FYI | Mar 28 2008
By Greg Peel
The rally in the US financial sector which began with the “rescue” of Bear Stearns, wobbled, and then recovered with the increased bid for Bear Stearns, is wobbling again. While no bank has been left unmolested by analyst earnings downgrades and expectations of capital raisings, it is the fourth largest investment bank – one up from Bear Stearns – that is currently copping the brunt of the rumours.
Last night shares in Lehman Bros fell 9% to US$38.71 – down from a high last year of US$82.05 but up from the pre-Bear-Stearns-bailout low of $20.25. This was the biggest fall among the investment banks and followed a 6% fall the day before, in what has been a bad couple of sessions for all investment banks. The primary basis for these falls has been earnings downgrades from highly respected Oppenheimer & Co bank analyst Meredith Whitney.
Whitney had already stood out from her peers last November by advising clients that Citigroup would be forced to cut its dividend and raise capital. The then Citi CEO (now axed) strenuously denied Whitney’s claims right up until the time Citi did exactly that, on both counts. This week Whitney has again made the jump on fellow bank analysts by moving to make earnings reassessments before the end of the quarter – severe earnings reassessments. The pack will follow next week, which is traditionally the time to announce new forecasts.
On Wednesday it was the turn of the commercial banks. Whitney sliced a total 84% of her previous estimates, and declared that Citigroup (which is both a commercial and an investment bank) would lose four times the amount she had previously estimated. Last night investment banks Merrill Lynch and (Swiss-based) UBS came in for the same treatment.
Whitney took her first quarter forecast for Merrills from a profit of US45c per share to a loss of US$3.00. Her 2008 full-year forecast dropped from a profit of US$4.00 to a profit of US20c. To date, analyst consensus shows a first quarter profit of US17c and a full-year profit of US$3.82. Whitney expects Merrills to write down another US$2bn in distressed asset value.
For UBS, the forecast was for a first quarter profit of US72c, now a loss of US$2.75. The full-year forecast profit has been reduced from US$3.70 to US45c. Whitney expects UBS to write down US$6.9bn.
All up, Whitney expects the sector to write down another US$50bn, including US$13bn from Citigroup.
These write-downs will lead to capital raisings and slashed dividends, Whitney suggested on CNBC this morning. In October last year, banks wrote down the value of US$100bn of CDOs and other securities. Once written down, the ratings agencies then downgraded their ratings given the new “mark to market” prices implied lesser value. This in turn meant banks’ capital requirements could not longer be satisfied, meaning either the raising of capital or the cutting of dividends or both. In February, the banks wrote down the value of a total of US$370bn of assets. One doesn’t have to be Einstein to join the dots from here. Whitney expects Citigroup will again cut its dividend, and Citi will be followed by “dozens” more in the sector.
If banks have written down on a mark to market basis, then they should be able to sell assets at that level. But they’re not, Whitney notes. This implies they are hanging on and hoping prices will return (or alternatively, there aren’t buyers at all and valuations are unrealistic). In the meantime, the value of the securities is ticking down every month. If the banks do decide they must sell, then there will be a flood of selling that will knock asset prices down even further. It is “agony of incrementalisation,” says Whitney.
Whitney would not buy any financial stocks at present.
When Bear Stearns hit the wall, Lehman Bros was considered by the market to be the next domino to fall. Its shares were sold down heavily. But on March 19, most media reports suggested that the rally on Wall Street – which saw the Dow jump over 400 points – was due to the Fed cutting rates by 75 basis points. This was not the story – 300 points of that gain occurred earlier when both Goldman Sachs and Lehman Bros announced first quarter profit estimations that far and away “beat the Street”. For the market, this was a blessed relief. Lehman shares jumped up 46% from near oblivion. But if Lehman’s result was so good (or in this case, so not bad – it was still a massive quarterly loss) then why was the Fed compelled to contact investment banks on the weekend prior (the weekend Bear was rescued) and specifically ask them not to say anything bad about Lehman to anyone, lest another “run” begin?
Apart from the general Oppenheimer downgrades last night, one thing that specifically spooked the market last night was a rapid build up in put option positions over Lehman stock. This is akin to massing the troops before launching an all-out attack. Rumours were circulating once again that Lehman was wavering.
The question is, however, were the rumours spreading because of the put build up, or were they being spread by the put buyers? It is not unprecedented for hedge funds to build big short positions and then begin spreading rumours that may be false, but prove self-fulfilling. The British authorities are already investigating just such a ploy with regards to Halifax Bank of Scotland earlier this week. Either way, Lehman was forced to announce that the rumours were indeed false and the bank was not in trouble. History is littered with such announcements that have preceded swift bankruptcy.
For whether or not Lehman is liquid, it has to remain solvent, and it won’t remain solvent if counterparties start pulling out their cash. This is exactly the sort of “run” that hit Bear Stearns – here one day, gone the next. Even if the rumours are unfounded, a run could see Lehman gone within days and years spent in the court trying to establish whether it was fraud or just plain fear.
Rumours or no rumours, Jesse Eisinger of Conde Nast Portfolio was never happy with the seemingly healthy (under the circumstances) Lehman profit announcement last week.
Lehman’s assets rose to US$786bn in the quarter – up 14% from the fourth quarter and up 40% from the first quarter ’07. In a time when every other bank is trying to reduce balance sheet exposures, Lehman has been building. Lehman also increased its leverage in the first quarter to 31.7x – up from the previous quarter and a long way up from last year’s 28.1x. At a time when the whole world is madly trying to deleverage, Lehman is building. Its leverage is now at its highest point since 2000.
The greater the leverage, the less asset values have to fall before a company wipes out its equity.
Eisinger is also staggered that Lehman included debt in its calculation of equity. This is a new method, and although Lehman suggests the method is SEC-compliant it’s a funny time to be changing accounting methods in your favour. The bottom line is Lehman has taken a mark-to-market profit on the reduction of the value of its debt. That is, if the market has, for example, reduced a $100 face value Lehman obligation to $95, that implies the market is only expecting Lehman to be able to pay back $95 of that $100. If it only pays back $95, it has saved $5 – ergo, a profit.
Talk about fuzzy logic.
But it gets better. Lehman ended the quarter with US$87.3bn of real estate assets including residential mortgage and commercial real estate paper. It wrote down the value of these assets by only 3%, while market indicators suggest greater devaluations. The total amount of mortgages on the books rose in the first quarter from US12.7bn to US$14.7bn. Of that total, US$1bn are “prime” mortgages and the rest are “Alt-A” – the reset mortgage considered only a squeak above “subprime” and for which the peak reset period has not yet hit.
The implication here is that Lehman spent the first quarter extending its exposure to distressed mortgages.
“The picture is emerging,” says Eisinger, “of an investment bank that is dancing as fast as it can”. If those new assets do come back in value, then Lehman will win big. If they are not sufficiently marked down, then profitability will be affected in the future. If they do not recover, then “time is against the firm”.
There was another rumour that hit the Street last night – one which explains the fluctuations in stock markets in the session. The financial sector opened weak on the Oppenheimer downgrades, but bounced hard when the news of the Fed auction was released. The Fed has taken two steps to shore up the investment banks since Bear Stearns. It has opened the “discount window” to investment banks for the first time since the depression, for short-term loans, and it has announced it is prepared to auction US$200bn of US Treasuries in a medium term swap for certain mortgage-backed securities.
Last night was the first such auction, and the Fed offered US$75bn worth of Treasuries which are currently yielding around 2.5%. Only US$86.1bn was bid for, and the US$75bn on offer was acquired for a mere 0.33%. Wall Street initially took this to be a fabulous piece of news – if the investment banks are in such dire straits then why didn’t they bid for a lot, lot more, at a much higher price? The Dow rallied back hard.
But then the Dow failed again, and slid rapidly to close on its lows. The rumour spread that the reason only US$86.1bn was effectively bid for is because the Fed rejected a large amount of the mortgage-backed assets being offered as not sufficiently of investment grade. This may only be a rumour, but it makes sense, and it is consistent with what’s been going on over at the discount window.
CNBC reports that when the Fed opened the window to the investment banks last week, an average of US$13.4bn per day was borrowed. This past week, that average has risen to US$32.9bn. On Wednesday, US$37bn was borrowed.
The Fed does not reveal who has approached the window, given the stigma attached to such “emergency” loans. However last week Goldman Sachs and Morgan Stanley were prepared to reveal that they had approached the window.
As was Lehman Bros.
