Inc. (GS) and Morgan Stanley (MS), the two remaining investment banks, appear less vulnerable – although in Goldman’s case its ability to sail serenely through the first year of the current mortgage-fallout morass is a bit more disquieting than reassuring, suggesting there could be hidden problems.

Overall, however, it may be well-worth looking at the financial-services firms that seem likely to survive – particularly in the insurance area, were risk management is generally better than in banking (because it’s a more-central part of the insurance business), or in Asia, where growth continues and the exposure to U.S. financial problems is limited. [Please click here for a news story detailing the latest developments in the U.S. financial-services sector, elsewhere in today’s issue of Money Morning.]

[Editor’s Note:When it comes to investment banking and the international financial markets, Money Morning Contributing Editor Martin Hutchinson brings readers a unique brand of expertise. In February 2000, for instance, when he was working as an advisor to the Republic of Macedonia, Hutchinson figured out how to restore the life savings of 800,000 Macedonians who had been stripped of nearly $1 billion by the breakup of Yugoslavia and the Kosovo. In a Money Morning column last week, Hutchinson predicted that Lehman Brothers would fail. Subscribers to our affiliated monthly newsletter, The Money Map Report, will be ahead of the game on his next prediction, thanks to a column he’s written for the upcoming Oct. 1 issue, which should appear in the next several days.]

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