As Probes Add Up, Wall Street Profits May Go Down

Will the latest round of probes into large banks mark the beginning of the end of Wall Street's streak of big profits? It's a question weighing heavily on investors' minds. After all, a large amount of earnings come from the Street's trading desks where many of the large bets under investigation are made.

One thing is certain: Law-enforcement agencies are on high alert as part of a broader net cast by lawmakers to rein in Wall Street and get bankers to clean up their act. In this climate, any banker in his right mind will think twice before taking more than the usual share of risk. And generally, low risk equals low profits.

Shares of J.P. Morgan Chase (JPM), Citigroup (C) and Goldman Sachs (GS) are trading down on concerns that profits in coming months will diminish, costs related to investigations will go up and Wall Street's will to fight regulation will weaken.

According to news reports, the U.S. attorney's office, the Securities & Exchange Commission and New York Attorney General Andrew Cuomo (pictured) are all pursuing criminal investigations into several large Wall Street banks -- J.P. Morgan, Citi, Goldman, Morgan Stanley (MS), among others -- looking into whether they did anything improper when selling investors mortgage-related bonds prior to the financial crisis.

Losing Lucrative Transactions?

"These investigations are just one step in the process that will have a huge impact on how Wall Street conducts business," says Walter Todd, a portfolio manager who invests in financial stocks at Greenwood Capital. The banks "will end up paying a lot more for legal and compliance work that will be associated with all their deals, which will increase the cost of doing business."

Todd says the investigations along with the upcoming financial reform legislation will prevent the banks from doing many of the most lucrative transactions that they've done in the past. That could have a broader impact on how businesses are financed globally.

Nancy Bush, principal of NAB Research, doesn't think regulation and the criminal probes will necessarily drive business out of this country as some fear, but it would reconfigure the U.S. financial business. "Wall Street types will simply gravitate toward less-regulated venues, like hedge funds, or regional banks where the regulation isn't so onerous," she says.

Tearing Up a Legal Fabric

The criminal investigations could also end up muzzling some top executives who've been very vocal in their condemnation of tough regulation from Washington. JPMorgan CEO Jamie Dimon, for instance, has made many trips to Washington in the past year speaking out against regulation that will likely crimp business at his bank. His confidence stems from the fact that JPMorgan had managed to emerge from the financial crisis relatively unscathed in terms of reputation. Until now, that is.

Indeed, these investigations are questioning the fundamental basis of Wall Street's defense, which is that it's completely
legal to sell investments that the banks were betting against. In fact, Goldman CEO Lloyd Blankfein even argued in recent testimony that nothing is wrong with such transactions. But today, that notion is being reevaluated, and the legal fabric that Wall Street has hidden behind is being torn.

The recent observations by members of the Senate Permanent Subcommittee on Investigations give an idea on how lawmakers and the public view Goldman's rich profits and bonuses during the financial crisis. Carl Levin (D-Mich.), who heads the subcommittee, reminded Blankfein how Goldman got full payment -- via billions in taxpayer bailout dollars -- on credit default swap transactions from American International Group (AIG), the insurance giant that was teetering on the edge at the time. "Why isn't that unjust enrichment?" Levin asked.

And Senator Jon Tester (D-Mont.) said Goldman's deals aren't about hedging. "This is just playing around from my perspective," he said. Tester observes that it was this kind of "playing around" that led to the financial crisis. For the big Wall Street firms, however, critics, regulators and lawmakers are now hardly playing around.