Brokers' Profits Riskier

The Hedge Factor

The hedge fund industry's woes (i.e., poor results and disintermediation) will begin to weigh on brokerage industry profits in the current quarter. Like the explosion in credit products, the mushrooming of growth of hedge funds has been a key contributor to brokerage profitability.

For example, it has been estimated that nearly one-third of Goldman Sachs' (GS Quote) income has been derived from the prime brokerage and trading with hedge funds. In a more choppy and trendless trading environment and a less hospitable credit market, hedge funds will be increasingly vulnerable to a contraction in the number of hedge funds and to a moderation in inflows, or even disintermediation. Prime brokerage and equity and fixed-income trading volume seems destined to moderate in the next few years.

Besides the loss of fee income from lower trading and prime brokerage, the industry is exposed to mark-to-market risks in collateralized debt obligations, continuous linked settlements, mortgage-backed securities and private-equity bridge loans (owned in fee) that it is obligated to fund. Moreover, many brokerage firms' money market funds exposed themselves to subprime packaged products in an attempt to enhance yield. This is the next big shoe to drop.

Proprietary Risk

The proprietary desks at Goldman and at other brokerages have fueled earnings growth; they have been the gravy on top of the main course of credit and hedge funds. Importantly, they have benefited from a simultaneous and steadily trending move upward in almost every asset class (commodities, equities, bonds and real estate).

The 2002-2006 prop desk profitability will not be replicated in a more uneven market in commodities, equities and fixed income. (Consider that it is likely that Goldman's prop desks took some of the same risks as its customer-based and broken Alpha Fund.)

Political Risks Growing

To this observer, it is clear that the Democratic tsunami of 2006 will likely be extended into 2008's presidential election. The Democrats' agenda and initiatives are clearly aimed at reducing the schism between America's haves and have-nots. It is being manifested in attempts to change the taxation of private-equity profits and in other challenges to Republican policy.

And in reading between the lines of President Bush and Treasury Secretary Paulson's responses to the credit crisis, it is clear that even the Republican Party is moving toward the Democrats on this issue, as they both seem to be saying that Wall Street and the mortgage-lending communities should take the hits to their income statements without the benefit of government intervention.

Private equity players -- such as Blackstone (BX Quote) -- are starting to develop a vertically integrated organization by building up their own in-house M&A capabilities so that they can bypass the brokerages' fee apparatus. Or as Grandma Koufax used to say, "Dougie, why buy the cow when you can get the milk for free?"