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.

Earnings, Losses, and Excuses

First the good news:

• Both JP Morgan and Intel reported solid earnings. Profit at JP Morgan rose by 55% from a year earlier to $3.3 billion helped by a sharp 30% reduction in provisions for credit losses. Oh, and zero percent interest rates. It's always nice when you can borrow money at zero percent from your friends at the Fed and then charge consumers 20%. Really pads the bottom line.
• Meanwhile Intel's quarterly profit nearly quadrupled to $2.44 billion, while revenue rose 44% to $10.3 billion. The tech giant's good quarter bodes well for the rest of the tech sector.

In somewhat disappointing news:

• Investors in Morgan Stanley's $8.8 billion MSREF VI real-estate fund were recently informed that they have likely lost two-thirds of their money. The WSJ helpfully points out that this would probably make it the largest dollar loss in the history of private equity...so far. The losses stem from a buying frenzy during the peak in the commercial real estate market using oodles of leverage. The property purchases were global, so you know, at least they were diversified. Possibly the biggest bummer about the loss is that it's really putting a damper on the firm's plans to raise the $10 billion follow-up vehicle called MSREF VII. Here's a bit of unsolicited marketing advice for the folks at MSREF that I learned in MBA school: maybe you want to rebrand? Give the fund a different name, or something? If I'd lost two-thirds of my money in your last fund, I'm definitely not investing in your new fund, because at this point I'm thinking you guys aren't very good at investing in real estate.

In hilarious, as well as infuriating news:

• From Kerry Killinger, overseer of the multi-billion dollar fraud-infused-subprime-option-arm bubble-frenzy that was Wa Mu in its hey day before it collapsed under the weight of its stinky mortgage self: "For those that were part of the inner circle and were 'too clubby to fail,' the benefits were obvious. For those outside the club, the penalty was severe." Because underwriting over $100 billion in negative am mortgages without asking for a single W2, or verifying that the borrower actually had only $10K in annual income and $3 in his bank account before giving him a $2 million mortgage on a house that had sold for $300,000 last year had NOTHING TO DO WITH WASHINGTON MUTUAL'S COLLAPSE. No, it was the lack of a government bailout. You see, if only Washington Mutual had been bailed out by the government instead, it would've survived and would've been in tip top shape. This was all part of Mr. Killinger's business plan, and the FDIC had to go and ruin it all by seizing his bank. I mean, really, they had some nerve.

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.

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.     

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?   

Bank of America Slashes Estimates for Goldman, Lehman, Morgan

Analysts at Bank of America cut earnings estimates for Goldman, Lehman and Morgan Stanley today. In the event that you have been on a mission to the moon for the past three months and some delivery snafu has prevented you from receiving your copy of The Wall Street Journal, which has outlined in painstaking detail how terrible the environment has been for nearly every single line of business that the brokers rely on, day after day, you can depend on the trusty analysis from these jokers at Bank of America. Somehow, over Memorial Day weekend, it occurred to them that maybe, just maybe, they need to lower their unrealistic earnings targets so they don’t wind up looking like fools in front of the investment community when the brokers report their dismal earnings results next week. When Lehman reports a loss, instead of a profit as these guys were predicting before today, they can say “See, we predicted they would lose money!” I suppose that if analysts continue to lower earnings estimates a week before earnings every single quarter, than their overzealous earnings targets for these stocks may actually begin to resemble reality. Here’s a tip to all the brokerage analysts out there: you may wish to extend your ability to forecast earnings beyond the one week timeframe, or risk becoming a part of next week’s unemployment numbers.