Category / Broker/dealers
A timely reminder from Matt Levine:
nobody owns stock, they just own interests in their brokers’ interests in DTCC’s interest in stock. “Oh I own AAPL shares,” you say, but you don’t; you own like a second derivative on Apple shares. A delta-one derivative but still.
Am I the only one who finds the claim that Lehman described their collateral as goat poo unbelievable? Isn’t that just too nice, too inoffensive, too measured a term for a Lehman banker to use? ‘Camel shit’: believable; ‘goat poo’: not so much.
There is at least one piece of good news in troubles that the Obama administration are having with filling some jobs. As the WSJ reports, Annette Nazareth, who was expected to be tapped as deputy Treasury secretary, has withdrawn. Annette was responsible for the consolidated supervised entity program at the SEC that was so successful at supervising the big 5 broker/dealers that one failed, two were sold in conditions of distress (extreme distress in the Bear’s case) and two became banks. Why anyone thought that she should be Timmy’s deputy is beyond me.
From the FED, Information on Principal Accounts of Maiden Lane LLC as at Wednesday, Oct 22, 2008
Net portfolio holdings of Maiden Lane LLC: $26,802M
Outstanding principal amount of loan extended by the Federal Reserve Bank of New York: $28,820M
So the FED is a couple of billion underwater. On October 16th, the assets were valued at $29,492M.
Only four years too late, the New York Times has an article on the SEC CSE regime and how it didn’t do enough to constrain the broker/dealer’s risk taking. It’s nice the Times is finally getting around to this kind of thing, but no one was interested in financial regulation and the scandal that was the US broker/dealer capital regime when there actually were some big broker/dealers around to take advantage of it.
With Bloomberg reporting that the bailout has been agreed after days of intense debate, the last few days have been a great time to sneak out financial news that you do not want too well read. One would never suspect the SEC of acting that way, of course, but it is interesting that the audit of the SEC’s oversight of Bear Stearns came out on the 25th. The two parts are here and here, and they do not reflect very well on the SEC’s Trading and Markets Division (TM). For instance:
TM became aware of numerous potential red flags prior to Bear Stearns’ collapse, regarding its concentration of mortgage securities, high leverage, shortcomings of risk management in mortgage-backed securities and lack of compliance with the spirit of certain Basel II standards, but did not take actions to limit these risk factors
The broker/dealer capital regime (CSE, introduced in 2004 by the SEC as an attempt to fend off EU regulation of the broker/dealer’s European subsidiaries) does not fare well either:
Bear Stearns was compliant with the CSE program’s capital and liquidity requirements; however, its collapse raises questions about the adequacy of these requirements
The SEC was in such a hurry to offer their 5 big clients a friendly capital regime that it approved their applications before it had even completed the inspection:
The Commission issued four of the five Orders approving firms to use the alternative capital method, and thus become CSEs (including Bear Stearns) before the inspection process was completed;
Go and read both the documents: they are peaches.
To be fair, the SEC admits there are problems. Chairman Cox released a statement saying `the CSE program was fundamentally flawed from the beginning’ and ending the program forthwith.
The US now has zero broker/dealer. Bloomberg reports:
Goldman Sachs Group Inc. and Morgan Stanley concluded there is no future in remaining investment banks now that investors have determined the model is broken.The Federal Reserve’s approval of their bid to become banks ends the ascendancy of the securities firms,
Now it gets interesting. I assume they will have to do bank capital adequacy calculations. And when they do, we will finally have a direct comparison of how inadequate the SEC’s regime was…
Some morning reading:
On the duty of auditors. A taxing matter addresses the inherent conflict of interest and suggests that it might be a good idea for auditors to be hired by the SEC rather than the company.
Ultimate loss projections are increased by Moody’s. MBIA and Ambac have not been in a train wreck for weeks and they are getting jealous of all the attention Fannie, Freddie, AIG, Lehman, Merrill and so on are getting. The FT has the details.
One aspect of a run on a broker/dealer. Dealbreaker points out how a B/D share price fall can push clients into moving money from non-seg’d to seg’d accounts. The result is akin to a run on a bank.
And finally, given that Cristiano Ronaldo is on a lot of people’s lists as `worst role model in sport’, please will the Treasury drop AIG’s sponsorship of Man U as a matter of urgency, or at very least demand that Ronaldo’s legs are pledged as long term collateral and lodged permanently in a vault at the New York FED?
Citibank was a large commercial bank which started to develop its own investment banking capability. Then a large capital markets broker/dealer, Salomon Brothers, got into trouble, so Citi bought them. And it snapped up Smith Barney too, so it had retail brokerage. The resulting behemoth tried to do too much and got into big trouble in the credit crunch with one of the largest write-offs of any bank. Using cheap funding from the commercial bank to fund credit assets in the broker/dealer was not a good idea.
Bank of America was a large commercial bank which started to develop its own investment banking capability but then more or less gave up. Merrill Lynch, a large capital markets and retail broker/dealer got into trouble and BofA have just bought them. Can we guess what might happen next readers? Are Universal Banks really the answer to every problem in the financial system?
…in investment banking. That, if you remember, was what Kenneth Lewis, Bank of America’s chief executive, said a year ago. Now it appears BofA is looking at Lehman. Fun, fun, fun. Still, broker/dealers almost never end up being sold to the people who would get the most from them — remember DLJ and Credit Suisse — but rather to those whose greed exceeds their fear by the largest amount. HSBC appears to be driven be fear: if BoA isn’t, it may end up with a rather better deal in its second crunch acquisition than it did in its first.
Update. Michael Lewis is most amusing on Bloomberg’s site:
KDB proved it may have finally grasped what should be for Asians a cardinal investment principle: Never buy anything an American investment banker is selling.
I’m glad I took profits on LEH and got out: it’s down 30% today. Dow Jones say that KDB are no longer interested, and the BBC thinks they have funding stress. Which they might well do. The WSJ reports heavy activity in the out of the money puts, while Reuters discusses the on again off again sale of Neuberger.
Surely this is a great time for a bid. Buying Lehman would finally catapult HSBC into the premier league of investment banking. BNP Paribas could use the US coverage, but they may be busy contemplating Fortis. It would be a fantastic trade for Unicredito too, and I wouldn’t put it past Ermotti — do they have the capital to spare though? And could they afford Lehman, even at current prices? RBS is sadly digesting ABN (what a silly purchase that was) and so probably isn’t interested. CIBC presumably had a look, as we know did RBC. I still like HSBC here…
I am (1) above the waterline on Lehman and (2) starting to take it personally. This is usually a very bad sign for a position. There are doubtless hazards to navigate ahead but I think there may be more value there if Fuld can get something done soon. Despite Bloomberg’s (reasonable) concerns about Lehman’s mortgage assets and, according to FT alphaville, only three suitors remaining in the chase for the asset management unit I still there is the possibility of a surprise on the upside here.
No, not a post on Kristeva (although you might call it one on American Pragmatism). Rather — and this is a little cruel, so of course I am going to do it anyway — a link to a series of embarrassing pictures showing Citi’s research call on the broker/dealers and their actual performance. It’s not pretty, but then trying to make short term calls on the markets rarely is. That’s my excuse for Lehman being off 6% today, and I am sticking to it…
The WSJ reports that JP Morgan’s CEO is skeptical of the broker/dealer’s newly published capital ratios:
“I challenge those numbers,” Mr. Dimon said, throwing a verbal roundhouse at rivals Goldman Sachs Group, Morgan Stanley, Merrill Lynch and Lehman Brothers.He went on to question whether the methods the investment banks used to calculate a measure of financial strength known as the Tier 1 ratio were the same as those used by commercial banks.
In fact Dimon wasn’t tough enough. He went on to say: “I’m not sure that those investment banks are using true Basel II type numbers, but we don’t know the detail.” In fact we do know that the SEC capital requirements are definitely not true Basel II type numbers. So Lehman’s “Tier 1 ratio”, say, at 13%, doesn’t mean what you might think it does. Caveat lector.
News flash: Bernanke has been speaking on consolidated supervision of US institutions. According to Bloomberg:
Federal Reserve Chairman Ben S. Bernanke said Congress should give a single federal regulator enhanced power to set standards for the capital, liquidity and risk management of investment banks.
(The emphasis is mine.)
Am I the only one to think that a more comprehensive solution to the fractured US regulatory landscape is needed than just to increase cooperation and information-sharing between the central bank and [the] SEC as the WSJ reports is in the offing? What about alignment of capital requirements? You need to rebuild the whole building, guys, not throw a tarp over it and call it fixed.
Goodness was I wrong about MER and LEH vs. GS and MS… Experience sometimes is not cheap at any price.
Clearly there is a lot of money shorting Lehman, and I won’t deny it can’t go down further. But honestly, do you think the Americans will let another broker/dealer fail? They had five big ones before the Bear: now it’s four. Three feels like too few to me, and I suspect both the FED and the SEC agree. I think I might be a seller of the default swaps.
And by the way, in what possible world are Merrill and Lehman A- rated but Ambac and MBIA still AAA? Admittedly there are signs that Moody’s might finally (six months too late) be ready to do the right thing with the monolines, but really, these four ratings taken together make no sense.
Merrill and Lehman were downgraded to single A yesterday: Morgan Stanley is at A+ according to Bloomberg. If only one of them was being downgraded, the news would be catastrophic. As it is, is the new standard for a derivatives counterparty becoming single A? And if not, how will the broker/dealers derivatives business survive?
JPMorgan Chase & Co. won approval of its purchase of Bear Stearns Cos., shuttering an 85-year-old firm whose collapse ranks along with Drexel Burnham Lambert as one of the biggest in Wall Street history…Bear Stearns shareholders endorsed the sale during a 10- minute meeting today
Don’t say a prayer for me now, save it ’til the quarter after… Apart from the Bear’s employees, I don’t see many tears being shed about this one.
I am convinced that there will be a good buying opportunity for financials at some point in the Crunch. Has it arrived? It would be a brave person who was certain it had, and events of the last few weeks are curious. Consider (courtesy of Bloomberg) first two of the hardest hit large broker/dealers, Merrill and Lehman:
This underperformance contrasts with the broker/dealers who seem to have higher market confidence – Morgan Stanley and Goldman – and the Bank who ate the Bear, JPM. Even Citi has not been as hard hit recently as MER and LEH:
This strikes me as odd. Thain had every incentive to kitchen sink the Merrill write down, and we could easily see write ups in coming months if Merrill’s prices predict lower default rates than are actually experienced. Lehman has skillfully negotiated a crisis of confidence and shown itself to be better managed than the Bear. I’m not sure I’m ready to be outright long US financial yet. But one could be tempted to consider a long in the harder hit broker/dealers vs. a short in the other two.
The broker dealers still have laughably generous capital requirements and access to the FED window. But in a step that suggests more of a snore than being full awake to the issues, the SEC is going to make Wall Street investment banks disclose their capital and liquidity levels according to Bloomberg. Not yet of course, but soon. Really.
Why is JPM raising new capital? Better commentators than me seem confused, but isn’t it just the Bear portfolio? JPM’s sweetheart deal with the FED amortises over eighteen months and so they need new capital to support the extra Bear assets. And the cost of this capital?
The non-cumulative securities priced to yield 419 basis points more than U.S. Treasuries due in 2018 and pay a fixed rate of 7.9 percent for 10 years.
I’m away from my desk at the moment so posting volume is reduced, but I do want to draw attention to an excellent piece by David Roche in the FT. Firstly he points out the importance of non banks to the liquidity of the US financial system:
The Federal Reserve has belatedly recognised that investment banks, hedge funds and other non-deposit-taking financial institutions are as vital as banks to both the financial and “real” economies. The Fed is lending them massive amounts of capital through newly created facilities. It is right that central banks should be able to do so; NDFI’s create more “asset money” than banks but are much riskier institutions.
NDFIs, though, are not regulated as deposit takers, and in particular the broker/dealers benefit from SEC supervision. As David continues:
What is wrong is that the Fed is doing so without having oversight or supervision of the borrowers.
He then looks at both the size and the velocity of NDFI money:
Investment bank, hedge fund and broker balance sheets are about half the size of the commercial banks in the US and about one-quarter the size in Europe. Both assets and liabilities of NDFIs are dominated by repos, meaning that NDFIs lend and borrow based upon collateral of assets that are constantly marked to market. As asset prices fluctuate, leverage must constantly be adjusted.
This is related to the procyclicality of a leveraged fair value player as I discussed here. As David explains:
In a bear market, as asset prices fall, leverage is reduced. This causes lenders to ask for more collateral on existing loans and borrowers to sell assets so as to reduce the need for such loans and for additional collateral.The opposite happens in a bull market when rising asset prices cause the balance sheets of NDFIs to expand. The liquidity this creates is used to invest in assets, boosting their prices and creating demand and collateral for more borrowing to make more investments.
So the balance sheets of NDFIs are highly geared to asset price cycles. They act in a pro-cyclical manner, reinforcing bull and bear market cycles and through them economic cycles. So the effect on “asset money” is greater than that of deleveraging by banks, which lend for a wider range of purposes than NDFIs.
Commenting on the Paulson proposals for overhaul of the US system of financial regulation, I said:
I still think the political battles will be prolonged, that they are likely to result in watering down of even these fairly modest proposals, and that this is not nearly enough.
The next round of those battles has started. Bloomberg reports:
Three former leaders of the U.S. Securities and Exchange Commission say the Bush administration’s proposed overhaul of financial regulation threatens to weaken the agency, a process that may already be under way with help from the SEC itself.
David Ruder, Arthur Levitt and William Donaldson, all former SEC chairmen, said a Treasury Department push for the agency to adopt the regulatory approach of the much smaller Commodity Futures Trading Commission would be a mistake.
It’s “not useful” for the SEC to have “a prudential-based attitude in which regulators solve problems by discussing them informally with market participants and ask them to change,” Ruder, a Republican SEC chairman under President Ronald Reagan, said in an interview. “We have to have an enforcement approach.”
Levitt, who led the SEC from 1993 to 2001 under President Bill Clinton and who supports an SEC and CFTC merger, says the terms proposed by Treasury are “wrongheaded” because they would give the trading commission “primacy.”
SEC Chairman Christopher Cox, 55, hasn’t endorsed a merger between the two agencies, said SEC spokesman John Nester. “He would insist on a system of oversight that best protects investors, promotes fair markets and facilitates capital formation.”
Culture wars are inevitable in any merger. Personally I think an old style SEC (rather than the watered down current version) made for an effective conduct of business regulator.
Its regulatory capital regime is, however, badly flawed and potentially imprudent, and taking that aspect away from the SEC would make a lot of sense. Presumably none of this is going to happen before Bush departs so the wars will last a while. So talking of old conflicts, here is the church which currently occupies the site where Joan of Arc died.
Bloomberg has an interesting article on Goldman which again highlights the preferential capital position of the US broker/dealers vs. the banks.
Less than 48 hours after a government-backed deal rescued Bear Stearns Cos. from bankruptcy, David Viniar, Goldman Sachs Group Inc.’s chief financial officer, was asked if the crisis would have “permanent implications” for Wall Street’s appetite for leverage. His answer: “No, I don’t.”
Tell that to his rivals, most of whom are selling assets, raising additional capital and hoarding cash as they grapple with unprecedented losses. The financial industry has booked more than $230 billion of writedowns and losses, as debt securities, mostly held with borrowed money, plummeted in value.
Goldman alone is holding course, refusing to trim its leverage, a measure of how reliant a firm is on debt. The adjusted leverage ratio of assets to equity jumped to 18.6 at the end of February, from 17.5 at the end of November. “We have no need as we sit here right now to shrink our balance sheet,” Viniar told analysts on the March 18 conference call.
Now we don’t know what the composition of Goldman’s BS is. But it is safe to suggest most of it will be assets that are 100% weighted under Basel 1. On that crude basis, Goldman’s capital ratio is roughly 5.4% (= 1/18.6) vs. a minimum of 8% for a bank. Surely this at least suggests the possibility of smelling a rat?
Update. Another Bloomberg article puts a more diplomatic version of the same question:
The U.S. has allowed a number of institutions such as Bear to emerge that really are in the business of doing what banks do but haven’t been folded into the banking system in a way that affords them the same kind of protection from runs that banks have.
The NY Times has a useful summary of the Treasury proposals for regulatory reform. Consider this:
The optimal structure should establish a new prudential financial regulator, PFRA. PFRA should focus on financial institutions with some type of explicit government guarantees associated with their business operations. Most prominent examples of this type of government guarantee in the United States would include federal deposit insurance and state-established insurance guarantee funds.
In other words, the PFRA will not include the broker/dealers as they do not have guarantees (except for the relatively small bank subs of some broker/dealers). I was wrong, then, when I said these proposals were positive: they really suck. So, in honour of this totally failing to see the big picture moment, I offer you the first annual DeM lookalike competition. One plays a government official who uses unethical but often ineffective methods to try to enforce his will. The other’s a bit better at protecting the interests of his buddies. Which is Vic, which is Hank?
Perhaps it will not be entirely unrequited at $10 a share. The NYT has the scoop, the FT has additional details, and some amusing speculation can be found on Naked Capitalism.
Update. It’s official (or at least on Bloomberg). JP ups the offer to roughly $10/share, and buys 39.5% of the firm in newly-issued stock (40% or more requires a shareholder vote). That’s done then. Who caught the bride’s bouquet?
If the JP deal to buy the Bear holds at $2 a share, they have got themselves a rather attractive looking deal. It must have taken courage to get to this point, and I’m sure they will find some nasties once all the stones are lifted, but the overall impression from the call is of a transaction that works well for JP, if not for Bear shareholders, especially given their option on the Bear’s HQ. If the Bear can go for $2, though, it makes one wonder what Lehman is worth.
Update. BSC closed on Wednesday at $5.33, well over JP’s offer. Will Joseph Lewis, one of the largest shareholders, be able to arrange a better deal? The cultural fit with JP can’t be good, but at $2 they probably are not too concerned about that. Barclays might be a better fit, but are they in a position to find the cash, especially without FED support? One rumour doing the rounds is that Deutsche were interested. In any event, the consensus seems to be that JP has got it more or less sown up: see here for a discussion from Dealbreaker.
Meanwhile, Felix Salmon has a nice discussion on why the Bear share price is so far above JP’s offer. The argument is that the bond holders have a lot to lose if the purchase does not go through and much to gain if it does. So they are buying the stock in order to vote for the merger.
Liquidity depends on confidence, and the Bear lost it. Rumours have been circulating all week – see here for a summary from Naked Capitalism – and finally the Bear had to be bailed out on Friday. The SEC comments:
The decision by the Federal Reserve Bank of New York to provide The Bear Stearns Companies temporary funding through J.P. Morgan Chase & Co. today followed a significant deterioration in Bear Stearns’ liquidity on Thursday. The Division of Trading and Markets has monitored both the capital and the liquidity of the firm on a daily basis in recent weeks. [...]“As of its most recent capital calculation as of the end of February 2008, Bear Stearns’ holding company capital exceeded relevant regulatory standards. According to the information supplied to the SEC by Bear Stearns as of Tuesday, March 11, the holding company had a substantial capital cushion. In addition, as of March 11, the firm had over $17 billion in cash and unencumbered liquid assets.
“Beginning on that day, however, and increasingly throughout the week, lenders and customers of Bear Stearns began to remove funds from the firm, despite its stable capital position. As a result, Bear Stearns’ excess liquidity rapidly eroded.
As so the FED stepped in and we have the current back-to-back rescue via JPM.
There are several interesting questions about this. One is why the FED acted at all. Bear Stearns is not one of the largest firms – it does not feature on the Bank of England list of systemically important institutions for instance – but it is a key player in three areas of stress at the moment, prime brokerage, muni bonds and MBS trading. Certainly the failure of the Bear would have had an impact on confidence, and it might well have caused some knock on hedge fund failures. But if BSC is too big to fail then the CEOs of a range of institutions across the US must be sleeping easier at the moment.
The second is how the FED acted. Apparently it could have lent to BSC directly (at least after a board vote in favour) but instead it chose to lend to JPM with JPM on-lending to BSC. JPM has no risk here so one obvious reason for their involvement is that they want to buy some or all of the Bear. Certainly the Bear’s HQ, the prime brokerage operation, perhaps parts of the mortgage business, and apparently asset management are interesting potential suitors. (Why anyone would want an asset management operation involved in a recent hedge fund collapse is another question.) Anyway, perhaps ‘suitor’ is the wrong word. Do we have a term in English for the man you are about to be forced into an arranged marriage with?
Now if I were you, I’d move straight on and check the successor language in your ISDA docs and/or prime brokerage agreement. Figuring out who your new counterparty is might take a little work as this story plays out.
