Brokers land in the rough

Last week, Morgan Stanley agreed to buy half of Smith Barney and form the nation's second-largest brokerage, a behemoth with more than 20,000 employees. Meanwhile, Bank of America is working feverishly on its absorption of Merrill Lynch to form what will rank as the nation's largest brokerage, with $2.5 trillion of client assets. Too bad about the timing. “People aren't buying cars nowadays, much less securities,” says Allen Gutterman, president of a small Manhattan recruiting company who closed his own brokerage account and is using his cash to build a business. At this point, the last person he wants to hear from is a stockbroker pitching the latest investment idea. “This is about self-preservation,” he says. With the Standard & Poor's 500 having slumped 39% last year — the biggest drop since 1937 and its third-worst performance ever — the business of serving individual investors is headed for its worst stretch in decades. “It is going to be a severe, painful, sustained downturn,” says Brad Hintz, an analyst at Sanford C. Bernstein & Co. Sobering precedents History suggests it will be even worse than that. After the stock market collapsed in 1987, commission revenue collected by major Wall Street brokerage houses plummeted 42% within a year and didn't fully recover for five years, according to Mr. Hintz's research. Following the implosion of the technology-stock bubble in 2000, the picture was much the same. Back then, for example, it took fully six years for retail trading activity at Charles Schwab to recover. By most accounts, investors are only beginning what looks to be a long retreat. “They are slow to react, but when retail investors get scared, they stuff money in their mattresses for many years — until they forget just how scared they were,” Mr. Hintz says. At this point, investors are not just frightened, they're irate. A survey of 750 millionaires earlier this month by research firm Spectrem Group showed that only 36% felt their broker had performed well during the financial crisis. Only 14% said they would turn to brokers more often for advice. Even worse, dissatisfaction ran highest among clients of full-service brokerage houses, like Merrill and Morgan Stanley. So far, so good The good news is that to date, the brokerage business has held up remarkably well. While Merrill's investment bankers racked up $18 billion in losses over the three quarters ending Sept. 30, its thundering herd of 17,000 brokers actually held their own. Revenues in that division slipped a scant 2%, to $10.2 billion. The story was much the same at Smith Barney, by far Citigroup's best-performing division last year. It posted revenue of $8.5 billion over the 12 months ending Sept. 30. Morgan Stanley's retail division also turned in a solid performance, with revenues rising 6%, to $6.4 billion, in the fiscal year ended last November. But last year's numbers look good in part because so much of the market carnage came late in the year, after the mid-September collapses of Lehman Brothers and American International Group. Those failures triggered a 25% drop in the Dow Jones industrial average in just four weeks. Last year's results were also helped by a wave of transaction fees generated by customers fleeing stocks and investing in safer holdings. With that reshuffling winding down, brokers' revenues are headed for a fall. Fox-Pitt Kelton analyst David Trone predicts the newly minted Morgan Stanley Smith Barney, to be run by Morgan Stanley Co-President James Gorman, will see revenue decline by 10% next year from the levels the firms posted separately last year. History suggests that forecast may yet prove optimistic. The tech wreck in 2000 led to a 24% fall in the S&P 500 over the next three years, and retail revenues at Merrill declined by 26% over that stretch. Back then, the firm was forced to sack a third of its brokers. Morgan Stanley knows it faces a tough road ahead. “We're building this for the long term and expect that when the cycle does turn, as it inevitably will, this business will be extraordinarily successful,” a spokesman says. BofA, whose brokerage arm is led by Dan Sontag, didn't respond to a message seeking comment. BofA and Morgan Stanley are already moving to slash costs in the face of looming revenue declines. Beyond eliminating obvious overlaps in the merged firms, cuts will be hard to come by. While prices for investment bankers and traders have plummeted, those of brokers with large stables of clients have held their own. Mark Elzweig, a Manhattan-based financial recruiter, says brokers who generated $1 million or more in annual revenue are being offered bonuses to switch firms equal to 230% of their past year's production, a minuscule drop from the 250% offered in flusher times. “Good brokers have never been more in demand,” Mr. Elzweig says. That is good news for brokers but bad news for BofA, which plans to slice $7 billion out of its combined cost base with Merrill. It also doesn't bode well for Morgan Stanley and Smith Barney, which aim to eliminate $1.1 billion in their operating costs.