Bernstein Research See Disclosure Appendix of this report for important disclosures and analyst certifications The Brokerage Industry : The Brokerage Industry : The Canary in the Financial Institutions’ Coal The Canary in the Financial Institutions’ Coal Mine Mine Brad Hintz – Equity Analyst, U.S. Securities Industry November 2007
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Bernstein ResearchSee Disclosure Appendix of this report for important disclosures and analyst certifications
The Brokerage Industry : The Brokerage Industry : The Canary in the Financial Institutions’ Coal MineThe Canary in the Financial Institutions’ Coal Mine
Brad Hintz – Equity Analyst, U.S. Securities IndustryNovember 2007
2 Bernstein ResearchSource: Company Reports, Bloomberg, Bernstein Analysis, Factset.
US Brokerages: Coverage
Target 11/23/2007 EPS* P/E Last Book Price-to-Rating Price Price 2006A 2007E 2008E 2006A 2007E 2008E Abs. Rel. Dividends Value Book Yield
Ensign Hintz, Nothing is as good or as bad as first reports would indicate.
Master Chief Petty Officer ‘Gunner’ Wilborne, USN
4 Bernstein Research
Events of Q3 ‘07
Re-pricing of Global Credit Market, led by problems in the MBS/CDO sector. The Federal Reserve opened Discount Window to limit systemic risk. US interest rates were lowered. U.S. economic growth slowing with softening of the housing market. The Euro-area’s economic growth rates are diverging with the U.K., Spain,
and Germany growing at or above 3%, and France and Italy at about 1.5%. The Euro is strengthening versus the US Dollar.
The ECB and the BOE provided financing to limit systemic risk. The ECB ceased tightening rates.
Asian economies remain strong.
5 Bernstein Research
Credit Spreads Widen
Increase in Credit Spreads
5072
4547
129
6
103
322
61
-
50
100
150
200
250
300
350
Baa-ratedCorporates
High-Yield MBS
bas
is p
oin
ts
8/98-10/98
3/05-5/05
Feb. 20th - YTD
Hi-Yield Debt Spreads
200
250
300
350
400
450
500
550
600
1/2/
07
2/2/
07
3/2/
07
4/2/
07
5/2/
07
6/2/
07
7/2/
07
8/2/
07
9/2/
07
10/2
/07
11/2
/07
ba
sis
po
ints
Source: Lehman Brothers Fixed Income Research, Bernstein Analysis
Mortgage Backed Securities
20
40
60
80
100
120
140
1/2/
07
2/2/
07
3/2/
07
4/2/
07
5/2/
07
6/2/
07
7/2/
07
8/2/
07
9/2/
07
10/2
/07
11/2
/07
Cre
dit
Sp
read
s (i
n b
p)
6 Bernstein Research
Impact of Q3 ‘07
Creditors have become more discriminating about risk
Funding problems at Countrywide Financial, Bear Stearns, Northern Rock and Landesbank Sachsen contributed to tighter conditions in the money markets.
Negative sentiment dried up liquidity and led to forced asset sales by conduits/SIVs and negative net asset valuations in ABCP markets.
Brokers and Universal Banks were the most affected in terms of market events of Q3 ‘07 due to off-balance-sheet exposures and risks in leveraged loan commitments, MBS, and CDO positions.
7 Bernstein Research
Fixed Income Market Reaction
CDS Spreads
82
108
135 135
160
020406080
100120140160180
GS MS MER LEH BSC
bas
is p
oin
ts
Increase in CDS Spreads- ytd
61
85
118 113
139
0
20
40
60
80
100
120
140
160
GS MS MER LEH BSC
bas
is p
oin
ts
Average Broker CDS Spread
10
30
50
70
90
110
130
150
01/0
3/07
02/0
3/07
03/0
3/07
04/0
3/07
05/0
3/07
06/0
3/07
07/0
3/07
08/0
3/07
09/0
3/07
10/0
3/07
11/0
3/07
bas
is p
oin
ts
Source: Lehman Brothers Fixed Income Research, Bernstein Analysis
Underwriting volumes of MBS securities fell 57% sequentially and 52% from third-quarter 2006 volumes
Lehman Brothers was the top MBS underwriter through the first 3 quarters 2007 replacing Bear Stearns who is currently ranked #2. Morgan Stanley is ranked #3, the first time it has penetrated the top 10 since 2004
BSC forecasts MBS for 2008 will be 85% agency…or more!
1.3
1.5
1.7
1.9
2.1
2.3
2.5
May
-00
Nov
-00
May
-01
Nov
-01
May
-02
Nov
-02
May
-03
Nov
-03
May
-04
Nov
-04
May
-05
Nov
-05
May
-06
Nov
-06
May
-07
Mill
ion
Un
its
Housing Starts 2000-Present
$0
$50
$100
$150
$200
$250
$300
$350
Q1 '0
3
Q2 '0
3
Q3 '0
3
Q4 '0
3
Q1 '0
4
Q2 '0
4
Q3 '0
4
Q4 '0
4
Q1 '0
5
Q2 '0
5
Q3 '0
5
Q4 '0
5
Q1 '0
6
Q2 '0
6
Q3 '0
6
Q4 '0
6
Q1 '0
7
Q2 '0
7
Q3 '0
7
$ B
illio
n
Domestic Qtrly MBS Issuance
Source: Dealogic, Bloomberg, Bernstein Analysis
21 Bernstein Research
Mortgage Backed Securities
Source: Dealogic, Bernstein Analysis
2006 Global MBS Market Share
0.0%1.0%2.0%3.0%4.0%5.0%6.0%7.0%8.0%9.0%
10.0%R
BS
LEH
BS
C
Deu
tsch
e
CS
Citi
Cou
ntry
wid
e
GS
JPM
Bof
A
UB
S
MS
Bar
clay
s
ME
R
WM
Top 5 Domestic MBS Underwriters - by Year2002 2003 2004 2005 2006 2007-ytd
“The Current Spread Required to Sell a New CDO Means that there is No Margin from Originating the Security.” -- Merrill Lynch
Top CDO Underwriters2003 2004 2005 2006
1st Deutsche MER MER MER2nd Citi WB Citi Citi3rd MER Citi WB UBS4th GS JPM GS WB5th Credit Suisse UBS Credit Suisse JPM
MER's Market Share 7.4% 12.1% 13.2% 13.8%
25 Bernstein Research
CDO
Problems Continue to Plague the CDO Market as Ratings Reductions have forced holders to sell into an illiquid market.
The Market has not Stabilized Yet. Spreads on AA, A, BBB Rated Credit Default Swaps on Home Equity Loans Have Begun to Rise Again.
ABX HE A Rated 2007-2 Spreads
Source:Markit
800
1000
1200
1400
1600
1800
2000
07/1
7/07
07/3
1/07
08/1
4/07
08/2
8/07
09/1
1/07
09/2
5/07
10/0
9/07
basi
s po
ints
26 Bernstein Research
Investment Banking Outlook
27 Bernstein Research
Investment Banking
Strong M&A activity in both the USA and Europe. Financial Sponsor activity in USA is 40% of total and is 20% of EU total. Corporate Strategic M&A booming in the USA and the EU.
Equity Underwriting Market Conditions Were Positive H1 2007 and IPO Calendars Remain Strong. Deal values total $832 billion YTD, versus $781 billion in all of 2006.
Debt Underwriting is Recovering. $50 Billion In Corporate Debt Will Need to be Refinanced in Q4 07 and $250 Billion Refinanced in 2008. CDO Underwriting has Effectively Ceased. MBS Underwriting is Sharply Declining. EU Debt Market is Posting Record Growth Rates.
28 Bernstein Research
How Do You Make Money in Investment Banking?
Mergers and Acquisitions (35 bp) High Margin IPO (700 bp)
flow is now (soft dollar) - Secondaries 150 -350 bp
Electronic or - IPOs 700 bp
Program - H/F Clients (30% of street commissions) - Margin loans 37.5 bp
- Securities Lending (100-125 bp)
25% of commissionsSmall H/Fs provide a bettermix of trades Three firms own 66%
of Prime Brokerage Mkt:
GS estimated that 50% of its trades 1. MSnever see a salesperson 2. BSC 66%(electronic or program). 3. GS
4. MER 4%
and declining
Order Routing
Quant. Proprietary Trading - A Profitable Overlay - More VaR & More Balance Sheet
Client's TradeEquity/ CreditOptimization and
ROE = 17%
Equity Capital Markets
Desk
OTC
Electronic /
Prime
Salesforce
Desk
Desk
Block Research
Brokerage
ProgramTrading
Derivatives
Banking Used toSupport Research
"Easy" Trades to Liquinet,to ECNs, to Agency Housesfor Soft Dollar Payments
Programor Synthetic Program
43 Bernstein Research
Chasing Flow – Flow Provides Information Reduces Risk and Attracts Liquidity
Firm 9M 2007 Rank Market Share Firm 2006 Rank Market ShareUBS 30,657,733 1 12.4% UBS 39,766,632 1 8.9%Knight Equity Markets 28,213,508 2 11.4% Knight Equity Markets 36,923,281 2 8.2%Morgan Stanley 23,615,666 3 9.5% Morgan Stanley 29,853,303 3 6.7%Merrill Lynch, Pierce Fenner 17,287,281 4 7.0% Merrill Lynch, Pierce Fenner 28,800,061 4 6.4%E-Trade Capital Markets 13,400,247 5 5.4% Credit Suisse 21,591,946 5 4.8%Lehman Brothers 11,721,071 6 4.7% Citigroup 21,029,122 6 4.7%Credit Suisse 11,194,662 7 4.5% E-Trade Capital Markets 20,634,703 7 4.6%Goldman Sachs Group 10,993,377 8 4.4% JPMorgan 16,375,650 8 3.7%Banc of America Securities 10,610,301 9 4.3% Bear Stearns And Company 16,229,526 9 3.6%JPMorgan 10,414,749 10 4.2% Goldman Sachs Group 15,720,272 10 3.5%
Block Trading for Listed Securities – Volume (000)
Block Trading for Nasdaq – Volume (000)
Source: BlockDATA, Bernstein Analysis
Volume (in 000s)Firm 9M 2007 Rank Market Share Firm 2006 Rank Market ShareMerrill Lynch, Pierce Fenner 44,896,912 1 12.1% Merrill Lynch, Pierce Fenner 60,454,443 1 11.6%UBS 41,197,125 2 11.1% UBS 58,964,327 2 11.3%Morgan Stanley 40,416,685 3 10.9% Morgan Stanley 40,125,130 3 7.7%Lehman Brothers, Inc. 28,371,989 4 7.7% Lehman Brothers, Inc. 34,407,281 4 6.6%Deutsche Bank 24,597,462 5 6.6% Goldman Sachs Group 31,692,721 5 6.1%Credit Suisse 21,408,473 6 5.8% Credit Suisse 30,851,768 6 5.9%Knight Equity Markets 19,106,726 7 5.2% Bear Stearns And Company 23,267,713 7 4.5%JP MorganChase 16,913,003 8 4.6% Knight Equity Markets 20,781,426 8 4.0%Banc Of America Securities 15,336,209 9 4.1% Banc Of America Securities 20,138,433 9 3.9%Goldman Sachs Group 12,474,762 10 3.4% Citigroup 19,992,713 10 3.8%
44 Bernstein Research
Reliance on Equity Underwriting
The Street’s Institutional Equity Businesses receive One-Half of All Equity Underwriting Revenues.
High Margin, IPO Revenues Mask the Underlying Margin Problems in Equities
Underwriting Market Share Gains are Difficult to Achieve.
Cyclicality of Underwriting Makes this A Perilous Strategy.
Source: SIA, Bernstein Analysis
Domestic Equity Underwriting Revenues - Rolling 4 Qtr Average
-
200
400
600
800
1,000
1,200
1,400
1,600
90:Q
4
91:Q
2
91:Q
4
92:Q
2
92:Q
4
93:Q
2
93:Q
4
94:Q
2
94:Q
4
95:Q
2
95:Q
4
96:Q
2
96:Q
4
97:Q
2
97:Q
4
98:Q
2
98:Q
4
99:Q
2
99:Q
4
00:Q
2
00:Q
4
01:Q
2
01:Q
4
02:Q
2
02:Q
4
03:Q
2
03:Q
4
04:Q
2
04:Q
4
05:Q
2
05:Q
4
06:Q
2
06:Q
4
$, m
il
IPO Boom Masks Problems
45 Bernstein Research
Retail Brokerage Outlook
“We’re Still Hiring. We Don’t Anticipate a Slowdown unless the Economy Slows and Unemployment Rises”
Bob McCann – Merrill Lynch
46 Bernstein Research
Retail Brokerage
Cycle: Retail activity hit lows in February 2003, setting off a pricing war that
has significantly reduced commission rates. As a result, the Street has shifted to fee-based pricing.
2005-2007 has seen a robust pick-up in volume, customer investment flow and retail investor confidence. The Street has been able to increase pricing for distribution services.
Acquisitions of Piper, AG Edwards, Advest, Legg Mason indicate value of scale and channel size
47 Bernstein Research
Retail – Activity Levels Are Nearing 2000 Peak Volumes
Investment Banks’ ROEs (1990-’06) -- Regress Toward the Mean
Source: Corporate Reports, Bernstein Analysis
Probability Histogram
53 Bernstein ResearchSource: Bernstein Analysis.
Valuation
54 Bernstein Research
Valuation Methodology – Regression Formula & Output
1
2
3
4
5
Tang
Pric
e to
Boo
k (F
actS
et) A
ctua
l
1.0 2.0 3.0 4.0 5.0
Tang Price to Book (FactSet) Predicted
P<.0001 RSq=0.61 RMSE=0.5742
Actual by Predicted Plot
Whole Model
Response Tang Price to Book (FactSet)
Source: SIA, Jump, Bernstein Analysis, Company Reports
Target Tangible Price Book = 5.33 + 0.77 * Forecasted Tang. ROE / Ke
- 0.62 * Credit Rating+ 0.90 * Internet Dummy Variable
Note - For Credit Ratings w e apply the follow ing conversion: AA-/Aa3= 6, A+/A1=7, A/A2=8, etc.
R-Squared = 73%
Bernstein Research
31 2 4
7%
Source: FactSet, Bloomberg, Company Reports
Valuation Methodology (Price-to-Book Value)
The major brokerage firms’ common stocks trade on a price-to-book basis. The brokerage firms and the major universal banks have historically traded in a band ranging from 1.05 to 2.79 times book value 90% of the time. The mean price to book value for the group during this period is 1.76 times. The standard deviation was 0.76.
GS
BSC
MER
MS
LEH
46
56 Bernstein Research
Price-to-Book\Earnings+ Valuation Deciles
Source: FactSet, Bloomberg, Company Reports* TMT years includes 1998-2000
Disclosure AppendixSRO REQUIRED DISCLOSURES • References to "Bernstein" relate to Sanford C. Bernstein & Co., LLC and Sanford C. Bernstein Limited, collectively. • Bernstein analysts are compensated based on aggregate contributions to the research franchise as measured by account penetration, productivity and proactivity of investment ideas. No analysts are compensated based on performance in, or contributions to, generating investment banking revenues. • Bernstein rates stocks based on forecasts of relative performance for the next 6 -12 months versus the S&P 500 for U.S. listed stocks and versus the MSCI Pan Europe Index for stocks listed on the European exchanges - unless otherwise specified. We have three categories of ratings: Outperform: Stock will outpace the market index by more than 15 pp in the year ahead. Market-Perform: Stock will perform in line with the market index to within +/ -15 pp in the year ahead. Underperform: Stock will trail the performance of the market index by more than 15 pp in the year ahead. • As of 10/10/2007, Bernstein's ratings were distributed as follows: Outperform/Buy - 41.5%; Market-Perform/Hold - 47.1%; Underperform/Sell - 11.5%. • Brad Hintz, as a former Managing Director at Morgan Stanley Group (MS), owns an equity position in MS that is held in a Morgan Stanley Group ESOP Trust at Mellon Bank as convertible preferred stock. These MS ESOP securities were awarded to him as compensation and are fully vested. Mr. Hintz is also an investor in Morgan Stanley Capital Partners III, LP — a merchant banking fund where Morgan Stanley maintains an equity interest as a limited partner. On June 9, 2006, Mr. Hintz notified U.S. Trust that he was closing his Russell 1000 Equity Index account with all assets in the account to be transferred to a newly established brokerage account at Charles Schwab & Co., Inc. The transfer of assets to Charles Schwab was completed by June 30, 2006 that included four positions within his sector. These positions included 100 shares of Chicago Mercantile Exchange, 600 shares of E*Trade, 375 shares of Raymond James and 400 shares of TD Ameritrade Holdings. In addition, as a result of the complete spin off of Di scover from Morgan Stanley on June 30, 2007, Mr. Hintz received a long position in Discover stock as a beneficiary of the Morgan Stanley ESOP. These shares of Discover will ultimately be distributed to Mr. Hintz by the ESOP trustee. • On May 4, 2007, an action by a purported Lehman Brothers Holdings Inc. shareholder was filed in the U.S. District Court, Southern District of New York, against Lehman and twenty-five individual defendants, all of whom are current or former officers or directors of Lehman, including Mr. Hintz. Mr. Hintz was employed as the CFO of Lehman from March 1996 to August 1998. Generally, the complaint alleges that Lehman backdated and manipulated the timing of certain options grants from 1995 to 2002 and that this was not disclosed i n certain SEC filings for Lehman, including several filed while Mr. Hintz was CFO. The complaint does not allege that Mr. Hintz received any of the options grants. In connection with a related lawsuit filed on April 13, 2007, Lehman has stated that allegations of options backdating are completely without merit and it will defend against them vigorously. • Accounts over which Bernstein and/or their affiliates exercise investment discretion own more than 1% of the outstanding common stock of the following companies GS / Goldman Sachs, ICE / IntercontinentalExchange Inc, LEH / Lehman Brothers Holdings Inc, MER / Merrill Lynch, MS / Morgan Stanley. • Bernstein currently makes a market in the following companies SCHW / Charles Schwab Corp. • The following companies are or during the past twelve (12) months were clients of Bernstein, which provided non -investment banking-securities related services and received compensation for such services BSC / Bear Stearns, GS / Goldman Sachs, LEH / Lehman Brothers Holdin gs Inc, MER / Merrill Lynch, MS / Morgan Stanley, SCHW / Charles Schwab Corp. • An affiliate of Bernstein received compensation for non-investment banking-securities related services from the following companies GS / Goldman Sachs, LEH / Lehman Brothers Holdings Inc, MER / Merrill Lynch, MS / Morgan Stanley, SCHW / Charles Schwab Corp. • This research report covers six or more companies. For price chart disclosures, please visit www.bernsteinresearch.com, you can also write to either: Sanford C. Bernstein & Co. LLC, Director of Compliance, 1345 Avenue of the Americas, New York, N.Y. 10105 or Sanford C. Bernstein Limited, Director of Compliance, Devonshire House, One Mayfair Place, London W1J8AJ, United Kingdom.
59 Bernstein Research
Disclosure Appendix12-Month Rating History as of 11/26/2007 ========================================== BSC: Initiated Coverage: M - 9/11/2001; CME: Initiated Coverage: O - 6/19/2007; GS: Initiated Coverage: O - 9/11/2001; Rating History: M - 12/16/2005;ICE: Initiated Coverage: O - 6/19/2007; LEH: Initiated Coverage: M - 5/5/2006; MER: Initiated Coverage: U - 9/11/2001; Rating History: M - 10/25/2007;MS: Initiated Coverage: M - 3/24/2006; Rating History: O - 8/9/2007;NMX: Initiated Coverage: M - 6/19/2007; SCHW: Initiated Coverage: U - 10/3/2002; Rating History: O - 3/9/2007; OTHER DISCLOSURES To our readers in the United States: Sanford C. Bernstein & Co., LLC is distributing this report in the United States and accepts responsibility for its contents. Any U.S. person receiving this report and wishing to effect securities transactions in any security discus sed herein should do so only through Sanford C. Bernstein & Co., LLC. To our readers in the United Kingdom: This report has been issued or approved for issue in the United Kingdom by Sanford C. Bernstein Limited, authorised and regulated by the Financial Services Authority and located at Devonshire House, 1 Mayfair Place, London W1J 8SB, +44 (0)20 -7170-5000. To our readers in member states of the EEA: This report is being distributed in the EEA by Sanford C. Bernstein Limited, which is authorised and regulated in the United Kingdom by the Financial Services Authority and holds a passport under the Investment Services Directive. To our readers in Australia: Sanford C. Bernstein & Co., LLC and Sanford C. Bernstein Limited are exempt from the requirement to hold an Australian financial services licence under the Corporations Act 2001 in respect of the provision of the following financial services to wholesale clients: • providing financial product advice; • dealing in a financial product; • making a market for a financial product; and • providing a custodial or depository service. Sanford C. Bernstein & Co., LLC and Sanford C. Bernstein Limited are regulated by the Securities and Exchange Commission under US laws and by the Financial Services Authority under UK laws, respectively, which differ from Australian laws. One or more of the officers, directors, or employees of Sanford C. Bernstein & Co., LLC, Sanford C. Bernstein Limited and/or its affiliates may at any time hold, increase or decrease positions in securities of any company mentioned herein. Sanford C. Bernstein & Co., LLC, Sanford C. Bernstein Limited, or its or their affiliates may provide investment management or other services to the pension or profit sharing plans, or employees of any company mentioned herein , and may give advice to others as to investments in such companies. These entities may effect transactions that are similar to or different from those recommended herein. CERTIFICATIONS • I/(we), Brad Hintz, Senior Analyst(s), certify that all of the views expressed in this report accurately reflect my/(our) personal views about any and all of the subject securities or issuers and that no part of my/(our) compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views in this report. Copyright 2007, Sanford C. Bernstein & Co., LLC, a subsidiary of AllianceBernstein L.P. ~ 1345 Avenue of the Americas ~ NY, NY 10105 ~ 212/756 -4400. All rights reserved. This publication is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of, or located in any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation or whic h would subject Bernstein or any of their subsidiaries or affiliates to any registration or licensing requirement within such jurisdiction. This publication is based upon public sources we believe to be reliable, but no representation is made by us that the publication is accurate or complete. We do not undertake to advise you of any change in the reported information or in the opinions herein. This publication was prepared and issued by Bernstein for distribution to eligible counterparties or professional clients. This publication is not an offer to buy or sell any security, and it does not constitute investment, legal or tax advice. The investments referred to herein may not be suitable for you. Investors must make their own investment decisions in consult ation with their professional advisors in light of their specific circumstances. The value of investments may fluctuate, and investments that are denominated in foreign currencies may fluctuate in value as a result of exposure to exchange rate movements. I nformation about past performance of an investment is not necessarily a guide to, indicator of, or assurance of, future performance.