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Capital Markets
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Much of the general public is often perplexed to see how, when the economy and the financial system have the equivalent of a cardiac arrest, as they did in 2008 and again in 2020, Wall Street banks literally go from near-death experiences to becoming even bigger and better than they were before the crisis. The answer isn’t some magical comeback story in which bank executives with ice in their veins turn certain defeat into an improbable victory. The answer is simply, The Fed.
Here is a good example from a December 28, 2020 article in the Financial Times, “Global banks generate record $125bn fee haul in 2020:”
Global Banks made $124.5 billion in fees this year as companies raced to raise cash in order to survive the pandemic. Companies have raised more than $5 trillion in debt this year, setting another record. While multinationals first moved to draw down credit lines in March, they quickly shifted to the bond market to lock in longer term funding.
Consider that statement. Global banks set a record in bond and equity underwriting fees in a year where, for at least a couple of months, it looked as though it would be an epic year in bank balance sheet destruction. In seemingly one moment, corporate America was making a run on the banking system, and then, magically, the situation completely reversed.
Major banks are paid fees to make billions of dollars in funds available to their corporate customers, should a sudden need for cash liquidity arise. When the lines are made available, the banks assume that a majority of the lines won’t all be drawn down on at once. That is a big assumption to make, and an incorrect one in times of major economic crisis. As the lines were being drawn down on in March by many major corporations, private equity firms were also busy advising the hundreds of private companies in their portfolios to draw down their bank lines to retain potential life-saving cash as well.
The Fed and Wall Street like to say that the 2020 crisis, as opposed to the last crisis, was not a banking solvency issue. However, if we look at the Federal Reserve AA rated Financial Commercial Paper index in March, a different story is revealed.
On March 6, 2020 the rate printed was 0.86%. By March 12 it was 1.19%. By March 20, the rate printed 2.12%; on March 26, it was 2.53%. The financial system was having a liquidity crisis, perhaps greater than 2008, as well as a credit meltdown, if not for a massive monetary policy response from the Federal Reserve—made even more powerful by coordination with the U.S. Treasury.
More evidence of a blowout year for Wall Street was recently highlighted in the Wall Street Journal article “SPACs Rescued Wall Street from the Doldrums,” on January 22, 2021,
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Goldman’s equity underwriting brought in a record $1.12 billion in fees in the fourth quarter, nearly triple what it had the year before. For the year, the business took in $3.41 billion in fees, more than double 2019’s $1.48 billion. (Its advisory unit brought home $3.07 billion).
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At Morgan Stanley, 2 in the equity-underwriting business for the year, fees more than
doubled in the fourth quarter. For the year, they rose 81% to $3.09 billion, also eclipsing deal-making fees. -
JPMorgan Chase & Co. came in third in equity underwriting, boosting its fees 88% in the fourth quarter. Fees surged 66% for the year, to $2.76 billion.
So how does Wall Street go from ruin to riches practically in the blink of an eye while much of the rest of the population remain stuck in the mud or worse?
Central Bank’s extraordinary monetary policy effect on Wall Street is a lot like the description of a nuclear fission chain reaction. We have all seen the diagram of how a neutron is fired into a particle of Uranium 235, splitting the atoms of Uranium 235, releasing energy which in turn fires off more neutrons, splitting more atoms and rapidly producing an astronomical amount of energy.
Think of the Fed’s extraordinary monetary policy (zero funding rates, massive expansion of their balance sheet through quantitative easing, and partnering with Treasury for asset lending and buying programs) as the neutron being fired into the radioactive particle (Uranium 235). Without firing that neutron, nothing happens. With it, however, a spectacular chain reaction rapidly builds until an incredible amount of energy is produced in the form of investment banking fees and profits from market making in stocks, bonds, currencies, and commodities.
The following is how we see the “Monetary Nuclear Chain Reaction:”
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When there is a deep crisis that freezes up the liquidity in markets leveraged entities, such as hedge funds, there is a need to liquidate assets to meet margin requirements. These forced liquidations depress many financial asset market prices sharply. When there is forced selling to meet margin calls, the first assets that are sold are the most liquid. This akin to the old idiom, “throwing babies out with the bath water.”
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Once the Fed acts to stabilize the financial markets, it signals to investors with capital that it is safe to start buying those “babies.” Furthermore, part of the Fed’s policy of using their balance sheet to lower yields on risk-free assets to unpalatable levels, risk taking is encouraged. With capital now dedicated to finding cheap assets, market activity starts to pick up. This is a positive for Wall Street market-making trading desks.
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Soon, investment grade corporations and municipalities see their existing debt trading well. In turn they come to the market to borrow again, issuing new bonds. Now, bond underwriting fees increase for Wall Street.
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Similarly, existing non-investment grade bonds and syndicated loans start being snapped up as they are identified as “cheap” as well. While some of the assets are fundamentally cheap, many are facing a real economic crisis and may not be so cheap. Nevertheless, “animal spirits” are beginning to rise. This allows banks to clear their existing inventories of high-yield bonds and loans that they were stuck with when the markets froze.
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The market demand grows for new supply of non-investment grade bonds and loans. The Fed’s quantitative easing has lowered risk-free rates and it explicit and implicit support of riskier markets present high-yield companies with the opportunity to refinance existing debt and issue new debt. For Wall Street, this means more lucrative underwriting fees and greater secondary market-making trading.
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Popular and very lucrative structured products like Collateralized Loan Obligations (CLOs) begin to come back as the price of the underlying syndicated loans pick up. Within a couple of months, new issue CLOs begin to be produced. Lucrative underwriting fees for both new syndicated loans and CLOs start being generated again. Additionally, the secondary trading market opens up for both CLOs and syndicated loans providing Wall Street trading income.
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Meanwhile in the equity markets, the moribund stock market, spurred on by the Fed’s simulative and stabilizing policies, starts to stir and increase in value. Trading volumes pick up faster and faster, creating higher volumes and producing stronger market making income for Wall Street banks.
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As stock valuations of corporate increase, they become valuable currency to create a robust merger and acquisition environment—which adds more lucrative fees for Wall Street.
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As stocks rise, private companies and popular start-up companies come to market sooner in the form of Initial Public Offerings (IPOs). IPO investment banking activity generates tremendous fee and advisory income for Wall Street.
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The same could be said for commodity, emerging markets, and foreign currency trading. Greater volume and volatility (and in the case of emerging markets, underwriting fees) create bumper years for those trading desks as well.
There is a reason why 2009 and 2020 were weirdly two of the best years ever for Wall Street banks—and they have the Fed to thank for it.
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