This is a refresher to the
The Riskiest Bank on the Street piece that I posted a few months ago on Morgan Stanley. Let me get straight to the salient points.
High exposure to level 3 assets to cause
- Morgan Stanley’s exposure to level 2 and level 3 assets (this is about more than subprime) stood at $226 bn and
$74 bn as of November 30, 2007. Morgan Stanley has the highest ‘Level 3
assets-to-equity’ of 236% after Bear Stearns. In 4Q2007, Morgan Stanley
reported a $9.4 bn write-off primarily relating subprime related mortgages.
With nearly 50% decline in ABX-HE-BBB 06-2 index since November 2007, more
losses are likely to be reported in the coming quarters.
Drying liquidity in the repo market to impact
Morgan Stanley’s funding - The $4.5 trillion repo market, accounting for 20-25% of
assets of five top brokerage firms, enables short-term financing by selling
securities and agreeing to repurchase them. During good times these loans were
inexpensive and could be easily rolled over. However with declining value of
securities used as collateral, lenders in repo market have become increasingly
worried about losing money on securities used as collateral. In addition to
being selective and cautious while lending, lenders are also demanding higher
amount of collateral. For instance, for every $100 to be lent, lenders are
requiring $105 for bonds backed by Fannie Mae and Freddie Mac (up from $102 few
weeks ago) and $130 for bonds backed by 'Alt-A' loans. This is leading to
tightening credit conditions and severe liquidity crunch in the repo market.
The liquidly crisis took its toll on Bear Stearns
(see The Breaking of the Bear)
which sought an emergency funding from the Federal Reserve on March 14,
as its clients withdrew assets while their creditors stopped renewing
short-term loans. Bear Stearns' financing crisis has created wide
concerns on the brokerage firms relying heavily on repo markets for
cash requirements. Morgan Stanley relies heavily on short term
$162.8 bn or 16% of total assets in form of repo financing as of
2007. Although we believe that Morgan Stanley along with other
could face short-term cash problems owing to declining confidence in
capital markets, the Fed’s recent initiative by allowing brokers to
directly from the central bank (and lowering the Fed rate to 2.25%)
the liquidity concerns to a considerable extent. This is something that
I will explore in depth in the very near future, since much of the
level three assets may or may not qualify for "Fed Funding". This may
portend less liquidity than the popular media may have you believe. See
the overview of recent events for more on the Fed's move .
Decline in investment banking revenues
- In view of
declining activity in the capital markets, Morgan Stanley in line with
brokerage firms, is expected to show a decline in investment-banking
In 1Q08, Lehman brothers and Goldman Sachs reported a 20% and 16.4%
decline in net revenues. As per Bloomberg, Morgan Stanley’s sale of
equity-linked offerings declined to $7.77 bn in 1Q08 compared to $14 bn
while Morgan Stanley’s sales of high-yield bonds plunged to $101.5 mn
$2.46 bn in 1Q207. Morgan
Stanley’s reported earnings dropped 47% in 1Q08. This has been hailed
as a near "blowout" quarter by the sell side and the media, even though
it clearly shows a rapidly deteriorating business and is a very
disappointing result. The street's game of lowering expectations to
create the aura of "better than expected" results should not pass
muster with the quality of readers that I have visit my blog.
Challenges ahead - Brokerage firms are
facing several challenges owing to a slow down in economy, increased regulation,
lightening credit conditions and reduced capital market activity particularly
relating to mergers & acquisitions and corporate-finance. Traditionally
brokerage firms have borrowed money to growth their business. Now with credit
being harder to come by despite falling interest rates, brokerage firms going
forward will operate at reduced leverage levels impacting their future
Valuation – Owing to continuing write-downs due to
widening credit spreads and persistent weakness in the credit markets, we
expect financial services firms’ valuation to remain under pressure until the
credit market situation eases off significantly. Decline in fixed-income
securities has negatively impacted the book value of securities. Based on a 15%
haircut of illiquid assets, Morgan Stanley’s adjusted book value stands at
$18.4 per share. Based on price-to-book value multiple of 1.23, Morgan
Stanley’s valuation comes approximately $22.7 per share implying a downward
potential of 47.0% from current share price of $42.9.
Next up will be a complete and verbose forensic analysis of Assured Guaranty.
Source: As per latest filings
Here is a quip from an email that I recieved earlier that prompted me to explain how I fell about the I banking industry now:
Longer term, politically the Fed may be forced to cut them off --- but we are obviously quite a ways away from that happening just yet. (referring to the I banks that just got access to the Fed window)
Great call on Bear. If these guys can now submit almost anything to the fed window --- munis, mortgages, etc. and fund at FF+25, doesn't that take funding off the table and then really it becomes an issue of the credit quality of the collateral. In past banking cycles --- low Fed funding almost always reliquified the banks, and I assume it will work again this cycle.
Is it time to move on to the next stage --- companies that are going to experience credit issues on assets but can not fall into the arms of the central bank?
Well, to begin with the I banks are holding a lot of stuff they can’t submit to the Fed. They were also starving for liquidity despite what they said (ex. Bear Stearn’s Schwartz on CNBC, who is bound to get sued for those statements). This is why they all hit the window the day after it was opened. The industry in general is heading for a downturn. Many can’t be patient, but a macro bet against the investment banking business is not a bad bet at all, particularly if you catch it after a euphoric rally like we just had. Look at GS and LEH stock already, less than 24 hours after “beating the Street”. MS is moving lower too.
I am having my analysts look into exactly where the Fed assistance will or will not help the banks and I will probably post my findings some time late next week. The fed has mitigated the Bear Stearns style run on the bank, but all is still not well. There is a lot of counterparty credit risk abound, and the I banks shoulder most of it. They are the ones exposed to the parties that cannot run to the Fed!
If I were a Bear Stearns employee or shareholder I would opt to force the firm into bankruptcy protection over selling for 1.25% of last year’s share price. At $2, the sales price is analogous to an under priced put option for the shareholders to hold the threat of bankruptcy over the Fed’s head. Once in bankruptcy protection, the prime brokerage clients and CDS counterparties will try to run for cover and all hell will break loose with the other banks. I think you realize there are a lot of under capitalized CDS counterparties abound that in no way could pay off on these things. These are the guys that use one CDS to hedge against another. Once the domino effect gets going…
With all of that being said, you are right about looking for the other weak credit companies. I need to find the TMAs and Carlyle Capitals. Theoretically, the I banks should extend their new found credit to these companies, but I doubt it would happen.
In addition, I listen to the talking heads on CNBC who say that we need to stabilize housing prices in order to move forward, blah, blah, blah.... I consider this to be total nonsense and indicative of extreme ignorance in regards to what the problems are in the macro sector and how we got here in the first place.
These many issues that we see around us will not go away until housing prices go back to historical norms. If you stabilize prices before prices go back down to where they should be, you will simply have another bust - on top of the one that we just had.
It is as simple as this. People are not going to buy houses until they can afford to buy houses. Housing prices have outstripped real incomes by multiples. This relationship is what must be stabilized and reversed.
From RGE Monitor:
- FT: Financial Stability Forum urges prompt writedowns and warned that the full impact of the credit squeeze had yet to be felt. Banks wrote down $140bn by Q4 ($84bn in U.S., about $40bn in Europe) subprime securities so far, finance ministers expect $400bn. Half of it expected in U.S., other half rest of world.
- Fitch: Basel II rules allow easier clean break with off-balance sheet vehicles.
- SIFMA: Outstanding volume for the European securitization market stood at €1.32 trillion, as of 30 September 2007. Euro-denominated CDO market volume 2004-2007= €285.4bn (around $410bn)
- WSJ: EU banks reported to be exposed to monoliners via popular 'negative basis trades' in past few years (arbitrage opportunity technically due to oversupply when CDS spread (i.e. cost to buy protection) on a single name is smaller than the bond yield--> buy both bond and protection from monoliner and cash in the risk-free spread difference.)
--> 6 banks out of 8 planning monoline rescue were European; expected losses in $20-140bn range
- European banks also reported to be exposed to commercial real estate loans/CMBS and leveraged loans stemming from buy-out boom. These markets are turning now and additional writedowns are expected ($100-200bn)
- UK, Spain, Ireland financial sector additionally exposed to domestic housing bust--> Spanish banks e.g. less exposed to U.S. subprime fallout and off-balance sheet SIVs but draws heavily on ECB lending facility which delays actual writedowns on unviable collateral. I have warned members of this blog about this several times.
- Bloomberg: Treasuries rose and three-month bill rates plunged to to 0.56%, the lowest level in almost 50 years on speculation credit market losses will widen (e.g. ex-LTCM Meriwether's fund facing losses, Thornburg Mortgage Inc. may go bankrupt)
- Flight to quality trades:
- The rate on the three-month Treasury bill, viewed by investors as a haven in times of trouble, dropped 32 basis points to 0.56% on Feb 19;
- Capital preservation trade: buy Treasuries sell stocks;
- TED spreads (= LIBOR- T-Bill) spiking upwards in all markets
- BNP: Signs of interbank lending stress and liquidity hoarding eased after Fed actions on March 16/17; spreads on the rise again in US, UK and Euro market. Interbank spread decomposition shows that crunch is driven by upward trending credit premium since 2008 instead of liquidity premium as was the case in H2 2007. Fed interventions ultimately can address liquidity, not credit concerns.
- Fed, BoE, ECB intervening in their respective markets (see all measures below)
- Krugman: Flight to quality and cash hoarding lead to Treasury yields close to zero--> if there is no compensation for holding Treasury paper, investors prefer to hold cash--> normal monetary policy channel via buying and selling of Treasuries breaks down (i.e. liquidity trap)
From CNBC.com :
Lehman Brothers Holdings is unlikely to face the kind of liquidity crisis that brought down Bear Stearns
over the weekend because of the Federal Reserve's decision to let Wall
Street brokerage firms borrow directly from the central bank, CFO Erin
Callan told CNBC. It appears that in the short
term, she is right. But it also shows a big hole in both the business
model of the I banks and a dire macro situation that had to be averted
by the Fed. This is not a positive sign.
certainly takes the question of liquidity off the table," Callan said
in a live interview. "I think [the Fed's decision is] the great news
that happened over the weekend." Again, I agree.
Callan said Tuesday that Lehman , which reported better-than-expected earnings on Tuesday but
has faced persistent rumors of a Bear Stearns-type liquidity crisis,
plans to borrow from the Fed through the discount window. This
is problem indicator number one. After harping on how strong your
liquidity position was and how you didn't need money, why in the world
would you go to the Fed for money, and particularly why so soon??? I
know they probably need some to help fund the accounts that left you
for fear of insolvency.
followed up on Callan's announcement by borrowing from the window
within minutes of her appearance. At 5 p.m. New York time, Lehman
borrowed $2 billion, sources said -- a small amount relative to the
bank's $375 billion balance sheet. Hmmm, this smells very fishy. They just got finished invoking the "Short me, Please" phrase , as well.
Goldman Sachs also used the discount window late Tuesday, sources said, but it wasn't clear how much money the investment bank asked for. Again,
highly suspicious. This is a tool that wasn't invoked since the Great
Depression! Doesn't this raise speculative alarms with ANYONE besides
"It’s going to be actively used" by many brokerages, Callan said. “We’ll be a participant. It’s a great opportunity." This
shows that many brokerages were either insolvent or on the brink of
insolvency. Since I am probably not the only one that sees this, I
expect credit risk monitory will increase sharply, thus making banks
much stingier. Or is it that every primary dealer is a good credit risk
since they are all backstopped by the Fed now. This is an interesting
The Fed announced the new lending facility for Wall Street firms on Sunday night, shortly after it helped facilitate the sale of Bear Stearns to JP Morgan Chase . And
if that deal doesn't go through, and is edged into bankruptcy, who will
honor BSC's CDS obligations? After all, I really don't see Joe Lewis
are the burned and spurned employees approving the deal, and they
collectively control 40% of the vote!
the plan, primary dealers -- big Wall Street firms that deal directly
with the Fed in financial markets -- would be allowed to borrow
directly from the Fed for at least the next six months.
which normally lends through its discount window only to banks that
take deposits, can lend to nondepository institutions under special
circumstances. It last did so in the 1930s. The Great Depression!
the CNBC interview, Callan acknowledged that Lehman has had a difficult
time recently amid all the rumors that it's in financial trouble. I
heard you were losing a lot of accounts and a lot of counterparties
were quite skeptical, yet it appears as if you did a professional job
in handling the situation.
know we're always the next name on the list," she said. “There isn’t a
great appreciation for the fact that we’ve evolved our franchise
dramatically over the last decade. In fact, we’ve structured our
liquidity exactly for this kind of situation. So, we feel like we’re in
a good spot."
However, Callan said
Lehman's difficulties aren't over. “Expect to see more [writedowns] in
the second quarter," she said. "Later in the year things will start to
stabilize more in asset prices.” And how do
you know this? The cause of the asset price destabilization, housing,
will probably not stabilize later in the year, so who do you think the
derivative written on top of housing will? What about the things that
are just starting to get worse: leveraged loans, high yield securities,
consumer finance securities written at the apex of an easy money bubble
that is popping in a recession, high yield securities with naught the
covenant protection of the past...
feels like, at this point, the greater part of the calendar year will
be rough sledding and I wouldn’t expect it to feel pretty stable until
As far as I can discern, Lehman effectively had a run on the bank Monday. They admitted portions of it in the WSJ article I linked to earlier, and word is that many clients left to the tune of several billion dollars. They same appears to be happening in the UK, this is after:
- one of their largest mortgage banks faced a run and had to be nationalized,;
- The biggest US investment banks, numbers 1, 2 and 5 just ran to the government for emergency funds and investment bank 5's shareholders just got wiped out.
- Investment banks 1 and 4 reported 50% drops in earnings and revenue, but rallied because analysts dropped expectations enough to say that they were beat;
- They then started to recommend "buys" on each other;
- The mechanism used by the Fed to prop up the I banks was used only once before, and that was during the worst economic period in the history of this country - the "Great Depression".
It doesn't take a detective to figure out all is not well in Smallville! There is probably a big negative waiting in the near future for the financial sector. The problem is that I have not fully deduced what it is, yet. I am growing extremely suspect of the Fed's move. I definitely understand why they felt they had to do it, the issue is the true facts surrounding the move and what the repercussions are. I think the US tax payers can kiss that $30 billion dollar back stop goodbye.
From the WSJ:
Stocks were unable to
hold onto Tuesday’s 400-plus point rally in the Dow industrials and
attendant rallies in other indexes, and steadily marched lower through
the afternoon, until news of a lawsuit filed by Merrill Lynch against a
unit of bond insurer Security Capital Assurance, alleging the company
is trying to avoid obligations of up to $3.1 billion under seven credit default swaps.
Merrill’s own CDS widened on the news, moving to 250 basis points from
210 basis points, according to Phoenix Partners Group, and the stock
market dove, with the Dow giving back a good lot of the previous day’s
I stated several
times in the comments that the CDS market may very well lead us into
the next serious leg down. Many of the guys who wrote these either
don't have the cash to pay up or are wrapped up in hedges using CDS
which will easily get @#$@ed up once one leg of the hedge falls.
My blog has been quite popular as of late,
most likely because it may appear to some that I have a crystal ball.
My last 5 or so warnings have resulted in 50 point or so price drops in
the shares of the companies in questions. Let me be both modest and
honest. I am not that smart and do not have a crystal ball. There is a
simple premise behind all of this that allows me to understand what is
going on, but this premise does not get any press play and is not
harped on by the analyst community. Many major players in our financial system are simply insolvent.
Plain and simple. The liquidity issues that you see are simply a result
of that insolvency, not a cause. When you lever up on assets at the top
of a bubble and that bubble pops, you become insolvent, delevered or
not. If forced to delever, the balance sheet insolvency now becomes an
income statement insolvency as the cash outflow outstrips the cash
inflows, but it all stems from the original balance sheet insolvency -
not the other way around.
Borrowing more money, no matter what the
terms, will not aide you in your dilemma. That is, of course, unless
you can borrow large amounts of that money quickly on non-recourse
terms. But that is not really borrowing money, it is someone giving you
money with the option to pay it back.
It is the equivalent of a straight bailout, isn't it? That is what just
happened last weekend, which leads me to the next paragraph...
I have been alleging that many investment banks, monoline insurers, home builders and commercial banks are effectively insolvent. Nouriel Roubinin wrote an accurate piece on the topic.
Between that and the the five or six major analytical pieces that I put
together, I believe a pattern emerges (please take note of the dates
the pieces were written and the share prices at the time of the post).
I believe the pattern is indisputable. You could have made a fortune on
the short side of these analyses, and you could have lost a fortune on
the long side, just ask the employess and shareholders of Bear Stearns,
Ambac, MBIA, Lennar, etc. My condolences go out to the rank and file
employees of all of these companies whose savings have been lost in the
share price devalution. Hopefully, there is a lesson to be learned
Are the Mortgage Insurers in Serious Trouble? 9/3/2007
A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton -11/13/2007
Tie-in to the Halloween Story11/21/2007
Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion in Equity 11/29/2007
- Follow up to the Ambac Analysis 12/4/2007
More on Commercial Real Estate
More on Residential Real Estate
Banks, Brokers, & Bullsh1+ part 1
- Banks, Brokers, & Bullsh1+ part 2
- Money Panic
- Bear Fight
- The Breaking of the Bear
- The Riskiest Bank on the Street
- Here comes the CRE Bust (Quip on Lehman Brothers)
- Is Lehman a Lemming in Disguise (from a conributing individual investor)
- Liquidity vs Insolvency
- Bear Stearns Bear Market, Revisited
More on Investment Banks
As you can see, the path was not impossible to determine as
practically all of these companies shared the same catalyst to their
downfall - excessive leverage at the top of an asset and credit cycle
bubble. Now, the Fed is attempting to lend directly to institutions
that it has no jursidiction over. If I am not mistaken, the Fed's
balance sheet is only good for $400 billion dollars or so. There are a
lot of potential "runs on the non-bank" coming down the pike, enought
to drain the coffers. This is an ingenious, albeit very risky endeavor.
Moral hazard abounds. I know the Fed believes that they have nixed the
moral hazard argument in the butt by wiping out the Bear Stearns
shareholders, but this is an imperfect argument. The shareholders have
to approve this $2 buyout deal, and $2 is low enough to risk a battle
with the Fed and their agents. This is a major flaw in the plan that I
see as coming back to bite the markets. If this happens when the next
shoe drops, I can see the Fed getting overwhelmed.
As an investor and analytical pundit, I will be looking for the next
shoe to drop, which I believe I have found. I will keep you posted.
According to the WSJ.com, Lehman did a phenomenal job at damage control, most likely learning their lesson from Bear Stearns.
and Lehman beat estimates, but that is not as positive as the press is
making it seem. Estimates were lowered. If you lower the fence, it
doesn't mean you jumped higher to get over it. They lost a lot of
money on illiquid securities. The Fed's work has backstopped companies
against liquidity runs, but after Bear Stearn's, the banks trust each
other even less than they did last week.
We are sure to get a
dead cat bounce here. I am still quite bearish on the investment
banking industry, though. The revenue and earnings prospects have
diminished significantly, and the cause of this mess (devalued housing)
is still on a sharpening downward slide. The key is to look at the
results of the mortgage insurers, mortgage bankers, and homebuilders to
see where the bankers will be the following quarter.
believe the leveraged loan, consumer finance and high yield markets
will start showing evidence of the cracks that have been forming over
the last year or so.
And those BSC calls that were going for a few pennies yesterday were a
good deal when nobody wanted them. Contrarian investing at its best!!!
British billionaire Joe Lewis is working to
block JP Morgan Chase's 236 mln usd takeover of peer Bear Stearns
(NYSE:BSC) in order to negate a 1 bln usd loss he now faces as a major
shareholder of the ailing investment bank, the Daily Telegraph reported.
Lewis, whose Tavistock Group is Bear's second largest investor with a
9.4 pct stake, is understood to be deeply unhappy with JP Morgan's 2
usd-a-share offer, the newspaper added without naming sources.
Lewis is involved in a number of alternative strategies, including
talking to potential rival bidders who might act as a white knight, it
Other options he is considering include voting against JP Morgan's
offer at the scheduled shareholders' meeting, something that would only
work if he were to garner the support of other investors.