My advice to John Thain (not that he asked)

I’m not a management consultant, nor do I play one on TV.  I have worked in and around Wall Street for a little while, however.  That makes me not surprised to see a chart like this one, courtesy of the WSJ yesterday.

[chart]

While I don’t have the exact numbers, if you ask me it looks like Merrill Lynch will write off in two years nearly a decades’ worth of earnings.  I haven’t gone through the balance sheet, but I would hazard an educated guess that virtually all of those losses are tied to the fact that Merrill has operated as a giant, yet conflicted, credit hedge fund for the past five years.  Conflicted in that as an underwriter and promoter of structured securities, it can’t suddenly switch and turn bearish like actual hedge funds.

As an outside director I would ask why Merrill Lynch was in that business in the first place.  Merrill’s great asset is its nationwide network of stockbrokers and its reputation as an asset manager.  Asset managers trade at higher multiples than investment banks for a good reason.  Money managers deliver in nice annuity stream of fee income, while investment banking is so volatile that…you can wipe out a decade’s worth of earnings in two years.

For big banks, investment banking is like the movie business.  It is the glamorous world of high finance drawing bank CEOs like bugs to a flame.  Like investing in the movie business, the bank’s investors are last in line behind all of the star investment bankers who take something like 2/3 of the revenue, even in the good years.

The problem is that the profitability of old fashioned investment banking, brokerage and sales and trading services has gone down over the past decade, which explains why all the investment banks increased their leverage and entered the more exotic world of structured finance.  Without all the leverage, however, the profitability comes down.

As I have been saying over and over, the capacity in the financial services industry in general, and investment banking in particular, needs to shrink to reflect the new reality of reduced profitability and leverage. (With the goal of evenutally increasing profitability, of course.)

So my advice to the Merrill Lynch CEO John Thain would be thus: focus on asset managment.  That is Merrill’s great asset.  Investment banking and structured finance have dragged down your multiple and caused massive dilution to your shareholders.  Lehman Brothers needs to be a credit hedge fund to justify its existence.  You don’t.  You actually have something valuable, a brand that resonates with retail investors.  Focus on that and leave investment banking to the suckers.

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