A new reality
Up until last week bank analysts had modeled a strong quarter for Wall Street. But those upbeat expectations succumbed to reality once it became clear that there wasn't much business going on in the last three months of the year, especially in December. The cuts in expectations were drastic. For example, Sanford Bernstein's Brad Hintz on Friday slashed his earnings estimates for Goldman Sachs (GS) from $3.15 a share to 77 cents a share and its estimates for Morgan Stanley (MS) from a loss of 19 cents a share to a loss of 75 cents a share. Equally large cuts were seen by other analysts last week, with the largest cuts centered on banks that derive a large portion of their income from investment banking and trading.
But the big broker dealers, Goldman and Morgan, seem to be the hardest hit, as they've had to comply with new banking regulations. Goldman made billions of dollars trading its own account over the last decade, but since it became a bank holding company during the financial crisis, it's been forced to pull back on risk-taking activities. The value at risk, or VAR, on Goldman's trading desks, was down in the third quarter, contributing to the bank's second-ever quarterly loss as a public company. While Goldman is largely expected to make a meager profit in the fourth quarter, thanks to its debt underwriting shop, its return on tangible equity, an efficiency ratio, is slated to come in under 5%, a dismal showing.
Goldman employees are bracing for smaller bonuses this year as the firm's profit pie shrinks dramatically. While the bank's employees won't starve, they will probably start to wonder if all those sleepless nights last year were worth it. Goldman, along with Morgan Stanley, is implementing efficiency programs to boost profit margins, targeting $1.4 billion in cost cuts. That's equal to around 3% to 6% of the firms' 2011 operating expenses. But while cutting expenses does help profit margins, it won't grow revenue.
Meanwhile, Morgan Stanley is largely expected to report a steep loss in the fourth quarter, due in part to a one-time, $1.8 billion legal settlement. The bank is also expected to report an accounting loss for the quarter on its debt due to a shift in credit spreads.
Like Goldman, Morgan Stanley's profit has been hit hard as it dialed back the risk on its trading desks, eliminating what had been a major profit center at the bank. It is also targeting around $1.4 billion in cost cuts, including the elimination of some 1,600 jobs, which is around 3% of its workforce.
But unlike Goldman, Morgan Stanley has been busy trying to reinvent itself from within. It is aggressively growing its wealth management and fixed income market making businesses in an attempt to diversify its earnings streams. While both are relatively low margin businesses, the firm is hoping that it will generate enough money through scale. In the meantime, the direct and indirect costs associated with the transition will need to be paid, negatively impacting the firm's fourth quarter results.
