Rate Rise Could Hit Brokers Where It Hurts

When interest rates start rising, Wall Street firms could find themselves getting squeezed.

It's been tough going for the brokers lately. The pricking of the tech bubble and the subsequent economic downturn have stanched stock trading, IPOs and mergers and acquisitions. Profits have suffered greatly as a result, falling on average over 30% in 2001.

Yet earnings would have fallen far more if it hadn't been for the Fed embarking on one of its biggest easing campaigns ever, cutting the funds rate 11 times in 2001, to 1.75% from 6.5%. The sharp drop in interest rates boosted brokers' earnings by making bond trades more profitable; accordingly, some of the brokerage houses have increasingly looked to cash in on rate opportunities.

But with most observers now agreeing that rates are set to begin rising again this summer, the brokers' already weakened earning power could take another hit.

"As the yield curve flattens," says Keefe, Bruyette & Woods analyst Lauren Smith, "you'll see some of the elements of the fixed-income market that helped drive results over the last couple of quarters slow." Smith reinstated coverage of Goldman Sachs (GS Quote), Morgan Stanley (MWD Quote), Lehman Brothers (LEH Quote), Merrill Lynch (MER Quote) and Bear Stearns (BSC Quote) with holds last week. Her firm has done no underwriting in the sector.

Steepening Trade

The key to whatever earnings strength the brokers have shown lately is that with the latest round of Fed cuts, the so-called yield curve steepened dramatically. At the beginning of 2001, the difference between the funds rate and the yield on the 10-year Treasury went from a negative 1.5 percentage points to a positive 3.4 percentage points.

This was a boon for brokers' bond trading and fixed-income derivative desks because they could finance high-yielding long-term debt transactions with low-yielding short-term debt. And one can't help but think it made things better for the brokerage stocks. While they've suffered over the last couple of years, they haven't slipped as much as the broader market.

"You do better as a leveraged player in a steeper curve because you're financing everything at positive carry," says one bond-desk strategist. The result, he says, was that in 2001, "a lot of traders had career years they'll never have again. When's the last time the Fed eased that fast?"

Such auspicious trades are probably a big part of the reason the brokers have lately been posting earnings that, while down from year-ago levels, are much higher than what analysts had expected.

Derivatives Swell Notional value of Lehman's derivatives portfolio, in billions

Source: Lehman Brothers

It's impossible to accurately quantify how much brokers benefited from the steeper yield curve -- mostly because they don't want investors to know. Fixed-income trading revenue, particularly when it comes from derivative transactions, are fickle.

The firm that leaned on the yield curve for profits last quarter may come up short this quarter. And then there's always the chance a blown trade could take a chunk out of earnings. The prospect of increased earnings volatility isn't something investors like to hear. So they don't.

But shifting through 10-Ks and 10-Qs, says David Hendler, an analyst with fixed-income research boutique CreditSights, you can get a sense of how much Wall Street firms have "surfed the yield curve with derivatives transactions."

Surf City?

Goldman, for instance, has seen revenue from its fixed income, currency and commodities trading operations swell in recent quarters, as results from other operations paled. In the first quarter this year, FICC accounted for 21% of Goldman's total revenue, up from 12% in the first quarter of fiscal 2001. The increase reflected "higher net revenue across many of our businesses, particularly currencies, mortgages, fixed income derivatives and corporate bonds," said Goldman in its latest quarterly filing. Goldman declined to comment on its earnings.

Curve Ball? Fixed income, currency and commodities trading as percentage of Goldman revenue

Source: Goldman Sachs

At Morgan Stanley, total capital -- the value of securities owned -- increased by 24.2% to $61.6 billion in 2001. Meanwhile, Morgan's total assets increased by a more modest 14.6% to $482.6 billion. The shifting of assets toward securities (bonds, currencies, etc.) helped boost net-interest income and may reflect stepped-up fixed-income derivative activity. While it does not break down derivative trading results, in its last two earnings releases Morgan Stanley has noted strong revenue in interest rate derivative trading. A Morgan Stanley representative wasn't immediately available to comment.

Meanwhile, Lehman appears to have leaned heavily on derivative trading to support profits. According to its annual report, the broker increased the notional value of its derivative portfolio by 58% to $5.4 trillion. Hendler reckons derivatives trades may have boosted Lehman's earnings in 2001 by up to 15%. Lehman didn't immediately return calls seeking comment.

Flat Earth

The problem for the brokers now is that, with the economy on the mend, the yield curve is set to flatten. In a recent Reuters poll, economists at 14 of the 24 firms authorized to deal directly with the New York Fed said rates would get raised at the Federal Open Market Committee's June 26 meeting.

The bond market has already begun to price in higher rates; since the beginning of the year the spread between the 2-year and 10-year Treasuries has tightened to 1.65 percentage points from 2.07 percentage points. Making money from fixed-income trading and derivatives is getting harder.

As fixed-income trading and derivative profits slip, Wall Street firms had better hope and pray that equity underwriting and M&A activity come back strongly. So far things look bleak: Initial public offering activity remained meager in the first quarter while worldwide M&A slipped to a seven-year low.

With every day bringing them closer to the next Fed rate hike, the brokers could soon see their profit margins stuck between a rock and a hard place.