Investment banks bounce back

The epitaphs that were being written for Wall Street in the depths of last year’s credit and market crises appear to have been premature. Lehman Brothers Holdings Inc. and The Bear Stearns Cos. Inc. are of course gone, and Merrill Lynch & Co. Inc. has been subsumed into Bank of America Corp.

But despite a rapidly changing regulatory environment, a shift in their attitude toward operating on a seabed of debt and an acute sensitivity toward greed-driven depictions of themselves, survivors such as The Goldman Sachs Group Inc., Morgan Stanley and many regional firms appear to be thriving.

They’ve certainly convinced investors. The 11 stocks in the NYSE Arca Securities Broker-Dealer Index — which include those of retail firms such as Ameriprise Financial Inc. and The Charles Schwab Corp., as well as Goldman, Morgan Stanley and capital markets specialists such as Knight Capital Group Inc. — have “meaningfully outperformed” the S&P 500 this year as investors realized that “a jump-to-zero scenario” was overstated and opportunities existed for the remaining group of competitors to thrive in a variety of businesses, Sanford C. Bernstein & Co. LLC analyst Brad Hintz wrote in a recent report.

Goldman and Morgan Stanley, which adopted bank holding company charters last fall to qualify for cheap deposits and Troubled Asset Relief Program funding as they struggled to convince trading partners they could survive, have already repaid their TARP loans.

Substantial difficulties remain. Big investment banks are still sitting on hoards of underwater collateralized debt obligations and leveraged loans.

The fat profits they booked from trading over-the-counter derivatives are unlikely to return as Congress prepares margin-squeezing legislation requiring the products to trade as standardized contracts on exchanges and be guaranteed through clearinghouses.

Competition from boutiques and independent advisers to manage money for individual investors is growing. And firms are still struggling at the highest levels to figure out their comfort with risk and their corresponding willingness to allocate capital to low-margin but safe businesses.

However, analysts as well as regulators say it would be a mistake to underestimate Wall Street’s ability to rebound and to wield influence in the corridors of power. After meeting with several top Goldman executives in early September, Citigroup Inc. analysts raised their profit estimates, convinced that the firm’s trading technology prowess will give it an edge even under the more stringent derivatives-trading schemes being designed. Moreover, Goldman managers told the analysts that their lobbying in Washington is likely to produce regulations and laws more balanced “than some market participants may have initially feared,” the analysts wrote.

Mr. Hintz, a former Lehman Brothers chief financial officer, urged investors to balance the downside of “reduced leverage and low near-term profitability” against the lower costs of capital and reduced competition they now enjoy.

Moreover, he wrote, it would be a mistake to overlook Wall Street’s “track record of adaptability and efficient capital allocation.”

His sentiments were echoed last month by Annette Nazareth, a former member of the Securities and Exchange Commission.

Speaking to a group of securities lawyers and compliance officials, she warned that regulatory reform will have sweeping implications for securities firms’ fixed-income trading operations, among other areas. But in an interview after her talk, she sounded decidedly less like Cassandra.

“They’ll always find new business opportunities,” said Ms. Naz-areth, now a partner at Davis Polk & Wardwell LLP. “I’m a firm believer in the securities industry’s ability to find profit-making activities.”

E-mail Jed Horowitz at [email protected].