Investment Bank Crisis: The Greatest Show on Earth

by: Andy So

I would like to say “the circus” in reaction to the title of the post, but sadly today we are looking at the collapse of Lehman Brothers (LEH) and the worsening of the current credit crises.

Currently out of the top 5 investment banking firms in the U.S., (Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS), Merrill Lynch (MER), Lehman Brothers and Bear Stearns (NYSE:BSC), only two will remain in business going into the fall of 2008. The source of all of this is of course the over-leveraged nature of investment banks. At the end of 2007, Lehman Brothers was leveraged 31:1. They turned $1 into $33 through the magic of leverage. On a mark to market basis, every bank with exposure to complex CDO (Collateralized Debt Obligations) and derivatives is prone to an amazing loss of value at staggering speeds.

It’s important to understand what mark to market means. Investopedia states mark to market as “The act of recording the price or value of a security, portfolio or account to reflect its current market value rather than its book value.”

In a bullish market, the investment banks and stock market participants valued portfolios of mortgage securities and other derivatives far greater than their book value. In a bearish market, a portfolio of these securities falls far below book value. Since most investment banks trade on margin, a drop in mark to market forces the investment bank to write down the value of the security or portfolio as a defensive measure against even greater losses. A rapid drop in mark to market can also force a margin call as some hedge funds, for example, do not have sufficient additional collateral to protect against the margin call. Creditors who have lent money to investment banks will require certain margin and capital ratios and will refuse to extend additional credit to funds or investment banks as the value of their assets dwindle.

Holding a portfolio of CDO’s and MBS's (Mortgage Backed Securities) was a threat to investment banks since the beginning, due to the difficult nature of determining the actual owners of the collateral behind the security. A mortgage portfolio was often divided into pieces and packaged into MBS products, then sold and repackaged several times into other securities. The investment banks were essentially playing a game with each other with the lack of regulation and reporting in the structured finance market.

Holding a portfolio of common equities is much easier to value in comparison to CDO and MBS assets since you can take into account traditional valuation methods such as earnings and cash to debt ratios. Interestingly MBS's were regarded as rock solid since the collateral behind the mortgages, physical property, was previously regarded as good as cash. With the fear of mortgage defaults, MBS values are falling faster than the actual physical property values. This has lead to recent buying by private equity funds seeking to buy distressed mortgage backed assets for pennies on the dollar.

What we have witnessed with CDO’s and MBS's doesn’t stop there, similar problems exist for the entire OTC derivatives market. As stated by this Market Watch article: Buffett and Gross warn: $516 trillion bubble is a disaster waiting to happen.

In the words of Pimco’s bond fund king Bill Gross:

What we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August.

I’ve written about derivites in a past article in which I said:

Because derivatives are just contracts, just about anything can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region.

Estimates vary on the potential total economic risk derivatives present. I like to use the largest figure I’ve found. As of December 2007, The Bank of International Settlements estimated that the amount of listed credit derivatives, i.e. tradable in some form through an exchange, stood at roughly $548 trillion. The amount of OTC derivatives was estimated at $596 trillion notional value. This brings the total derivatives estimate by The Bank of International Settlements to 1,140 trillion.

With the possibility of a global financial meltdown it’s important to educate yourself on how to anticipate the failure of a business or bank. You need to know what is, and what isn’t at risk. It’s definitely not enough to read the news, since the figures you need to watch are often found buried in balance sheets.

  • On the top of my list is leverage and in a bear market less is better. This applies to all businesses and banks.
  • High capital reserve ratios. The more cash a bank has the better.
  • Diversified currency base. A bank or business holding a variety of foreign currency reserves has a better chance to hedge Forex risks, enhance liquidity and security.
  • Low exposure to derivatives and complex structured finance products.
  • A diversified business model to protect against falling earnings. It’s better to seek-out banks and businesses that have a variety of income streams.
  • Operation in international markets. If a bank is limited to business in the U.S. or Europre for example, it is at greater risk at suffering a loss from an economic downturn.
  • For banks you must have a careful watch of CDS (Credit Default Swaps). A credit default swap is the cost to guarantee a banks debt.

In examining where the potential risks are, we can help protect our own investments and determine which investments are safer bets. As we look at Asian banks for example, we can see that state owned Chinese Banks are flush with RMB and have far less exposure to derivatives. Many Chinese banks have diversified lines of business and derive income from retail banking services, an early credit card market with low penetration and growing wealth management divisions. European banks such as UBS (NYSE:UBS) also enjoy many of the same advantages in a far different geographical location.

Forbes published an article Monday titled: “UBS Likely To Avoid Lehman’s Fate” The Forbes author goes on to say:

The reason for this lies in UBS’ diversified business model, which brings in a relatively safe stream of profits from wealth management and private banking–despite that its investment banking division is in meltdown. This in turn has helped the bank avoid the kind of crisis in confidence faced by Lehman Brothers Holdings (nyse: LEH - news - people ), which threw in the towel and filed for bankruptcy over the weekend as its shares tanked and its credit default spreads widened.

“Credit default spreads for UBS are still relatively low,” said Dirk Becker, an analyst with Landsbanki. “They are still in the region where they can stay in business.”

Chinese and European banks are of course getting sold off along with the fall in financial markets. Investments in ETF’s that do hold these securities offer an opportunity to cycle out of U.S. financial equities if you decide that your portfolio should include a portion in the financial services sector.

With all of the bad news emerging from U.S. financial markets, I can’t help but draw the conclusion that the USD is due for a major fall in value. The U.S. literally doubled its national debt with the bailout of Fannie Mae (FNM) and Freddie Mac (FRE). We are printing dollars at an exceedingly rapid pace, the Fed has expanded its loan window to distressed investment banks and now we may be faced with another quarter point interest rate cut. All of this is dollar negative. As we watch the financial turmoil unfold and wait for markets to repair themselves, you may have already looked at currency diversification as part of your investment strategy. Before making money, capital preservation has and will always be of the upmost importance.