On numerous prior occasions (here, here and here) we have explained why Jefferies, as the last "pure-play" investment bank left standing and thus with a legacy one-month offset year-end calendar (Nov 30 fiscal year-end) is the best harbinger of Wall Street's reporting season: "it provides an invaluable glimpse into the fortunes of its Wall Street peers with a 4 week advance notice."
Then one quarter ago, things for Jefferies imploded when the firm which is now a part of Leucadia confirmed the bond trading bloodbath that its bigger peers would soon confirm when it for the first time in its merged history reported negative fixed income revenue. Back then CEO Dick Handler tried to put a favorable spin on the terrible result, as follows:
“We believe most of the issues we faced this past quarter in Fixed Income were due to distinct factors that began about a year ago and the largest portion of which relates to the turmoil in the oil and gas industry. For the first nine months of 2015, we have provided liquidity and traded approximately $5 billion in distressed energy securities for our clients. Our exposures in our distressed energy trading business decreased approximately 50% during the quarter and are currently down to $70 million in total net market value. We believe that, with our exposures in distressed securities reduced to current levels, there should be no similar impact on our future results.”
Alas, Handler was completely wrong, and the very next quarter there was a very "similar impact" on results, when earlier this morning Jefferies reported another quarter in which its Fixed Income revenue could best be described as dismal. Instead of rebounding solidly from the negative $18 million in revenue, Fixed Income posted a nominal $8.4 million in revenue: a whopping 83% collapse from the already subdued $48.6 million a year ago.
Follow's today's mea culpa:
"Fixed Income, which has been a solid to excellent business for Jefferies in prior years, did not perform well in 2015. Almost all our Fixed Income credit businesses were impacted by the prolonged anticipation of the lift-off in Federal Reserve rate-setting, the collapse in the global energy markets (where we have long been an active adviser, capital raiser and trader), reduced originations in leveraged finance and meaningfully reduced liquidity. There were a number of periods of extreme volatility, which were followed by periods of low trading volume."
In other words, everything that could have gone wrong did go wrong.
However, as we suggested last quarter, the real reason for the fixed income implosion had mostly to do with Jefferies prop trading decisions, and the fact that it kept so many bonds mismarked on its books. As a result, the bank had no choice but to finally engage in a long-overdue deleveraging of its balance sheet, read remarking to market.
This is how the WSJ summarized today's latest stunner from Jefferies: "Much of the trading shortfall was attributed to decisions to reduce Jefferies’s balance sheet “due to the challenge of liquidating positions in a volatile and less liquid environment,” Mr. Handler said in the release. Adjusted leverage at the end of November stood at its lowest level in about seven years, and securities inventory fell to $16.5 billion, down 13% from the third quarter."
And back to the press release:
“Our balance sheet at November 30, 2015 was $38.5 billion, down $4.2 billion from three months prior and $6.0 billion from the end of fiscal 2014. Leverage (excluding the impact of the Leucadia transaction, which added significant goodwill and a corresponding increase in equity from the transaction's consideration) was less than nine times, its lowest level in about seven years. In addition to the absolute reduction in our balance sheet, our long securities inventory was $16.5 billion at November 30, 2015, down $2.4 billion from August 31, 2015, and down $2.1 billion from November 30, 2014. These reductions were substantially effected during our fourth quarter and, while the impact was to reduce our quarterly Fixed Income Net Revenues and profitability due to the challenge of liquidating positions in a volatile and less liquid environment, we believe this will best position Jefferies to succeed in 2016 and beyond. In this connection, we note that our net distressed trading energy exposure was $39 million at year-end."
As the WSJ further adds, "Jefferies has counted riskier debt trading as a core business since well before the financial crisis, putting it in the cross hairs during a tumultuous period in the market for junk bonds. What’s more, a focus on both the energy industry and midsize companies has compounded Jefferies’s issues."
It wasn't just bond trading however, with equity trading also posting a substantial 28% drop year over year, with the declines offset by a 18% pick up in the company's investment banking business.
"A perfect storm" is how Sandler O'Neill analyst Jeff Harte summarized the results.
“They do more high-yield, and more distressed debt, and more to the middle market, and they have a big energy banking franchise,” Sandler O’Neill + Partners analyst Jeff Harte said. “I hate to say it’s been the perfect storm, but from a credit perspective it’s been the perfect storm—in a bad way.”
So after slashing its balance sheet exposure, will Jefferies also take the axe to payrolls? "Mr. Harte said he would expect Jefferies to slash expenses though job cuts, as other larger firms announced in the wake of another downturn in debt trading on Wall Street. “You’ve had Morgan Stanley make some cuts, and three of the big European competitors talking about making cuts,” he said. “The environment has gotten tough enough in” fixed income."
However, the biggest question for a company that at its core is a legacy fixed income trading house is whether it can survive in a world in which it has now dramatically restructured its business model from one meant to facilitate prop trading into a "flow-focused" one. For now, what Jefferies has to deal with is a more than 50% collapse in fixed income revenues in 2015 compared to the prior year.
The biggest irony is that while other banks are clamoring to be allowed to "prop trade" again, Jefferies which has had the green light to do just that as it never got an FDIC bailout and remains the only sizable pure-play investment bank, just got crushed precisely due to its junk bond prop trading.
And with a one month head start on all the other banks the next question is just what prop trading skeletons are hiding in everyone else's closets and will Jefferies again be a harbinger of the mauling Fixed Income trading will suffer across all of Wall Street when banks report their Q4 earnings some time in mid-January.