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 over-used 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"?
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