Asymmetrical Information

From the desk of Jane Galt:

Department of Bad Ideas

Daniel Gross points out another area in which banks were apparently using low margin business to sell high-margin investment banking businss: commercial loans. This has JP Morgan/Chase in a bit of a bind:

As the once-gentlemanly business of providing revolving credit lines evolved into a sharp-elbowed competition to provide investment banking services, Chase embraced the new aggressive tactics. Frequently, loans were seen as a lever to gain more highly profitable investment banking business.

In the late '90s, the most needy borrowers, not coincidentally, also provided the most lucrative investment banking opportunities. Deal-junkie energy traders (Enron), telecommunications infrastructure giants (WorldCom, Global Crossing), and serial acquirers like Tyco—Chase lent to them all with abandon. Of course, anybody who has applied for a line of credit knows that bankers routinely turn down opportunities to lend money. Increasingly, however, Chase abandoned the risk-averse posture of a commercial banker for the transaction-driven mania of an investment banker. Shying away from risky deals would have meant forfeiting lucrative fees and market share to Citigroup, as well as Merrill Lynch and Goldman Sachs.

Now Chase is paying the price for letting investment banking imperatives overwhelm sound lending judgment. Today Chase, with a market cap of $49 billion, is a mere shadow of Citigroup, which is worth $191 billion. As Chase retrenches, slashing jobs and exiting businesses, Citigroup continues to expand through acquisitions. Indeed, despite all the reputational damage it has suffered, much of Citigroup's core business is sound. The same can't be said for Chase. And it's easier to make over an image than a balance sheet.

During the late 90's, Chase was on a desperate quest to build themselves an investment bank. The reason was the incredible margins on investment banking business. With fees at 7% of an IPO no matter how little work you put in, the temptation was irresistable. Unfortunately, most of the top-notch houses had already been snapped up (Citigroup owns Saloman Smith Barney), so Chase ended up acquiring H&Q, a good, but very small, equity boutique. Having done so, it was apparently an equally irresistable temptation to use those boring old commercial loans to goose the exciting new banking business.

The fat margins in the banking business seem to have made everyone in the financial sector either irresponsible or insane. Why was this so?

Well, the margins are awfully fat. An IPO involves maybe a couple of hundred or thousand hours of work on the part of the bankers. Yet fees start around $5 million for that work. Conservativel, that's an hourly rate of $2500. And while it doesn't take that much more work to do a $1 billion IPO than to do one for $10 million, the fees are the same: 7% of the proceeds. (Not to mention any money banks make by giving underpriced IPO's to their special friends, who immediately flip it and thereby generate nice commissions for the bank).

Why are they so fat? Say it with me now: regulation. The SEC has kept the shape of the market essentially unchanged for 80 years, without which the business of listing a security would probably be but a shadow of its former self. Also, because only certain people can do IPO and merger work, the SEC forms a barrier to entry into the business. So there are sufficiently few banks for tacit price collusion to be possible. (It's not as bad as it sounds. Tacit price collusion just means no one lowers their price, because the other banks would retaliate. It's not just in banks, either; it's the reason all American cars at a given level have roughly the same price, and all the toothpaste in the store costs about the same.) The fees are 7% because the financial community is sufficiently incestuous to make sure that no one drops their fees to 6.5% to win more business. And because CFO's and CEO's aren't really very price sensitive. It's much more important to them to do an IPO with a big bank and impress the shareholders than to squeeze out ever last drop of price concessions, because after all, it's not their money they're giving away.

But that's not the only reason, because fees have been 7% for a long time, and the insane subversion of other business lines to the will of the investment banking juggernaut is recent. The other thing you have to remember is the bubble. The bubble made that 7% a lot bigger. And made it ever easier to get other business by giving special treats to their friends.

Well, they're paying the price now. But they won't learn from it, because Wall Street is a very young business, and thrives on the influx of young aggressive men who don't remember the last crisis. Sigh. On the other hand, I think JP Margan/Chase is going to change its name to JP MOrgan some time in the not-to-distant future, and it will be nice to have the House of Morgan back again. In name if not in spirit.

Posted by Jane Galt at December 7, 2002 09:14 AM | TrackBack | Technorati inbound links