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Brokers Keep Rallying, but the Numbers Don't Add Up

Investment banks still rely on volatile revenue streams. Are these prices sustainable?

It had to happen some time: Wall Street, after hyping so many stock market sectors, has made itself the focus of a mania.

Brokerage firms like




Donaldson Lufkin & Jenrette



J.P. Morgan

(JPM) - Get JPMorgan Chase & Co. (JPM) Report

are set to be acquired for eye-popping prices. Meanwhile, stocks in the large brokerages that remain independent -- think

Merrill Lynch



Morgan Stanley



Goldman Sachs

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-- are charging to new, once unthinkable, highs.

Brokers Rally
Dow Jones brokers index

Though nothing much has changed in brokerage land over the past year, these highly volatile firms have suddenly become as sought after as petrol in Gloucestershire. How so? Consolidation has become an urgent priority on Wall Street, prompting firms to merge in a bid to remain competitive. This thinking was behind


$11 billion

bid for PaineWebber,

Credit Suisse's

$12 billion planned

purchase of DLJ and

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acquisition of J.P. Morgan for over $30 billion.


But just because a small number of panicked bank execs in Geneva and Manhattan are prepared to pay through the nose, it doesn't make these prices any saner. The fact is that U.S. brokerages are still heavily dependent on volatile trading revenue. The asset management fees that they all want more of still make up a small part of revenue.

Investors also ought to know that brokerages' financials don't, for the most part, reveal enough information to safely conclude that they are doing as well as so many rabid sell-side analysts suggest. Instead, their numbers reveal many areas of potential concern. For example,

Bear Stearns


, which didn't comment for this piece, reported fiscal third-quarter earnings Thursday that were down from the year-ago period, as expenses rose at twice the pace of revenue (12% vs. 6%). What did Bear's stock do? Rallied, of course.

Lehman Brothers


, whose stock is up an incredible 93% since the end of May, shows why people should be skeptical. Here's a firm that in its fiscal first half made 50% of its $4 billion in net revenue from trading, which it terms principal transactions. That share is 10 percentage points higher than it was in the middle of 1998, just before the markets were smashed by the Russian devaluation and the near-collapse of the giant hedge fund,

Long Term Capital Management


Not all of this line is Lehman gambling with its own capital in the hope of making trading gains; it's also revenue from matching customer orders for equities and bonds. However, the bank doesn't say how much comes from either source in its publicly filed financials, and Lehman didn't comment for this piece. But even if most of it comes from client flows, this income is far from risk-free, as the bank has to keep securities on its balance sheet when it makes markets. Illustrating how volatile trading revenue can be, the Russian and LTCM crises caused it to plunge 80% in Lehman's 1998 fiscal second half, vs. that year's first half.

It pays to look at the contribution of trading to profits, too. For example, J.P. Morgan's trading revenue was a mere 9% of the total revenue in this year's first half, but contributed a sizable 20% of the bank's pretax income.

Since the LTCM meltdown, investment banks say they have scaled back their risks, and there's no reason to doubt them. But Kathy Shanley, analyst at

Gimme Credit

, says: "It's difficult to see what's going on in the trading segment, and to determine how an investment bank's balance sheet is positioned."

Those Rising Costs

Irrepressible expenses are another problem that afflicts brokerages, as witnessed by Bear's third-quarter numbers. And for all the furor surrounding investment banking -- i.e., arranging and underwriting issues and merger deals -- it's a very expensive business. Lehman's investment bankers accounted for a third of its expenses in its fiscal first half, but contributed only 18% of the pretax earnings.

The brokerages' answer to the problem of overdependence on investment banking and trading is to get more asset management revenue, because it tends to be more stable. Yet these aren't increasing fast as a share of overall revenue. For instance, in its fiscal first half, they're just 8.5% of revenue at Morgan Stanley, whose $120 billion market capitalization is second only to


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, the nation's largest financial institution. (Morgan Stanley didn't return a call seeking comment.)

Merrill Lynch's asset management revenues are much weightier than its peers, but their share isn't growing: at 20% they were static in its fiscal first half, vs. the year earlier period. A Merrill spokesman responds: "Investors are recognizing that we've been allocating more of our resources to faster-growing segments of the market and positioning ourselves to benefit from secular growth trends such as the global growth in managed savings, Europe, technology investment banking and high-net-worth wealth."

But we may be on the verge of some sanity. When the Swiss banks UBS and Credit Suisse made their offers for PaineWebber and DLJ, few observers actually asked whether they could make these acquisitions pay off, mainly because little is known about Swiss banks' financials. But the Chase-Morgan deal got a much more cautious reaction, even though Chase is paying the same sort of valuation as the Swiss did on their deals -- over three times book value.

However, even short-sellers, who bet to profit from stocks' declines, aren't training their sights on brokerage stocks. "As long you have stupid Europeans paying ridiculous prices, we're staying away," says one New York-based short-seller.

As originally published, this story contained an error. Please see

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