Investment Banks: Through a Glass, Darkly

Bear Stearns is gone. Lehman Brothers (LEH) is fighting to stay afloat as an independent company. Merrill Lynch (MER) is right up there with the investment banking operations of Citigroup (C) as the domestic firms with the most bad mortgage exposure. Goldman Sachs (GS) is seen as the cream of the crop, but they surely are being dragged down with everyone else too, even though they reported pretty good numbers Tuesday morning.

Although the investment banks are down a ton, I have not been taking the contrarian side of that trade and scooping up any shares. And I do not plan to do so either. There are two main reasons I just do not feel comfortable investing in pure investment banks.

First, the highest margin products for these firms have either peaked this cycle already or have disappeared completely and will take years to recover. Structured products carried the highest levels of profitability, but many are no longer going to have a place within the industry. Others will take months or even years to regain their luster.

M&A activity has also peaked with the private equity boom. Deals are still going to get done, but 2007 was the peak of the cycle. As a result, overall margins at investment banks will decline as they de-lever and no longer sell as much of their highest margin products.

Second, the balance sheets at these investment banks really are black boxes from an investor perspective. Even though disclosures have improved in many cases over the last few quarters, we really do not know exactly how these firms make their money and what they are holding. Their financial statements break out categories such as sales and trading or principal transactions, but that really does not tell us what exactly they are selling and trading. Balance sheets remain quite opaque.

Without transparency and high margin products to keep profits growing [ROE's will decline as leverage comes down] and investors informed, it is really hard for me to justify investing in these firms that have no core banking deposits like traditional banks do. The Wall Street business model is just a lot more complicated than a traditional bank. As a result, the latter group is far more attractive to me when bargain hunting in financials.

Disclosure: No positions in the companies mentioned at the time of writing

Comments

[zenalgorithm]

The FED and SEC will force them to be more transparent.........on... they are no longer insolvent...

[squashnut]

I think you meant "...when..."... or "...if..."

[Emerald]

Big picture comments, no analysis. You assume all mortgage paper is basically worthless, not simply mispriced. More writeoffs will follow but eventually some of this paper becomes seasoned and priceable. Three years from now, there will be partial writeups. Get in at a low price to book and you will make a lot of money. Buy a diversified portfolio or an ETF on the big companies.

[phantomfivefive]

You know that accounting rule that allows you to book a gain on a mark-to-market writedown of your own debt? How much of that was in Morgan Stanley's earnings?

[chartguy]

Uh, GS reported yesterday and MS today (first paragraph).

[Fish Gone Bad]

Phantomfivefive is right on the money. That new accounting rule is insane. When the value of the debt decreases, the companies can book this as a profit. The companies then pay out 50% of the profits to their employees. I can not see any reason to invest in a company that will have its most profitable day ever on the day it goes bankrupt.

Clark Jenkins
FishGoneBad.com

[Reinko]

There are many ways to look at leverages but when you compare total market cap to total (borrowed and invested by others) assets, leverages are still climbing because of detoriating stock values.

And if the above way of leverage measuring is at 1:25 this simply means that a decline of 4% in assets wipes out all market cap...

So these kind of banks are still rather shaky structures. And it might well be that one of those banks (I think it was Goldman) was able to unscrew one of the structured investment vehicles but that was only a holding of long term debt financed with cheaper short term debt.
It makes we wonder: how the hell are they going to unscrew those collaterized debt obligation stuff?

I mean anyone can repair a bycicle but when your CDO yet engine explodes while you are flying you have some problem.

At last: Don't forget that at almost all investment banks Level 3 assets are still climbing.