Broker-dealer funding

How much fun to be a treasurer at an investment bank right now? Funding costs for long-term debt – which dominates the broker-dealers’ funding – have soared.

Spreads on credit default swaps, which tend to correlate with the cash market, have jumped by tens of basis points for the big banks. They have widened an even more drastic 100bp-200bp for the more focused broker-dealers, even after tightening somewhat from the March peaks.

And there’s not just the price to worry about. Some handy maturities, such as two to three-year floating debt, are hard to raise because the natural buyers of this paper, structured vehicles, are at present going the way of the dodo.

How big an impact will these extra funding costs have? The four big US broker-dealers all have chunks of debt maturing in 2008, ranging from about $18bn for Lehman Brothers to $43bn for Merrill Lynch. So they will have to be relatively big issuers this year, even if they choose to sell some of their assets and use the proceeds to pay down a portion of the debt.

The overall cost of long-term debt may not rise much given that only a part of this becomes due in 2008. But if spreads remain wide this year, the extra cost could easily add up to a few hundred million dollars, pre-tax. In February, UBS research estimated increases ranging from $220m to $580m for the main broker-dealers.

The net impact to earnings is trickier to quantify. There should be ways of offsetting margin pressure by homing in on the asset side. Broker-dealers will have to price new business to reflect their higher costs. And they can try to avoid illiquid fixed-rate assets. But while broker-dealers’ trading businesses float on both sides, it may not be easy to pass on all the higher costs.

Traders, for one, will have to get used to higher hurdle rates to justify their use of the group’s capital.

True, there are other levers to pull. Broker-dealers can scour world markets for the best place to raise debt. They can cut costs. They can be more aggressive in deleveraging. But Wall Street earnings already face a squeeze. This hardly helps.

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