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For Goldman and Morgan, a year to forget

January 9, 2012: 11:50 AM ET

Dismal fourth-quarter earnings reports are on deck, but there could be a silver lining for Goldman Sachs and Morgan Stanley this year.

By Cyrus Sanati, contributor

goldman_sachs_morgan_stanleyFORTUNE -- The Wall Street money-making machine looks to have malfunctioned badly in the last quarter as nervous companies and investors stayed out of the capital markets. Troubles in Europe and on the trading desks also contributed to what could be a loss-making quarter for some of the Street's biggest names.

Bank analysts finally got the memo last week and drastically slashed their rosy earnings expectations, sending banks shares down sharply. This should have been no surprise given all the changes happening on Wall Street. The banking sector will continue to face headwinds this year as the crisis in Europe persists and the banks tinker with their new "risk-light" business models. But regulatory clarity and new growth opportunities could help Wall Street get its mojo back sooner rather than later.

The fourth quarter of the year is usually slow for Wall Street given all the holidays and year-end activities. Asset managers usually ratchet back their trading, while companies tend to put off announcing new deals until after the New Year.

But the fourth quarter of 2011 seems to have been even slower than usual. Global investment banking revenue is expected to total just $13.9 billion for the quarter, down 37% from the same period last year, according to data from Dealogic. The equity side of the business is expected to have brought in just $2.6 billion, down a whopping 67% from last year as companies decided to put off IPOs and secondary offerings. Revenue from mergers and acquisition is also expected to be down markedly in the quarter, generating an estimated $4.3 billion for Wall Street, down around 23% from last year.

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The muted activity in investment banking is expected to be accompanied by an equally weak showing in the banks' trading divisions. Analysts see the banks lowering their risk profiles in the quarter in order to comply with higher capital mandates. The spinning out of the banks' lucrative trading desks, due to new regulations, is also expected to have had a negative impact on the banks' bottom lines last quarter.

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.

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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.

An opportunity in Europe?

Both Morgan and Goldman will continue to right size their balance sheets and attempt to find new ways to make money. Both will need to deal with economic troubles that have companies shying away from going public or issuing debt. A return to some sort of normalcy isn't expected until the European debt situation is finally resolved.

But while European crisis is damaging, it could present Goldman and Morgan with an opportunity. European banks are being forced to raise their capital requirements and sell off assets. This slimming down of the European banks could see up to $13 billion in revenues up for grabs, according to analysts at Deutsche Bank. Goldman and Morgan Stanley are well-positioned to eat up some of that business given their size and global reach.

Another bright spot for the banks this year is potential end of the regulatory uncertainty associated with the Wall Street reform bill. Investors will most likely find out by the end of the year how some of the more controversial sections of the bill, like the Volcker rule and Lincoln rules on derivatives, will look. If the rules are implemented with a light touch, Wall Street could possibly see a massive resurgence in profit.

Wall Street is under construction and this previous quarter reflects all the messiness associated with making tough repairs in a volatile environment. Both Morgan Stanley and Goldman Sachs are trading below their intrinsic asset values, so there is clearly some nervousness associated with their ability to make money in the future. Deciding what they want to be and how they want to get there will go a long way to restore investor confidence.

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