Category: investment banks

Music stops for Chuck Prince

Back in July of this year Citigroup CEO Chuck Prince made the following statement regarding the LBO craze:

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

Chuck has tangoed his way out of the building. Where is the love?

Just a few weeks ago, board members including Robert Rubin, the influential chairman of Citigroup’s executive committee, expressed support for Mr. Prince and said that his job wasn’t in jeopardy. “I think Chuck’s going to be here for a lot of years,” Mr. Rubin said in an interview last month.

My Comments: One by one the banking sector leaves the denial stage. Prince beat Bear’s Jimmy Cayne to the door yet more will follow this group before long. Moving closer to the panic stage.

Merrill Lynch under pressure

Over the last week or so we’ve witnessed a rude awakening within the credit complex. Recently, Merrill Lynch found religion in admitting a slight error in estimating “subprime write downs” when the final tally was twice the original $4.2 billion. Following this announcement the board forced CEO Stan O’Neal to the Hamptons, permanently but don’t shed any tears for Stanley. Stanley O’Neal was the same guy who accepted several hundred thousand stock options 3 days after the 9/11 incident and then sold most of this stock in January 2007 which coincided with a financial services conference where he touted Merrill’s expertise in subprime lending and structured finance. Since then mother Merrill has destroyed roughly 22% in shareholder equity while watching the stock decline some 42% YTD.

Today, we learn of an SEC investigation into Merrill’s hedge fund practices tied to structured finance.

In a further sign investors’ confidence in the firm’s creditworthiness is deteriorating, credit-default swaps tied to Merrill Lynch bonds climbed 30 basis points to 135 basis points, according to broker Phoenix Partners Group. The contracts, which protect bondholders against default, are trading at the highest level in more than five years, Credit Suisse Group said.

The SEC will probably examine whether dealings with hedge funds complied with accounting rules or whether Merrill “tried to engage in what looks like sleight of hand,” said Peter Henning, a former attorney in the criminal division of the U.S. Justice Department who teaches at Wayne University in Detroit. The deals may be legal, depending on how firm Merrill’s obligation was to buy back assets or the likelihood that it would be forced to do so, he said.

The SEC’s “concern will go back to what happened at Enron,” the Houston-based energy-trading company that collapsed in an accounting scandal in 2001, Henning said. “Are they temporarily offloading assets or securities to dress up their balance sheet in the short term?”

My comments: Merrill Lynch is no different than most of the other broker dealers who refused to mark to market. According to FASB 157 the 15th of November makes mark to myth part of the history books so expect a few more CEOs to be ousted before year end. Hint: One plays bridge with Warren Buffett.

Bank writeoffs: Is the worst behind us?

As reported, today Merrill Lynch joined the subprime hit parade with a $5.5 billion writedown. They join Citigroup and Deutsche Bank earlier this week ($9.8 billion) and Bear Stearns, Goldman Sachs and Morgan Stanley last month ($4.3 billion).

Investor response, so far, has been remarkably positive:

But the mood among bank CEOs has been one of optimism. Executives from firms like Merrill and Citi have said that other areas of their businesses continue to perform well and that there have been signs that credit conditions are improving.

“Have a little confidence – we do,” Bear Stearns CEO Jimmy Cayne implored investors following a half-day meeting Thursday.

So far, investors have been quick to embrace the writedowns, sending shares of Merrill, Citigroup and UBS higher on the belief that the worst of the credit crisis is behind them.

Not everyone is convinced:

Punk, Ziegel & Co.’s Richard Bove labeled that kind of thinking as “deluded.” Mortgage and derivatives businesses at many of these firms have taken a wallop and may not recover for several quarters.

“The assumption that by writing off the stuff, these business will turn around and become vibrant is almost insane,” said Bove. “It’s not going to happen.”

My comment: We are clearly in the Bove camp. The U.S. has over $10 trillion in mortgage debt with half taken on from 2001-2005, a period of the greatest housing/credit bubble this country has seen. And the damage is going to be limited to $50 billion or so? No way.

Lehman Brothers reports Q3 results

The headline for Lehman’s (LEH) 3rd quarter read: EPS of $1.54 beats estimates by 7 cents, -2% from a year earlier. Behind the numbers, the company EPS got an extra 12 cents from a lower tax rate and 1 cent from lower share count due to stock buybacks. Total miss: $0.13 per share. CNBC trumpeted strong year-over-year growth in investment banking, asset management, and net interest income. On its conference call, the company’s executives claimed to see light at the end of the credit crunch tunnel.

Year-over-year results were a mixed bag:

  • Asset management: $479 mil, +29.0%
  • Commissions: $674 mil, +19.5%
  • Trading & principal investments: $1,612 mil, -26.9%
  • Investment banking: $1,071 mil, +47.5%
  • Net interest income: $479 mil, +50.6%
  • Net revenue: $4,308 mil, +3.1%
  • Pre-tax income: $1,205 mil, -11.9% (28.0% of net revenue, down from 32.7%)

Comparisons to the 2nd quarter were generally ugly:

  • Asset management: +14.0%
  • Commissions: +18.7%
  • Trading & principal investments: -44.2%
  • Investment banking: -6.9%
  • Net interest income: -2.4%
  • Net revenue: -21.8%
  • Pre-tax income: -35.9%

At the end of the 2nd quarter, Lehman held $412 billion in long-term investments. Yet, despite carnage in credit land through most of the 3rd quarter, the company only took $700 million in asset writedowns…

The Firm recorded very substantial valuation reductions, most significantly on leveraged loan commitments and residential mortgage-related positions. These losses were partially offset by large valuation gains on economic hedges and other liabilities. The result of these valuation items was a net reduction in revenues of approximately $700 million.

The most troubling aspect of the quarter was that the balance sheet continued to grow and leverage increased:

  • Total assets: $656.0 bil, +38.4% y-o-y and +8.3% from Q2
  • Total assets / tangible equity: 37.2x, vs. 34.7x in Q2 and 31.5x in Q3 ’06


  1. Core business is deteriorating.
  2. Company has taken serious blows to its balance sheet, yet appears unwilling to face the music (likely expecting a new wave of asset inflation, a la the Bernanke Fed).
  3. Company is addicted to perpetual balance sheet expansion and incapable of reigning it in.
  4. The upcoming 10-Q should make for interesting reading.

Fair Value accounting dragnet: Just the facts

Last month the WSJ reported that SEC examiners would be analyzing valuation techniques related to structured finance in order to verify brokerage securities and loan positions.

According to Chris Whalen:

The Fed’s decision to waive Section 23A of the Federal Reserve Act (Reg W) and allow Bank of America (NYSE:BAC), Citigroup (NYSE:C), and JPMorgan Chase NYSE:JPM) to make large loans to their broker dealer units may be a sign of impending trouble. These loans, which are apparently to support collateralized debt obligations (“CDOs”), are an indication of mounting liquidity problem among the larger Sell Side shops.

The table above, courtesy of Richard Bove of Punk Ziegel & Co, displays data on holdings of these firms which are subject to Fair Value accounting (FASB 157 and 159). Fair Value accounting breaks holding into three categories:
  • Level 1 holdings are relatively easy to value since they are traded daily. Holdings include stocks, treasuries, or commodities.
  • Level 2 holdings are more opaque. This group trades intermittently so holdings are determined by computer models. Holdings include anything from loans, derivatives, restricted stock and thinly traded debt securities.
  • Level 3 holdings are valued solely at the discretion of the holder since there are no comparable issues being traded. Holdings include private equity, residuals from securitizations or complex derivatives.
The past 60 days has truly tested mark to model (Level 2&3) and the results are disastrous. How do we know this? Because mark to market or broker has resulted in transactions well below what supposed book or model values were. In some instances investment grade paper sold for 25 cents on the dollar. Thus, the market has implicated the brokers, banks, hedge funds and rating agencies for obvious reasons.

Looking at the table above we see $5.6 trillion in holdings being held by 8 firms. There is $0.3 trillion that cannot be valued objectively. This is 63% of the combined firms’ common equity. There is $4.1 trillion in Level 2 holdings which we would say are overstated by a minimum of 8-10%. This is 7.9x the combined firms’ common equity.

In summary, the banks, brokers, auditors, SEC, rating agencies and hedge funds will have their hands full trying to value $5.6 trillion in securities, 78.9% of which do not trade on a regular basis.

Allowing the free market to force a mark to market will create relentless write downs for this sector over the next few years. On the other hand continued denial results in perpetuating the twilight zone economy.

Wall Street getting squeezed by rising credit costs

Since mid-June 10-year Treasury yields have dropped 85 basis points to 4.32%, yet Wall Street’s borrowing costs are going up, as Bloomberg reported:

Wall Street is getting no benefit from the biggest bond market rally in five years.

Lehman Brothers Holdings Inc. faces higher borrowing costs today than it did in June, even after the steepest quarterly drop in U.S. Treasury yields since 2002 pushed interest rates down for everyone from Procter & Gamble Co. to AT&T Inc. Investors are so leery of Bear Stearns Cos. that its 10-year bonds trade at a discount to Colombia, the South American nation that’s barely investment grade. Goldman Sachs Group Inc. is being punished with a higher yield than Caterpillar Inc., the heavy-equipment maker.

The Big 5 investment banks are now paying 1.80%-2.35% over Treasurys on subordinated 10-year debt:

Goldman Sachs 6.25% senior notes due 9/2017: 6.040%
Morgan Stanley 5.45% senior notes due 1/2017: 5.926%
Goldman Sachs 5.625% subordinated notes due 1/2017: 6.167%
Merrill Lynch 5.7% subordinated notes due 5/2017: 6.110%
Lehman Bros 5.75% subordinated notes due 1/2017: 6.658%
Bear Stearns 5.55% subordinated notes due 1/2017: 6.720%

Higher borrowing costs will take a bite out of profits:

The explosion in credit spreads on Wall Street may take an even heavier toll on profit next year, when the five firms have almost $133 billion of bonds maturing, according to data compiled by Bloomberg. Bond indexes maintained by Merrill show that the cost of refinancing that debt has swelled by about $1.3 billion since the beginning of 2007, excluding the cushioning effect of any interest-rate hedges.

“Any securities firm is an institution that requires access to capital to fund itself,” said Mitch Stapley, who helps manage $12.7 billion at Fifth Third Asset Management in Grand Rapids, Michigan. Wider spreads “will impact their profitability,” he said.
Goldman is the only firm to have distributed its refinancing obligations so there’s no outsized amount of debt coming due in a single year.

Merrill has $42 billion of bonds maturing next year, the most on Wall Street and about 50 percent more than in 2009. Morgan Stanley is next at $34 billion.

$1.3 billion in extra borrowing costs pale next to a combined $30.6 billion in combined net income in 2006. Still, the boom in Wall Street profits appears to be over; net income as recently as 2004 was a more pedestrian $17.2 billion.

As Lloyd Blankfein warned in June, an end to the days of cheap credit wouldn’t be pretty for Wall Street:

Goldman CEO Lloyd Blankfein, who led the firm to a Wall Street record $9.54 billion in earnings last year, said in June that low interest rates and easy credit helped fuel the five-year boom in real estate, LBOs and emerging-market investments. He also warned them what to expect when spreads widen.

You’d see “a lot of that wealth, which was created over the years, unravel very quickly,” he said at a June 27 conference at the New York Stock Exchange. “You wouldn’t enjoy that.”

My comment: The investment banks are caught in a vice – bad bets being exposed, business drying up, lenders getting nervous, and financing costs going up.

Pimco’s Gross buys Goldman, Merrill, Deutsche debt

Bill Gross upgrades his financial establishment membership to silver status. Article on Bloomberg.

While publicly supporting baseball, motherhood, and “fiscal” bailouts for homebuyers on margin who bet the ranch and lost, his actions belie any thought he’d turn down a handout to Wall Street if his investments seemed in the least bit threatened.

WordPress Themes