Keep it simple and stupid

After Lehman's demise and Merrill's sale to Bank of America, investors are now questioning Morgan Stanley and Goldman Sachs. The issue is quite straightforward: can investment banks survive without the backing of commercial banks? Should Morgan and Goldman remain independent? Is their business model adequate?

An investment bank essentially has four main areas of business: Mergers&Acquisitions, Prime Brokerage, Proprietary Trading and OTC Credit Derivatives. M&A and Brokerage services are directly impacted by bear cycles in equity markets - they are volatile. Trading is always a wildcard - you never know what to expect. Credit Derivatives are steady - it's where CEO's can leverage their profits. However, with the current strain in the Credit Default Swap market - the most important OTC derivative - there's reason to believe that perhaps the cash cow may soon be gone.

The Credit Default Swap (CDS) was the breakthrough in credit derivatives back in the 1990's. It's the link between commercial and investment banks. Typically, the commercial bank makes a loan to a client and then sells the default risk to an investor through a CDS. This vehicle is structured by an investment bank that also intermediates the relationship between the commercial bank and the investor. In the end, everyone is supposedly happy. The commercial bank is protected against the risk of his client going under. The investor receives a premium for what he or she perceives as a riskless loan. The investment bank also receives generous fees. And the CDS is traded in "Over the Counter" markets far away from regulatory oversight.

It's estimated that the CDS market is today worth around $60 trillion. Since the creation of CDS', many other credit derivatives have become mainstream. Among them, CBO's, CLO's, CFO's, CDO's, CCO's, ECO's and many more. A hord of highly sophisticated securities and special vehicles to which investor Warren Buffett famously attached the WMD (Weapons of Mass Destruction) label. Unfortunately, some of these derivatives have been created with the sole objective of fooling other market participants into their need.

As writer Satyajit Das puts it in his "Traders, Guns & Money", a brilliant and colourful tale on the knowns and unkowns in the dazzling world of derivatives, "(...) the entry of investment banks into credit markets provided the impetus for derivatives on credit. It was the biggest party since the beginning of derivatives". The party might be over. Investment banks will be back to bread and butter. Simple things everyone can understand. Enough to keep the business running and profitable. Probably not good enough to maintain the profit growth registed in the past 15 years. But still respectable.