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Jefferies Group's (JEF) year end is November 30th. They aren't scheduled to provide year-end results until Dec. 20th, but I wouldn't be surprised if they announced at least preliminary numbers much sooner than that.

First, I think they will be able to show a much much lower leverage position than the market expects. As of August 31 (last quarter) they had total assets of 45.1 billion. They had shareholder equity of 3.5 billion. That gets me to a simple leverage calculation of 12.9 times. Let's look at what they did in Italy the Monday after they provided a detailed position report. They reduced longs and shorts by $1.1 billion. So their long position was reduced by $1.1 billion and their long position in "reverse repos" was also reduced by $1.1 billion. So the balance sheet should have decreased by $2.2 billion. That would take my simple leverage down from 12.9 to 12.3 times.

I believe JEF was able to do that balance sheet reduction with minimal cost to P&L. They had some curve trades on and were possibly a bit lax on letting traders build up too many off-setting trades rather than forcing them to keep line items down, but nothing overly serious from what I could tell. What if they continued to reduce their line items across all their books? Maybe in good times, they were trying to make an extra 1/8th here or there by running some longs versus shorts, but with their survival at stake, maybe they decided to enforce some very tight line item discipline?

Since the accounting doesn't differentiate between longs, or longs and shorts or longs with closely related shorts, maybe they continued to do the smart/prudent thing and trim their marking making "hedged and wedged" positions. Maybe even the corporate bond inventory, which would typically involve being short treasuries to keep the trade on a spread basis was also told to shrink - it happened to a lot of investment banks in 2007 and 2008, so why not here?

I don't know how much of this they did, but from what they did that Monday morning, I suspect they have been reducing line items from trading books. What if they managed to reduce $4 billion of longs and $4 billion of shorts? That would drop the balance sheet down to a 10.6 times by my simple calculation. Is it possible they did that? I think it is. I think that no one was focused on their "leverage" and they had no "financing" issues, so they had messy books. To the extent they are "volckerizing" them, we could be seeing a very big leverage reduction with minimal impact to earnings.

In fact, in the last letter they sent out, which I thought was good except for the part about complaining about "rogue hedge funds," they mentioned positive earnings this quarter. It will have been a tricky quarter because there is some cost to balance sheet reduction. They likely saw some reduced flows because of client concern. On the other hand the volatility has caused bid/offer spreads on fixed income products to increase which can be good for the company, and the big firms are all very defensive right now, so boutiques as a whole are seeing business improve.

If they can come in close to last quarter's earnings, with a much reduced leverage ratio without having diluted shareholders, I would think the shares could rebound hard, and see them close the gap in price with Morgan Stanley (NYSE:MS). It would also enhance their price if they are purchased, which is another option that is out there.

Being bearish on the outcome for Europe makes it hard to like any bank outright, but JEF seems a better bet than TBTF banks, especially if they did clean up their balance sheet and announce right after the quarter ends.

Source: The Bull Case For Jefferies Group

Additional disclosure: I have been long or flat JEF for the past few weeks. I will reduce position size into strength.