When Kraft Foods Inc sold shares to investors this week in the largest US initial public offering (IPO) this year, it did so without any help from Merrill Lynch & Co, the firm that employs the most stock brokers. Merrill also did not play a leading role when Lucent Technologies sold US$3.6 billion of stock in a spin-off of its Agere Systems unit in March.
Those were the two biggest offerings this year and the first of the 20 biggest on record in which Merrill did not hold the coveted position of lead manager or co-manager.They also were spin-offs by major corporations that have been asking investment banks like Merrill, Goldman Sachs and Morgan Stanley to do more than they are willing or able to do. Increasingly, companies like Philip Morris, which sold Kraft shares to the public, are demanding that Wall Street firms extend big, barely profitable loans if they want to have a shot at the highly profitable assignments of managing offerings of stocks and bonds or advising on mergers.
PHOTO: NY TIMES
High stakes
The stakes are rising as a handful of giant domestic and foreign commercial banks are making an aggressive push to break the stranglehold of the elite group of investment banks.
David Komansky, Merrill's chairman, recently told the firm's brokers that the chief executive of a long-time client had notified him that Merrill would not handle the company's next stock offering. Next time around, Komansky said he was told, the unidentified company planned to hire "one of four or five commercial banks because they provided something like US$2 billion" in credit to the company. Merrill officials declined to name the company.
"Right now, it's a challenge for us," Komansky told the brokers. "Clearly, the banks are using their muscle," he said, to get between the investment banks and some of their biggest clients.
The heightened competition could not come at a worse time for stand-alone investment banks. Mired in their first year of declining profits in almost a decade, they have laid off thousands of bankers and cut costs as revenue from underwriting and trading has dropped sharply.
Meanwhile, the dwindling group of major commercial banks have more leverage than ever. After years of consolidation, there are only a few banks that can meet the borrowing needs of big domestic and global corporations. When those borrowers get into a financial bind, as many telecommunications and technology companies have in the last year, they are more inclined to try to appease the people whose loans are keeping them afloat.
After Merrill and Goldman Sachs balked last year at joining the list of lenders to Philip Morris, the company crossed them off the list of prospective underwriters for Kraft, according to several Wall Street executives. Top billing for the US$8.7 billion stock sale went to affiliates of two big banks, Credit Suisse First Boston and the Salomon Smith Barney unit of Citigroup, vaulting them into the No. 2 and No. 3 positions, respectively, among underwriters for new offerings this year.
Citigroup also has moved ahead of Goldman, Morgan Stanley and Merrill to the top spot this year in disclosed fees from underwriting stocks and bonds. Citigroup has earned almost US$1 billion of the US$5.6 billion in underwriting fees this year, according to Thomson Financial Securities Data.
Citigroup and J.P. Morgan Chase -- formed after last year's acquisition of J.P. Morgan by Chase Manhattan Corp -- also have been crowing about their coups in landing advisory roles in corporate mergers and acquisitions. Banks earn the fattest fees from advising on mergers and underwriting stock offerings. Both of those businesses have slowed dramatically this year, so the interlopers are getting a rude reception.
Officials of rival investment banks argue that J.P. Morgan Chase and Citigroup have been buying business by cutting prices. They can do that, their critics say, because they have abundant access to cheap money provided by their depositors and they do not account for the true cost of the loans they make and commit to make.
Goldman Sachs lodged a complaint about the banks' methods with makers of accounting rules, arguing that the big banks are understating the risk of the loan commitments they are making. If banks had to carry those loans at their true value, Goldman officials said, they would price them differently and lose some of their competitive edge.
While Goldman has been sounding off, Merrill has been trying to fight back by building up its own banks. The firm has been sweeping its brokerage customers' cash into accounts at small banks that it owns so that it has a source for loans to corporate clients that demand them.
"The traditional investment banks are finding the new competitive structure very threatening and are reacting with all the weapons they can think of," said Michael Carpenter, the chairman of Citigroup's corporate and investment bank. "I don't blame them."
Competitive pressures
The mounting pressure from better capitalized competitors is fueling rumors that some of the biggest firms on Wall Street, including Merrill and Morgan Stanley, may be forced into mergers to add heft. Though officials of both firms dismiss speculation that they cannot hold their own against Citigroup and the newly formed J.P. Morgan Chase, that notion has begun to sink in with corporate executives.
"Investment banks are having the commercial banks encroach on their territory," said John Cannon, treasurer of Venator Group, the company that operates the Foot Locker chain of athletic-shoe stores. "That's why you're going to see more mergers among investment banks, more mergers like Salomon and Citibank."
Last Monday, Venator announced that it had refinanced its outstanding bank debt, replacing some of it with US$125 million in bonds that can be converted into shares of its stock. The bond sale was not managed by Venator's primary financial adviser, Morgan Stanley, but by J.P. Morgan Chase, which earned a fee estimated to be more than US$3 million for the service. The next day, the stock analyst at J.P. Morgan Chase who follows retailers, Harry Ikenson, issued his first assessment of Venator's stock, calling it a "buy."
Pressing the point
The most aggressive marketers of the concept of one-stop shopping on Wall Street these days are the executives at J.P. Morgan Chase. They readily admit that they are focused on turning borrowers into issuers. "We've never said that holding loans is a great way to make money," said Marc Shapiro, vice chairman of J.P. Morgan Chase. "Other banks, broadly speaking, are saying, `This is a product that doesn't support itself very well.' So, all banks are saying, `Where else can we make money on this relationship?'"
Banks have to tiptoe around the issue because they are prohibited by regulators from holding credit hostage for underwriting ransom, a practice known in the industry as tying. Investment bankers have long accused commercial bankers of tying but the charge is being heard much more often with the advent of the domestic mega-bank.
Until 1999, when Congress repealed the Glass-Steagall Act, a set of Depression-era laws, commercial banks were kept separate from investment banks. Merrill and other securities firms supported revisions of the laws because they said it was unfair that banks could buy brokerage firms, within certain limits, but brokerage firms could not buy banks.
Trend setters
Even before the laws changed, investment firm Travelers Group successfully merged with Citibank and combined the bank's corporate lending business with Travelers' investment banking unit, which itself was the product of a merger of the Smith Barney brokerage firm and the Salomon Brothers investment bank. The formation of Citigroup reverberated on Wall Street and spurred a raft of predictions of similar mergers between the remaining independents. But the closest thing to a copycat deal was Chase Manhattan's purchase of the J.P. Morgan investment bank for US$30.9 billion.
Before those combinations, the only commercial banks that owned major investment banks were foreign. While those foreign banks largely failed in their efforts to penetrate the US investment banking business, a few, including Credit Suisse and UBS of Switzerland and Deutsche Bank of Germany, have now developed into serious competitors after acquiring investment banks in New York and Europe.
That trio, along with Citigroup and J.P. Morgan Chase, is in the process of changing the competitive landscape and possibly the economics of investment banking, said Judah Kraushaar, an analyst at Merrill Lynch who follows bank and brokerage stocks.
"There is a creeping capital intensity to the securities business that's being propelled by a handful of commercial banks who come to the table with very large balance sheets," Kraushaar said. "These five banks have more opportunity to use their balance-sheet muscle to get into the business."
The progress is most evident in the bond business. Underwriting bonds is not as profitable as underwriting stocks or advising on mergers, nor is it as critical to the clients' long-term health, Wall Street executives argue.
A delicate touch
Mergers and acquisitions are "the brain surgery of investment banking and a large equity offering is the equivalent of spinal surgery in investment banking," said John Thain, co-chief operating officer of Goldman Sachs. "I don't think you do either of those with the guy who gives you the cheapest rate."
Citigroup already has established its bond-selling prowess. It has increased its leading share of that business to about 22 percent this year and it is vying for Merrill's crown as the leading overall underwriter of stocks and bonds.
The burning debate on Wall Street revolves around whether Citigroup and any of the other hybrid banks can parlay bond business into the initial offerings and merger assignments they lust after. And, if they do, will that success push the stand-alone investment banks to give up their independence?
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