Investment banks deliver murky results

By Dan Freed, TheStreet

Earnings from large securities firms varied  in the third quarter, and results for the fourth quarter will remain difficult to predict despite efforts by regulators and banks to stabilize the businesses.

Goldman Sachs (GS) and Morgan Stanley (MS) have been increasing their capital cushions and beefing up areas such as asset management that offer more stable income. But trading still accounts for the majority of their profits and losses, and performance in that business has been volatile.

Trading performance has been spotty at the investment banking divisions of Goldman Sachs, Morgan Stanley, Citigroup (C), Bank of America (BAC) and JPMorgan Chase (JPM). And the companies still offer few details on the performance of different trading desks.

Companies in other sectors can point to orders they have received from clients that will affect the next quarter's results. Investment banks can talk about mergers and acquisitions they're working on. But not only do such deals fall apart, they rarely matter.

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Analysts rely heavily on informal forecasts from management toward the end of the quarter to give them a sense of how trading profits are shaping up.

What is clear is that Morgan Stanley continues to struggle more than many of its peers, and certainly more than Goldman, to show consistency in its trading division.

Morgan Stanley's $2.894 billion in revenue in its institutional securities business, for example, missed Sandler O'Neill estimates by 10%, or $329 million. However, those were revised estimates. Sandler's third-quarter estimates for the Morgan Stanley division three months ago were $4.13 billion, and Morgan Stanley's largest unit missed that estimate by 30%.

As for Goldman, its trading and principal investment unit revenue of $6.38 billion was 17% higher than Sandler's revised estimates. Sandler would have done far better with the original estimates it had in July of $6.02 billion, which were only 6% short of the mark.

While the numbers are all over the place, the only consistent thread in recent years has been that Goldman usually beats expectations and Morgan Stanley occasionally comes up with a big miss.

"Morgan Stanley was the weakest of the bunch, and they've had a fairly erratic recent history in terms of trading profits," said Soleil Securities analyst Carole Berger.

Asian business was strong for all the major U.S. investment banks, something Berger expects to continue.

"Asia is an emerging market that continues to grow very rapidly for all of them, and Goldman happens to be particularly well-positioned," she said, while noting Citigroup also benefitted from Latin American businesses.

Berger expects big banks to meet new capital rules without having to raise additional equity, though she predicts return on equity to go down across the board.

"What you would like to see is that even though the return on equity is going down, there's less risk to that return, and if that's true then I might be able to be willing to pay almost as much for the lower return on equity than I paid for the higher return on equity with a lot of risk before," she says.

However, Berger expects banks to find a way to ramp up risk again.

"Risk is cyclical, right? Right after every recession that I've ever lived through, the industry tightens up and you get very good credit quality for a couple of years. The real test will come five or six or seven years from now when we've moved further away from the last credit cycle and the competitive juices get going and we're reaching for every piece of business that can be done and we start cutting corners."

Peter Kovalski, analyst and portfolio manager at Alpine Closed End Funds, is even less convinced that investment banks have gone through any fundamental change.

He says financial institutions' regulators went through a similar focus on risk-based assets in the early nineties, forcing banks to increase capital reserves in accordance with a perception of the amount of risk banks were taking on.

"There was concern back then that return on equity was not going to be as good, and low and behold, the industry found other products to make money off of," Kovalski says.

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