PREVIEW-Weaker global markets, M&A slump to hit Wall Street bank profits

NEW YORK, July 2 (Reuters) - The second quarter was likely tough for Wall Street bank profits as markets weakened globally and merger advisory revenue dropped, leading analysts to lower their profit estimates in recent days.

Trading revenue for the industry likely dropped 20 percent from the first quarter, as falling markets and lower trading volumes cut into the value of securities banks hold to trade with customers, said Richard Staite, analyst at Atlantic Equities in London. Staite expects trading revenue for the industry to have risen just 10 percent from last year’s dismal quarter, when the European debt crisis hurt profits.

Second-quarter results are expected to underscore the challenges banks faced as bond yields began to rise. There is broad agreement on Wall Street that, in the long run, higher interest rates will help bank profits.

But in the second quarter, announced mergers and acquisitions volumes fell 8 percent from a year ago, according to Thomson Reuters data. The deal pipeline is now at the lowest level in almost 20 years, Credit Suisse analyst Howard Chen said in a recent report.

As rates are shifting, so are big banks’ business models, exacerbating market stress. Higher capital standards and restrictions on trading for speculative profits under the Dodd-Frank financial reform law has led banks to reduce exposure to riskier assets, and cut the amount of time bonds can be held in trading inventory.

“The big banks have really kind of taken themselves out of the equation in certain markets because of Dodd-Frank and other regulations that have required them to pull their capital back,” said Scott Colyer, chief executive officer and chief investment officer at Advisors Asset Management, which has $11 billion in assets. “There definitely is a lack of liquidity out there.”

But as interest rates rise toward historical norms, more pain is expected for banks and investors alike.

Wall Street executives including Goldman Sachs Group Inc CEO Lloyd Blankfein and JPMorgan Chase & Co CEO Jamie Dimon have been fretting about interest-rate movements for months.

On May 2, as the 10-year Treasury yield was about to close near 1.6 percent, Blankfein said he was worried about a sudden spike in rates sending a shock through the market the way it did in 1994. Five weeks later, after 10-year yields had breached the 2 percent mark, Dimon warned that rising rates would be “scary” for investors. But he also said on June 11 that trading revenue was doing better than prior forecasts of being up 10 to 15 percent from the same quarter last year.

Through the quarter, the yield on the 10-year U.S. Treasury note ranged more than 100 basis points from its low point to its high point of 2.67 percent. Several times, the volatile yield moved than 10 basis points in a single day, cause for concern in a market investors turn to for stability.

Traders and investors said one factor helped banks as bond markets dropped in the United States and elsewhere in June. Bank traders and salespeople worked quickly to reduce inventories and at times refused to buy low-rated corporate bonds or municipal bonds from customers.

New capital rules have made it more expensive to hold risky bonds, and a restriction on proprietary trading in the United States known as the Volcker rule has also prodded banks to avoid market bets. As a result, banks have been less inclined to maintain big securities inventories, particularly when markets are dropping daily.

“This is the business model post-financial-crisis era: dealers are acting more like brokers or agents than market-makers,” said Wesley Sparks, head of U.S. fixed income at Schroeder Investment Management. “The buyside has to find our own market clearing level on a daily basis for individual bonds, and when sentiment is uniformly one way - whether positive or negative - the buyers really call the shots.”

FICC trading can be a big breadwinner for banks in better times. At Goldman Sachs, for instance, that unit has delivered nearly one-third of net revenue since 2010. Morgan Stanley is a smaller player in fixed-income markets, but investors are watching its performance to gauge success of strategic changes outlined by CEO James Gorman. Both banks are trying to produce consistent returns of at least 10 percent in that business while getting rid of tens of billions of dollars’ worth of risky assets that tie up too much capital.

Trading bonds and related derivatives is also a large revenue source for capital markets divisions of firms like JPMorgan Chase & Co, Bank of America Corp and Citigroup Inc, and can drive results in any given quarter. (Reporting by Lauren Tara LaCapra; editing by Dan Wilchins and David Gregorio)