Outlook for Investment Banking


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Outlook for Investment Banking

  1. 1. MORGAN STANLEY RESEARCH EUROPE Morgan Stanley & Co. International Huw van Steenis plc+ Huw.vanSteenis@morganstanley.com +44 (0)20 7425 9747 April 1, 2008 Industry View Outlook for Investment Cautious Banking & Capital Market Financials Nick Studer nick.studer@oliverwyman.com +44 (0) 20 7 333 8333 James Davis james.davis@oliverwyman.com +44 (0) 20 7 333 8333 Morgan Stanley has revised its estimates for CSG, DBK and UBS. Please contact Morgan Stanley for details on new estimates of earnings, book value and valuation discussion. This valuation section solely reflects the views of Morgan Stanley Research, not Oliver Wyman • The industry is facing the most severe investment banking crisis in 30 years. Morgan Stanley and Oliver Wyman — in this joint report — estimate that six quarters of industry earnings will have been wiped out from marks and weaker revenues to April 2008. • We forecast underlying investment banking revenue pools to be down ~(20)% in 2008 before a further US$75 billion+ of marks in our base case. Our base case includes credit revenues down 60% and IBD down 40%. Our bear case has total revenues including marks down 45% on 2007. Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As • We expect longer term RoEs to fall as banks seek to a result, investors should be aware that the firm may delever and regulators ask banks to hold more have a conflict of interest that could affect the cushion. We estimate half of the increase in RoEs in objectivity of Morgan Stanley Research. Investors the last four years has come from higher leverage, should consider Morgan Stanley Research as only a single factor in making their investment decision. which we think will start to be reduced when Customers of Morgan Stanley in the US can receive ‘log-jammed’ credit clears. independent, third-party research on companies covered in Morgan Stanley Research, at no cost to • While cautious near term, we are optimistic further out them, where such research is available. Customers as the cycle turns and we see numerous opportunities can access this independent research at www.morganstanley.com/equityresearch or can call for rebound and growth, including the return of credit 1-800-624-2063 to request a copy of this research. distribution, albeit in a very different form. For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report. += Analysts employed by non-US affiliates are not registered pursuant to NASD/NYSE rules
  2. 2. MORGAN STANLEY RESEARCH April 1, 2008 Outlook for Investment Banking & Capital Market Financials Investment Case The global securities markets are in the midst of profound in the first three quarters of the downturn to Easter 2008. cyclical and structural change. This joint Morgan Stanley- This already starts to rival the 1989/90 downturn, which Oliver Wyman research project seeks to explore the outlook was the most severe of the five crises in the last 20 years, and implications for the leading capital market banks, although wiping out six-and-a-half quarters of industry earnings. It includes wider implications for a variety of financials. While the also looks more severe than the Dot Com or 94/95 Mexican industry conclusions are largely joint, any stock-specific or crises (see Exhibit 1 and 7). valuation sections solely reflect the views of Morgan Stanley Research, not Oliver Wyman. We would like to express our • A number of the industry leaders we’ve interviewed share thanks to the business leaders who shared their views and our sense of some parallels to the 1989 crisis: after a long feedback on our forecasts. period of rising leverage, a sharp deterioration in credit (then LBOs, now US mortgages), the liquidity crisis that put The current crisis in 2008 Drexel out of business, as well as broader bank funding and credit issues (the S&L crisis). As in 1989-92, today banks’ Investment banking and capital markets competitors look credit spreads trade outside the equivalently rated set to experience the worst hit to earnings in twenty years. industrials, leading to further credit contraction and substantial yield curve steepening and fiscal response was • We estimate that already nearly six quarters of industry needed. earnings will have been wiped out, largely by MTM losses, Exhibit 1 Severity of recent capital market crises Duration of crisis Depth of crisis Total crisis severity Time (in quarters) until earnings Total industry earnings in the worst Earnings lost (in no. of pre-crisis Crisis returned to pre-crisis levels quarter as % of pre-crisis earnings quarter earnings) during duration of crisis Black Monday (1987) 1 500% 4.1Q Junk Bond 6 400% 6.6Q (1989-90) Mexico (1994-95) 4 300% 5.1Q Asia, LTCM, and Russia 1.3Q 2 150% (1997-99) Dot.com, Enron 4.1Q (excludes 2-3Q of 7 50% fines and legal fees) (2000-01) Sub-prime, Liquidity 3 so far 5.9Q so far 300% 7.5-9.5Q est. total (2007-) 8-10 est. total 0 5 10 -500% -250% 0% 0 5 10 Source: Company data, SIFMA, Oliver Wyman Analysis 2
  3. 3. MORGAN STANLEY RESEARCH April 1, 2008 Outlook for Investment Banking & Capital Market Financials Our industry forecasts for 2008 suggest strength in a • Asia, emerging markets and FIG funding are also likely to number of areas, but these will not be enough to rescue perform well in 2008, we think, together with multiple niche revenues or earnings, which are likely to be once again held growth areas. However, it is clear that credit and IBD will be back by major MTM losses and a pronounced fall in credit and sharply weaker. We forecast IBD revenues to be down IBD revenues. ~45% in our base case and credit revenues down ~60% in our base case. • 1H07 and ongoing growth pockets in 2H significantly dampened the effect of the losses last year (see Exhibit 2). • The substantial and sharp moves in credit markets, intense funding pressures, and a reduction in aggregate leverage • In our 2008 base case we are forecasting a reduction in continue to cause us real concern, driving our near-term revenues of ~20% before marks, incremental marks of caution. Low visibility and a wide range of outcomes US$60-100 billion, and overall post-mark revenues down a perhaps make estimating tougher than most years. further 18% in 2008 (Exhibit 3). • The biggest risks to our view are around liquidity and • Global imbalances are creating a strong market for FX, deleveraging, with potential for major downside, but we feel rates, commodities, and equities: high volatility is driving swift and repeated policy intervention is reducing the tail strong volumes, and reduced risk capital from some risks in markets. Our bull case has revenues before losses weakened players is leading to a material widening in down 15% or post losses up 12% in 2008. Our bear case, bid/offer spreads. Those players with strong and efficient on the other hand, has revenues before losses falling 30%, flow businesses and the capital to express proprietary or including losses 45%. trades (yield curve steepening) will have a useful natural hedge for earnings in 2008. This said, we do expect a slowing from the 1Q growth rate. Exhibit 2 2005-08 industry revenue evolution: bear, base and bull case scenarios Pre- and post- loss revenues by product Pre- and post- loss revenue scenarios Industry revenues 2005-08 Base case, $BN Industry revenues 2008, $BN 350 Bear Base Bull $210BN $275BN $315BN $255BN -30% -45% -20% -18% -15% 12% 300 $112 $40 250 BN -35% BN $80 -45% $80 BN BN IBD -55% 10% 200 -5% EMG -10% $110 BN 10% 150 0% Equities -10% 100 5% -5% Commods -15% -60% -60% Credit -70% 50 -15% -10% -5% Volatility 0 2005 2006 2007 Net 2008 Net Rev Net Rev Net Rev Net Rev Base Rev Rev Rev Rev Source: Oliver Wyman data and analysis, Morgan Stanley Research 3
  4. 4. MORGAN STANLEY RESEARCH April 1, 2008 Outlook for Investment Banking & Capital Market Financials Exhibit 3 Revenue outlook Product area 07-08 growth 08 revs $BN Key areas Equities Flat 95 Volatility drives volumes; Tough prop market and margin pressure (0%) Stability in structured product, less so in Prime Brokerage FX and Rates Shrinkage 70 Trading environment less benevolent but growth across client segments (-5-10%) Asia particularly strong Commodities Flat to slightly down 10 Investor demand continues to drive growth in Oil, P&G, precious metals (-5%) Risks lie in deleveraging bursting price bubble Growth in niche adjacencies, but small overall Emerging markets Modest Shrinkage 15 Growth in local products to local clients as demand increases in sophistication (-5%) Dramatic growth in intra-EM flows Corporate finance Contraction 45 Decline in large-ticket lev fin, M&A and ECM (Down -45%) Move into smaller-ticket deals, “recovery” buy-outs, carve-outs Smaller markets (esp Asia) remaining strong Credit Continued 15 Flow trading supported by volatility and hedging contraction Deterioration in EU residential and global commercial (Down -60%) Growth in distressed, stressed and principal, private placement models, FIG Total ex losses -20% 250 Credit losses (60-100) Further write-downs in lev fin, US CRE and ABS and monolines Total inc losses -18% 170 Source: Oliver Wyman data and analysis, Morgan Stanley research Exhibit 4 Explanation of industry revenues 2006-2007 2006-7 revenue evolution, $BN Strong perform ance in volatility products - Rates rebound 2006 Revenue $276 from weak 06, strong growth in H2; FX with significant growth in H2 Good growth in Equities (24%) – both cash & derivatives strong; Prim e Brokerage with m ixed results in Q3/4 – Positively or refocus on tier 1 funds Positive / neutral Impact unaffected $57 Com m odities flat – Strong Q1 offset by a deterioration in products Negative Impacts 2H Power & Gas and Oil EMG - foreign capital inflows in Q3/4, rebound of EEMEA, Adversely continued boom in BRIC impacted - $17 IBD: Record H1 slowed in H2, overall up 25% products Credit: Very strong H1 followed by collapse in structured Asset write- in H2, flow CDS better than expected causing overall - $112 annual decline of ~25-30% downs Securitised Products: Very strong H1, but utter collapse in H2, causing overall annual decline of 40-45% -$72BN 2007 Revenue $204 Total write-downs of $112 BN across the industry 0 100 200 300 400 Source: Oliver Wyman data and analysis 4
  5. 5. MORGAN STANLEY RESEARCH April 1, 2008 Outlook for Investment Banking & Capital Market Financials Investment banking revenues continue to tilt further to balance sheet — the debate we were having on the EMEA and Asia in 2008 Investment banks a number of years ago until the credit super-cycle overtook events. • The US now represents under half of industry profit pools and we forecast Asia + Europe could represent some ~60% • On the other hand, the more diversified equities business of industry pre-mark revenues by the end of 2008 (more (cash, delta one, structured products, prime brokerage, post marks — Exhibit 5). However, given the size of the etc.) appears in far better health, more focussed on Europe, marks, geographic growth alone is not enough to offset a Asia and emerging markets, and with far lower staffing to decline at the industry level. While we see obvious risks in revenues than at many times in history; the same cannot be some regions, we think that growth rates will remain said for credit, which looks set for multi-year change. reasonable — as testified by the early reporters in 1Q. • Winners will be distinguished by selected principal Exhibit 5 activities, advantaged distribution, innovative design of new 2006-08 pre-loss revenues by region (US$ billion) distribution products (a process not financial engineering oriented) and cost reengineering. $275 BN 15% $315 BN -20% $255 BN 350 Another major concern is the funding environment. Like in 300 1989-92, the cost of bank funding has gapped out and trades 19% 16% wider than comparable investment grade industrials/ 250 21% Asia corporates. See Exhibit 7. 200 38% 37% 150 40% Europe • Our base case is that funding remains expensive. In part, 100 this is a demand-driven issue as SIVs and other levered 47% 42% 39% buyers of senior bank debt have exited the market, but 50 Americas banks have also been unable to reduce assets and 0 2006 2007 2008 base leverage as fast as they would have liked going into this crisis (Exhibit 6). As many credit assets are stuck and some off-balance sheet assets have had to be brought on, Source: Oliver Wyman data and analysis balance sheets have remained bloated and leverage ratios One of our biggest concerns is regarding the shape and remained high (particularly for those that saw material earnings power of the credit businesses, which today looks losses); reduced engagement in the inter-bank and senior in some ways like the equities business in 2000/01 — with debt markets has been one lever to reduce balance sheets. much restructuring ahead. We forecast credit revenues could be down (60)% in 2008 in our base case. • The pace of readjustment as banks manage down their risk continues to depend critically on how ‘logjammed’ the credit • High-margin businesses have evaporated revealing an markets remain. overburdened cost base for flow business — and it took several years to ‘right size’ in equities. • While on its own not sufficient, we think that firms with diverse sources of funding — with retail and commercial • We see a need for fundamental changes in distribution deposits clearly helping — and a diversified business will models (more underlying transparency, more basic have a funding advantage over the coming years, and this structures, and fund vehicles — fulfilling transparency and may lead to a material reassessment of business models data needs). We also see a return of the importance of the over time. 5
  6. 6. MORGAN STANLEY RESEARCH April 1, 2008 Outlook for Investment Banking & Capital Market Financials Exhibit 6 run rate — far shorter than in many other areas of banking Aggregate change in assets and leverage for large or commerce, as capital can be re-allocated quickly and US broker-dealers: US brokers attempted to de-lever risk duration is shorter than at wholesale or retail banks. in 4Q07, but failed 0.20 0.20 • Only once in twenty years have revenues fallen for two 0.15 0.15 years in a row (2001/02) as we think is likely to happen in Change in Total Assets (Log Change) Change in Total Assets (Log Change) 0.10 0.10 2007/08 (including marks). 0.05 0.05 2007Q3 2007Q3 0.00 0.00 • A much steeper yield curve and low real rates have always -0.05 -0.05 2007Q4 helped re-start revenue momentum. In fact, the strongest -0.10 -0.10 correlation of Investment banking growth is to these two -0.15 1998Q4 1998Q4 factors and global growth. Moreover, balance sheet repair -0.15 has been faster than prior cycles given the SWF -0.20 -0.20 -0.2 -0.2 -0.15 -0.15 -0.1 -0.1 -0.05 -0.05 0 0 0.05 0.05 0.1 0.1 0.15 0.15 0.2 0.2 investments (Exhibit 8). Change in Leverage (Log Change) Change in Leverage (Log Change) Note: Growth rates are asset-weighted. Data 1992 to 4Q07 • In the more event-driven products (M&A, ECM, Leverage Source: Leveraged Losses, Lessons from the Mortgage Market Meltdown, Greenlaw, Hatzius, Kashyap and Shin. Updated by Morgan Stanley Research Finance) the time for activity levels to return to previous peaks has typically been of the order of four to six years, and sometimes longer — recovery should be trading-led in Exhibit 7 the short term. One GCM head reminded us that it took 19 Echoes of late 1980s/early 1990s when IG FIG years to beat the prior LBO record (RJRNabisco by TXU). spreads also traded outside IG industrials, leading to credit contraction and recession • Overall, while we are naturally acutely worried by the recent — a steeper yield was key to drive banks out market developments and think that this crisis will run 300 279 In the last Credit 1400 longer than many previous events, given global growth and Feb-91: US invades Iraq Cycle, Financials Traded Tighter than the intense policy response we are hopeful that a return to Industrials 245 prior earnings levels is still possible in the next six to eight 1200 250 22 225 IG Financial Financials Traded Wide to Industrials IG Industrial HY (RHS) 1000 quarters from now. 195 200 for Fully 3 Years in this Cycle 176 800 Exhibit 8 150 SWF have invested US$43 billion in capital markets 600 capital infusions in the last six months, helping the 100 process of balance sheet repair 400 50 50 44.5 200 45 40 10.2 0 0 Jan-87 Jan-90 Jan-93 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08 35 Source: Company data, FactSet, Morgan Stanley Research 5.8 30 $bn 25 20 18.2 14.7 Going forward 15 0.6 28.4 3.8 10 7.6 While we are cautious in the near term, we are more 4.8 14.1 14.4 5 2.6 2.3 upbeat further out since brokers are essentially geared plays 4.8 0.7 1.2 0.2 7.6 2.6 0.7 1.1 0 0.2 on global growth and our analysis of past crises offers caution Q106 Q206 Q306 Q406 Q107 Q207 Q307 Q407 Q108TD on being too bearish (Exhibit 9) SWF (Investment/Cap Mkt Banks) SWF (Other) Chinese Financials Source: Company data, WSJ, FT, Morgan Stanley Research • Major crises in the last 20 years have lasted just four to seven quarters before industry earnings have hit the prior 6
  7. 7. MORGAN STANLEY RESEARCH April 1, 2008 Outlook for Investment Banking & Capital Market Financials Exhibit 9 Investment banking revenues and key drivers in 1986-2007 — a geared play on growth rates and equities OW Investment bank pre-tax earnings index (1997=100) 600 6 Global GDP growth (IMF) 10Yr - 2Yr T-Bill Spread 500 5 MSCI world equities 400 4 GDP growth % Indices 300 3 200 2 100 1 0 0 1988 1993 1998 2001 2003 2006 1986 1987 1989 1990 1991 1992 1994 1995 1996 1997 1999 2000 2002 2004 2005 2007 -100 -1 Black Monday Junk Bond/LBO Mexico Asia, LTCM Dot-com, Enron and Russia and 9/11 Prediction of Industry revenues (R2=90%) Prediction of Industry earnings (R2=85%) Explanatory variables Single factor R2 Effective Weight Single factor R2 Effective Weight MSCI Global Equities 80% 60% 65% 120% Treasury Yield 70% -100% 40% -90% Global GDP Growth 40% 50% 20% 70% Root VXO 5% -150% Source: Oliver Wyman data and analysis, company reports, Bloomberg, Federal Reserve We believe sustainable RoEs have to come down, as they have been boosted by several hundred bps in the last five years • Industry RoEs in the last five years have been 17.5% vs. 15.4% in the prior five years for the leading players (and clearly at lower levels for the wider industry — Exhibit 10); banks have enjoyed high-margin sweet spots, a high velocity of credit and increases in balance sheet leverage. 7
  8. 8. MORGAN STANLEY RESEARCH April 1, 2008 Outlook for Investment Banking & Capital Market Financials Exhibit 10 Exhibit 11 RoE for major investment banks We expect banks to delever from the increases in RoE for major investment banks the last four years Reported RoE, 1993-2006* Assets to Equity 40% Maximum Median Minimum Broker/Dealer Assets-to-Equity 50 (BSC, LEH, GS, MS, MER) 46 30% 42 Assets / Tangible Equity 38 20% 34 10% 30 26 0% 22 Assets / Equity 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 18 -10% 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 Source: Company data, Morgan Stanley Research -20% -30% Cycle 1993-99 Cycle 2000-06 One key aspect to any forecasting is the nature of Ave RoE = 15.4% Ave RoE = 17.5% Source: Oliver Wyman analysis, company reports regulatory (and investor) response to the current crisis. * sample includes Citi, CS, DBK (CIB for 2006-1998), GS (2006-1999), JPM (I-Bank for 2006-2003), LEH, ML (CIB only), MS (2006-1997), BSC, UBS • We think we are on fairly solid ground to suggest regulators will focus far more on liquidity risk against on- and off-balance sheet obligations via either revisions to Basel II • Leverage alone appears to have driven almost half of the regulation or national regulations. Our meetings suggest RoE growth from 2003-07, with improving business mix the many regulators are already considering making banks add majority of the rest. We expect that selective deleveraging, more capital via Pillar 2 requirements or an additional piece greater capital buffer requirements (especially for of regulation. This would dilute RoEs from increased cash off-balance sheet obligations) and cyclical reduction in (as opposed to capital) drag. credit turns will reduce longer-term RoE expectations by ~150-200bps, although with a cyclical undershoot first. • What is less clear is the regulatory impact on specific products and markets (securitisation, for example), • However, rapid deleveraging is very hard in the short term although we expect that far greater attention will be paid to for continuing businesses because the most liquid balance the underlying levels of true risk transfer in credit risk sheets are in the more attractive growth and profit areas, transfer and funding vehicles. It is also possible that risk and much of the rest have been essentially stuck (in RMBS, weightings could change (for mortgages for instance) or the CMBS, leverage loans, etc.). It is also true that the highest nature of using external credit ratings in the adjudication of growth markets are also the most highly capital intensive — risk capital — given recent problems, regulators may wish so competitors will be forced to increasingly choose their to review whether its a good thing to hardwire rating spots. agencies' views into the capital ratio requirements for banks, as some aspects of Basel II are already in. • Winners will be distinguished by successful shifting of the growth portfolio (spot picking), advantaged third-party RoEs have also been boosted by operational gearing and money and distribution capabilities, and clear metrics and an improvement in cost: income ratios of 5 percentage MIS on financial resources. Significant advantage will also points in the last five years — but more structural cost come to those players that have risk management, improvements will be required in the near term (Exhibit 11). investment skills and free capital to take advantage of the opportunities that arise. • Overall, through-cycle cost discipline for much of the industry has been relatively poor as margins are generally fat — cost cuts are often short term and tactical and 8
  9. 9. MORGAN STANLEY RESEARCH April 1, 2008 Outlook for Investment Banking & Capital Market Financials improvement has always come from growing into profitable • Our sense from interviews with industry leaders is that the new sweet spots. downturn is, if anything, making brokers accelerate their plans to grow their asset and wealth management units, • Over the last few years cost: income ratios have been particularly to take advantage of Asian, European and particularly boosted by a business shift towards fixed emerging market growth (both inflows and strategies). income and international businesses — fixed income in particular now looks set to retreat. Entry into a mark-to-market world by such a large number of participants has created a much more acute crisis in • Winners will be distinguished by success in reengineering this cycle — it is impossible now to put the cat back in the bag, the cost base front-to-back and side-to-side, including a and the net effect will be lower notional risk appetite by once-and-for-all shift to more sustainable, risk-adjusted intermediaries compensation models and redeployment of talent to growth While securitisation has been viewed as reducing risk for any areas. one player, risk concentrations and mark-to-market accounting forcing institutions to eat losses incredibly quickly makes the RoEs have clearly also been boosted by the rapid growth system more intense in the heart of the crisis than in previous of capital light asset and wealth management businesses. cycles; previously, time was the healer to work out difficult We think these too will see cyclical slowing, although brokers assets. See Exhibit 13, which suggests this cycle has been far will continue to expand these areas. quicker than previous ones. In addition, banks, as long-term holders of assets, knew they had to hold a more market-based • Falls in markets, a shift by retail investors out of system where so many participants are subject to higher-margin products, lower activity levels and mark-to-market disciplines. This means there are fewer steady operational leverage will challenge profit growth, and hands with deep pockets to dampen the volatility. Morgan Stanley currently forecast a fall in earnings for all asset and wealth management divisions of the capital market banks. Exhibit 12 Investment bank industry earnings and cost volatility Investment bank industry earnings and cost volatility 1987-2006 Index: 1987 = 100 Change in revenues (indexed ) Change in costs (indexed) Cost-income 60 110% 50 100% 40 30 90% 20 80% 10 0 70% 1989 1990 1999 2000 1987 1988 1991 1992 1993 1994 1995 1996 1997 1998 2001 2002 2003 2004 2005 2006 -10 60% -20 -30 50% Source: Oliver Wyman data and analysis, company reports 9
  10. 10. MORGAN STANLEY RESEARCH April 1, 2008 Outlook for Investment Banking & Capital Market Financials • Synthetic mechanisms (especially indices) in thin asset o Greater transparency on underlying assets through classes have increased price volatility for intermediaries, better loan-level performance data. and particularly for investors. o Greater participation of own balance sheet to mitigate • Beyond any issues relating to credit-assessment ability and moral hazard. trust, we expect a repricing of the price of risk to reflect this higher mark-to-market volatility — and intermediaries will o Greater control of the risks of the whole value chain — be forced to take less notional risk in these businesses as a including liquidity risk and third parties whose risk result. management and conduct may pass on economic and reputational damage Exhibit 13 Spreads already at recessionary levels: this credit o We do think the development of new categories (SME, bear market was shorter but far more violent than insurance) will be pushed out materially. previous ones Duration Trough Spread Peak Spread Total Credit Trough Credit Peak (Months) (BBB) (BBB) Widening o Winners should be the players (underwriters, data Mar-69 Dec-70 21 109 302 193 providers or issuers) able to build the necessary Aug-73 Feb-75 18 78 299 221 transparent infrastructure, while maintaining resourcing Nov-78 May-80 18 79 225 146 levels to suffer a lengthy market rebuild; losers will Sep-81 Jan-83 16 135 276 141 Apr-89 Jan-91 21 111 250 139 attempt a return to greater product complexity. Jun-99 Nov-02 113 156 387 231 Feb-07 3/13/2008 13 114 323 209 Client landscape Average 34 111 290 179 We expect this downturn will put pressure on a number of Median 19 110 288 170 players and strategies, but we still think the broad Source: Morgan Stanley, the Yield Book, Moody’s, Bloomberg polarisation of cheap beta by scale providers (that is, index, One of the big questions on all managements’ minds is ETFs, swaps) and alpha or alternative beta by modern asset whether this crisis will substantially challenge the managers will continue (our asset management barbell). long-term trend towards securisation of assets. In the • We think advantage will turn to larger hedge fund groups medium term, we believe the return of fixed income must be with road-tested risk management and provide fiduciary driven by a return to credit distribution/securitisation, but we comfort. The top-50 hedge fund groups will continue to expect some major changes. take share in the sector (Exhibit 14). But as large, • There are no new geographies or (non-credit intense) asset sophisticated groups grow, there will be competitive tension classes with the depth and breadth to drive significant on margins, what they in-source, and thus the need for fixed-income growth. such a high-touch prime brokerage businesses. Some alternatives groups will also look to pick other investment • The benefits to investors (as well, obviously, to banks) banking sweet spots. This said, we do expect material remain choice of exposure to specific asset classes and rationalisation of opportunistic credit funds and credit risk types, diversification, and avoiding double taxation of strategies, as investment banks change the terms of investing in credit via a bank. funding to reflect higher credit and liquidity risk. • Some of the market failings are addressable (sloppy • There will be intense focus on long-only investors in the underwriting standards, asset-liability mismatch in credit and fixed-income markets as paper is passed from warehousing, and overcomplexity, underscrutiny and poor highly levered to unlevered and lightly levered investors, as research of structured products). well as a search to distribute the huge issuance needed from the FIG sector. This re-assertion of long-only and • Solutions will likely include: traditional investors will help sell-side players with broad and deep footprints. o Greater transparency on underlying assets through specialist credit investment funds with emphasis on due • We expect another round of asset management diligence on underlyings. consolidation, particularly as players globalise or seek scale. We also think that a number of deals will be 10
  11. 11. MORGAN STANLEY RESEARCH April 1, 2008 Outlook for Investment Banking & Capital Market Financials prompted by banks’ and some insurers’ need for capital pools of liquidity, but ongoing turmoil will lead to significant and funding. changes in order within this group. • We think the longer-term trend of HNW investors and o Players hit hardest by the write-downs also suffered the aggregators (private banks, brokers) becoming more most dramatic declines in sales and trading revenues in important as capital markets and asset management will other businesses — despite infusions of equity, continue after a cyclical slowdown. This said, we expect a bouncing back is challenging. material slowing in the sales of structured products to clients in Europe as funding pressures will mean banks o As competitors are forced to choose their spots through cannibalise funds for deposits or their own bonds. the cost and balance sheet pressures highlighted above, we view selected business/division divestiture • We see ongoing cyclical and secular rise in importance of (some to PE, some to competitors) and shutdown of FIG clients — which many players believe will be the single other businesses as inevitable. largest growing pool of revenues in 2008. o However, some players should surprise on the upside • Naturally, we expect private equity sponsors’ influence to — aggressive capital re-deployers will double down in wane, although given their deep pools of capital raised, we growth pockets, while activities in stressed assets expect a shift in emphasis to international and smaller should give some players payback in 2008 (as liquidity deals. constraints diminish) rather than the two to three years or more that true distressed will achieve. • SWF clients will remain influential but still more important for investment management and trading revenues pools • Scope for more mergers involving the global players, than IBD. delivering potentially huge synergies in costs and funding is possible, but still not very likely, in our view. Exhibit 14 Broker-dealers seeking cheap and reliable deposit funding ‘Big getting bigger’ global industry AUM (%) may be tempted into deals, but as with credit cards post 100% 1998, this transformation may be gradual and take several 90% years (note that Capital One’s first depository merger with 80% 44 42 34 Hibernia occurred seven years after the funding crisis). 48 70% 63 60% • We think universal banking players (of all sizes) will diverge 20 50% 18 — some will choose to jettison the wholesale business (in 18 40% 17 response to shareholder pressures), some will use the 30% 11 opportunity to grow market share, and some will retrench to 20% 38 40 46 a sustainable niche. 35 26 10% 0% o For the damaged regional players, the collapse of 2003 2004 2005 2006 2007 fixed-income profitability may be the last straw after a Top 50 Funds 51-100 All Other Funds decade of disappointment. Source: Absolute Return, Alpha, Morgan Stanley Prime Brokerage o However, undamaged regionals and domestics are Competitive landscape somewhat bolstered (not present in most challenged We think this cycle could lead to another major reshaping businesses; more exposed to areas now booming; driven by outsized losses, shareholder pressure and the benefiting from relative gain in importance of balance change in funding dynamics. We expect a number of players to sheet and local customer franchise). re-examine their commitment and business models, although the majority of the global players will stay the course. o Additionally, there will likely be new entrants as leading banks from resource-rich countries seek stakes • ‘Bulge Bracket’ players in general have significant (beyond the SWFs); further potential for a recombining advantages due to their access to the deepest and stickiest of deposit-holders and I-Banking. 11
  12. 12. MORGAN STANLEY RESEARCH April 1, 2008 Outlook for Investment Banking & Capital Market Financials In parallel with crisis management, overall institutional Path to recovery strategies will have to be refocused. History including 1989-92 suggests a common checklist • Adapting and accelerating programmes are already for a marked recovery: these are still only partially checked, in-flight (selective deployment of principal activity, suggesting that rocky conditions will continue. shift onshore in emerging markets, choices in asset • A steeper yield curve and other policy response to cut off origination vs distribution, convergence of IB and tails. We believe swift and repeated Fed and US policy asset management business models). intervention is helping this, although Europe (particularly the UK) has been behind on this agenda and the inflation • Refocusing group structure and extraction of group debate overhangs. synergies will be increasingly critical — less than 20% of group synergy efforts are typically successful and • The process of balance sheet repair starting in earnest to many destroy value. enable the banks to sustain their balance sheets (the Investment banks are well ahead of many European • All players under pressure to create more sustainable, banks). risk-adjusted compensation models. • Greater transparency on where the risks lie (progress, Additionally, players elsewhere along the capital markets although still too much idiosyncratic risk and surprises activity chain may benefit. undermining the best-practice attempts). • The need for increased transparency in OTC markets will give exchanges a boost in their attempts to take over these • Alleviation of funding pressures (which in part is a function markets, particularly those with Central Clearing of the above, but also could come from fewer forced sellers Counterparts for derivatives, as banks look to reduce risk of banks paper such as the SIVs). and improve efficiency. Challenges lie in defending valuations and fending off increasing attacks from new • Capitulation by some sellers and long-only/unlevered competitors such as Inter-Dealer Brokers (IDBs) or bank investors picking up the paper from the levered sellers consortia — especially as pricing power reduces in the data (again, in the last month we have started to see examples business. of this). • IDBs will continue to benefit from trading levels as well as While we do not wish to appear panglossian, we are of the view growth in the niche asset classes; challenges remain in that we are perhaps a little further through the issues than competing with the exchanges for OTC markets as well as some may think, although we see plenty of risks ahead. in investing carefully across growth businesses. Exhibit 15 Steeper yield curve was critical to help in 1989, and • Data and research providers have new markets to cover we think will be key in this cycle too from the increasing demands for information on underlying Large Cap Bks Avg. Rel P/E to SPX 10Y-2Y 5Y-3M 100% 350 performance; the key challenge will be to cheaply and 100bps of +ive carry was critical in 91 quickly craft the necessary infrastructure. 90% 300 250 • Processing banks, with generally low credit intensity, are 80% 200 less threatened. Significant growth opportunities exist, with 150 alternative investors, emerging markets, derivatives 70% 100 processing, new traded products, and extended risk and 60% 50 performance management services all high on the agenda; 0 significant challenges remain however, particularly around 50% building new services while managing creaking and -50 expensive infrastructure, as well as in handling regulatory 40% -100 1/1990 1/1991 1/1992 1/1993 1/1994 1/1995 1/1996 1/1997 1/1998 1/1999 1/2000 1/2001 1/2002 1/2003 1/2004 1/2005 1/2006 1/2007 1/2008 changes (especially in Europe). Source: FactSet, Morgan Stanley Research 12
  13. 13. MORGAN STANLEY RESEARCH April 1, 2008 Outlook for Investment Banking & Capital Market Financials Valuation and Recommendations This valuation section solely reflects the views of Morgan Stanley Research, not Oliver Wyman This section is intentionally blank - please contact Morgan Stanley directly for valuation and recommendations. 13