Conventional wisdom on Wall Street is that in these lean times, investment firms have become ripe pickings for larger commercial banks -- the more so now that Eliot Spitzer has single-handedly shaved 20% off some valuations in the sector.
But a closer look reveals that commercial and investment banking often don't make a good fit.
Such mergers are sometimes rationalized on grounds that they create a one-stop financial services supermarket. Commercial banks have the financial heft to package investment banking deals with cheap loans, at a time when credit for many companies is tight. But offering credit in exchange for investment banking business is a strategy that has often hurt commercial banks more than it helped them. The practice can also create more potential for conflicts of interest, now a hot-button issue that most banks would like to avoid.
Talk of a big acquisition by a commercial bank has intensified as already-depressed share prices of many of the big investment banks spiraled lower on concerns about New York Attorney General Spitzer's crusade. Since April 8, when he released the now infamous
emails, Merrill shares have fallen 19% to $43.50. Shares of
have lost 8% to $79.17, while
is down 13% to $48.48.
Despite a flurry of acquisitions of mid-sized investment banks by commercial banks in recent years, including Chase Manhattan's merger with J.P. Morgan to create
J.P. Morgan Chase
, independent firms still rule the investment banking roost. Goldman Sachs, Morgan Stanley and Merrill Lynch occupy the top three slots.
Trailing them are Salomon Smith Barney, owned by U.S. megabank
, and Credit Suisse First Boston, which is a subsidiary of Switzerland's Credit Suisse. Also in the top 10, UBS Warburg and UBS PaineWebber are operated by Switzerland's No. 1 bank, UBS. Investment banking firm Banc of America Securities is run by
Bank of America
While independent shops have given up market share in bond underwriting to commercial banks, they haven't lost any in equities, or mergers and acquisitions advice, the bulk of their business, says Prudential analyst David Trone. "The only real synergies are on the debt underwriting side," said Trone. "Where the CFO is making capital financing decisions, the lines between a loan and a bond begin to blur a little bit. That's why the banks have stolen market share there."
But on the equity underwriting and mergers and acquisitions sides, most companies look for investment banking expertise first. "Healthy companies can get loans from a list of 50 global banks," said Trone. "They aren't under pressure to give their investment banking business to anyone. They will use those advisers perceived as best-in-class, and Goldman Sachs is at the top of that list," he says.
Ultimately, customers don't want one-stop shopping when it comes to financing, in part because of the discretion required for sophisticated investment banking deals, says Roy Smith, finance professor at New York University's Stern School of Business. They also require extensive global networks, rapid decisions and quick delivery, and there is a wide gap between the quality of the services offered by those with a lot of market share and those with a little less.
In this sense, some mid-sized firms have fallen behind and remain targets for commercial banks who want to take a gamble on investment banking. "The more mid-sized firms really don't have the global reach and find themselves falling behind," said Trone. "They are the ones that have sold in the last couple of years. Leadership has been consistently saying you can't be a mid-sized global firm."
Aside from J.P. Morgan's absorption into Chase, other mid-sized firms that were acquired include Donaldson Lufkin & Jenrette, which was picked up by CSFB; Dean Witter, which was bought by Morgan Stanley; and Paine Webber, which was acquired by Switzerland's UBS.
Ultimately, the commercial banks that have been able to leverage their balance sheet to get mergers and acquisition and equity underwriting business have mostly been able to do so with desperate, cash-poor companies that no one else would lend to, says Trone. The results weren't pretty. J.P. Morgan Chase is a case in point.
The bank made risky loans to numerous investment banking clients that have since gone bankrupt or are perceived as questionable risks. Among them were troubled conglomerate
, which got $14 billion in credit from J.P. Morgan Chase after it was shut out of the commercial paper market. The bank also extended $2.3 billion in credit to now-bankrupt telecommunications company Global Crossing. And then there's
, which drew down some $2.6 billion in loans. In the fourth quarter, J.P. Morgan wrote off some $435 million of Enron debt -- that's three-quarters of its total revenue from mergers and acquisitions in the second half of last year. The company also faces a class-action suit brought by Enron shareholders.
Given J.P. Morgan's trouble, and following Merrill and CSFB's recent run-ins with regulators, commercial banks may be more cautious about offering loans in exchange for investment banking business, says Samuel Hayes, professor of finance at the Harvard Business School. "Giving larger loans than might be prudent puts their balance sheets at more risk, reducing the safety of depositors," he said.