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The Future of Investment Banking:

Subprime and Its Impact on the Industry

Larry Tabb | V06:017 | October 2008 | www.tabbgroup.com


The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

Vision
Although this Note may not seem optimistic, my thoughts for the future are
bright. Even though the industry landscape has been radically altered over
the past month or two, the things we do as an industry will absolutely
survive and prosper. National, state, and local governments will need to issue
debt, banks will need to lend, corporations will have to issue equity and
manage risk, institutions and individuals will have to raise capital and
investors (institutional, hedge funds, corporate, and individual) will need to
invest. At the heart of it, that is what our industry does. It raises capital for
those that don’t have the knowledge for, or access to, financial markets, and
helps investors structure their financial future.

While the macro, long-term picture is sound, the industry is in flux. Within
the past six months, five of the largest investment banks have either folded,
been sold to commercial banks, or have become commercial banks
themselves; and two of the top ten commercial banks have had forced
transitions. In addition, American International Group (AIG)—one of the
largest insurers, has been bailed out by the federal government, and Freddie
Mac and Fannie Mae have been nationalized. At least ten European banks
have been nationalized or bailed out and there are also rumors that
additional financial services firms both in the US and Europe may also not
survive to year end.

The current condition in the US is mostly a result of greed and poor


governance, and there is certainly enough of that to go around. We can
blame the speculator who thought real estate only went up; borrowers who
took on too much debt; banks that gave loans to virtually anyone who
applied; investors who wanted higher interest rates; investment banks that
took on too much leverage; or auditors and legislators who applied pressure
to banks to make loans to the less financially capable, and regulators who
turned a blind eye and should have know better. There is certainly at least
$840 billion of blame to go around.

While blame may be cathartic, the real question is what is next? Is the
independent investment bank really dead? Well for now it is, but what does
this mean for banks, investors, the general economy and for the market?

Hopefully we can assume once the markets stabilize, commercial banks—


including Morgan Stanley and Goldman Sachs—will be forced (by regulators,
legislators, and boards) to become more conservative. As banks become
more conservative, their risk and compensation levels will go down and the
more highly compensated and risk tolerant will leave to set up or join new
institutions. These new organizations will become the investment banks of
the future.

These newly minted investment banks will be structured as partnerships,


they will be more adroit and nimble, and take on much of the risky aspects of

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 2008 The Tabb Group, LLC, Westborough, MA USA
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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

the traditional investment banks of the past. The major difference will be that
these new organizations will be much smaller and less capable of instigating
financial Armageddon; and because these firms will be partnerships, they will
be more cognizant of their risk level and more hesitant to take risks that will
jeopardize their well being.

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

Table of Contents
VISION 0

INTRODUCTION 3

WHAT HAPPENED? 4
Historic Low Interest Rates 4
Leverage 5
Securitization 5
Greed 6
Loans for All 6
Financial Performance 7
The Blind Eye 8
The Unpleasant Role of a Risk Manager 8
A Toxic Mess 9

RIGHTING THE SHIP 10


Downside of Leverage 10
The Bail Out 11
Cheap Funding Is the Name of the Game 12
Deposits Are Sacred 12

AN INVESTOR’S PERSPECTIVE 14
From OTC to Exchange-traded 15
OTC-clearing—The First Move 15

A NEW BUSINESS MODEL 18

PUBLIC, PRIVATE, OR PARTNERSHIP—WHAT’S THE RIGHT STRUCTURE? 19


Hedge Funds Add to the Fray 20

REGULATION 22
Originators 22
Credit Ratings Agencies 22
Commercial Banks 22
A New Glass-Steagall 22

FUTURE BANK 24

OPPORTUNITIES 26
New Investment Banking Franchises 26
Consolidation 26
Exchanges and Central Counterparties 26
Electronic Trading 27
Risk Management 28

CONCLUSION 30

ABOUT 31
TABB Group 31
The Author 31

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

Introduction
The current credit crisis is the most financially devastating event that the US
and possibly the world have seen since the Great Depression. This crisis will
cause banks to write-off more than three quarters of a trillion US dollars.
Freddie Mac, Fannie Mae, Lehman Brothers, Bear Stearns, Merrill Lynch, AIG,
Washington Mutual, Wachovia, as well as dozens of mortgage companies,
and what looks to be a plethora of smaller and regional banks have either
failed, been forced into shotgun marriages, been taken over, bailed out by
the US government, or are teetering on the brink.

The independent investment banks are gone, and some commercial banks
have had such extreme loses that they had to individually write down the
value of their assets by more than $50 billion. How can this happen? How
can investment and commercial banks lose that much money? And more
importantly what will the capital markets look like in five years? Will there
even be a capital markets in five years?

This Vision Note takes an in-depth look at current industry issues: Much of
this Note is based upon conversations with senior industry management as
well as my readings and thoughts. Although this Note reflects the events that
occurred August through early October 2008, the market is still in too much
flux for this to be the definitive treatise on the subprime and investment
banking crisis of 2008. It will take experts and historians years if not decades
to thoroughly understand, articulate, and proscribe fixes for our financial
markets.

Although it may take years to determine the cause and impact, the subprime
crisis needs to be put into more immediate perspective so banks, brokers,
industry professionals, and the entire financial services ecosystem can begin
adjusting their business models, support systems, and strategies to react to
the massive change affecting our industry. In addition, regulators and
legislators must quickly begin to put these issues into perspective as they
implement changes that may inadvertently cause more harm than good.

In the following pages, I will try to put this crisis into context, examining
some of the causes, and investigating some of the possible outcomes,
challenges, and opportunities that the industry will face in the coming years.

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

What Happened?
To fully understand what the industry will look like in a post subprime world,
you need to have an understanding of what went wrong.

While you can say that this current state was built on greed (true) and
corruption (untrue), to really understand what went wrong we need to parse
the problem into smaller components: historically low interest rates,
misaligned incentives, pressure from Washington to lend to the less
fortunate, poor corporate governance structures, an incorrect pricing of risk,
an incomplete understanding of risk management, conflicts of interest, faulty
securitization theory, and of course a faltering US economy. Although any
one of these issues could be challenging itself, the combination of these
factors amplified the individual risks and exacerbated the carnage.

Historic Low Interest Rates


During the 41-year period from 1965 through 2006, the US had experienced
an unprecedented period of
Exhibit 1
declining interest rates. From an US Treasury 1, 5, and 30 Year Bond Yields
apex of 14.68% in 1981 to nadir of 18%

4.29% in '05, the US Treasury 30 16%

year bond was on a declining trend 14%

(see Exhibit 1). Although high 12%

interest rates usually translate to 10%

greater risk, they also generally 8%

enable banks to enjoy greater 6%

interest rate spreads and greater 4%

profits on their lending. As rates 2%

decline, banks either need to raise


0%
65

68

71

74

77

80

83

86

89

92

95

98

01

04

07
19

19

19

19

19

19

19

19

19

19

19

19

20

20

20
and use more capital, reduce their 1 YR T Bill 5 Yr T Note 30 Yr T Bond

funding cost, increase their Source: Financial Forecast Center


investment yield, or employ more
leverage in order to keep the same
Exhibit 2
profitability. Return on a 0.2% Spread on Underlying
Base Rate for Five Year Term (No Leverage)
A simple but glaring example: If you $35,000
are earning a 20bp (0.2%) spread
$30,000
between the cost and return of
capital and interest rates are at $25,000

historic lows, the amount of earned $20,000


interest will be significantly lower $15,000
than the same 20bp spread when $10,000
rates are at historic highs (see
Exhibit 2). Using this logic, banks $5,000

earning 20bp return at 16% on a $1 $0


% % % % % % 0% 0% 0% 0% 0% 0% 0%
million investment would yield over
00 00 00 00 00 00 .0 .0 .0 .0 .0 .0 .0
4. 5. 6. 7. 8. 9. 10 11 12 13 14 15 16

$32 thousand more over five years Source: TABB Group

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

than they would if they were earning the same spread at 4%. This translates
to a 9bp spread at 4.5% versus a 32bp spread at 16%. Therefore, in order to
generate the same interest revenue, banks would need to invest almost 6
times the capital at 4% than they would need at 16% rates (over five
years)—see Exhibit 2.

Leverage
When leverage is employed the game changes. Given a 2% margin on a $1
billion principle leveraged 35 times, (which was common for the large
investment banks) on high quality collateral (Treasurys), banks could make
$66.9 million in interest revenue off of a 9pb spread. Although it seems
promising, at only 6.7% return on capital ($66.9M/1B), it's not really that
much to write home about. However, it is relatively risk-free.

What if investors don’t want 6.7% on their money (or the 2.27% yield for the
5-year US Treasury Note in 6/03) when the stock market returned 28% and
hedge funds returned 17.5% as they were in 2003?

How do you boost interest rates?

There are generally two ways to boost interest rates: Lock in funds for a
longer time (which would have returned all of 4.37% in June of 2003 for
investing in the 30-year US Treasury Bond), or lend to less credit quality
investors. However, lending to less credit-worthy customers increases your
chance of default and generally investors don’t like to lose their principal.

Securitization
Asset securitization strategies were thought to mitigate this risk. Given a
stable economy, close to full employment, and increasing asset values (home
prices), the rate of default on even lesser-quality credit was not historically
very significant—3 to 4%. So if we make a number of subprime or Alt-A
loans, pool them together, and slice Exhibit 3
them into tranches (groups), we can Comparison of Return on $1B Capital Base
allocate the payments on the Employed on Treasurys vs. Subprime Debt

performing loans to the top tier, $700

then the next group of performing $600

loans to the second tier, and so on


Dollars Returned (in Millions)

$500

until the non-performing loans all $400

wind up at the bottom tier. This $300

way, all of the lower credit quality


loan holders pay, say, London Inter-
$200

Bank Offered Rate (LIBOR) plus 5%, $100

which would equal 10% or so, but $0


1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35

the first-tier holders only get a little X Leverage Employed

higher than the 4.5% US Treasury 9bp Spread on Treasurys 350bp Spread on Subprime

Source: TABB Group


rate, say 5%. Through
securitization, banks were beginning to make 5% or 500pb on their

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

securitization programs, instead of making .09% or 9bp leveraged US


Treasury investments.

Since lesser credit quality tranches pay less, and given a 3 to 4% default
rate, the total spread of the transaction could easily be 350pb. Once this
leveraged 35 times multiplied by a capital base of $1 billion—supporting
close to $17 billion in securitized debt, and you are talking about over $600
million in annual revenues versus the $67 million supported by leveraging US
Treasurys (see Exhibit 3).

Greed
While there were other drivers, investment banking greed played a major
role in this debacle. Just look at the economics: Six-hundred million dollars
generated from subprime securitizations versus $67 million generated from a
leveraged Treasurys business model using the same $1 billion in capital
during an all time low interest rate environment, a period of increasing
housing prices, and virtually full employment. How does a CEO, or anyone for
that matter, have the strength to derail this speeding train? In addition,
banks were selling these instruments to investors who were scooping them
up as fast as they were created, so the bank only had the assets on their
books for a limited time. How can this go wrong? If the choice is leveraged
Treasurys returning 6.7% or leveraged subprime securitizations returning
63% ($628M/$1B), during a perfect world (2003 to 2006) with a low default
rate and a rising real estate market, how many folks would pick the former?
The investment banks certainly didn’t.

The Wall Street Journal/Inside Mortgage Finance pegs the amount of


subprime debt topping out at about $500 billion per a year in 2005—most of
which was grist for the securitization mill (see Exhibit 4). Given the above
leverage (35x), this translates to roughly $30 billion of capital and $18.8
billion in profits. And this was only for 2005.

This business was also very concentrated with the top five players accounting
for almost 40% of the 2006 market. Three of these players (Lehman, Merrill,
and Countrywide) have subsequently either declared bankruptcy, been sold
off, or both.

Loans for All


While the pressure to keep this pump primed was fantastic, its genesis was
not the investment banks. This balloon was started by the Clinton
administrations’ pressure on Fannie Mae and Freddie Mac to expand the
ranks of homeowners to a less financially stable population. Fannie Mae and
Freddie Mac obliged, and lowered the lending standards they accepted for
acquiring mortgages and investment banks were brought in to figure out
ways to mitigate risk. The unfortunate part of this story was its success. The
investment banks realized that by securitizing these loans, not only did it

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

appear that risk was mitigated, but investors gobbled up the paper as its
yields were better than other alternatives.

The rampant success of this program caused investment banks to acquire


mortgage companies just to give out loans. Loan officers were given
origination quotas, bonuses, and told to make loans to just about anyone
instead of being incentivized to manage credit. This is exactly who they made
loans to—just about anyone.
Exhibit 4
US Subprime Issuance 1998-2006
Credit quality and the ability to
repay really didn’t matter since
these loans were only supposed to
be on the books for a few months—
until they could be aggregated,
carved, and packaged into asset-
backed securities. And with a 3% to
4% default rate, even if the
mortgagor defaulted, with
appreciating real estate values, the
servicer would just foreclose and sell
the property for more than the value Source: Inside Mortgage Finance / Wall Street Journal
of the mortgage. All is right with the
world, and Washington and Wall Street were aligned.

Financial Performance
Add to this the public pressures to outperform your last quarter, as well as
provide eight-figure bonuses to investment bankers that don’t hold a major
stake in the organization, and it becomes a very difficult decision to lever
Treasurys instead of subprime debt. No one gets bonuses for returning 6.7%
on capital; but if you achieve 60% or 70% returns with little perceived risk,
then you are a hero—your stock goes up, your bonus goes up, and everyone
is happy.

The fixed income business at many of the bulge-bracket investment banks


has been instrumental to the success of these investment banks. In 2006,
the last unencumbered year, fixed income underwriting and trading revenues
for the top 10 brokers was $79.4 billion (62% of combined fixed income and
equity underwriting and trading revenues). Fixed income underwriting and
trading revenues declined by $64 billion in '07 to only 29% of consolidated
revenues and this year with the announced write-downs, the losses will be
staggering (see Exhibit 5).

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

The Blind Eye


Willing accomplices in this debacle
are the credit-rating agencies. The Exhibit 5
Fixed Income vs. Equity Revenues of Top 10
credit agencies were in a position to Investment Banks (2005-2007)
gauge the financial soundness of Fixed Income vs. Equity Revenues of FI Revenues over Equity Revenues
Top 10 Investment Banks (in $US billions
many of these structured products. (Trading & Underwriting in $US billions)

It was their job to both model the $68.7

credit structures and rate their


2005 2005 $30.7
$38.0

default probability. There were only


two flaws in this process: First, the $93.0

credit rating agencies were looking 2006


$56.5
2006 $36.5

at these products through the lenses


of recent history, and given a $29.3

positive economy, increasing 2007


$72.0
($42.7) 2007

housing prices, low unemployment,


and the nature of diversification and Total Equity
Source: Company Reports
Total Fixed Income

securitization, they felt the chance


of default was low and gave the
structures high-quality ratings. Second, the credit rating agencies were being
paid by product underwriters. Giving them a poor credit rating would not be
good for customer relations or revenue streams.

The credit rating was critical. Without a high quality credit rating, many
institutions would not acquire the products. In addition, the misaligned credit
rating caused banks, brokers, and investors of all stripes to misjudge the
amount of risk associated with these products. This turned out to be a fatal
flaw.

The Unpleasant Role of a Risk Manager


Besides the predominant risk management strategies being based upon
flawed credit ratings, try being a risk manager in this environment. Aside
from credit rating agencies telling you that these products are sound, try
stepping into the corner office and telling the CEO that he should stop the
goose from laying golden eggs. Yes, you know that this market isn’t right.
Yes, you know that these 60% returns are built on a house of cards. Yes, you
know that when leverage works in reverse, and spreads invert or product
values go down it can be disastrous. Yes, you know that these products
aren’t worth the electrons they are written on and finally yes, this market
could come crashing down. But who has more juice—the guy returning 60%
or the risk manager telling management that they should lever up Treasurys
at 6.7%? Where do you think the risk manager who pushed for the Treasurys
ended up? Is there a Siberia for risk managers?

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

A Toxic Mess
There were approximately $500 billion in subprime mortgages originated in
2005, $480 billion in 2006, and approximately $200 billion of additional
subprime debt was originated during the first six months of 2007. Most of it
was carved up into securities and sold to investors, or got stuck on the books
of the origination conduit.

Couple that with Alt-A mortgages, auto and home equity loans, a flagging
economy, rising energy prices, increasing unemployment, and a top to the
housing boom. In addition, start adding on default rates of 11% to 12%
experienced in November 2007 instead of 3% to 4% from over the past four
or five years and all of a sudden this “no brainer” starts to give you real
migraines: A migraine that will need an $840 billion capital infusion to clean
up.

Welcome to October 2008.

Key points
▲ The subprime crisis was all built on greed, not corruption, and there
was more than enough blame to go around.
▲ Government initiatives, historically low interest rates, misaligned
incentives, poor corporate governance structures, an incorrect pricing
of risk, an incomplete understanding of risk management, conflicts of
interest, faulty securitization theory, compounded by a faltering US
economy conspired to get us where we are today.
▲ With leveraged Treasurys only returning less that 7% and leveraged
subprime returning more than 60%, it was difficult to stop this very
predictable runaway train wreck.
▲ Securitization enabled firms to supposedly mitigate risk but also
increased velocity allowing banks to provide more credit at lower
rates.
▲ The lax lending practices of wholly-owned mortgage banks and
conduits enabled banks to create a massive quantity of high-yielding
mortgages to fill securitization factories.
▲ Pressure to make quarterly earnings forecasts put pressure on banks
to keep these structures flowing.
▲ Risk managers were unable to stop the runaway train, even when it
was apparent that the economy was turning south; because who is
going to tell the CEO to stop the goose from laying the golden eggs?

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

Righting the Ship


Firms are drowning. Although they have sold off major amounts of subprime
debt, they still have large amounts on their books, and it isn’t going
anywhere. Unless the US Treasury steps in, as Treasury Secretary Henry
Paulson has proposed, it appears that no one else wants to buy this subprime
debt at the price that the banks are willing to sell it. They could possibly sell
off premium securitized tranches (the ones with first claims to payment
proceeds), but much of that has already been sold, and what is left on firms’
balance sheets are the lower-quality tranches.

The benefits of the low-quality tranches are that they are cheap but risky. In
good times, once the payments for the top quality tranches are paid, the
remaining proceeds are used to pay off the successive tranches, until all of
the proceeds are allocated. If everyone pays back their loans, then the low
quality tranches appreciate and returns can be tremendous. However, if the
economy turns south and a greater number of loans go into default, then the
prices tank and lower quality tranches quickly become worthless.

While not all subprime and Alt-A debt is, has, or will default, perceived risks
are such that investors now worry about which tranches will be paid and
which will default. These concerns about default debt basically seized the
market, causing banks to write down the value of these products. The
current estimate (pre- US Treasury bailout) of subprime write-downs by
banks globally is estimated at $500 billion. This could easily reach a trillion if
the US Treasury bailout is approved.

Institutions holding this debt either need it off their books (fully write it off),
which many firms do not have the capital to do, or to partner with a bank
with large assets to cover any losses. This has pushed Bear Stearns into the
hands of JP Morgan Chase, Merrill Lynch into Bank of America, Lehman
Brothers into bankruptcy, AIG into accepting a LIBOR + 8.5% dissolution
loan, forced Morgan Stanley into becoming a commercial bank and selling
20% off to Mitsubishi UBJ, and also Goldman Sachs into becoming a
commercial bank and selling $5 billion worth of 10% preferred stock with
another $5 billion in warrants to Warren Buffett’s Berkshire Hathaway. And
this does not include the European problems in financial institutions such as
Northern Rock, Fortis, Hypo Real Estate, Bradford & Bingley, and virtually all
of the major Icelandic banks.

Downside of Leverage
When the economy is good, leverage is the gas that propels these firms to
really perform. Even if given a 350bp spread between cost and use of funds,
without leverage, a firm’s return on equity is only 8%; but with 35 times
leverage, our 8% return can be transformed into 63% returns.

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

However, leverage can also cut the other way. If things go badly, it can get
very messy. In our example where $1b is levered 35 times at a 5% margin
rate, it only takes a market value decline of less that 6% to wipe out the
entire $1 billion in capital. We have seen a lot more than a 6% decline in the
value of these highly leveraged subprime debt securitizations. Many of the
investment banks had other businesses and were not fully invested in
subprime, but many banks and investment banks had major leverage and
significant exposure.

The Bail Out


As firms rush to get this debt off their books, they can’t mark the debt down
too much—if they do, they threaten to wipe out their capital base—which has
been precarious of late.

The combination of leverage and a decline in the market value of toxic assets
has sent these banks reeling and looking for deep-pocketed partners. As
mentioned above, Bear Stearns sold to JP Morgan Chase, Merrill Lynch to
Bank of America, Lehman Brothers went bankrupt and sold its US
broker/dealer to Barclays and its European and Asian operations to Nomura
Securities, Fannie Mae and Freddie Exhibit 6
Mac were nationalized, AIG was Lost Market Capitalization of Top Ten
bailed out by the Federal Reserve, Investment Banks (12/31/07 to 10/10/08)

and US Congress just passed the UBS $86.9

Federal Reserve and the US Citi $83.6

Treasury Department’s $840 billion Merrill Lynch $58.0

plan to acquire and auction off much Goldman Sachs $54.0

of the subprime debt, enabling Morgan Stanley $48.2

banks to get this toxic waste off Deutsche Bank $42.3

their books. Lehman Brothers $41.2

Credit Suisse $28.5

This has or will cost investors and Bear Stearns $11.5

taxpayers trillions of dollars. Just JP Morgan Chase $7.0

the decrease in market


Source: Yahoo Finance, Google Finance, Company
capitalization of the top ten Records
investment banks from 12/31/07 to
10/10/08 adds up to more than $460 billion, or 54% of their end-of-year
value, and that doesn’t include bailouts and write-downs by other institutions
(see Exhibit 6).

In addition to investment banks writing these positions off or selling them to


a new style Resolution Trust, they will need to deleverage. Deleveraging has
its own challenges. Without leverage, investment banks have four options:
Banks can be satisfied with the returns that traditional investors earn on
fixed income assets (minimal); migrate from a banking model where firms
borrow at lower rates than they invest to an agency/commission model that
charges transactional fees, such as the institutional equities business; link up
with a bank that has a less expensive cost of capital; or get out of the fixed
income business altogether.

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

Cheap Funding Is the Name of the Game


Cheap funding is the reason why commercial banks have been the preferred
partner for these investment banking firms. Banks have also aggressively
tried to break into the investment banking business for years—many without
success. This downfall has provided traditional commercial banks with the
opportunity to get into this business at bargain-basement prices. Banks have
been willing partners for a number of reasons. First, while a few banks had
major subprime business, many less adventurous banks didn’t. Second,
banks have a lower cost of funding (deposits), which is essential if you want
to stay in the fixed income business and the subprime business is dead.
Third, because of banks' deposit base, they have both deposit insurance as
well as tighter linkages with the Federal Reserve, which has access to the
ultimate funding source: the national printing press.

Now that the securitization markets have dried up, investment banks will
have a harder time tapping into the same high-yielding credit streams.
Without subprime (or lower quality investment opportunities), investment
banks will find it more difficult to lend money 300bp to 500bp above the
commercial borrowing rates. So to maintain some semblance of return, these
banks will need to reduce their cost of funds. What is the lowest cost of
funding? Deposits. Demand deposit (checking) accounts typically offer no or
very low interest rates. Savings accounts offer minimally more interest but
certainly not anything as high as an institutional CD, or even collateralized
loan or repurchase agreement.

These deposits enable investment banks to gain greater spreads on capital


than they could get elsewhere on the commercial market. Without cheap
funds, it will be challenging for investment banks to stay in the fixed income
business, which has accounted for more than half of their total revenue over
the past five years.

Deposits Are Sacred


Deposits are a funny thing. Individuals, corporations, and non-profits place
their deposits into a bank and expect it to be safe. They expect 100% surety,
immediate access, and complete transparency with their cash. This is even
true with money funds. On September 18, 2008, a major money manager’s
cash equivalent money fund declined to less than a dollar. The money
manager shut the fund down, and the custodian’s stock dropped 60%
intraday and ended down 20%. Deposits are not funny—they are actually
sacred.

Now that investment banks are merging with or becoming commercial banks,
we should not expect that these newly or soon to be newly integrated
investment banking arms of commercial banks will continue with their
traditional ways. While commercial banks do have less expensive funding
capabilities, I doubt if they will be allowed to take advantage of these funding
sources with the same gusto that they leveraged subprime debt.

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

The remaining fixed income divisions of these investment banks will need to
develop new operating models. They will not be able to carry on with the
same level of leverage or their same product set.

Key points
▲ Institutions holding subprime securitized debt either need to get this
debt off their books (fully write it off)—which many firms do not have
the capital to do—or partner with a bank with large assets to cover any
losses.
▲ Although banks need to write this debt off, they can’t. When
employing this much leverage, a market value decline of less that 6%
can wipe out all of the initial capital used to lever this business.
▲ The impact of this crisis has been dramatic. The decrease in market
capitalization of the top ten investment banks from 12/31/07 to
10/10/08 adds up to more than $460 billion or 54% of their end-of-
year value; and that doesn’t include bailouts and write-downs by other
institutions.
▲ Deleveraging has its own challenges. Without leverage, investment
banks have four options:
o Banks can be satisfied with the returns that traditional investors
earn on fixed income assets (minimal).
o They can migrate from a banking model where they borrow at
lower rates than they invest to an agency/commission model
such as the equities business that charges transactional fees.
o They can link up with a bank that has a less expensive cost of
capital.
o Get out of the fixed income business completely.
▲ The rush to become a commercial bank is all about cheap money as a
funding source: deposits and savings.
▲ Deposits enable banks to enjoy greater spreads on capital than they
could get elsewhere in the commercial market.
▲ Without cheap funds, it would be challenging for investment banks to
stay in the fixed income business.
▲ However, once a firm becomes a bank and takes deposits it must
become more risk adverse.

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

An Investor’s Perspective
The subprime crisis has also been devastating for investors. First, mortgage
and asset-backed securities markets fell, then the auction rate securities
market seized, municipal markets stalled, credit derivatives markets went
crazy, and finally global equity prices plummeted. Many investors are
currently stuck with a host of products they can not value or sell. All of this
has created a financial crisis of a magnitude never seen in modern history.

One of the critical take aways of this crisis is the importance of transparency
and liquidity: the ability to better value, price, and trade a product as well as
comprehend its underlying and associated holding risks. This is a challenge
especially true with the structured products market (asset backed). The
inability to understand the underlying components of each asset and its
associated risks has caused these markets to virtually dry up.

The theory of securitization was to simplify and limit risk by aggregating,


packaging, and restructuring the cash flows of risky mortgages/loans into
more predictable and less risky assets. However, instead of reducing risk,
securitization increased the complexity of these products and obfuscated the
probability of payback, which has caused the whole asset class to become
virtually worthless.

While investment banks will try to bring back securitized products, a number
of changes need to be enacted before this paper will move. First, the
underlying collateral must be top quality. Second, there must be a new
methodology or process to rate these structures—one that will both be
believed and trusted, preferably issued by a credit rating agency that was not
involved in the last disaster. Third, these new structures must be more
transparent and predictable than the past structures, and fourth, time. Time
needs to pass before investors will trust securitized products again.

This means that securitized structures will not be as popular or profitable for
investment banks to issue, trade, distribute, or position. It will force
investment banks to curtail the origination of complex and arcane products
and force them to focus on the simple and more transparent structures. As
this occurs, it will force investors to push banks to develop simpler, more
generic, and more fungible products that can more easily be valued, traded,
and marked.

In addition, the consolidation of banks and their reluctance to underwrite risk


or take risk on their balance sheet will force a change in the way the debt
and derivatives markets operate.

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

From OTC to Exchange-traded


The push toward investing in transparently priced and valued products in
conjunction with the banks’ desire to get risk off their balance sheets will
force a restructuring of the way products are issued, underwritten,
distributed, traded, and cleared.

Over-the-counter (OTC) products are traditionally traded as principal and not


agent. Securities are bought into inventory and sold to investors at
(hopefully) a positive spread. During the period that the bank is in
possession of the assets, they sit on the firm’s balance sheet. This could be
for seconds, hours, days, weeks, or months depending upon the product and
its ability to be distributed. OTC derivatives on the other hand, have longer
settlement periods. Although derivatives are typically hedged to mitigate
risk, these products usually stay on banks' balance sheets until maturity. This
is typically for months or even years in the case of longer-term swaps.

As banks try to reduce their risk and their balance sheets, the ability to
position or offset exposures will become less palatable to bank management.
In addition, given investors’ desire for transparency and the banks’ need to
jettison risk from their balance sheets, there is a major impetus for both
banks and investors to migrate these markets from OTC to exchange-traded.

The move from OTC to exchange-traded will not be simple. One of the
beautiful things about the OTC market is that issuers have historically
tailored structures that completely align with their needs. If the issuer
needed a 2.3 year maturity, no problem; if the issuer needed certain caveats
or covenants, no problem—the underwriters would just craft the bond or
derivative structure to the exact specifications of the issuer.

Given a transition to a more exchange-driven market, we wouldn’t expect to


see the same product diversity, customization, or issuer flexibility within the
OTC market. However, given investors’ need for transparency and liquidity,
issuer flexibility will be the first thing sacrificed; as without the demand or
the desire of a bank to underwrite a custom structure, customization is a
nice-to-have.

OTC-clearing—The First Move


Before the OTC markets begin to migrate to a more structured exchange-
type format, there needs to be an interim step: centralized clearing.
Centralized clearing allows banks to net their exposures and get them off the
banks’ balance sheet. Long and short in the same security or contract type
are netted and the agreement is transferred to the clearing entity to manage
any residual risk and processing. The result is a reduction of exposure and a
net down of counterparty risk.

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

In netting exposures, the central counterparty becomes the other side of the
trade, and if exposures net, the transactions are effectively novated and
eliminated.

The central clearing entity is usually a separately capitalized entity that is


backed by the capital of its clearing members. The capital is calculated and
adjusted, depending upon a firm’s credit worthiness and is used to offset
members’ default.

Once the clearing entity is formulated and it is integrated into members’


workflow, it becomes easier to set up an exchange. The front-end trading
tends to be easier to develop than the clearing, settlement, and risk
mitigation process.

Currently, we see significant competition to develop a central


clearing/exchange platform for the approximately $55 trillion credit default
swap (CDS) market. Initially the Federal Reserve was working with eleven
firms (which may be fewer today given the recent consolidation) to develop a
clearinghouse for credit default swaps. The initiative dubbed Clearing
Corporation was scheduled to kick off during the fourth quarter 2008, but,
given the current market challenges, this initiative was pushed back to the
first quarter of 2009. In addition to Clearing Corporation, the CME and
Citadel; the InterContinental Exchange which has teamed with the Clearing
Corporation, Markit (a market data/valuation industry consortium) and
RiskMetrics; Eurex (owned by Deutsche Boerse) and NYSE Euronext have
shown intentions of developing either an exchange and or a CDS clearing
platform.

The development of a CDS central clearing facility enables dealers to net


exposure, reduce risk, and streamline the processing of these products. If
this initiative is successful we can expect other OTC products to follow suit
and exchanges to leverage this infrastructure to facilitate trading—given
acceptance of an exchange-model for CDS or other products by dealers.

Key points
▲ Investors have been devastated by the subprime/securitization
debacle.
▲ We believe the current crisis will switch investor focus from customized
product to transparent and liquid products.
▲ This will force investment banks to curtail the origination of complex
and arcane products and force them to focus on simple and more
transparent structures.
▲ This will be a time when exchange-traded and centrally cleared
products will be more desirable than OTC.
▲ Moving toward an exchange/centrally cleared structure will enable
banks to reduce risk, lower their balance sheets, and provide more
commission income.

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

▲ Currently there are four major initiatives focusing on transition of the


CDS market from an over-the-counter market to either an exchange-
traded or at least a centrally cleared product.
▲ Investors during this time of volatility and lack of transparency will
make fungible, easily valued, traded, and marked products more
popular than bespoke and complex products.

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17
The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

A New Business Model


With securitization in retreat and investors demanding more transparency,
banks and investment banks will have to significantly change their business
model. The traditional commercial/investment bank business model to loan
out money, securitize the debt, sell the debt to investors, and use the
proceeds to make more loans is either dead or in deep hibernation. This
highly leveraged business model is profitable when it works. The problem is,
this model is and will be broken for years. The result is banks and investment
banks will need to keep their originated loans on their books until they are
either are sold (less likely) or they mature (more likely).

Hopefully, this means that banks will get back into the habit of making good
loans to reputable borrowers and curtail the process of making loans to folks
that have no way of paying them off.

While banks will make better loans, each loan they originate will stay on the
balance sheet until it is paid off or sold. It is the basic business model of
banks of yore: take deposits, make loans—how boring is that? This business
model does not employ significant leverage and subsequently is not as
profitable without a very low cost deposit base. It is certainly not the type of
business model that supports eight-, or even six-figure bonuses. However, it
will probably get firms in less trouble.

It will not just be the subprime mortgage securitization business that gets
shut down; it will be virtually any securitized debt product—auto loans, home
equity loans, credit card receivables, corporate loans, and anything else
being securitized. The only product that may survive this would be whole
loans as those are sold off whole and are not aggregated, sliced, and diced
into a series of tranches.

Banks will return to the similar institutions they were 30 years ago, deposit
taking organizations that lend money in fairly innocuous ways, unless
investment banks develop a more creative and transparent way of financing
this debt.

Key points
▲ The combination of a reduction in securitized product, keeping loans
on the balance sheet, and increased desirability of exchange products
will make banks look more like banks 30 years ago than the
investment banks of 2006.
▲ This will provide an opportunity for smaller investment banks to take
risk.

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18
The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

Public, Private, or Partnership—What’s the Right


Structure?
A major problem arising is the mismatch between business model and
governance structure. Historically, investment banks have been partnerships.
These partnerships eventually transitioned during the '80s and '90s into
public corporations as greater leverage, increasing investment, and
increasing pressures to be global drove the need for greater capital.

This, I believe, while critical to increase the size of the business and to
compete with global European universal banks, was the beginning of the
downfall of these storied houses.

As these firms became larger and more complex, their leverage and risk
increased to the extent that it not only became more difficult for outside
investors to understand the riskiness of their positions, but it also became
more difficult for the firm to understand the ramifications of their actions. In
addition, the short-term incentive nature of the trading business and the
long-term viability of the firm came into conflict.

An investment banker’s incentive structure was typically a multiple of his or


her salary. It was not odd for the average bonus at a top investment bank to
be over $350,000 annually; and this calculation included secretaries,
operational staff, and technologists whose bonuses were much less. Seven-
digit bonuses were not odd, and top performers could earn eight digits. In
addition, annual compensation was significantly more valuable than many
individual’s ownership positions. When this compensation structure exists, it
becomes much more important for the individual to maximize his or her
short-term contribution, even if it conflicts with the long-term goals of the
firm.

While public ownership and individual compensation schemes create certain


incentives, partnerships create others. Historically, partnerships at these
firms were granted to senior management, major producers, and rising stars.
Much of partners’ net worth was tied up in the ownership of the partnership.
In addition, the desire to become a partner was so great that it became a
governor on the amount of risk a future partner would take.

This type of ownership creates an interesting dialogue. Aggressive business


leaders pitch new ventures, while conservative voices vote for sanity.
Although the discussions may be heated, everyone around the table is
extremely vested and keenly aware of the risks and opportunities.
Conversely, in a public structure, the owners are not nearly as vested.
Owners can be as distant as mutual fund holders, ex-employees, or just Joe
Six-Pack. Public companies do not usually have concentrated ownership, and
even large non-inside equity holders do not have the same insight into the
business as its leaders, management, and heavy hitters.

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

In effect, these banks were using unsophisticated investors’ capital to take


risks that many of their management and staff did not understand, let alone
their unsophisticated investor base. A well capitalized partnership structure,
where partners are vested and tied to the success of the organization, would
be a more effective ownership structure for this type of institution.

The major challenge to this type of ownership structure would be capital. As


the world becomes more global and integrated, it would be difficult for a
partnership to raise the type of capital needed to manage global deals, take
large positions, and execute large transactions. While this is certainly true,
we are not sure that global banks will be as able to underwrite major risk-
based deals for a while, anyway.

Hedge Funds Add to the Fray


Many hedge funds are in trouble. Not that they broke the law, disobeyed
their mandates, or even jaywalked. It is just the nature of the markets and
the new regulatory structures place hedge funds at a distinct disadvantage in
this environment. And this disadvantage, I believe, ties into the governance
structure debate for investment and commercial banks.

Hedge funds generally make their money through performance fees—these


structures typically charge 2 and 20 or 3 and 30. What that means is these
funds charge a 2% or 3% AuM fee plus a performance fee of 20% or 30% of
the profits. If a hedge fund’s market value declines 15% or 20%, before the
fund can begin to collect a performance fee, it would need to make up the
loss and generate positive returns above its previous high-water mark. In
essence, the greater the loss, the deeper the hole these funds need to dig
out of before they can generate performance fees.

If the hole becomes too deep, it is easier to close the fund, return cash to the
investors, and start from scratch. This scenario is becoming a more popular
alternative as performance fee-based funds sink deeper into negative return
territory. According to Hedge Fund Research, the number of hedge fund
closures hit 350 for the first half of 2008. This was 15% higher than for the
first half of 2007, TABB Group believes the second half of 2008 will be far
worse than the first with second half '08 closures tripling first half, shuttering
700 to 1,000 funds or 15% of the industry.

Another issue that has and could possibly exacerbate this trend is the SEC
short sale restrictions. The SEC has just removed short sale restrictions
which mandated that over 900 financial stocks could not be shorted by
anyone without a market maker exemption. While this ban was recently
removed, with all of the market volatility it would not be surprising to see the
SEC re-implement these restrictions if market conditions continue to
deteriorate. While short sale restrictions may benefit the attacked firms, it
challenges many funds’ investment mandates. Short sale restrictions
basically cripple both statistical arbitrage and short extension funds (120/20

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

and 130/30s), as these bans directly threaten their business models. If these
bans and restrictions are reimplemented, then the majority of these funds
will close since their investment mandate will be impossible to fulfill.

If market conditions continue to deteriorate and the bans are reinstated, we


expect that some of these shuttered funds will become self-capitalized
market makers or broker-dealers. While market makers/broker-dealers also
have short-sale restrictions, they have more leeway than investors and
hedge funds in shorting. In addition, with banks reducing their risk
positions/risk capital, the combination of reduced competition from larger
investment/commercial banks; increased supply of unemployed quants from
shuttered hedge funds; and regulations that favor intermediaries over
investors, we see these adding up to an increased opportunity for new and
smaller risk-oriented market makers/broker dealers.

With adversity and change comes opportunity.

Key points
▲ The ownership structure of publicly owned investment banks is flawed
as many if not most investors do not understand the risk these
organizations take.
▲ As investment banks become commercial banks and greater regulation
is applied to these newly minted commercial banks, we believe that
the more risk accepting aspects of these banks will migrate to
separately capitalized privately held enterprises. These will mostly be
partnerships.
▲ The shut down of many hedge funds may play into this factor as well.
▲ The short-sale restrictions, if reinstated, will destroy many stat arb
and short extension fund strategies.
▲ Depending upon how the regulatory structure works out, these
managers may also find it easier to work in a brokerage/market maker
infrastructure rather than a fund infrastructure.
▲ This will provide an opportunity for smaller players to assume some of
the risks the larger, now commercial, banks will not be able to
manage.

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

Regulation
Although no one likes to admit it, new regulation will occur. It will come from
all directions and toward all players, including mortgage brokers, credit
rating agencies, commercial banks, investment banks, and even investors,
both individual and institutional. However, regulation will not happen
immediately; it will occur over the next year or two. While the regulators and
legislators are calming the markets (or bailing out the markets), solvency will
be the first concern. However, we can easily see that once the turmoil is
over, reform will begin.

Originators
Some of the simplest and most straightforward rules will be guided toward
loan originators. The easiest ones to predict are the elimination of non-
documented loans and some base level of proof that the borrower has the
financial capability to take on the debt. By placing regulations in this sphere,
you eliminate the natural tendency for mortgage bankers to charge extra
points in lieu of accurate documentation. In addition, we may see some
guidelines or product restrictions such as maximum loan-to-value ratios, and
possibly even an elimination of interest-only and reverse amortization
mortgages—that last restriction would probably be a long shot.

Credit Ratings Agencies


We will certainly see increased regulation of the credit rating agencies as
well. These rules will most likely revolve around reducing conflicts of interest
rather than standardizing ratings formulas. We believe that there will be
restrictions banning the accepting of issuer-based fees to ratings agencies.
While this may drastically change the credit rating agencies' business
models, without such a change it will be difficult to eliminate the perception
that the issuer “bought” a rating that it did not deserve. The only other way
to eliminate this perception is to make the rating process more transparent.
This, we believe, will not occur as it would present a more critical blow to the
rating agencies’ business models, as the models could be easily replicated,
eliminating the need for buying the service altogether.

Commercial Banks
New regulations on commercial banks are more difficult to predict because
they will be more extensive. Current leverage ratios of 30 to 1 and upwards
will be curtailed back to traditional measures (12 to 1) or even less. New risk
measurement requirements will be implemented, but this may take years, as
the industry will first reexamine and redefine the current risk management
best practices before any new measures can be implemented.

A New Glass-Steagall
As investment banks are consolidated into commercial banks and the fixed
income businesses look to tap into the lower cost of funding associated with

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

deposits and commercial banking endeavors, we would also not be surprised


if we see new Glass-Steagall type legislation, which will again draw the lines
between investment and commercial banks.

With the US government bailing out the investment and commercial banking
industries to the tune of close, if not more than, $1 trillion, we can be sure
that the US government ensures that this type of fiasco does not happen
again. If the government was intelligent (which we know can be a stretch), it
would look to put limitations on what products and services investment
banks can do within a commercial banking framework.

While the Glass-Steagall Act mostly split investment and commercial banking
across equity/corporate underwriting (investment banking only) and fixed
income (both investment and commercial banking) lines, most if not all of
the challenges stemming from the subprime crisis occurred on the
commercial banking side. It was not the equity side of the business that blew
up, it was the fixed income side, which has historically been thought of as
the safer side. While I don’t think the government would split out the
mortgage or the loan business from the commercial banking side, besides
better managing the amount of leverage implemented on commercial banks,
we could easily see that various risk-type businesses being split from these
US Universal Banks.

This may mean that while the new Universal Banks have both equity and
fixed income businesses, they may be prohibited from proprietary trading,
taking sizeable risk positions, and/or underwriting corporate securities (both
equity and corporate debt), leaving the Universal Bank’s role in capital
market as more of a processor, custodian, and agency trading operation
rather than proprietary desks using retail deposits and naive investor capital.

Key points
▲ While nothing is written yet, TABB Group believes that we will see a
host of new regulations
▲ At the least we will see the following:
o Restrictions on mortgage bankers to prohibit non-doc loans and
possibly zero-principal loans
o New regulations on credit rating agencies
o Leverage restrictions on banks
o Restrictions on various businesses banks will be able to perform
▲ We also believe there will be a new Glass-Steagall type legislation that
separates risk-taking enterprises from traditional banking activities to
ensure this type of bailout will not be needed again.

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

Future Bank
The consolidated investment/commercial bank will be a very different bank
from the investment banks of the past dozen or more years. I believe they
will look much more like the banks of twenty years ago than the banks of
recent history.

Without securitization—and to be specific, securitization of Alt-A and


subprime debt—banks will not be able to generate the wide spreads of the
past few years. That said, the commercial banking business will be more
profitable than it has been for the past twenty years. Without the velocity
that securitization provides and the leverage investment banks employed in
turning over bank assets to investors, commercial banks will need to charge
higher rates. In addition, the challenges of the investment sector will push a
greater amount of funds out of the investment realm into the safety of bank-
insured deposits. The increase in supply of deposits will reduce the interest
paid on accounts and the inability to resell loans, forcing them to remain on
the books, which will force the price of lending up.

However, this is a commercial and not an investment banking game, so the


investment banks that have not paired with a commercial bank will be out of
the picture. This is why most investment banks have either linked with a
commercial bank or have become commercial banks themselves.

These new commercial banks will be less leveraged and financially less
complex. Their business models will be more straightforward, such as retail
banks, wealth managers, credit card banks, custodians, wholesale banks,
agency brokers (which will be more than just equities as more products
move toward exchange-traded), and other more traditional banking-related
business models.

Given the consolidation of investment banks into commercial banks, and the
government’s desire not to have another bailout at least for another few
years, as mentioned above, we believe that the more risk-based businesses
will be spun off into a separate new entity. This entity will be a partnership-
based business that leverages its own capital to bankroll activities, such as
proprietary trading and underwriting.

These organizations will look more like hedge funds than investment banks,
but being dealers, they will be SEC-registered and have the benefits and
responsibilities afforded to registered intermediaries. These businesses will
be much smaller than they are now and, at least initially, they will have less
ability to harm the economy.

Key points
▲ Future banks will be significantly different that they are today.

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

▲ Without securitization, the velocity of money will decrease as loans will


need to stay on the banks’ books instead of being sold off.
▲ This will force banks to make better loans.
▲ However, it will also make the bank more risk adverse.
▲ Compensation structures will be adjusted downward because they will
be providing more conservative functions.
▲ This will cause the “best and brightest” to look elsewhere for
employment—more than likely to private partnership boutique
investment banks.

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

Opportunities
While the banking world will certainly change over the next five to ten years,
we can certainly guarantee that there will be a significant number of
opportunities and challenges.

The challenges will certainly lie in consolidation, rationalizing business lines,


determining new business models, working with a host of unhinged clients,
and working with regulators and legislators to determine the proper structure
of the investment and banking industries.

While this occurs there will also be opportunities.

New Investment Banking Franchises


We believe one of the biggest opportunities in the marketplace will be for the
development of new investment banking franchises. These boutique fully
capitalized partnerships will be more nimble and opportunistic that their
bulge bracket brethren that will be hamstrung by greater levels of regulation,
bureaucracy, and decreasing compensation scales.

These de novo or hedge fund-type broker conversions will be able to


leverage the correspondent infrastructures provided by firms such as
Pershing, Fidelity/National Financial, Goldman, Penson, and the old Bear
Stearns correspondent business that was recently integrated into JP Morgan.
Depending upon the mix of business, these infrastructures provide robust
pre-built out infrastructures that are fairly easy to integrate.

Consolidation
In consolidation, firms and banks will need to select and integrate their
infrastructures. To accomplish this, they will need to determine their future
needs, examine their current infrastructure, develop a gap analysis, acquire
the right solutions (if they don’t exist today), and integrate and rationalize
their applications to develop a unified operating environment.

The initial integration phases will focus on rationalization and integration.


This will enable firms to eliminate duplicative systems. Although this sounds
easy, it's difficult to achieve. Technologies are rarely identical, and unless a
business is being shuttered, it will need to be converted onto the surviving
platform. In the meantime these systems must be analyzed, benchmarked,
tested, paralleled, and converted. This will take significant operational,
technological, connectivity, and conversion resources.

Exchanges and Central Counterparties


In a world where banks must take less risk and use less of their balance
sheet, central counterparties and exchanges enable the more effective

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

transfer of risk. These entities enable OTC markets to migrate to


commission-oriented exchange-based agency markets. This allows banks to
maintain customer relationships without taking on the risk of traditional OTC
businesses.

Even though the majority of exchanges have gone public and are for-profit
enterprises, exchanges have traditionally enjoyed the status of independent
and level. They are highly regulated and non-risk-taking enterprises that are
for the most part trusted entities.

While the dealers may not want to give up their once-lucrative OTC business,
during this time of restricted credit and diminished balance sheets, migrating
these businesses to exchange-based models may be the best for both
institutional clients as well as the dealers themselves.

As more products move on-exchange, they will begin to take on the


characteristics of the equities and exchange-traded derivatives products.
Moving on-exchange will allow these products to gain transparency, which
will increase liquidity and reduce the systematic risk these products require
when being traded off-exchange. In addition, it will allow firms to apply
advance trading technologies such as direct market access and algorithmic
trading solutions to these products, increasing client flow and liquidity while
reducing balance sheet risk.

Central counterparty solutions will also gain favor in this migration away from
bank balance sheets. Central counterparty solutions allow firms to more
effectively compare trades and eventually offset complimentary risks.
Traditionally, central counterparties have been set up as industry utilities
where risk was mutualized between participating dealers. In Europe,
however, the trend has been to use clearing banks as the sole central
counterparty for equity clearing. The most prominent example of this was
Fortis’ European Multilateral Clearing Facility (EMCF). This entity provided the
central counterparty clearing for Chi-X and the soon to go live NASDAQ
Europe and EURO BATS MTF initiatives. However, Fortis has recently become
victim to the global credit crisis and was recently nationalized by Belgium and
Luxembourg and subsequently sold to BNP Paribas. TABB Group believes that
this recent challenge may push clearing initiatives back to the major Central
Counterparties (CCPs) or another mutualized-risk facility such as the
Depository Trust and Clearing Corporation’s EuroCCP initiative. Either way,
the challenges of Fortis have drawn attention to the challenges of a single
commercial entity providing central counterparty solutions without the
development of a mutualized clearing fund.

Electronic Trading
As more products move toward central clearing and exchange-based models,
banks will need to invest in electronic trading technologies. Unlike traditional
phone-based OTC markets where banks can easily consolidate their business
and realign it to the remaining traders and sales people, when products begin

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

to move electronically, banks need to invest or they are out of the business.
There is no half way.

With technology costs declining, clients gaining more experience, brokers


rolling out more advanced trading technologies, and the anticipated
migration of more products to agency-based electronic models, we see the
investment and usage of electronic trading technologies only becoming more
common.

The migration of more products to advanced trading technologies will


increase demand for connectivity, order management, execution
management, and high-speed/low latency market data solutions.

Risk Management
It will be difficult for firms to write off nearly $500 billion without pressure to
invest in more risk management technologies. Now it would seem that this
pressure to buy more risk management solutions would begin immediately;
however, there will be a gap between investment in current infrastructures to
both better integrate and analyze risk using today’s methods, and firms’
more utopian risk management solutions.

Although firms will begin investing immediately in fixing the gaps in their
current risk management process, which will include investments in data
management and integration solutions as well as grid and cluster-based
solutions to improve their calculation times, it will take some time for firms to
analyze and rebuild their risk infrastructures from the ground up, which is
what is needed after such a colossal failure.

In firms’ quest for their ultimate risk solution, they will have to not only
develop new analytics, they will also need to revamp the way they think,
analyze, and manage risk throughout the organization. We believe firms’
major investments in risk will not take place until the industry develops a
new way to measure risk. With the amount of losses occurred using risk
management philosophies and models of today, we don’t see new risk
methodologies emerging until a new paradigm in measuring and monitoring
risk can be developed. However, when that day comes, you can guarantee
that these new risk management technologies will rely on more real-time
data collection and analysis.

Key points
▲ The most significant opportunities that will arise from this new era are-
o development of new partnership-governed investment banks
o integration services for the merged banks
o help with new compliance and regulation
o banking systems and technologies for the newly minted
commercial banks

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

▲ For exchanges and depositories there will be significant opportunities


as traditionally OTC business will be migrated to centrally cleared and
/ or exchange-traded.
▲ Electronic trading will continue in full force as the migration of OTC to
exchange as well as the desire to cut costs will move more volume
from manual to electronic.
▲ Risk management will be an extremely lucrative enterprise in these
new organizations.
o However, we will not just see an increased investment in
existing technologies, as these technologies are the ones that
got firms in the trouble they were in.
o We will first need to see a new risk management methodology
develop and be socialized before we will see massive new
investments in risk management.
o However, until these new risk management methodologies are
developed, firms will want the old risk measures expedited—so
investments in clusters, grids, and data management will be
extensive.

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

Conclusion
With the challenges that Wall Street has experienced over the past few
weeks, we can without hesitation declare that the day of the bulge-bracket
investment bank is over. It is as extinct as the dinosaur, and will probably
not walk the face of the earth for years to come.

While the investment banks are gone, the services that the investment banks
provided will never go out of style in a capitalist society. Governments,
corporations, and entities will continue to demand capital, and individuals
and entities will need to invest. It is just the regulatory frameworks that will
change.

Under these new regulatory guidelines, we can assume that the Universal
Banks of the present will come under more rigorous scrutiny and guidelines
than the investment banks of the past. With depositors’ money at risk, we
can only hope that some of the riskier practices of the past will be curtailed
as their balance sheets become increasingly filled with low-cost insured
deposits.

Under this transition we can assume that the banking models become
simplified—almost boring—as the banking sector tries to rebuild trust, capital
and the demonstration of safe investment philosophies. With simplification,
deleveraging, and reduced risk, we can also assume that the cost structure
and bonus structure of these institutions will change. This triumvirate of
drivers—regulation, risk, and compensation—will force the more well
compensated (and those that want to be) as well as the more risk inclined to
set up new and smaller broker-dealers that will not be deposit-based. This
will allow these smaller and less deposit-constrained institutions to be more
open in their activities.

In addition, with the large amount of hedge fund closings, we can be assured
that some of these new funds will change charters, become self-capitalized,
and either join with these new dealers or become dealers themselves.

These new dealers will not be public, and that is a good thing. These entities
will be either partnerships or privately funded vehicles where the people that
have an ownership stake completely understand their risk structures. And if
they blow up, it won’t be uninformed investors’ capital at stake.

While it is going to be a challenging few years for our industry, our industry
is also one of the most dynamic and innovative that has ever been devised.
And while some of that innovative nature has put the industry in jeopardy,
what will come out of this will be a more sound and more right-sized
structure that will not only survive but thrive.

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

About
TABB Group
TABB Group is a financial markets advisory and thought leadership firm.
Focusing on the intersection of the financial markets and technology, TABB
Group has produced major studies on the future of trading technologies, the
impact of market structure, and changes in the use of real-time technologies.
TABB Group members are regularly cited in the press and speak at industry
conferences. For more information about TABB Group, go to
www.tabbgroup.com.

The Author
Larry Tabb is founder and CEO of TABB Group, the financial markets research
and strategic advisory firm focused exclusively on capital markets. Founded
in 2003 and based on the interview-based research methodology of “first-
person knowledge,” TABB Group analyzes and quantifies the investing value
chain from the fiduciary, investment manager, broker, exchange and
custodian, helping senior business leaders gain a truer understanding of
financial markets issues.

Quoted extensively and in virtually all industry and general news


publications, he has been cited in The Wall Street Journal, Financial Times,
Associated Press, CNN, Bloomberg, CNBC, Reuters, Dow-Jones News,
Barron’s, Forbes, Business Week, Financial News, Wall Street & Technology,
Securities Industry News, Waters, Global Investment Technology,
Computerworld, eWEEK, American Banker, The Banker, Lipper HedgeWorld,
Hedge Fund Review and Wall Street Letter. He continues to be a featured
speaker at major industry and business conferences throughout the US,
Europe, Asia and Canada.

Before founding TABB Group, Larry was vice president of TowerGroup’s


Securities & Investments practice, where he founded the practice in 1996
and managed research across the capital markets, investment management,
retail brokerage, and wealth management segments.

Prior to joining TowerGroup, he managed business analysis for Lehman


Brothers’ Trading Services Division and was responsible for overseeing the
specification, testing and implementation of dozens of major systems during
his tenure. He also led capital markets technology planning at Lehman
Brothers, where he developed one- and three-year technology plans from
1988 through 1992. He began his financial markets career managing various
operations for the North American Investment Bank of Citibank, including
front-office trading and finance operations, back-office money market
operations and, for US Treasury debt, proprietary trading clearance and
settlement operations.

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The Future of Investment Banking: Subprime and Its Impact on the Industry | October 2008

www.tabbgroup.com

New York
+1.646.722.7800

London
+(0) 207 368 3377

Westborough, MA
+1.508.836.2031

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