Wall Street's Stress Test

Broker earnings to give investors early damage report from credit crunch
By Alistair Barr, MarketWatch

Investors are about to get a look at the first major reports on the damage from this summer's credit crunch.
In a little more than a week, Wall Street's biggest firms report quarterly results. These companies are lynchpins of the global financial system, so their performance will be scrutinized for clues on how banks, other companies, capital markets and the broader economy are coping with a crisis that has hit close to home for some top brokers.
More than their peers, Lehman and Bear may be the most exposed to the credit crunch because they rely on fixed-income sales and trading more than rivals such as Morgan Stanley and Merrill, analysts said. Indeed, Lehman gets almost half its 2006 revenue from the business, while Bear got 44% of its revenue from there last year, according to Bernstein estimates.
Among the questions that are foremost on analysts' minds when the big brokers report later this month:
1/ Will firms have to cut the value of assets they're holding, resulting in charges that will cut into earnings?
2/ How much did the slowdown in fixed-income markets eat into the revenue that investment banks generate from selling and securitizing assets such as mortgage-backed securities?
3/ How deeply has the credit crunch cut the number of M&A deals that investment banks work on, especially those involving private-equity firms?

Market turmoil has its upside for investment banks too though. But it's still unclear whether higher trading volumes and surging volatility in equity, commodity and currency markets will make up for a torrent of bad news.
Wall Street's titans dominate trading and sales of securities in equity, bond and other markets, while advising on and helping to finance some of the biggest mergers and acquisitions. They've also been at the center of a surge in financial innovation in recent years that's created a huge credit derivatives market and rampant securitization, in which assets like mortgages and other loans are sliced into asset-backed securities and sold to investors. But many of these trends, which just a few months ago produced record earnings on Wall Street, have abruptly halted and even gone into reverse as problems in the subprime corner of the U.S. mortgage business spread across most of the credit market.

'Summer from hell'

In what Hintz calls "the summer from hell," bond investors fled to the safest government securities, while spreads widened dramatically on riskier forms of high-yield and other debt and leveraged loans used to finance buyouts. (The spread is the difference between yields on riskier debt and safer debt such as Treasurys).
The mortgage-backed securities market, which helped fuel the housing boom, froze up. The values of collateralized debt obligations, a further wrinkle in the recent securitization trend, collapsed. Some parts of the commercial paper market shut down and leveraged loans became difficult to sell.
The turmoil has already claimed many victims. More than 130 subprime mortgage origination companies have shut down or stopped offering loans since late 2006, Bernstein estimates. Several hedge funds have collapsed, notably two run by Bear Stearns. Even Goldman had to pump $2 billion of its own money into one of its big hedge funds after losses in August.

Kicking the tires

Some investors are waiting to see how these firms have faired in their fiscal third quarters before committing more money, Hintz said.
Momentum investors, who buy stocks of companies with rising earnings, have sold their positions in investment banks already, helping to push the shares lower. But value investors, who like undervalued stocks, are now interested because some brokers, such as Bear Stearns, are trading near historically low valuations, Hintz explained.
"Value investors are all waiting for the brokerage earnings," he said. "Will anyone blow up? How will future earnings be impaired by problems in the credit markets. They are doing a lot of research, kicking the tires, right now."
"Brave value investors will buy just before the earnings come out, but others will wait for a couple of them to report first before buying," he added. "If the investment banks make it through this quarter without announcing big write downs, then these will be very attractive stocks for value investors."
Valuation concerns
The credit crunch has increased concerns about how well investment banks value some of their assets. The firms hold some complicated securities that don't trade much, making them more difficult to value than things like stocks and government bonds.
"The more important, broader question is whether they can truly value the assets that they hold," Bove said. "And the answer is that they cannot. They've overstated their assets and therefore their book values, so the stocks should go lower."
These assets include so-called residuals, which are often riskier parts of mortgage-backed securities (MBS) and collateralized debt obligations (CDOs).
When an investment bank securitizes loans, they chop them up into different "tranches." Some slices are less risky, pay lower interest rates and have higher ratings. But to get AAA ratings on the best bits, investment banks sometimes have to take the riskiest tranches that are exposed to the first losses on the underlying loans, Bove explained. These are residuals.
Bear, Lehman, Goldman, Morgan Stanley and Merrill have between $4 billion and $11 billion of "residual interests" on their balance sheets, according to a report that Michael Hecht, an analyst at Banc of America Securities, issued on Friday. These include MBS, other asset-backed securities, CDOs, muni and corporate bonds, he added.
When investment banks arrange financing for LBOs, they usually provide a bridge loan to help the deal close quickly. They then sell the debt in the market. When LBO financing stalls or fails, these banks are left with so-called hung loans.
Such hung loans on the balance sheets of investment banks may have to be valued lower, cutting into earnings, Hecht and other analysts say.
The combination of lower valuations of residuals and hung loans could take a big chunk out of profit this quarter.
"We also expect a 34% sequential quarter decline" in third-quarter earnings per share, Jeff Harte, an analyst at Sandler O'Neill, wrote on Friday. He sees "significant asset markdowns, particularly in mortgage related securities and leveraged loan commitments."

Marking to model

Some assets are so esoteric and trade so infrequently that investment banks have to value them based on mathematical models, rather than the market prices of similar or related securities. These are known as Level 3 assets.
This, in theory, gives firms lots of leeway in valuing these assets, which include things like derivatives, private-equity investments, residuals of CDOs and mortgage-servicing rights, Bove said.
Wall Street firms use mark-to-model techniques to value 9% of the Level 3 trading inventory on their balance sheets, estimates Bernstein's Hintz. Goldman is top at 15%, while Merrill is bottom at 2%. (See table)
brokerage Percentage of Level 3 trading inventory valued using mark-to-model techniques
Goldman Sachs 15%
Morgan Stanley 13%
Lehman Brothers 8%
Bear Stearns 7%
Merrill Lynch 2%
Source: Bernstein Research

Level 2 assets are those that may not trade much, but that can be valued by checking market prices of similar securities and making assumptions about variables such as interest rates, Bove explained. These can include MBS, some corporate bonds and CDOs, he added.

The five largest U.S. brokers and the biggest universal banks -- Citigroup, J.P. Morgan Chase and Bank of America -- have $4.1 trillion of Level 2 assets on their balance sheets, according to Bove, who got the data from the companies' regulatory filings. That's almost 10 times their shareholder equity, Bove noted.
"A 5% wiggle in that number and you're looking at significant wipe out of shareholder equity," he warned.

'Highly unlikely'

Still, Hintz and other analysts are more sanguine about such valuation issues.
"A major concern is that all of the marks investment banks are using to value holdings are wrong and they will have to take large write downs," Hintz said. "That's a great press story but highly unlikely."
Investment banks track the value of their holdings very carefully, using computers that analyze a huge central "pot" of data. This feeds into other parts of their operations, including accounting, risk management and systems that check on counterparty and credit risks, Hintz explained.
Then, hundreds of controllers check the valuations of the assets on the balance sheet. When Hintz was CFO at Lehman in the late 1990's, he said, the bank had more than 800 staff in this area.
Such arrangements would make it very difficult for traders at these firms to value positions artificially high, he said. With so many other things relying on such valuations, it's also in investment banks' best interest to get it right and be conservative, he added.
"It is very difficult for inaccurate mark to model valuations to remain a secret," Hintz said. "And if I get my marks wrong, everything else is messed up in the firm. They may want to play games with valuations, but doing so would mean everything else was wrong too."

Fixed-income fallout

The credit crunch has also disrupted several markets in which investment banks have generated lucrative fees recently.
Sales of asset-backed securities are down 28% in the third quarter versus the second quarter and MBS issuance is off 24%, according to Banc of America Securities.
Sales of high-yield debt are down almost 32% in the quarter, versus the previous quarter, the bank also estimated.
Weakness in the MBS market will likely hit Lehman and Bear the hardest, analysts said. Bear was the leading underwriter of MBS last year, with an 11% market share, according to Dealogic data complied by Bernstein. Lehman was second with 10%.
Bernstein's Hintz expects Bear's third-quarter fixed-income sales and trading revenue to slump by half versus the second quarter. Lehman's may drop 37%, while Goldman and Morgan Stanley could see declines of 28% to 30%, he added.
Credit market problems have already disrupted some large leveraged buyouts. If investment banks continue to struggle to sell leverage loans that help pay for these acquisitions, M&A volumes may continue to drop from what were record levels earlier this year.
The volume of completed M&A deals during the third quarter is down by roughly 25%, Bernstein estimated recently, citing Dealogic data.
Still, equity trading volumes surged in July and August, while stock, commodity and currency markets became much more volatile. That will likely boost revenue and earnings in the equity and derivatives trading departments of investment banks, analysts said.
Equity trading volumes on the New York Stock Exchange are up 17% this quarter versus the previous three months and up 24% from a year ago, Banc of America Securities' Hecht noted on Friday.
Equity options volume is up 62% from a year earlier, he also noted.
Indeed, Hecht expects third-quarter results from the top investment banks to be a "stabilizing" event and advised clients to invest in the stocks ahead of the reports.