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UBS’s Pain…Goldman’s Gain?

Michael Santoli
Michael Santoli
The Exchange

The relative ease with which Goldman Sachs Group (GS) managed through the assault of Hurricane Sandy, with self-generated power illuminating its headquarters in an otherwise blacked-out Lower Manhattan, drew a predictable number of cynical online jibes. For some people, the firm's knack for hyper-competent preparedness in every pursuit comes off as another instance of a privileged elite's insistence on serving itself first.

Less discussed, though, is a different disaster in Goldman's neighborhood that stands to benefit the powerful firm by emphasizing its comparative strength and staying power. This was the dramatic decision this week by UBS AG (UBS), the huge Swiss bank, to radically shrink itself in large part by exiting the bond underwriting and trading business. The UBS restructuring will cost 10,000 employees their jobs, while removing one important player from the highly competitive bond-trading game, which is Wall Street's largest single profit center.

The financial crisis  that culminated in Lehman Brothers' collapse ushered in new banking regulations requiring that firms hold more capital to support their trading and lending activities, while prohibiting certain kinds of trading using a bank's own money. Though many of the exact rules are yet to be written, their approach has combined with historically low interest rates and tepid trading volumes to badly crimp the profitability of the so-called universal banks such as Goldman, JP Morgan Chase Inc. (JPM), Morgan Stanley Group (MS) and Citigroup Inc. (C).

When a Bank Cries "Uncle"

The hope among Wall Street executives, usually unspoken, has been that some large but not leading competitors would cry "Uncle" and depart the capital-markets field, removing some of the personnel and excess capital that had crowded in over the past two decades. European banks, hampered by a slow-moving home-market credit crisis, have for years appeared to be the obvious candidates to pull out. Now the process has begun.

UBS' retreat has prompted speculation that its Swiss counterpart, Credit Suisse Group (CS), might soon reduce its commitment to the global fixed-income trading business. Barclays PLC (BCS), the embattled British bank that absorbed much of Lehman, is on the defensive across several fronts, including a central role in the Libor rate-fixing scandal. Japan's Nomura Securities is also viewed as rethinking a global spending spree that included an expensive expansion of its New York-based investment bank.

Less competition from abroad, in underwriting and trading securities for institutions, would be a marginal positive for all the major New York banks. Yet Goldman is the purest play on the wholesale capital markets business, with none of the retail-banking or mortgage lending heft of J.P. Morgan, the wealth-management focus of Morgan Stanley or the credit-card or international commercial-lending concentration of Citigroup.

Goldman earns more than half its profits from acting as a broker to large investors in the bond, foreign exchange and commodities markets. While it has cut expenses including employee compensation, it has resisted wholesale headcount cuts in its core areas, maintaining its top market share in serving large fund managers and advising companies on financing and acquisitions. Its decades-long push to build its franchise in growing emerging economies will continue to pay off in the years to come. The firm has spent most of the past year conserving its capital, fortifying its balance sheet as it waits for regulatory and competitive clarity.

As opposed to the boom years of the mid-2000s, when Goldman's stock traded at a yawning premium to its book value, today the stock -- at around $122 -- is priced at a discount, conveying the market's concerns about the ability of it and all other banks to earn a proper return on its capital over time.

A more rational industry with fewer banks throwing bad money after good just to stay in the game would help persuade investors that the remaining major U.S. players, Goldman foremost among them, are well-positioned. Perhaps the 2% climb in Goldman's shares Wednesday, atop a 33% gain so far this year, is a hint of this notion spreading.

The punch line of the old joke about a bear stalking two guys has one of men telling the other, "I don't have to outrun the bear; I just need to run faster than you." In this analogy, Goldman is certainly faster than the other firms trying to stay a step ahead of the bear now lumbering down Wall Street.