Letting it ride

Securities firms are boosting capital levels dramatically to blunt threats from huge banks -- and to supercharge proprietary trading profits. Risks be damned.

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Chief executives of Wall Street firms like to talk about how people are their biggest asset. But now more than ever, it takes more than intellectual capital to compete. It also requires actual capital -- and lots of it. Commercial banks continue to use their huge balance sheets aggressively to wrest business from investment banks, forcing old-line firms to extend loans to keep pace. And with corporate deal flow and customer trading volumes still down from their 2000 peaks, firms are turning to proprietary trading to make up for the lost profits.

“This business is getting more and more capital-intensive every day,” says one Morgan Stanley managing director. “You need it to compete with the universal banks, and you need it for proprietary trading. It’s become a fact of life.”

Consider Morgan Stanley and Goldman, Sachs & Co., which in 2004 each boosted their capital levels by 34 percent, according to this magazine’s annual survey of broker-dealer capital position. Morgan Stanley takes the top position in the rankings, with $111 billion in equity and long-term debt, followed by Goldman ($106 billion) and Merrill Lynch & Co. ($103 billion). Merrill fails to occupy the top spot for the first time since 1988, when that distinction belonged to Shearson Lehman Hutton. After boosting its capital base by 17 percent in 2003, Merrill grew it last year at the slower rate of 7 percent, failing to keep pace with Morgan Stanley and Goldman.

Other firms that have moved up significantly in the rankings include: Wachovia Capital Markets, which nearly doubled its capital base and moves from No. 18 to No. 13; Interactive Brokers Group, a Greenwich, Connecticut, options market maker and retail brokerage that rises from No. 20 to No. 16; and fast-growing middle-market investment bank Jefferies Group, which jumps to No. 17 from No. 23 last year and No. 29 in 2003.

As the premier global investment banking franchises, Morgan Stanley and Goldman clearly have the most to lose from the assault by commercial banks, which continue to use their corporate lending relationships to wedge their way into more merger advisory and securities underwriting work. (Many of these firms, like Citigroup and J.P. Morgan, have far larger balance sheets than the pure brokerage firms, but that capital is not reflected in these rankings, which register only capital allocated to securities subsidiaries.) They also are known as the most aggressive -- and skilled -- proprietary traders on the Street. So it’s no surprise that they have dramatically ramped up their capital levels. Another year of historically low interest rates in 2004 certainly helped them in this goal: Each firm grew equity capital by a modest amount, but Morgan Stanley increased its long-term debt by 43 percent, to $82.6 billion, while Goldman grew debt by 40 percent, to $80.7 billion.

Putting more capital on the line, of course, heightens risk. With lending commitments up significantly -- by 69 percent industrywide since 2002, according to UBS analyst Glenn Schorr -- and more firms seeking to goose profits by betting their own money in trading markets, it may be only a matter of time before losses start to pile up. “The absolute level of risk at the investment banks is up roughly 40 percent since 2002,” wrote Schorr in a February report on the topic, adding, “There’s no such thing as a free lunch.”