Earnings and Headlines 7/21/2010

• Morgan Stanley had a great quarter! Seriously! I know, I can't believe it either (see yesterday's highly inaccurate prediction below.) The investment bank roared back into the big leagues with a second quarter profit of $1.96 billion, up from $149 million a year earlier. $514 million of that was related to the sale of its retail asset-management arm, but earnings on a continuing basis were still better than expected. Results in its new and improved asset management unit were boosted by the purchase of Smith Barney from Citi. CFO Ruth Porat stated that although the banking industry will undergo a period of intense scrutiny, the firm was not a target of a major investigation. So things are looking up including the stock price, which is up 8%. Now go sell your real estate arm while you have the chance.
• BlackRock also had strong results, posting a near doubling in quarterly profit to $432 million. The surge in profits was attributed to the purchase of BGI last year. Seems like the thing to do to boost profits is go out and buy a money manager.
• Wells Fargo posted a profit of $2.88 billion, higher than last year's $2.58 billion but on slightly lower revenues. Results were better than expected and the stock is up 5%.
• The WSJ's quarterly housing report is out and shows a deteriorating housing market. It's nothing you didn't already know; pending sales down sharply after expiration of tax credit, new housing construction down, inventories up across the board. etc etc. But it has a nice city by city chart that makes you say things like "Wow, I'm glad I don't live in Detroit."
• MBA purchase applications are actually up slightly, which may have something to do with mortgage interest rates being at their lowest levels in the history of the universe.

Morgan Stanley, Lehman, and Real Estate Investing

The day before Morgan Stanley is set to report earnings, the WSJ runs a story about the investment bank's attempts to deal with the $46 billion disaster that is MSREF, its commercial property investment funds. MSREF never met a commercial real estate investment it didn't love during the boom and is now stuck with a host of turkeys in every corner of the world. What now? Should it sell the pile of ailing (yet diversified!) real estate investments? After all, both Citi and Bank of America have sold off significant real-estate investment fund businesses in the past month, to Apollo and Blackrock respectively. Also, ING is looking to do the same and MS really does just like to do what everyone else is doing, just later, and less profitably. Should it hold on and hope for the best? After all, the fund still earns management fees even when it does stuff like lose 75% of its investors' money. Maybe leak a story to the press, see if anyone out there has any better ideas?

Here's an idea: Maybe Lehman can buy it? After all, Lehman's bankruptcy has done nothing to slow down the frantic pace of activity at the real estate arm of the now-defunct investment bank. The WSJ reports that Lehman just took over Innkeepers, a REIT that owns more than 70 hotels. Well, this was less of a traditional takeover and more of a "you're wearing it" type of deal, as the hotel operator filed for bankruptcy and Lehman was its largest creditor. Lehman's debt in Innkeepers stems from its participation in the 2007 $1.5 billion buyout performed by none other than Apollo Investment, a subsidiary of the same folks that just bought Citi's real estate portfolio (see above.) Buy low AND high. I think that's called dollar cost averaging.

What should Morgan Stanley do? Tomorrow's earnings announcement will offer some clues as to whether the firm can finally return to its former glory as a premier investment bank, rather than a GS also-ran. If so, maybe MS has a shot at reaping a solid price for its ailing commercial real estate investment funds based on the prestige factor associated with its name. Because it's not going to get top dollar based on the fund's performance.

I'm predicting a lousy quarter for MS. They might even lose money. Why? Because all its competitors have had a lousy quarter and MS does exactly the same thing, except usually worse, even though the market seems to grant them some sort of a premium. How much longer can the premium prevail? Tune in tomorrow.

Morgan Stanley In CDO Probe

Federal prosecutors are investigating whether Morgan Stanley misled investors about its crappy CDO deals. You're never going to believe this, but apparently MS arranged and marketed CDOs to its investors while simultaneously betting against them! I mean that sounds like something that only Goldman Sachs would do! Yet who is Morgan Stanley really? Oh that's right: a less profitable Goldmans Sachs. I've even heard that Morgan Stanley's strategy is replicating Goldman Sachs, once it actually figures out what the hell those stupid vampire squids are doing over there to make so much G-ddamned money! In any event, the probe is on.

Whitehall Bests MSREF For "Worst Real Estate Fund Ever"

So the conversation must've gone something like this:

GS exec 1: This commercial real estate fund needs to sound very exclusive. Because everyone wants in but we definitely want the riffraff to know they're not good enough.

GS exec 2: Right! It needs to sound pure from the taint of retail investors.

GS exec 1: How about White Shoe?

GS exec 2: Yes, I like the "white" part. But "shoe" is not highbrow enough.

Gs exec 1: White House?

GS exec 2: Too political.

GS exec 1" White Door? White Room? White Bridge? White Street?

GS exec 2: No. Something more grand, impressive. I've got it "Whitehall"

GS exec 2: Perfect!

For all those rich folks lucky enough to get in on Goldman's snooty sounding Whitehall Street international real estate investment fund, you should give them a call. Your two cents are waiting for you. For two cents on the dollar, or $30 million, is about what is left of the $1.8 billion in equity that the fund started with back in 2005, when piling leverage on to a bunch of commercial real estate investments at the peak of a bubble still sounded like a great idea. Anyone keeping score, and Wall Street loves to keep score, should note that this bests the 70% or so loss revealed yesterday by Morgan Stanley's international real estate investment fund. But the fund doesn't expire until 2014, so they have plenty of time to make it back.

UBS Digs its Claws In, MS Faces Shareholders' Ire

On the heels more losses for UBS investors, shareholders can at least rest easy that management hasn't completely forgotten about them. Last year, the Swiss bank introduced a plan that would pay 900 million francs to managing directors in equal parts over three years, because even managers of the financial Titanic need to be motivated. The plan, however, came with clawback provisions in the event that the bank continued to post losses. At some point, management must've thought, we've got to stop losing money. Right? I mean, statistically it just can't be possible to continue to lose money like this, can it? Yet UBS managed to beat the odds by posting a 2.74 billion-franc loss for 2009, which sounds awful, unless you compare it to the prior year's 21.3 billion-franc loss. In any event, managers can say goodbye to the 300 million they were due to collect this year as it will be clawed-back. UBS is still paying out 2.9 billion francs in bonuses for 2009, so it's not like anyone is going hungry.

Speaking of comp, Morgan Stanley is finally stealing attention away from Goldman Sachs in the compensation ire department. After a lackluster year where the investment bank was short on profits, it still managed to fork over 62% of its revenues to employees. Shareholders are rightfully pissed off and are not going to let this type of thing fly anymore. Well, except for the guy quoted in the article who said:

"I'm willing to give them a free pass given the decline in revenue" last year, "but going forward, there needs to be an attitude that shareholders are first in line."

It's attitudes like these that have kept the comp scam going as long as it has. Willing to give them a free pass this year??? Why? In all the years, this is the year they shouldn't get a free pass. They got about two trillion free passes from the government. Zero percent interest rates? That's a free pass. How about $2 trillion in fixed income purchases from the Fed? Also a free pass. 62% of revenues in comp? Dude, grow a spine and sell your damn stock. I've been carping for some time about Morgan Stanley not getting its share of bad press compared to Goldman. I'm glad somebody is finally putting two and two together over how preposterous it is to grant pay packages based on competitors' performances.

Bank Earnings Fail To Impress Market

• Bank of America managed to only lose $194 million in the fourth quarter. Oh, wait a minute, that's only if you exclude the $5 billion or so it cost the largest US lender to repay the government. But a $194 million loss just sounds better, doesn't it? So let's just pretend that BAC never had to hit up the Treasury for a bailout and forget that silly "non-recurring" expense. What's really important is that the bank can return to paying its employees whatever it wants and paying out dividends without any consideration as to whether it can afford to or not.
• Wells Fargo posted a profit of $2.8 billion, or 8 cents a share, beating expectations of a small loss. Revenues also rose by 1% to $22.7 billion.
• Meanwhile, Morgan Stanley, the former investment banking powerhouse that is currently a cowering and meek Goldman Sachs wanna-be, missed earnings estimates. Frankly, it's hard to figure out exactly what MS did this quarter given the confusing media reports. The Financial Times claims that the investment bank recorded net income of $1.1 billion but a loss of 93 cents a share including the TARP payment. I like how the earnings are in hard dollars but the loss is in earnings per share. Sounds better that way right? The folks at the WSJ report that MS posted a profit of $617 million or 29 cents a share, but earnings from continuing operations were 14 cents a share. The WSJ conveniently excludes the loss including the TARP repayment (I guess they're bullish?). Meanwhile, Bloomberg gives the only information you need to know, that MS will pay out a whopping 62% of revenues in compensation. What I want to know is this: If you are going to pretend like you are Goldman Sachs and pay GS-style bonuses, shouldn't you at least make money like GS does?

Financial Headlines 12/17/2009

• Yesterday's Fed decision yielded little unexpected news. Chairman Bernanke and his cronies basically said that the economy was a bit better, but not enough for them to actually do anything to stop the potential for a massive bubble reflation. The fed funds target will remain stuck between zero and .25%, so please, won't you please, keep buying the long bond cause we're going to need to sell ALOT more of those. But don't worry about agencies and MBS, we plan to buy another $150 billion or so of those. Oh, and by the by, you should expect some volatility in Feb after we let most of the artificial liquidity supports expire.
• Citi completed its $20 billion offering. The sale was considered a bit of a bummer, as the shares wound up being priced at around a 20% discount. Furthermore, the government backed out of its plans to sell up to $5 billion in Citi's shares that was intended to lower its stake from 34% to 30%. According to the FT, the government backed out because it would have suffered a loss on its investment. Frankly, that's a fairly stupid reason to back out of selling stock. I know the government wants to keep crowing about what a great money manager it turned out to be and how much money it has made on the TARP so far. You know, because Paulson and Geithner were smart enough to buy preferred stock in GS with a 5% dividend when Buffett got his with a 10% dividend? While the rest of the market was pricing in insolvency and the government could've and should've received a 25% dividend? Yeah, they're a bunch of geniuses. In any event, they're probably going to wait until the stock hits $2 and then try to offer it out at $3.
• In the cheery world of commercial real estate, Morgan Stanley handed over 5 more office buildings in downtown San Francisco to lenders. In yet another example of why we don't want these "savvy" investors, who don't lend to small businesses or consumers, playing with money that carries an implied government guarantee, the buildings have lost around 50% of their value since the purchase. The buildings were part of a $2.5 billion deal where MS purchased 10 buildings from Blackstone Group in May 2007. Blackstone had just purchased the buildings in its $39 billion buyout of Equity Office Properties and then flipped them for a nice profit. It's still hard to fathom how nobody recognized a bubble back in 2007 when office building flipping was a major financial activity.
• Bank of America finally found a new CEO. The job went to Brian T. Moynihan, a longtime B of A employee. In a sign that big transformative changes will be afoot as a result of hiring an insider, Mr. Moynihan said that he doesn't foresee any "big changes," nor does he plan to exit any of the companies current businesses. So yeah, his hiring will make a really big difference.

Mack's Exodus Surprises Some

In a surprise move, Morgan Stanley's CEO John Mack is stepping down. Mr. Mack leaves after four very rocky years at the helm of the formerly esteemed investment bank which almost bit the dust a few times in the last year. It seems like a lifetime ago that Mr. Mack was brought in to run MS by a few high profile investors who instigated a coup to oust the more conservative, former Dean Witter broker, Phil Purcell. Vikram Pandit famously walked off the trading floor to a round of applause and quit in protest, when Mr. Purcell promoted a woman (EGADS!) over him. Nobody should have to stay at their job after that sort of indignity. Mr. Mack was brought in to straighten up the place and keep all of those talented revenue producers from leaving. The firm ratcheted up its risk and went on to lose buckets of money in CDOs, CMBS, RMBS, you name it. Mr. Pandit started his own hedge fund that never made a dime but was bought by Citigroup anyway for $800 million at the peak. He now has the distinct pleasure of running the disaster that is Citi. And Morgan Stanley will now be run by a conservative former broker (they call it wealth management now.) This is what people mean when they call investment banking cyclical.

More on Morgan Stanley

It appears as if I didn't spend enough time heckling Morgan Stanley's earnings yesterday. The earnings themselves were lackluster and not particularly inspiring so I glossed over them. Furthermore, it was not until later in the day that the real juice was reported by Bloomberg; that the company had set aside 72% of its revenue for employee pay. Morgan Stanley's stock sold off in the morning on the earnings release but then bounced back nicely by the end of the day. I'm curious as to why shareholders are interested in owning a part of a company that is always willing to screw them over to pay its employees excessive compensation. I call it excessive because clearly all that "talent" at Morgan Stanley isn't pulling its weight if the bank is just going to continue to post losses. If the talent was worth the money, then employee comp would be roughly 50% of revenues as it has been historically. Of course, compensation experts argue that Morgan must keep up with the spiraling pay at Goldman. But really? Is Goldman going to hire every single finance executive on the planet? In any event, I suspect that Morgan Stanley is just trying to pay everybody out before the investment bank really starts taking it on the chin on its $17 billion portfolio of commercial real estate. That time bomb is ticking and I'd be trying to get paid before it goes off too.

WFC, MS Earnings

Morgan Stanley's earnings were subpar, according to the ticker. Second-quarter income plunged 87% to $149 million from $1.14 billion, while revenue declined 11% to $5.41 billion. Although the results beat the average analyst's estimates, the stock is still trading lower before the open. The weakness in earnings came from a large loss related to the company's credit spreads tightening in the quarter, as well as the cost of paying back the $10 billion in TARP funds it owes Uncle Sam. Fixed income and investment banking revenue jumped 44% and 19% respectively, while institutional-securities swung to a loss on a revenue decline of 24%. In any event, compared to Goldman's blowout quarter, it's hard to be impressed.

Wells Fargo's second-quarter earnings soared 81% to $3.17 billion or 57 cents a share, up from $1.75 billion or 53 cents a share in the prior year. Revenue nearly doubled to $22.5 billion from $11.46 billion, with Wachovia making up 39% of the total. Still, the market is not impressed with the earnings report as the company's stock is trading lower before the open. Credit-loss provisions were $5.09 billion, up 69% from a year ago and 11% from the prior quarter. Meanwhile net charge-offs rose to 2.1% of average loans from 1.54% in the prior quarter, while nonperforming assets grew to 2.2% from 1.5%. With the continued deterioration of the economy, particularly in California, investors are perhaps concerned that the credit loss provisions aren't adequate to cover future losses on Wachovia's legacy option arm and commercial real estate portfolio.

Street to Log Best Quarter Since Crisis

According to the WSJ, securities firms are set to log their most lucrative financial performance since the credit crisis erupted. The article mentions that the usual suspects such as JP Morgan, Goldman Sachs, Morgan Stanley and Bank of America are banking huge profits. The best part is, the article says that "instead of relying on risk and leverage to drive profits," they are deriving profits from trading and underwriting. Apparently, whoever wrote the article doesn't seem to know that the definition of trading is "taking risk." Sure, you can call it market making, but you're still risking capital to make money from buying, selling, and hedging financial instruments, particularly if we're talking about derivatives trading. Furthermore, the article goes on to say that the record underwriting fees that the banks collected in the quarter were mostly from underwriting shares for banks (i.e. themselves) that were forced to raise capital to replenish their beaten down coffers. The article doesn't even mention all of the cheap financing that the government has thrown at them to keep their financing costs down, a huge oversight, in my opinion. If you could borrow money at zero percent from the government, you'd be having a banner quarter too. Too bad your bank just raised your credit card fees, jacked up your rates, cut off your credit and won't let you refi your house. So thoughtful of those banks to pass all those savings along to the consumer right?

If banks think that continuing to underwrite their own equity and debt offerings ad infinitum is a sustainable business model, then they are sadly mistaken. Eventually, investors are going to figure out that whole dilution business and not participate in the 50th capital raising plan that Bank of America or Citi, for example, try to shove down investor's throat. The article cautioned about one time accounting issues that are likely to obscure the results, but as usual, I'll be waiting for the actual earnings announcement and the 10-Q release before I make any judgements about the financial health of our financial institutions.

Bank Capital Raising Frenzy Continues

On the heels of its $8 billion capital raise last month, Morgan Stanley, perhaps stunned by how high its stock price has remained, is raising another $2.2 billion in equity. Gotta pay back that TARP so it can return to paying bonuses at the expense of shareholders. Interesting that shareholders are still willing to buy into that philosophy. Yesterday afternoon, JP Morgan and American Express both announced plans to raise more capital. This is the first time to the trough for JP Morgan, which is raising $5 billion. Meanwhile, AmEx raised a more modest $500 million yesterday.

If you don’t believe that paying back the TARP is primarily a compensation issue, then just check out Citi’s announcement today. The beleaguered bank is halting severance payments to five former executives that left last year. According to the WSJ article, Citi had promised roughly $100 million in payouts to these executives, and has already made roughly half of the payments but is halting the rest. The bank is betting that the executives will be too embarrassed to file lawsuits, as evidenced by the outrage caused by the AIG payouts. For evidence that Wall Street’s ideas about paying “talent” ridiculous sums of money for seemingly no reason, I present you with exhibit A: Michael Klein. Mr. Klein, a 23 year veteran of Citigroup, was the head of investment banking. He RESIGNED in last July. Funny thing is, I have resigned from a few jobs in my time, and I’ve never been granted severance. Severance is for people who are laid off, not those who resign. Despite this, Citi offered to pay Mr. Klein a “severance” of $42 million in return for not poaching any of the bank’s investment bankers. I know that Citi is on a huge cost cutting scheme, reducing the amount of money it spends on paper clips and copies, etc. But $42 million buys a lot of paper clips. Why on earth the bank, which is suffering from some serious financial problems, felt obligated to pay someone this kind of money when he was leaving the firm and would no longer contribute one iota of value to Citi, shows a complete and total lack of economic prioritizing. Citi knows that this kind of wanton flushing of money down the toilet no longer flies as it has no shot in paying back the government any time soon. The rest of the 19 banks don’t want to be subject to the same constraints next time they feel like paying someone $42 million for no good reason.

As I’ve noted before, I want the banks to pay back the TARP. I don’t think taxpayer money should be funding risk-taking. I don’t care what banks pay their employees, but I don’t think the government should subsidize outrageous Wall Street style compensation, especially when the unemployment rate is 9%. But my conditions for TARP repayment are the following: You pay back the TARP, and this whole government-backing-the -banks scheme is over. Going forward, no more TARP, no more FDIC guarantees, and no more pledging any collateral other than treasuries to the Fed for loans. No more Too Big To Fail. The government shouldn’t be bailing out risk takers.

Morgan Stanley Earnings Subpar

Morgan Stanley posted a worse than expected loss of $177 million or 57 cents a share, as a dramatic improvement in the spreads on its own debt impacted its earnings by a negative $1.5 billion. Revenue slumped 62% to $3.04 billion. The company also announced it was slashing its dividend by 81%. It’s about time. Analysts were expecting a loss of 8 cents a share on revenue of $5 billion.

I’m not sure how the recent financial stock cheerleaders are going to paint this into a positive, but I’m sure they’ll find a way. I’d be hard pressed to call this earnings release anything other than horrible and the stock is actually trading lower in pre-market trading. On the other hand, with results like these, spreads on MS debt are likely to widen back out, helping the investment bank post a profit next quarter.

Morgan Stanley Also a Loser This Quarter

Morgan Stanley reported a $2.2 billion fourth-quarter loss, wider than most analysts expectations, yet narrower than the same quarter a year ago.  Morgan joins Goldman in proving that even with massive stimulus from the Fed and Treasury, it's impossible to make money if nobody is willing to trade, invest, or pay for advice.  

Once again, even that $2.2 billion loss is extremely optimistic, as revenue was positively impacted by a $2.7 billion gain associated with the widening of Morgan Stanley's credit spreads.  In summary:

•  The Fed has lowered interest rates to zero
•  The Fed is lending the banks money versus crap collateral
•  The Treasury handed Morgan $10 billion
•  The FDIC guaranteed its debt
  
• Morgan was able to book $2.7 billion in profit from the deterioration in its credit worthiness
• The company still lost over $2 billion

Anyone else wonder why the Fed is terrified?

Discount Window Borrowings Surge

Thursday afternoon's Federal Reserve balance sheet release was filled with painful evidence of how serious the liquidity squeeze remains for banks and dealers.  The significant increase in borrowing from the Fed would have been bigger news were it not overshadowed by the FDIC's seizure of WaMu and the fight over Paulson's $700 billion bailout package.  Primary dealers borrowed $105 billion from the Primary Dealer Credit Facility on September 24th, a shocking amount considering the stigma associated with borrowing from the discount window.  If you were curious why Goldman Sachs asked Warren Buffett for an investment or why the storied investment bank converted itself into a bank holding company, this is the answer.  Finding short-term financing is growing increasingly difficult and the Fed can't seem to create new lending facilities fast enough to keep up with demand for dollars.  Banks borrowed $72 billion from the new asset-backed commercial paper money market or mutual fund liquidity facility, a non-recourse loan facility offered to US depository institutions and bank holding companies to finance purchases of ABCP from money market funds.  The Fed is also accepting equities through the discount window, which I'm certain indicates that the financial apocalypse is upon us.  The loan to AIG has increased from $28 to $44 billion within a week.  I suppose AIG is still determined to pay off the loan and remain a non-government owned company, but it does not appear to be moving in the right direction.  The good news is, we still haven't lost any money on the Bear Stearns loan, although the last time the asset was valued was June 30th.  I'm awaiting the quarterly update and I'm assuming it is not good.

If the money markets don't thaw soon, and there is very little reason to believe that they will after WaMu's failure and the stall-out of the Paulson plan, the Fed will likely need another loan from the Treasury so it can increase its lending to the dealer community.  This is commonly known as running the printing press in a third world nation.  In the US, it's just Bernanke and Paulson doing what they do best; juicing up Wall Street so it can live to fight another day.  The Financial Times is reporting that Morgan Stanley lost close to a third of the assets in its prime brokerage last week (hundreds of billions of dollars) as hedge funds fled to rival banks.  The rumor circulated all last week, but was only published as news in a major financial publication for the first time tonight.  This is yet another unintended consequence of Lehman's failure.  Hedge fund clients are concerned that if Morgan fails due to the severe liquidity squeeze, they will wind up like Lehman's clients; unable to access their assets in a wildly fluctuating market.  Needless to say, concerns about the future of Morgan will likely hurt the market tomorrow.  At least this time, they won't blame the shorts.     

Morgan, Goldman Now Banks; Wachovia Left Out in the Cold

Both Morgan Stanley and Goldman Sachs lobbied the Federal Reserve to become bank holding companies over the weekend.  Their bid was approved by the Fed, ending the era of the independent investment bank.  Both Morgan and Goldman will now be subject to much stricter capital requirements and regulatory oversight.  Although the transition into a bank holding company will reduce their chances of making outsize returns on equity in the future, it allows them to remain independent. 

Morgan Stanley has apparently abandoned merger talks with Wachovia as it found Mitsubishi a willing investor in the firm.  Mitsubishi UFJ will pay $8.4 billion for a 20% stake in Morgan Stanley.  This leaves Wachovia out in the cold.  The bank still has problem assets it needs to unload and is searching for more capital.  Mr. Paulson better speed that plan through.  Too bad that investors who understand how bad this is for Wachovia can't short the stock...

Money Markets in Complete Panic

The Fed conducted two auctions under its TSLF program today which attracted significant demand from primary dealers.  Under the TSLF, dealers offer hard-to-finance securities in return for Treasuries.  Investors are hoarding Treasuries because they are unwilling to hold any other collateral for fear that a counterparty will default leaving them with securities that they can't sell.  This hoarding has caused Treasury bills to trade close to zero, a highly unusual situation that last occurred around the time that Bear Stearns was on the brink and then not since World War II.  The TSLF is meant to alleviate this problem by helping dealers to finance their less desirable securities and giving them treasuries in return.  The results of the TSLF, which generated record demand at record spreads was an indication of how desperate dealers are to secure funding  The 28-day auction drew $71.25 billion in bids versus the $35 billion offered by the Fed with a stop-out was 3.00% (quoted as a spread).  The 14-day auction drew $64.35 billion versus the $35 billion offered with a stop-out of 2.50%.    

If you are looking for an explanation as to why Morgan Stanley and Goldman Sachs' stocks were getting pummeled the last few days despite their relatively decent earnings results, this is it.  Although the SEC and some pension fund managers believe this is an attack on the US financial system by opportunistic hedge funds, I believe it is investors reacting to the potentially catastrophic consequences of a complete seizure in the money markets that is bigger than the Fed's capability to resolve.  Morgan and Goldman rely on the money markets for financing, which are still digesting the consequences of the rash of bailouts, takeovers, and  bankruptcies.  Two money market funds just reported that they broke the buck due to investments in Lehman commercial paper.  How willing will money market funds be to invest in any more broker dealer investments? 

Calculated Risk highlights a quote from Morgan CEO John Mack in a NY Times article that is terrifying.  According to two people briefed on talks between John Mack and Citi CEO Vikram Pandit, Mr. Mack said "We need a merger partner or we're not going to make it."  It has been confirmed in the mainstream press that Mr. Mack is seeking a buyer for Morgan Stanley, however, that quote has a sense of urgency that is very unsettling.  If Morgan strikes a deal, can Goldman survive as an independent dealer or will it too be forced to find a partner?  I honestly don't know, and I suspect that the market's trajectory will continue downward until these issues are resolved.  

Update:  The Fed increased the amount of dollars that Central Banks around the world can offer from $67 billion to $247 billion.  Let's hope it is enough.

The Fate of Morgan and Goldman

While Lehman's assets are getting a true mark to market in bankruptcy court and Merrill and Bank of America are busy hammering out the details of their proposed merger, investors have turned their attention to Morgan Stanley and Goldman Sachs.  Both investment banks reported positive yet much lower earnings this quarter, but questions about their future as stand-alone investment banks remain.  Why?  Because the money markets are no longer willing to support an investment banking model.  Investors have finally figured out how risky it is to borrow money short to finance a huge, risky trading operation.  Morgan Stanley and Goldman Sachs have emerged as the best risk managers on The Street, yet sentiment has now appeared to turn against them.  Despite the AIG bailout by the US government, which was a far better alternative for the investment banks than allowing a bankruptcy filing, both Morgan Stanley and Goldman Sachs' stocks are getting routed in pre-market trading.  Credit default swaps on Morgan Stanley have now spiked to levels last seen on Lehman Brothers' debt.  Remember Lehman?  That other investment bank that went bankrupt last weekend?  If you thought the turmoil was over, think again.    

Rogue Traders and Level III Assets, What's the Difference?

Morgan Stanley suspended a credit trader today for mismarking his trading positions to the tune of $120 million.  The company was forced to take a "negative adjustment" related to erroneous valuations of his positions.  Morgan Stanley's CFO, Colm Kelleher, was quick to point out that the firm discovered the error and took swift action by suspending the trader.  A suspension may seem harsh for a high school senior headed into final exams (please refer to the movie "Risky Business" if you doubt me.)  However, on Wall Street, where traders are compensated based on their trading profits, a suspension seems a bit weak.  Personally, I'd go after any compensation the trader had received in the past.  Call me crazy for thinking that people shouldn't get paid ridiculous sums of money for phantom profits.

This rogue trading incident, although meager compared to the SocGen fiasco caused by Jerome Kerviel earlier in the year, brings to light a much larger issue:  How trustworthy are the marks on investment banks portfolios of assets?  Banks claim to have highly sophisticated risk management tools in place to make sure that risks are adequately quantified and that prices are indicative of where assets trade in the marketplace.  In light of the recent inaccurate pricing of assets at Morgan Stanley, Merrill Lynch, Credit Suisse, Toronto-Dominion, and SocGen, it is clearly an issue that banks struggle with and should cause investors to wonder how many other rogue trading incidents are occurring right now that have yet to come to light.  Based on anecdotal evidence from personal experience working at investment banks, traders who mismark positions are typically asked to leave, and the embarrassing losses are generally buried into earnings and never disclosed.  They become much harder to hide when there are no earnings to offset the losses.  My guess is that we'll be hearing more of these sorts of incidents in the ensuing bear market.    

A bigger issue still is the assets on investment bank balance sheets that are currently classified as Level III, or assets that have no observable prices or even observable inputs in the market.  Much has been made of this issue recently as banks have been scrutinized for moving formerly somewhat liquid assets into this accounting classification as prices dried up.  While nobody is accusing banks of purposefully mismarking Level III assets (well, other than the accusations hurled at Lehman Brothers by David Einhorn, which turned out to be true) many wonder if the prices are anywhere in the neighborhood of their true value.  Is there any difference between a price that a trader invents to pad his own pocket purposefully and a price that a bank invents because no other prices are available?  One is pure deception, while the other is a best guess with some unknown probability of being in the ballpark.  If there is a difference, does it really matter?   

FedEx, Morgan Stanley, Fifth Third Bank Contribute To Market Gloom

FedEx reported a fourth quarter loss of $241 million on rising fuel costs and a write down of its Kinko's unit.  The company provided a bleak outlook for the rest of the year, lowering its estimates for first quarter and stating that earnings would be difficult to predict due to sagging demand coupled with volatile energy prices.  Somebody please call Bernake and let him know that when companies start mentioning volatile commodity prices as a reason for lack of predictability in earnings, he has not achieved his goal of "price stability" regardless of what the core rate of inflation indicates.  

Meanwhile, in banking news, Morgan Stanley reported a 57% decline in earnings on a 60% drop in revenues and Firth Third Bancorp announced it will raise $2 billion of convertible preferred shares and slash its dividend to raise its tier 1 capital ratio to 8.5%.  It is becoming apparent to the market that Goldman's earnings report yesterday was a aberration.  Somehow through savvy trading (and apparently an increase in risk according to the Financial Times Lex column today), Goldman has managed to avoid suffering major losses.  On the same day that Goldman proved its trading prowess through its earnings report, analysts from the firm released a research note claiming that banks may need to raise another $65 billion in capital.  Perhaps Goldman's good earnings proved to the market that those guys know what they are talking about, and bank stocks promptly took a beating.  The sell-off looks likely to continue today as investors become more and more aware that the worst is not over for US banks.  Delinquencies are rising, assets are deteriorating, and continued weakness in the housing sector shows no signs of abating.  The Fed's hands are tied now that inflation is rearing its ugly head.  I offer a small suggestion to the remaining banks who need to raise capital: you may want to get that offering circulating ASAP.  I have a sneaking suspicion that if you wait for the other $60 billion in capital to be raised before you get your act together, there may not be any left for you.