Negative News Flow In the Investment Banking and Asset Management Space

I wanted to share a series of negative news flow relating to the weakness in the core businesses of the investment banks owing to increased volatility in the capital markets over the last few months. This ebb from the sell side trails the opinion of BoomBustBlog research which forwarned of the same very early in the first quarter as well as last quarter of 2009l The news flow points out that the upcoming results of GS, MS and JPM might be disappointing or below expectations – as if we already didn’t know this.

• According to some of the recent MSM articles, the recent surge in volatility has led to record low activity in the underwriting and M&A activity.

Global M&A value for the first half of 2010 grew 3% to $1.18 trillion, compared with $1.15 trillion a year earlier, according to Dealogic’s figures. But while values were up against the year-earlier period, the $552.7 billion in value generated in the second quarter was down almost 7% compared with the first quarter of the year – WSJ.com.

Wall Street investment banks sold $1.36 trillion of stocks and bonds in the second quarter, down 33% from the second quarter of 2009 and the lowest quarterly total since the fourth quarter of 2008, according to Dealogic.

• Also, the capital markets volatility will have severe implications for the trading revenues of investment banks like GS and MS which derive substantial portions of their revenues from trading activities. Analysts have been downgrading earnings estimates for these banks and GS’s earnings have been particularly slashed since it generates nearly 60-70% of total revenues from trading.

Barclays Capital analyst, Roger Freeman, cut earnings estimates for Goldman Sachs Group (GS) and Morgan Stanley (MS) on June 23, 2010. Freeman slashed his second-quarter profit forecast for Goldman by nearly 64% to $1.95 a share from $5.35 a share. Freeman is expecting 40% lower trading revenues in FICC and equity segments in 2Q10 against 1Q10. His estimate for Morgan Stanley dropped 29% to 55 cents a share from 77 cents a share – WSJ.com.

Bank of America analyst, Guy Moszkowski, also slashed earnings estimates for GS and MS. He revised GS’ 2Q10 earnings estimates to $1.76 per share, 51% lower than the previous estimate of $3.57. The new estimates reflect a 45% decline in equity trading revenue and 40% drop in fixed-income trading revenue compared with the first quarter. MS’s 2Q10 EPS estimate was cut 35%, to 58 cents a share from 89 cents. The estimate on JPMorgan Chase & Co. was trimmed to 70 cents a share from 77 cents, and Citigroup Inc. was lowered to 2 cents a share from 4 cents – Businessweek.

I would also like to add that the recent volatility and market decline has also impacted the AUM of asset managers and there has been downward price revision by analysts. The assets under management of BEN declined 5% (m-o-m) in May, 2010 and the June figures are not yet out. Consequently, the target price estimates have been lowered by many analysts. In June, FBR Capital lowered its target for BEN to $105 from $118 and Barclays capital lowered its target for BEN to $125 from $133. Analyst at Goldman Sachs have also made significant downward revisions in this sector.

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Now, the news flow in light of applied BoomBustBlog research:

The Asset Manager Trade is Printing Money Almost as Fast as Ben Bernanke 

One month ago I suggested that it was “It May Be Time To Revisit the Asset Managers“, a blog post wherein I advised subscribers to review the research released last year before the market run-up. These asset managers are very sensitive to sharp market moves and drops in broad market oft leads to compressions in assets under management (AUM). Well, now that a significant amount of damage has been done and the cat is out of the bag, I’ll announce to the public that asset manager’s ticker, BEN - subscribers can download the 2009 Intelligence Note here. Ben is down 35 points off of its highs and over 10 points since that announcement. The options on this particular company have had very low IV, making them a cheap, levered way of assumig a bearish stance. Below, please find a chart of the OTM puts and the bang recieved from buying those (relatively) cheap puts.

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That super-contrarian Goldman Trade is killing the non-believers.

All those who follow me regularly know how bearish I have been on Goldman Sachs. The GS bear trade returned very high three digit returns in ‘09 and Q1 ‘09, and it is back again with a vengeance – after all No One Can Say I Didn’t Warn Them About Goldman Sachs, Several Times…

I warned readers and subscribers regarding Goldman valuation several times starting in 2008 (reference Can You Believe There Are Still Analysts Arguing How Undervalued Goldman Sachs Is? Those July 150 Puts Say Otherwise, Let’s Take a Look and A Realistic View of Goldman Sachs and Thier Lastest Quarterly Results). I also want to make it clear that I thoroughly warned on ethics in dealing with the customer (see When the Patina Fades… The Rise and Fall of Goldman Sachs??? ). Goldman customers power the bonus pool through the losses they accumulate both by doing business with Goldman and following Goldman’s investment advice as Goldman takes the other side of the trade. This is now only starting to come out in the mainstream media, although I harped on this topic throughout 2008, see Blog vs. Broker, whom do you trust!.

Reference The Brown Stinky Stuff is Splattering Off the Fan Blades and Landing on That Shiny New Building on the West Side Highway:

The Goldman short from early 2008 continues to print money, challenging B. Bernanke and his steroidal presses for the dollar volume efficiency prize of the year:

• 2008: Goldman Sachs Snapshot: Risk vs. Reward vs. Reputations on the Street (trading from $180 to over $200).
• 2009: Get Your Federally Insured Hedge Fund Here
• 2010: No One Can Say I Didn’t Warn Them About Goldman Sachs, Several Times…, and Can You Believe There Are Still Analysts Arguing How Undervalued Goldman Sachs Is? Those July 150 Puts Say Otherwise, Let’s Take a Look

Although the GS positions weren’t as profitable in ‘09 and this year (at least not yet, we still may have some room to run) as in ‘08, I am continually proud of this research and trading. The reason? It was one of the most contrarian of contrarian moves and proves once again that math, truly forensic research and an objective perspective will continuously best the crowd following, “Goldman is too connected” huffing, “This is the best company on the Street” touting, Buffet position worshiping, momo chasing, “I just do what everybody else in the industry does” crowd. This should show BoomBustBlog skeptics that sometimes it takes more than brand name marketing and political connections to maintain an unjust premium in a risky business. If anyone ever bothered to actually take a close look, they would have found that, adjusted for risk, Goldman barely covers its cost of capital (see A Realistic View of Goldman Sachs and Thier Lastest Quarterly Results). How can such a thing slip past so many people for so long? Because most were blinded by the brand…

Hey, I and my fellow BoomBustBloggers saw it…

So, How Many Banks and Analysts Were Bearish On Goldman Before Today? and Is the Threat to the Banks Over? Implied Volatility Says So.

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Map those base Jumping, spilunking, sky diving drops in Goldman’s share price with the research linked below.

Goldman is currently trading at $131.15, materially below what is shown in the chart above, and has room to move downward.

Subscribers can reference our valuation of Goldman via this link: GS 4Q09 Final Review and Updated Valuation 2010-02-01 03:04:55 528.52 Kb

More of Reggie on Goldman Sachs

Subscribe Goldman Sachs Stress Test Retail2009-04-20 10:08:06 720.25 Kb – 17 pages Goldman Sachs Stress Test Professional 2009-04-20 10:06:45 4.04 Mb – 131 pages

Free research and opinion

• Reggie Middleton begin_of_the_skype_highlighting     end_of_the_skype_highlighting begin_of_the_skype_highlighting     end_of_the_skype_highlighting on Goldman Sachs’ fourth quarter, 2008 results
• Goldman and Morgan losses in the news, about 11 months late
• Blog vs. Broker, whom do you trust!
• Monkey business on Goldman Superheroes
• Reggie Middleton begin_of_the_skype_highlighting     end_of_the_skype_highlighting begin_of_the_skype_highlighting     end_of_the_skype_highlighting asks, “Do you guys know who you’re messin’ with?”
• Reggie Middleton begin_of_the_skype_highlighting     end_of_the_skype_highlighting begin_of_the_skype_highlighting     end_of_the_skype_highlighting on Risk, Reward and Reputations on the Street: the Goldman Sachs Forensic Analysis
• Reggie Middleton begin_of_the_skype_highlighting     end_of_the_skype_highlighting begin_of_the_skype_highlighting     end_of_the_skype_highlighting on Goldman Sachs Q3 2008

§  As Reality hits, the Masters of the Universe are starting to look like regular bank employees

Reggie Middleton begin_of_the_skype_highlighting     end_of_the_skype_highlighting begin_of_the_skype_highlighting     end_of_the_skype_highlighting’s Goldman Sach’s Stress Test: Breaking Ranks with the Crowd Once Again!

Who is the Newest Riskiest Bank on the Street?

More Premium Stuff!

Goldman Sachs Report June 21, 2008 2008-10-20 16:48:01 361.18 Kb

Reggie Middleton begin_of_the_skype_highlighting     end_of_the_skype_highlighting begin_of_the_skype_highlighting     end_of_the_skype_highlighting on Goldman Sachs’ fourth quarter, 2008 results

Goldman Sachs – Buffet’s strategic investment and public offering 2008-09-26 02:29:15 895.36 Kb

Goldman Sachs’ Bank Holding Company Fundamental Valuation and Forensic Analysis – Professional 2008-12-18 10:12:37 267.49 Kb

Goldman Sachs’ Bank Holding Company Fundamental Valuation and Forensic Analysis – Retail 2008-10-20 15:45:05 348.99 Kb

GS ABS Inventory 2008-02-25 06:48:56 1.22 Mb

Goldman Sachs Valuation Model updated for PPIP – Retail 2009-04-04 19:50:51 388.04 Kb

Goldman Sachs’ Bank Holding Company Fundamental Valuation and Forensic Analysis – Professional 2008-12-18 10:12:37 267.49 Kb

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On Morgan Stanley

From “On Morgan Stanley’s Latest Quarterly Earnings – More Than Meets the Eye???“, the topics notated in the analysts’ notes above were brought to the attention of BoomBustBlog subscribers way back in the first quarter:

1Q10 Results review

For 1Q10, MS reported significant increase in its net revenues to $9.1 billion from $6.3 billion in 4Q09 and $2.9 billion in 1Q09, primarily driven by trading and principal investments revenues which increased to $4.1 billion versus $1.3 billion and $205 million in 4Q09 and 1Q09, respectively. Trading and principal investment revenues in 1Q10 increased off improvement in debt-related credit spreads and better results in Fixed Income. Revenues from Investment banking and Asset management, distribution and admin fees increased 21.4% and 126.7% (y-on-y) to 1060 million and $1,963 million, respectively. However, both the categories reported a quarter-on-quarter decline in revenues of 36.6% and 0.6%, respectively. Commissions earned for the year increased 63.8% (y-o-y) and 1.1% (q-o-q) to $1.3 billion. Compensation expenses increased to $4.4 billion from $2.0 billion in1Q09 and $3.8 billion in 4Q09, while non-compensation expenses were up 38.4% (y-o-y) mainly off MSSB inclusion and higher business activity. Consequently, net income from continuing operations increased to $2.1 billion, which was further supported by a $382 million tax benefit associated with prior year’s undistributed earnings of certain non-U.S. subsidiaries.

All paying subscribers can download our analysis and view of MS’s latest results here: MS 1Q10 Review (351.75 kB 2010-05-24 09:43:31). Historical MS analysis and valuations may downloaded as follows:

MS 4Q09 results (275.43 kB 2010-01-28 04:38:11)

MS Simulated Government Stress Test (2.49 MB 2009-05-05 11:36:25)

MS Stess Test Model Assumptions and Stress Test Valuation (339.99 kB 2009-04-22 07:55:17)

Those who don’t subscribe should reference my warnings of the concentration and reliance on FICC revenues (foreign exchange, currencies, and fixed income trading).  Morgan Stanley’s exposure to this as well as what I have illustrated in full detail via the  the Pan-European Sovereign Debt Crisis series, has increased materially. As excerpted from “The Next Step in the Bank Implosion Cycle???“:

The amount of bubbliciousness, overvaluation and risk in the market is outrageous, particularly considering the fact that we haven’t even come close to deflating the bubble from earlier this year and last year! Even more alarming is some of the largest banks in the world, and some of the most respected (and disrespected) banks are heavily leveraged into this trade one way or the other. The alleged swap hedges that these guys allegedly have will be put to the test, and put to the test relatively soon. As I have alleged in previous posts (As the markets climb on top of one big, incestuous pool of concentrated risk… ), you cannot truly hedge multi-billion risks in a closed circle of only 4 counterparties, all of whom are in the same businesses taking the same risks.

Click to expand!

So, How are Banks Entangled in the Mother of All Carry Trades?

Trading revenues for U.S Commercial banks have witnessed robust growth since 4Q08 on back of higher (although of late declining) bid-ask spreads and fewer write-downs on investment portfolios. According to the Office of the Comptroller of the Currency, commercial banks’ reported trading revenues rose to a record $5.2 bn in 2Q09, which is extreme (to say the least) compared to $1.6 bn in 2Q08 and average of $802 mn in past 8 quarters.

High dependency on Forex and interest rate contracts

Continued growth in trading revenues on back of growth in overall derivative contracts, (especially for interest rate and foreign exchange contracts) has raised doubt on the sustainability of revenues over hear at the BoomBustBlog analyst lab. According to the Office of the Comptroller of the Currency, notional amount of derivatives contracts of U.S Commercial banks grew at a CAGR of 20.5% to $203 trillion by 2Q-09 from $87.9 trillion in 2004 with interest rate contracts and foreign exchange contracts comprising a substantial 84.5% and 7.5% of total notional value of derivatives, respectively. Interest rate contracts have grown at a CAGR of 20.1% to $171.9 trillion between 4Q-04 to 2Q-09 while Forex contracts have grown at a CAGR of 13.4% to $15.2 trillion between 4Q-04 to 2Q-09.

Subscribers, see MS Simulated Government Stress Test 2009-05-05 11:36:25 2.49 Mb and MS Stess Test Model Assumptions and Stress Test Valuation 2009-04-22 07:55:17 339.99 Kb

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On JP Morgan and Wells Fargo

Excerpted from: An Independent Look into JP Morgan:

Click graph to enlarge

Cute graphic above, eh? There is plenty of this in the public preview. When considering the staggering level of derivatives employed by JPM, it is frightening to even consider the fact that the quality of JPM’s derivative exposure is even worse than Bear Stearns and Lehman‘s derivative portfolio just prior to their fall. Total net derivative exposure rated below BBB and below for JP Morgan currently stands at 35.4% while the same stood at 17.0% for Bear Stearns (February 2008) and 9.2% for Lehman (May 2008). We all know what happened to Bear Stearns and Lehman Brothers, don’t we??? I warned all about Bear Stearns (Is this the Breaking of the Bear?: On Sunday, 27 January 2008) and Lehman (“Is Lehman really a lemming in disguise?“: On February 20th, 2008) months before their collapse by taking a close, unbiased look at their balance sheet. Both of these companies were rated investment grade at the time, just like “you know  who”. Now, I am not saying JPM is about to collapse, since it is one of the anointed ones chosen by the government and guaranteed not to fail – unlike Bear Stearns and Lehman Brothers, and it is (after all) investment grade rated. Who would you put your faith in, the big ratings agencies or your favorite blogger? Then again, if it acts like a duck, walks like a duck, and quacks like a duck, is it a chicken??? I’ll leave the rest up for my readers to decide.

The FICC and currency volatility stemming from the Pan-European Sovereign Debt Crisis is bound to have a material effect on JPM’s operations. I warned about this last year.

In terms of absolute dollar exposure, JP Morgan has the largest exposure towards both Interest rate and Forex contracts with notional value of interest rate contracts at $64.6 trillion and Forex contracts at $6.2 trillion exposing itself to volatile changes in both interest rates and currency movements (non-subscribers should reference An Independent Look into JP Morgan, while subscribers should reference JPM Report (Subscription-only) Final – Professional, and JPM Forensic Report (Subscription-only) Final- Retail). However, Goldman Sachs with interest rate contracts to total assets at 318.x and Forex contracts to total assets at 11.2x has the largest relative exposure (see Goldman Sachs Q2 2009 Pre-announcement opinion 2009-07-13 00:08:57 920.92 Kb,  Goldman Sachs Stress Test Professional 2009-04-20 10:06:45 4.04 Mb, Goldman Sachs Stress Test Retail 2009-04-20 10:08:06 720.25 Kb,). As subscribers can see from the afore-linked analysis, Goldman is trading at an extreme premium from a risk adjusted book value perspective.

As a result of a surge in interest rate and Forex contracts, dependency on revenues from these products has increased substantially and has in turn been a source of considerable volatility to total revenues. As of 2Q-09 combined trading revenues (cash and off balance sheet exposure) from Interest rate and Forex for JP Morgan stood at $2.4 trillion, or 9.5% of the total revenues while the same for GS and BAC (subscribers, see BAC Swap exposure_011009 2009-10-15 01:02:21 279.76 Kb) stood at $(196) million and $433 million, respectively. As can be seen, Goldman’s trading teams are not nearly as infallible as urban myth makes them out to be.

Although JP Morgan’s exposure to interest rate contracts has declined to $64.5 trillion as of 2Q09 from $75.2 trillion as of 3Q07, trading revenues from Interest rate contracts (cash and off balance sheet position) have witnessed a significant volatility spike and have increased marginally to $1,512 in 2Q09 compared with $1,496 in 3Q07. Although JPM’s Forex exposure has decreased from its peak of $8.2 trillion in 3Q08, at $3.2 trillion in 2Q09 the exposure is still is higher than 3Q07 levels. Even for Bank of America and Citi , the revenues from Interest rate and forex products have been volatile despite a moderate reduction in overall exposure. With top 5 banks having about 97% market share of the total banking industry notional amounts as of June 30, 2009, the revenues from trading activities for these banks are practically guaranteed to be highly volatile in the event of significant market disruption – a disruption aptly described by the esteemed Professor Roubini as a rush to the exit in the “Mother of All Carry Trades” as the largest macro experiment in the history of this country starts to unwind, or even if the participants in this carry trade think it is about to start to unwind.

The table below shows the trend in trading revenues from Interest rate and Forex positions for top banks in U.S.

Click to enlarge…

Banks exposure to interest rate and foreign exchange contracts

With volatility in currency markets exploding to astounding levels (with average EUR-USD volatility of 16.5% over the past year (September 2008-09) compared to 8.9%  over the previous year), commercial and investment banks trading revenues are expected to remain highly unpredictable. This, coupled with huge Forex and Interest rate derivative exposure for major commercial banks, could trigger a wave of losses in the event of significant market disruptions – or a race to the exit door of this speculative carry trade. Additionally most of these Forex and Interest rate contracts are over-the-contract (OTC) contracts with 96.2% of total derivative contracts being traded as OTC. This means no central clearing, no standardization in contracts, the potential for extreme opacity in pricing, diversity in valuation as well as a dearth of liquidity when it is most needed – at the time when everyone is looking to exit. Goldman Sachs has the largest OTC traded contracts with 98.5% of its derivative contracts traded over the counter. With the 5 largest banks representing 97% of the total banking industry notional amount of derivatives and most of these contracts being traded off exchange, the effectiveness of derivatives as a hedging instrument raises serious questions since most of these banks are counterparty to one another in one very small, very tight circle (see the free article, “As the markets climb on top of one big, incestuous pool of concentrated risk… “).

The table below compares interest rate contracts and foreign exchange contracts for JPM, GS, Citi, BAC and WFC.

JP Morgan has the largest exposure in terms of notional value with $64,604 trillion of notional value of interest rate contracts and $6,977 trillion of notional value of foreign exchange contracts. In terms of actual risk exposure measured by gross derivative exposure before netting of counterparties, JP Morgan with $1,798 bn of gross derivative receivable, or 21.7x of tangible equity, has the largest gross derivative risk exposure followed by Bank of America ($1,760 bn, or 18.1x). Bank of America with $1,393 bn of gross derivatives relating to interest rate has the highest exposure towards interest rate sensitivity while JP Morgan with $154 bn of Foreign exchange contracts has the highest exposure from currency volatility. We have explored this in forensic detail for subscribers, and have offered a free preview for visitors to the blog: (JPM Public Excerpt of Forensic Analysis Subscription 2009-09-18 00:56:22 488.64 Kb), which is free to download, and JPM Report (Subscription-only) Final – Professional, or JPM Forensic Report (Subscription-only) Final- Retail as well as a free blog article on BAC off balance sheet exposure If a Bubble Bubble Bursts Off Balance Sheet, Will Anyone Be There to Hear It?: Pt 3 – BAC).

Subscribers, see WFC Research Note Sep 2009 2009-09-30 13:01:30 281.29 Kb, ~ WFC Off Balance Sheet Exposure 2009-10-19 04:25:53 258.77 Kb ~ WFC Investment Note 22 May 09 – Retail 2009-05-27 01:55:50 554.15 Kb ~ WFC Investment Note 22 May 09 – Pro 2009-05-27 01:56:54 853.53 Kb ~ Wells Fargo ABS Inventory 2008-08-30 06:40:27 798.22 Kb to expound on our opinions of Wells Fargo, below.