Banks, Brokers and Bull

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Includes: BSC, C, GS, LEH, MER, MS
by: Reggie Middleton

Last week, Morgan Stanley (NYSE:MS) called Citibank (NYSE:C) the “short play of the year for 2008”. That is rather rare – an investment bank not only issuing a plainly worded sell recommendation, but an actual short recommendation? And on a fellow bank??? I read it and said, “Hmmm!” Morgan Stanley has some damn nerve calling another bank a short. They are the RISKIEST bank on the street. Let’s take a quick visual overview, and then let’s go over how I came to that conclusion (click all charts to enlarge).

In just about every major category of risk bloggable, Morgan Stanley leads the pack! Those who live in glass houses shouldn’t throw stones…

Quick Definitions

Before we go on, let’s make sure we are all on the same page as to what is in this inflammatory graph I just posted. I know it may not be fun if you are not into GAAP, FAS, financial engineering, or any of that other sexy stuff - but if you think education is expensive (in terms of time), then you definitely wouldn’t want to try ignorance – especially if you buy banking and brokerage stocks. I’ll try to make it as funs as possible without offending anyone too much. The following asset classifications have been in the financial rags quite often lately.

FAS 157 Asset Classifications

Level 1 represent assets that have observable free market prices. An example would be a stock traded on the NYSE or NASDAQ.

Level 2 assets don’t have an observable price, but they are calculated/modeled using inputs that are based on assets with observable prices. An example could be a plain vanilla interest-rate swap whose components are observable data points such as the price of a 10-year Treasury bond. This can get very tricky, very quickly since the inputs are market based but the calculations/models can be highly subjective and quite theoretical. This is where the financial engineering of many banks can come back to bite them in the ass. Let’s take the example just mentioned, and turn it into swaption: A swaption is an option granting its owner the right, but not the obligation to enter into an underlying swap. Although options can be traded on a variety of swaps, the term "swaption" typically refers to options on interest rate swaps. This list can get more extensive and complicated: variance swap, barrier option, Quanto swaps, etc. In addition to getting complicated, they can get increasingly difficult to unwind. The kicker is, the more you need to unwind them in a crunch, the harder they are to unwind. Thus good times are good, but bad times can get very bad. This is what happened to Long Term Capital Management. LTCM had lots of leverage, lots of complicated instruments, and even more models (model risk, see below). The problem was that reality hit theory, and it hit it very hard. Don’t worry, funds and prop desks will not make those old mistakes again. There is a whole crop of new mistakes for us to make.

Okay, so what is the value of the swaption cum swap, or anything else mentioned above in a sharply trending market? What is the value of a portfolio of barrier options if the optionality portion is deeply out of the money? You don’t know the answers to these questions? Well, guess what? I bet the CEO of Citibank, Bear Stearns (NYSE:BSC), Morgan Stanley and Goldman Sachs (NYSE:GS) don’t know either. There are probably a lot of institutional counterparties (hey don’t GS and MS have large prime brokerage arms?) of the big banks who trade these things and corporate owners of these level 2 instruments that don’t know either. Thus, you are in good company. For those who don’t know, prime brokerage is the extremely lucrative business of being the full service broker to hedge funds. You know those unrated (as if that really means anything with Moody’s (NYSE:MCO) et. al.), unregulated investment pools who, through the prime brokerage arms of the big banks yield often unwieldy leverage of 20x or more… Much more. There many counterparties to these transactions that don’t have the capital to pay up in the case of an outlier even, ala LTCM. Hey, I have a hedge fund, so I am not the pot trying to call the kettle black, here. I am just trying to point out the amount of risk and exposure that sits on these balance sheets that are not picked up by the average investor. Level 2 assets pose much more of a liquidity risk and valuation liability than I have been reading about, and almost no one has harped on the counterparty credit risk we have in our financial system.

Theoretically, these esoteric level 2 assets should be moved into a level 3 category, but because they have observable market inputs they can be classified as level 2, and it appears as if they certainly are. Look at the bank chart above to see.

Level 3 is for assets where one or more of those inputs don’t have observable prices. This is group of assets that are no more than management’s best guesstimate. It literally is reliant on management estimates and opinions. I wish these banks would allow me to shift my assets into the level three category for the purposes of credit evaluation. I’ll take a 50 LTV cash out refinance loan on my house, because the dog house outback is worth $125 million, in my opinion. Level 3 assets are measured using management’s opinion of value due to a lack significant unobservable inputs that could be used to plug into the valuation model used for level 2 assets above (and as we have pointed out, that in and of itself, can get pretty hairy). So, we have bullsh1t, that won’t fit into other bullsh1t (excuse me, financial models). In simpler, and far less crass words (for my more sensitive readers) - stuff that absolutely nobody wants to buy. If someone was willing to buy, and someone else was willing to sell, there would be a market and observable inputs in the form of a market price, right??? These unobservable inputs are actually quite observable; management just doesn’t like what they observed! That’s funny, isn’t it? Why don’t they ask me my opinion of the value? And while we’re at it, I don’t like what I observed in my brokerage account’s P&L statement the other day, so I am going to unobserve it (you know, consider it unobservable), and value it at $4,300 gazillion.

Level 4 – This not in FAS 157 or any fancy accounting rule book. This is just where I will classify off balance sheet assets. Oh yeah, that’s right I can’t classify, value, or even identify them because they are off balance sheet. That is most likely the reason they are off balance sheet. It is here, in level 4 where most of the risk lies. Props go out to Vikram Pandit, the new CEO of Citibank for bringing the bullshit (SIVs) back to the balance sheet where it belonged in the first place. Everybody derided you the first 12 hours of your new position, but you did the right thing. Now its time for everyone else to follow suit.

When will the bullsh1t cease??? Well, it doesn’t cease here because we have more to review as represented in the introductory charts above.

Leverage explained

Morgan Stanley has about $35 billion in equity, but wields about $1,120 billion in assets. This means that the difference is leverage (or borrowed monies). This is the business model for the street, in general, but that doesn’t make it a good one, per se. Take MSs 34x leverage and apply it to the inherent leverage contained in the instruments it trades as well as the counterparties it deals with, and you have a recipe for disaster if the right sequence of events occur. For instance, looking into the exchange traded futures markets, you have the opportunity to more than quintuple your leverage, thus your return. But… is the risk worth the return? I mean, what is the risk adjusted reward here?

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