Clearing firms, facing declining revenue and in-creased competition, have something new to worry about: More and more broker-dealers are seeking loans as an incentive to sign on with a new firm.
While haggling over margin terms and other forms of financing have always been part of negotiations, some in the industry have seen requests for subordinated-debt financing become more common recently as thinly capitalized, smaller broker-dealers look for ways to shore up their balance sheets.
“Particularly among prospects, I have definitely seen more people with their hands out than ever before,” said Christopher Frankel, chief executive of Legent Clearing LLC.
“The past couple of years of financial stress have created issues for certain folks,” said Daniel Son, president of Penson Worldwide Inc. “Are broker-dealers looking for a deal? It's always been going on, but it's more prevalent today than in the past.”
Mr. Son added that Penson does not provide loans to broker-dealers to finance operations.
Some clearing firms are more than willing to strike a deal as the number of operating broker-dealers declines and the fight for market share intensifies. Currently, 4,676 broker-dealers operate in the U.S., a loss of 435 firms — or 8.5% — from 2005, according to the Financial Industry Regulatory Authority Inc.
Clearing firms see deal making as a double-edged sword, said one brokerage executive, who asked not to be identified.
“It's a pain when an existing broker-dealer customer goes to its clearing firm and is looking for money,” the executive said. The clearing firm can use financing as a bargaining chip in talks to bring in new business, he added.
One example was the bargain made by the broker-dealer units of Ladenburg Thalmann Financial Services and National Financial Services LLC, the clearing arm of mutual fund giant
Fidelity Investments.
Last August, National Financial gave Ladenburg a $10 million, seven-year forgivable loan to become the exclusive clearing firm for Ladenburg's three broker-dealers: Ladenburg Thalmann & Co. Inc., Triad Advisors Inc. and Investacorp Inc.
That meant Investacorp had to drop clearing agreements with J.P. Morgan Clearing Corp. and Ridge Clearing and Outsourcing Solutions Inc.
“Ladenburg is a strong, well-capitalized company, and this is a mutually beneficial strategic relationship,” a spokesman, Jonathan Doorley, wrote in an e-mail. “The funds are being used to support Ladenburg's acquisition and growth strategy.”
But such deals can backfire.
In 2009, Legent loaned Jesup & Lamont Securities Corp. $2 million to become the broker-dealer's primary clearing firm. Just last month, after failing to meet required capital standards, Jesup & Lamont halted all trading except for client liquidations and laid off all but a bare-bones staff. (See story, page 25.)
GETTING IN LINE
Regarding its loan to Jesup & Lamont, Legent chief executive Mr. Frankel said: “We're going to be in line with the rest of the creditors.”
Other clearing firms, such as Pershing LLC and National Financial Services, declined to comment about loans to broker-dealers, citing the confidentiality of client relationships.
The thinning out of the broker-dealer industry is having a financial impact on clearing firms in other ways as well.
GunnAllen Financial Inc. went out of business in March after its capital became insufficient to meet regulatory minimums for continued operations.
The firm's failure was one of the reasons Penson was able to reduce its acquisition price for Ridge Clearing, GunnAllen's clearing firm.
When the purchase was announced in November, the value of the deal was pegged at $60 million to $70 million.
But when the transaction closed last month, Penson wound up paying Ridge $35.2 million in stock and debt, or about half the originally announced price.
That deal gave Penson about 100 new clients and made it the second-largest clearing firm, as measured by the number of broker-dealers it serves.
CONSOLIDATION CONTINUES
Meanwhile, the long-term trend of consolidation among clearing firms is not abating. Legent announced last month that it was being acquired by United Western Bank for $13 million in cash and just over $2 million in stock.
Like their broker-dealer clients, clearing firms' profits can hinge upon market conditions, including interest rates.
Traditionally, a key driver of profitability at independent broker-dealers has been cash products such as money market mutual funds and bank deposits.
A TOUGH SLOG
With interest rates at historic lows, that revenue stream has run dry, executives said.
The low-interest-rate environment has created a tough slog for both broker-dealers and clearing firms.
Net-interest income at Penson, for example, fell to $65.9 million last year, from $88.4 million in 2007 — a 25% decline. Analysts at Raymond James & Associates Inc. project that Penson's net interest income this year will fall further, to $62.5 million.
An increase in interest rates can't come soon enough for Penson and other clearing firms.
“We are interest-rate-sensitive and are ready for interest rates to go up,” Mr. Son said.
E-mail Bruce Kelly at [email protected].
