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Investment Banks Hooked on Easy Credit Crack Are Suffering From the Overdose and Withdrawal May Kill the Wayward Investor!

Reggie Middleton's picture
Submitted by Reggie Middleton on 11/05/2010 07:58 -0400



 

Yesterday I released our quarterly opinion and valuation update for Morgan Stanley.
They had a horrible quarter, and we feel the mainstream financial media
failed to illustrate just how bad the quarter actually was. In our
attempt to demonstrate Morgan's performance to the public I included
some excerpts from the subscription report, namely the page below (click
to expand to print quality) from which I quote James Gorman, CEO Morgan Stanley:

"We certainly aren’t going to measure our ROE over a summer month quarter where
the world was trying to understand whether we would have a sovereign
debt crisis in Europe and whether we would have a double-dip recession
in the U.S., and whether China would be in for a hard landing. So, we
have to take a longer-term view, as I'm sure and I know you understand. "

With
all due respect Mr. Gorman, it matters little what period you measure
your ROE over, it has drastically underperformed both its peer group and
Morgan's cost of capital. Let's take a closer look, shall we...

 

BoomBustblogger Taylor inquired about an apparent anomaly in the MS Peer Group ROE comparison chart:

Hi Reggie,

Maybe I am reading your chart wrong
but in your last page you say that MS has the lowest ROE of the three
and it is “clearly trending down”. If MS is the green line, it looks
like it made a U-shaped dip and is now trending up, while GS is clearly
trending down and JPM is kind of flat-lining if not trending mildly
up. Also, according to the chart which ends at 2010e, MS has the
highest ROE.

Did I misread the chart or did you mislabel it? What is going on here?

Great work either way, I appreciated
the compare/contrast to the MSM coverage. Just reading the CEO’s
comments made me think “This is not confidence inspiring, comes across
as fluffy” as an initial reaction. Never a good sign. I want to hear a
Jamie Dimon-esque “I’ve got Obama by the balls!”, if anything. Kidding :)

The fact that MS ROE for 2010 is marginally higher than GS and JPM
comes from the fact that they had strong trading revenues in Q1 and Q2
which has distorted ROE in favour of MS for full year 2010. MS had
principal transaction revenues of $7.4bn and they generated a higher
return in Q1 and Q2 (23% and 15%). However, if we extrapolate the chart
to 2011-2012, their normalized ROE is expected at c8% at best.
Also, to note that these financial ratios are accounting ratios. I
believe a real return on equity should be on market cap and not book
value which is the return for the investors. If a company has book
value of $100 and market cap of $150 and earns $10, the implied return
for investors is not 10% but 6.6%. Book value if taken should be
economic book value. But most of these banks don’t mark up their long
term investments to market value as accounting policy permits banks to
keep these long term investments at book value even if market value is
50% off. That said, the point of analysis was to demonstrate how banks
are faring with respec to their capital (accounting) and show a trend
analysis with peers.
The tightening regulatory standards, rising bars on capital
requirements, curb on prop trading, difficult trading conditions, risk
aversion, deleveraging is definitely going to challenge investment
banks’ ability to earn excess return on cost of capital. Most sell side
valuations do not reflect the such factors. We have done a detailed
analysis of MS valuation including the pitfalls of Basel III compliance
in the subscription report – File Icon Morgan Stanley Q3 2010 Analysis and Updated Valuation (click here to subscribe).

I will open up a portion of the model that I am offering to Pro and
Institutional subscribers next week to illustrate MS ROE performance on a
more granular basis.

On a quarter by quarter basis, you can see how poorly MS performs
regarding ROE. In addition, it is apparent that Morgan Stanley is truly
juicing the leverage in an attempt to generate those middling returns.
This is dangerous! Take note that as leverage tapers, ROE plummets – and
this is return on accounting earnings. Let’s take a look at things from
a more realistic, economic perspective…

Next week is professional and institutional subscriber week, wherein I
will drill down into several companies and topics with even more
precision than I normally do, including the offering of proprietary
model output and an actual model or two.

Relevant subscription material:

Relevant free blog posts:

 
»

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Fri, 11/05/2010 - 12:38 | 702905 Sabibaby
Sabibaby's picture

Excellent as usual Reggie. I keep coming up with an analogy of a vase that's fallen off a pedestal.

Banksters and even Obama keep proclaiming the vase is still in perfect condition on top the pedestal while everyone looking sees with their own two eyes that the vase is clearly on the floor in pieces.

The TBTF won't acknowledge the broken vase and merely point to the pedestal with nothing on top not realizing that to have any sort of credibility whatsoever the must first acknowledge there's no vase on the pedestal and second must pick up the pieces and glue the vase back together.

This will be a long and arduous process because we're two+ years into this and nobody high up wants to look at the broken vase, instead they only focus on the pedestal.

 

Fri, 11/05/2010 - 11:29 | 702694 Kayman
Kayman's picture

Reggie

Thanks for the analysis.  Ultimately all the TBTF banks are bloodless zombies being fed fresh blood from Ben, that he is drawing from current and future claims from the American middle class and their children.

I think QEII is proof that the TBTF paper, currently held and the paper "purchased" by the Fed is worthless.  Naturally, all the bonuses have been paid and are being paid from the skim.

Without jail time for these fraudsters, it is going to be impossible to get the economy going again.  After all, every contract is based on a "meeting of the minds"- consensus, and if you cannot trust the other party to the transaction, the economy is going to continue to shrink.

Thanks for your ever interesting writings.

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