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Tax Law Change Looks Bullish for Investment Banks

Investment bankers have had a somewhat disappointing year, but there are signs deal activity is picking up.

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It is important to distinguish between the two main businesses of investment banking units, at least at large institutions like Goldman Sachs , Morgan Stanley , Citigroup , Bank of America and JPMorgan Chase . Investment banks have both trading and investment banking businesses.

The traders, by and large, have been doing very well, and when they are making money, their earnings typically dwarf those of the investment bankers. However, it is the traders who are likely to take the biggest hit from new banking laws working their way through Congress. So the banks need all the help they can get from their investment bankers, who earn fees for advising on initial public offerings, M&A and other types of deals.

As this chart demonstrates, revenues from M&A, bond, equity and debt underwriting are only slightly better than they were at this time last year, when stocks were coming off March's multi-year lows.

In general, deal activity goes up at the same time the stock market does. So while the successful IPO Tuesday of CBOE Holdings Tuesday has been heralded as a hopeful sign for future deals, that hope will flicker out quickly if the stock market fizzles.

However, a CNBC report Thursday pointed out that a new wrinkle is developing this year that has nothing to do with the stock market. It has to do with taxes paid by private equity firms and other money managers. Currently, those firms pay capital gains tax rates of 15 percent on profits they earn.

Starting next year, assuming proposed legislative reforms pass as expected, the firms will begin paying taxes of more than 30 percent — closer to the ordinary income tax rate.

As a result, CNBC reports, private equity firms are looking to exit profitable investments before the year is over and the tax rate goes up. That would mean more M&A and IPOs, and more fees for investment bankers. Faber argues the phenomenon already appears to be making an impact. According to data from Dealogic, private equity firms have already racked up more than $12 billion worth of exits in June, a greater total than in any full month since June 2008.

If the past two weeks prove more than a blip and the trend continues throughout the year, investment banking fees could make a much greater contribution to big banks' revenues in the second half of 2010 than analysts are expecting.

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Disclosures:

Disclosure information was not available for Freed or his company.

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