I have seen the future and it is different than the past.  Much different. I’m talking about the future of my industry, investment banking. I had been hesitant to articulate a view about the road ahead previously, because there was still significant uncertainty in the financial markets as to how we might deal with the remaining issues stemming from the most recent meltdown.  The potential for there to be another seachange event which recasts the recasted paradigm, was, at the time, real, and still is.

Entering this past weekend, there appeared to be three major uncertainties related to the U.S. financial system weighing on stocks (in order of importance in my view) — the health and wellness of Freddie Mac and cousin Fannie Mae, the future of Lehman Brothers and the future of Washington Mutual (WaMu).  Since the inception of the U.S. financial markets crisis many of the large money centered banks took billions and billions of dollars from sovereign wealth funds (approximately $105 billion for stakes in Citigroup, Inc., Morgan Stanley, Merrill Lynch & Co. and UBS AG).   So much money was ingested from foreigner states and funds that Congress started to become a little concerned. However, with the demise of Bear Stearns (Citic Securities Co. aren’t you happy that deal never got done), the sovereign wealth solution dropped off the table.  This left the world wondering what was going to happen to the remaining behemoths.

Over the past weekend, we learned more about the fate of each of these entities, or at least we thought we did.  Fannie and Freddie, “too big to fail” according to the Oracle Warren Buffet, were seized by the U.S. government, who will put in billions of dollars of liquidity in the system, helping mortgage rates and freeing up the logjam for those who need to refinance out of the adjustable rate mortgages.  Upon the news 30-year fixed mortgages dropped 125 basis points. On the Washington Mutual front, Chief Executive Kerry Killinger was let go to make way for Alan Fishman, who ran Sovereign Bank among others.  Fishman may turn out to simply be a steward while WaMu shops for a sale, which might be challenging in this environment.  However, it is clear that they are prepared to chart a new course.  Fishman will take a critical eye to all WaMu’s assets and businesses and have the ability to inact change because he is not tied to the past.  What remains to be seen is if the market likes the idea.  The jury is still out, but there is movement. On the Lehman Brothers front, a sale was rumored potentially in whole, but more likely in parts, potentially through a bankruptcy filing.

The market took the collective news as a positive on Monday and the Dow Jones Industrial Average climbed 290 points. Then Tuesday came and we gave it all back.  The uncertainty regarding the financial health of Lehman Brothers was cited as the primary cause of the malaise.  It’s shares fell 45% on the day to a decade low.  However, after hours the stock was trading up nearly 10% as they announced the intention to outline their plan to shareholders on Wednesday.  I can’t see regulators okaying a private equity sale, but you never know, this is a point in time where rules might be fungible in the name of macro health.

On Wednesday, Lehman Brothers announced a $3.9 billion write-off, a spin off of a portion of it’s real estate assets, and a sale or majority recapitalization of its asset management group.  All of them still hypotheticals.  It’s shares took another tumble. WaMu’s shares also fell approximately 30%, to a two decade year low as concerns about it’s liquidity crept into the fore.  Today news emerged that Lehman Brothers has been “forced” into sale discussions as a means of mitigating the situation.  I think a better way to phrase it, is that someone with enough clout finally told them their go it alone strategy would not solve anything (who was going to be the equity in the real estate spin off, aka “bad bank”?).

However, for those of us “in the business” it is clear that the business models of yesterday will no longer survive, with or without a Lehman Brothers or WaMu sale or negotiated outcome(s).  You see, the dirty little secret is the bulge bracket banks don’t make money on investment banking, but rather on proprietary trading.  To generate the returns necessary to underwrite the investment banking business they borrow large sums of money, add some equity, trade on the basket, and used the profits to fund the “sexy” side of the business.  Bear Stearns was the most aggressively leveraged and had the greatest exposure to the housing market, followed by Lehman Brothers. With those out of the way, the potential for another investment banking failure appears much less real, since most of the other bludges have taken outside capital, as outlined above (Goldman never needed capital, in part due to their large asset management business, but also due to their limited exposure to the mortgage industry and derivative securities thereof).  However, rumors about Merrill Lynch have begun to swirl, expect them to be proactive regarding a transaction given that they are ahead of the short sellers, for now.  That all being said, without the profits from proprietary trading, expect scores of bankers to be put on the street at year end.  The doldrums in the IPO market will also hamper equity research heavy investment banks as open market trading profits dwindle as well.

This is not a pleasant reality for scores of MBAs from elite school hoping to catch on at Goldman Sachs, Morgan Stanley, and the like.  It is even more bleak for Managing Directors with thin books of business. Take the plight of Joshua Persky, an ex-Houlihan Lokey banker, who took to the corner of Park Avenue and 50th Street in July wearing a sandwich board that said, “Experienced M.I.T Grad for Hire.” The sign included his name and contact information.  Unfortunately, Mr. Persky, remains unemployed (read about the Oracle of NY here).

So if the past is not the future, than what does the new paradigm look like?  While it remains unclear, I suspect you will see a significant fracturing of the investment banking community as “rain makers” (see metaphorical definition here) put out their own shingle and compete with their prior employer for deals in the $250 million – $1 billion enterprise value.  Ken Moelis, former head of investment banking at UBS AG, got a jump start on the competition, opening Moleis & Company, (company website here) a merchant banking firm trading on the name Moelis made at UBS AG and previously at Donaldson Lufkin & Jenrette.  If banks like Moelis & Company can generate in excess of $500,000 in annual revenues per banker (Team Moelis employs 125+ bankers), everyone should do just fine financially, in banker terms.  Frank Quattorne’s Qatalyst Group, falls into the same category (see what top boutiques have been up to here).

I also expect to see the investment banking world become much more vertically oriented.   As high quality middle market, technology, sustainable industry and new media firms consider engaging agents, domain expertise is going to be a key differentiating factor.   The banker will be more important than the brand.  This is the ultimate in humble pie for the industry.  The question is how do these banks survive the economic fluctuations that can seemingly take an industry from swan to duck nearly overnight (see technology distribution as an example).  Folks like Martin Wolf & Co. have forged relationships overseas to take advantage of the power of foreign buyers.

To those graduating MBAs, my advice is to focus on a large weather proof industry — energy, health care, sustainable industies (okay weatherproof for now) and new media.  Consider striking out overseas where transaction velocity in certain sectors is more robust or go into industry and develop your domain through base level experience.

Stay tuned for further chapters.  This one might not be over.

/bryan

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