(De)Leveraging Their Bets
Posted on: August 5, 2008 - Email Article - Printable Version
The idea of leverage is to use borrowed money as a means of enhancing (multiplying) returns. In effect, the percentage gain on each dollar of your equity is boosted by fronting only a fraction of the capital required. Leverage became essential to the broker dealer model as a means of making outsized returns on a limited capital base. This model allowed for hefty profits as the banks could be invested across a broad spectrum using a relatively small amount of their own capital.
Forced to Deleverage
A company can deleverage in two ways. First, it can issue additional stock (which of course equity investors hate), to reduce its debt-to-equity ratio. Second, it can sell assets to pay off its debt (reducing balance sheet size). With the onset of the credit crunch, a forced deleveraging has occurred as outsized returns quickly turned to massive losses.
Leverage Persists?
While most investment banks have no doubt been ardent in their effort to deleverage, the overall financial system is more leveraged today than it was back in July. The basic problem? The equity base of these firms has been wiped out so quickly that the reduction in debt has not been able to keep pace. A scary thought, but not surprising when we see the likes of Lehman Brothers [LEH: 0.00, N/A (N/A)] lose ~fifty percent of its equity in a single day. Worldwide, approximately $400 billion in losses have been taken by financial institutions. The amount of fresh equity raised has been about $300 billion. With investors looking for these firms to sure up their balance sheets and be far less leveraged than they were back in July, it is evident we have a long way to go.
The End of an Era
Much of the credit crunch was caused by maturity transformation vehicles used by the financial firms to leverage their balance sheets. At one point, securitization used to borrow long while funding short accounted for $5.9 trillion of financing. As this implies, the beauty of these vehicles was that they allowed the investment banks to finance short term debt at longer term rates. This market, including auction-rates preferred securities and variable-rate demand notes (VRDNs), became almost completely illiquid earlier this year. These failed auctions means several investors are stuck waiting (maybe thirty more years) for their once liquid bonds to mature. This liquidity freeze has likely brought the end to a (VRDN) market that has run without interruption for nearly thirty years.
The result of this will be a shift into more traditional debt by investment banks. This will be accompanied by a resteepening of the yield curve to reward investors for their increased duration. Credit spreads will also remain significantly wider over next several years. The financial system has no doubt made a move to safety and risk mitigation.
As a note, there seems to be a good amount of irony in the market’s continued flight to quality. The debt markets are finally compensating investors appropriately for their risk, and investors are content sitting their money in treasuries.
Merrill’s Lynching
Investors cheered yesterday because Merrill Lynch [MER: 13.35, -1.55 (-10.40%)] got more of the “junk” o
ff of their balance sheet. But the real question is what is their business model moving forward? With Merrill now trading around book value, I think short term investors accepted Merrill’s balance sheet clean up. However, looking at the history of the firm, a near collapse of their equity several years ago left them looking for a growth stimulus. The solution was the high margin structured products market, including mortgage derivatives (CDOs, CPDOs, etc.) The point being, Merrill basically built its growth on the dominance of the structured products market, a market that has essentially disappeared.
The Future of Investment Banks…
The issues with Bear, Freddie, Fannie, and Lehman have certainly raised interesting regulatory issues that will come full circle during this election year. However, that is not my interest in writing this piece. I contend that there will be consolidation of the investment and commercials banks simply out of necessity.
As a follow up to Steve’s piece, I think it is appropriate to comment on the possibilities for the future of the investment banks. While a lack of leverage buffers these firms on the downside, it also limits their profits on the upside. The question becomes will investment banks be able to produce enough ROE with such reduced leverage? As the investment banks scale back from 32-40x leverage range to ~25x, the loss in ROE will make it very difficult to sustain themselves with a more limited capital base. With several of the investment banks business models lacking immediate stimulus, their lack of leverage will make the climb back to profitability even slower.
The one exception may be Goldman Sachs [GS: 66.79, -7.89 (-10.57%)]. The aura around Goldman has only shined brighter during the credit crunch, and they could find themselves in a unique position as the lone independent broker dealer. Still, one misstep by Goldman in a deleveraged environment and they could find themselves falling from their lofty perch (and in need of a capital injection).
Side notes…
-
I would not underestimate the sense of pride in the history of these independent firms, particularly Goldman and Morgan Stanley (my present employer). Don’t think they will lose their independence without a fight.
-
The implications of this new leverage environment are probably more dismal for the likes of hedge funds, PE shops, etc, but perhaps the topic of another piece…
-Adam Brown
Disclaimer: The mutual fund the author is associated with is long GS.
The Following Stocks Were Mentioned In This Article: GS, LEH, MER
Related Posts:
Comments
1 Comment »
Trackback responses to this post
 
|
 Receive our "Election Proofing Your Portfolio" report for no cost when you sign up to our newsletter to receive our updates. Don't worry, we hate spam too! |
Popular Posts
Editor's Picks
Recent Posts
