The investment banks are back in the news and the markets fear a repeat of the events of 2008-09. It is worth analyzing in further detail what exactly what wrong before in order to help judge the potential for future trouble. Leverage has been blamed as the main culprit of the toppling of Lehman Brothers and Bear Stearns and the near collapse of a number of other major investment banks. However, leverage alone was not responsible, rather it was the combination of leverage and failed investments. Leverage only becomes a problem when events go badly. Nevertheless, if the investment banks were less leveraged the problems would have been far more manageable, but just how leveraged were the investment banks at the time and how do they compare today?
The problem with answering that question is the seeming complexity of investment banks’ balances sheets. The key to gaining a better understanding of the operations of an investment bank is to understand that not all assets or liabilities are created equally and therefore do not have the same potential for loss. Today, many understand that investment banks have assets and liabilities that net against each other but either unaware of the magnitudes or simply question whether the netting is effective. The second point is valid, but will not be addressed; rather, the sole point of this analysis is to give investors a sense of magnitudes and how the investment banking industry has changed over the past several years.
The following table shows the assets and liabilities of five investment banks, at year end 2007, and three as of the third quarter of 2011 (Link to PDF version):
The ultimate purpose of this table is to determine how a company finances its business. The table starts by listing the assets and liabilities of each company taken directly from their financial reports (rows 1 through 15). For greater clarity, in the liabilities section there are numbers beside each category which show which asset account the liability is netted against in the “source / (use) of financing” section, below. In that section we can best see the financing of an investment bank.
Starting with 2007, in addition to equity we can see in row 16 that all the investment banks rely primarily on debt as a source of financing (positive numbers are sources of cash). Another important source as seen in row 17 was customer financing, which is essentially the effect of having accounts payable greater than accounts receivable (all related to securities, not physical goods). There is no focus on short versus long-term financing here is that is not the risk we are trying to analyze. While it is never good to rely too much on short-term funding, that is not what created problems at the investment banks in 2008 although it may have exacerbated the situation once the crisis began.
The investment banks use their sources of financing to support two basic activities: 1) a collateralized or secured securities lending portfolio; and 2) an inventory of securities such as equities and bonds that the company owns in order to support its trading business and investment banking activity. The first activity is a low return business where an investment bank lends cash against securities taken into possession by the investment bank or borrow cash against securities transferred into possession of another party. The companies play both sides of the game because they are market makers, but are typically net lenders of cash in this activity (the asset side is greater than the liability). This can be seen in row 19.
The second activity is where investment banks generated a large preponderance of their risks in 2008 and to a lesser degree today. Rows 20 through 22 show the net amount of securities, investments and loans owned by the investment banks under study. While at year end 2007, the companies had offsetting positions (they were both long and short), on net they mostly were large owners of securities and this was the greatest use of their capital. To get a sense of how much exposure the companies had, row 25 shows the amount of securities owned excluding government securities relative to tangible equity capital. To be clear, a negative number here is a use of cash or in other words a negative number implies the company had a net long position. Excluding government securities is useful since they often have much less risk, and in fact during the crisis were increasing in value. On this metric we can see that Merrill, Morgan Stanley (MS) and Lehman were all quite leveraged while Goldman (GS) was somewhat safer. Jefferies (JEF) did not have a significant net long position relative to the other banks.
Row 26 is the same metric applied to the entire book of securities owned by each company. One interesting piece of information is that Lehman was net short government bonds at the time, likely not as a proprietary bet, but as a way to fund their business. This net short would have concealed somewhat the amount by which Lehman was long riskier securities on a superficial viewing.
An equity investor in these companies at the time was really placing a leveraged bet on rising markets to a large degree. Some of these holdings were in support of investment banking deals and genuine trading activity, but it is possible that the investment banks held more than they needed to in this regard or held too little equity in order to boost returns.
As was mentioned earlier, leverage alone is not sufficient to bankrupt a company. In fact, leverage in rising markets will generate outsized returns to the holder of the assets. Goldman was better prepared for the downturn than its competitors in that it used less leverage, but ultimately it was the deterioration in assets, for example Lehman’s real estate exposures, which in conjunction with leverage forced them into failure.
From here we can push the analysis two directions. First, it is clear that Jefferies in 2007 operated at a fundamentally different risk level then the other investment banks under study. Versus a mean of 8.5x leverage on the securities owned portfolio for the other banks, Jefferies was at 2.0x and 1.6x excluding government exposures. This fact probably explains why Jefferies made it through the crisis relatively unscathed.
Second, we can look at how investment banks are run today from a leverage on securities owned perspective. Given the recent worries about Goldman, Morgan Stanley and Jefferies this may help some investors. In the case of Goldman and Morgan Stanley, risk has clearly ratcheted down considerably. The securities books are smaller and the companies have additional equity capital. Jefferies has increased its risk here somewhat, but on a total book basis it is still below the two other companies today and far below the norms of the other investment banks in 2007.
It should be noted that other risks are present in this business beyond the risks analyzed here. It is well possible that while on a net basis the investment banks appear safe, that some aspect of the gross exposure will impact them or some other risk entirely is present that is impacting the valuations of these companies. However, in my view it is useful to put perspective and delineation around today’s issues versus those of the past and understand how they are different.
Disclosure: I am long JEF. Mr. Johnson is a former of employee of Morgan Stanley and Jefferies & Co. He has no continuing business relationship with either firm.