Results announced by Merrill Lynch on Wednesday have created a massive problem for headline writers in the financial media. That’s because the firm’s iconic image of a bull would normally lend itself to headlines such as “Bears maul Wall Street’s Bull”, but unfortunately enough, the bear as in Bear Stearns was also mauled a few weeks ago when it reported results.
Other animals and birds are overused in related headlines already “Inflation porked up” and “Retail sales drop like dead ducks”. There is now therefore a search for the most appropriate animal imagery that can properly convey the sense of angst being felt in financial markets and especially in the increasingly shaky board rooms of major banks. Financial writers of course always have used such imagery, reflecting the “animal spirits” that John Maynard Keynes talked about many decades ago.
But I jest. The figures for the third quarter (July to September) released by Merrill were really nothing to laugh at. At the very least, the losses of some US$8 billion for the period showed singular asymmetry with past financial results. The figure was more than what the broker made for all of last year (2006), and about four times its entire compensation figure, ie bonuses paid to employees for the same year (we will circle back to this later).
It was also about one-sixth of the company’s market capitalization. Each one of those comparisons deserves introspection, albeit by different people – for example, while stock market regulators would focus on the first and employees on the second, retail stock investors must take some time to think about the last point.
In the old days, that is until about five years ago, investment banks were purely in the business of intermediating risk. This meant advising companies on what to pay for buying another company, buying stocks and other investments on behalf of investors, pricing and launching new equity transactions (IPOs) or bonds. They would trade across a number of markets ranging from foreign exchange and commodities to credit and equities to ensure there was enough information available at all time for the firm to properly advise its clients.
For example, to advise a mining company on what to price its new stock offering at, the firm would need information on the equity valuation of related companies in the business across the world, expected growth rates for customer in various countries that the company was selling its products in and other information such as the comparable cost of capital by using debt markets instead. On the other side of the equation, the investment bank would advise investors on why (or whether) they should purchase the new IPO, expected return and the like. The bank would collect a fee from both sides – a lump sum from the mining company, and brokerage commissions from investors for selling them the stock.
The last major crisis that investment banks faced pertained to these businesses, and in particular the technology companies during the dotcom bubble period in the 1990s. In that situation, the investment banks were found wanting in their analysis of prospects for companies that they were advising to “go public”, ie sell their equity to investors. Exaggerating the revenue potential was one thing, but it soon turned out that the major investment banks didn’t believe in their own baloney, in essence looking for a fall guy that turned out to be the average retail investor – the person who was investing his savings or his children’s education money based on the advice of his broker, who turned out to be rather untrustworthy after all.
With US regulators jumping on the case, a cathartic process that let a new governor to emerge in New York (Eliot Spitzer, the attorney general for New York who championed the case for investors against Wall Street banks), and the business model soon changed. Unable and unwilling to manage such conflicts of interest, the investment banks were forced to increase their reliance on trading revenues. This in turn meant that they had to take a lot more risk on their balance sheets.
Investment banks like to pretend that they employ many an Einstein in their ranks, but the truth is, of course, far more mundane. It is usually difficult to make money trading something that everyone knows and understands. The three banks down the road from you will probably offer pretty much the same interest rate on your deposits for that reason alone, in essence making your choice of where to put your money dependent on sundry factors like the length of the teller’s skirt.
For the investment banks, this absence of people to stuff (retail investors) meant that financial products simply had to get more complex for them to make any money. Complexity in this case doesn’t mean cleverness so much as a lack of transparency – if your competitors cannot see what you put in your sandwich, it is difficult for them to understand just how much money you make selling it. This meant that other banks either had to hire your people at a fat premium or figure out for themselves areas where they could manufacture increasingly complex products themselves. This would in turn engender other banks to hire your people (“poach” in industry parlance) and so the circle went, creating billions of dollars in compensation for workers across the financial system.
The increasing complexity of derivative products was encouraged by rating agencies, who wanted to increase their own fees, and were therefore willing to casually assign the highest ratings to products that were in essence the most leveraged exposure to bad ideas imaginable. This was also a good business model, but more akin to the “traditional” view of investment banks that I highlighted in an earlier paragraph. Rating agencies may soon be forced by the US Congress and other regulators to mend their ways, and reduce conflicts of interest
The fish, the fish
Continuing with the animal analogies, the great investor Warren Buffett once compared bond markets to a game of poker with the immortal lines, “There is always a fish at the table. If you don’t know who the fish is, it’s you.” This bit of gaming outcomes was all too apparent in the world of finance. Investment banks sold complex, opaque products to unsuspecting investors, but the value of the product depended very much on the likelihood of demand.
To some extent therefore the price of complex derivatives can be compared to what happens in any fish market. If for any reason no buyer shows up, prices of fresh fish fall dramatically as they have to be sold as either frozen food or worse, as fish feed. That leaves very little room for maneuver for the average fisherman.
The world of investment banking, by creating increasingly complex products, also went down this same path wherein demand for its products was the only real proof of prices ever available. In other words, the fact that an investor bought a security from you at say 100 meant that the value of the security was 100. If there was no investor, then by logical deduction there was no price either. You could argue that by reducing the price to 90 there would be buyers, but once again that needed to be proven.
This is where the “honor among thieves” broke down. Investment banks all hold billions of such complex financial products, for which there is no obvious source of demand left. Most of the other US brokers like Bear Stearns, Lehman Brothers, Goldman Sachs etc, when announcing their results last month for the June-August quarter (different investment banks have different financial year end), assumed certain values for these unsold securities.
Barely a month later, other banks, including the investment banking arms of various US commercial banks, reported earnings that were markedly lower. The worst of these was unarguably Merrill Lynch, whose results on Wednesday showed a dramatic reduction in the prices of various securities – in some cases, investments that had been priced at about 90 at the end of August were reduced to 30 or 40 at the end of September.
Extrapolating from this, it is clear that the investment banks which reported previously may well have more losses on their books. In that case, their stock market values will fall more dramatically in coming weeks as investors get used both to the losses and more importantly, the lies. The banks could certainly claim that their own models are correct while those of the banks posting losses this month were wrong, but given the cross-pollination of people that I talked about previously, this looks vastly unlikely.
There is a silver lining to all this though, at least for Americans. This week, Bear Stearns and China’s CITIC Securities announced that they had exchanged a US$1 billion stake in each other to foment greater business cooperation. That announcement goes back to the point in my earlier articles that Asia will be called on to bail out the US financial system. Just like finding a buyer for a bear, a buyer for the bull will be found. The circus will continue, but the applause increasingly looks forced and sounds false. There are people out there whose pants are on fire, but who has the courage to start singing “Liar, liar”?