Back to the Drawing Board

Burned by complex deals, investment banks show a new appreciation for simplicity.

Talk about a harbinger: When FairPoint Communications finally received long-awaited regulatory approval to acquire Verizon Communications’s New England landline assets in March, the banks financing the deal panicked. The Lehman Brothers–led group began blitzing the Charlotte, North Carolina–based company with calls, using state regulators’ newly revised capital requirements as an apparent excuse to hike the borrowing rate on the $2.5 billion financing package they had agreed to a year earlier.

In the period since terms were first set in 2007, spreads for double-B credits like FairPoint doubled. On the banks’ side, they were facing $200 million to $300 million in losses unless they somehow squeezed concessions out of FairPoint. At the prevailing market rate, though, the $2.5 billion deal would have been prohibitively expensive for the midsize telecom carrier.

“You could feel the tension,” says John Crowley, FairPoint’s CFO at the time. “You could tell they were calling to do something they weren’t comfortable doing but had to do anyway.”

Six months later, of course, Lehman filed for bankruptcy protection. But FairPoint’s experience exemplifies some of the risky bets that many investment banks routinely made with their balance sheets during the credit glut — and then regretted. The lessons still fresh, investment banks are now entering a period of conservatism. They are restricting balance-sheet use, retreating from highly complex products like collateralized debt obligations (CDOs), and renewing emphasis on the basics — advisory work, equity research, trading and underwriting, asset management, and basic forms of securitization.

“The Street’s risk appetite is shrinking,” says Brad Hintz, banking analyst at Alliance Bernstein. “It is shrinking because the regulators have learned a lesson, the rating agencies have learned a lesson, and the Street itself has learned a lesson.”

Hintz made those comments prior to last month’s stunning developments on Wall Street; there may, in fact, be more lessons to learn. This Wall Street realignment calls for CFOs to more closely scrutinize investment-banking relationships to determine if the partnership still suits them. Has a Wall Street bank changed its business mix? Can it deliver on a financing commitment? Does it still possess expertise in a client’s sector? Can it be relied upon as a counterparty?

Wall Street’s Retreat

To survive and compete, banks are retooling. Universal banks such as UBS and Wachovia tried to be one-stop shops by jumping into investment banking. Investment banks tried to compete by stepping up lending. But some of these diversified firms are seeking to exit certain businesses and specialize again.

When it doesn’t involve balance-sheet risks, investment banking can be a lucrative and low-risk business. But in recent years, as commercial banks have entered the securities business, heated competition has driven dealmakers to package advice with financing (thus taking on substantially more risk) to win clients.

Analysts expect that the surviving brokerages, which have to borrow in order to finance deals and compete with commercial banks, will retreat from waving their balance sheets at potential advisory clients. “You are going to see the Street cede market share from its lending business to commercial banks,” Hintz says. “The Street found that when they have a commitment to somebody that they cannot finance themselves, they can end up with a hung bridge loan.”


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