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Brokers' Profits Riskier

As credit tightens, expectations remain bold; profit warnings could begin quickly.
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This blog post originally appeared on RealMoney Silver on Aug. 14 at 8:17 a.m. EDT.

The longs view the brokerage stocks, at roughly nine times earnings and trading at historically modest premiums to book value, as statistically cheap. As I

mentioned

in

Barron's

, I disagree with that even more firmly than when I wrote

cautionary remarks

back in June.

Though the shares are oversold for the short term, both cyclical and secular forces are conspiring to put the brokerage industry's profits in jeopardy. A moderation or contraction in credit products,

private equity and hedge fund industry growth, when combined with mark-to-market and prime brokerage liabilities, suggest that the risks of ownership of brokerage stocks outweigh the rewards.

As a result of these conditions, earnings expectations remain far too bold, and company profit warnings are expected to begin posthaste. Last night,

UBS

(UBS) - Get Free Report

warned (over there) that second-half profits will disappoint, and its shares have dropped by nearly 4%.

Bubble Buddies

The brokerage industry's fortunes are joined at the hip with the bubbles in credit (and derivatives) expansion and private equity, two correlated and intertwined asset classes. Unfortunately, these two bubbles have recently been pierced, marking a clear first-half 2007 peak in industry profitability. (This peak will not likely be reversed for at least another two years.)

Over the last decade, brokerages have feasted at the trough of credit availability. However, the current credit crunch, leading to a temporary cessation of private-equity deals, is clearly changing that tailwind into a headwind. Brokerages' returns on investments have been goosed by the rapid growth in all types of fixed-income (and derivative) products, and the cycle's reversal spells lower securitization packaging fees and lower secondary credit market trading volume of the many credit and derivative products.

Moreover, the $8 billion-plus in first-half advisory fees -- principally M&A, which is importantly influenced by private equity deals -- will decline dramatically in 2007's second half and seems destined to moderate further into 2008.

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) - Get Free Report

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) - Get Free Report

-- 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?"

At time of publication, Kass and/or his funds were short Blackstone, although holdings can change at any time.

Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd. Until 1996, he was senior portfolio manager at Omega Advisors, a $6 billion investment partnership. Before that he was executive senior vice president and director of institutional equities of First Albany Corporation and JW Charles/CSG. He also was a General Partner of Glickenhaus & Co., and held various positions with Putnam Management and Kidder, Peabody. Kass received his bachelor's from Alfred University, and received a master's of business administration in finance from the University of Pennsylvania's Wharton School in 1972. He co-authored "Citibank: The Ralph Nader Report" with Nader and the Center for the Study of Responsive Law and currently serves as a guest host on CNBC's "Squawk Box."