Our world has changed. The subprime mess has forced one of the most significant players in our industry, Bear Stearns, into the hands of JPMorgan. It has caused the write-off of more than $200 billion in capital from global banks and investment houses, and it has led to the elimination of hundreds of thousands of industry jobs. It also has caused investors to shun certain fixed-income instruments like the plague. And while these certainly are significant challenges, I'm not sure the dark times are over.
So let's take stock. Looking to juice historically low fixed-income returns, banks and investment houses lent significantly to subprime borrowers, whose IOUs were carved up and repackaged into various asset-backed and structured products, which were sold to many suspecting and unsuspecting investors. As interest rates increased and the economy slowed, however, borrowers defaulted on these loans, and the values of the linked assets declined.
We also learned that this subprime debt increasingly was mixed with other, more credit-worthy debt, contaminating investments thought to be of higher quality. Adding insult to injury, the transparency of how this subprime debt was carved and repackaged was less than optimal, and even ratings agencies had a difficult time valuing the securities. As the values of these assets came into question, investors, banks and investment houses were forced to massively write down the value of these assets.
The valuation challenges and write-downs chased investors away from mortgage-backed securities, asset-backed securities, auction rate notes and many other fixed-income instruments. And as the economy soured and banks raised their credit standards, whole segments of the asset-backed origination conduit seized, and mortgage bankers, originators and repackagers were no longer needed.
So what does this mean going forward? The fixed-income business for the past few years has generated a significant percentage of industry profits. For three of the largest players -- Merrill Lynch, Goldman Sachs and Morgan Stanley (which are representative of the larger investment banks) -- the fixed-income business (for 2005 and 2006) comprised between 50 percent and 60 percent of their global trading profits, contributing $24 billion to their 2005/2006 top lines.
Certainly, 2005 and 2006 were business high-water marks, and hopefully 2007 and 2008 will represent low-water marks. However, some fixed-income markets will not be coming back -- ever. While mortgage markets are cyclical and will rebound, I am not so sure that the subprime business, asset-backed commercial paper (ABCP) or auction rate notes will regain their stature for years to come.
So the question now is, how will investment banks make up the revenue shortfall (between 12 percent and 23 percent of total revenues for Merrill, Goldman and Morgan)? Certainly, firms will cut costs, expand their equities business, move into nontainted markets, develop new customer segments and grow product lines. But will this be enough? Hopefully so. Otherwise, we will see more extreme measures, such as extreme cost management, leading to consolidation and, possibly, failure.
Now, I am not predicting consolidation and/or the failure of any major bank (especially the three mentioned above). But one wonders whether some industry players and investors feel that the risk is worth staying in the game. For the time being, it may not be worthwhile.
But this industry is one of the most flexible and resourceful on the globe, and while major markets may be in turmoil, my bet is that we'll figure out a new model. And while many of these markets won't return, and the industry may get leaner before we expand again, we will find new opportunities, new investments and new ways to manage money, risk and the global financial markets.